##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-QSB (Mark One) þ
    
    Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended March 31, 2005 OR o
    
    Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the transition period from _______________to___________________ COMMISSION FILE No.: 333-122090 DISCOVERY BANCORP Incorporated Under the Laws of the State of California
 I.R.S. EMPLOYER IDENTIFICATION NO.: 20-1814766 338 Via Vera Cruz
San Marcos, California 92078
(760) 736-8900 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 o          No x Indicate
by checkmark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes o No x Indicate the number of shares outstanding of each of the issuers classes of common stock, as
of the latest practicable date: 1,037,548 shares of common stock as of June 28, 2005.   -1-




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##### 



DISCOVERY BANCORP Discovery Bancorp (Bancorp or the Holding Company) was incorporated on October 7, 2004,
under the laws of the State of California, at the direction of the Board of Directors of Discovery
Bank (the Bank), for the purpose of becoming the Banks holding company. Upon consummation of
the holding company reorgaization on June 22, 2005, Bancorp became a bank holding company
registered under the Bank Holding Company Act of 1956, as amended, and Bancorps principal business
is serving as a holding company for the Bank. In addition to serving as the holding company for
the Bank, Bancorp, through its wholly-owned subsidiary, Celtic Merger Corp., intends to acquire
certain assets and assume certain liabilities of Celtic Capital Corporation (Celtic). At March 31, 2005, the bank holding company reorganization was not consummated and Bancorp was
a shell corporation with one shareholder holding 200 shares of common stock. Bancorp had nominal
assets, liabilities and shareholders equity, with Bancorp having incurred expenses related to its
organization, the proposed Celtic acquisition, and a proposed offering intended to raise capital to
cover Bancorps organizational costs, the Celtic acquisition and to provide additional capital for
the Bank and for Bancorp. This Quarterly Report on Form 10-QSB provides financial information regarding Bancorp as of
and for the organizational period ending March 31, 2005. Because of the then pending acquisition
of the Bank (which was consummated on June 22, 2005) and the pending Celtic transaction,
information regarding the Bank and Celtic as of and for the periods ending March 31, 2005 and 2004
are also included in this Report. Also included with this Report are pro forma financials
reflecting the Celtic acquisition and the proposed offering. -2-




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##### 



Part I
FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS DISCOVERY BANCORP
UNAUDITED FINANCIAL STATEMENTS DISCOVERY BANCORP
BALANCE SHEETS (UNAUDITED) March 31,
    
    
    December 31,2005
    
    
    2004ASSETSCash & Due From Banks
    
    $
    50,034
    
    
    $
    6,930Prepaid acquisition costs
    
    
    67,133
    
    
    
    38,133TOTAL ASSETS
    
    $
    117,167
    
    
    $
    45,063LIABILITIESLoans payable to Directors of Discovery Bank
    
    $
    277,000
    
    
    $
    100,000Accrued interest payable and other liabilities
    
    
    
    
    
    
    TOTAL LIABILITIES
    
    
    277,000
    
    
    
    100,000STOCKHOLDERS DEFICITCommon stock, no par value: authorized
10,000,000 shares, issued and outstanding 200
shares at March 31, 2005
    
    
    2,000
    
    
    
    2,000Accumulated deficit
    
    
    (161,833
    )
    
    
    (56,937
    )TOTAL STOCKHOLDERS DEFICIT
    
    
    (159,833
    )
    
    
    (54,937
    )TOTAL LIABILITIES AND STOCKHOLDERS DEFICIT
    
    $
    117,167
    
    
    $
    45,063
 The accompanying notes are an integral part of these financial statements. -3-




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##### 



DISCOVERY BANCORP
STATEMENTS OF OPERATIONS (UNAUDITED) From Inception OfFor The Three
    
    
    Operations OnMonths Ended
    
    
    October 7, 2004 toMarch 31, 2005
    
    
    December 31, 2004INTEREST INCOME:Interest income
    
    $
    
    
    
    $
    NON  INTEREST EXPENSE:Accounting
    
    
    65,163
    
    
    
    10,831Legal
    
    
    36,985
    
    
    
    46,106Office supplies
    
    
    242
    
    
    
    Other operating
    
    
    2,506
    
    
    
    104,896
    
    
    
    56,937LOSS BEFORE INCOME TAXES
    
    
    (104,896
    )
    
    
    (56,937
    )INCOME TAX PROVISION
    
    
    
    
    
    
    NET LOSS
    
    $
    (104,896
    )
    
    $
    (56,937
    )
 The accompanying notes are an integral part of these financial statements. -4-




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##### 



DISCOVERY BANCORP STATEMENTS OF STOCKHOLDERS DEFICIT (UNAUDITED) Common Stock no par value;10,000,000 shares authorized
    
    
    
    
    
    
    TotalShares
    
    
    
    
    
    
    Accumulated
    
    
    ShareholdersOutstanding
    
    
    Amount
    
    
    Deficit
    
    
    DeficitBalance at inception, October 7, 2004
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Proceeds from issuance of
capital stock
    
    
    200
    
    
    
    2,000
    
    
    
    
    
    
    
    2,000Net loss for the
period from inception of
operations on October 7,
2004 to December 31, 2004
    
    
    
    
    
    
    
    
    
    
    (56,937
    )
    
    
    (56,937
    )Balance,December 31,
2004
    
    
    200
    
    
    
    2,000
    
    
    
    (56,937
    )
    
    
    (54,937
    )Net loss for the three
months ended March 31, 2005
    
    
    
    
    
    
    
    
    
    
    (104,896
    )
    
    
    (104,896
    )Balance,March 31, 2005
    
    
    200
    
    
    $
    2,000
    
    
    $
    (161,833
    )
    
    $
    (159,833
    )
 The accompanying notes are an integral part of these financial statements. -5-




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##### 



DISCOVERY BANCORP STATEMENTS OF CASH FLOWS (UNAUDITED) From Inception OfOperations OnThree Months Ended
    
    
    October 7, 2004 toMarch 31, 2005
    
    
    December 31, 2004CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (104,896
    )
    
    $
    (56,937
    )Adjustments to reconcile net loss to net cash used in
operating activities:Prepaid acquisition costs
    
    
    (29,000
    )
    
    
    (38,133
    )Net cash used in operating activities
    
    
    (133,896
    )
    
    
    (95,070
    )CASH FLOWS PROVIDED BY FINANCING ACTIVITIES:Proceeds from loans payable to Directors of Discovery Bank
    
    
    177,000
    
    
    
    100,000Proceeds from sale of common stock
    
    
    
    
    
    
    2,000Increase in cash and cash equivalents
    
    
    43,104
    
    
    
    102,000Cash, beginning of period
    
    
    6,930
    
    
    
    End of period
    
    $
    50,034
    
    
    $
    6,930
 The accompanying notes are an integral part of these financial statements. -6-




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##### 



FOOTNOTES TO UNAUDITED FINACNIAL STATEMENTS Note #1  Summary of Significant Accounting Policies The Statements of Financial Condition, Statements of Operations, and Statements of Cash Flows for
the periods ended March 31, 2005, have been prepared by Discovery Bancorp but were not audited. In
the opinion of management, all adjustments (which include normal recurring adjustments) necessary
to present fairly the financial position, results of operations and changes in financial condition
as of or for the periods ended March 31, 2005 have been recorded. Results for the periods ended
March 31, 2005 are not necessarily indicative of results that may be expected for any other interim
period or the year as a whole. Nature of Operations Discovery Bancorp (the Company) is a bank holding company headquartered in San Marcos, California
that will provide through its subsidiary, Discovery Bank (the Bank), a broad array of products and
services throughout its operating areas in San Diego County. The Bank operates two branches, which
provide commercial and consumer banking services. Use of Estimates In preparing consolidated financial statements in conformity with accounting principles generally
accepted in the United States of America, management is required to make estimates and assumptions
that affect the reported amounts of assets and liabilities as of the date of the statement of
condition and reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates. Material estimates that are particularly susceptible to
significant change in the near term relate to the determination of the valuation of deferred tax
assets, and other-than-temporary impairment losses. Basis of presentation These are statements for the Company only and do not include the operations of the Bank. Income taxes No income tax benefit has been recorded in the Companys results of operations because the Company
intends to formulate an intercompany tax allocation arrangement and file a consolidated tax return
with the Bank. As of March 31, 2005, the Company has not formulated such an arrangement with the
Bank. Subsequent Event Subsequent to March 31, 2005, the shareholders of Discovery Bank approved the bank holding company
reorganization which was consummated on June 22, 2005, resulting in Discovery Bank becoming
Discovery Bancorps wholly-owned subsidiary. Note 2. Recently Issued Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123R (Revised 2004), Share-Based Payment, which is a
revision of SFAS No. 123. SFAS No. 123R supersedes APB No. 25 and amends FASB Statement No. 95,
Statement of Cash Flows. SFAS No. 123R requires all share-based payments to employees, including
grants of employee stock options, to be recognized as compensation expense through the income
statement based on their fair values at issue date. Pro forma disclosure will no longer be an
alternative. SFAS No. 123R also requires the benefits of tax deductions in excess of recognized
compensation cost to be reported as a financing cash flow, rather than as an operating cash flow
required under current guidelines. The Company plans to transition to the fair value based accounting for stock compensation on
January 1, 2006 using the modified version of prospective application (modified prospective
method). Under the modified prospective method as applicable to the Company, SFAS No. 123R
applies to new awards and to awards modified, repurchased, or cancelled after January 1, 2006.
Additionally, compensation cost for the portion of awards for which the requisite service has not
been rendered (generally referring to non-vested awards) that are outstanding as of January 1, 2006
must be recognized as the remaining requisite service rendered during the period of and/or the
periods after the adoption of SFAS 123R. The attribution of compensation cost for those earlier
awards will be based on the same method and on the same grant-date fair values previously
determined for the pro forma disclosures as presented in the Companys financial statements prior
to the adoption of SFAS No. 123R. -7-




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##### 



UNAUDITED FINANCIAL STATEMENTS DISCOVERY BANK CONSOLIDATED BALANCE SHEETS (UNAUDITED) March 31,
    
    2005
    
    
    2004ASSETSCash & Due From Banks
    
    $
    3,059,934
    
    
    $
    2,482,145Fed Funds Sold
    
    
    9,315,000
    
    
    
    2,885,000Cash and cash equivalents
    
    
    12,374,934
    
    
    
    5,367,145Interest-bearing deposits at banks
    
    
    2,883,226
    
    
    
    2,540,842Investment securities
    
    
    3,124,590
    
    
    
    2,524,863Common stock, substantially restricted
    
    
    483,000
    
    
    
    276,900Loans, Net
    
    
    93,397,712
    
    
    
    64,888,537Accrued interest receivable and other assets
    
    
    817,132
    
    
    
    509,332Deferred income tax asset, net of valuation allowance
    
    
    262,412
    
    
    
    205,000Premises and equipment, net
    
    
    6,065,434
    
    
    
    313,351TOTAL ASSETS
    
    $
    119,408,440
    
    
    $
    76,625,970LIABILITIESDepositsNon-interest-bearing demand
    
    $
    15,453,496
    
    
    $
    12,824,900Interest-bearing demand
    
    
    25,647,979
    
    
    
    15,175,440Savings
    
    
    1,592,333
    
    
    
    1,220,072Time, under $100,000
    
    
    30,575,940
    
    
    
    19,756,786Time, $100,000 and over
    
    
    26,606,368
    
    
    
    14,721,515Total deposits
    
    
    99,876,116
    
    
    
    63,698,713Borrowings
    
    
    8,500,000
    
    
    
    3,000,000Accrued interest payable and other liabilities
    
    
    608,104
    
    
    
    170,055STOCKHOLDERS EQUITYCommon stock
    
    
    10,754,630
    
    
    
    10,754,630Accumulated deficit
    
    
    (283,918
    )
    
    
    (1,001,652
    )Accumulated other comprehensive income (loss)
    
    
    (46,492
    )
    
    
    4,22410,424,220
    
    
    
    9,757,202TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    119,408,440
    
    
    $
    76,625,970
 The accompanying notes are an integral part of these financial statements. -8-




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##### 



DISCOVERY BANK CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) FOR THE THREE MONTHS ENDED MARCH 31,
    
    2005
    
    
    2004INTEREST INCOMEInterest and fees on loans
    
    $
    1,564,447
    
    
    $
    1,012,969Interest on federal funds sold
    
    
    39,829
    
    
    
    5,209Interest on securities
    
    
    25,960
    
    
    
    15,341Other
    
    
    17,542
    
    
    
    16,5271,647,778
    
    
    
    1,050,046INTEREST EXPENSEDeposits
    
    
    451,361
    
    
    
    228,868Other
    
    
    55,023
    
    
    
    8,011506,384
    
    
    
    236,879NET INTEREST INCOME
    
    
    1,141,394
    
    
    
    813,167PROVISION FOR LOAN LOSSES
    
    
    158,942
    
    
    
    33,411NET INTEREST INCOME AFTER PROVISION
FOR LOAN LOSSES
    
    
    982,452
    
    
    
    779,756NON  INTEREST INCOMEService charges and other income
    
    
    153,302
    
    
    
    32,044NON  INTEREST EXPENSESalaries and employee benefits
    
    
    511,341
    
    
    
    416,213Net occupancy
    
    
    111,378
    
    
    
    50,909Furniture and equipment
    
    
    66,829
    
    
    
    44,352Data processing
    
    
    48,323
    
    
    
    40,555Advertising
    
    
    20,507
    
    
    
    22,797Professional
    
    
    64,619
    
    
    
    52,013Office supplies
    
    
    16,969
    
    
    
    14,803Other operating
    
    
    152,802
    
    
    
    92,471992,768
    
    
    
    734,113INCOME BEFORE INCOME TAXES
    
    
    142,986
    
    
    
    77,687INCOME TAX PROVISION
    
    
    36,740
    
    
    
    13,595NET INCOME
    
    $
    106,246
    
    
    $
    64,092Earnings per share
    
    $
    0.10
    
    
    $
    0.06Diluted Earnings per share
    
    $
    0.10
    
    
    $
    0.06
 The accompanying notes are an integral part of these financial statements. -9-




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##### 



DISCOVERY BANK CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (UNAUDITED) FOR THE PERIODS ENDED MARCH 31, 2005 AND 2004 Common Stock no par value;
    
    
    
    
    
    
    Accumulated10,000,000 shares authorized
    
    
    
    
    
    
    Other
    
    
    TotalShares
    
    
    
    
    
    
    Accumulated
    
    
    Comprehensive
    
    
    Stockholders'Outstanding
    
    
    Amount
    
    
    Deficit
    
    
    Income(Loss)
    
    
    EquityBalance,January 1, 2004
    
    
    1,037,298
    
    
    $
    10,754,630
    
    
    $
    (1,065,744
    )
    
    $
    7,356
    
    
    $
    9,696,242Net income
    
    
    
    
    
    
    
    
    
    
    64,092
    
    
    
    
    
    
    
    64,092Unrealized losses on
investment securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,132
    )
    
    
    (3,132
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    60,960Balance,March 31, 2004
    
    
    1,037,298
    
    
    $
    10,754,630
    
    
    $
    (1,001,652
    )
    
    $
    4,224
    
    
    $
    9,757,202Balance,January 1, 2005
    
    
    1,037,298
    
    
    $
    10,754,630
    
    
    $
    (390,167
    )
    
    $
    (10,034
    )
    
    $
    10,354,429Net income
    
    
    
    
    
    
    
    
    
    
    106,246
    
    
    
    
    
    
    
    106,246Unrealized losses on
investment securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (36,458
    )
    
    
    (36,458
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    55,340Balance,March 31, 2005
    
    
    1,037,298
    
    
    $
    10,754,630
    
    
    $
    (283,918
    )
    
    $
    (46,492
    )
    
    $
    10,424,220
 The accompanying notes are an integral part of these financial statements. -10-




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##### 



DISCOVERY BANK CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) MARCH 31,
    
    2005
    
    
    2004CASH FLOWS FROM OPERATING ACTIVITIES:Net Income
    
    $
    106,246
    
    
    $
    64,092Adjustments to reconcile net income to net cash provided by/ (used
in) operating activities:Provision for loan losses
    
    
    158,942
    
    
    
    33,411Depreciation and amortization
    
    
    93,428
    
    
    
    28,086Amortization of deferred loan fees
    
    
    (56,430
    )
    
    
    (45,726
    )Deferred tax assets
    
    
    29,188Accrued interest receivable and other assets
    
    
    (275,278
    )
    
    
    (96,793
    )Accrued interest payable and other liabilities
    
    
    373,734
    
    
    
    50,353Net cash provided by/ (used in) operating activities
    
    
    429,830
    
    
    
    33,423CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of premises and equipment
    
    
    (225,262
    )
    
    
    (105,109
    )Capitalization of deferred loan fees
    
    
    58,567
    
    
    
    36,034Purchases of interest bearing deposits at banks
    
    
    (191,603
    )
    
    
    (7,548
    )Purchase of common stock substantially restricted
    
    
    
    
    
    
    (3,100
    )Sales, maturities and paydowns of securities available-for-sale
    
    
    49,723
    
    
    
    1047,411Purchases of securities available-for-sale
    
    
    (505,039
    )
    
    
    (1,000,000
    )Net change in loans
    
    
    (13,522,218
    )
    
    
    (4,976,676
    )Net cash used for investing activities
    
    
    (14,335,832
    )
    
    
    (5,008,988
    )CASH FLOWS FROM FINANCING ACTIVITIES:Borrowings net of repayments
    
    
    (500,000
    )
    
    
    (1,305,000
    )Net change in deposits
    
    
    20,197,060
    
    
    
    9,537,322Net cash provided by financing activities
    
    
    19,697,060
    
    
    
    8,232,322Increase in cash and cash equivalents
    
    
    5,791,058
    
    
    
    3,256,757CASH AND CASH EQUIVALENTS BALANCEBeginning of year or period
    
    
    6,583,876
    
    
    
    2,110,388End of year or period
    
    $
    12,374,934
    
    
    $
    5,367,145Supplemental Disclosures of Cash Flow InformationCash paid during the year for:Income taxes
    
    $
    
    
    
    $
    34,852Interest
    
    $
    435,228
    
    
    $
    162,001Supplemental Disclosures of Noncash ActivitiesTotal change in unrealized (gains) losses on securities available-for-sale
    
    $
    (36,458
    )
    
    $
    (3,132
    )
 The accompanying notes are an integral part of these financial statements. -11-




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##### 



NOTES TO CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS Note #1  Summary of Significant Accounting Policies The Consolidated Balance Sheets, Consolidated Statements of Operations, Consolidated Statements of
Stockholders Equity, and Consolidated Statements of Cash Flows for the periods ended March 31,
2005 and 2004, have been prepared by Discovery Bank but were not audited. In the opinion of
management, all adjustments (which include normal recurring adjustments) necessary to present
fairly the financial position, results of operations and changes in financial condition as of or
for the period ended March 31, 2005 and 2004 have been made. Results for the three-month period
ended March 31, 2005 are not necessarily indicative of results that may be expected for any other
interim period or the year as a whole. These financial statements should be read in conjunction
with the Banks audited financial statement as of and for the year ended December 31, 2004. Note #2  Basis of presentation The accompanying unaudited financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America for interim financial information.
Accordingly, they do not include all the information and footnotes required by accounting
principles generally accepted in the United States of America for complete financial statements.
These consolidated financial statements should be reviewed in conjunction with the consolidated
financial statements and notes thereto included in the Banks December 31, 2004 Annual Report to
Stockholders. In the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation of the financial statements have been
included. Operating results for the three months ended March 31, 2005 are not necessarily
indicative of the results that may be expected for the year ended December 31, 2005. Note #3  Stock option plan The Bank has a stock-based employee compensation plan. The Bank accounts for this plan under the
recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees,and related interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted under the plan had an exercise
price equal to the market value of the underlying common stock as of the grant date. In accordance
with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock Based
Compensation (as amended by SFAS No. 148) the Bank is required to disclose the pro forma effect on
earnings of stock options granted, had compensation cost been recognized over the vesting period of
the options based on a fair value of the options. The following table illustrates the effect on net income if the Bank had applied the fair value
recognition provisions of FASB Statement No. 123(r), Accounting for Share-Based Payments,to
stock-based employee compensation. The significant assumptions used by the Banks management in
computing these amounts are disclosed in Note 12 to the Banks audited financial statements. 2005
    
    
    2004Net income
    
    $
    106,246
    
    
    $
    64,097Additional compensation for fair value of stock options
    
    
    14,644
    
    
    
    5,763Pro forma net income
    
    $
    91,602
    
    
    $
    58,329
 -12-




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##### 



Note #4  Earnings Per Share Basic earnings per share represents income available to common shareholders divided by the
weighted-average number of common shares outstanding during the period. Diluted earnings per share
reflect additional common shares that would have been outstanding if dilutive potential common
shares had been issued, as well as any adjustment to income that would result from the assumed
issuance. Potential common shares that may be issued by the Bank relate solely to outstanding stock
options, and are determined using the treasury stock method. The following is a reconciliation of basic EPS to diluted EPS for the three months ended March 31,
2005: WeightedAverage Shares
    
    
    Per ShareNet Income
    
    
    Outstanding
    
    
    AmountBasic EPS:Income available to common shareholders
    
    $
    106,246
    
    
    
    1,037,298
    
    
    $
    0.10Effect of dilutive securities:Stock options
    
    
    
    
    
    
    65,197
    
    
    
    (0.00
    )Diluted EPS:Income available to common shareholders
    
    $
    106,246
    
    
    
    1,102,495
    
    
    $
    0.10
 The following is a reconciliation of basic EPS to diluted EPS for the three months ended March
31, 2004: WeightedAverage Shares
    
    
    Per ShareNet Income
    
    
    Outstanding
    
    
    AmountBasic EPS:Income available to common shareholders
    
    $
    64,092
    
    
    
    1,037,298
    
    
    $
    0.06Effect of dilutive securities:Stock options
    
    
    
    
    
    
    46,830
    
    
    
    (0.00
    )Diluted EPS:Income available to common shareholders
    
    $
    64,092
    
    
    
    1,084,128
    
    
    $
    0.06
 Note #5  New accounting pronouncements FASB 154 replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting
Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting
for and reporting of a change in accounting principle. This Statement applies to all voluntary
changes in accounting principle. It also applies to changes required by an accounting pronouncement
in the unusual instance that the pronouncement does not include specific transition provisions.
When a pronouncement includes specific transition provisions, those provisions should be followed. Opinion 20 previously required that most voluntary changes in accounting principle be
recognized by including in net income of the period of the change the cumulative effect of changing
to the new accounting principle. This Statement requires retrospective application to prior
periods financial statements of changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the change. When it is
impracticable to determine the period specific effects of an accounting change on one or more
individual prior periods presented, this Statement requires that the new accounting principle be
applied to the balances of assets and liabilities as of the beginning of the earliest period for
which retrospective application is practicable and that a corresponding adjustment be made to the
opening balance of retained earnings (or other appropriate components of equity or net assets in
the statement of financial position) for that period rather than being reported in an income
statement. When it is impracticable to determine the cumulative effect of applying a change in
accounting principle to all prior periods, this Statement requires that the new accounting
principle be applied as if it were adopted prospectively from the earliest date practicable. -13-




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##### 



This Statement defines retrospective application as the application of a different accounting
principle to prior accounting periods as if that principle had always been used or as the
adjustment of previously issued financial statements to reflect a change in the reporting entity.
This Statement also redefines restatement as the revising of previously issued financial statements
to reflect the correction of an error. This Statement requires that retrospective application of a change in accounting principle be
limited to the direct effects of the change. Indirect effects of a change in accounting principle,
such as a change in nondiscretionary profit-sharing payments resulting from an accounting change,
should be recognized in the period of the accounting change. This Statement also requires that a change in depreciation, amortization, or depletion method
for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by
a change in accounting principle. This Statement carries forward without change the guidance contained in Opinion 20 for
reporting the correction of an error in previously issued financial statements and a change in
accounting estimate. This Statement also carries forward the guidance in Opinion 20 requiring
justification of a change in accounting principle on the basis of preferability. At March 31, 2005 the Bank had no changes in accounting principles. In June 2004, the Emerging Issues Task Force of the FASB issued final guidance on its Issue
No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments. A consensus was reached regarding disclosures about unrealized losses on
available-for-sale debt and equity securities accounted for under FASB Statements No. 115,
Accounting for Certain Investments in Debt and Equity Securities. This EITF describes a model involving three steps: (1) determine whether an investment is
impaired, (2) determine whether the impairment is other-than -temporary, and (3) recognize the
impairment loss in earnings. The EITF also requires several additional disclosures for cost-method
investments. The EITFs impairment accounting guidance was effective for reporting periods
beginning after June 15, 2004. For all other investments within the scope of this Issue, the
disclosures are effective in annual financial statements for fiscal years ending after June 15,
2004. The additional disclosures for cost method investments are effective for fiscal years ending
after June 15, 2004. The adoption of this EITF did not have a material impact on the Banks financial statements.
At March 31, 2005, management believes the impairments described above are temporary and,
accordingly, no impairment loss has been recognized in the Companys consolidated statement of
income. On March 9, 2004, the Staff of the Securities and Exchange Commission (the SEC Staff) issued
Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB
105). SAB 105 provides guidance on the initial recognition and measurement of loan commitments
that meet the definition of a derivative, and summarizes the related disclosure requirements. SAB
105 is effective for all loan commitments accounted for as derivatives that are entered into, or
substantially modified, on or after April 1, 2004. SAB 105 addresses loan commitments that the
Financial Accounting Standards Board (FASB) defines as derivatives in paragraph 6 of FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by FASB Statement
No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 133).
These loan commitments relate to the origination of mortgage loans that will be held for sale. SAB
105 does not apply to (1) commitments to purchase mortgage loans that do not meet the definition of
a derivative under paragraph 6 of FAS 133 or (2) commitments that are explicitly excluded from the
scope of FAS 133 (i.e., commitments to originate mortgage loans that will be held for investment
purposes and loan commitments to originate other types of loans). The Bank does not currently
originate mortgage loans to be held for sale. If that should change in the future, we would take
SAB 105 into consideration but do not expect it to have a material impact on the Companys
financial condition or operating results. -14-




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##### 



[MOSS ADAMS LLP LETTERHEAD] CERTIFIED PUBLIC ACCOUNTANTS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders
Discovery Bank We have audited the accompanying consolidated balance sheets of Discovery Bank and subsidiary
as of December 31, 2004 and 2003, and the related consolidated statements of operations,
stockholders equity and cash flows for the years ended December 31, 2004 and 2003. These financial
statements are the responsibility of the Banks management. Our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States.) Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all
material respects, the financial position of Discovery Bank and subsidiary as of December 31, 2004
and 2003, and the results of their operations and their cash flows for the years then ended, in
conformity with accounting principles generally accepted in the United States of America. /s/ MOSS ADAMS LLP Los Angeles, California
February 14, 2005 -15-




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DISCOVERY BANK
CONSOLIDATED BALANCE SHEETS DECEMBER 31,
    
    2004
    
    
    2003ASSETSCash and due from banks
    
    $
    1,638,876
    
    
    $
    1,495,388Federal funds sold
    
    
    4,945,000
    
    
    
    615,000Cash and cash equivalents
    
    
    6,583,876
    
    
    
    2,110,388Interest-bearing deposits at banks
    
    
    2,691,623
    
    
    
    2,533,294Investment securities, available-for-sale
    
    
    2,705,734
    
    
    
    2,568,846Common stocks substantially restricted
    
    
    483,000
    
    
    
    273,800Loans, net
    
    
    80,036,566
    
    
    
    59,935,580Deferred income tax asset, net of valuation allowance
    
    
    291,600
    
    
    
    205,000Premises and equipment, net
    
    
    5,933,602
    
    
    
    242,888Accrued interest receivable and other assets
    
    
    541,854
    
    
    
    412,540TOTAL ASSETS
    
    $
    99,267,855
    
    
    $
    68,282,336LIABILITIES AND STOCKHOLDERS EQUITYDepositsNon-interest-bearing demand
    
    $
    14,768,302
    
    
    $
    9,406,444Interest-bearing demand
    
    
    27,487,866
    
    
    
    14,945,397Savings
    
    
    1,449,503
    
    
    
    819,653Time, under $100,000
    
    
    18,035,413
    
    
    
    17,034,658Time, $100,000 and over
    
    
    17,937,972
    
    
    
    11,955,238Total deposits
    
    
    79,679,056
    
    
    
    54,161,390Borrowings
    
    
    9,000,000
    
    
    
    4,305,000Accrued interest payable and other liabilities
    
    
    234,368
    
    
    
    119,704TOTAL LIABILITIES
    
    
    88,913,424
    
    
    
    58,586,094Commitments and contingencies (Note 9 and 13)STOCKHOLDERS EQUITYCommon stock
    
    
    10,754,630
    
    
    
    10,754,630Accumulated deficit
    
    
    (390,167
    )
    
    
    (1,065,744
    )Accumulated other comprehensive income
    
    
    (10,034
    )
    
    
    7,35610,354,429
    
    
    
    9,696,242TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    99,267,855
    
    
    $
    68,282,336
 The accompanying notes are an integral part of these financial statements. -16-




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##### 



DISCOVERY BANK
CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31,
    
    2004
    
    
    2003INTEREST INCOMEInterest and fees on loans
    
    $
    4,805,935
    
    
    $
    3,172,662Interest on federal funds sold
    
    
    49,136
    
    
    
    40,094Interest on securities
    
    
    77,782
    
    
    
    47,148Other
    
    
    71,715
    
    
    
    32,3555,004,568
    
    
    
    3,292,259INTEREST EXPENSEDeposits
    
    
    1,105,032
    
    
    
    850,093Other
    
    
    75,302
    
    
    
    15,9831,180,334
    
    
    
    866,076NET INTEREST INCOME
    
    
    3,824,234
    
    
    
    2,426,183PROVISION FOR LOAN LOSSES
    
    
    237,798
    
    
    
    288,589NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
    
    
    3,586,436
    
    
    
    2,137,594NON  INTEREST INCOMEService charges and other income
    
    
    152,379
    
    
    
    456,786NON  INTEREST EXPENSESalaries and employee benefits
    
    
    1,836,912
    
    
    
    1,310,738Occupancy
    
    
    130,312
    
    
    
    190,190Furniture and equipment
    
    
    173,392
    
    
    
    97,032Data processing
    
    
    182,226
    
    
    
    125,823Advertising
    
    
    89,281
    
    
    
    147,077Professional
    
    
    227,932
    
    
    
    120,423Office supplies
    
    
    54,554
    
    
    
    28,035Other operating
    
    
    454,429
    
    
    
    284,3853,149,038
    
    
    
    2,303,703INCOME BEFORE INCOME TAXES
    
    
    589,777
    
    
    
    290,677INCOME TAX BENEFIT
    
    
    (85,800
    )
    
    
    (149,200
    )NET INCOME
    
    $
    675,577
    
    
    $
    439,877Earnings per share
    
    $
    0.65
    
    
    $
    0.49Diluted Earnings per share
    
    $
    0.61
    
    
    $
    0.46
 The accompanying notes are an integral part of these financial statements. -17-




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##### 



DISCOVERY BANK CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITYFOR THE YEARS ENDED DECEMBER 31, 2003 AND 2004 Common Stock, No Par Value
    
    
    
    
    
    
    Accumulated10,000,000 Shares Authorized
    
    
    
    
    
    
    Other
    
    
    TotalShares
    
    
    
    
    
    
    Accumulated
    
    
    Comprehensive
    
    
    Shareholders'Outstanding
    
    
    Amount
    
    
    Deficit
    
    
    Income (Loss)
    
    
    EquityBalance December 31, 2002
    
    
    795,298
    
    
    
    7,669,642
    
    
    $
    (1,505,620
    )
    
    $
    13,608
    
    
    $
    6,177,630Proceeds from Offering
    
    
    242,000
    
    
    
    3,084,988
    
    
    
    
    
    
    
    
    
    
    
    3,084,988Net Income
    
    
    
    
    
    
    
    
    
    
    439,876
    
    
    
    
    
    
    
    439,876Unrealized Gains on
Investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,252
    )
    
    
    (6,252
    )Total Comprehensive Loss.
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    433,624Balance December 31, 2003
    
    
    1,037,298
    
    
    
    10,754,630
    
    
    
    (1,065,744
    )
    
    
    7,356
    
    
    
    9,696,242Net Income
    
    
    
    
    
    
    
    
    
    
    675,577
    
    
    
    
    
    
    
    675,577Unrealized Losses
on Investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,390
    )
    
    
    (17,390
    )Total Comprehensive Loss.
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    658,187Balance December 31, 2004
    
    
    1,037,298
    
    
    $
    10,754,630
    
    
    $
    (390,167
    )
    
    $
    (10,034
    )
    
    $
    10,354,429
 The accompanying notes are an integral part of these financial statements. -18-




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##### 



DISCOVERY BANK
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31,
    
    2004
    
    
    2003CASH FLOWS FROM OPERATING ACTIVITIES:Net Income
    
    $
    675,577
    
    
    $
    439,876Adjustments to reconcile net income to net cash provided by/ (used in)
operating activities:Provision for loan losses
    
    
    237,798
    
    
    
    288,589Depreciation and amortization
    
    
    161,163
    
    
    
    86,282Amortization of deferred loan fees
    
    
    (234,573
    )
    
    
    (51,237
    )Loss on disposal of fixed assets
    
    
    1,986
    
    
    
    Change in:Deferred tax assets
    
    
    (86,600
    )
    
    
    (205,000
    )Accrued interest receivable and other assets
    
    
    (129,314
    )
    
    
    (171,885
    )Accrued interest payable and other liabilities
    
    
    114,664
    
    
    
    (262,112
    )Net cash provided by/ (used in) operating activities
    
    
    740,701
    
    
    
    124,513CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of premises and equipment
    
    
    (5,872,637
    )
    
    
    (116,019
    )Proceeds from sales of premises and equipment
    
    
    19,986Capitalization of deferred loan fees
    
    
    213,086
    
    
    
    132,797Purchases of interest bearing deposits at banks
    
    
    (158,329
    )
    
    
    (2,533,294
    )Redemption of interest bearing deposits at banks
    
    
    
    
    
    
    498,000Purchase of common stock substantially restricted
    
    
    (209,200
    )
    
    
    (213,800
    )Sales, maturities and paydowns of securities available-for-sale
    
    
    2,343,776
    
    
    
    Purchases of securities available-for-sale
    
    
    (2,492,600
    )
    
    
    (1,980,877
    )Net change in loans
    
    
    (20,384,931
    )
    
    
    (23,103,655
    )Net cash used for investing activities
    
    
    (26,540,849
    )
    
    
    (27,316,848
    )CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from borrowings, net of repayments
    
    
    4,755,968
    
    
    
    4,305,000Proceeds from issuance of common stock, net of capital raising costs
    
    
    
    
    
    
    3,084,988Net change in deposits
    
    
    25,517,668
    
    
    
    18,765,575Net cash provided by financing activities
    
    
    30,273,636
    
    
    
    26,155,563(Decrease) Increase in cash and cash equivalents
    
    
    4,473,488
    
    
    
    (1,036,772
    )CASH AND CASH EQUIVALENTS BALANCEBeginning of year or period
    
    
    2,110,388
    
    
    
    3,147,160End of year or period
    
    $
    6,583,876
    
    
    $
    2,110,388Supplemental Disclosures of Cash Flow InformationCash paid during the year for:Income taxes
    
    $
    28,500
    
    
    $
    800Interest
    
    $
    1,159,713
    
    
    $
    863,597Supplemental Disclosures of Noncash ActivitiesTotal change in unrealized (gains) losses on securities available-for-sale
    
    $
    (17,390
    )
    
    $
    (6,252
    )
 The accompanying notes are an integral part of these financial statements. -19-




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DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations- Discovery Bank (hereinafter the Bank) operates under a state charter,
granted in September 2001, and provides a full range of banking services to individual and
corporate customers through two branches located in San Marcos and Poway, California. The Bank,
which commenced operations in September 2001, under the name Discovery Valley Bank, generates
commercial and consumer loans and receives deposits from customers located primarily in San Diego
County, California and the surrounding areas. As a state bank, the Bank is subject to regulation by
the California Department of Financial Institutions (DFI) and the Federal Deposit Insurance
Corporation (FDIC). On December 26, 2002, the stockholders approved a change in name from
Discovery Valley Bank to Discovery Bank. The Banks articles of incorporation were amended in
January 2003. The Bank was organized by the issuance of 795,298 shares of common stock, the proceeds of
which amounted to $7,669,642, net of capital raising costs and expenses. During the year ended
December 31, 2003, the Bank underwent a secondary offering which resulted in the issuance of an
additional 242,000 shares of common stock, the proceeds of which amounted to $3,084,988, net of
capital raising costs and expenses. In conjunction with the secondary offering, the Bank also
issued 60,500 warrants. The Bank is also authorized to issue 10,000,000 shares of preferred stock. As of December 31,
2004 and 2003, there was no preferred stock issued and outstanding. During the third quarter of 2004, the Bank formed a wholly owned subsidiary, San Marcos
Building, LLC, for the purpose of purchasing a 28,000 square foot, two-story commercial building to
house the Banks corporate offices and head branch location. The Bank occupies approximately 13,000
square feet with the remaining space leased on a short term basis. Net assets of the subsidiary
consisting of the premise and land of $5,107,383 is reflected as premises within the consolidated
financial statements. Financial Statement Presentation and Use of Estimates- The consolidated financial statements
have been prepared in accordance with accounting principles generally accepted in the United States
of America and reporting practices applicable to the banking industry. In preparing financial
statements, management is required to make estimates and assumptions that affect the reported
amounts of assets and liabilities, and the disclosure of contingent assets and liabilities as of
the balance sheet date. These estimates also affect the amounts of revenues and expenses reported
during the period. Actual results could differ from the estimated amounts. Reclassifications- Certain prior year amounts have been reclassified to conform to the
current year presentation. Concentrations of Credit Risk- Assets and liabilities that subject the Bank to concentrations
of credit risk consist of interest bearing deposits at other banks, investments, loans, and
deposits. Most of the Banks customers are located within San Diego County and the surrounding
areas. The types of securities the Bank invests in are discussed in Note 2 and the Banks primary
lending products are discussed in Note 3. For the years ended December 31, 2004 and 2003, the Bank
did not have any significant concentrations to any one customer or industry. The Bank obtains what
it believes to be sufficient collateral to secure potential losses. The extent and value of the
collateral varies based upon the details underlying each loan agreement. As of December 31, 2004 and 2003, the Bank had cash deposits at other financial institutions
in excess of FDIC insured limits. However, as the Bank places these deposits with major financial
institutions, management believes the risk of loss to be minimal. The Bank is required to keep a
cash balance at Pacific Coast Bankers Bank equal to $100,000 as of December 31, 2004. -20-




