**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-K**

 
| **(Mark One)**                                                                                                                                                                                                                                   |
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| **ý**                                                                                                                                                                                                                                       | ** ** | **Annual report pursuant to Section 13 or 15(d) of  the Securities Exchange Act of 1934** |
|                                                                                                                                                                                                                                             |   |   |
| **For the  fiscal year ended December 31, 2004**                                                                                                                                                                                                 |
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| ** **                                                                                                                                                                                                                                       | ** ** | **OR** |
|                                                                                                                                                                                                                                             |   |   |
| **o**                                                                                                                                                                                                                                            | ** ** | **Transition report pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
|                                                                                                                                                                                                                                             |   |   |
| **For the  transition period from                   to                  .** |
|                                                                                                                                                                                                                                             |   |   |
| **Commission  File Number 000-50771**                                                                                                                                                                                                            |

 

**BG Financial Group, Inc.**

(Exact name of registrant as specified in Charter)

 
| ** **                                                                  | **Tennessee**                                                 | ** **                             |   | ** ** | **62-1852691** | ** ** |
|-----------------------------------------------------------------------------|---------------------------------------------------------------|----------------------------------------|--------|------------|----------------|------------|
| (State or  other jurisdiction  of incorporation or organization)            |                                                          | (I.R.S.  Employer  Identification No.) |
|                                                                        |                                                          |                                   |
| ** **                                                                  | **3095  East Andrew Johnson Highway, Greeneville, Tennessee** | ** **                             |   | ** ** | **37745**      | ** ** |
| (Address of  principal executive office)                                    |                                                          | (Zip Code)                             |
|                                                                        |                                                          |                                   |
| Registrant’s  telephone number, including area code **(423) 636-1555** |                                                          |                                   |
|                                                                             |                                                               |                                        |        |            |                |            |  |  |

 

Securities registered pursuant to Section 12(b) of the Act:

**None**

 

Securities registered pursuant to Section 12(g) of the Act:

**Common Stock, $0.333 par value per share**

 

Indicate bycheck mark whether registrant (1) has filed reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days:  Yes ý  No o.

 

Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.    ý

 

The aggregatemarket value of the registrant’s voting stock held by non-affiliates of theregistrant at February 28, 2005 was $36.1 million, based upon the average saleprice on that date.

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act).  Yes o. No ý.

 

 

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TABLE OFCONTENTS

 
| **PART 1**    |                                                                                                                 |
|---------------|----------------------------------------------------------------------------------------------------------------------|
|          |                                                                                                                 |   |
| ITEM  1.      | BUSINESS                                                                                                             | 1 |
| ITEM  2.      | PROPERTIES                                                                                                           | 12 |
| ITEM  3.      | LEGAL PROCEEDINGS                                                                                                    | 13 |
| ITEM  4.      | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                 | 13 |
|          |                                                                                                                 |   |
| **PART II**   |                                                                                                                 |
|          |                                                                                                                 |   |
| ITEM  5.      | MARKET  FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER  PURCHASES OF EQUITY SECURITIES | 13 |
| ITEM 6.       | SELECTED FINANCIAL DATA                                                                                              | 15 |
| ITEM 7.       | MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATION                           | 16 |
| ITEM 7A.      | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISK                                                          | 30 |
| ITEM 8.       | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                          | 30 |
| ITEM 9.       | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURE                                | 30 |
| ITEM 9A.      | CONTROLS AND PROCEDURES                                                                                              | 30 |
| ITEM 9B.      | OTHER INFORMATION                                                                                                    | 31 |
|          |                                                                                                                 |   |
| **PART  III** |                                                                                                                 |
|          |                                                                                                                 |   |
| ITEM 10.      | DIRECTORS AND EXECUTIVE OFFICERS OF THE  REGISTRANT                                                                  | 31 |
| ITEM 11.      | EXECUTIVE COMPENSATION                                                                                               | 31 |
| ITEM 12.      | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS  AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS                      | 31 |
| ITEM 13.      | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                       | 31 |
| ITEM 14.      | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                               | 31 |
|          |                                                                                                                 |   |
| **PART IV**   |                                                                                                                 |
|          |                                                                                                                 |   |
| ITEM 15.      | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                                           | 32 |

 

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PART I

 

**ITEM 1.**                                                     BUSINESS

 

General

 

BG FinancialGroup, Inc. (the “Corporation”) is a one-bank holding company formed as aTennessee corporation to own the shares of Bank of Greeneville (the “Bank”).  The Corporation was incorporated on October10, 2003, for the purpose of acquiring 100% of the shares of the Bank by meansof a share exchange, and becoming a registered bank holding company under theFederal Reserve Act.  The share exchangewas completed on January 23, 2004.  Theactivities of the Corporation are subject to the supervision of the Board ofGovernors of the Federal Reserve System (“Federal Reserve Board”).  The offices of the Corporation are the sameas the principal office of the Bank.  TheBank is the only subsidiary of the Corporation.