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DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Cash and Cash Equivalents- For purposes of the statement of cash flows, cash and cash
equivalents includes cash, balances due from banks, and federal funds sold, that are purchased with
an original maturity date less than ninety days. Certificates of deposit Interest-bearing deposits in banks are purchased with an original
maturity date greater than ninety days, mature within one to five years and are carried at cost. Securities The Bank is required to specifically identify its securities as
held-to-maturity, available-for-sale or trading securities. The Bank invested in no
securities that were classified as trading or held-to-maturity during the years ended December
31, 2004 and 2003. Securities available-for-sale consist of securities not classified as trading securities or as
securities held-to-maturity. Securities available-for-sale are recorded at fair value. Fair value
for these investment securities are based on quoted market prices. Unrealized holding gains and
losses, net of tax, on available-for-sale securities are reported as other comprehensive income
(loss) and carried as accumulated comprehensive income (loss) within stockholders equity until
realized. Premiums and discounts on purchased securities are recognized as interest income using the
effective interest method over the term of the securities. Declines in the fair value of
held-to-maturity and available-for-sale securities below cost that are deemed to be other than
temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities
are recorded on the trade date and are determined using the specific identification method. Loans The Bank grants mortgage, commercial, and consumer loans to customers. A substantial
portion of the loan portfolio is secured by real estate throughout San Diego County and the
surrounding areas. The ability of the Banks debtors to honor their contracts is dependent upon the
real estate and general economic conditions in the area. Loans that management has the intent and ability to hold for the foreseeable future, until
maturity or until pay-off are reported at their outstanding unpaid principal balances adjusted for
charge-offs, the allowance for loan losses and any deferred fees or costs on originated loans.
Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain
direct origination costs, are deferred and recognized as an adjustment of the related loan yield
using the straight line interest method which approximates the effective interest method. The accrual of interest on loans is discontinued at the time a loan becomes ninety-days
delinquent unless the credit is well secured and in process of collection. In some cases, loans can
be placed on nonaccrual or charged-off at an earlier date if collection of principal and interest
is considered doubtful. All interest accrued, but not collected, for loans that are placed on nonaccrual or are
charged-off is reversed against interest income. The interest on these loans is accounted for on
the cash-basis or cost-recovery method, until the loans qualify for return to accrual status. Loans
are returned to accrual status when all the principal and interest amounts contractually due become
current and future payments are reasonably assured. Allowance
For Loan Losses The allowance for loan losses is established as losses are
estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are
charged against the allowance when management believes the collectibility of loan principal becomes
unlikely. Subsequent recoveries, if any, are credited to the allowance. -21-




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DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) The allowance for loan losses is evaluated on an ongoing basis by management and is based upon
managements periodic review of the collectibility of the loans in light of historical experience,
the nature and volume of the loan portfolio, adverse situations that may affect a borrowers
ability to repay, changes in the estimated value of any underlying collateral and prevailing
economic conditions. This evaluation is inherently subjective, as it requires estimates that are
susceptible to significant revision as conditions change. A loan is considered impaired when, based on current information and events, it is probable
that the Bank will be unable to collect the scheduled payments of principal and interest when due
according to the contractual terms of the loan agreement. Factors considered by management in
determining impairment include payment status, collateral value, and the probability of collecting
future scheduled principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired. Management
determines the significance of payment delays and payment shortfalls on a case-by-case basis,
taking into consideration all of the circumstances surrounding the loan and the borrower, including
the length of the delay, the reasons for the delay, the borrowers prior payment record, and the
amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a
loan by loan basis for commercial, construction, and consumer term loans by either the present
value of expected future cash flows discounted at the loans effective interest rate, the
obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Premises
and Equipment  Premises and equipment are carried at cost, less accumulated
depreciation. Depreciation is computed using the straight-line method over the estimated useful
lives of the assets, which range from three to twenty five years. Leasehold improvements are
amortized over the shorter of the term of the lease or the estimated useful lives of improvements.
Maintenance and repairs are expensed as incurred while major improvements or additions are
capitalized. Gains and losses on dispositions are included in current operations. Advertising
Costs  Advertising costs are expensed in the period incurred. Financial Instruments In the ordinary course of business, the Bank has entered into
off-balance sheet agreements consisting of commitments to extend credit, commercial letters of
credit, and standby letters of credit. Such financial instruments are recorded in the financial
statements when they are funded or related fees are incurred or received. Income Taxes The Bank records its provision for income taxes under the liability method.
Deferred tax assets and liabilities are reflected at currently enacted 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. Deferred taxes result from temporary differences
in the recognition of certain income and expense amounts between the Banks financial statements
and its tax return. The principal items giving rise to these differences include the allowance for
loan losses, unused net operating losses, and organization and start-up costs. Employee Benefit Plan The Banks contributions to the qualifying employee retirement plan
are recorded as compensation cost in the period incurred. Stock Option Plan The Bank has a stock-based employee compensation plan, which is described
more fully in Note 12. The Bank accounts for this plan under the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees,and related
interpretations. No stock-based employee compensation cost is reflected in net income, as all
options granted under the plan have an exercise price equal to the market value of the underlying
common stock on the date of grant. -22-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) In December 2004, the FASB issued SFAS no. 123 (revised 2004), Share-Based Payment. This
Statement requires that compensation costs related to share-based payment transactions be
recognized in the financial statements. Measurement of the cost of employee service will be based
on the grant-date fair value of the equity or liability instruments issued. That cost will be
recognized over the period during which an employee is required to provide service in exchange for
the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R
replaces SFAS Statement No. 123, Accounting for Stock-Based Compensationand supersedes APB Opinion
No. 25, Accounting for Stock Issued to Employees. This Statement is effective for interim periods
beginning after June 15, 2005 and requires adoption using a modified prospective application or a
modified retrospective application. The Bank has not yet concluded on the method of adoption
allowed by the Statement and is currently evaluating the impact of this accounting guidance on its
financial condition and results of operations. Disclosure required under SFAS No. 123 is shown
below. The following table illustrates the effect on net income if the Bank had applied the fair
value recognition provisions of FASB Statement No. 123 (r), Accounting for Share-Based Payments,
to stock-based employee compensation. The significant assumptions used by the Banks management in
computing these amounts are disclosed in Note 12. 2004
    
    
    2003Net income
    
    $
    675,577
    
    
    $
    439,876Additional compensation for fair value of stock options
    
    
    107,282
    
    
    
    71,139Pro forma net income
    
    $
    568,295
    
    
    $
    368,737
 Earnings
Per Share (EPS)  Basic earnings per share represents income available to common
shareholders divided by the weighted-average number of common shares outstanding during the period.
Diluted earnings per share reflect additional common shares that would have been outstanding if
dilutive potential common shares had been issued, as well as any adjustment to income that would
result from the assumed issuance. Potential common shares that may be issued by the Bank relate
solely to outstanding stock options, and are determined using the treasury stock method. The following is a reconciliation of basic EPS to diluted EPS for the year ended December 31,
2004: Weighted Average
    
    
    Per ShareNet Income
    
    
    Shares Outstanding
    
    
    AmountBasic EPS:Income available to common shareholders
    
    $
    675,577
    
    
    
    1,037,298
    
    
    $
    0.65Effect of dilutive securities:Stock options
    
    
    
    
    
    
    58,157
    
    
    
    (0.04
    )Diluted EPS:Income available to common shareholders
    
    $
    675,577
    
    
    
    1,095,455
    
    
    $
    0.61
 -23-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) The following is a reconciliation of basic EPS to diluted EPS for the year ended December 31,
2003: PerWeighted Average
    
    
    ShareNet Income
    
    
    Shares Outstanding
    
    
    AmountBasic EPS:Income available to common shareholders
    
    $
    439,876
    
    
    
    897,017
    
    
    $
    0.49Effect of dilutive securities:Stock options
    
    
    
    
    
    
    38,957
    
    
    
    (0.03
    )Diluted EPS:Income available to common shareholders
    
    $
    439,876
    
    
    
    935,974
    
    
    $
    0.46
 Comprehensive
Income  Accounting principles generally require that recognized revenue,
expenses, gains and losses be included in net income. Certain changes in stockholders equity from
non-owner sources, such as unrealized gains and losses on available-for-sale securities, are
reported with net income as comprehensive income and shown as a separate component of the equity
section on the balance sheet. For the years ended December 31, 2004 and 2003, unrealized holding
gains (losses) on available-for-sale securities were the only items of other comprehensive income. Federal
Home Loan Bank and Pacific Coast Bankers Bank Stock  As a member of the Federal Home
Loan Bank (FHLB), the Bank is required to purchase FHLB stock in accordance with its advances,
securities, and deposit agreement. The stock is substantially restricted and may be redeemed at par
value, however only in connection with the Bank surrendering its FHLB membership. The Bank also
invests in the stock of Pacific Coast Bankers Bank (PCBB), in connection with its advance and
correspondent banking arrangement with PCBB. These investments are carried at cost as of December
31, 2004 and 2003. In June 2004, the Emerging Issues Task Force of the FASB issued final guidance on its Issue
No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments. A consensus was reached regarding disclosures about unrealized losses on
available-for-sale debt and equity securities accounted for under FASB Statements No. 115,
Accounting for Certain Investments in Debt and Equity Securities. This EITF describes a model involving three steps: (1) determine whether an investment is
impaired, (2) determine whether the impairment is other-than-temporary, and (3) recognize the
impairment loss in earnings. The EITF also requires several additional disclosures for cost-method
investments. The EITFs impairment accounting guidance was effective for reporting periods
beginning after June 15, 2004. For all other investments within the scope of this Issue, the
disclosures are effective in annual financial statements for fiscal years ending after June 15,
2004. The additional disclosures for cost method investments are effective for fiscal years ending
after June 15, 2004. The adoption of this EITF did not have a material impact on the Banks financial statements.
At December 31, 2004 and December 31, 2003, management believes the impairments described above are
temporary and, accordingly, no impairment loss has been recognized in the Banks statement of
income. On March 9, 2004, the Staff of the Securities and Exchange Commission (the SEC Staff) issued
Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB
105). SAB 105 provides guidance on the initial recognition and measurement of loan commitments
that meet the definition of a derivative, and summarizes the related disclosure requirements. SAB
105 is effective for all loan commitments accounted for as derivatives that are entered into, or
substantially modified, on or after April 1, 2004. SAB 105 -24-




---



##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) addresses loan commitments that the Financial Accounting Standards Board (FASB) defines as
derivatives in paragraph 6 of FASB Statement No. 133, Accounting for Derivative Instruments and
Hedging Activities, as amended by FASB Statement No. 149, Amendment of Statement 133 on Derivative
Instruments and Hedging Activities (FAS 133). These loan commitments relate to the origination of
mortgage loans that will be held for sale. SAB 105 does not apply to (1) commitments to purchase
mortgage loans that do not meet the definition of a derivative under paragraph 6 of FAS 133 or (2)
commitments that are explicitly excluded from the scope of FAS 133 (i.e., commitments to originate
mortgage loans that will be held for investment purposes and loan commitments to originate other
types of loans). The Bank does not currently originate mortgage loans to be held for sale. If that
should change in the future, we would take SAB 105 into consideration but do not expect it to have
a material impact on the Banks financial condition or operating results. In December 2003, under clearance of the FASB, the Accounting Standards Executive Committee
(AcSEC) of the AICPA issued Statement of Position (SOP) 03-3, Accounting for Certain Loans or
Debt Securities Acquired in a Transfer. This SOP establishes accounting standards for discounts on
purchased loans when the discount is attributable to credit quality. The SOP requires that the loan
discount, rather than contractual amounts, establishes the investors estimate of undiscounted
expected future principal and interest cash flows as a benchmark for yield and impairment
measurements. The SOP prohibits the carryover or creation of a valuation allowance in the initial
accounting for these loans. This SOP is effective from loans acquired in years beginning after
December 15, 2004. Since this SOP applies only to transfers after 2004, this Statement will have no
impact on the Banks financial position or results of operation at adoption. NOTE 2  INVESTMENT SECURITIES The Banks securities are available-for-sale. The amortized cost of securities and their
approximate fair values as of December 31 are: 2004Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    ValueAvailable-for-sale securities:U.S. government agency Securities
    
    $
    2,715,768
    
    
    $
    6,141
    
    
    $
    (16,175
    )
    
    $
    2,705,734Total securities
    
    $
    2,715,768
    
    
    $
    6,141
    
    
    $
    (16,175
    )
    
    $
    2,705,734
 -25-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2  INVESTMENT SECURITIES (Continued) 2003Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    ValueAvailable-for-sale securities:U.S. government agency Securities
    
    $
    1,645,672
    
    
    $
    17,806
    
    
    $
    (969
    )
    
    $
    1,662,509Mutual funds
    
    
    915,818
    
    
    $
    
    
    
    
    (9,481
    )
    
    
    906,337Total securities
    
    $
    2,561,490
    
    
    $
    17,806
    
    
    $
    (10,450
    )
    
    $
    2,568,846
 For the year ended December 31, 2004, the investment securities have fair values less
than amortized cost and therefore contain unrealized losses. The Bank has evaluated these
securities and has determined that the decline in value is related to the change in market interest
rates since purchase. The decline in value is not related to any company or industry specific
event. The unrealized losses amount to $16,175 as of December 31, 2004. No securities were in an
unrealized loss position for more than one year. The Bank anticipates full recovery of amortized cost with respect to these securities at
maturity or sooner in the event of a more favorable market interest rate environment. The amortized cost and estimated fair value of the available-for-sale securities at December
31, 2004, by contractual or expected maturity, are shown below. Expected maturities will differ
from contractual maturities because issuers may have the right to call or prepay obligations with
or without call or prepayment penalties. Amortized
    
    
    FairCost
    
    
    ValueDue in one year or less
    
    $
    250,000
    
    
    $
    251,325Due after one year through five years
    
    
    1,811,129
    
    
    
    1,807,690Due after five years
    
    
    654,639
    
    
    
    646,719Totals
    
    $
    2,715,766
    
    
    $
    2,705,734
 During the year ended December 31, 2004 the Bank sold mutual funds, the proceeds amounted to
$920,893. During the year ended December 31, 2003 there were no securities sold. The Bank did not have securities pledged to secure public deposits at December 31, 2004 or
2003. At December 31, 2004 the bank had no securities pledged as collateral. At December 31, 2003,
the Bank had $1,500,000 in securities pledged as collateral in accordance with their line of credit
agreement with Federal Home Loan Bank. -26-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3  LOANS The major classifications of loans at December 31 are summarized as follows: 2004
    
    
    2003Real estate
    
    $
    49,663,687
    
    
    $
    40,283,738Commercial
    
    
    26,001,621
    
    
    
    17,473,037Consumer
    
    
    5,545,858
    
    
    
    3,069,460Gross loans
    
    
    81,211,166
    
    
    
    60,826,235Less: deferred loan fees
    
    
    (176,463
    )
    
    
    (130,316
    )Less: allowance for loan losses
    
    
    (998,137
    )
    
    
    (760,339
    )$
    80,036,566
    
    
    $
    59,935,580
 At December 31 2004 and 2003, respectively $ 17,017,384 and $8,706,979 were pledged as
collateral for Federal Home Loan Bank revolving line of credit. See Note # 6 Transactions in the allowance for loan losses are summarized as follows: 2004
    
    
    2003Balance, beginning of year
    
    $
    760,339
    
    
    $
    471,750Provision for loan losses charged to expense
    
    
    237,798
    
    
    
    288,589Loans charged-off
    
    
    
    
    
    
    Recoveries of loans previously charged-off
    
    
    
    
    
    
    Balance, end of year
    
    $
    998,137
    
    
    $
    760,339
 There were no loans past due, not accruing interest or considered impaired as of December 31,
2004 or 2003. NOTE 4  PREMISES AND EQUIPMENT Premises and equipment consisted of the following at December 31: 2004
    
    
    2003Building
    
    $
    4,107,383
    
    
    $
    Equipment, furniture and fixtures
    
    
    1,001,737
    
    
    
    302,625Leasehold improvements
    
    
    
    
    
    
    117,095Land
    
    
    1,000,000
    
    
    
    6,109,120
    
    
    
    419,720Less: accumulated depreciation and amortization
    
    
    (175,518
    )
    
    
    (176,832
    )Premises and equipment, net
    
    $
    5,933,602
    
    
    $
    242,888
 -27-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 5  DEPOSITS At December 31, 2004, the scheduled maturities of time deposits are as follows: Time Deposits
    
    
    Time Deposits< $100,000
    
    
    > $100,0002005
    
    $
    18,035,413
    
    
    $
    17,937,9722006
    
    
    
    
    
    
    Thereafter
    
    
    
    
    
    
    $
    18,035,413
    
    
    $
    17,937,972
 NOTE 6  BORROWINGS The Bank has a continuous revolving line of credit with Federal Home Loan Bank (FHLB)
providing for working capital advances up to $9,834,000. Borrowings are payable on demand and are
fully collateralized by certain Bank assets. Interest on outstanding borrowings accrues at the
rates negotiated at the time of borrowing which range from 1.12% to 2.31% during 2004. The Bank had
$9,000,000 outstanding against the line as of December 31, 2004 at a rate of 2.35%. The Bank had
$4,305,000 outstanding against the line as of December 31, 2003. The Bank has an unsecured line of credit with Pacific Coast Bankers Bank (PCBB) providing for
fed fund purchases up to $2,500,000. Interest on outstanding borrowings accrues at the PCBB daily
fed fund rate. The Bank had no outstanding borrowings against the line as of December 31, 2004 and
2003. NOTE 7  INCOME TAXES The provision for income taxes consisted of the following for the periods ended December 31: 2004
    
    
    2003Current:Federal
    
    $
    
    
    
    $
    State
    
    
    800
    
    
    
    55,800800
    
    
    
    55,800Deferred:Federal
    
    
    148,800
    
    
    
    73,530State
    
    
    71,100
    
    
    
    27,970219,900
    
    
    
    101,500Increase (decrease) in valuation allowance
    
    
    (306,500
    )
    
    
    (306,500
    )(Benefit) provision for income taxes
    
    
    (85,800
    )
    
    $
    (149,200
    )
 The following summarizes the differences between the provision for income taxes for
financial statement purposes and the federal statutory rate of 34% for the years ended December 31,
2004 and December 31, 2003. 2004
    
    
    2003Tax provision at federal statutory rate
    
    
    34.0
    %
    
    
    34.0
    %State franchise tax, net of federal income tax benefit
    
    
    7.1
    
    
    
    7.1Permanent adjustments
    
    
    .1
    
    
    
    1.3Other
    
    
    (3.7
    )
    
    
    11.6Increase (decrease) in valuation allowance
    
    
    (52.0
    )
    
    
    (105.3
    )Tax (benefit) provision
    
    
    (14.5
    )%
    
    
    (51.3
    )%
 -28-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7  INCOME TAXES (Continued) The components of the net deferred tax asset are as follows at December 31: 2004
    
    
    2003Depreciation
    
    $
    (114,700
    )
    
    $
    (65,337
    )Allowance for loan losses
    
    
    315,200
    
    
    
    312,500Certain prepaid assets
    
    
    (46,200
    )
    
    
    (48,109
    )Federal net operating loss carryforward
    
    
    150,900
    
    
    
    255,488California net operating loss carryforward
    
    
    41,200
    
    
    
    -0-Organizational expenditures and start-up costs
    
    
    46,500
    
    
    
    41,086Accrual to cash adjustment
    
    
    (101,300
    )
    
    
    15,872Deferred tax asset
    
    
    291,600
    
    
    
    511,500Less valuation allowance
    
    
    -0-
    
    
    
    (306,500
    )Net deferred tax asset
    
    $
    291,600
    
    
    $
    205,000
 As of December 31, 2004, the Bank has net operating loss carryforwards of approximately
$444,000 and $575,000 available to reduce future federal and state taxable income, respectively.
The net operating loss carryforwards begin expiring in 2021 and expire through 2022. Prior to 2004,
the State of California suspended corporations from utilizing net operating losses. In 2004 the
Company utilized $570,000 of net operating losses on its California income tax filing. The Bank
recognizes its remaining California net operating losses as a deferred tax asset at December 31,
2004. In 2004, the Bank has recognized net deferred tax assets. Management believes that the Bank will
realize the deferred tax benefit in the normal course of business. The Bank has eliminated the
valuation allowance based upon forecasts that show sufficient taxable income prior to the net
operating loss expiring. -29-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8  REGULATORY CAPITAL The Bank is subject to various regulatory capital requirements administered by federal banking
agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly
additional discretionary, actions by regulators that, if undertaken, could have a direct material
effect on the Banks financial statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital guidelines that involve
quantitative measures of the Banks assets, liabilities, and certain off-balance-sheet items as
calculated under regulatory accounting practices. The Banks capital amounts and classification are
also subject to qualitative judgments by the regulators about components, risk weightings, and
other factors. Under existing state laws, the Bank is restricted in its ability to pay dividends. Quantitative measures established by regulation to ensure capital adequacy require the Bank to
maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital
to risk-weighted assets and of Tier 1 capital to average assets, all of which are defined in the
regulations. To be categorized as adequately capitalized, the Bank must maintain minimum total risk-based,
Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. Management believes the
institution is well capitalized under the prompt corrective action provisions. The Banks required and actual capital amounts and ratios are as follows: Minimum Capital
    
    
    Minimum To Be WellActual
    
    
    Requirement
    
    
    CapitalizedAmount
    
    
    Ratio
    
    
    Amount
    
    
    Ratio
    
    
    Amount
    
    
    RatioDecember 31, 2004:Total Risk-based Capital to Risk Weighted Assets
    
    $
    11,385,000
    
    
    
    12.41
    %
    
    $
    7,341,000
    
    
    
    8.00
    %
    
    $
    9,176,000
    
    
    
    10.00
    %Tier 1 Capital to Risk - Weighted Assets
    
    $
    10,365,000
    
    
    
    11.30
    %
    
    $
    3,670,000
    
    
    
    4.00
    %
    
    $
    5,505,000
    
    
    
    6.00
    %Tier 1 Capital to Average Assets
    
    $
    10,365,000
    
    
    
    10.57
    %
    
    $
    3,923,000
    
    
    
    4.00
    %
    
    $
    4,904,000
    
    
    
    5.00
    %
 -30-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 8  REGULATORY CAPITAL (Continued) Minimum Capital
    
    
    Minimum To Be WellActual
    
    
    Requirement
    
    
    CapitalizedAmount
    
    
    Ratio
    
    
    Amount
    
    
    Ratio
    
    
    Amount
    
    
    RatioDecember 31, 2003:Total Risk-based Capital to Risk Weighted Assets
    
    $
    10,400,000
    
    
    
    16.23
    %
    
    $
    5,146,000
    
    
    
    8.00
    %
    
    $
    6,433,000
    
    
    
    10.00
    %Tier 1 Capital to Risk -
Weighted Assets
    
    $
    9,680,000
    
    
    
    15.05
    %
    
    $
    2,573,000
    
    
    
    4.00
    %
    
    $
    3,860,000
    
    
    
    6.00
    %Tier 1 Capital to Average Assets
    
    $
    9,680,000
    
    
    
    15.27
    %
    
    $
    2,536,000
    
    
    
    4.00
    %
    
    $
    3,171,000
    
    
    
    5.00
    %
 NOTE 9  LEASE COMMITMENTS The Bank leased its main office space, branch facility, and a loan operations center under
various operating leases expiring through June 2007. Rent expense for the years ended December 31,
2004 and 2003 was approximately $154,000 and $136,000, respectively. Approximately $39,000 of the
2004 costs were for lease termination expenses, as the Bank terminated these leases effective
December 15, 2004. In July 2004 the Bank purchased a headquarters building for $4,950,000 and made improvements
of approximately $500,000. The Bank occupied the building on December 6, 2004. Occupancy expense
for December 31, 2004 includes rental income of $219,902 resulting in net occupancy expense of
$130,312. Minimum Payments required under non-cancelable operating leases with terms in excess of one
year are as follows for years ending December 31: 2008
    
    $
    32,5812009
    
    
    32,5802010
    
    
    27,150
 NOTE 10  RELATED PARTY TRANSACTIONS The Bank grants loans to and accepts deposits from directors, major stockholders and officers
as well as entities with which these individuals are associated. Management believes these
transactions were made in the ordinary course of business under substantially the same terms and
conditions, including interest rates and collateral requirements, as comparable transactions with
other customers, and did not involve more than normal credit risk or present other unfavorable
features. Loan balances outstanding from related parties at December 31, 2004 and 2003 were
approximately $4,010,000 and $1,784,000, respectively. Deposits from related parties at December
31, 2004 and 2003 were $2,700,000 and $1,189,000, respectively. The following chart represents related party loan transactions during the periods of December
31, 2002 to December 31, 2003 and December 31, 2003 to December 31, 2004. -31-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 10  RELATED PARTY TRANSACTIONS (Continued) Related Party Loan Transactions12-31-03 Beginning Balance
    
    Additions
    
    Repayment
    
    2004 Ending Balance$1,784,000
    
    
    $3,258,000
    
    
    $1,032,000
    
    
    $4,010,00012-31-02 Beginning Balance
    
    Additions
    
    Repayment
    
    2003 Ending Balance$496,000
    
    
    $1,677,000
    
    
    $389,000
    
    
    $1,784,000
 NOTE 11  EMPLOYEE BENEFIT PLAN The Bank has a 401(k) plan, established during fiscal year 2002, whereby substantially all
employees are eligible to participate. Employees may contribute up to 15 percent of their
compensation subject to certain limits based on federal tax laws. The Bank makes matching
contributions equal to 50 percent of the first 6 percent of an employees compensation contributed
to the 401(k) plan. Matching contributions vest to the employee equally over a five-year period.
For the years ended December 31, 2004 and 2003, the Bank contributed $32,459 and $15,650,
respectively, to the 401(k) plan. NOTE 12  STOCK OPTION PLAN The Bank has a stock option plan (hereinafter the Plan), which provides for non-qualified
stock options for non-officer directors and incentive stock options for employees for a maximum of
250,000 shares of authorized common stock. Pursuant to the Plan, the Bank has awarded options at
the initial offering price of $10 per share to directors and employees. The options granted vest
and become exercisable in incremental percentages over five years from the grant date and expire
ten years after grant. The pro forma information disclosed in Note 1 portrays as compensation the value of stock
options granted using an option valuation model. Management believes that the assumptions used in
the option-pricing model are highly subjective and represent only one estimate of possible value,
as there is no active market for the options granted. The fair value of the options granted in 2004
and 2003 is allocated to pro forma earnings over the vesting period of the options. The following
assumptions were used to estimate the fair value of the stock options granted: 2004
    
    
    2003Vesting period
    
    5 Years
    
    5 YearsRisk-free interest rate
    
    
    4.19
    %
    
    
    3.99
    %Dividend yield rate
    
    
    0
    %
    
    
    0
    %Price volatility
    
    
    23
    %
    
    
    25
    %Weighted average expected life of options
    
    5 Years
    
    5 Years
 -32-




---



##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 12  STOCK OPTION PLAN (Continued) Stock option transactions were: 2004
    
    
    2003Weighted
    
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    
    AverageExercise Price
    
    
    
    
    
    
    Exercise Price ofGrand Options
    
    
    of Shares Under
    
    
    Granted Options
    
    
    Shares Underfor Common Stock
    
    
    Plan
    
    
    for Common Stock
    
    
    PlanBeginning balance
    
    
    173,326
    
    
    
    10.54
    
    
    
    140,092
    
    
    
    10.00Granted
    
    
    33,884
    
    
    
    15.64
    
    
    
    34,234
    
    
    
    10.62Exercised
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Forfeited
    
    
    (1,000
    )
    
    
    11.30
    
    
    
    (1,000
    )
    
    
    10.00Ending Balance
    
    
    206,210
    
    
    
    11.38
    
    
    
    173,326
    
    
    
    10.54
 The following table summarizes information concerning currently outstanding and exercisable
options: WeightedAverage
    
    
    WeightedRemaining
    
    
    AverageNumber
    
    
    Contractual
    
    
    Exercise
    
    
    NumberOutstanding
    
    
    Life
    
    
    Price
    
    
    ExercisableIncentive stock options
    
    
    80,268
    
    
    7.5 Years
    
    $
    11.42
    
    
    
    39,491Non-qualified options
    
    
    125,942
    
    
    7.5 Years
    
    $
    11.42
    
    
    
    54,061206,210
    
    
    7.5 Years
    
    $
    11.38
    
    
    
    93,552
 NOTE 13  FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK The Bank is a party to financial instruments with off-balance-sheet risk in the normal course
of business to meet the financing needs of its customers and to reduce its own exposure to
fluctuations in interest rates. These financial instruments include commitments to extend credit,
standby letters of credit and financial guarantees. Those instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.
The contract or notional amounts of those instruments reflect the extent of the Banks involvement
in particular classes of financial instruments. The Banks exposure to credit loss in the event of nonperformance by the other party to the
financial instrument for commitments to extend credit, standby letters of credit, and financial
guarantees written is represented by the contractual notional amount of those instruments. The Bank
uses the same credit policies in making commitments and conditional obligations as it does for
on-balance sheet instruments. At December 31, 2004 and 2003, the following financial instruments were outstanding whose
contract amounts represent credit risk: 2004
    
    
    2003Unfunded commitments under lines of credit
    
    $
    21,896,174
    
    
    $
    17,516,235Commercial and standby letters of credit
    
    
    482,137
    
    
    
    312,681
 Commitments to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally have fixed expiration
dates or other termination clauses -33-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 13  FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK (Continued) and may require payment of a fee. Since many of the commitments are expected to expire without
being drawn upon, the total commitment amounts do not necessarily represent future cash
requirements. Standby letters of credit are conditional commitments issued by the Bank to guarantee the
performance of a customer to a third party. Those letters of credit are primarily issued to support
public and private borrowing arrangements. All standby letters of credit issued by the Bank expire
within one year of issuance. The credit risk involved in issuing letters of credit is essentially
the same as that involved in extending loan facilities to customers. The Bank generally holds
collateral supporting those commitments, if deemed necessary. Lines of credit and commercial and standby letters of credit are variable rate loans generally
tied to the prime rate or other variable indexes. -34-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14  FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of financial instruments is the amount at which an asset or obligation could be
exchanged in a current transaction between willing parties, other than in a forced liquidation.
Fair value estimates are made at a specific point in time based on the type of financial instrument
and relevant market information. Because no quoted market price exists for a significant portion of the Banks financial
instruments, the fair values of such financial instruments are derived based on the amount and
timing of future cash flows, estimated discount rates, as well as managements best judgment with
respect to current economic conditions. Many of these estimates involve uncertainties and matters
of significant judgment and cannot be determined with precision. The fair value information provided is indicative of the estimated fair values of those
financial instruments and should not be interpreted as an estimate of the fair market value of the
Bank taken as a whole. The disclosures do not address the value of recognized and unrecognized
nonfinancial assets and liabilities or the value of future anticipated business. In addition, 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. The following methods and assumptions were used to estimate the fair values of significant
financial instruments at December 31, 2004 and 2003: Cash and short-term investments- These financial instruments have relatively short maturities
or no defined maturities but are payable on demand, with little or no credit risk. For these
instruments, the carrying amounts represent a reasonable estimate of fair value. Investment securities, available-for-sale- Investment securities, available-for-sale, are
reported at their fair values based on quoted market prices. Loans- Fair values were estimated for performing loans by discounting the future cash flows
using market discount rates that reflect the credit and interest-rate risk inherent in the loans. Deposits- The fair values of demand deposits, savings deposits and money market accounts were
the amounts payable on demand at December 31, 2004 and 2003. The fair value of time deposits were
the amounts payable at maturity as all time deposits mature within one year. Short-term borrowings- For such short-term borrowings, the carrying amount was considered to
be a reasonable estimate of fair value. -35-




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##### 



DISCOVERY BANK NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 14  FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) Commitments to extend credit and letters of credit- The estimated fair value of financial
instruments with off-balance sheet risk is not significant at December 31, 2004 and 2003. The following table presents the carrying amounts and fair values of financial instruments at
December 31: 2004
    
    
    2003Carrying
    
    
    
    
    
    
    CarryingValue
    
    
    Fair Value
    
    
    Value
    
    
    Fair ValueFINANCIAL ASSETSCash and other short term Investments
    
    $
    6,583,876
    
    
    $
    6,583,876
    
    
    $
    2,110,388
    
    
    $
    2,110,388Interest-bearing deposits with Banks
    
    
    2,691,623
    
    
    
    2,691,623
    
    
    
    2,533,294
    
    
    
    2,533,294Investment securities, available for sale
    
    
    2,705,734
    
    
    
    2,705,734
    
    
    
    2,568,846
    
    
    
    2,568,846Loans
    
    
    80,036,566
    
    
    
    79,616,594
    
    
    
    59,935,580
    
    
    
    59,905,845FINANCIAL LIABILITIESDeposits
    
    $
    79,679,058
    
    
    $
    79,679,058
    
    
    $
    54,161,390
    
    
    $
    54,161,390Borrowings
    
    
    9,000,000
    
    
    
    9,000,000
    
    
    
    4,305,000
    
    
    
    4,305,000
 NOTE 15  EMPLOYMENT AGREEMENTS The Bank has entered into employment agreements with certain employees which provide for
annual bonuses based upon a predetermined formula, company owned automobiles, expense
reimbursements, stock options, and standard and customary medical, dental, and life insurance
benefits. The agreements also provide for severance compensation for termination without cause. -36-




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##### 



[MOSS ADAMS LLP LETTERHEAD] CERTIFIED PUBLIC ACCOUNTANTS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders
Discovery Bank We have audited the accompanying balance sheets of Discovery Bank as of December 31, 2003 and 2002,
and the related statements of operations, stockholders equity and cash flows for the years ended
December 31, 2003 and 2002. These financial statements are the responsibility of the Banks
management. Our responsibility is to express an opinion on these financial statements based on our
audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States.) Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of Discovery Bank as of December 31, 2003 and 2002, and the
results of its operations and its cash flows for the years then ended, in conformity with
accounting principles generally accepted in the United States of America. /s/ MOSS ADAMS LLP Los Angeles, California
January 13, 2004 -37-




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##### 



DISCOVERY BANK BALANCE SHEETS DECEMBER 31,
    
    2003
    
    
    2002ASSETSCash and due from banks
    
    $
    1,495,388
    
    
    $
    1,402,160Federal funds sold
    
    
    615,000
    
    
    
    1,745,000Cash and cash equivalents
    
    
    2,110,388
    
    
    
    3,147,160Interest-bearing deposits at banks
    
    
    2,533,294
    
    
    
    498,000Investment securities, available-for-sale
    
    
    2,842,646
    
    
    
    654,221Loans, net
    
    
    59,935,580
    
    
    
    37,202,074Accrued interest receivable and other assets
    
    
    412,540
    
    
    
    240,655Deferred income tax asset, net of valuation allowance
    
    
    205,000
    
    
    
    Premises and equipment, net
    
    
    242,888
    
    
    
    213,151TOTAL ASSETS
    
    $
    68,282,336
    
    
    $
    41,955,261LIABILITIESDepositsNon-interest-bearing demand
    
    $
    9,406,444
    
    
    $
    5,834,829Interest-bearing demand
    
    
    14,945,397
    
    
    
    5,181,688Savings
    
    
    819,653
    
    
    
    423,849Time, under $100,000
    
    
    17,034,658
    
    
    
    16,887,312Time, $100,000 and over
    
    
    11,955,238
    
    
    
    7,068,137Total deposits
    
    
    54,161,390
    
    
    
    35,395,815Borrowings
    
    
    4,305,000
    
    
    
    Accrued interest payable and other liabilities
    
    
    119,704
    
    
    
    381,816TOTAL LIABILITIES
    
    
    58,586,094
    
    
    
    35,777,631Commitments and contingencies (Note 9)STOCKHOLDERS EQUITYCommon stock
    
    
    10,754,630
    
    
    
    7,669,642Accumulated deficit
    
    
    (1,065,744
    )
    
    
    (1,505,620
    )Accumulated other comprehensive income
    
    
    7,356
    
    
    
    13,6089,696,242
    
    
    
    6,177,630TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    68,282,336
    
    
    $
    41,955,261
 The accompanying notes are an integral part of these financial statements. -38-




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##### 



DISCOVERY BANK STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31,
    
    2003
    
    
    2002INTEREST INCOMEInterest and fees on loans
    
    $
    3,172,662
    
    
    $
    1,709,777Interest on federal funds sold
    
    
    40,094
    
    
    
    34,649Interest on securities
    
    
    47,148
    
    
    
    47,176Other
    
    
    32,355
    
    
    
    14,5763,292,259
    
    
    
    1,806,178INTEREST EXPENSEDeposits
    
    
    850,093
    
    
    
    495,822Other
    
    
    15,983
    
    
    
    866,076
    
    
    
    495,822NET INTEREST INCOME
    
    
    2,426,183
    
    
    
    1,310,356PROVISION FOR LOAN LOSSES
    
    
    288,589
    
    
    
    390,713NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
    
    
    2,137,594
    
    
    
    919,643NON  INTEREST INCOMEService charges and other income
    
    
    456,786
    
    
    
    133,095NON  INTEREST EXPENSESalaries and employee benefits
    
    
    1,310,738
    
    
    
    1,048,773Occupancy
    
    
    190,190
    
    
    
    158,491Furniture and equipment
    
    
    97,032
    
    
    
    80,923Data processing
    
    
    125,823
    
    
    
    99,126Advertising
    
    
    147,077
    
    
    
    66,862Professional
    
    
    120,423
    
    
    
    144,307Office supplies
    
    
    28,035
    
    
    
    50,157Other operating
    
    
    284,385
    
    
    
    131,4762,303,703
    
    
    
    1,780,115INCOME (LOSS) BEFORE INCOME TAXES
    
    
    290,677
    
    
    
    (727,377
    )INCOME TAX (BENEFIT) PROVISION
    
    
    (149,200
    )
    
    
    800NET INCOME (LOSS)
    
    $
    439,877
    
    
    $
    (728,177
    )Earnings (loss) per share
    
    $
    0.49
    
    
    $
    (0.92
    )Diluted Earnings per share
    
    $
    0.46
    
    
    $
    (0.92
    )
 The accompanying notes are an integral part of these financial statements. -39-




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##### 



DISCOVERY BANK STATEMENTS OF STOCKHOLDERS EQUITY FOR THE YEARS ENDED DECEMBER 31, 2002 AND 2003 Common Stock no parvalue; 10,000,000 shares
    
    
    
    
    
    
    Accumulatedauthorized
    
    
    
    
    
    
    Other
    
    
    TotalShares
    
    
    
    
    
    
    Accumulated
    
    
    Comprehensive
    
    
    Stockholders'Outstanding
    
    
    Amount
    
    
    Deficit
    
    
    Income (Loss)
    
    
    EquityBalance,December 31, 2001
    
    
    795,298
    
    
    $
    7,669,642
    
    
    $
    (777,443
    )
    
    $
    (13,437
    )
    
    $
    6,878,762Net loss
    
    
    
    
    
    
    
    
    
    
    (728,177
    )
    
    
    
    
    
    
    (728,177
    )Unrealized losses on
investment securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    27,045
    
    
    
    27,045Total comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (701,132
    )Balance,December 31, 2002
    
    
    795,298
    
    
    
    7,669,642
    
    
    
    (1,505,620
    )
    
    
    13,608
    
    
    
    6,177,630Proceeds from stock offering
    
    
    242,000
    
    
    
    3,084,988
    
    
    
    
    
    
    
    
    
    
    
    3,084,988Net income
    
    
    
    
    
    
    
    
    
    
    439,876
    
    
    
    
    
    
    
    439,876Unrealized gains on investment
securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (6,252
    )
    
    
    (6,252
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    433,624Balance,December 31, 2003
    
    
    1,037,298
    
    
    $
    10,754,630
    
    
    $
    (1,065,744
    )
    
    $
    7,356
    
    
    $
    9,696,242
 The accompanying notes are an integral part of these financial statements. -40-




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##### 



DISCOVERY BANK STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31,
    
    2003
    
    
    2002CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    439,876
    
    
    $
    (728,177
    )Adjustments to reconcile net income (loss) to net cash provided by (used
in) operating activities:Provision for loan losses
    
    
    288,589
    
    
    
    390,713Depreciation and amortization
    
    
    86,282
    
    
    
    81,507Amortization of deferred loan fees
    
    
    (51,237
    )
    
    
    (13,138
    )Change in:Deferred tax assets, net
    
    
    (205,000
    )
    
    
    Accrued interest receivable and other assets
    
    
    (171,885
    )
    
    
    (157,285
    )Accrued interest payable and other liabilities
    
    
    (262,112
    )
    
    
    323,741Net cash provided by (used in) operating activities
    
    
    124,513
    
    
    
    (102,639
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of premises and equipment
    
    
    (116,019
    )
    
    
    (25,732
    )Capitalization of deferred loan fees
    
    
    132,797
    
    
    
    60,775Purchases of certificates of deposit
    
    
    (2,533,294
    )
    
    
    (99,000
    )Purchase of FHLB stock
    
    
    (213,800
    )
    
    
    Redemption of certificates of deposit
    
    
    498,000
    
    
    
    Purchases of securities available-for-sale
    
    
    (1,980,877
    )
    
    
    Sales, maturities and paydowns of securities available for sale
    
    
    0
    
    
    
    1,175,139Net change in loans
    
    
    (23,103,655
    )
    
    
    (31,239,602
    )Net cash used for investing activities
    
    
    (27,316,848
    )
    
    
    (30,128,420
    )CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from issuance of common stock, net of capital raising costs
    
    
    3,084,988
    
    
    
    Increase in borrowings
    
    
    4,305,000
    
    
    
    Net change in deposits
    
    
    18,765,575
    
    
    
    30,491,912Net cash provided by financing activities
    
    
    26,155,563
    
    
    
    30,491,912(Decrease) increase in cash and cash equivalents
    
    
    (1,036,772
    )
    
    
    260,853CASH BALANCEBeginning of year
    
    
    3,147,160
    
    
    
    2,886,307End of year
    
    $
    2,110,388
    
    
    $
    3,147,160Supplemental Disclosures of Cash Flow InformationCash paid during the year for:Income taxes
    
    $
    800
    
    
    $
    800Interest
    
    $
    863,597
    
    
    $
    463,715Supplemental Disclosures of Noncash Activities:Total change in unrealized (gains) losses on securities available-for-sale
    
    $
    (6,252
    )
    
    $
    27,045
 The accompanying notes are an integral part of these financial statements. -41-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 1  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations- Discovery Bank (hereinafter the Bank) operates under a state charter,
granted in September 2001, and provides a full range of banking services to individual and
corporate customers through one branch located in San Marcos, California. The Bank, which commenced
operations in September 2001, under the name Discovery Valley Bank, generates commercial and
consumer loans and receives deposits from customers located primarily in San Diego County,
California and the surrounding areas. As a state bank, the Bank is subject to regulation by the
California Department of Financial Institutions (DFI) and the Federal Deposit Insurance
Corporation (FDIC). On December 26, 2002, the stockholders approved a change in name from
Discovery Valley Bank to Discovery Bank. The Banks articles of incorporation were amended in
January 2003. The Bank was organized by the issuance of 795,298 shares of common stock, the proceeds of
which amounted to $7,669,642, net of capital raising costs and expenses. During the year ended
December 31, 2003, the Bank underwent a secondary offering which resulted in the issuance of an
additional 242,000 shares of common stock, the proceeds of which amounted to $3,084,988, net of
capital raising costs and expenses. In conjunction with the secondary offering, the Bank also
issued 60,500 warrants. The Bank is also authorized to issue 10,000,000 shares of preferred stock. As of December 31,
2003 and 2002, there was no preferred stock issued and outstanding. Financial Statement Presentation and Use of Estimates- The financial statements have been
prepared in accordance with accounting principles generally accepted in the United States of
America and reporting practices applicable to the banking industry. In preparing financial
statements, management is required to make estimates and assumptions that affect the reported
amounts of assets and liabilities, and the disclosure of contingent assets and liabilities as of
the balance sheet date. These estimates also affect the amounts of revenues and expenses reported
during the period. Actual results could differ from the estimated amounts. Reclassifications- Certain prior year amounts have been reclassified to conform to the
current year presentation. Concentrations of Credit Risk- Assets and liabilities that subject the Bank to concentrations
of credit risk consist of interest bearing deposits at other banks, investments, loans, and
deposits. Most of the Banks customers are located within San Diego County and the surrounding
areas. The types of securities the Bank invests in are discussed in Note 2 and the Banks primary
lending products are discussed in Note 3. For the years ended December 31, 2003 and 2002, the Bank
did not have any significant concentrations to any one customer or industry. The Bank obtains what
it believes to be sufficient collateral to secure potential losses. The extent and value of the
collateral varies based upon the details underlying each loan agreement. As of December 31, 2003 and 2002, the Bank had cash deposits at other financial institutions
in excess of FDIC insured limits. However, as the Bank places these deposits with major financial
institutions, management believes the risk of loss to be minimal. Cash and Cash Equivalents- For purposes of the statement of cash flows, cash and cash
equivalents includes cash, balances due from banks, and federal funds sold, that are purchased with
an original maturity date less than ninety days. Certificates of deposit Interest-bearing deposits in banks are purchased with an original
maturity date greater than ninety days, mature within one to five years and are carried at cost. -42-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 1  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Securities The Bank is required to specifically identify its securities as
held-to-maturity, available-for-sale or trading securities. The Bank invested in no
securities that were classified as trading or held-to-maturity during the years ended December
31, 2003 and 2002. Securities available-for-sale consist of securities not classified as trading securities or as
securities held-to-maturity. Securities available-for-sale are recorded at fair value. Fair value
for these investment securities are based on quoted market prices. Unrealized holding gains and
losses, net of tax, on available-for-sale securities are reported as other comprehensive income
(loss) and carried as accumulated comprehensive income (loss) within stockholders equity until
realized. Premiums and discounts on purchased securities are recognized as interest income using the
effective interest method over the term of the securities. Declines in the fair value of
held-to-maturity and available-for-sale securities below cost that are deemed to be other than
temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities
are recorded on the trade date and are determined using the specific identification method. Loans The Bank grants mortgage, commercial, and consumer loans to customers. A substantial
portion of the loan portfolio is secured by real estate throughout San Diego County and the
surrounding areas. The ability of the Banks debtors to honor their contracts is dependent upon the
real estate and general economic conditions in the area. Loans that management has the intent and ability to hold for the foreseeable future, until
maturity or until pay-off are reported at their outstanding unpaid principal balances adjusted for
charge-offs, the allowance for loan losses and any deferred fees or costs on originated loans.
Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain
direct origination costs, are deferred and recognized as an adjustment of the related loan yield
using the effective interest method. The accrual of interest on loans is discontinued at the time a loan becomes ninety-days
delinquent unless the credit is well secured and in process of collection. In some cases, loans can
be placed on nonaccrual or charged-off at an earlier date if collection of principal and interest
is considered doubtful. All interest accrued, but not collected, for loans that are placed on nonaccrual or are
charged-off is reversed against interest income. The interest on these loans is accounted for on
the cash-basis or cost-recovery method, until the loans qualify for return to accrual status. Loans
are returned to accrual status when all the principal and interest amounts contractually due become
current and future payments are reasonably assured. Allowance For Loan Losses- The allowance for loan losses is established as losses are
estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are
charged against the allowance when management believes the collectibility of loan principal becomes
unlikely. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on an ongoing basis by management and is based upon
managements periodic review of the collectibility of the loans in light of historical experience,
the nature and volume of the loan portfolio, adverse situations that may affect a borrowers
ability to repay, changes in the estimated value of any underlying collateral and prevailing
economic conditions. This evaluation is inherently subjective, as it requires estimates that are
susceptible to significant revision as conditions change. -43-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 1  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) A loan is considered impaired when, based on current information and events, it is probable
that the Bank will be unable to collect the scheduled payments of principal and interest when due
according to the contractual terms of the loan agreement. Factors considered by management in
determining impairment include payment status, collateral value, and the probability of collecting
future scheduled principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired. Management
determines the significance of payment delays and payment shortfalls on a case-by-case basis,
taking into consideration all of the circumstances surrounding the loan and the borrower, including
the length of the delay, the reasons for the delay, the borrowers prior payment record, and the
amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a
loan by loan basis for commercial, construction, and consumer term loans by either the present
value of expected future cash flows discounted at the loans effective interest rate, the
obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Premises and Equipment- Equipment, furniture, and fixtures are carried at cost, less
accumulated depreciation. Depreciation is computed using the straight-line method over the
estimated useful lives of the assets, which range from three to five years. Leasehold improvements
are amortized over the shorter of the term of the lease or the estimated useful lives of
improvements. Maintenance and repairs are expensed as incurred while major improvements or
additions are capitalized. Gains and losses on dispositions are included in current operations. Advertising Costs- Advertising costs are expensed in the period incurred. Financial Instruments In the ordinary course of business, the Bank has entered into
off-balance sheet agreements consisting of commitments to extend credit, commercial letters of
credit, and standby letters of credit. Such financial instruments are recorded in the financial
statements when they are funded or related fees are incurred or received. Income Taxes The Bank records its provision for income taxes under the liability method.
Deferred tax assets and liabilities are reflected at currently enacted 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. Deferred taxes result from temporary differences
in the recognition of certain income and expense amounts between the Banks financial statements
and its tax return. The principal items giving rise to these differences include the allowance for
loan losses, unused net operating losses, and organization and start-up costs. Retirement Plan The Banks contributions to the qualifying employee retirement plan are
recorded as compensation cost in the period incurred. Stock Option Plan The Bank has a stock-based employee compensation plan, which is described
more fully in Note 12. The Bank accounts for this plan under the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees,and related
interpretations. No stock-based employee compensation cost is reflected in net income, as all
options granted under the plan have an exercise price equal to the market value of the underlying
common stock on the date of grant. The following table illustrates the effect on net income if the
Bank had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for
Stock-Based Compensation,to stock-based employee compensation. The significant assumptions used
by the Banks management in computing these amounts are disclosed in Note 12. -44-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 1  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) 2003
    
    
    2002Net income (loss)
    
    $
    439,876
    
    
    $
    (728,177
    )Additional compensation for fair value of stock options
    
    
    71,139
    
    
    
    40,648Pro forma net income (loss)
    
    $
    368,737
    
    
    $
    (768,825
    )
 Earnings Per Share- Basic earnings per share represents income available to common
shareholders divided by the weighted-average number of common shares outstanding during the period.
Diluted earnings per share reflect additional common shares that would have been outstanding if
dilutive potential common shares had been issued, as well as any adjustment to income that would
result from the assumed issuance. Potential common shares that may be issued by the Bank relate
solely to outstanding stock options, and are determined using the treasury stock method The following is a reconciliation of basic EPS to diluted EPS for the year ended December 31,
2003: Weighted AverageNet Income
    
    
    Shares Outstanding
    
    
    Per Share AmountBasic EPS:Income available to common shareholders
    
    $
    439,876
    
    
    
    1,037,298
    
    
    $
    0.49Effect of dilutive securities:Stock options
    
    
    
    
    
    
    38,957
    
    
    
    (0.03
    )Diluted EPS:Income available to common shareholders
    
    $
    439,876
    
    
    
    1,079,255
    
    
    $
    0.46
 The following is a reconciliation of basic EPS to diluted EPS for the year ended December
31, 2002: Weighted Average
    
    
    Per ShareNet Loss
    
    
    Shares Outstanding
    
    
    AmountBasic EPS:Loss available to common shareholders
    
    
    ($728,177
    )
    
    
    795,298
    
    
    
    ($0.92
    )Effect of dilutive securities:Stock options
    
    
    
    
    
    
    27,693
    
    
    
    Diluted EPS:Income available to common shareholders
    
    
    ($728,177
    )
    
    
    822,991
    
    
    
    ($0.92
    )
 Comprehensive Income- Accounting principles generally require that recognized revenue,
expenses, gains and losses be included in net income. Certain changes in stockholders equity from
non-owner sources, such as unrealized gains and losses on available-for-sale securities, are
reported with net income as comprehensive income and shown as a separate component of the equity
section on the balance sheet. For the years ended December 31, 2003 and 2002, unrealized holding
gains (losses) on available-for-sale securities were the only items of other comprehensive income. Federal Home Loan Bank and Pacific Coast Bankers Bank Stock-As a member of the Federal Home
Loan Bank (FHLB), the Bank is required to purchase FHLB stock in accordance with its advances,
securities, and deposit agreement. The stock is available-for-sale and may be redeemed at par
value, however only in connection with the Bank surrendering its FHLB membership. The Bank also
invests in the stock of Pacific Coast Bankers Bank (PCBB), in connection with its advance and
correspondent banking arrangement with PCBB. These investments are carried at cost as of December
31, 2003 and 2002. -45-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 1  OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Recently issued accounting standards- In January 2003, the FASB issued Interpretation No.
46®, Consolidation of Variable Interest Entities(VIE). It defined a VIE as a corporation,
partnership, trust, or any other legal structure used for the business purpose that either a) does
not have equity investors with voting rights or b) has equity investors that do not provide
sufficient financial resources for the entity to support its activities. This interpretation will
require a VIE to be consolidated or deconsolidated by a company if that company is subject to a
majority of the risk of loss from the VIEs activities or entitled to receive a majority of the
entitys residual return. The provisions of interpretation No. 46 are required to be applied
immediately to VIEs created after December 15, 2003. The Bank does not have any VIEs and
accordingly the implementation of the Interpretation did not result in an impact on its financial
position or results of operations. In April 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative
Instruments and Hedging Activities. This Statement amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement is effective for contracts entered into or modified after June 30, 2003.
Adoption of the Statement did not result in an impact on the Banks statement of financial position
or results of operations. In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments
with Characteristics of both Liabilities and Equity.This Statement establishes standards for how
an issuer classifies and measures certain financial instruments with characteristics of both
liabilities and equity. It requires that an issuer classify a financial instrument that is within
its scope as a liability (or an asset in some circumstances). Many of those instruments were
previously classified as equity. This Statement is effective for financial instruments entered into
or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003, except for mandatory redeemable financial instruments of
nonpublic entities. Adoption of the Statement did not result in an impact on the Banks statement
of financial position or results of operations. In November 2003, the Emerging Issues Task Force (EITF) researched a consensus that certain
quantitative and qualitative disclosures should be required for debt and marketable equity
securities classified as available-for-sale or held-to-maturity under FASB Statements No. 115 and
124, that are impaired at the balance sheet date but for which an other-than-temporary impairment
has not been recognized. This EITF consensus is effective for fiscal years ending after December
15, 2003. Accordingly, the Bank has adopted this statement as of December 31, 2003 and the result
did not have an impact on the Banks statement of financial position or results of operations. NOTE 2  INVESTMENT SECURITIES, AVAILABLE-FOR-SALE The Banks securities are available-for-sale. The amortized cost of securities and their
approximate fair values as of December 31 are: -46-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 2  INVESTMENT SECURITIES, AVAILABLE-FOR-SALE (Continued) 2003Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    ValueAvailable-for-sale securities:U.S. government agency securities
    
    $
    1,645,672
    
    
    $
    17,806
    
    
    $
    (969
    )
    
    $
    1,662,509Mutual funds
    
    
    915,818
    
    
    
    
    
    
    
    (9,481
    )
    
    
    906,337FHLB stock
    
    
    213,800
    
    
    
    
    
    
    
    
    
    
    
    213,800PCBB stock
    
    
    60,000
    
    
    
    
    
    
    
    
    
    
    
    60,000Total securities
    
    $
    2,835,290
    
    
    $
    17,806
    
    
    $
    (10,450
    )
    
    $
    2,842,646
 2002Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    ValueAvailable-for-sale securities:U.S. government agency securities
    
    $
    580,613
    
    
    $
    13,608
    
    
    $
    
    
    
    $
    594,221PCBB stock
    
    
    60,000
    
    
    
    
    
    
    
    
    
    
    
    60,000Total securities
    
    $
    640,613
    
    
    $
    13,608
    
    
    $
    
    
    
    $
    654,221
 For the year ended December 31, 2003, some of the investment securities have fair values less
than amortized cost and therefore contain unrealized losses. The Bank has evaluated these
securities and has determined that the decline in value is temporary and is related to the change
in market interest rates since purchase. The decline in value is not related to any company or
industry specific event. There are approximately two investment securities with unrealized losses
amounting to $10,450 as of December 31, 2003. The Bank anticipates full recovery of amortized cost
with respect to these securities at maturity or sooner in the event of a more favorable market
interest rate environment. The amortized cost and estimated fair value of the available-for-sale securities at December
31, 2003, by contractual or expected maturity, are shown below. Expected maturities will differ
from contractual maturities because issuers may have the right to call or prepay obligations with
or without call or prepayment penalties. Amortized
    
    
    FairCost
    
    
    ValueDue in one year or less
    
    $
    
    
    
    $
    Due after one year through five years
    
    
    1,285,016
    
    
    
    1,297,302Due after five years through ten years
    
    
    360,656
    
    
    
    365,207No stated maturity date (common stock and mutual funds)
    
    
    1,189,618
    
    
    
    1,180,137Totals
    
    $
    2,835,290
    
    
    $
    2,842,646
 During the year ended December 31, 2003, there were no securities sold. For the year ended
December 31, 2002, proceeds from sales of securities available-for-sale amounted to $999,750. The
realized loss related to the sales in 2002 amounted to $250. The Bank did not have securities pledged to secure public deposits at December 31, 2003 or
2002. At December 31, 2003, the Bank had $1,500,000 in securities pledged as collateral in
accordance with their line of credit agreement with Federal Home Loan Bank. -47-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 3  LOANS The major classifications of loans at December 31 are summarized as follows: 2003
    
    
    2002Real estate
    
    $
    40,283,738
    
    
    $
    26,668,803Commercial
    
    
    17,473,037
    
    
    
    9,260,351Consumer
    
    
    3,069,460
    
    
    
    1,793,426Gross loans
    
    
    60,826,235
    
    
    
    37,722,580Less: deferred loan fees
    
    
    (130,316
    )
    
    
    (48,756
    )Less: allowance for loan losses
    
    
    (760,339
    )
    
    
    (471,750
    )$
    59,935,580
    
    
    $
    37,202,074
 Transactions in the allowance for loan losses are summarized as follows: 2003
    
    
    2002Balance, beginning of year
    
    $
    471,750
    
    
    $
    81,037Provision for loan losses charged to expense
    
    
    288,589
    
    
    
    390,713Loans charged-off
    
    
    
    
    
    
    Recoveries of loans previously charged-off
    
    
    
    
    
    
    Balance, end of year
    
    $
    760,339
    
    
    $
    471,750
 There were no loans past due, not accruing interest or considered impaired as of December 31,
2003 or 2002. -48-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 4  PREMISES AND EQUIPMENT Premises and equipment consisted of the following at December 31: 2003
    
    
    2002Equipment, furniture and fixtures
    
    $
    302,625
    
    
    $
    186,606Leasehold improvements
    
    
    117,095
    
    
    
    117,095419,720
    
    
    
    303,701Less: accumulated depreciation and amortization
    
    
    (176,832
    )
    
    
    (90,550
    )Premises and equipment, net
    
    $
    242,888
    
    
    $
    213,151
 NOTE 5  DEPOSITS At December 31, 2003, the scheduled maturities of time deposits are as follows: Time Deposits
    
    
    Time Deposits< $100,000
    
    
    > $100,0002004
    
    $
    16,935,658
    
    
    $
    11,654,0302005
    
    
    99,000
    
    
    
    200,000Thereafter
    
    
    
    
    
    
    101,208$
    17,034,658
    
    
    $
    11,955,238
 NOTE 6  LINE OF CREDIT The Bank has a continuous revolving line of credit with Federal Home Loan Bank (FHLB)
providing for working capital advances up to $9,308,000. Borrowings are payable on demand and are
fully collateralized by certain Bank assets. Interest on outstanding borrowings accrues at the
rates negotiated at the time of borrowing which range from 1.00% to 1.03%. The Bank had $4,305,000
outstanding against the line as of December 31, 2003. The Bank had no outstanding borrowings
against the line as of December 31, 2002. The Bank has an unsecured line of credit with Pacific Coast Bankers Bank (PCBB) providing for
fed fund purchases up to $2,500,000. Interest on outstanding borrowings accrues at the PCBB daily
fed funds rate. The Bank had no outstanding borrowings against the line as of December 31, 2003 and
2002. -49-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 7  INCOME TAXES The provision for income taxes consisted of the following for the periods ended December 31: 2003
    
    
    2002Current:Federal
    
    $
    
    
    
    $
    State
    
    
    55,800
    
    
    
    80055,800
    
    
    
    800Deferred:Federal
    
    
    73,530
    
    
    
    (155,113
    )State
    
    
    27,970
    
    
    
    (27,373
    )101,500
    
    
    
    (182,486
    )Increase (decrease) in valuation allowance
    
    
    (306,500
    )
    
    
    182,486(Benefit) provision for income taxes
    
    $
    (149,200
    )
    
    $
    800
 The following summarizes the differences between the provision for income taxes for financial
statement purposes and the federal statutory rate of 34% for the years ended December 31, 2003 and
December 31, 2002. 2003
    
    
    2002Tax provision at federal statutory rate
    
    
    34.0
    %
    
    
    (34.0
    )%State franchise tax, net of federal income tax benefit
    
    
    7.1
    
    
    
    (4.3
    )Permanent adjustments
    
    
    1.3
    
    
    
    (1.3
    )Other
    
    
    11.6
    
    
    
    Increase (decrease) in valuation allowance
    
    
    (105.3
    )
    
    
    39.7Tax (benefit) provision
    
    
    (51.3
    )%
    
    
    0.1
    %
 The components of the net deferred tax asset are as follows at December 31: 2003
    
    
    2002Net unrealized gain/loss on securities available-for-sale
    
    $
    
    
    
    $
    Depreciation
    
    
    (65,337
    )
    
    
    2,600Allowance for loan losses
    
    
    312,500
    
    
    
    194,100Certain prepaid assets
    
    
    (48,109
    )
    
    
    (31,800
    )Net benefit for state taxes
    
    
    
    
    
    
    300Net operating loss carryforward
    
    
    255,488
    
    
    
    360,100Organizational expenditures and start-up costs
    
    
    41,086
    
    
    
    56,600Software amortization
    
    
    15,872
    
    
    
    31,100Deferred tax asset
    
    
    511,500
    
    
    
    613,000Less valuation allowance
    
    
    (306,500
    )
    
    
    (613,000
    )Net deferred tax asset
    
    $
    205,000
    
    
    $
    
 -50-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 7  INCOME TAXES (Continued) As of December 31, 2003, the Bank has net operating loss carryforwards of approximately
$908,000 and $722,000 available to reduce future federal and state taxable income, respectively.
The net operating loss carryforwards begin expiring in 2021 and expire through 2022. Utilization of
state net operating loss carryforwards has been suspended until 2004. In 2003, the Bank has recognized net deferred tax assets. Management believes that the Bank will
realize a tax portion of the deferred tax benefit in the normal cause of business. The Bank has
reduced its valuation allowance by $306,500 because, some uncertainty still remains as to the
Banks ability to ultimately use all of its operating loss carryforwards to reduce future taxable
income. -51-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 8  REGULATORY CAPITAL The Bank is subject to various regulatory capital requirements administered by federal banking
agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly
additional discretionary, actions by regulators that, if undertaken, could have a direct material
effect on the Banks financial statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital guidelines that involve
quantitative measures of the Banks assets, liabilities, and certain off-balance-sheet items as
calculated under regulatory accounting practices. The Banks capital amounts and classification are
also subject to qualitative judgments by the regulators about components, risk weightings, and
other factors. Under existing state laws, the Bank is restricted in its ability to pay dividends. Quantitative measures established by regulation to ensure capital adequacy require the Bank to
maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital
to risk-weighted assets and of Tier 1 capital to average assets, all of which are defined in the
regulations. To be categorized as adequately capitalized, the Bank must maintain minimum total risk-based,
Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. Management believes the
institution is well capitalized under the prompt corrective action provisions. The Banks required and actual capital amounts and ratios are as follows: Minimum Capital
    
    
    Minimum To Be WellActual
    
    
    
    
    
    
    Requirement
    
    
    CapitalizedAmount
    
    
    Ratio
    
    
    Amount
    
    
    Ratio
    
    
    Amount
    
    
    RatioDecember 31, 2003:Total Risk-based
Capital to Risk
Weighted Assets
    
    $
    10,400,000
    
    
    
    16.23
    %
    
    $
    5,146,000
    
    
    
    8.00
    %
    
    $
    6,433,000
    
    
    
    10.00
    %Tier 1 Capital to Risk
- Weighted Assets
    
    $
    9,680,000
    
    
    
    15.05
    %
    
    $
    2,573,000
    
    
    
    4.00
    %
    
    $
    3,860,000
    
    
    
    6.00
    %Tier 1 Capital to
Average Assets
    
    $
    9,680,000
    
    
    
    15.27
    %
    
    $
    2,536,000
    
    
    
    4.00
    %
    
    $
    3,171,000
    
    
    
    5.00
    %
 -52-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 8  REGULATORY CAPITAL (Continued) Minimum Capital
    
    
    Minimum To Be WellActual
    
    
    Requirement
    
    
    CapitalizedAmount
    
    
    Ratio
    
    
    Amount
    
    
    Ratio
    
    
    Amount
    
    
    RatioDecember 31, 2002:Total Risk-based
Capital to Risk
Weighted Assets
    
    $
    6,636,000
    
    
    
    16.83
    %
    
    $
    3,155,000
    
    
    
    8.00
    %
    
    $
    3,944,000
    
    
    
    10.00
    %Tier 1 Capital to Risk
- Weighted Assets
    
    $
    6,163,286
    
    
    
    15.63
    %
    
    $
    1,577,000
    
    
    
    4.00
    %
    
    $
    2,366,000
    
    
    
    6.00
    %Tier 1 Capital to
Average Assets
    
    $
    6,163,286
    
    
    
    15.09
    %
    
    $
    1,134,000
    
    
    
    4.00
    %
    
    $
    2,043,000
    
    
    
    5.00
    %
 NOTE 9  LEASE COMMITMENTS The Bank leases its main office space, branch facility, and a loan operations center under
various operating leases expiring through June 2007. Rent expense for the years ended December 31,
2003 and 2002 was approximately $136,000 and $109,000, respectively. Minimum payments required under non-cancelable operating leases with terms in excess of one
year are as follows for years ending December 31: 2004
    
    $
    110,5392005
    
    
    84,7562006
    
    
    58,6682007
    
    
    27,150
 NOTE 10  RELATED PARTY TRANSACTIONS The Bank grants loans to and accepts deposits from directors, major stockholders and officers
as well as entities with which these individuals are associated. Management believes these
transactions were made in the ordinary course of business under substantially the same terms and
conditions, including interest rates and collateral requirements, as comparable transactions with
other customers, and did not involve more than normal credit risk or present other unfavorable
features. Loan balances outstanding from related parties at December 31, 2003 and 2002 were
approximately $1,784,000 and $496,000, respectively. Deposits from related parties at December 31,
2003 and 2003 were $1,189,000 and $1,462,000, respectively. -53-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 11  EMPLOYEE BENEFIT PLAN The Bank has a 401(k) plan, established during fiscal year 2002, whereby substantially all
employees are eligible to participate. Employees may contribute up to 15 percent of their
compensation subject to certain limits based on federal tax laws. The Bank makes matching
contributions equal to 50 percent of the first 6 percent of an employees compensation contributed
to the 401(k) plan. Matching contributions vest to the employee equally over a five-year period.
For the years ended December 31, 2003 and 2002, the Bank contributed $15,650 and $9,050,
respectively, to the 401(k) plan. NOTE 12  STOCK OPTION PLAN The Bank has a stock option plan (hereinafter the Plan), which provides for non-qualified
stock options for non-officer directors and incentive stock options for employees for a maximum of
250,000 shares of authorized common stock. Pursuant to the Plan, the Bank has awarded options at
the initial offering price of $10 per share to directors and employees. The options granted vest
and become exercisable in incremental percentages over five years from the grant date and expire
ten years after grant. The pro forma information disclosed in Note 1 recognizes as compensation the value of stock
options granted using an option valuation model. Management believes that the assumptions used in
the option-pricing model are highly subjective and represent only one estimate of possible value,
as there is no active market for the options granted. The fair value of the options granted in 2003
and 2002 is allocated to pro forma earnings over the vesting period of the options. The following
assumptions were used to estimate the fair value of the stock options granted: 2003
    
    
    2002Vesting period
    
    5 Years
    
    5 YearsRisk-free interest rate
    
    
    3.99
    %
    
    
    4.19
    %Dividend yield rate
    
    
    0
    %
    
    
    0
    %Price volatility
    
    
    25
    %
    
    
    0
    %Weighted average expected life of options
    
    5 Years
    
    5 Years
 -54-




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##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 12  STOCK OPTION PLAN (Continued) Stock option transactions were: 2003
    
    
    2002Weighted
    
    
    
    
    
    
    WeightedGranted
    
    
    Average
    
    
    Granted
    
    
    AverageOptions
    
    
    Exercise
    
    
    Options
    
    
    Exercisefor
    
    
    Price of
    
    
    for
    
    
    Price ofCommon
    
    
    Shares
    
    
    Common
    
    
    SharesStock
    
    
    Under Plan
    
    
    Stock
    
    
    Under PlanBeginning balance
    
    
    140,092
    
    
    $
    10.00
    
    
    
    142,045
    
    
    $
    10.00Granted
    
    
    34,234
    
    
    $
    10.62
    
    
    
    8,250
    
    
    $
    10.62Exercised
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Forfeited
    
    
    (1,000
    )
    
    $
    10.00
    
    
    
    (10,203
    )
    
    $
    10.06Ending balance
    
    
    173,326
    
    
    $
    10.54
    
    
    
    140,092
    
    
    $
    10.00
 The following table summarizes information concerning currently outstanding and exercisable
options: WeightedAverage
    
    
    WeightedRemaining
    
    
    AverageNumber
    
    
    Contractual
    
    
    Exercise
    
    
    NumberOutstanding
    
    
    Life
    
    
    Price
    
    
    ExercisableIncentive stock options
    
    
    69,268
    
    
    8 Years
    
    $
    10.75
    
    
    
    25,638Non-qualified options
    
    
    104,058
    
    
    8 Years
    
    $
    10.45
    
    
    
    33,250173,326
    
    
    8 Years
    
    $
    10.54
    
    
    
    58,888
 NOTE 13  FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK The Bank is a party to financial instruments with off-balance-sheet risk in the normal course
of business to meet the financing needs of its customers and to reduce its own exposure to
fluctuations in interest rates. These financial instruments include commitments to extend credit,
standby letters of credit and financial guarantees. Those instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.
The contract or notional amounts of those instruments reflect the extent of the Banks involvement
in particular classes of financial instruments. The Banks exposure to credit loss in the event of nonperformance by the other party to the
financial instrument for commitments to extend credit, standby letters of credit, and financial
guarantees written is represented by the contractual notional amount of those instruments. The Bank
uses the same credit policies in making commitments and conditional obligations as it does for
on-balance sheet instruments. At December 31, 2003 and 2002, the following financial instruments were outstanding whose
contract amounts represent credit risk: 2003
    
    
    2002Unfunded commitments under lines of credit
    
    $
    17,516,235
    
    
    $
    11,489,424Commercial and standby letters of credit
    
    
    312,681
    
    
    
    5,000
 -55-




---



##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 13  FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK (Continued) Commitments to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally have fixed expiration
dates or other termination clauses and may require payment of a fee. Since many of the commitments
are expected to expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. Standby letters of credit are conditional commitments issued by the Bank to guarantee the
performance of a customer to a third party. Those letters of credit are primarily issued to support
public and private borrowing arrangements. All standby letters of credit issued by the Bank expire
within one year of issuance. The credit risk involved in issuing letters of credit is essentially
the same as that involved in extending loan facilities to customers. The Bank generally holds
collateral supporting those commitments, if deemed necessary. NOTE 14  FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of financial instruments is the amount at which an asset or obligation could be
exchanged in a current transaction between willing parties, other than in a forced liquidation.
Fair value estimates are made at a specific point in time based on the type of financial instrument
and relevant market information. Because no quoted market price exists for a significant portion of the Corporations financial
instruments, the fair values of such financial instruments are derived based on the amount and
timing of future cash flows, estimated discount rates, as well as managements best judgment with
respect to current economic conditions. Many of these estimates involve uncertainties and matters
of significant judgment and cannot be determined with precision. The fair value information provided is indicative of the estimated fair values of those
financial instruments and should not be interpreted as an estimate of the fair market value of the
Corporation taken as a whole. The disclosures do not address the value of recognized and
unrecognized nonfinancial assets and liabilities or the value of future anticipated business. In
addition, 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. The following methods and assumptions were used to estimate the fair values of significant
financial instruments at December 31, 2003 and 2002: Cash and short-term investments- These financial instruments have relatively short maturities
or no defined maturities but are payable on demand, with little or no credit risk. For these
instruments, the carrying amounts represent a reasonable estimate of fair value. Investment securities, available-for-sale- Investment securities, available-for-sale, are
reported at there fair values based on quoted market prices. Loans- Fair values were estimated for performing loans by discounting the future cash flows
using market discount rates that reflect the credit and interest-rate risk inherent in the loans. Deposits- The fair values of demand deposits, savings deposits and money market accounts were
the amounts payable on demand at December 31, 2003 and 2002. The fair value of time deposits was
based on the discounted value of contractual cash flows. The discount rate was estimated utilizing
the rates currently offered for deposits of similar remaining maturities. -56-




---



##### 



DISCOVERY BANK NOTES TO FINANCIAL STATEMENTS NOTE 14  FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) Short-term borrowings- For such short-term borrowings, the carrying amount was considered to
be a reasonable estimate of fair value. Commitments to extend credit and letters of credit- The estimated fair value of financial
instruments with off-balance sheet risk is not significant at December 31, 2003 and 2002. The following table presents the carrying amounts and fair values of financial instruments at
December 31: 2003
    
    
    2002Carrying
    
    
    Fair
    
    
    Carrying
    
    
    FairValue
    
    
    Value
    
    
    Value
    
    
    ValueFINANCIAL ASSETSCash and other short-term Investments
    
    $
    2,110,388
    
    
    $
    2,110,388
    
    
    $
    3,147,160
    
    
    $
    3,147,160Interest-bearing deposits with banks
    
    
    2,533,294
    
    
    
    2,533,294
    
    
    
    498,000
    
    
    
    498,000Investment securities, available-for-sale
    
    
    2,842,646
    
    
    
    2,842,646
    
    
    
    654,221
    
    
    
    654,221Loans
    
    
    59,935,580
    
    
    
    59,905,845
    
    
    
    37,202,074
    
    
    
    37,186,265FINANCIAL LIABILITIESDeposits
    
    $
    54,161,390
    
    
    $
    54,161,390
    
    
    $
    35,395,815
    
    
    $
    35,395,815Short-term borrowings
    
    
    4,305,000
    
    
    
    4,305,000
    
    
    
    
    
    
    
    
 -57-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINED BALANCE SHEETS
MARCH 31, 2005 AND 2004 2005
    
    
    2004ASSETSCash
    
    $
    3,253,702
    
    
    $
    964,596Finance receivables, net
    
    
    18,838,404
    
    
    
    19,107,435Fixed assets, net
    
    
    94,183
    
    
    
    93,399Cash surrender value of life insurance
    
    
    224,252
    
    
    
    178,713Prepaid expenses
    
    
    14,514
    
    
    
    60,697Note receivable, officer
    
    
    12,500
    
    
    
    12,500Other assets
    
    
    56,791
    
    
    
    35,436Deferred income taxes
    
    
    28,100
    
    
    
    28,400$
    22,522,446
    
    
    $
    20,481,176LIABILITIES AND STOCKHOLDERS DEFICITLiabilitiesNote payable, bank
    
    $
    18,287,722
    
    
    $
    15,040,861Accounts payable and accrued expenses
    
    
    180,691
    
    
    
    133,103Notes payable, other
    
    
    824
    
    
    
    730,734Subordinated notes payable
    
    
    3,997,796
    
    
    
    3,501,371Junior subordinated debt
    
    
    
    
    
    
    1,250,00022,467,033
    
    
    
    20,656,069Stockholders equity (deficit)Common stock
    
    
    76,320
    
    
    
    75,000Additional paid-in capital
    
    
    460,604
    
    
    
    441,424Accumulated deficit
    
    
    (481,511
    )
    
    
    (691,317
    )55,413
    
    
    
    (174,893
    )$
    22,522,446
    
    
    $
    20,481,176
 -58-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINED STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT
PERIODS ENDING MARCH 31, 2005 AND 2004 2005
    
    
    2004Interest incomeInterest and fees on finance receivables
    
    $
    1,124,977
    
    
    $
    956,151Less interest paid to participants
    
    
    121,760
    
    
    
    21,5131,003,217
    
    
    
    934,638Interest expense
    
    
    391,012
    
    
    
    296,564Net interest income
    
    
    612,205
    
    
    
    638,074Provision for credit losses
    
    
    
    
    
    
    35Net interest income after provision for credit losses
    
    
    612,205
    
    
    
    638,039Costs and expensesSalaries and employee benefits
    
    
    345,253
    
    
    
    393,013Office and occupancy expense
    
    
    54,362
    
    
    
    74,562Other operating expenses
    
    
    161,772
    
    
    
    246,546561,387
    
    
    
    714,121Income (loss) before income tax expense
    
    
    50,818
    
    
    
    (76,082
    )Income tax expense
    
    
    
    
    
    
    Net income (loss)
    
    
    50,818
    
    
    
    (76,082
    )Accumulated deficit, beginning of period
    
    
    (529,531
    )
    
    
    (612,437
    )Distributions
    
    
    2,798
    
    
    
    2,798Accumulated deficit, end of period
    
    $
    (481,511
    )
    
    $
    (691,317
    )
 -59-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINED STATEMENTS OF CASH FLOWS
PERIODS ENDING MARCH 31, 2005 AND 2004 2005
    
    
    2004Cash flows from operating activitiesNet income (loss)
    
    $
    50,818
    
    
    $
    (76,082
    )Adjustments to reconcile net income (loss) to net cash
used in operating activities:Depreciation
    
    
    6,215
    
    
    
    7,699Provision for credit losses
    
    
    
    
    
    
    35Interest expense added to subordinated notes
    
    
    25,746
    
    
    
    22,843Change in:Accounts payable and accrued expenses
    
    
    (108,050
    )
    
    
    (104,186
    )Net change in other operating assets and liabilities
    
    
    (16,249
    )
    
    
    (7,236
    )Net cash used in operating activities
    
    
    (41,520
    )
    
    
    (156,927
    )Cash flows from investing activitiesPurchase of fixed assets
    
    
    (20,502
    )
    
    
    (8,700
    )Net change in finance receivables, net of participations
    
    
    3,952,099
    
    
    
    (2,080,826
    )Net cash provided by (used in) investing activities
    
    
    3,931,597
    
    
    
    (2,089,526
    )Cash flows from financing activitiesNet borrowings (repayments) on notes payable, bank
    
    
    (1,629,966
    )
    
    
    2,543,726Net borrowings (repayments) on subordinated notes payable
    
    
    411,972
    
    
    
    (44,082
    )Net borrowings (repayments) on notes payable, other
    
    
    (732,582
    )
    
    
    15Borrowings on junior subordinated debt
    
    
    
    
    
    
    2,708Dividends paid
    
    
    (2,798
    )
    
    
    (2,798
    )Net cash provided by (used in) financing activities
    
    
    (1,953,374
    )
    
    
    2,499,569Increase in cash
    
    
    1,936,703
    
    
    
    253,116Beginning cash balance
    
    
    1,316,999
    
    
    
    711,480Ending cash balance
    
    $
    3,253,702
    
    
    $
    964,596
 -60-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING BALANCE SHEET MARCH 31, 2005 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedASSETSCash
    
    $
    3,254,772
    
    
    $
    (1,070
    )
    
    $
    
    
    
    $
    3,253,702Finance receivables, net
    
    
    18,838,404
    
    
    
    1,043,832
    
    
    
    (1,043,832
    )
    
    
    18,838,404Fixed assets, net
    
    
    94,183
    
    
    
    
    
    
    
    
    
    
    
    94,183Cash surrender value of life insurance
    
    
    224,252
    
    
    
    
    
    
    
    
    
    
    
    224,252Prepaid expenses
    
    
    14,514
    
    
    
    
    
    
    
    
    
    
    
    14,514Note receivable, officer
    
    
    
    
    
    
    12,500
    
    
    
    
    
    
    
    12,500Other assets
    
    
    49,693
    
    
    
    7,098
    
    
    
    
    
    
    
    56,791Deferred income taxes
    
    
    28,100
    
    
    
    
    
    
    
    
    
    
    
    28,100Total assets
    
    $
    22,503,918
    
    
    $
    1,062,360
    
    
    $
    (1,043,832
    )
    
    $
    22,522,446LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)LiabilitiesNote payable, bank
    
    $
    18,287,722
    
    
    $
    
    
    
    $
    
    
    
    $
    18,287,722Accounts payable and
accrued expenses
    
    
    178,505
    
    
    
    2,186
    
    
    
    
    
    
    
    180,691Notes payable, other
    
    
    824
    
    
    
    
    
    
    
    
    
    
    
    824Subordinated notes payable
    
    
    4,765,535
    
    
    
    276,093
    
    
    
    (1,043,832
    )
    
    
    3,997,796Total liabilities
    
    
    23,232,586
    
    
    
    278,279
    
    
    
    (1,043,832
    )
    
    
    22,467,033Stockholders equity (deficit)Common stock
    
    
    26,320
    
    
    
    50,000
    
    
    
    
    
    
    
    76,320Additional paid-in capital
    
    
    162,747
    
    
    
    297,857
    
    
    
    
    
    
    
    460,604Retained earnings (deficit)
    
    
    (917,735
    )
    
    
    436,224
    
    
    
    
    
    
    
    (481,511
    )(728,668
    )
    
    
    784,081
    
    
    
    
    
    
    
    55,413$
    22,503,918
    
    
    $
    1,062,360
    
    
    $
    (1,043,832
    )
    
    $
    22,522,446
 -61-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING BALANCE SHEET MARCH 31, 2004 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedASSETSCash
    
    $
    959,985
    
    
    $
    4,611
    
    
    $
    
    
    
    $
    964,596Finance receivables, net
    
    
    19,107,435
    
    
    
    1,031,706
    
    
    
    (1,031,706
    )
    
    
    19,107,435Fixed assets, net
    
    
    92,985
    
    
    
    414
    
    
    
    
    
    
    
    93,399Cash surrender value of life insurance
    
    
    178,713
    
    
    
    
    
    
    
    
    
    
    
    178,713Prepaid expenses
    
    
    60,697
    
    
    
    
    
    
    
    
    
    
    
    60,697Note receivable, officer
    
    
    
    
    
    
    12,500
    
    
    
    
    
    
    
    12,500Other assets
    
    
    29,459
    
    
    
    5,977
    
    
    
    
    
    
    
    35,436Deferred income taxes
    
    
    28,400
    
    
    
    
    
    
    
    
    
    
    
    28,400Total assets
    
    $
    20,457,674
    
    
    $
    1,055,208
    
    
    $
    (1,031,706
    )
    
    $
    20,481,176LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)LiabilitiesNote payable, bank
    
    $
    15,040,861
    
    
    $
    
    
    
    $
    
    
    
    $
    15,040,861Accounts payable and accrued
expenses
    
    
    129,238
    
    
    
    3,865
    
    
    
    
    
    
    
    133,103Notes payable, other
    
    
    730,734
    
    
    
    
    
    
    
    
    
    
    
    730,734Subordinated notes payable
    
    
    4,268,849
    
    
    
    264,228
    
    
    
    (1,031,706
    )
    
    
    3,501,371Junior subordinated debt
    
    
    1,250,000
    
    
    
    
    
    
    
    
    
    
    
    1,250,000Total liabilities
    
    
    21,419,682
    
    
    
    268,093
    
    
    
    (1,031,706
    )
    
    
    20,656,069Stockholders equity (deficit)Common stock
    
    
    25,000
    
    
    
    50,000
    
    
    
    
    
    
    
    75,000Additional paid-in capital
    
    
    143,567
    
    
    
    297,857
    
    
    
    
    
    
    
    441,424Retained earnings (deficit)
    
    
    (1,130,575
    )
    
    
    439,258
    
    
    
    
    
    
    
    (691,317
    )(962,008
    )
    
    
    787,115
    
    
    
    
    
    
    
    (174,893
    )$
    20,457,674
    
    
    $
    1,055,208
    
    
    $
    (1,031,706
    )
    
    $
    20,481,176
 -62-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING STATEMENT OF OPERATIONS AND ACCUMULATED DEFICIT
PERIOD ENDED MARCH 31, 2005 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedInterest incomeInterest and fees on finance receivables
    
    $
    1,124,977
    
    
    $
    24,303
    
    
    $
    (24,303
    )
    
    $
    1,124,977Less interest paid to participants
    
    
    121,760
    
    
    
    
    
    
    
    
    
    
    
    121,7601,003,217
    
    
    
    24,303
    
    
    
    (24,303
    )
    
    
    1,003,217Interest expense
    
    
    408,899
    
    
    
    6,416
    
    
    
    (24,303
    )
    
    
    391,012Net interest income
    
    
    594,318
    
    
    
    17,887
    
    
    
    
    
    
    
    612,205Provision for credit losses
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net interest income after
provision for credit losses
    
    
    594,318
    
    
    
    17,887
    
    
    
    
    
    
    
    612,205Costs and expensesSalaries and employee benefits
    
    
    343,878
    
    
    
    1,375
    
    
    
    
    
    
    
    345,253Office and occupancy expense
    
    
    52,187
    
    
    
    2,175
    
    
    
    
    
    
    
    54,362Other operating expenses
    
    
    151,052
    
    
    
    10,720
    
    
    
    
    
    
    
    161,772547,117
    
    
    
    14,270
    
    
    
    
    
    
    
    561,387Income before income tax expense
    
    
    47,201
    
    
    
    3,617
    
    
    
    
    
    
    
    50,818Income tax expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    
    47,201
    
    
    
    3,617
    
    
    
    
    
    
    
    50,818Retained earnings (deficit),
beginning of period
    
    
    (964,936
    )
    
    
    435,405
    
    
    
    
    
    
    
    (529,531
    )Distributions
    
    
    
    
    
    
    2,798
    
    
    
    
    
    
    
    2,798Returned earnings (deficit),
end of period
    
    $
    (917,735
    )
    
    $
    436,224
    
    
    $
    
    
    
    $
    (481,511
    )
 -63-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING STATEMENT OF OPERATIONS AND ACCUMULATED DEFICIT
PERIOD ENDED MARCH 31, 2004 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedInterest incomeInterest and fees on finance receivables
    
    $
    956,151
    
    
    $
    20,598
    
    
    $
    (20,598
    )
    
    $
    956,151Less interest paid to participants
    
    
    21,513
    
    
    
    
    
    
    
    
    
    
    
    21,513934,638
    
    
    
    20,598
    
    
    
    (20,598
    )
    
    
    934,638Interest expense
    
    
    311,895
    
    
    
    5,267
    
    
    
    (20,598
    )
    
    
    296,564Net interest income
    
    
    622,743
    
    
    
    15,331
    
    
    
    
    
    
    
    638,074Provision for credit losses
    
    
    35
    
    
    
    
    
    
    
    
    
    
    
    35Net interest income after
provision for credit losses
    
    
    622,708
    
    
    
    15,331
    
    
    
    
    
    
    
    638,039Costs and expensesSalaries and employee benefits
    
    
    391,638
    
    
    
    1,375
    
    
    
    
    
    
    
    393,013Office and occupancy expense
    
    
    73,478
    
    
    
    1,084
    
    
    
    
    
    
    
    74,562Other operating expenses
    
    
    240,720
    
    
    
    5,826
    
    
    
    
    
    
    
    246,546705,836
    
    
    
    8,285
    
    
    
    
    
    
    
    714,121Income (loss) before
income tax expense
    
    
    (83,128
    )
    
    
    7,046
    
    
    
    
    
    
    
    (76,082
    )Income tax expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    
    (83,128
    )
    
    
    7,046
    
    
    
    
    
    
    
    (76,082
    )Retained earnings (deficit),
beginning of period
    
    
    (1,047,447
    )
    
    
    435,010
    
    
    
    
    
    
    
    (612,437
    )Distributions
    
    
    
    
    
    
    2,798
    
    
    
    
    
    
    
    2,798Retained earnings (deficit),
end of period
    
    $
    (1,130,575
    )
    
    $
    439,258
    
    
    $
    
    
    
    $
    (691,317
    )
 -64-




---



##### 



INDEPENDENT AUDITORS REPORT To the Board of Directors and Stockholders of
Celtic Capital Corporation and
Columbia Capital Corporation: We have audited the accompanying combined balance sheets of Celtic Capital Corporation and Columbia
Capital Corporation as of December 31, 2004 and 2003, and the related combined statements of
operations, changes in stockholders equity (deficit), and cash flows for the years then ended.
These financial statements are the responsibility of the Companys management. Our responsibility
is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United
States of America. Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the combined financial statements referred to above present fairly, in all material
respects, the combined financial position of Celtic Capital Corporation and Columbia Capital
Corporation as of December 31, 2004 and 2003, and the combined results of operations and cash flows
for the years then ended in conformity with accounting principles generally accepted in the United
States of America. Our audits were conducted for the purpose of forming an opinion on the basic financial statements
taken as a whole. The supplementary schedules of combining information for 2004 and 2003 are
presented for the purpose of additional analysis and are not a required part of the basic financial
statements. Such information has been subjected to the auditing procedures applied in the audits of
the basic financial statements and, in our opinion, is fairly stated on all material respects in
relation to the basic financial statements taken as a whole. /s/ GOOD SWARTZ BROWN & BERNS, LLP Los Angeles, California
March 2, 2005 -65-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINED BALANCE SHEETS
DECEMBER 31, 2004 AND 2003 2004
    
    
    2003ASSETSCash
    
    $
    1,316,999
    
    
    $
    711,480Finance receivables, net
    
    
    22,790,503
    
    
    
    17,026,644Fixed assets, net
    
    
    79,896
    
    
    
    92,398Cash surrender value of life insurance
    
    
    224,252
    
    
    
    178,713Prepaid expenses
    
    
    14,514
    
    
    
    57,595Note receivable, officer
    
    
    12,500
    
    
    
    12,500Other assets
    
    
    40,542
    
    
    
    31,302Deferred income taxes
    
    
    28,100
    
    
    
    28,400$
    24,507,306
    
    
    $
    18,139,032LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)LiabilitiesNote payable, bank
    
    $
    19,917,688
    
    
    $
    12,497,135Accounts payable and accrued expenses
    
    
    288,741
    
    
    
    237,289Notes payable, other
    
    
    733,406
    
    
    
    730,719Subordinated notes payable
    
    
    3,560,078
    
    
    
    3,522,610Junior subordinated debt
    
    
    
    
    
    
    1,247,29224,499,913
    
    
    
    18,235,045Commitments and contingencies (Notes 9 and 13)Stockholders equity (deficit)Common stock (see Note 14)
    
    
    76,320
    
    
    
    75,000Additional paid-in capital
    
    
    460,604
    
    
    
    441,424Accumulated deficit
    
    
    (529,531
    )
    
    
    (612,437
    )7,393
    
    
    
    (96,013
    )$
    24,507,306
    
    
    $
    18,139,032
 See notes to combined financial statements. -66-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2004 AND 2003 2004
    
    
    2003Interest incomeInterest and fees on finance receivables
    
    $
    4,512,152
    
    
    $
    4,777,484Less interest paid to participants
    
    
    289,440
    
    
    
    246,8164,222,712
    
    
    
    4,530,668Interest expense
    
    
    1,374,979
    
    
    
    1,306,901Net interest income
    
    
    2,847,733
    
    
    
    3,223,767Provision for credit losses
    
    
    38,035
    
    
    
    177,500Net interest income after provision for credit losses
    
    
    2,809,698
    
    
    
    3,046,267Costs and expensesSalaries and employee benefits
    
    
    1,683,317
    
    
    
    1,663,042Office and occupancy expense
    
    
    535,584
    
    
    
    703,673Other operating expenses
    
    
    496,399
    
    
    
    541,521Costs of abandoned merger
    
    
    
    
    
    
    122,3392,715,300
    
    
    
    3,030,575Income before income tax expense
    
    
    94,398
    
    
    
    15,692Income tax expense
    
    
    300
    
    
    
    3,150Net income
    
    $
    94,098
    
    
    $
    12,542
 See notes to combined financial statements. -67-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (DEFICIT)
YEARS ENDED DECEMBER 31, 2004 AND 2003 Additional Common
    
    
    paid-in
    
    
    Accumulatedstock
    
    
    capital
    
    
    deficit
    
    
    TotalBalance, January 1, 2003
    
    $
    75,000
    
    
    $
    441,424
    
    
    $
    (613,787
    )
    
    $
    (97,363
    )Net income
    
    
    
    
    
    
    
    
    
    
    12,542
    
    
    
    12,542Dividends
    
    
    
    
    
    
    
    
    
    
    (11,192
    )
    
    
    (11,192
    )Balance, December 31, 2003
    
    
    75,000
    
    
    
    441,424
    
    
    
    (612,437
    )
    
    
    (96,013
    )Net income
    
    
    
    
    
    
    
    
    
    
    94,098
    
    
    
    94,098Issuance of stock (Note 11)
    
    
    1,320
    
    
    
    19,180
    
    
    
    
    
    
    
    20,500Dividends
    
    
    
    
    
    
    
    
    
    
    (11,192
    )
    
    
    (11,192
    )Balance, December 31, 2004
    
    $
    76,320
    
    
    $
    460,604
    
    
    $
    (529,531
    )
    
    $
    7,393
 See notes to combined financial statements. -68-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2004 AND 2003 2004
    
    
    2003Cash flows from operating activitiesNet income
    
    $
    94,098
    
    
    $
    12,542Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation
    
    
    32,658
    
    
    
    41,749Provision for credit losses
    
    
    38,035
    
    
    
    177,500Deferred taxes
    
    
    300
    
    
    
    3,600Amortization of loan discount
    
    
    
    
    
    
    16,248Amortization of loan acquisition cost
    
    
    
    
    
    
    6,769Interest expense added to subordinated notes
    
    
    11,216
    
    
    
    126,094Change in:Accounts payable and accrued expenses
    
    
    51,452
    
    
    
    (100,644
    )Net change in other operating assets and liabilities
    
    
    (11,698
    )
    
    
    66,114Net cash provided by operating activities
    
    
    216,061
    
    
    
    349,972Cash flows from investing activitiesPurchase of fixed assets
    
    
    (20,156
    )
    
    
    (14,667
    )Net change in finance receivables, net of participations
    
    
    (5,801,894
    )
    
    
    2,880,976Net cash provided by (used in) investing activities
    
    
    (5,822,050
    )
    
    
    2,866,309Cash flows from financing activitiesNet borrowings (repayments) on notes payable, bank
    
    
    7,420,553
    
    
    
    (2,093,412
    )Net borrowings (repayments) on subordinated notes payable
    
    
    26,252
    
    
    
    (147,820
    )Net repayments on notes payable, other
    
    
    2,687
    
    
    
    (78,750
    )Repayments on Junior Subordinated debt
    
    
    (1,247,292
    )
    
    
    (1,250,000
    )Dividends paid
    
    
    (11,192
    )
    
    
    (11,192
    )Common stock issued
    
    
    20,500
    
    
    
    Net cash provided by (used in) financing activities
    
    
    6,211,508
    
    
    
    (3,581,174
    )Increase (decrease) in cash
    
    
    605,519
    
    
    
    (364,893
    )Beginning cash balance
    
    
    711,480
    
    
    
    1,076,373Ending cash balance
    
    $
    1,316,999
    
    
    $
    711,480Supplemental disclosures of cash flows informationCash paid during the year for:Interest
    
    $
    1,504,085
    
    
    $
    1,420,936Income taxes
    
    $
    800
    
    
    $
    1,600
 See notes to combined financial statements. -69-




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##### 



Noncash investing and financing activities During the years 2004 and 2003, interest expense was added to the principal balance of
Subordinated Notes and Junior Subordinated debt in the amounts of $11,216 and $126,094,
respectively. -70-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 1. Business activity and summary of significant accounting policies The accounting and reporting policies of Celtic Capital Corporation and Columbia Capital
Corporation conform with accounting principles generally accepted in the United States of America
and general practice within the finance industry. A summary of the significant accounting policies
consistently applied in preparation of the accompanying combined financial statements follows. Business activity and basis of presentation The combined December 31, 2004 and 2003 financial statements include the accounts of Celtic
Capital Corporation and Columbia Capital Corporation (the Group), which are related through common
ownership and management. All intercompany accounts have been eliminated. The Group makes commercial business loans, which are primarily secured by the accounts
receivable and personal property of its borrowers and is licensed to conduct business as a finance
lender and broker. The loans are often secured secondarily by the real property and/or the personal
assets of the owners of borrowing companies. The Groups customer base is located mainly in
California. Concentrations of credit risk Financial instruments that potentially subject the Group to concentrations of credit risk
consist principally of trade accounts receivable and uninsured cash balances. Concentrations of credit risk with respect to loans receivable are limited due to the diverse
customer base and variety of industries in which the Groups customers operate. The Group requires
collateral from its customers and performs ongoing credit evaluations of its customers collateral.
The Group limits its exposure on certain credits by engaging in participations on a pari passu
basis with other lenders. Under current regulations, the bank accounts are insured up to $100,000 by the Federal Deposit
Insurance Corporation (FDIC). At December 31, 2004 and 2003 there were uninsured bank balances in
the amounts of $1,238,081 and $606,664, respectively. Allowance for credit losses The determination of the balance in the allowance for credit losses is based on an analysis of
the loan portfolio and reflects an amount which, in managements judgment, is adequate to provide
for potential losses after giving consideration to the character of the loan portfolio, current
economic conditions, past loss experience and such other factors as warrant current recognition in
estimating credit losses. Property and equipment and depreciation Property and equipment are stated at cost. Depreciation is computed using the accelerated
method based on the estimated useful lives of the assets, generally ranging from five to seven
years. Expenditures for major renewals and improvements that extend the useful lives of property
and equipment are capitalized. Expenditures for repairs and maintenance are charged to expense as
incurred. -71-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 1. Business activity and summary of significant accounting policies  Continued Income and deferred taxes The Group has elected to be taxed under sections of the federal income tax law, which provide
that, in lieu of corporate income taxes, the stockholders separately account for their pro-rata
shares of the Companies items of income, deductions, losses and credits. Therefore, these
statements do not include any provision for corporate federal income taxes. Similar provisions
apply for California income tax reporting; however, California tax law provides for a tax of 3.5%
at the corporate level. Accordingly, the income tax provision consists of the income tax on
California taxable income of the Group. The Group accounts for income taxes in accordance with Statement of Financial Accounting
Standard No. 109, Accounting for Income Taxes which requires the use of the liability method of
accounting for income taxes. Accordingly, deferred tax assets and liabilities are determined based
on the difference between the financial statement and tax bases of assets and liabilities, using
enacted tax rates in effect for the year in which the differences are expected to reverse. Current
income taxes are based on the years income, taxable for state income tax reporting purposes, plus
or minus the change during the period in deferred tax assets and liabilities. Deferred income taxes have been provided primarily as a result of different methods of
reporting credit loss reserves for financial reporting and income tax purposes. Advertising costs Advertising costs are expensed as incurred. Advertising costs charged to operations were
$81,816 and $87,780 for the years ended December 31, 2004 and 2003, respectively. Estimates The preparation of financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. Significant estimates include the allowance for
credit losses. Reclassifications Certain amounts have been reclassified in the 2003 combined financial statements to conform to
the classification used in 2004. Revenue recognition The Group computes its interest charges monthly on the average daily loan balances. In
addition, administrative fees, which are based on the average daily collateral balance, are
recognized when charged. Prepayment charges imposed on loans paid off before their expiration date
are recognized as income at the time of termination, when, in managements opinion, there is
sufficient collateral to assure collectibility; otherwise, income is recognized as collected. The Group has adopted a policy of deferring net loan fee income (fees in excess of
unreimbursed direct costs). Net loan fee income is capitalized and amortized to income over the
term of the related financing. -72-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 2. Finance receivables At December 31, 2004 and 2003, finance receivables consist of the following: 2004
    
    
    2003Accounts receivable loans
    
    $
    23,089,725
    
    
    $
    16,108,740Equipment loans
    
    
    3,242,243
    
    
    
    1,655,939Inventory loans
    
    
    527,559
    
    
    
    361,49626,859,527
    
    
    
    18,126,175Less: Pari passu participations
    
    
    (3,719,024
    )
    
    
    (850,036
    )23,140,503
    
    
    
    17,276,139Less: Allowance for credit losses
    
    
    (305,000
    )
    
    
    (255,000
    )Deferred income
    
    
    (45,000
    )
    
    
    5,505$
    22,790,503
    
    
    $
    17,026,644
 All the accounts receivable loans have been made to commercial customers and are due at
various dates within three years. Experience of the Group has shown that a majority of these
accounts receivable loans are continuously renewed. Term and Inventory loans mature at various
dates between one and two years and are primarily secured by inventory, equipment, and real estate. On December 31, 2004, contractual maturities of finance receivables, net of participations,
were as follows: 2005
    
    
    2006
    
    
    2007
    
    
    TotalAccounts receivable loans
    
    $
    18,240,613
    
    
    $
    2,056,281
    
    
    $
    248,337
    
    
    $
    20,545,231Equipment loans
    
    
    2,051,966
    
    
    
    
    
    
    
    93,854
    
    
    
    2,145,820Inventory loans
    
    
    32,498
    
    
    
    305,119
    
    
    
    111,835
    
    
    
    449,452$
    20,325,077
    
    
    $
    2,361,400
    
    
    $
    454,026
    
    
    $
    23,140,503
 The Group is the lead lender in pari passu participation with other lenders in total gross
loans of $8,698,367 and $2,858,980 at December 31, 2004 and 2003 respectively. -73-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 2. Finance receivables  Continued Management has reviewed the outstanding finance loans and has determined based on client
reported collateral, loan trend analysis and internal audits, that the reserve for credit losses of
$305,000 and $255,000 at December 31, 2004 and 2003, respectively, is adequate. The Group has
developed their internal control procedures to mitigate and detect fraud at the customer level;
however, management is not able to fully assess the risk of fraud or the effect on the Group should
a fraud occur. The reserve for credit losses has not been adjusted to reflect a risk outside the
normal credit loss history of the Group. Changes in the allowance for credit losses for the years ended December 31, 2004 and 2003 were
as follows: Balance as of December 31, 2002
    
    $
    327,500Provision for credit losses
    
    
    177,500Loans charged off
    
    
    (250,000
    )Recoveries
    
    
    Balance as of December 31, 2003
    
    
    255,000Provision for credit losses
    
    
    38,035Loans charged off
    
    
    Recoveries
    
    
    11,965Balance as of December 31, 2004
    
    $
    305,000
 As of December 31, 2004 the Group had outstanding loans to three customers aggregating
$6,011,831 which amounted to 26% of the outstanding loans receivable. Interest income from these
three customers was $553,172 for the year ended December 31, 2004. As of December 31, 2003 the Group had outstanding loans to three customers aggregating
$4,748,545 which amounted to 26% of the outstanding loans receivable. Interest income from these
three customers was $523,587 for the year ended December 31, 2003. -74-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 3. Fixed assets At December 31, 2004 and 2003, fixed assets consist of the following: Asset Life
    
    
    2004
    
    
    2003Office furniture, equipment and computer software
    
    
    5-7
    
    
    $
    369,335
    
    
    $
    386,033Less accumulated depreciation
    
    
    
    
    
    
    (289,439
    )
    
    
    (293,635
    )Fixed assets, net
    
    
    
    
    
    $
    79,896
    
    
    $
    92,398
 In 2004 and 2003, depreciation charged to expense was $32,658 and $41,749, respectively. 4. Note receivable, officer At December 31, 2004 and 2003, the Group has loaned $12,500 and $12,500, respectively, to a
key executive of the Group. Amounts outstanding are non-interest bearing and are due on demand. 5. Note payable, bank The Group has a $25,000,000 revolving line-of-credit with a bank. The line-of-credit matures
in August 2004. The agreement provides for the bank to advance funds up to the maximum line of
credit, provided the total amount of outstanding advances at any one time does not exceed the
Borrowers Borrowing Base (BBB). The BBB is based on a percentage of the Groups good quality
accounts receivable, equipment and inventory, pledged to it by its debtors. The line of credit is
subject to covenants requiring the combined companies to meet certain leverage and net worth ratios
and contains restrictions as to the incurrence of additional debt, capital expenditures and payment
of dividends. Principal is payable on demand, and interest is payable monthly at prime plus 1%. The
outstanding balance under this revolving line of credit was $19,917,688 and $12,497,135 at December
31, 2004 and 2003, respectively. The note payable is secured by pledged loans and other assets of
the Group and is personally guaranteed by officers of the Corporations. During 2004 the Group renegotiated this line-of-credit. The terms remained substantially the
same except the lender approved the use of the line to pay off the remaining balance of
approximately $1,250,000 of their Junior Subordinated Debt (see Note 8) and extended the term of
the lending agreement to April 2007. The revolving line-of-credit agreement contains covenants regarding certain financial
statement amounts, ratios and activities of the Group. At December 31, 2004, the Group was in
compliance with all such covenants. 6. Notes payable, other Notes payable, other, consists of two 30-day demand loans with interest at prime minus 1%, and
9%, respectively per annum. The holders of the notes are also borrowers from the Company. The cash
proceeds from these notes are held as collateral to secure the borrowers indebtedness. -75-




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##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 7. Subordinated notes payable The Group has issued various notes payable (unsecured) which have been subordinated to the
bank referred to in Note 5. Repayment of principal on these notes is subject to liquidity
requirements and lender approval. All are due within one year or on demand. If not redeemed, the
notes automatically roll over for an additional term. Interest is paid either monthly or is added
to the outstanding balance. The notes generally bear interest at prime plus 4 percent per annum. At December 31, 2004 and 2003, subordinated notes payable included related party notes of
$611,073 and $513,546, respectively. Interest paid to related parties during the years ended
December 31, 2004 and 2003 was approximately $55,000 and $36,000, respectively. -76-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 8. Junior subordinated debt and stock warrant In March 1999, Celtic Capital entered into an agreement to borrow up to $5,000,000 from a bank
in the form of Junior Subordinated Debt (Note). This unsecured Note was due and payable January 31,
2004 with no scheduled principal payments, and bears interest, payable monthly at 12% per annum.
During 2003 the Company repaid $1,250,000 of principal on this Note. In connection with this indebtedness, Celtic Capital issued a detachable warrant, which
permits the holder to purchase 35% of Celtic Capitals common stock for $.01 per share. The
exercise of this warrant is not contingent on the payment of the Note. A value of $75,000 has been assigned to this warrant. A corresponding discount for the same
amount has been applied as a reduction of this indebtedness and is being amortized over the term of
the Note and charged to interest expense. Amortization charged to interest expense for the years
ending December 31, 2004 and 2003 was $-0- and $16,248. At December 31, 2003, the purchaser has
rights to purchase 22% of Celtic Capitals Common Stock at $.01 per share. During 2004 this loan was paid off as part of a renegotiation of its revolving line of credit
with its lender (see Note 5). Upon payoff of the loan, warrants held by the lender to purchase 7%
of the Groups common stock were cancelled. The lender now holds warrants allowing them to purchase
up to 15% of Celtic Capitals common stock for $.01 per share. All warrants are exercisable and
expire in March 2009. In conjunction with the proposed sale of substantially all of its assets, the
company is currently in negotiation with the lender to buy back the warrants (Note 15). 9. Financial instruments with off-balance-sheet risk In the normal course of business, the Group is a party to financial instruments in the form of
unfunded loan commitments, that have off-balance-sheet risk. These instruments involve, to varying
degrees, elements of credit risk in excess of the amount recognized in the combined balance sheets.
The Group uses the same credit policies in making commitments and conditional obligations as it
does for on-balance-sheet instruments. Commitments to extend credit are agreements to lend to a
customer as long as there is no violation of any condition established in the contract and there is
sufficient eligible collateral. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. Since many of the commitments are expected to
be drawn upon, the total commitment amount generally represent future cash requirements. The Group
evaluates each customers credit worthiness on a case by case basis. The amount of collateral is
based on managements credit evaluation. Financial instruments whose contract amounts represent off-balance-sheet credit risk are the
unfunded portion of the receivable loans. This unfunded portion of receivable loans, net of
participations, is limited to available collateral. The unfunded portion of receivable loans, net
of participations, was approximately $4,813,000 and $4,350,000 at December 31, 2004 and 2003,
respectively. -77-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 10. Income taxes For the years ended December 31, 2004 and 2003, the Groups provision for income tax expense
consists of the following: 2004
    
    
    2003Current:State
    
    $
    800
    
    
    $
    800Deferred
    
    
    300
    
    
    
    3,600Over accrual of prior year taxes
    
    
    (800
    )
    
    
    (1,250
    )$
    300
    
    
    $
    3,150
 At December 31, 2004 and 2003, the components of the net deferred tax asset consist of the
following: 2004
    
    
    2003Total deferred tax assets
    
    $
    28,100
    
    
    $
    28,400
 Deferred taxes are provided for the tax effects of net operating loss (NOL) carryforwards and
allowance for doubtful accounts. At December 31, 2004, the Group has approximately $482,000 of
state NOL carryforwards expiring in the year 2016. These losses will expire if not used by 2016.
The above described carryforwards are included in the Groups calculation of its deferred tax
asset, however, realization of the deferred tax asset is dependent on the Group generating
sufficient taxable income prior to expiration of the NOL carryforwards. Although realization is not
assured, management believes it is more likely than not that the net deferred tax asset will be
realized. The amount of the net deferred tax asset considered realizable, however, could be reduced
in the near term if estimates of future taxable income during the carryforward period are reduced. 11. Incentive compensation plan and stock compensation plan In 2000, Celtic Capital Corporation entered into an unqualified deferred compensation
agreement with one of its key managers. The agreement entitles the employee to receive deferred
compensation based on years of service and the operation of a performance driven formula as defined
in the agreement. Payments due under this agreement are due over three years. The employees rights
under this agreement vest at a rate of 25% each January first, and are 100% vested by January 1,
2003. However, in the event of the sale of more than 50% of the stock or assets, the employee may
be entitled to a certain portion of the sales proceeds without regard to years of service. As of
December 31, 2003 the Group has incurred no liability related to this agreement, because the
requirements of the performance driven formula were not met. In May 2004 the Group entered into an
agreement with the employee to terminate the Plan and issue shares of common stock. As part of the
agreement to terminate the Plan, Celtic has issued new common shares to equal 5% of the total
outstanding shares of the Celtic. Total value of the shares are $20,500. 12. Retirement plan Celtic Capital Corporation adopted a 401(k) retirement plan effective January 1, 1998. The
plan covers all employees who are at least twenty-one years of age with ninety days of service and
everyone who was employed as of January 1, 1998. The Group may make a discretionary matching
contribution up to a maximum of $7,000 per employee each year. The Group made contributions of
$45,589 and $43,990 for the years ended December 31, 2004 and 2003, respectively. -78-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 13. Commitments and contingencies Commitments The Group occupies premises under leases that expire in August 2009. Monthly rent is
approximately $10,300. Future minimum aggregate base rent commitments under this lease are as
follows: Years ending December 31,2005
    
    $
    124,7852006
    
    
    128,5392007
    
    
    132,3792008
    
    
    136,3372009
    
    
    92,702Total
    
    $
    614,742
 The Group also rents other offices on a month-to-month basis for monthly rents totaling
approximately $2,800. Rental expense charged to operations for the years ended December 31, 2004 and 2003 was
$204,473 and $195,491, respectively. 14. Capitalization The combined capital stock of the Group at December 31, 2004 and 2003 consist of the
following: 2004
    
    
    2003Common stock:Celtic Capital Corporation,
1,000,000 no-par shares authorized,
2,632 and 2,500 shares issued and
outstanding, respectively
    
    $
    26,320
    
    
    $
    25,000Columbia Capital Corporation,
100,000 no-par shares authorized,
1,000 shares issued and outstanding
    
    
    50,000
    
    
    
    50,000$
    76,320
    
    
    $
    75,000Additional paid-in capital:Celtic Capital Corporation
    
    $
    162,747
    
    
    $
    143,567Columbia Capital Corporation
    
    
    297,857
    
    
    
    297,857$
    460,604
    
    
    $
    441,424
 -79-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION NOTES TO COMBINED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003 15. Subsequent event Subsequent to the year end, the company signed an agreement, subject to various conditions, to
sell substantially all of its assets. In conjunction with the sale of the assets, the buyer will
assume the note payable, bank. The purchase price is the net book value of the assets, net of the
note payable, bank, $900,000 in cash, and $800,000 of stock in the buyers company. -80-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING BALANCE SHEET
DECEMBER 31, 2004 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedASSETSCash
    
    $
    1,318,568
    
    
    $
    (1,569
    )
    
    $
    
    
    
    $
    1,316,999Finance receivables, net
    
    
    22,790,503
    
    
    
    1,040,449
    
    
    
    (1,040,449
    )
    
    
    22,790,503Fixed assets, net
    
    
    79,896
    
    
    
    
    
    
    
    
    
    
    
    79,896Cash surrender value of life insurance
    
    
    224,252
    
    
    
    
    
    
    
    
    
    
    
    224,252Prepaid expenses
    
    
    14,514
    
    
    
    
    
    
    
    
    
    
    
    14,514Note receivable, officer
    
    
    
    
    
    
    12,500
    
    
    
    
    
    
    
    12,500Other assets
    
    
    33,818
    
    
    
    6,724
    
    
    
    
    
    
    
    40,542Deferred income taxes
    
    
    28,100
    
    
    
    
    
    
    
    
    
    
    
    28,100Total assets
    
    $
    24,489,651
    
    
    $
    1,058,104
    
    
    $
    (1,040,449
    )
    
    $
    24,507,306LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)LiabilitiesNote payable, bank
    
    $
    19,917,688
    
    
    $
    
    
    
    $
    
    
    
    $
    19,917,688Accounts payable and accrued expenses
    
    
    286,695
    
    
    
    2,046
    
    
    
    
    
    
    
    288,741Notes payable, other
    
    
    733,406
    
    
    
    
    
    
    
    
    
    
    
    733,406Subordinated notes payable
    
    
    4,327,732
    
    
    
    272,795
    
    
    
    (1,040,449
    )
    
    
    3,560,078Junior subordinated debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total liabilities
    
    
    25,265,521
    
    
    
    274,841
    
    
    
    (1,040,449
    )
    
    
    24,499,913Stockholders equity (deficit)Common stock
    
    
    26,320
    
    
    
    50,000
    
    
    
    
    
    
    
    76,320Additional paid-in capital
    
    
    162,747
    
    
    
    297,857
    
    
    
    
    
    
    
    460,604Retained earnings (deficit)
    
    
    (964,937
    )
    
    
    435,406
    
    
    
    
    
    
    
    (529,531
    )(775,870
    )
    
    
    783,263
    
    
    
    
    
    
    
    7,393$
    24,489,651
    
    
    $
    1,058,104
    
    
    $
    (1,040,449
    )
    
    $
    24,507,306
 -81-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING BALANCE SHEET
DECEMBER 31, 2003 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedASSETSCash
    
    $
    713,220
    
    
    $
    (1,740
    )
    
    $
    
    
    
    $
    711,480Finance receivables, net
    
    
    17,026,644
    
    
    
    1,029,039
    
    
    
    (1,029,039
    )
    
    
    17,026,644Fixed assets, net
    
    
    91,984
    
    
    
    414
    
    
    
    
    
    
    
    92,398Cash surrender value of life insurance
    
    
    178,713
    
    
    
    
    
    
    
    
    
    
    
    178,713Prepaid expenses
    
    
    57,595
    
    
    
    
    
    
    
    
    
    
    
    57,595Note receivable, officer
    
    
    
    
    
    
    12,500
    
    
    
    
    
    
    
    12,500Other assets
    
    
    25,325
    
    
    
    5,977
    
    
    
    
    
    
    
    31,302Deferred income taxes
    
    
    28,400
    
    
    
    
    
    
    
    
    
    
    
    28,400Total assets
    
    $
    18,121,881
    
    
    $
    1,046,190
    
    
    $
    (1,029,039
    )
    
    $
    18,139,032LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)LiabilitiesNote payable, bank
    
    $
    12,497,135
    
    
    $
    
    
    
    $
    
    
    
    $
    12,497,135Accounts payable and accrued expenses
    
    
    235,545
    
    
    
    1,744
    
    
    
    
    
    
    
    237,289Notes payable, other
    
    
    730,719
    
    
    
    
    
    
    
    
    
    
    
    730,719Subordinated notes payable
    
    
    4,290,070
    
    
    
    261,579
    
    
    
    (1,029,039
    )
    
    
    3,522,610Junior subordinated debt
    
    
    1,247,292
    
    
    
    
    
    
    
    
    
    
    
    1,247,292Total liabilities
    
    
    19,000,761
    
    
    
    263,323
    
    
    
    (1,029,039
    )
    
    
    18,235,045Stockholders equity (deficit)Common stock
    
    
    25,000
    
    
    
    50,000
    
    
    
    
    
    
    
    75,000Additional paid-in capital
    
    
    143,567
    
    
    
    297,857
    
    
    
    
    
    
    
    441,424Retained earnings (deficit)
    
    
    (1,047,447
    )
    
    
    435,010
    
    
    
    
    
    
    
    (612,437
    )(878,880
    )
    
    
    782,867
    
    
    
    
    
    
    
    (96,013
    )$
    18,121,881
    
    
    $
    1,046,190
    
    
    $
    (1,029,039
    )
    
    $
    18,139,032
 -82-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING STATEMENT OF OPERATIONS
YEAR ENDED DECEMBER 31, 2004 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedInterest incomeInterest and fees on finance receivables
    
    $
    4,512,152
    
    
    $
    85,752
    
    
    $
    (85,752
    )
    
    $
    4,512,152Less interest paid to participants
    
    
    289,440
    
    
    
    
    
    
    
    
    
    
    
    289,4404,222,712
    
    
    
    85,752
    
    
    
    (85,752
    )
    
    
    4,222,712Interest expense
    
    
    1,438,542
    
    
    
    22,189
    
    
    
    (85,752
    )
    
    
    1,374,979Net interest income
    
    
    2,784,170
    
    
    
    63,563
    
    
    
    
    
    
    
    2,847,733Provision for credit losses
    
    
    38,035
    
    
    
    
    
    
    
    
    
    
    
    38,035Net interest income after provision for
credit losses
    
    
    2,746,135
    
    
    
    63,563
    
    
    
    
    
    
    
    2,809,698Costs and expensesSalaries and employee benefits
    
    
    1,681,942
    
    
    
    1,375
    
    
    
    
    
    
    
    1,683,317Office and occupancy expense
    
    
    516,856
    
    
    
    18,728
    
    
    
    
    
    
    
    535,584Other operating expenses
    
    
    464,527
    
    
    
    31,872
    
    
    
    
    
    
    
    496,3992,663,325
    
    
    
    51,975
    
    
    
    
    
    
    
    2,715,300Income before income tax expense
    
    
    82,810
    
    
    
    11,588
    
    
    
    
    
    
    
    94,398Income tax expense
    
    
    300
    
    
    
    
    
    
    
    
    
    
    
    300Net income
    
    $
    82,510
    
    
    $
    11,588
    
    
    $
    
    
    
    $
    94,098
 -83-




---



##### 



CELTIC CAPITAL CORPORATION AND
COLUMBIA CAPITAL CORPORATION COMBINING STATEMENT OF OPERATIONS
YEAR ENDED DECEMBER 31, 2003 Celtic
    
    
    ColumbiaCapital
    
    
    Capital
    
    
    CombiningCorporation
    
    
    Corporation
    
    
    eliminations
    
    
    CombinedInterest incomeInterest and fees on finance receivables
    
    $
    4,777,484
    
    
    $
    83,150
    
    
    $
    (83,150
    )
    
    $
    4,777,484Less interest paid to participants
    
    
    246,816
    
    
    
    
    
    
    
    
    
    
    
    246,8164,530,668
    
    
    
    83,150
    
    
    
    (83,150
    )
    
    
    4,530,668Interest expense
    
    
    1,369,185
    
    
    
    20,866
    
    
    
    (83,150
    )
    
    
    1,306,901Net interest income
    
    
    3,161,483
    
    
    
    62,284
    
    
    
    
    
    
    
    3,223,767Provision for credit losses
    
    
    177,500
    
    
    
    
    
    
    
    
    
    
    
    177,500Net interest income after provision for
credit losses
    
    
    2,983,983
    
    
    
    62,284
    
    
    
    
    
    
    
    3,046,267Costs and expensesSalaries and employee benefits
    
    
    1,661,354
    
    
    
    1,688
    
    
    
    
    
    
    
    1,663,042Office and occupancy expense
    
    
    678,140
    
    
    
    25,533
    
    
    
    
    
    
    
    703,673Other operating expenses
    
    
    503,202
    
    
    
    38,319
    
    
    
    
    
    
    
    541,521Costs of abandoned merger
    
    
    122,339
    
    
    
    
    
    
    
    
    
    
    
    122,3392,965,035
    
    
    
    65,540
    
    
    
    
    
    
    
    3,030,575Income (loss) before income tax expense.
    
    
    18,948
    
    
    
    (3,256
    )
    
    
    
    
    
    
    15,692Income tax expense
    
    
    3,150
    
    
    
    
    
    
    
    
    
    
    
    3,150Net income (loss)
    
    $
    15,798
    
    
    $
    (3,256
    )
    
    $
    
    
    
    $
    12,542
 -84-




---



##### 



PRO FORMA FINANCIAL INFORMATION The following unaudited pro forma financial statements give effect to the proposed offering
and the Celtic acquisition under the purchase accounting method in accordance with accounting
principles generally accepted in the United States. The unaudited pro forma financial statements
are derived from the audited and unaudited financial statements of the Bank and Celtic. The Holding Company has incurred reorganization expenses and expenses as a result of the
proposed acquisition of Celtic. The Holding Company reorganization expenses are reflected in the
Pro Forma Adjustments columns, the anticipated costs relating to the Celtic acquisition are
reflected in the Celtic Capital columns, and the anticipated costs of the offering are reflected
in the Net Offering Proceeds columns of the Pro Forma Balance Sheets that follow. It is also
anticipated that the proposed transactions will provide the Holding Company with certain future
financial benefits that include reduced net operating expenses and opportunities to earn more
revenue. However, these anticipated cost savings and enhanced revenue opportunities are not
reflected in the pro forma financial statements. Therefore, the pro forma financial statements,
while helpful in illustrating the financial characteristics of the combined company under one set
of assumptions, do not attempt to predict or suggest future results. The pro forma financial
statements also do not attempt to show how the Holding Company would actually have performed had
the Bank and Celtic been combined throughout the periods presented. The pro forma financial
statements include all the adjustments, consisting of only normal recurring adjustments, necessary
for a fair statement of results of the historical periods. The following Pro Forma Balance Sheet as of March 31, 2005 presents financial data for the
Holding Company after giving effect to the completion of:  
    
    the raising of $4.8 million through the proposed offering (the minimum necessary to
have sufficient funds to close the Celtic acquisition as of March 31, 2005); and  
    
    the proposed acquisition of Celtic, including the issuance of an additional $832,000
worth of the Holding Companys common stock in connection with the Celtic acquisition: -85-




---



##### 



Pro Forma Balance SheetMarch 31, 2005Discovery
    
    
    Net Offering
    
    
    Celtic
    
    
    Pro Forma
    
    
    Pro FormaBancorp(1)
    
    
    Proceeds(2)
    
    
    Capital(3)
    
    
    Adjustments
    
    
    ConsolidatedASSETSCash and cash equivalents
    
    $
    12,374,934
    
    
    $
    4,824,360
    
    
    $
    3,254,772
    
    
    
    ($7,741,345
    )(4)
    
    $
    12,712,721Investments
    
    
    6,490,816
    
    
    
    
    
    
    
    0
    
    
    
    
    
    
    
    6,490,816Loans
    
    
    93,397,712
    
    
    
    
    
    
    
    18,838,404
    
    
    
    (569,291
    )(5)
    
    
    111,666,825Goodwill
    
    
    
    
    
    
    
    
    
    
    0
    
    
    
    1,732,000
    (6)
    
    
    1,732,000Other assets
    
    
    7,144,978
    
    
    
    
    
    
    
    410,742
    
    
    
    (316,559
    )(7)
    
    
    7,239,161Total Assets
    
    $
    119,408,440
    
    
    $
    4,824,360
    
    
    $
    22,503,918
    
    
    
    ($6,895,195
    )
    
    $
    139,841,523LIABILITIESTotal deposits
    
    $
    99,876,116
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    99,876,116Borrowings
    
    
    8,500,000
    
    
    
    
    
    
    $
    18,287,722
    
    
    
    ($3,216,999
    )(8)
    
    
    23,570,723Accrued interest payable and
other liabilities
    
    
    608,104
    
    
    
    
    
    
    
    4,944,866
    
    
    
    (4,944,866
    )(9)
    
    
    608,104Total Liabilities
    
    
    108,984,220
    
    
    
    
    
    
    
    23,232,588
    
    
    
    (8,161,885
    )
    
    
    124,054,943STOCKHOLDERS EQUITYCommon stock
    
    
    10,754,630
    
    
    $
    4,824,360
    
    
    
    0
    
    
    
    832,000
    (10)
    
    
    16,410,990Accumulated deficit
    
    
    (283,918
    )
    
    
    
    
    
    
    (728,670
    )
    
    
    434,670
    (11)
    
    
    (577,918
    )Accumulated other
comprehensive income
    
    
    (46,492
    )
    
    
    
    
    
    
    0
    
    
    
    
    
    
    
    (46,492
    )Total Stockholders Equity
    
    
    10,424,220
    
    
    
    4,824,360
    
    
    
    (728,670
    )
    
    
    1,266,670
    
    
    
    15,786,580TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    119,408,440
    
    
    $
    4,824,360
    
    
    $
    22,503,918
    
    
    
    ($6,895,195
    )
    
    $
    139,841,523
 
 (1) Represents Discovery Banks March
31, 2005 historic amounts.(2) Represents the minimum net proceeds from
the proposed offering (net of estimated offering expenses, including
commissions, of $464,440) necessary to close the Celtic acquisition as of March
31, 2005. For purposes of this pro forma presentation it is assumed that
330,550 shares will be sold at $16.00 per share for aggregate proceeds of
$5,288,800.(3) Represents the historic assets and
liabilities of Celtic at March 31, 2005.(4) Represents the estimated cash purchase
price for Celtic as of March 31, 2005 (the Net Payment Amount of $3,330,346
plus the cash premium of $900,000), the projected reduction in Celtics
outstanding borrowings being assumed of $3,216,999, less the projected
reduction in interest expense of $11,000 as a result of the projected reduction
of outstanding borrowings, plus the payment of the Holding Companys
estimated organizational costs of $305,000.(5) The loan balance being purchased from
Celtic is net of $164,115 in deferred loan fees and $733,406 in loans not being
purchased.(6) Goodwill represents the difference
between the aggregate purchase price for Celtic and the estimated value of the
assets being acquired net of the liabilities being assumed.(7) Celtics cash surrender value of
life insurance, prepaid expenses, other assets and deferred income taxes,
aggregating $316,559, are not being purchased. Celtics furniture,
fixtures and equipment are being purchased.(8) Represents the projected reduction in
Celtics outstanding borrowings being assumed.(9) Represents Celtics liabilities
not being assumed.(10) Represents the stock consideration to
be paid for the Celtic acquisition, plus the stock consideration to be provided
to Mr. Mark Hafner at the closing of the Celtic acquisition pursuant to his
employment agreement, at an estimated $16.00 per share. No assurance can be
given regarding the valuation of the Holding Companys common stock at
the Celtic closing.(11) Represents the pro forma adjustment to
eliminate Celtics accumulated deficit, which is not being assumed, plus
the projected reduction in interest expense of $11,000 as a result of the
projected reduction in Celtics borrowings, net of the projected Holding
Company organizational costs of $305,000. -86-




---



##### 



The following Pro Forma Balance Sheet as of March 31, 2005 presents financial data for
the Holding Company after giving effect to the completion of:  
    
    the raising of $12.0 million through this offering (the maximum proposed offering);
and  
    
    the proposed acquisition of Celtic, including the issuance of an additional $832,000
worth of the Holding Companys common stock in connection with the Celtic acquisition: Pro Forma Balance SheetMarch 31, 2005Discovery
    
    
    Net Offering
    
    
    Celtic
    
    
    Pro Forma
    
    
    Pro FormaBancorp(1)
    
    
    Proceeds(2)
    
    
    Capital(3)
    
    
    Adjustments
    
    
    ConsolidatedASSETSCash and cash equivalents.
    
    $
    12,374,934
    
    
    $
    11,200,000
    
    
    $
    3,254,772
    
    
    
    ($7,741,345
    )(4)
    
    $
    19,088,361Investments
    
    
    6,490,816
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,490,816Loans
    
    
    93,397,712
    
    
    
    
    
    
    
    18,838,404
    
    
    
    (569,291
    )(5)
    
    
    111,666,825Goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,732,000
    (6)
    
    
    1,732,000Other assets
    
    
    7,144,978
    
    
    
    
    
    
    
    410,742
    
    
    
    (316,559
    )(7)
    
    
    7,239,161Total Assets
    
    $
    119,408,440
    
    
    $
    11,200,000
    
    
    $
    22,503,918
    
    
    
    ($6,895,195
    )
    
    $
    146,217,163LIABILITIESTotal deposits
    
    $
    99,876,116
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    99,876,116Borrowings
    
    
    8,500,000
    
    
    
    
    
    
    $
    18,287,722
    
    
    
    ($3,216,999
    )(8)
    
    
    23,570,723Accrued interest payable
and other liabilities
    
    
    608,104
    
    
    
    
    
    
    
    4,944,866
    
    
    
    (4,944,866
    )(9)
    
    
    608,104Total Liabilities
    
    
    108,984,220
    
    
    
    
    
    
    
    23,232,588
    
    
    
    (8,161,865
    )
    
    
    124,054,943STOCKHOLDERS EQUITYCommon stock
    
    
    10,754,630
    
    
    $
    11,200,000
    
    
    
    
    
    
    
    832,000
    (10)
    
    
    22,786,630Accumulated deficit
    
    
    (283,918
    )
    
    
    
    
    
    
    (728,670
    )
    
    
    434,670
    (11)
    
    
    (577,918
    )Accumulated other
comprehensive income
    
    
    (46,492
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (45,492
    )Total Stockholders Equity
    
    
    10,424,220
    
    
    
    11,200,000
    
    
    
    (728,670
    )
    
    
    1,266,670
    
    
    
    22,162,220TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    119,408,440
    
    
    $
    11,200,000
    
    
    $
    22,503,918
    
    
    
    ($6,895,195
    )
    
    $
    146,217,163
 
 (1) Represents Discovery Banks March
31, 2005 historic amounts.(2) Represents the maximum net proceeds from
the proposed offering (net of estimated offering expenses, including
commissions, of $800,000). For purposes of this pro forma presentation it is
assumed that 750,000 shares will be sold at $16.00 per share for aggregate
proceeds of $12,000,000. No assurance can be given regarding the net proceeds
of this offering.(3) Represents the historic assets and
liabilities of Celtic at March 31, 2005.(4) Represents the estimated cash purchase
price for Celtic as of March 31, 2005 (the Net Payment Amount of $3,330,345
plus the cash premium of $900,000), the projected reduction in Celtics
outstanding borrowings being assumed of $3,216,999, less the projected
reduction in interest expense of $11,000 as a result of the projected reduction
of outstanding borrowings, plus the payment of the Holding Companys
estimated organizational costs of $305,000.(5) The loan balance being purchased from
Celtic is net of $164,115 in deferred loan fees and $733,406 in loans not being
purchased.(6) Goodwill represents the difference
between the aggregate purchase price for Celtic and the estimated value of the
assets being acquired net of the liabilities being assumed.(7) Celtics cash surrender value of
life insurance, prepaid expenses, other assets and deferred income taxes,
aggregating $316,559, are not being purchased. Celtics furniture,
fixtures and equipment are being purchased.(8) Represents the projected reduction in
Celtics outstanding borrowings being assumed.(9) Represents Celtics liabilities
not being assumed.(10) Represents the stock consideration to
be paid for the Celtic acquisition, plus the stock consideration to be provided
to Mr. Mark Hafner at the closing of the Celtic acquisition pursuant to his
employment agreement, at an estimated $16.00 per share. No assurance can be
given regarding the valuation of the Holding Companys common stock at
the Celtic closing.(11) Represents the pro forma adjustment to
eliminate Celtics accumulated deficit, which is not being assumed, plus
the projected reduction in interest expense of $11,000 as a result of the
projected reduction in Celtics borrowings, net of the projected Holding
Company organizational costs of $305,000. -87-




---



##### 



The following Pro Forma Balance Sheet as of December 31, 2004, presents financial data
for the Holding Company after giving effect to the completion of:  
    
    the raising of $6.0 million through this offering (the minimum necessary to have
sufficient funds to close the Celtic acquisition as of December 31, 2004); and  
    
    the proposed acquisition of Celtic, including the issuance of an additional $832,000
worth of the Holding Companys common stock in connection with the Celtic acquisition: Pro Forma Balance SheetDecember 31, 2004Discovery
    
    
    Net Offering
    
    
    Celtic
    
    
    Pro Forma
    
    
    Pro FormaBancorp(1)
    
    
    Proceeds(2)
    
    
    Capital(3)
    
    
    Adjustments
    
    
    ConsolidatedASSETSCash and cash equivalents
    
    $
    6,583,876
    
    
    $
    5,454,598
    
    
    $
    1,318,568
    
    
    $
    (6,376,159
    )(4)
    
    $
    6,980,883Investments
    
    
    5,880,357
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,880,357Loans
    
    
    80,036,566
    
    
    
    
    
    
    
    22,790,503
    
    
    
    (688,406
    )(5)
    
    
    102,138,663Goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,732,000
    (6)
    
    
    1,732,000Other assets
    
    
    6,767,056
    
    
    
    
    
    
    
    380,580
    
    
    
    (300,684
    )(7)
    
    
    6,846,952Total Assets
    
    $
    99,267,855
    
    
    $
    5,454,598
    
    
    $
    24,489,651
    
    
    $
    (5,633,249
    )
    
    $
    123,578,855LIABILITIESTotal deposits
    
    $
    79,679,058
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    79,679,058Borrowings
    
    
    9,000,000
    
    
    
    
    
    
    $
    19,917,688
    
    
    $
    (1,685,286
    )(8)
    
    
    27,232,402Accrued interest payable
and other liabilities
    
    
    234,368
    
    
    
    
    
    
    
    5,347,833
    
    
    
    (5,347,833
    )(9)
    
    
    234,368Total Liabilities
    
    
    88,913,426
    
    
    
    
    
    
    
    25,265,521
    
    
    
    (7,033,119
    )
    
    
    107,145,828STOCKHOLDERS EQUITYCommon stock
    
    
    10,754,630
    
    
    $
    5,454,598
    
    
    
    
    
    
    
    832,000
    (10)
    
    
    17,041,228Accumulated deficit
    
    
    (390,167
    )
    
    
    
    
    
    
    (775,870
    )
    
    
    567,870
    (11)
    
    
    (598,167
    )Accumulated other
comprehensive income
    
    
    (10,034
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,034
    )Total Shareholders Equity
    
    
    10,354,429
    
    
    
    5,454,598
    
    
    
    (775,870
    )
    
    
    1,399,870
    
    
    
    16,433,027TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    99,267,855
    
    
    $
    5,454,598
    
    
    $
    24,489,651
    
    
    $
    (5,633,249
    )
    
    $
    123,578,855
 
 (1) Represents Discovery Banks
December 31, 2004 historic amounts.(2) Represents the minimum net proceeds from
the proposed offering (net of estimated offering expenses, including
commissions, of $497,610) necessary to close the Celtic acquisition as of
December 31, 2004. For purposes of this pro forma presentation it is assumed
that 372,013 shares will be sold at $16.00 per share for aggregate proceeds of
$5,952,208.(3) Represents the historic assets and
liabilities of Celtic at December 31, 2004.(4) Represents the estimated cash purchase
price for Celtic as of December 31, 2004 (the Net Payment Amount of $3,582,873
plus the cash premium of $900,000), the projected reduction in Celtics
outstanding borrowings being assumed of $1,685,286, less the projected
reduction in interest expense of $97,000 as a result of the projected reduction
of outstanding borrowings, plus the payment of the Holding Companys
estimated organizational costs of $305,000.(5) The loan balance being purchased from
Celtic is net of $45,000 in deferred loan fees and $733,406 in loans not being
purchased.(6) Goodwill represents the difference
between the aggregate purchase price for Celtic and the estimated value of the
assets being acquired net of the liabilities being assumed.(7) Celtics cash surrender value of
life insurance, prepaid expenses, other assets and deferred income taxes,
aggregating $300,684, are not being purchased. Celtics furniture,
fixtures and equipment are being purchased.(8) Represents the projected reduction in
Celtics outstanding borrowings being assumed.(9) Represents Celtics liabilities
not being assumed.(10) Represents the stock consideration to
be paid for the Celtic acquisition, plus the stock consideration to be provided
to Mr. Mark Hafner at the closing of the Celtic acquisition pursuant to his
employment agreement, at an estimated $16.00 per share. No assurance can be
given regarding the valuation of the Holding Companys common stock at
the Celtic closing.(11) Represents the pro forma adjustment to
eliminate Celtics accumulated deficit, which is not being assumed, plus
the projected reduction in interest expense of $97,000 as a result of the
projected reduction in Celtics borrowings, net of the projected Holding
Company organizational costs of $305,000. -88-




---



##### 



The following Pro Forma Balance Sheet as of December 31, 2004, presents financial data
for the Holding Company after giving effect to the completion of:  
    
    the raising of $12.0 million through this offering (the maximum proposed offering);
and  
    
    the proposed acquisition of Celtic, including the issuance of an additional $832,000
worth of the Holding Companys common stock in connection with the Celtic acquisition: Pro Forma Balance SheetDecember 31, 2004Discovery
    
    
    Net Offering
    
    
    Celtic
    
    
    Pro Forma
    
    
    Pro FormaBancorp(1)
    
    
    Proceeds(2)
    
    
    Capital(3)
    
    
    Adjustments
    
    
    ConsolidatedASSETSCash and cash equivalents
    
    $
    6,583,876
    
    
    $
    11,200,000
    
    
    $
    1,318,568
    
    
    $
    (6,376,159
    )(4)
    
    $
    12,726,285Investments
    
    
    5,880,357
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,880,357Loans
    
    
    80,036,566
    
    
    
    
    
    
    
    22,790,503
    
    
    
    (688,406
    )(5)
    
    
    102,138,663Goodwill
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,732,000
    (6)
    
    
    1,732,000Other assets
    
    
    6,767,056
    
    
    
    
    
    
    
    380,580
    
    
    
    (300,684
    )(7)
    
    
    6,846,952Total Assets
    
    $
    99,267,855
    
    
    $
    11,200,000
    
    
    $
    24,489,651
    
    
    $
    (5,633,249
    )
    
    $
    129,324,257LIABILITIESTotal deposits
    
    $
    79,679,058
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    79,679,058Borrowings
    
    
    9,000,000
    
    
    
    
    
    
    $
    19,917,688
    
    
    $
    (1,685,286
    )(8)
    
    
    27,320,402Accrued interest payable
and other liabilities
    
    
    234,368
    
    
    
    
    
    
    
    5,347,833
    
    
    
    (5,347,833
    )(9)
    
    
    234,368Total Liabilities
    
    
    88,913,426
    
    
    
    
    
    
    
    25,265,521
    
    
    
    (7,033,119
    )
    
    
    107,145,828STOCKHOLDERS EQUITYCommon stock
    
    
    10,754,630
    
    
    $
    11,200,000
    
    
    
    
    
    
    
    832,000
    (10)
    
    
    22,786,630Accumulated deficit
    
    
    (390,167
    )
    
    
    
    
    
    
    (775,870
    )
    
    
    567,870
    (11)
    
    
    (598,167
    )Accumulated other
comprehensive income
    
    
    (10,034
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,034
    )Total Shareholders Equity
    
    
    10,354,429
    
    
    
    11,200,000
    
    
    
    (775,870
    )
    
    
    1,399,870
    
    
    
    22,178,429TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    99,267,855
    
    
    $
    11,200,000
    
    
    $
    24,489,651
    
    
    $
    (5,633,249
    )
    
    $
    129,324,257
 
 (1) Represents Discovery Banks
December 31, 2004 historic amounts.(2) Represents the maximum net proceeds from
the proposed offering (net of estimated offering expenses, including
commissions, of $800,000). For purposes of this pro forma presentation it is
assumed that 750,000 shares will be sold at $16.00 per share for aggregate
proceeds of $12,000,000. No assurance can be given regarding the net proceeds
of this offering.(3) Represents the historic assets and
liabilities of Celtic at December 31, 2004.(4) Represents the estimated cash purchase
price for Celtic as of December 31, 2004 (the Net Payment Amount of $3,582,873
plus the cash premium of $900,000), the projected reduction in Celtics
outstanding borrowings being assumed of $1,685,286, less the projected
reduction in interest expense of $97,000 as a result of the projected reduction
of outstanding borrowings, plus the payment of the Holding Companys
estimated organizational costs of $305,000.(5) The loan balance being purchased from
Celtic is net of $45,000 in deferred loan fees and $733,406 in loans not being
purchased.(6) Goodwill represents the difference
between the aggregate purchase price for Celtic and the estimated value of the
assets being acquired net of the liabilities being assumed.(7) Celtics cash surrender value of
life insurance, prepaid expenses, other assets and deferred income taxes,
aggregating $300,684, are not being purchased. Celtics furniture,
fixtures and equipment are being purchased.(8) Represents the projected reduction in
Celtics outstanding borrowings being assumed.(9) Represents Celtics liabilities
not being assumed.(10) Represents the stock consideration to
be paid for the Celtic acquisition, plus the stock consideration to be provided
to Mr. Mark Hafner at the closing of the Celtic acquisition pursuant to his
employment agreement, at an estimated $16.00 per share. No assurance can be
given regarding the valuation of the Holding Companys common stock at
the Celtic closing.(11) Represents the pro forma adjustment to
eliminate Celtics accumulated deficit, which is not being assumed, plus
the projected reduction in interest expense of $97,000 as a result of the
projected reduction in Celtics borrowings, net of the projected Holding
Company organizational costs of $305,000. -89-




---



##### 



The following Pro Forma Statement of Operations for the three month period ended March
31, 2005, gives effect to the Celtic acquisition as if it occurred at the beginning of the period.
The Holding Companys organizational costs of $305,000 are included in Other Expenses. Pro Forma Statement of Operations For the Three MonthPeriod Ended March 31, 2005(dollars in thousands, except per share data)Pro FormaDiscovery
    
    
    
    
    
    
    Adjustment(12)
    
    
    CombinedBancorp
    
    
    CelticInterest income
    
    $
    1,647
    
    
    $
    1,003
    
    
    
    
    
    
    $
    2,650Interest expense
    
    
    506
    
    
    
    409
    
    
    
    ($11
    )
    
    
    904Net interest income
    
    
    1,141
    
    
    
    594
    
    
    
    11
    
    
    
    1,746Provision for possible loan losses
    
    
    159
    
    
    
    0
    
    
    
    
    
    
    
    159Net interest income (loss) after
provision for possible loan losses
    
    
    982
    
    
    
    594
    
    
    
    11
    
    
    
    1,587Other income
    
    
    54
    
    
    
    0
    
    
    
    
    
    
    
    54Other expenses
    
    
    893
    
    
    
    547
    
    
    
    305
    
    
    
    1,745Income (loss) before provision for
income taxes
    
    
    143
    
    
    
    47
    
    
    
    (294
    )
    
    
    (104
    )Income taxes (credit)
    
    
    37
    
    
    
    0
    
    
    
    
    
    
    
    37Net income (loss)
    
    $
    106
    
    
    $
    47
    
    
    
    ($294
    )
    
    
    ($141
    )PER SHARE DATA-MINIMUM:(13)Basic
    
    $
    0.10
    
    
    
    
    
    
    
    
    
    
    
    ($0.10
    )Diluted
    
    $
    0.10
    
    
    
    
    
    
    
    
    
    
    
    ($0.09
    )Book value
    
    $
    10.05
    
    
    
    
    
    
    
    
    
    
    $
    11.12Weighted Average Shares Outstanding
    
    
    1,037,298
    
    
    
    
    
    
    
    
    
    
    
    1,419,848Diluted Shares Outstanding
    
    
    1,102,495
    
    
    
    
    
    
    
    
    
    
    
    1,485,045PER SHARE DATA-MAXIMUM:(1)Basic
    
    $
    0.36
    
    
    
    
    
    
    
    
    
    
    
    ($0.08
    )Diluted
    
    $
    0.33
    
    
    
    
    
    
    
    
    
    
    
    ($0.07
    )Book value
    
    $
    9.98
    
    
    
    
    
    
    
    
    
    
    
    ($12.05
    )Weighted Average Shares Outstanding
    
    
    1,037,298
    
    
    
    
    
    
    
    
    
    
    
    1,839,298Diluted Shares Outstanding
    
    
    1,102,495
    
    
    
    
    
    
    
    
    
    
    
    1,904,495
 
 (1) These pro forma adjustments represent
the estimated interest expense savings of $11,000 as a result of the projected
reduction of Celtics outstanding borrowings, at the average annual rate
for the first quarter of 2005, and the Holding Companys estimated
organizational costs of $305,000.(12) This pro forma per share data
assumes this offering was conducted at the beginning of the period, that gross
proceeds of $5.3 million (the minimum necessary to close the Celtic acquisition
as of March 31, 2005) represent the sale of 330,550 shares at $16.00 per share,
that an additional 52,000, shares were issued in connection with the Celtic
acquisition (50,000 shares to Celtic, equal to $800,000 at $16.00 per share,
plus 2,000 shares to Mr. Mark Hafner pursuant to his employment agreement), and
that no earnings were generated from the net proceeds of the proposed offering.
No assurance can be given regarding the net proceeds of the proposed offering.(13) This pro forma per share data
assumes this offering was conducted at the beginning of the period, that gross
proceeds of $12.0 million (the maximum offering) represent the sale of 750,000
shares at $16.00 per share, that an additional 52,000 shares were issued in
connection with the Celtic acquisition (50,000 shares to Celtic, equal to
$800,000 at $16.00 per share, plus 2,000 shares to Mr. Mark Hafner pursuant to
his employment agreement), and that no earnings were generated from the net
proceeds of the proposed offering. No assurance can be given regarding the net
proceeds of the proposed offering. -90-




---



##### 



The following Pro Forma Statement of Operations for the year ended December 31, 2004, gives
effect to the Celtic acquisition as if it had occurred at the beginning of the year. The Holding
Companys organizational costs of $305,000 are included in Other Expenses. Pro Forma Statement of Operations For the Year EndedDecember 31, 2004(dollars in thousands, except per share data)Discovery
    
    
    
    
    
    
    Pro FormaBancorp
    
    
    Celtic
    
    
    Adjustment(2)
    
    
    CombinedInterest income
    
    $
    5,005
    
    
    $
    4,223
    
    
    
    
    
    
    $
    9,228Interest expense
    
    
    1,180
    
    
    
    1,439
    
    
    $
    (97
    )
    
    
    2,522Net interest income
    
    
    3,825
    
    
    
    2,784
    
    
    
    97
    
    
    
    6,706Provision for possible loan losses
    
    
    238
    
    
    
    38
    
    
    
    
    
    
    
    276Net interest income (loss) after
provision for possible loan losses.
    
    
    3,587
    
    
    
    2,746
    
    
    
    97
    
    
    
    6,430Other income
    
    
    152
    
    
    
    0
    
    
    
    
    
    
    
    152Other expenses
    
    
    3,149
    
    
    
    2,663
    
    
    
    305
    
    
    
    6,117Income (loss) before provision for
income taxes
    
    
    590
    
    
    
    83
    
    
    
    (208
    )
    
    
    465Income taxes (credit)
    
    
    (86
    )
    
    
    0
    
    
    
    
    
    
    
    (86
    )Net income (loss)
    
    $
    676
    
    
    $
    83
    
    
    $
    (208
    )
    
    $
    551PER SHARE DATA-MINIMUM:(3)Basic
    
    $
    0.65
    
    
    
    
    
    
    
    
    
    
    $
    0.38Diluted
    
    $
    0.61
    
    
    
    
    
    
    
    
    
    
    $
    0.36Book value
    
    $
    9.98
    
    
    
    
    
    
    
    
    
    
    $
    12.34Weighted Average Shares Outstanding.
    
    
    1,037,298
    
    
    
    
    
    
    
    
    
    
    
    1,461,311Diluted Shares Outstanding
    
    
    1,095,455
    
    
    
    
    
    
    
    
    
    
    
    1,519,468PER SHARE DATA-MAXIMUM:(1)Basic
    
    $
    0.36
    
    
    
    
    
    
    
    
    
    
    $
    0.30Diluted
    
    $
    0.33
    
    
    
    
    
    
    
    
    
    
    $
    0.29Book value
    
    $
    9.98
    
    
    
    
    
    
    
    
    
    
    $
    11.96Weighted Average Shares Outstanding.
    
    
    1,037,298
    
    
    
    
    
    
    
    
    
    
    
    1,839,298Diluted Shares Outstanding
    
    
    1,095,455
    
    
    
    
    
    
    
    
    
    
    
    1,897,455
 
 (1) These pro forma adjustments represent
the estimated interest expense savings of $97,000 as a result of the projected
reduction of Celtics outstanding borrowings, at the average annual rate
for 2004, and the Holding Companys estimated organizational costs of
$305,000.(2) This pro forma per share data assumes
this offering was conducted at the beginning of the period, that gross proceeds
of $6.0 million (the minimum necessary to close the Celtic acquisition as of
December 31, 2004) represent the sale of 372,013 shares at $16.00 per share,
that an additional 52,000 shares were issued in connection with the Celtic
acquisition (50,000 shares to Celtic, equal to $800,000 at $16.00 per share,
plus 2,000 shares to Mr. Mark Hafner pursuant to his employment agreement), and
that no earnings were generated from the net proceeds of the proposed offering.
No assurance can be given regarding the net proceeds of the proposed offering.(3) This pro forma per share data assumes
this offering was conducted at the beginning of the period, that gross proceeds
of $12.0 million (the maximum offering) represent the sale of 750,000 shares at
$16.00 per share, that an additional 52,000 shares were issued in connection
with the Celtic acquisition (50,000 shares to Celtic, equal to
$800,000 at $16.00 per share, plus 2,000 shares to Mr. Mark Hafner pursuant to
his employment agreement), and that no earnings were generated from the net
proceeds of the proposed offering. No assurance can be given regarding the net
proceeds of the proposed offering. -91-




---



##### 



TEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION DISCOVERY BANCORP From incorporation through March 31, 2005, Bancorps only activities have been related to its
organization, which entails the merger of the Bank with Bancorps wholly-owned subsidiary, DB
Merger Company, the Celtic acquisition, and a proposed offering to raise capital. Please refer to
Bancorps Registration Statement on Form S-4 for more information regarding the holding company
reorganization, the Celtic acquisition and the proposed offering. Please also refer to Bancorps
Registration Statement on Form SB-2 regarding the proposed offering. DISCOVERY BANK Introduction The following discussion is designed to provide a better understanding of significant trends
related to the Banks financial condition, results of operations, liquidity, capital resources and
interest rate sensitivity. It is derived from the Banks unaudited consolidated financial
statements and notes thereto for the three months ended March 31, 2005 and March 31, 2004, and the
audited consolidated financial statements for the years ended December 31, 2004, 2003 and 2002, and
the notes thereto included elsewhere herein. Comparisons of the three months ended March 31, 2005
to March 31, 2004, and comparisons of the years ended December 31, 2004 and December 31, 2003 to
the preceding calendar years are primarily impacted by the Banks growth. For purposes of this
section (Managements Discussion and Analysis of Financial Condition and Results of Operations),
the terms we and our mean Discovery Bank on a stand-alone basis. Our continued growth since commencement of operations in September 2001 has been the primary
factor impacting profitability over the periods reflected in this discussion. However, although we
anticipate that our continued growth will further enhance the results of our operations, our future
results of operations could materially differ from those suggested by the forward-looking
statements contained in this Prospectus or the annualized results of our operations for the three
months ended March 31, 2005, depending upon changes to things such as:  
    
    competition within the banking industry;
    
    changes in the interest rate environment;
    
    general economic conditions, nationally, regionally and in our market areas,
including declines in real estate values;
    
    the effects of terrorism and the conduct of the war on terrorism by the United
States and its allies;
    
    the regulatory environment;
    
    business conditions and inflation;
    
    the securities markets;
    
    technology;
    
    regulatory compliance issues;
    
    planned asset growth;
    
    unanticipated loan losses;
    
    unanticipated increases in operating expenses; and
    
    the ability to generate fee and other non-interest income. Critical Accounting Policies Our financial statements, and the notes thereto, have been prepared in accordance with
accounting principles generally accepted in the United States of America. The preparation of our
financial statements requires us to make a number of estimates and assumptions that affect the
reported amounts and disclosures in -92-




---



##### 



the financial statements. On an ongoing basis, we evaluate our estimates and assumptions based
upon historical experience and various other factors and circumstances. We believe that our
estimates and assumptions are reasonable; however, actual results may differ significantly from
these estimates and assumptions which could have a material impact on the carrying value of assets
and liabilities at the balance sheet dates and on our results of operations for the reporting
periods. Our significant accounting policies and practices are described in Note 1 to the audited
financial statements as of December 31, 2004. The accounting policies that involve our significant
estimates and assumptions, which have a material impact on the carrying value of certain assets and
liabilities, are considered critical accounting policies. We have identified our policies for
allowance for loan losses, securities available for sale, and income taxes as critical accounting
policies which are summarized below. Allowance for Loan Losses. We maintain an allowance for loan losses at an amount which we
believe is sufficient to provide adequate protection against losses in the loan portfolio. Our
periodic evaluation of the adequacy of the allowance is based on such factors as our past loan loss
experience, known and inherent risks in the portfolio, adverse situations that have occurred but
are not yet known that may affect the borrowers ability to repay, the estimated value of
underlying collateral, and economic conditions. As we utilize information currently available to
evaluate the allowance for loan losses, the allowance for loan losses is subjective and may be
adjusted in the future depending on changes in economic conditions or other factors. During the time we hold collateral, we are subject to credit risks, including risks of
borrower defaults, bankruptcies and special hazard losses that are not covered by standard hazard
insurance (such as those occurring from earthquakes or floods). Although we have established an
allowance for loan losses that we consider adequate, there can be no assurance that the established
allowance for loan losses will be sufficient to offset losses on loans in the future. Securities Available-for-Sale.Securities available-for-sale are recorded at fair value,
based on quoted market prices. Unrealized holding gains and losses, net of income taxes, in
securities available-for-sale, based on quoted market prices, are reported as other comprehensive
income (loss) in the period incurred. Premiums and discounts on purchased securities are
recognized as an adjustment to yield over the term of the security. Declines in the fair value of
securities available-for-sale below the original purchase price that are deemed to be other than
temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities
available-for-sale are recorded on the trade date and are determined using the specific
identification method. Income Taxes. We record our provision for income taxes under the liability method. Deferred
tax assets and liabilities are reflected at currently enacted 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. Deferred taxes result from temporary differences in the recognition
of certain income and expense amounts between our financial statements and our tax return. The
principal items giving rise to these differences include the allowance for loan losses, unused net
operating losses, and organization and start-up costs. We have recognized a deferred income tax
asset for the year ended December 31, 2004 and the three months ended March 31, 2005, of $292,000
and $262,000, respectively. We evaluate such realizablity based upon anticipated tax income from
forecast models. General We earned $106,000 for the three months ended March 31, 2005 compared to earnings of $64,000
for the three months ended March 31, 2004. Diluted earnings per share were $0.10 for the three
months ended March 31, 2005 compared to $0.06 for the three months ended March 31, 2004. Our
continued growth in interest-earning assets, funded by our growth in deposits, is responsible for
the improved performance from March 2004 before tax earnings. The Banks 2005 first quarter
earnings performance was negatively impacted by strong loan growth, which prompted the need to
increase the quarterly provision for loan losses to $159,000 -93-




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##### 



compared to only $33,000 for the first quarter of 2004. However, we anticipate that this loan
growth will result in greater interest income throughout the remainder of 2005. The Bank opened its first full service branch located in Poway, California, within the market
area of its headquarters, in January of 2004. During 2004, the Poway location had losses of
$190,000. The branch became profitable during the first quarter of 2005. We earned $676,000 for the year ended December 31, 2004 compared to earnings of $440,000 for
the year ended December 31, 2003. Diluted earnings per share for 2004 were $0.61 compared to $0.46
for 2003. Our continued growth in interest-earning assets, funded by our growth in deposits, is
responsible for the improved performance during 2004. For the year ended December 31, 2004,
earnings after tax included a net tax benefit of $86,000. Earnings for the year ended December 31,
2004 were negatively impacted by start up costs for our Poway Branch, which began full service
deposit operation in January 2004. Net operating loss for the Poway branch for the year ending
December 31, 2004 was approximately $190,000. The branch became profitable during the first
quarter of 2005. Effective December 15, 2004, the Bank terminated the lease agreement for the premises at 1145
San Marino Dr. and relocated its main office to 338 Via Vera Cruz, San Marcos. The new premises
consists of a two story commercial building with approximately 28,000 square feet of usable space.
The Bank occupies approximately 13,000 square feet with the remaining space leased to unrelated
parties on a short-term basis. The building was purchased by the Banks subsidiary, San Marcos
Building, LLC for $4,950,000 with escrow closing on July 22, 2004. The subsidiary is wholly-owned
by the Bank. Total assets increased $20.1 million or 20.3%, to $119,408,000 at March 31, 2005, from
$99,268,000 at December 31, 2004. Loans, net of unearned income, increased 16.7% to $94,555,000 at
March 31, 2005, from $81,035,000 at December 31, 2004. The increases in total assets and loans
were primarily funded by a $20.2 million increase in deposits to $99,876,000 at March 31, 2005,
from $79,679,000 at December 31, 2004. Total assets increased $8.3 million or 12.2%, to $76,626,000 at March 31, 2004, from
$68,282,000 at December 31, 2003. Loans, net of unearned income, increased 8.2% to $65,683,000 at
March 31, 2004, from $60,696,000 at December 31, 2003. The increases in total assets and loans
were primarily funded by a $9.5 million increase in deposits to $63,699,000 at March 31, 2004, from
$54,161,000 at December 31, 2003. Total assets increased $31.0 million or 45.4%, to $99,268,000 at December 31, 2004, from
$68,282,000 at December 31, 2003. Loans, net of unearned income, increased 33.5% to $81,035,000 at
December 31, 2004, from $60,696,000 at December 31, 2003. The increases in total assets and loans
were primarily funded by a $25.5 million increase in deposits to $79,679,000 at December 31, 2004,
from $54,161,000 at December 31, 2003. Stockholders equity was $10,424,000 at March 31, 2005, compared to $10,354,000 at December
31, 2004 and $9,757,000 at March 31, 2004, and $9,696,000 at December 31, 2003. The increases
reflect improved profitability during the referenced periods. The following sections present various tables reflecting our financial condition and results
of operations. Average balances reflect daily averages, which were computed using quarterly
averages. All averages and rates shown for the quarterly periods ended March 31 have been
annualized using 365/90 for 2005 and 2004. No assurance can be given that the annualized rates and
results of operations for the three months ended March 31, 2005 are indicative of the rates and
results of operations that may be expected for the year ending December 31, 2005. Distribution of Assets, Liabilities and Stockholders Equity Our earnings depend largely upon the difference between the income we receive from
interest-earning assets, which are principally our loan portfolio and investment securities; and
the interest paid on our interest- -94-




---



##### 



bearing liabilities, which consist of deposits and borrowings. This difference is net
interest income. Net interest margin is net interest income expressed as a percentage of average
total interest-earning assets. Net interest spread is the difference between the rate earned on
interest-earning assets and the rate paid on interest-bearing liabilities. The following tables provide information, for the periods indicated, on the average amounts
outstanding for the major categories of interest-earning assets and interest-bearing liabilities,
the amount of interest earned or paid, the yields and rates on major categories of interest-earning
assets and interest-bearing liabilities, and the net interest margin and net interest spread: Three Months Ended March 31,2005
    
    
    2004Interest
    
    
    Rates
    
    
    
    
    
    
    Interest
    
    
    RatesAverage
    
    
    Income/
    
    
    Earned/
    
    
    Average
    
    
    Income/
    
    
    EarnedBalance
    
    
    Expense
    
    
    Paid(1)
    
    
    Balance
    
    
    Expense
    
    
    / Paid(1)(dollars in thousands)AssetsInvestment securities
    
    $
    2,907
    
    
    $
    26
    
    
    
    3.63
    %
    
    $
    2,303
    
    
    $
    15
    
    
    
    2.64
    %Interest-bearing deposits
    
    
    2,879
    
    
    
    18
    
    
    
    2.54
    %
    
    
    2,535
    
    
    
    17
    
    
    
    2.72
    %Federal funds sold
    
    
    6,191
    
    
    
    40
    
    
    
    2.62
    %
    
    
    1,957
    
    
    
    5
    
    
    
    1.04
    %Loans, net of unearned(2)
    
    
    87,254
    
    
    
    1,564
    (3)
    
    
    7.27
    %
    
    
    62,344
    
    
    
    1,013
    
    
    
    6.59
    %Total Interest-Earning Assets
    
    
    99,231
    
    
    
    1,648
    
    
    
    6.74
    %
    
    
    69,139
    
    
    
    1,050
    
    
    
    6.16
    %Noninterest-earning assets
    
    
    10,095
    
    
    
    
    
    
    
    
    
    
    
    3,198Total Assets
    
    $
    109,326
    
    
    
    
    
    
    
    
    
    
    $
    72,337LiabilitiesTransaction and NOW accounts
    
    $
    6,746
    
    
    
    17
    
    
    
    1.02
    %
    
    $
    5,026
    
    
    
    13
    
    
    
    1.05
    %Savings and money market
    
    
    20,855
    
    
    
    101
    
    
    
    1.96
    %
    
    
    10,754
    
    
    
    41
    
    
    
    1.55
    %Time deposits
    
    
    45,957
    
    
    
    333
    
    
    
    2.94
    %
    
    
    32,878
    
    
    
    175
    
    
    
    2.16
    %Borrowings
    
    
    8,756
    
    
    
    55
    
    
    
    2.55
    %
    
    
    2,851
    
    
    
    8
    
    
    
    1.14
    %Total Interest-Bearing Liabilities
    
    
    82,314
    
    
    
    506
    
    
    
    2.49
    %
    
    
    51,509
    
    
    
    237
    
    
    
    1.87
    %Demand deposits
    
    
    16,140
    
    
    
    
    
    
    
    
    
    
    
    10,583Other liabilities
    
    
    411
    
    
    
    
    
    
    
    
    
    
    
    145Total Liabilities
    
    
    98,865
    
    
    
    
    
    
    
    
    
    
    
    62,237Stockholders Equity
    
    
    10,461
    
    
    
    
    
    
    
    
    
    
    
    10,100Total Liabilities and Stockholders
Equity
    
    $
    109,326
    
    
    
    
    
    
    
    
    
    
    $
    72,337Net interest margin(4)
    
    
    
    
    
    $
    1,142
    
    
    
    4.67
    %
    
    
    
    
    
    $
    813
    
    
    
    4.77
    %Net interest spread(5)
    
    
    
    
    
    
    
    
    
    
    4.25
    %
    
    
    
    
    
    
    
    
    
    
    4.29
    %
 
 (1) The rates have been annualized. No
assurances can be given that the annualized rates and results of
operations for the three months ended
March 31, 2005 are indicative of the rates and results of operations
that may be expected for the year ended December 31, 2005.(2) Average loans are net of unearned loan
fees and allowances for loan losses. Unearned loan fees were $179,000 and
$121,000 at March 31, 2005 and 2004, respectively. Allowances for loan losses
were $1,157,000 and $794,000 at March 31, 2005 and 2004, respectively.(3) Interest income includes loan fees of
$62,980 and $45,726 for the three months ended March 31, 2005 and 2004,
respectively.(4) Net interest margin is the net yield on
average total interest-earning assets.(5) Net interest spread is the absolute
difference between the rate earned on interest-bearing assets and the rate paid
on interest-bearing liabilities. -95-




---



##### 



Year Ended December 31,2004
    
    
    2003Rates
    
    
    
    
    
    
    Interest
    
    
    RatesAverage
    
    
    Interest
    
    
    Earned/
    
    
    Average
    
    
    Income/
    
    
    EarnedBalance
    
    
    Income/ Expense
    
    
    Paid
    
    
    Balance
    
    
    Expense
    
    
    / Paid(dollars in thousands)AssetsInvestment securities
    
    $
    2,356
    
    
    $
    89
    
    
    
    3.78
    %
    
    $
    1,435
    
    
    $
    47
    
    
    
    3.28
    %Interest-bearing deposits
    
    
    2,680
    
    
    
    60
    
    
    
    2.24
    %
    
    
    1,350
    
    
    
    32
    
    
    
    2.37
    %Federal funds sold
    
    
    3,423
    
    
    
    49
    
    
    
    1.43
    %
    
    
    3,795
    
    
    
    40
    
    
    
    1.05
    %Loans, net of unearned(1)
    
    
    71,861
    
    
    
    4,806
    (2)
    
    
    6.69
    %
    
    
    46,265
    
    
    
    3,173
    
    
    
    6.86
    %Total Interest-Earning Assets
    
    
    80,320
    
    
    
    5,004
    
    
    
    6.23
    %
    
    
    52,845
    
    
    
    3,292
    
    
    
    6.23
    %Noninterest-earning assets
    
    
    5,754
    
    
    
    
    
    
    
    
    
    
    
    1,862Total Assets
    
    $
    86,074
    
    
    
    
    
    
    
    
    
    
    $
    54,707LiabilitiesTransaction and NOW accounts
    
    $
    6,930
    
    
    
    75
    
    
    
    1.08
    %
    
    $
    3,465
    
    
    
    49
    
    
    
    1.41
    %Savings and money market
    
    
    14,999
    
    
    
    239
    
    
    
    1.59
    %
    
    
    7,577
    
    
    
    112
    
    
    
    1.48
    %Time deposits
    
    
    35,933
    
    
    
    791
    
    
    
    2.20
    %
    
    
    26,961
    
    
    
    689
    
    
    
    2.56
    %Borrowings
    
    
    4,723
    
    
    
    75
    
    
    
    1.59
    %
    
    
    1,321
    
    
    
    16
    
    
    
    1.21
    %Total Interest-Bearing Liabilities
    
    
    62,585
    
    
    
    1,180
    
    
    
    1.89
    %
    
    
    39,324
    
    
    
    866
    
    
    
    2.20
    %Demand deposits
    
    
    13,171
    
    
    
    
    
    
    
    
    
    
    
    7,119Other liabilities
    
    
    268
    
    
    
    
    
    
    
    
    
    
    
    594Total Liabilities
    
    
    76,024
    
    
    
    
    
    
    
    
    
    
    
    47,037Stockholders Equity
    
    
    10,050
    
    
    
    
    
    
    
    
    
    
    
    7,670Total Liabilities and Stockholders
Equity
    
    $
    86,074
    
    
    
    
    
    
    
    
    
    
    $
    54,707Net interest margin(3)
    
    
    
    
    
    $
    3,824
    
    
    
    4.76
    %
    
    
    
    
    
    $
    2,426
    
    
    
    4.59
    %Net interest spread(4)
    
    
    
    
    
    
    
    
    
    
    4.34
    %
    
    
    
    
    
    
    
    
    
    
    4.03
    %
 Three Months Ended March 31, 2005 and 2004. Average interest-earning assets increased to
$99,231,000 during the three months ended March 31, 2005, from $69,139,000 during the same period
in 2004. The average yield on these assets increased to 6.74% from 6.16%. Average interest-bearing
liabilities, consisting primarily of interest-bearing deposits, increased to $82,314,000 during the
three months ended March 31, 2005, from $51,509,000 during the same period in 2004. The average
rate paid on these liabilities increased to 2.49% for the three months ended March 31, 2005, from
1.87% for the same period in 2004. The increase in the yield on interest-earning assets resulted
from interest rate increases during the first quarter of 2005. The increase in the rate paid on
interest-bearing liabilities was primarily the result of the rate increases experienced within
market. Average noninterest-bearing demand deposit accounts, consisting primarily of business
checking accounts, increased 52.5% for the three months ended March 31, 2005 to $16,140,000 from
$10,583,000 for same period in 2004. Net interest income for the three months ended March 31, 2005, was $1,142,000, which increased
$329,000, or 40.5%, over the same period in the prior year. Our net interest margin decreased 10
basis points to 4.67% for the three months ended March 31, 2005, compared to 4.77% for the same
period in 2004. The decrease in net interest margin was primarily the result of the higher rates
paid on interest-bearing liabilities. 
 (1) Average loans are net of unearned loan
fees and allowances for loan losses. Unearned loan fees were $177,000 and
$130,000 at December 31, 2004 and 2003, respectively. Allowances for loan
losses were $998,000 and $760,000 at December 31, 2004 and 2003, respectively.(2) Interest income includes loan fees of
$234,573 and $221,840 for the years ended December 31, 2004 and 2003,
respectively.(3) Net interest margin is the net yield on
average total interest-earning assets.(4) Net interest spread is the absolute
difference between the rate earned on interest-earning assets and the rate paid
on interest-bearing liabilities. -96-




---



##### 



Years Ended December 31, 2004 and 2003.Average interest-earning assets increased to
$80,320,000 during the year ended December 31, 2004, from $52,845,000 during the same period in
2003. The average yield on these assets remained the same at 6.23%. The prime rate increase during
the last six months of 2004 was offset with the competitive pricing as the source for loan business
decreased with competition from other new independent banks. Average interest-bearing liabilities,
consisting primarily of interest-bearing deposits, increased to $62,585,000 during the year ended
December 31, 2004, from $39,324,000 during the same period in 2003. The average rate paid on these
liabilities decreased to 1.89% for the year ended December 31, 2004, from 2.20% for the same period
in 2003. The decline in the rate paid on interest-bearing liabilities was the result of increased
utilization of the Federal Home Loan Banks Collateralized Mortgage Backed Line of Credit facility.
This borrowing rate is priced approximately 100 basis points below the financial institutions
market rate. In addition, our growth in core deposits offset the need to offer very competitive
rates in the time certificate of deposit market. Average noninterest-bearing demand deposit
accounts, consisting primarily of business checking accounts, increased 85.0% for the year ended
December 31, 2004 to $13,171,000 from $ 7,119,000 for same period in 2003. Net interest income for the year ended December 31, 2004, was $ 3,824,000, which increased
$1,398,000, or 57.6%, over the same period in the prior year. Our net interest margin increased 17
basis points to 4.76% for the year ended December 31, 2004, compared to 4.59% for the same period
in 2003. The increase in net interest margin was the result of an overall lower cost of funding
loan growth. Net Interest Income and Net Yield Net interest income is affected by changes in the level and the mix of interest-earning assets
and interest-bearing liabilities. The changes between periods in these assets and liabilities are
referred to as volume changes. The impact on net interest income from changes in average volume is
measured by multiplying the change in volume between the current period and the prior period by the
prior period rate. Net interest income is also affected by changes in the yields earned on assets and rates paid
on liabilities. These are referred to as rate changes and the impact on net interest income from
these changes is measured by multiplying the change in rate between the current and prior period by
the average volume of the prior period. Changes in rate-volume between periods, which is measured
by the change in rate multiplied by the change in volume, are allocated on a pro rata basis between
the volume and the rate changes. The following table reflects the rate and volume changes for the
periods indicated: -97-




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##### 



For the Three Months EndedMarch 31, 2005 Compared to the
    
    
    For the Year Ended December 31,Three Months Ended March 31,
    
    
    2004 Compared to the Year Ended2004
    
    
    December 31, 2003Increase (Decrease) Due To Change
    
    
    Increase (Decrease) Due ToIn
    
    
    Change InTotal
    
    
    
    
    
    
    
    
    
    
    TotalVolume
    
    
    Rate
    
    
    Change
    
    
    Volume
    
    
    Rate
    
    
    Change(dollars in thousands)Interest-Earning AssetsInvestment securities
    
    $
    4
    
    
    $
    7
    
    
    $
    11
    
    
    $
    30
    
    
    $
    12
    
    
    $
    42Interest-earning deposits.
    
    
    2
    
    
    
    (1
    )
    
    
    1
    
    
    
    32
    
    
    
    (4
    )
    
    
    28Federal funds sold
    
    
    11
    
    
    
    24
    
    
    
    35
    
    
    
    (4
    )
    
    
    13
    
    
    
    9Loans
    
    
    405
    
    
    
    146
    
    
    
    551
    
    
    
    1,755
    
    
    
    (122
    )
    
    
    1,633Total Interest Income
    
    
    422
    
    
    
    176
    
    
    
    598
    
    
    
    1,813
    
    
    
    (101
    )
    
    
    1,712Interest-Bearing LiabilitiesTransaction and Now
Accounts
    
    
    4
    
    
    
    0
    
    
    
    4
    
    
    
    49
    
    
    
    (23
    )
    
    
    26MMDA and Savings
    
    
    39
    
    
    
    21
    
    
    
    60
    
    
    
    110
    
    
    
    17
    
    
    
    127Time Deposits
    
    
    70
    
    
    
    88
    
    
    
    158
    
    
    
    229
    
    
    
    (127
    )
    
    
    102FHLB Advance
    
    
    17
    
    
    
    30
    
    
    
    47
    
    
    
    41
    
    
    
    18
    
    
    
    59Total Interest Expense
    
    
    130
    
    
    
    139
    
    
    
    269
    
    
    
    429
    
    
    
    (115
    )
    
    
    314Net Interest Income
    
    $
    292
    
    
    $
    37
    
    
    $
    329
    
    
    $
    1,384
    
    
    $
    14
    
    
    $
    1,398
 Investments In order to maintain a reserve of readily saleable assets to meet our liquidity and loan
requirements, we purchase United States Treasury and Agency securities and other investments.
Sales of Federal Funds and short-term loans to other banks are regularly utilized. Placement of
funds in certificates of deposit with other financial institutions may be made as alternative
investments pending utilization of funds for loans or other purposes. Except for $1.5 million in
securities pledged as collateral for our line of credit with the Federal Home Loan Bank, none of
our securities are pledged to meet security requirements imposed as a condition to receipt of
public fund deposits or for other purposes. Our policy is to stagger the maturities of our
investments to meet our overall liquidity requirements. At March 31, 2005, March 31, 2004, December 31, 2004 and December 31, 2003, our investment
portfolio consisted of U.S. Agency securities and mutual funds. As of March 31, 2005 and December
31, 2004, we also owned $60,000 in Pacific Coast Bankers Bancorp common stock and $423,000 in
Federal Home Loan Bank stock. All of our securities are classified as available-for-sale.
Available-for-sale securities are bonds, notes, debentures, and certain equity securities that are
not classified as trading securities or as held-to-maturity securities. Unrealized holding gains
and losses, net of tax, on available-for-sale securities are reported as a net amount in a separate
component of capital until realized. Gains and losses on the sale of available-for-sale securities
are determined using the specific identification method. Premiums and discounts are recognized in
interest income using the interest method over the period to maturity. The following tables summarize the amounts and the distributions of our investment securities
as of the dates indicated: -98-




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##### 



March 31,(unaudited)
    
    
    December 31,2005
    
    
    2004
    
    
    2004
    
    
    2003(dollars in thousands)Book ValueObligations of US Govt Agencies
    
    $
    3,171
    
    
    $
    1,600
    
    
    $
    2,716
    
    
    $
    1,646Mutual Funds
    
    
    0
    
    
    
    921
    
    
    
    -0-
    
    
    
    915Other (PCBB & FHLB)
    
    
    483
    
    
    
    277
    
    
    
    483
    
    
    
    274Total
    
    $
    3,654
    
    
    $
    2,798
    
    
    $
    3,199
    
    
    $
    2,835Fair Market ValueObligations of US Govt Agencies
    
    $
    3,125
    
    
    $
    1,614
    
    
    $
    2,706
    
    
    $
    1,663Mutual Funds
    
    
    0
    
    
    
    911
    
    
    
    -0-
    
    
    
    906Total
    
    $
    3,125
    
    
    $
    2,525
    
    
    $
    2,706
    
    
    $
    2,569Other (PCBB & FHLB)
    
    
    483
    
    
    
    277
    
    
    
    483
    
    
    
    274Total
    
    $
    3,608
    
    
    $
    2,802
    
    
    $
    3,189
    
    
    $
    2,843
 Management has reviewed the fair market value of our U.S. Government Agencies investments and
believes that the impairments are temporary. The following table summarizes our U.S. Government Agencies securities, showing book value
(stated at cost, adjusted for amortization of premiums and accretion of discounts), market value
and their weighted average yield at March 31, 2005 (unaudited). Our Pacific Coast Bankers
Bancshares and Federal Home Loan Bank stock have no stated maturity. Five YearsOne Year
    
    
    One Year Through
    
    
    Through Tenor Less
    
    
    Five Years
    
    
    Years
    
    
    Over Ten Years
    
    
    TotalAmount
    
    
    Yield
    
    
    Amount
    
    
    Yield
    
    
    Amount
    
    
    Yield
    
    
    Amount
    
    
    Yield
    
    
    Amount
    
    
    Yield(dollars in thousands)Available-for-SaleU.S. Government
Agencies
    
    $
    250
    
    
    
    4.15
    %
    
    $
    2,290
    
    
    
    3.36
    %
    
    $
    0
    
    
    
    0.00
    %
    
    $
    631
    
    
    
    4.08
    %
    
    $
    3,171
    
    
    
    3.57
    %Total Market Value
    
    $
    250
    
    
    
    
    
    
    $
    2,262
    
    
    
    
    
    
    $
    0
    
    
    
    
    
    
    $
    613
    
    
    
    
    
    
    $
    3,125
 -99-




---



##### 



Loans Loan Categories.The following table sets forth the components of total net loans outstanding
in each category at the dates indicated: March 31,(unaudited)2005
    
    
    2004Percent of
    
    
    
    
    
    
    Percent ofAmount
    
    
    Total
    
    
    Amount
    
    
    Total(dollars in thousands)Loan CategoryReal estate loans:Construction loans
    
    $
    14,298
    
    
    
    15
    %
    
    $
    10,548
    
    
    
    16
    %Real estate 1st trust deeds
    
    
    40,425
    
    
    
    43
    
    
    
    23,827
    
    
    
    36Other real estate mortgage.
    
    
    3,820
    
    
    
    4
    
    
    
    3,156
    
    
    
    5Total real estate
    
    
    58,543
    
    
    
    62
    
    
    
    37,531
    
    
    
    57Commercial secured loans
    
    
    28,506
    
    
    
    30
    
    
    
    23,024
    
    
    
    35Commercial unsecured loans
    
    
    1,598
    
    
    
    2
    
    
    
    190
    
    
    
    0Consumer and other
    
    
    6,086
    
    
    
    6
    
    
    
    5,058
    
    
    
    8Total Loans
    
    
    94,733
    
    
    
    100
    %
    
    
    65,803
    
    
    
    100
    %Less deferred loan income
    
    
    (178
    )
    
    
    
    
    
    
    (120
    )Less allowance for loan losses
    
    
    (1,157
    )
    
    
    
    
    
    
    (794
    )Net Loans
    
    $
    93,398
    
    
    
    
    
    
    $
    64,889
 December 31,2004
    
    
    2003Percent of
    
    
    
    
    
    
    Percent ofAmount
    
    
    Total
    
    
    Amount
    
    
    Total(dollars in thousands)Loan CategoryReal estate loans:Construction loans
    
    $
    10,420
    
    
    
    13
    %
    
    $
    12,444
    
    
    
    20
    %Real estate 1st trust deeds
    
    
    36,716
    
    
    
    45
    
    
    
    26,268
    
    
    
    43Other real estate mortgage.
    
    
    2,528
    
    
    
    3
    
    
    
    1,572
    
    
    
    3Total real estate
    
    
    49,664
    
    
    
    61
    
    
    
    40,284
    
    
    
    66Commercial secured loans
    
    
    24,855
    
    
    
    31
    
    
    
    16,725
    
    
    
    28Commercial unsecured loans
    
    
    1,147
    
    
    
    1
    
    
    
    748
    
    
    
    1Consumer and other
    
    
    5,546
    
    
    
    7
    
    
    
    3,069
    
    
    
    5Total Loans
    
    
    81,212
    
    
    
    100
    %
    
    
    60,826
    
    
    
    100
    %Less deferred loan income
    
    
    (177
    )
    
    
    
    
    
    
    (130
    )Less allowance for loan losses
    
    
    (998
    )
    
    
    
    
    
    
    (760
    )Net Loans
    
    $
    80,037
    
    
    
    
    
    
    $
    59,936
 We provide a variety of credit products to meet the needs of borrowers in our service area.
We offer both secured and unsecured loans for working capital, equipment acquisition, expansion,
purchase or improvement of real property, as well as seasonal loans and lines of credit. We
maintain a portfolio of interim construction loans. Other real estate loans primarily consist of
commercial loans secured by real estate collateral and real estate loans with maturities
restricted to ten years. Commercial loans are made available to business and professional
customers. Consumer loans are offered for a variety of personal, family household needs, including
automobiles, home equity loans and unsecured revolving lines of credit. -100-




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##### 



Our loan portfolio has consistently increased since we commenced operations in September 2001.
Loan growth is the result of increased lending in our immediate market area and the opening of an
additional banking office in Poway in 2004, which services the nearby communities of Poway, Carmel
Mountain, Rancho Bernardo, Rancho Penesquitos, Ramona and Scripps Ranch. In addition, our
increasing lending limits that result from the growth of our capital allows us to make larger
loans. The size of a loan that a bank can make is limited by regulation to a percentage of the
institutions regulatory capital. Commercial loans are made for the purpose of providing working capital, financing the purchase
of equipment or for other business purposes. Such loans include loans with maturities ranging from
thirty days to one year and term loans, which are loans with maturities normally ranging from one
to five years. Commercial loans may be unsecured or secured, including real estate collateral as
well as special purpose or rapidly depreciating assets, such as equipment, inventory, receivables,
junior liens on property or personal guarantees which may not provide an adequate source of
repayment in the event of default. These loans may also have partial guarantees from the Small
Business Administration. A growing portion of our commercial loans are asset-based loans, which
are loans secured by current assets, such as receivables or inventory, or fixed assets, such as
equipment. These loans are used for working capital, equipment purchases, seasonal cash shortages,
and a variety of other purposes, and are structured on either a revolving or term basis. Commercial loans secured by real estate are generally greater in amount, more difficult to
evaluate and monitor, and are often dependent on the successful operation and management of the
properties. Repayment of such loans may be affected by adverse conditions in the real estate
market or the economy. Poor location, special use characteristics and overall attractiveness of
the properties may impair the value of properties in the event of foreclosure. Commercial loans are generally more dependent on the borrowers continuing financial strength
and management ability. The borrowers cash flow and ability to service the debt from earnings is
the primary source of repayment rather than the liquidation of any pledged collateral. Commercial
loans are generally for shorter terms and are often subject to annual review and generally require
more administrative and management attention. We make SBA guaranteed loans. Although the guaranteed portion of the SBA loans may be sold in
the secondary market, to date we have retained these loans in our portfolio. Our SBA loans are
categorized as commercial or real estate depending on the underlying collateral. We maintain a portfolio of real estate construction loans, consisting of single-family homes
and commercial construction loans. At March 31, 2005 and December 31, 2004, real estate
construction loans comprised approximately 15% and 13%, respectively, of our loan portfolio. Our
real estate construction loans are primarily interim loans made to finance the construction of
commercial and single family residential property. These loans are typically short term.
Construction lending is generally considered to involve a higher degree of risk than permanent
mortgage lending because of the inherent difficulty in estimating both a propertys value at
completion of the project and the cost of the project. If the estimate of construction cost proves
to be inaccurate, we may be required to advance funds beyond the amount originally committed to
permit completion of the project. If the estimate of value upon completion proves to be inaccurate,
we may be confronted with a project the value of which is insufficient to assure full repayment.
Disagreements between borrowers and builders and the failure of builders to pay subcontractors may
also jeopardize projects. Loans to builders to construct projects for which no purchaser has been
identified carry additional risk because the payoff for the loan may be dependent on the
contractors ability to sell the property prior to the due date of the loan. We address these
risks by adhering to strict underwriting policies, disbursement procedures and monitoring
practices. Our real estate 1st trust deed loans consist primarily of loans made based on the
borrowers cash flow and which are secured by deeds of trust on commercial and residential property
to provide another source of repayment in the event of default. At March 31, 2005 and December 31,
2004, 1st trust deed secured loans comprised approximately 43% and 45%, respectively, of
our loan portfolio. -101-




---



##### 



Other real estate mortgage loans consist of loans made based primarily on the borrowers cash
flow and which are secured by junior liens as secondary sources of repayments. Maturities on these
loans are generally restricted to ten years (on an amortization ranging from ten to twenty-five
years with a balloon payment due at maturity). Any loans extended for greater than five years have
re-pricing provisions that adjust the interest rate to market rates at times prior to maturity. Consumer loans, as well as home equity lines of credit, are made for the purpose of financing
automobiles, various types of consumer goods and other personal purposes. Consumer loans generally
provide for the monthly payment of principal and interest. Consumer loans are often unsecured or
secured by rapidly depreciating assets, such as automobiles. In such cases, any repossessed
collateral for a defaulted consumer loan may not provide an adequate source of repayment of the
outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.
The remaining deficiency often does not warrant further substantial collection efforts against the
borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are
dependent on the borrowers continuing financial stability, and thus are more likely to be
adversely affected by job loss, divorce, illness or personal bankruptcy. Also, the application of
various federal and state laws, including federal and state bankruptcy and insolvency laws, may
limit the amount which can be recovered on such loans. We do not have any concentrations in our loan portfolio by industry or group of industries,
except for the level of loans that are secured by real estate as presented in the table above. We
have not made loans to any foreign entities. In addition, we have not made any loans to finance
leveraged buyouts or for highly leveraged transactions. Loan Origination and Underwriting.Our primary lending emphasis is in construction,
commercial real estate and business loans, including SBA loans. Major credit risk factors for all
categories of loans include: changes in national and local economic conditions; the experience,
ability and depth of our lending staff; changes in the quality of our internal and external loan
review systems; and the impact of certain external factors such as competition, legal and
regulatory changes. For construction and other real estate related loans, additional major risk
factors include: changes in the valuation of real property; increases in commercial, industrial and
retail vacancy rates; market absorption levels; excess market supply; and rising interest rates.
To address these credit risks, all loan requests require preparation of a credit commitment report
that details the purpose of the loan, terms, repayment source, collateral, credit rating of the
borrower and a general description of the borrowers background and/or business. The loan request
is then subjected to various levels of review to assure that larger loans are reviewed by more
experienced lenders and/or the Banks loan committee. The Banks loan policy establishes criteria
for various types of loans, such as loan to collateral value ratios or loan to debt ratios.
Further, the Bank utilizes outside loan reviewers to review and assess the loans made on an ongoing
basis. Branch officers are assigned lending limits commensurate with their experience and skill and
are capped at $5,000 for unsecured loans and $25,000 for secured loans. Loan requests exceeding
branch officer limits are referred to Loan Administration for underwriting, review and approval.
Lending limits for Loan Administration lenders are capped at $50,000 for unsecured and secured
loans. The President/Chief Executive Officer and the Chief Credit Officer have combined lending
limits when acting jointly of $500,000 for secured and $150,000 for unsecured loans. All requests
exceeding the authority of the President/Chief Executive Officer and the Chief Credit Officer
combined are submitted to the Board of Directors Loan Committee for approval. Additionally, all
new loans, regardless of amount, are reviewed by the Loan Committee monthly and all new loans of
$50,000 or more or relationships that aggregate $50,000 or more are reported to the Board monthly.
All processing, boarding and servicing of loans are performed by Loan Administration regardless of
loan amount. Construction loans for small tract projects or non-residential properties generally require a
minimum of 20% equity contribution by the borrower and a maximum advance of 75% of current
appraisal. Loan terms can range from 12 to 18 months depending on the nature of the project. We
require a first lien position on the property to be constructed and often take a junior lien on
other real estate property as well. Land draws are -102-




---



##### 



generally limited to 50% of cost. Pricing is generally in the range of Wall Street Journal Prime plus 1.5% to
2.5%, loan fees of .5% to 1% and a documentation fee of $250 to $500. Commercial real estate loans are generally underwritten at a maximum loan to appraised value
of 75%; however, we will often advance up to 90% of the value when using the SBA 504 or 7a loan
guarantee programs as part of the financing structure for owner-users. Income property loans
generally require a debt service coverage ratio of 1.25:1 to 1.30:1 depending on the type of
property. Loan terms can range from 20 to 25 years with pricing adjustments at 3 or 5 year
intervals. We require a first lien position on the subject property and often take a junior lien
on other real estate property as well. Pricing is generally in the range of Wall Street Journal
Prime plus 1% to 2% with a negotiated floor rate, loan fees of .5% to 1% and a documentation fee of
$250 to $500. We also offer short-term fixed rate loans when necessary. Commercial business loans and SBA 7a loans are offered to existing and start-up businesses for
various purposes. Such loans are generally collateralized with assets of the business and junior
liens on personal residences. Commercial business loans are underwritten on the basis of the
borrowers cash flow and ability to service the debt from earnings rather than on the basis of the
underlying collateral value. We seek to structure these loans so that they have more than one
source of repayment. The borrower is required to provide sufficient information to allow us to
make an adequate credit evaluation. In most instances, this information consists of financial
statements, tax returns, projected cash flows, current financial information on any guarantor and
information about any collateral. Loans to closely held business borrowers typically require
personal guarantees by the principals. Lines of credit and asset-based loans are written for 12
months. SBA loans can have terms of up to 20 years. Pricing is generally in the range of Wall
Street Journal Prime plus 2% to 2.75% with a negotiated floor rate, loan fees of .5% to 1% and a
documentation fee of $250 to $500. Loan fees for non-SBA loans can range from .5% to 1%. Current appraisals, insurance and perfected liens are generally required for any collateral
taken on loans. Loan Maturities.The following table sets forth the maturity distribution of our loans
outstanding at December 31, 2004. At that date, we had $7,089,000 in loans with maturity greater
than fifteen years. In addition, the table shows the distribution of such loans between those
loans with predetermined (fixed) interest rates and those with variable (floating) interest rates.
Floating rates generally fluctuate with changes in the national prime rate or our Reference Rate.
As of December 31, 2004, approximately 95% of our loan portfolio was comprised of floating interest
rate loans. -103-




---



##### 



MaturingWithin One
    
    
    One to Five
    
    
    After FiveYear
    
    
    Years
    
    
    Years
    
    
    Total(dollars in thousands)Real estate loans:Construction and Land
    
    $
    6,831
    
    
    $
    3,590
    
    
    $
    0
    
    
    $
    10,421Real Estate 1st Trust Deeds
    
    
    2,022
    
    
    
    5,243
    
    
    
    29,451
    
    
    
    36,716Other Real Estate
    
    
    1,796
    
    
    
    288
    
    
    
    444
    
    
    
    2,528Total real estate
    
    
    10,649
    
    
    
    9,121
    
    
    
    29,895
    
    
    
    49,665Commercial Secured Loans
    
    
    11,771
    
    
    
    4,016
    
    
    
    9,068
    
    
    
    24,855Commercial Unsecured Loans
    
    
    1,130
    
    
    
    16
    
    
    
    0
    
    
    
    1,146Consumer & other
    
    
    803
    
    
    
    725
    
    
    
    4,018
    
    
    
    5,546Total
    
    $
    24,353
    
    
    $
    13,878
    
    
    $
    42,981
    
    
    $
    81,212Loans with predetermined interest
rates
    
    $
    1,291
    
    
    $
    857
    
    
    $
    1,830
    
    
    $
    3,978Loans with floating or adjustable
interest rates
    
    
    23,062
    
    
    
    13,021
    
    
    
    41,151
    
    
    
    77,234Total
    
    $
    24,353
    
    
    $
    13,878
    
    
    $
    42,981
    
    
    $
    81,212
 Loan Commitments.In the normal course of business, we maintain outstanding loan commitments
to extend credit. We use the same credit policies in making loan commitments as we do in extending
loans to customers. We evaluate each customers creditworthiness on a case-by-case basis. The
amount of collateral obtained, if deemed necessary, is based on managements credit evaluation of
the customer. The types of collateral held vary, but may include accounts receivable, inventory,
property, equipment and residential and income producing commercial properties. We had unfunded
loan commitments, including standby letters of credit, totaling $20.6 million and $26.2 million at
March 31, 2005 and December 31, 2004, respectively, primarily consisting of commercial,
construction and equity lines of credit. Based upon our experience, the outstanding loan
commitments and standby letters of credit are expected to grow throughout the year as loan demand
continues to increase, subject to, economic conditions. Adverse economic conditions, a decline in real estate values, or a significant increase in
interest rates could negatively affect the construction loan business and require an increase in
the provision for loan losses, which in turn, could adversely affect our future prospects, results
of operations, and profitability. Non-Performing Assets.It is our policy to place loans on non-accrual status when principal
or interest payments are past due 90 days or more. Certain loans will be placed on nonaccrual
earlier if there is a reasonable doubt as to the collectibility of principal and interest. Loans
which are in the process of renewal in the normal course of business or are well secured and in the
process of collection will continue to accrue interest if we consider the risk of loss to be
minimal. There were no non-accrual loans, loans past due 90 days or more, restructured loans, or
impaired loans or loans that have or had a higher than normal risk of loss at March 31, 2005 or
December 31, 2004. As of March 31, 2005, we have identified $3,169,574 in loans on our internal
watch list for special attention by our management and board of directors, of which $1,273,746 is
guaranteed by government and other agencies. These loans reflect weakened financial conditions or
evidence other factors warranting closer monitoring, but are performing in accordance with their
terms. Allowance and Provision for Loan Losses We maintain an allowance for loan and lease losses to provide for probable losses in the loan
portfolio. Additions to the allowance are made by charges to operating expenses in the form of a
provision for loan and -104-




---



##### 



lease losses. All loans which are judged to be uncollectible are charged against the
allowance while any recoveries are credited to the allowance. We have instituted loan policies,
designed primarily for internal use, to adequately evaluate and assess the analysis of risk factors
associated with our loan portfolio and to enable us to assess such risk factors prior to granting
new loans and to assess the sufficiency of the allowance. We conduct a critical evaluation of the
loan portfolio monthly. This evaluation includes an assessment of the following factors: the
results of our internal loan review, any external loan review and any regulatory examination, loan
loss experience, estimated potential loss exposure on each credit, concentrations of credit, value
of collateral, any known impairment in the borrowers ability to repay and present economic
conditions. Until the Bank has established some historical trend of losses, it relies on industry
standards to evaluate allowance adequacy. Each month we also review the allowance and make additional transfers to the allowance as
needed. For the three months ended March 31, 2005, the provision for loan losses was $159,000 as
compared to $33,000 for the three months ended March 31, 2004. For the year ended December 31,
2004, the provision for loan losses was $238,000 as compared to $288,000 for the year ended
December 31, 2003. At March 31, 2005, the allowance was 1.22% of the loans then outstanding. At December 31,
2004, the allowance for loan losses was 1.23% of loans outstanding. Although we deemed these
levels adequate, no assurance can be given that further economic difficulties or other
circumstances which would adversely affect our borrowers and their ability to repay outstanding
loans will not occur which would be reflected in increased losses in our loan portfolio, which
losses could possibly exceed the amount then reserved for loan losses. The following table summarizes our loan loss experience, transactions in the allowance for
loan and lease losses and certain pertinent ratios for the periods indicated: March 31,(unaudited)
    
    
    December 31,2005
    
    
    2004
    
    
    2004
    
    
    2003(dollars in thousands)Outstanding loans:End of the period
    
    $
    94,733
    
    
    $
    65,803
    
    
    $
    81,212
    
    
    $
    60,826Average for the period
    
    $
    87,254
    
    
    $
    62,344
    
    
    $
    71,861
    
    
    $
    46,265Allowance for loan losses:Balance at beginning of period
    
    $
    998
    
    
    $
    760
    
    
    $
    760
    
    
    $
    472Loans charged off
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Recoveries
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Provisions charged to operating expense
    
    
    159
    
    
    
    33
    
    
    
    238
    
    
    
    288Balance at end of period
    
    $
    1,157
    
    
    $
    794
    (1)
    
    $
    998
    
    
    $
    760Ratios:Net charge-offs (recoveries) to average loans
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Allowance to loans at period end
    
    
    1.22
    %
    
    
    1.21
    %
    
    
    1.23
    %
    
    
    1.25
    %
 The table below sets forth the allocation of the allowance for loan and lease losses by loan
type as of the dates specified. The allocation of individual categories of loans includes amounts
applicable to specifically identified as well as unidentified losses inherent in that segment of
the loan portfolio and will necessarily change whenever management determines that the risk
characteristics of the loan portfolio have changed. Management believes that any breakdown or
allocation of the allowance for loan and lease losses into loan categories lends an appearance of
exactness which does not exist, in that the allowance is utilized as a single unallocated allowance
available for all loans and undisbursed commitments. The allocation below should not be
interpreted as an indication of the specific amounts of or loan categories in which future
charge-offs may occur: 
 (1) Rounded. -105-




---



##### 



March 31, 2005
    
    
    December 31,(unaudited)
    
    
    2004
    
    
    2003Percent of
    
    
    
    
    
    
    Percent of
    
    
    
    
    
    
    Percent ofAllowance
    
    
    Loans in
    
    
    Allowance
    
    
    Loans in
    
    
    
    
    
    
    Loans infor Loan
    
    
    Category to
    
    
    for Loan
    
    
    Category to
    
    
    Allowance for
    
    
    Category toLosses
    
    
    Total Loans
    
    
    Losses
    
    
    Total Loans
    
    
    Loan Losses
    
    
    Total Loans(dollars in thousands)Real Estate:Construction
    
    $
    172
    
    
    
    15
    %
    
    $
    141
    
    
    
    13
    %
    
    $
    162
    
    
    
    21
    %1st Trust Deed R.E.
    
    
    401
    
    
    
    43
    
    
    
    373
    
    
    
    45
    
    
    
    266
    
    
    
    43Other Real Estate
    
    
    44
    
    
    
    4
    
    
    
    91
    
    
    
    3
    
    
    
    20
    
    
    
    3Total real estate
    
    
    617
    
    
    
    62
    
    
    
    605
    
    
    
    61
    
    
    
    448
    
    
    
    66Commercial Secured
    
    
    402
    
    
    
    30
    
    
    
    322
    
    
    
    31
    
    
    
    278
    
    
    
    28Commercial Unsecured
    
    
    3
    
    
    
    2
    
    
    
    14
    
    
    
    1
    
    
    
    9
    
    
    
    1Consumer & other
    
    
    60
    
    
    
    6
    
    
    
    57
    
    
    
    7
    
    
    
    8
    
    
    
    5Unallocated allowance
    
    
    75
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    17
    
    
    
    0Total
    
    $
    1,157
    
    
    
    100
    %
    
    $
    998
    
    
    
    100
    %
    
    $
    760
    
    
    
    100
    %
 Non-Interest Income Non-interest income increased $121,000 to $153,000 for the three months ended March 31, 2005,
as compared to the three months ended March 31, 2004. The increase was primarily the result of
rental income associated with San Marcos, LLC. Non-interest income decreased $304,000 to $152,000 for the year ended December 31, 2004, as
compared to the year ended December 31, 2003. The decrease was primarily the result of
extraordinary premiums paid to the Bank on referral loans in 2003 that were not recurring in 2004. Non-Interest Expense Non-interest expenses consist of salaries and related benefits, occupancy and equipment
expense and other expenses. The tables below set forth the components of non-interest expenses as
of the periods indicated: Three Months Ended March 31,(unaudited)
    
    
    Percentage2005
    
    
    2004
    
    
    Change(dollars in thousands)Salaries and benefits
    
    $
    512
    
    
    $
    416
    
    
    
    23.1
    %Occupancy expense
    
    
    111
    
    
    
    51
    
    
    
    117.7
    %Furniture & Equipment
    
    
    67
    
    
    
    44
    
    
    
    52.3
    %Data Processing
    
    
    48
    
    
    
    40
    
    
    
    20.0
    %Advertising
    
    
    21
    
    
    
    23
    
    
    
    (8.7
    %)Professional fees
    
    
    64
    
    
    
    52
    
    
    
    23.1
    %Office supplies
    
    
    17
    
    
    
    15
    
    
    
    13.3
    %Other expenses
    
    
    153
    
    
    
    93
    
    
    
    64.5
    %Total
    
    $
    993
    
    
    $
    734
    
    
    
    35.3
    %
 -106-




---



##### 



Years Ended December 31,
    
    
    Percentage2004
    
    
    2003
    
    
    Change(dollars in thousands)Salaries and benefits
    
    $
    1,837
    
    
    $
    1,311
    
    
    
    40.1
    %Occupancy expense
    
    
    130
    
    
    
    190
    
    
    
    (31.6
    )%Furniture & Equipment
    
    
    173
    
    
    
    97
    
    
    
    78.4
    %Data Processing
    
    
    182
    
    
    
    126
    
    
    
    44.4
    %Advertising
    
    
    89
    
    
    
    147
    
    
    
    (39.5
    )%Professional fees
    
    
    228
    
    
    
    121
    
    
    
    88.4
    %Office supplies
    
    
    55
    
    
    
    28
    
    
    
    96.4
    %Other expenses
    
    
    455
    
    
    
    284
    
    
    
    60.2
    %Total
    
    $
    3,149
    
    
    $
    2,304
    
    
    
    36.7
    %
 Our non-interest expenses increased by $259,000, or 35.3%, for the three months ended March
31, 2005, compared to the three months ended March 31, 2004. The largest increases were in
occupancy expense, which increased from $51,000 to $111,000; furniture fixtures and equipment,
which increased from $44,000 to $67,000; and professional fees, which increased from $52,000 to
$64,000. The increases in these categories and non-interest expenses overall reflected our growth,
including the opening of our Poway office. Our non-interest expenses increased by $845,000, or 36.7%, for the year ended December 31,
2004, compared to the year ended December 31, 2003. The largest increases were in salaries and
benefits, which increased from $1,311,000 to $1,837,000; furniture, fixtures and equipment, which
increased from $97,000 to $173,000; professional fees which increased from $121,000 to $228,000;
data processing expenses, which increased from $126,000 to $182,000; office supplies expense, which
increased from $28,000 to $55,000; and other expenses, which increased from $284,000 to $455,000.
The increases in these categories and non-interest expenses overall reflected our growth, including
the opening of our Poway office. Income Taxes We had net operating loss carryforwards of approximately $444,000 and $575,000 available to
reduce future federal and state taxable income, respectively, as of December 31, 2004. The net
operating loss carryforwards begin expiring in 2021 and expire through 2022. Prior to 2004, the
State of California suspended corporations from utilizing net operating losses. In 2004, the Bank
utilized $570,000 of net operating losses on its California income tax filing. The Bank
recognized its remaining California net operating loses as a deferred tax asset at December 31,
2004. At March 31, 2005, the Federal net operating loss carryforward was reduced to approximately
$220,000, and a California net operating loss carryforward of $335,000 and a deferred tax asset of
$262,000. Our effective tax rates were 25.9%, 18.0%, (14.6%), and (51.2%) for the three months ended
March 31, 2005 and 2004, and the years ended December 31, 2004 and 2003, respectively, reflecting
our utilization of net operating loss carryforwards and increasing profitability. Cash and Cash Equivalents Cash and cash equivalents consist of cash on hand and due from correspondent banks and federal
funds sold. We maintain balances at correspondent banks adequate to cover daily clearings and
other charges. Funds in excess of these needs are invested in overnight federal funds at
correspondent banks. Cash and cash equivalents were $12,375,000 at March 31, 2005 and $5,367,000
at March 31, 2004. The increase from 2004 to 2005 was to provide liquidity as our asset size
increased. Cash and cash equivalents were $6,584,000 at December 31, 2004 and $2,110,000 at
December 31, 2003. -107-




---



##### 



Deposits Deposits represent our primary source of funds to support our various lending and investment
activities. Substantially all of our deposits are from individuals and businesses within our
service area. We have utilized brokered deposits from time to time, but they have never exceeded
12% of total deposits. We have no known foreign deposits. The following tables set forth the average balance and the average rate paid on each deposit
category for the periods indicated: Three Months Ended March 31, 2005(unaudited)2005
    
    
    2004Amount
    
    
    Percentage Rate
    
    
    Amount
    
    
    Percentage Rate(dollars in thousands)Noninterest-bearing demand
    
    $
    16,140
    
    
    
    
    
    
    $
    10,583
    
    
    
    Transaction & NOW
    
    
    6,746
    
    
    
    1.02
    %
    
    
    5,026
    
    
    
    1.05
    %Savings & money market
    
    
    20,855
    
    
    
    1.96
    %
    
    
    10,754
    
    
    
    1.55
    %Time
    
    
    45,957
    
    
    
    2.94
    %
    
    
    32,878
    
    
    
    2.16
    %Total Deposits
    
    $
    89,698
    
    
    
    2.02
    %
    
    $
    59,241
    
    
    
    1.13
    %
 Year Ended December 31,2004
    
    
    2003Amount
    
    
    Percentage Rate
    
    
    Amount
    
    
    Percentage Rate(dollars in thousands)Noninterest-bearing demand
    
    $
    13,171
    
    
    
    
    
    
    $
    7,119
    
    
    
    Transaction & NOW
    
    
    6,930
    
    
    
    1.08
    %
    
    
    3,465
    
    
    
    1.41
    %Savings & money market
    
    
    14,999
    
    
    
    1.59
    %
    
    
    7,577
    
    
    
    1.48
    %Time
    
    
    35,933
    
    
    
    2.20
    %
    
    
    26,961
    
    
    
    2.56
    %Total Deposits
    
    $
    71,033
    
    
    
    1.56
    %
    
    $
    45,122
    
    
    
    1.92
    %
 The following table sets forth the maturity of time certificates of deposit of $100,000 or
more at March 31, 2005: March 31, 2005(unaudited)(dollars in thousands)Three months or less
    
    $
    2,651Over three to six months.
    
    
    8,779Over six to twelve months
    
    
    15,176Over twelve months
    
    
    -0-Total
    
    $
    26,606
 Borrowings Federal Home Loan Advances at December 31, 2004 totaled $9,000,000, the highest outstanding
during the year, with a rate of 2.35%. Average borrowing for the period was $4,723,000 with a
weighted average rate of 1.59%. Federal Home Loan Advances at March 31, 2005 totaled $8,500,000,
the highest during the period, at a variable advance rate ranging at rates from 2.30% to 2.94%.
Average borrowing for the period was $8,756,000 with a weighted average rate of 2.55%. All
advances are open-end overnight borrowings to supplement liquidity and are repaid during the
periods when liquidity needs are met with deposits. -108-




---



##### 



Capital Resources Under regulatory capital adequacy guidelines, capital adequacy is measured as a percentage of
risk-adjusted assets in which risk percentages are applied to assets on as well as off-balance
sheet, such as unused loan commitments and standby letters of credit. The guidelines require that
a portion of total capital be core, or Tier 1, capital consisting of common stockholders equity
and perpetual preferred stock, less goodwill and certain other deductions. Tier 2 capital consists
of other elements, primarily non-perpetual preferred stock, subordinated debt and mandatory
convertible debt, plus the allowance for loan losses, subject to certain limitations. The
guidelines also evaluate the leverage ratio, which is Tier I capital divided by average assets.
Moreover, as a new bank we were required to maintain Tier 1 capital to average assets of at least
8% during our first three years of operations. The following table provides information regarding our regulatory capital ratios at March 31,
2005, December 31, 2004 and December 31, 2003. The reduction in our ratios reflects the Banks
growth. At March 31, 2005, December 31, 2004 and December 31, 2003, we met or exceeded regulatory
capital requirements to be considered well capitalized, as defined in the regulations issued by
the FDIC, and it is the Banks intention to remain well capitalized in the future. Well
    
    
    March 31,Capitalized"
    
    
    2005
    
    
    December 31,Requirement
    
    
    (unaudited)
    
    
    2004
    
    
    2003Total risk-based capital ratio.
    
    
    10.00
    %
    
    
    11.44
    %
    
    
    12.41
    %
    
    
    16.23
    %Tier 1 risk-based capital ratio
    
    
    6.00
    %
    
    
    10.28
    %
    
    
    11.30
    %
    
    
    15.05
    %Tier 1 leverage capital ratio
    
    
    5.00
    %
    
    
    9.56
    %
    
    
    10.57
    %
    
    
    15.27
    %
 Please refer to the discussion and financial data under Pro Forma Financial Information for
information regarding the impact the Celtic transaction will have on the Holding Companys capital
resources (on a consolidated basis). Liquidity and Liquidity Management Liquidity management for banks requires that funds always be available to pay deposit
withdrawals and maturing financial obligations in accordance with their terms and to meet customer
requests for loans. The acquisition of deposits has been our primary source of funds used to
invest in earning assets. Other sources of funds have been the cash provided from operations, the
proceeds of common stock sales and from borrowings. We expect that deposits will continue to be
the primary source of funds in future periods. We emphasize seeking demand deposits from business
customers in our market area. If necessary, we can also pursue the higher cost time deposits.
Liquidity management for banks requires that funds always be available to pay deposit withdrawals
and maturing financial obligations promptly and fully in accordance with their terms. One method
banks utilize for acquiring additional liabilities is through the acceptance of brokered deposits
(defined to include not only deposits received through deposit brokers, but also deposits bearing
interest in excess of 75 basis points over market rates), typically attracting large certificates
of deposit at high interest rates. We utilize brokered deposits to facilitate liquidity needs. At March 31, 2005, December 31,
2004 and December 31, 2003, we had brokered deposits of $20.8 million, $9.1 million and $4.1
million, respectively. During 2005 we utilized brokered deposits and deposits from other
financial institutions to fund our loan growth. To meet liquidity needs, we maintain a portion of our funds in cash deposits in other banks,
Federal Funds sold, and investment securities. As of December 31, 2004 and March 31, 2005, our
liquidity ratio was 13.20% and 16.56%, respectively (defined as liquid assets as a percentage of
deposits). Liquid assets were composed of Federal Funds sold, available-for-sale investment
securities less securities that are pledged to secure treasury, tax and loan deposits and other
purposes as required by law, interest-bearing deposits in other -109-




---



##### 



financial institutions and cash and due from banks. Our liquidity ratio at December 31, 2004
was slightly below our policy target of 15% with the ratio at March 31, 2005 more than our policy
target of 15%. We monitor our liquidity ratios daily and since March 31, 2005, our liquidity
ratios have met our policy guidelines on average. The Bank attempts to maximize its loan to
deposit ratios and minimize its liquidity ratios, consistent with its liquidity needs and policy,
to maximize net interest margins. We maintain a $2.5 million line of credit with a correspondent bank for the purchase of
overnight Federal funds. We also have a credit line with the Federal Home Loan Bank of San
Francisco which would allow us to borrow up to 15% of our assets. As of March 31, 2005, loans and
securities pledged as collateral for this facility would have allowed us to borrow up to
approximately $9.5 million. These facilities have been used regularly to provide funding for loans
at less cost than brokered deposits. (See Borrowings above.) Recent Accounting Pronouncements In May 2005 the FASB issued FASB 154 which replaces APB Opinion No. 20, Accounting Changes,
and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes
the requirements for the accounting for and reporting of a change in accounting principle. This
Statement applies to all voluntary changes in accounting principle. It also applies to changes
required by an accounting pronouncement in the unusual instance that the pronouncement does not
include specific transition provisions. When a pronouncement includes specific transition
provisions, those provisions should be followed. Opinion 20 previously required that most voluntary changes in accounting principle be
recognized by including in net income of the period of the change the cumulative effect of changing
to the new accounting principle. This Statement requires retrospective application to prior
periods financial statements of changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the change. When it is
impracticable to determine the period specific effects of an accounting change on one or more
individual prior periods presented, this Statement requires that the new accounting principle be
applied to the balances of assets and liabilities as of the beginning of the earliest period for
which retrospective application is practicable and that a corresponding adjustment be made to the
opening balance of retained earnings (or other appropriate components of equity or net assets in
the statement of financial position) for that period rather than being reported in an income
statement. When it is impracticable to determine the cumulative effect of applying a change in
accounting principle to all prior periods, this Statement requires that the new accounting
principle be applied as if it were adopted prospectively from the earliest date practicable. This Statement defines retrospective application as the application of a different accounting
principle to prior accounting periods as if that principle had always been used or as the
adjustment of previously issued financial statements to reflect a change in the reporting entity.
This Statement also redefines restatement as the revising of previously issued financial statements
to reflect the correction of an error. This Statement requires that retrospective application of a change in accounting principle be
limited to the direct effects of the change. Indirect effects of a change in accounting principle,
such as a change in nondiscretionary profit-sharing payments resulting from an accounting change,
should be recognized in the period of the accounting change. This Statement also requires that a change in depreciation, amortization, or depletion method
for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by
a change in accounting principle. This Statement carries forward without change the guidance contained in Opinion 20 for
reporting the correction of an error in previously issued financial statements and a change in
accounting estimate. This Statement also carries forward the guidance in Opinion 20 requiring
justification of a change in accounting principle on the basis of preferability. At March 31, 2005 the Company and the Bank had no changes in accounting principles. -110-




---



##### 



In June 2004, the Emerging Issues Task Force of the FASB issued final guidance on its Issue
No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments. A consensus
was reached regarding disclosures about unrealized losses on available-for-sale debt and
equity securities accounted for under FASB Statements No. 115, Accounting for Certain Investments
in Debt and Equity Securities. This EITF describes a model involving three steps: (1) determine whether an investment is
impaired, (2) determine whether the impairment is other-than -temporary, and (3) recognize the
impairment loss in earnings. The EITF also requires several additional disclosures for cost-method
investments. The EITFs impairment accounting guidance was effective for reporting periods
beginning after June 15, 2004. For all other investments within the scope of this Issue, the
disclosures are effective in annual financial statements for fiscal years ending after June 15,
2004. The additional disclosures for cost method investments are effective for fiscal years ending
after June 15, 2004. The adoption of this EITF did not have a material impact on the Banks financial statements.
At December 31, 2004 and 2003, management believes the impairments described above are temporary
and, accordingly, no impairment loss has been recognized in the Companys consolidated statement of
income. As of March 31, 2005, management continues to believe these impairments are temporary in
nature. On March 9, 2004, the Staff of the Securities and Exchange Commission (the SEC Staff) issued
Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments (SAB
105). SAB 105 provides guidance on the initial recognition and measurement of loan commitments
that meet the definition of a derivative, and summarizes the related disclosure requirements. SAB
105 is effective for all loan commitments accounted for as derivatives that are entered into, or
substantially modified, on or after April 1, 2004. SAB 105 addresses loan commitments that the
Financial Accounting Standards Board (FASB) defines as derivatives in paragraph 6 of FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by FASB Statement
No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 133).
These loan commitments relate to the origination of mortgage loans that will be held for sale. SAB
105 does not apply to (1) commitments to purchase mortgage loans that do not meet the definition of
a derivative under paragraph 6 of FAS 133 or (2) commitments that are explicitly excluded from the
scope of FAS 133 (i.e., commitments to originate mortgage loans that will be held for investment
purposes and loan commitments to originate other types of loans). The Bank does not currently
originate mortgage loans to be held for sale. If that should change in the future, we would take
SAB 105 into consideration but do not expect it to have a material impact on the Companys
financial condition or operating results. In December 2003, under clearance of the FASB, the Accounting Standards Executive Committee
(AcSEC) of the AICPA issued Statement of Position (SOP) 03-3, Accounting for Certain Loans or
Debt Securities Acquired in a Transfer. This SOP establishes accounting standards for discounts on
purchased loans when the discount is attributable to credit quality. The SOP requires that the
loan discount, rather than the contractual amounts, establishes the investors estimate of
undiscounted expected future principal and interest cash flows as a benchmark for yield and
impairment measurements. The SOP prohibits the carryover or creation of a valuation allowance in
the initial accounting for these loans. This SOP is effective from loans acquired in years
beginning after December 15, 2004. Since this SOP applies only to transfers after 2004, this
Statement will have not impact on the Banks financial position or results of operation at
adoption. Quantitative And Qualitative Disclosures About Market Risk The following discussion regarding our market risks should be read in conjunction with
Managements Discussion and Analysis of Financial Condition and Results of Operations herein. For
purposes of this section, the terms we and our mean Discovery Bank on a stand-alone basis. Our market risk arises primarily from credit risk and interest rate risk inherent in our
lending and deposit taking activities and the risk of inflation. Risk management is an important
part of our operations and a key element of our overall financial results. The FDIC, in recent
years, has emphasized appropriate risk -111-




---



##### 



management, prompting banks to have adequate systems to
identify, monitor and manage risks. Our board of directors and committees meet on a regular basis
to oversee our operations. We monitor our business activities
and apply various strategies to manage the risks to which we are exposed. We have adopted
various policies and have empowered the committees of our board of directors with oversight
responsibility concerning different aspects of our operations. Our Audit Committee is responsible
for overseeing internal auditing functions and for interfacing with our independent outside
auditors. Our Loan Committee establishes the Loan Policy, reviews loans made by management and
approves loans in excess of managements lending authority. Our Loan Committee also reviews watch
list loans and the adequacy of our allowance for loan losses. Our Asset/Liability Risk Committee
establishes our Investment Policy and our Asset/Liability Policy, reviews investments made by
management, and monitors our investment portfolio, interest rate risk and liquidity planning. Credit Risk. Credit risk generally arises as a result of our lending activities and may be
present with our investment activities. To manage the credit risk inherent in our lending
activities, we rely on adherence to underwriting standards and loan policies as well as our
allowance for loan losses. We employ frequent monitoring procedures and take prompt corrective
action when necessary. Additionally, our loans are examined regularly by our regulatory agencies. Interest Rate Risk.Interest rate risk is the exposure of a banks financial condition, both
earnings and the market value of assets and liabilities, to adverse movements in interest rates.
Interest rate risk results from differences in the maturity or timing of interest-earning assets
and interest-bearing liabilities, changes in the slope of the yield curve over time, imperfect
correlation in the adjustment of rates earned and paid on different instruments with otherwise
similar characteristics (e.g. three-month Treasury bill versus three-month LIBOR) and from
interest-rate-related options embedded in bank products (e.g. loan prepayments, floors and caps,
callable investment securities, early withdrawal of time deposits, etc). The potential impact of interest rate risk is significant because of the liquidity and capital
adequacy consequences that reduced earnings or losses could imply. We recognize and accept that
interest rate risks are a routine part of bank operations and will from time to time impact our
profits and capital position. The objective of interest rate risk management is to control
exposure of net interest income to risks associated with interest rate movements in the market, to
achieve consistent growth in net interest income and to profit from favorable market opportunities. The careful planning of asset and liability maturities and the matching of interest rates to
correspond with this maturity matching is an integral part of the active management of an
institutions net yield. To the extent maturities of interest-earning assets and interest-bearing
liabilities do not match in a changing interest rate environment (an interest rate sensitivity
gap), net yields may be affected. Thus, if rate sensitive assets exceed rate sensitive
liabilities for a given period, the interest rate would be positively gapped and we would benefit
from an increase in interest rates. Conversely, if rate sensitive liabilities exceed rate
sensitive assets for a given period, the interest rate would be negatively gapped and we would
not benefit from an increase in interest rates. Even with perfectly matched repricing of
interest-earning assets and interest-bearing liabilities, risks remain in the form of prepayment of
assets, timing lags in adjusting certain assets and liabilities that have varying sensitivities to
market interest rates and basis risk. In our overall attempt to match interest-earning assets and
interest-bearing liabilities, we take into account rates and maturities to be offered in connection
with our certificates of deposit and our variable rate loans. We have generally been able to control our exposure to changing interest rates by maintaining
a large percentage of floating interest rate loans and a majority of our time certificates in
relatively short maturities. The following table sets forth the distribution of repricing opportunities of our
interest-earning assets and interest-bearing liabilities, the cumulative interest rate sensitivity
gap, which is interest rate sensitive assets less interest rate sensitive liabilities cumulative
period to period, and the cumulative gap as a percentage of total assets and total interest-earning
assets as of March 31, 2005. The table also sets forth the time periods during which
interest-earning assets and interest-bearing liabilities will mature or may reprice in accordance
with their contractual terms. The interest rate relationships between the repriceable assets and
repriceable liabilities are -112-




---



##### 



not necessarily constant and may be affected by many factors, including
the behavior of customers in response to changes in interest rates. This table should, therefore,
be used only as a guide as to the possible effect changes in interest rates might have on our net
interest margins. CumulativeLess Than
    
    
    Less Than
    
    
    Less Than
    
    
    Beyond 5
    
    
    Non Rate3 Months
    
    
    1 Year
    
    
    5 Years
    
    
    Years
    
    
    Sensative
    
    
    Total(dollars in thousands)Deposits with financial
institutions
    
    $
    398
    
    
    $
    1,709
    
    
    $
    2,883
    
    
    $
    2,883
    
    
    $
    0
    
    
    $
    2,883Federal funds sold
    
    
    9,315
    
    
    
    9,315
    
    
    
    9,315
    
    
    
    9,315
    
    
    
    0
    
    
    
    9,315Investment Securities
    
    
    250
    
    
    
    250
    
    
    
    2,512
    
    
    
    3,125
    
    
    
    0
    
    
    
    3,125Loans gross
    
    
    75,802
    
    
    
    76,268
    
    
    
    85,442
    
    
    
    94,723
    
    
    
    10
    
    
    
    94,733Total rate sensitive assets
    
    
    85,765
    
    
    
    87,542
    
    
    
    100,152
    
    
    
    110,046
    
    
    
    10
    
    
    
    110,056All other assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,613
    
    
    
    9,613Total Assets
    
    $
    85,765
    
    
    $
    87,542
    
    
    $
    100,152
    
    
    $
    110,046
    
    
    $
    9,623
    
    
    $
    119,669Interest Bearing Demand
    
    $
    25,648
    
    
    $
    25,648
    
    
    $
    25,648
    
    
    $
    25,648
    
    
    $
    0
    
    
    $
    25,648Savings
    
    
    1,592
    
    
    
    1,592
    
    
    
    1,592
    
    
    
    1,592
    
    
    
    0
    
    
    
    1,592Time deposits under 100M
    
    
    4,424
    
    
    
    30,576
    
    
    
    30,576
    
    
    
    30,576
    
    
    
    0
    
    
    
    30,576Time deposits over 100M
    
    
    2,651
    
    
    
    26,606
    
    
    
    26,606
    
    
    
    26,606
    
    
    
    0
    
    
    
    26,606Other interest liabilities
    
    
    8,500
    
    
    
    8,500
    
    
    
    8,500
    
    
    
    8,500
    
    
    
    0
    
    
    
    8,500Total rate sensitive
liabilities
    
    
    42,815
    
    
    
    92,922
    
    
    
    92,922
    
    
    
    92,222
    
    
    
    0
    
    
    
    92,922All other liabilities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    16,323
    
    
    
    16,323Stockholders equity
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,424
    
    
    
    10,424Total Liabilities and Equity
    
    $
    42,815
    
    
    $
    92,922
    
    
    $
    92,222
    
    
    $
    92,222
    
    
    $
    26,747
    
    
    $
    119,669Cumulative rate sensitive gap.
    
    $
    42,950
    
    
    $
    (5,380
    )
    
    $
    7,230
    
    
    $
    17,124
    
    
    $
    (17,124
    )Cumulative rate sensitive gap
as a % of total assets
    
    
    35.89
    %
    
    
    (4.50
    )%
    
    
    6.04
    %
    
    
    14.31
    %
    
    
    (14.31
    )%
 NOTE: All amounts are reported at their contractual maturity or repricing periods. This
analysis makes certain assumptions as to interest rate sensitivity of savings and NOW accounts
which have no stated maturity and have had very little price fluctuation since commencement of
operations. Money market accounts are repriced at discretion of management and generally are more
rate sensitive. The Banks policy is to limit maturities on certificate of deposits to one year,
in most cases, so virtually all reprice within that time frame. The Bank has exhibited the ability
to renew or replace these certificates as they mature; however, the Bank bears the risk that their
renewal will be at higher rates of interest. On March 31, 2005, we had $85,765 in assets and $42,815 in liabilities repricing within three
months and $87,542 in assets and $92,922 in liabilities repricing within one year. This means that
we had a positive gap of 35.89% within three months and we had a slight negative one year
cumulative gap of (4.50%). Our cumulative interest gap returns to positive over longer maturities.
Over the one year time frame interest income may be affected to a lesser extent than interest
expense if rates were to increase at the same time and level for both assets and liabilities as the
model forecasts. It is more typical for loans to be repriced immediately as the prime rate changes
and deposits to lag at a percentage of that rate change. If rates were to fall during this one
year period, interest income would decline by a lesser amount than interest expense and net income
would increase. Conversely, if rates were to rise the opposite would apply. Over the one year
time frame our slight negative gap position indicates that we could benefit slightly from decreases
in interest rates, but the opposite is true for other time frames. -113-




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##### 



The Banks policy quantifies acceptable gap ratios. These targets are monitored quarterly and
reviewed annually by the board of directors to determine acceptable gap risks. We monitor and
evaluate our gap position, but do not anticipate substantial changes in those gap ratios. We do not engage in any hedging activities and do not have any derivative securities in our
portfolio. We utilize the results of a dynamic simulation model to quantify the estimated exposure of net
interest income to sustained interest rate changes. The simulation model, a third-party service,
estimates the impact of changing interest rates on the interest income from all interest-earning
assets and the interest expense paid on all interest-bearing liabilities reflected on our balance
sheet. A parallel and pro rata shift in rates over a 12-month period is assumed. This model is
reviewed annually and audited on a regular basis to determine accuracy of data and forecasts. The
following reflects our net interest income sensitivity analysis as of March 31, 2005, based on the
simulation. This table shows the impact of hypothetical interest rate changes on net interest
income and net interest margins. Adjusted Net
    
    
    ChangeInterest Rate Scenario
    
    Interest Income
    
    
    From BaseUp 300 basis points
    
    $
    6,525
    
    
    
    23.24
    %Up 200 basis points
    
    $
    6,163
    
    
    
    16.39
    %Up 100 basis points
    
    $
    5,754
    
    
    
    8.68
    %Base
    
    $
    5,295
    
    
    
    0.00
    %Down 100 basis points.
    
    $
    5,028
    
    
    
    (5.04
    )%Down 200 basis points.
    
    $
    4,763
    
    
    
    (10.04
    )%Down 300 basis points.
    
    $
    4,551
    
    
    
    (14.04
    )%
 Inflation The impact of inflation on a financial institution can differ significantly from that exerted
on other companies. Banks, as financial intermediaries, have many assets and liabilities which may
move in concert with inflation both as to interest rates and value. However, financial
institutions are also affected by inflations impact on non-interest expenses, such as salaries and
occupancy expenses. From January 2001 through mid 2003 the FRB decreased interest rates numerous times, reducing
the overnight Federal Funds rate from 6.50% to as low as 1.00%, the lowest level in over four
decades. Since June 2004, the FRB has reversed direction and increased rates eight times to 3.00%.
The nature and timing of any future changes in such policies and their impact on us cannot be
predicted; however, because of our ratio of rate sensitive assets to rate sensitive liabilities, we
tend to benefit slightly in the short term from an increasing interest rate market and, conversely,
suffer in a decreasing interest rate market. As such, the management of the money supply by the
FRB to control the rate of inflation has an impact on our earnings. The changes in interest rates
may also have a corresponding impact on the ability of borrowers to repay loans with us. -114-




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##### 



CELTIC CAPITAL CORPORATION Introduction The following discussion is designed to provide a better understanding of significant trends
related to Celtics financial condition, results of operations, liquidity, capital resources and
interest rate sensitivity. It is derived from Celtics unaudited combined financial statements and
notes thereto for the three months ended March 31, 2005 and March 31, 2004, and the audited
financial statements for the years ended December 31, 2004 and 2003, and the notes thereto included
elsewhere herein. Note that the audited and unaudited combined financial statements included
herein are the consolidated financials of Celtic Capital Corporation and Columbia Capital
Corporation. This discussion relates to Celtic on a stand-alone basis. The Combining Balance
Sheets and Combining Statements of Operations can be found within the Supplementary Combining
Information attached at the end of the combined financial statements. These schedules break out
the balances and operations relating to each entity. Celtics profitability has been greatly impacted over the past few years by the dependence and
high cost of the subordinated debt that makes up Celtics entire capital base. Having an
appropriately structured capital base, as is being proposed with the acquisition, is critical to an
asset-based lending operation. Additionally, Celtics future results of operations could
materially differ from those suggested by the forward-looking statements contained in this
prospectus, depending upon:  
    
    competition within the finance industry;
    
    changes in the interest rate environment;
    
    general economic conditions, nationally, regionally and in our market areas,
including declines in real estate values;
    
    the effects of terrorism, including the events of September 11, 2001 and thereafter,
and the conduct of the war on terrorism by the United States and its allies;
    
    the regulatory environment;
    
    business conditions and inflation;
    
    technology;
    
    regulatory compliance issues;
    
    planned asset growth;
    
    unanticipated loan losses;
    
    unanticipated increases in operating expenses; and
    
    the ability to generate fee and other non-interest income. Moreover, inasmuch as the Company is not purchasing all of Celtics assets nor assuming all of
Celtics liabilities, and we will operate our wholly-owned subsidiary, Celtic Merger Corp., with a
different salary base and cost of funds, this discussion does not necessarily reflect the results
of operations and financial condition for Celtic Merger Corp. after consummation of the
acquisition. Critical Accounting Policies. Celtics combined financial statements, and the notes thereto, have been prepared in
accordance with accounting principles generally accepted in the United States of America. The
preparation of the financial statements requires Celtic to make a number of estimates and
assumptions that affect the reported amounts and disclosures. On an ongoing basis, Celtic evaluates
its estimates and assumptions based upon historical experience and various other factors and
circumstances. Celtic believes that its estimates and assumptions are reasonable; however, actual
results may differ significantly from these estimates and assumptions which could have a material
impact on the carrying value of assets and liabilities at the balance sheet dates and on the
results of operations for the reporting periods. -115-




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##### 



Celtic has identified its policy for allowance for loan losses, which involves the most
significant estimates and assumptions which have a material impact on the carrying value of its
assets, as its critical accounting policy. Celtic maintains an allowance for loan losses at an
amount which Celtic believes is sufficient to provide adequate protection against losses in the
loan portfolio. Celtics periodic evaluation of the adequacy of the allowance is based on such
factors as past loan loss experience, known and inherent risks in the portfolio, adverse situations
that have occurred but are not yet known that may affect the borrowers ability to repay, the
estimated value of underlying collateral, and economic conditions. As Celtic utilizes information
currently available to evaluate the allowance for loan losses, the allowance for loan losses is
subjective and may be adjusted in the future depending on changes in economic conditions or other
factors. During the time Celtic holds collateral, Celtic is subject to credit risks, including risks of
borrower defaults, bankruptcies and special hazard losses that are not covered by standard hazard
insurance (such as those occurring from earthquakes or floods). Although Celtic has established an
allowance for loan losses that it considers adequate, there can be no assurance that the
established allowance for loan losses will be sufficient to offset losses on loans in the future. General. Celtic earned $47,000 for the three months ended March 31, 2005 compared to a loss of $83,000
for the three months ended March 31, 2004. This increase in profitability is mainly attributable
to reductions of non-interest expenses as outlined below in the section entitled Costs and
Expenses. Celtic earned $83,000 for the year ended December 31, 2004 compared to a $16,000 for the year
ended December 31, 2003. At the beginning of 2004, Celtic launched a new marketing campaign
whereby Celtic went to 100% web-based marketing. The result of this was a decrease in marketing
costs by approximately $50,000. Additionally, during the third quarter of 2004, Celtic eliminated
an internal marketing position, saving $130,000 annually. Effective October 1, 2004, Celtic negotiated better lease terms with its Santa Monica lessor,
resulting in a monthly decrease in lease expense of $4,700, and an extension of the lease until
August 31, 2009. The rental rate increases 3% annually, effective September 1st of each
year. The space, which Celtic has occupied since July of 1990, is sufficient in size to handle
Celtics anticipated growth over the next few years. Total assets decreased $1,986,000 or 8.1%, to $22,504,000 at March 31, 2005, from $24,490,000
at December 31, 2004. Loans, net, decreased 17.3% to $18,838,000 at March 31, 2005, from
$22,791,000 at December 31, 2004. These decreases were due to normal fluctuations in the business
cycle of Celtic. Total assets increased $2,336,000 or 12.9%, to $20,458,000 at March 31, 2004, from $18,122,000
at December 31, 2003. Loans, net, increased 12.2% to $19,107,000 at March 31, 2004, from
$17,027,000 at December 31, 2003. Total assets increased $6,368,000 or 35.1%, to $24,490,000 at December 31, 2004, from
$18,122,000 at December 31, 2003. Loans, net, increased 33.9% to $22,791,000 at December 31, 2004,
from $17,027,000 at December 31, 2003. The increases in total assets and loans were primarily
funded by a $7,421,000 increase in notes payable to banks to $19,918,000 at December 31, 2004, from
$12,497,000 at December 31, 2003. Shareholders equity (deficit) was ($729,000) at March 31, 2005, compared to ($962,000) at
March 31, 2004. The following sections present various tables reflecting Celtics financial condition and
results of operations. Average balances reflect daily averages. -116-




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##### 



Distribution of Assets, Liabilities and Shareholders Equity (Deficit). Celtics earnings depends largely upon the difference between the income Celtic receives from
loans and the interest paid on borrowings. This difference is net interest income. Net interest
margin is net interest income expressed as a percentage of average total interest-earning assets.
Net interest spread is the difference between the rate earned on interest-earning assets and the
rate paid on interest-bearing liabilities. The following tables provide information, for the periods indicated, on the average amounts
outstanding for interest-earning assets and interest-bearing liabilities, the amount of interest
earned or paid, the yields and rates on interest-earning assets and interest-bearing liabilities,
and net interest margins and net interest spreads: Three Months Ended March 31,2005
    
    
    2004Interest
    
    
    Rates
    
    
    
    
    
    
    Interest
    
    
    RatesAverage
    
    
    Income/
    
    
    Earned/
    
    
    Average
    
    
    Income/
    
    
    Earned/Balance
    
    
    Expense
    
    
    Paid(1)
    
    
    Balance
    
    
    Expense
    
    
    Paid(1)(dollars in thousands)AssetsLoans, net of unearned fees(2)
    
    $
    20,603
    
    
    $
    1,003
    
    
    
    19.47
    %
    
    $
    18,493
    
    
    $
    935
    
    
    
    20.22
    %Total Interest-Earning Assets
    
    
    20,603
    
    
    
    1,003
    
    
    
    19.47
    %
    
    
    18,493
    
    
    
    935
    
    
    
    20.22
    %Noninterest-earning assets
    
    
    1,258
    
    
    
    
    
    
    
    
    
    
    
    1,605Total Assets
    
    $
    21,861
    
    
    
    
    
    
    
    
    
    
    $
    20,098LiabilitiesNotes payable, bank
    
    $
    17,372
    
    
    
    301
    
    
    
    6.93
    %
    
    $
    14,053
    
    
    
    179
    
    
    
    5.09
    %Subordinated notes payable
    
    
    4,629
    
    
    
    108
    
    
    
    9.33
    %
    
    
    5,507
    
    
    
    133
    
    
    
    9.66
    %Total Interest-Bearing Liabilities
    
    
    22,001
    
    
    
    409
    
    
    
    7.44
    %
    
    
    19,560
    
    
    
    312
    
    
    
    6.38
    %Other liabilities
    
    
    790
    
    
    
    
    
    
    
    
    
    
    
    1,463Total Liabilities
    
    
    22,791
    
    
    
    
    
    
    
    
    
    
    
    21,023Shareholders Equity (Deficit)
    
    
    (930
    )
    
    
    
    
    
    
    
    
    
    
    (925
    )Total Liabilities and Shareholders
Equity (Deficit)
    
    $
    21,861
    
    
    
    
    
    
    
    
    
    
    $
    20,098Net interest margin(3)
    
    
    
    
    
    $
    594
    
    
    
    11.53
    %
    
    
    
    
    
    $
    623
    
    
    
    13.48
    %Net interest spread(4)
    
    
    
    
    
    
    
    
    
    
    12.04
    %
    
    
    
    
    
    
    
    
    
    
    13.84
    %
 
 (1) The ratios have been annualized. No
assurances can be given that the annualized rates and results of operations for
the three months ended March 31, 2005 are indicative of the rates and operation
results that may be expected for the year ended December 31, 2005.(2) Average loans are net of unearned loan
fees. Loan interest income includes loan fees of $0 in 2005 and $61,000 in
2004.(3) Net interest margin is the net yield on
average total interest-earning assets.(4) Net interest spread is the absolute
difference between the rate earned on interest-earning assets and the rate paid
on interest-bearing liabilities. -117-




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##### 



Year Ended December 31,2004
    
    
    2003Interest
    
    
    Rates
    
    
    
    
    
    
    Interest
    
    
    RatesAverage
    
    
    Income/
    
    
    Earned
    
    
    Average
    
    
    Income/
    
    
    EarnedBalance
    
    
    Expense
    
    
    / Paid
    
    
    Balance
    
    
    Expense
    
    
    / Paid(dollars in thousands)AssetsLoans, net of unearned fees(1)
    
    $
    20,790
    
    
    $
    4,223
    
    
    
    20.31
    %
    
    $
    18,895
    
    
    $
    4,530
    
    
    
    23.97
    %Total Interest-Earning Assets
    
    
    20,790
    
    
    
    4,223
    
    
    
    20.31
    %
    
    
    18,895
    
    
    
    4,530
    
    
    
    23.97
    %Noninterest-earning assets
    
    
    1,043
    
    
    
    
    
    
    
    
    
    
    
    1,391Total Assets
    
    $
    21,833
    
    
    
    
    
    
    
    
    
    
    $
    20,286LiabilitiesNotes payable, bank
    
    $
    17,719
    
    
    
    1,024
    
    
    
    5.78
    %
    
    $
    13,505
    
    
    
    704
    
    
    
    5.21
    %Subordinated notes payable
    
    
    4,247
    
    
    
    415
    
    
    
    9.77
    %
    
    
    6,454
    
    
    
    665
    
    
    
    10.30
    %Total Interest-Bearing Liabilities
    
    
    21,966
    
    
    
    1,439
    
    
    
    6.55
    %
    
    
    19,959
    
    
    
    1,369
    
    
    
    6.86
    %Other liabilities
    
    
    787
    
    
    
    
    
    
    
    
    
    
    
    1,178Total Liabilities
    
    
    22,753
    
    
    
    
    
    
    
    
    
    
    
    21,137Shareholders Equity (Deficit)
    
    
    (920
    )
    
    
    
    
    
    
    
    
    
    
    (851
    )Total Liabilities and Shareholders
Equity (Deficit)
    
    $
    21,833
    
    
    
    
    
    
    
    
    
    
    $
    20,286Net interest margin(2)
    
    
    
    
    
    $
    2,784
    
    
    
    13.39
    %
    
    
    
    
    
    $
    3,161
    
    
    
    16.73
    %Net interest spread(3)
    
    
    
    
    
    
    
    
    
    
    13.76
    %
    
    
    
    
    
    
    
    
    
    
    17.12
    %
 Three Months Ended March 31, 2005 and 2004. Average interest-earning assets increased to
$20,603,000 during the three months ended March 31, 2005, from $18,493,000 during the same period
in 2004. The average yield on these assets decreased to 19.47% from 20.22%. Average
interest-bearing liabilities, consisting primarily of notes payable to bank, increased to
$22,001,000 during the three months ended March 31, 2005, from $19,560,000 during the same period
in 2004. The average rate paid on these liabilities increased to 7.44% for the three months ended
March 31, 2005, from 6.38% for the same period in 2004. The overall increase in cost of funds was
the result of the increase in interest rates in the market. Net interest income for the three months ended March 31, 2005, was $594,000, which decreased
$29,000 or 4.7%, over the same period in the prior year. Celtics net interest margin decreased
195 basis points to 11.53% for the three months ended March 31, 2005, compared to 13.48% for the
same period in 2004. The decrease in net interest margin was primarily the result of decreased
yields on loans of 75 basis points while the rates paid on interest-bearing liabilities increased
by 106 basis points. Years Ended December 31, 2004 and 2003. Average interest-earning assets increased to
$20,790,000 during the year ended December 31, 2004, from $18,895,000 during the same period in
2003. The average yield on these assets decreased to 20.31% from 23.97%. Average interest-bearing
liabilities, consisting primarily of notes payable to bank, increased to $21,966,000 during the
year ended December 31, 2004, from $19,959,000 during the same period in 2003. The average rate
paid on these liabilities decreased to 6.55% for the year ended December 31, 2004, from 6.86% for
the same period in 2003. The overall decrease in cost of funds was the result of the decrease in
subordinated notes payable from $6,454,000 to $4,247,000. Celtic relied on increased funding
through notes payable to banks, at the lower cost of 5.78% versus 9.77%, to make up this difference
and also to fund the internal growth realized during the year. 
 (1) Average loans are net of unearned loan
fees. Loan interest income includes loan fees of $298,058 in 2004 and $468,244
in 2003.(2) Net interest margin is the net yield on
average total interest-earning assets.(3) Net interest spread is the absolute
difference between the rate earned on interest-earning assets and the rate paid
on interest-bearing liabilities. -118-




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##### 



Net interest income for the year ended December 31, 2004, was $2,784,000, which decreased
$377,000, or 11.9%, over the same period in the prior year. Celtics net interest margin decreased
334 basis points to 13.39% for the year ended December 31, 2004, compared to 16.73% for the same
period in 2003. The decrease in net interest margin was primarily the result of decreased yields
on loans of 366 basis points while the rates paid on interest-bearing liabilities decreased to a
lesser degree of 31 basis points. Net Interest Income and Net Yield. Net interest income is affected by changes in the level and the mix of interest-earning assets
and interest-bearing liabilities. The changes between periods in these assets and liabilities are
referred to as volume changes. The impact on net interest income from changes in average volume is
measured by multiplying the change in volume between the current period and the prior period by the
prior period rate. Net interest income is also affected by changes in the yields earned on assets and rates paid
on liabilities. These are referred to as rate changes and the impact on net interest income from
these changes is measured by multiplying the change in rate between the current and prior period by
the average volume of the prior period. Changes in rate-volume between periods, which is measured
by the change in rate multiplied by the change in volume, are allocated on a pro rata basis between
the volume and the rate changes. The following table reflects the rate and volume changes for the
periods indicated: For the Three Months Ended
    
    
    For the Year EndedMarch 31, 2005 Compared to the
    
    
    December 31, 2004 ComparedThree Months Ended March 31,
    
    
    to the Year Ended December2004
    
    
    31, 2003Changes Due To
    
    
    Total
    
    
    Changes Due To
    
    
    TotalVolume
    
    
    Rate
    
    
    Change
    
    
    Volume
    
    
    Rate
    
    
    Change(dollars in thousands)Interest-Earning AssetsLoans
    
    $
    107
    
    
    
    ($39
    )
    
    $
    68
    
    
    $
    454
    
    
    
    ($761
    )
    
    
    ($307
    )Total Interest Income
    
    
    107
    
    
    
    (39
    )
    
    
    68
    
    
    
    454
    
    
    
    (761
    )
    
    
    (307
    )Interest-Bearing LiabilitiesNotes payable, bank
    
    
    42
    
    
    
    80
    
    
    
    122
    
    
    
    220
    
    
    
    100
    
    
    
    320Subordinated notes payable
    
    
    (21
    )
    
    
    (4
    )
    
    
    (25
    )
    
    
    (227
    )
    
    
    (23
    )
    
    
    (250
    )Total Interest Expense
    
    
    21
    
    
    
    76
    
    
    
    97
    
    
    
    (7
    )
    
    
    (77
    )
    
    
    (70
    )Net Interest Income
(Expense)
    
    $
    86
    
    
    
    ($115
    )
    
    
    ($29
    )
    
    $
    461
    
    
    
    ($838
    )
    
    $
    377
 -119-




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##### 



Loans. Loan Categories.The following table sets forth the components of total net loans outstanding
in each category at the dates indicated: March 31,(unaudited)2005
    
    
    2004Percent of
    
    
    
    
    
    
    Percent ofAmount
    
    
    Total
    
    
    Amount
    
    
    Total(dollars in thousands)Loan CategoryAccount Receivable
    
    $
    17,044
    
    
    
    88.28
    %
    
    $
    17,088
    
    
    
    88.20
    %Equipment
    
    
    1,910
    
    
    
    9.89
    
    
    
    1,572
    
    
    
    8.11Inventory
    
    
    353
    
    
    
    1.83
    
    
    
    714
    
    
    
    3.69Total Loans
    
    
    19,307
    
    
    
    100.00
    %
    
    
    19,374
    
    
    
    100.00
    %Less deferred loan income
(benefit)
    
    
    (164
    )
    
    
    
    
    
    
    0Less Allowance
    
    
    (305
    )
    
    
    
    
    
    
    (267
    )Loans, net of deferred income
    
    $
    18,838
    
    
    
    
    
    
    $
    19,107
 December 31,2004
    
    
    2003Percent of
    
    
    
    
    
    
    Percent ofAmount
    
    
    Total
    
    
    Amount
    
    
    Total(dollars in thousands)Loan CategoryAccount Receivable
    
    $
    20,546
    
    
    
    88.79
    %
    
    $
    15,455
    
    
    
    89.46
    %Equipment
    
    
    2,146
    
    
    
    9.27
    
    
    
    1,460
    
    
    
    8.45Inventory
    
    
    449
    
    
    
    1.94
    
    
    
    361
    
    
    
    2.09Total Loans
    
    
    23,141
    
    
    
    100.00
    %
    
    
    17,276
    
    
    
    100.00
    %Less deferred loan income
(benefit)
    
    
    45
    
    
    
    
    
    
    
    (5
    )Less Allowance
    
    
    (305
    )
    
    
    
    
    
    
    (225
    )Loans, net of deferred income
    
    $
    22,791
    
    
    
    
    
    
    $
    17,026
 Celtic provides a variety of asset-based lending products to meet the needs of commercial
borrowers in its service areas, such as loans secured by current assets, including accounts
receivable, inventory, or fixed assets, such as equipment. These loans are used for working
capital, equipment purchases, seasonal cash shortages, and a variety of other purposes, and are
structured on either a revolving or term basis. Celtics loan growth is the result of increased lending in its market areas, together with
improved client retention. During 2004, Celtic increased its average turn over from 30 months to 37
months, due mainly to the continued difficulties its borrowers were experiencing in the general
economic condition of their businesses. Asset-based loans are generally more dependent on the performance of the borrowers collateral
(i.e. collection of accounts receivable and sale of inventory) and managements abilities rather
than the borrowers financial strength. The borrowers cash flow and ability to service the debt
from earnings, while important, is viewed as secondary to the value placed on the liquidation value
of any pledged collateral. Asset-based loans are generally for shorter terms and are often subject
to annual review and generally require more administrative and management attention than commercial
bank loans. -120-




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##### 



Celtic does not have any concentrations in its loan portfolio by industry or group of
industries; however, Celtics loan portfolio has ranged between 25 to 35 loan borrowers whose loans
have averaged
approximately $800,000 in size. To mitigate concentration risk, Celtic has not generally
loaned in excess of 10% of its outstanding loan portfolio to any one borrower. Any loan amounts
above this percentage are generally participated out to other lenders. Celtic has not made any
loans to foreign entities. Loan Origination and Underwriting.Celtic originates commercial loans that are collateralized
primarily by personal property. The principal factors considered in making lending decisions are
the amount of the loan in comparison to the value of the collateral, the borrowers financial
condition and the borrowers capacity to repay the loan. Celtic attempts to minimize lending risk
by limiting the total amount loaned to any one borrower. Additionally, Celtic monitors and
restricts its credit exposure in specific industries and geographic areas. Celtic conducts due
diligence on each new borrower. If there is an equipment loan proposed, Celtic contacts an
independent auctioneer to conduct a liquidation value appraisal. Upon completion of the due
diligence process, Celtics loan committee reviews the due diligence, appraisal (if applicable) and
public record search information to determine the feasibility/desirability of the transaction. The
loan committee is responsible for final loan structuring and pricing, including the advance rate.
Typically, advance rates depend on the collateral being financed. Accounts receivable advance
rates range from 65% to 80%, equipment from 50% to 75%, and inventory from 10% 50%. Loan Maturities.The following table sets forth the maturity distribution of Celtics loans
outstanding at December 31, 2004. At that date, Celtic had no loans with maturity greater than
five years. At that date, all of Celtics loans had variable (floating) interest rates. Floating
rates generally fluctuate with changes in Wells Fargos prime interest rate. MaturingWithin One
    
    
    One to FiveYear
    
    
    Years
    
    
    Total(dollars in thousands)Accounts Receivable
    
    $
    18,241
    
    
    $
    2,305
    
    
    $
    20,546Equipment
    
    
    2,052
    
    
    
    94
    
    
    
    2,146Inventory
    
    
    32
    
    
    
    417
    
    
    
    449Total
    
    $
    20,325
    
    
    $
    2,816
    
    
    $
    23,141
 Loan Commitments.Prior to funding a new transaction, Celtic does an extensive due diligence
of the prospective borrowers business to determine the credit worthiness of the prospect. During
the due diligence a maximum line of credit is determined, based, in part, on the needs of the
business. Celtic then lends the lesser of the maximum line of credit approved or the amount
determined by its lending formula with the respective borrower (the borrowing base). Typically,
Celtic will lend up to 80% of the eligible accounts receivable, 75% of the auction value appraisal
on machinery and equipment, and up to 50% on eligible inventory. As the eligible collateral pool
increases, Celtics loan increases, provided it does not exceed the maximum line of credit
approved. Should a borrower need an increase to the maximum line of credit, a current audit as
well as Celtics internal trend reports, are reviewed by Celtics loan committee for approval of an
increase in the maximum line of credit. Unfunded loan commitments represent the difference in the
amount the borrower has available (the lesser of the maximum line of credit and the borrowing base)
and the borrowers actual loan balance. Celtic had unfunded loan commitments, net of
participations, totaling $1,938,000 and $4,813,000 at March 31, 2005 and December 31, 2004,
respectively. Non-Performing Assets.It is Celtics policy to place loans on non-accrual status when
principal or interest payments exhibit a reasonable doubt as to collectibility. Loans which are in
the process of renewal in the normal course of business or are well secured and in the process of
collection will continue to accrue interest if Celtic considers the risk of loss to be minimal. -121-




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If concerns arise as to the viability of the borrower, the portfolio manager will recommend to
senior management one or more of these alternatives:  
    
    Meet with the borrower to discuss concerns of Celtics management and to rapidly
develop a turnaround plan;
    
    Strengthen Celtics collateral to loan position such as by reducing the advance
rate, lowering the overall line of credit, or building reserves; and
    
    Asking the borrower to find an alternative lender to pay off Celtics loan. If any of the above occurs increased verifications will be required. If not already in place,
the client is usually changed to a direct notification account, whereby Celtic notifies the
borrowers account debtors to pay Celtic directly for any invoices due to the borrower. Unless
Celtic agrees to a turnaround plan, the borrower is usually given a 60 day written notice of
Celtics intent to terminate the contract. During the 60-day period, Celtic will increase
monitoring of the borrower. If the borrower commits a significant event of default (such as
fraud), the funding ceases and Celtic will immediately begin liquidating its collateral. In cases where a bankruptcy is filed, Celtic will submit a motion for relief from the
automatic stay and requests approval to liquidate its collateral. Any objections to this are
usually easily overcome. In less severe situations, the borrower is able to find alternate financing and simply pay off
Celtics loans in full. There were no non-accrual or impaired loans or loans that have or had a higher than normal
risk of loss at March 31, 2005 or December 31, 2004. As of March 31, 2005, Celtic had no loans
identified on its internal watch list for special attention by its management or board of
directors. Allowance and Provision for Loan Losses Celtic maintains an allowance for loan losses to provide for probable losses in the loan
portfolio. Additions to the allowance are made by charges to operating expenses in the form of a
provision for loan losses. All loans which are judged to be uncollectible are charged against the
allowance while any recoveries are credited to the allowance. Celtic has reviewed the outstanding
loans and has determined, based on client reported collateral, loan trend analysis and internal
audits, that its allowance for loan losses of $305,000 is adequate. Celtic has developed its
internal control procedures to mitigate and detect fraud at the customer level; however, Celtic is
not able to fully assess the risk of fraud or the effect on Celtic should fraud occur. In March of
2001, Celtic uncovered a large fraud perpetrated by one of its borrowers. The fraud resulted in a
bad debt write off in 2001 of $850,000, and a loss from operations of in excess of $1 million.
This loss caused Celtics senior lender to request that Celtic find alternative financing. The
change in senior lenders caused a significant increase in Celtics cost of funds which, in turn,
led to decreased profitability. The loss also impacted Celtics ability to grow the portfolio, as
the loss in capital reduced their borrowing capabilities by $4 to $5 million. Since this fraud was
detected, Celtic has instituted a wide range of enhancements in its collateral monitoring, credit
approval and loan review processes. The allowance for loan losses has not been adjusted to reflect
a risk outside Celtics normal credit loss history. Celtic has instituted loan policies, designed
primarily for internal use, to evaluate and assess the analysis of risk factors associated with its
loan portfolio and to enable it to assess such risk factors prior to granting new loans and to
assess the sufficiency of the allowance. Celtic conducts a critical evaluation of the loan
portfolio monthly. This evaluation includes an assessment of the following factors: the results of
its internal loan review, any external loan review and any regulatory examination, loan loss
experience, estimated potential loss exposure on each credit, concentrations of credit, value of
collateral, any known impairment in the borrowers ability to repay and present economic
conditions. Each month Celtic also reviews the allowance and makes additional transfers to the allowance
as needed. At December 31, 2004, the allowance for loan losses was $305,000 as compared to
$255,000 at -122-




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December 31, 2003. The provision for loan losses charged to operating expense during
the year ended December 31, 2004 was $38,035, compared to $177,500 for the prior year. At March 31, 2005, the allowance was $305,000 or 1.58% of the loans then outstanding. At
December 31, 2004, the allowance for loan losses was $305,000, or 1.32% of loans outstanding.
Although Celtic deemed
these levels adequate, no assurance can be given that further economic difficulties or other
circumstances which would adversely affect Celtics borrowers and their ability to repay
outstanding loans will not occur which would be reflected in increased losses in Celtics loan
portfolio, which losses could possibly exceed the amount then reserved for loan losses. The following table summarizes Celtics loan loss experience, transactions in the allowance
for loan and lease losses and certain pertinent ratios for the periods indicated: March 31,(unaudited)
    
    
    December 31,2005
    
    
    2004
    
    
    2004
    
    
    2003(dollars in thousands)Outstanding loans:End of the period
    
    $
    19,308
    
    
    $
    19,374
    
    
    $
    23,096
    
    
    $
    17,281Average for the period
    
    $
    20,603
    
    
    $
    18,493
    
    
    $
    20,790
    
    
    $
    18,895Allowance for loan losses:Balance at beginning of period
    
    $
    305
    
    
    $
    255
    
    
    $
    255
    
    
    $
    328Loans charged off
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    250Recoveries
    
    
    0
    
    
    
    12
    
    
    
    12
    
    
    
    0Provisions charged to operating expense
    
    
    0
    
    
    
    0
    
    
    
    38
    
    
    
    177Balance at end of period
    
    $
    305
    
    
    $
    267
    
    
    $
    305
    
    
    $
    255Ratios:Net charge-offs (recoveries) to average loans
    
    
    0.00
    %
    
    
    (0.06
    %)
    
    
    (0.06
    %)
    
    
    1.32
    %Allowance to loans at period end
    
    
    1.58
    %
    
    
    1.38
    %
    
    
    1.32
    %
    
    
    1.48
    %
 The table below sets forth the allocation of the allowance for loan losses by loan type as of
the dates specified. The allocation of individual categories of loans includes amounts applicable
to specifically identified as well as unidentified losses inherent in that segment of the loan
portfolio and will necessarily change whenever Celtic determines that the risk characteristics of
the loan portfolio have changed. Celtic believes that any breakdown or allocation of the allowance
for loan losses into loan categories lends an appearance of exactness which does not exist, in that
the allowance is utilized as a single unallocated allowance available for all loans. The allocation
below should not be interpreted as an indication of the specific amounts of or loan categories in
which future charge-offs may occur: At March 31,2005
    
    
    2004Percent of
    
    
    
    
    
    
    Percent ofAllowance
    
    
    Loans in
    
    
    Allowance
    
    
    Loans infor Loan
    
    
    Category to
    
    
    for Loan
    
    
    Category toLosses
    
    
    Total Loans
    
    
    Losses
    
    
    Total Loans(dollars in thousands)Accounts Receivable
    
    $
    284
    
    
    
    88.28
    %
    
    $
    238
    
    
    
    88.20
    %Equipment
    
    
    16
    
    
    
    9.89
    %
    
    
    20
    
    
    
    8.12
    %Inventory
    
    
    5
    
    
    
    1.83
    %
    
    
    9
    
    
    
    3.68
    %Total
    
    $
    305
    
    
    
    100.00
    %
    
    $
    267
    
    
    
    100.00
    %
 -123-




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Costs and Expenses. Costs and expenses consist of salaries and related benefits, office and occupancy, other
operating expenses and merger related expenses. The tables below set forth the components of
non-interest expenses as of the periods indicated: Three Months Ended March 31,(unaudited)
    
    
    Percentage2005
    
    
    2004
    
    
    Change(dollars in thousands)Salaries and benefits
    
    $
    344
    
    
    $
    392
    
    
    
    (12.24
    %)Office and occupancy.
    
    
    52
    
    
    
    73
    
    
    
    (28.77
    %)Other operating
    
    
    151
    
    
    
    241
    
    
    
    (37.34
    %)Total
    
    $
    547
    
    
    $
    706
    
    
    
    (22.52
    %)
 Years Ended December 31,
    
    
    Percentage2004
    
    
    2003
    
    
    Change(dollars in thousands)Salaries and benefits
    
    $
    1,682
    
    
    $
    1,662
    
    
    
    1.20
    %Office and occupancy
    
    
    517
    
    
    
    678
    
    
    
    (23.75
    %)Other operating
    
    
    464
    
    
    
    503
    
    
    
    (7.75
    %)Merger related expenses
    
    
    0
    
    
    
    122
    
    
    
    (100.00
    %)Total
    
    $
    2,663
    
    
    $
    2,965
    
    
    
    (10.19
    %)
 Celtics costs and expenses decreased by $159,000 or 22.52%, for the three months ended March
31, 2005, compared to the three months ended March 31, 2004. Celtics costs and expenses decreased by $302,000, or 10.19%, for the year ended December 31,
2004, compared to the year ended December 31, 2003. The largest expense savings realized were in
office and occupancy, which decreased from $678,000 to $517,000 and merger related expenses, which
decreased from $122,000 to $0. Merger related expenses incurred in 2003 were a result of legal and
accounting expenses in connection with a failed merger of Celtic with a company in New Jersey.
Celtic was to be acquired by the New Jersey company which proved unable to raise the funds required
and, as a result, the deal was not consummated. Office and occupancy expenses were reduced
primarily due to a renegotiated lease for Celtics primary office space and reductions in most
office expense categories due to the restructuring of the marketing department and the move to a
100% web-based marketing plan for 2004. This resulted in reduced printing, mailing and other
miscellaneous categories. Income Taxes Celtic is a Sub-Chapter S corporation and is taxed at the shareholder level. The taxes paid
by Celtic relate to state taxes. Capital Resources Currently Celtic is under capitalized and the proposed transaction with Bancorp will provide
the capital needed to continue operations. -124-




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Liquidity and Liquidity Management Liquidity and liquidity management for Celtic is essentially the management of liquid
resources to fund loans and provide for the payment of expenses. Celtic maintains cash balances to
cover immediately foreseeable operating needs, including funding loans. Funds in excess of these
needs are used to decrease the operating lines of credit used to fund loans. Cash was $3,255,000
at March 31, 2005 and $1,319,000 at December 31, 2004. The increase from December 31, 2004 to
March 31, 2005 was to due to normal month-end fluctuations in cash receipts and expenditures. Notes payable to banks represent Celtics primary source of funds to support its lending
activities. These amounts are due upon demand. These notes are normally limited to 80% of the
outstanding loans and the shortfall is funded through internal capital or other borrowings. The
Holding Company anticipates restructuring Celtics notes payable to banks at a lower interest rate. Celtics capital structure has been primarily made up of subordinated notes payable. These
notes are mainly held by family and friends of Celtics principals and either pay or accrue
interest monthly. Subordinated notes represent a secondary source of liquidity. Subordinated
notes payable at March 31, 2005, and December 31, 2004, were $4,766,000 and $4,328,000,
respectively, with a rate of 4% over the prime rate. These subordinated notes will not be assumed
in the Celtic acquisition. Off Balance Sheet Arrangements Unfunded loan commitments represent the difference in the amount the borrower has available
(the lesser of the maximum line of credit and the borrowing base) and the borrowers actual loan
balance. Celtic had unfunded loan commitments, net of participations, totaling $1,938,000 and
$4,813,000 at March 31, 2005 and December 31, 2004, respectively. Similarly, Celtic maintains excess availability with its senior lender, which is calculated
the same as Celtic does with its borrowers. Celtic had unfunded availability with its senior
lender totaling $1,254,000 and $639,000 at March 31, 2005, and December 31, 2004, respectively. Quantitative And Qualitative Disclosures About Market Risk Celtics market risk arises primarily from credit risk, with interest rate risk as a secondary
source. Risk management is an important part of Celtics operations and a key element of its
overall financial results. Celtic monitors its business activities and applies various strategies
to manage the risks to which it is exposed. Celtics primary strategy to mitigate interest rate
risk is to board notes with variable rates based on prime. By doing so, when interest rates rise or
fall, depending upon current economic conditions, Celtic anticipates the rates realized on notes
increase or decrease by a similar degree to the increase or decrease realized from its funding
sources, which are also based on prime. Credit Risk.Credit risk generally arises as a result of lending activities and may be
present with investment activities. To manage the credit risk inherent in lending activities,
Celtic relies on adherence to underwriting standards and loan policies as well as the establishment
of an adequate allowance for loan losses. Celtic employs frequent monitoring procedures and takes
prompt corrective action when necessary. Interest Rate Risk.Interest rate risk is the exposure of Celtics financial condition,
both earnings and the market value of assets and liabilities, to adverse movements in interest
rates. Interest rate risk results from differences in the maturity or timing of interest-earning
assets and interest-bearing liabilities. Celtic manages this risk, as noted above, by utilizing
variable rate funding sources to fund its variable rate loans which are also based on prime. ITEM 3. CONTROLS AND PROCEDURES Bancorp maintains disclosure controls and procedures that are designed to ensure that
information required to be disclosed in Bancorps Exchange Act reports is recorded, processed,
summarized and reported within the time periods specified and that such information is accumulated
and communicated to Bancorps -125-




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management, including its Chief Executive Officer and Chief Financial Officer, as appropriate,
to allow timely decisions regarding required disclosure. Bancorps Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the
effectiveness of Bancorps disclosure controls and procedures as of date within ninety days before
the filing date of this report. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer have concluded that Bancorps disclosure controls and procedures are effective,
providing them with material information relating to Bancorp as required to be disclosed in the
reports Bancorp files or submits under the Exchange Act on a timely basis. There were no significant changes in Bancorps internal controls or in other factors that
could significantly affect Bancorps disclosure controls and procedures subsequent to the date of
their evaluation, nor were there any significant deficiencies or material weaknesses in Bancorps
internal controls. Part II
OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS There are no material legal proceedings to which Bancorp is a party or to which any of its
property is subject. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5. OTHER INFORMATION Not applicable. -126-




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ITEM 6. EXHIBITS The following exhibits are filed as a part of this report:: Exhibit No.
    
    Description of Exhibit1
    
    Underwriting Agreement(4)2
    
    Plan of Reorganization and Merger Agreement, dated October 20, 2004 by and
between Discovery Bank and DB Merger Company(2)3.1
    
    Articles of Incorporation of Discovery Bancorp(2)3.2
    
    Bylaws of Discovery Bancorp(2)4.1
    
    Form of Discovery Bank Warrant(2)4.2
    
    Shareholder Agreement dated October 20, 2004(2)10.1
    
    Discovery Bancorp 2004 Stock Option Plan, as amended(3)10.2
    
    Form of Discovery Bancorp Stock Option Agreement(2)10.3
    
    Form of Discovery Bancorp Indemnity Agreement(2)10.4
    
    Lease Agreement (338 Via Vera Cruz)(2)10.5
    
    Employment Agreement dated January 1, 2005 with James P. Kelley, II(3)10.6
    
    Employment Agreement dated January 1, 2005 with Joseph C. Carona(3)10.7
    
    Employment Agreement dated January 1, 2005 with Lou Ellen Ficke(3)10.8
    
    Employment Agreement dated January 1, 2005 with Stanley Cruse(3)10.9
    
    Celtic Asset Purchase Agreement dated January 27, 2005(3)21
    
    Subsidiaries(4)31.1
    
    Certification of James P. Kelley, II31.2
    
    Certification of Lou Ellen Ficke32.1
    
    Section 1350 Cerftification of James P. Kelley, II32.2
    
    Section 1350 Certification of Lou Ellen Ficke
 
 (1) This exhibit is incorporated by reference
from the Registrants Registration Statement on Form SB-2, filed on June
23, 2005.(2) These exhibits are incorporated by
reference from the Registrants Registration Statement on Form S-4, filed
January 18, 2005.(3) These exhibits are incorporated by
reference from the Registrants Pre-Effective Amendment No. 1 to the
Registration Statement on Form S-4, filed April 6, 2005.(4) Filed as an exhibit to Registrants
Current Report on Form 8-K dated June 27, 2005. -127-




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SIGNATURES In accordance with the the requirements of the Securities Exchange Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized. DISCOVERY BANCORPDate: June 30, 2005
    /s/ James P. Kelley, IIJames P. Kelley, II,President and Chief Executive Officer/s/ Lou Ellen FickeLou Ellen FickeExecutive Vice President and Chief Financial Officer -128-