 

Bank ofGreeneville commenced operations as a state chartered bank on July 9,2001.  The Bank has total assets ofapproximately $91 million at December 31, 2004. The Bank ‘s deposit accounts are insured by the FDIC, up to the maximumapplicable limits thereof.  The Bank isnot a member of the Federal Reserve System.

 

The Bank’scustomer base consists primarily of small to medium-sized business retailers,manufacturers, distributors, contractors, professionals, service businesses andlocal residents.  The Bank offers a fullrange of competitive retail and commercial banking services.  The deposit services offered include varioustypes of checking accounts, savings accounts, money market investment accounts,certificates of deposits, and retirement accounts.  Lending services include consumer installmentloans, various types of mortgage loans, personal lines of credit, home equityloans, credit cards, real estate construction loans, commercial loans to smalland medium size businesses and professionals, and letters of credit.  The Bank also offers safe deposit boxes ofvarious sizes.  The Bank issues VISA andMasterCard credit cards and is a merchant depository for cardholder draftsunder both types of credit cards.  TheBank offers its customers drive-through banking services at both offices andautomated teller machines (“ATMs”). The Bank has trust powers but does not havea trust department.

 

The Bank issubject to the regulatory authority of the Department of Financial Institutionsof the State of Tennessee (“TDFI”) and the Federal Deposit InsuranceCorporation (“FDIC”).

 

The Bank’sprincipal executive offices are located at 3095 East Andrew Johnson Highway,Greeneville, Tennessee 37745, and its telephone number is (423) 636-1555.

 

FirstCommunity Corporation 

 

FirstCommunity Corporation is a bank holding company that commenced operations in1994.  Its principal asset is the capitalstock of First Community Bank of East Tennessee in Rogersville, Tennessee (aTennessee state-chartered bank that began operations in April 1993).  In 2000, the Board of Directors of FirstCommunity Corporation decided to expand its business into Greene County.  After consultation with legal counsel andregulators, and after the services were obtained of J. Robert Grubbs, along-time Greene County banker, First Community Bank of East Tennessee opened abranch in Greeneville on July 26, 2000.

 

On July 6,2001, First Community Bank of East Tennessee sold all its Greeneville branchassets and liabilities, including loans, investments, property, fixed assets,and deposits to the Bank pursuant to a Purchase and Assumption Agreement.  The sale occurred at the net book value ofthe assets and liabilities assumed with an adjustment for any net operatingloss or gain incurred by the branch operations.

 

Market Areaand Competition

 

All phases ofthe Bank’s business are highly competitive. The Bank is subject to intense competition from various financialinstitutions and other companies or firms that offer financial services.  The Bank competes for deposits with othercommercial banks, savings and loan associations, credit unions and issuers ofcommercial paper and other securities, such as money-market and mutualfunds.  In making loans, the Bank isexpected to compete with other commercial banks, savings and loan associations,consumer finance companies, credit unions, leasing companies, and otherlenders.

 

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In GreeneCounty as of June 30, 2004, there were eight (8) banks and one (1) savings andloan institution, with at least 27 offices actively engaged in bankingactivities, including three (3) major state-wide financial institutions.  In addition, there are numerous creditunions, finance companies, and other financial services providers.

 

Employees

 

At December31, 2004, the Bank employed 35 persons on a full-time basis, and 6 persons on apart-time basis.  The Bank’s employeesare not represented by any union or other collective bargaining agreement andthe Bank believes its employee relations are satisfactory.

 

Supervisionand Regulation

 

BankHolding Company Regulation

 

The Corporation is a bankholding company within the meaning of the Bank Holding Company Act of 1956, asamended (the “Holding Company Act”), and is registered with the Federal ReserveBoard.  Its banking subsidiaries aresubject to restrictions under federal law which limit the transfer of funds bythe subsidiary banks to their respective holding companies and nonbankingsubsidiaries, whether in the form of loans, extensions of credit, investments,or asset purchases.  Such transfers byany subsidiary bank to its holding company or any non-banking subsidiary are limitedin amount to 10% of the subsidiary bank’s capital and surplus and, with respectto the Corporation and all such nonbanking subsidiaries, to an aggregate of 20%of such bank’s capital and surplus. Furthermore, such loans and extensions of credit are required to besecured in specified amounts.  TheHolding Company Act also prohibits, subject to certain exceptions, a bankholding company from engaging in or acquiring direct or indirect control ofmore than 5% of the voting stock of any company engaged in non bankingactivities.  An exception to thisprohibition is for activities expressly found by the Federal Reserve Board tobe so closely related to banking or managing or controlling banks as to be aproper incident thereto or financial in nature.

 

As a bank holding company,the Corporation is required to file with the Federal Reserve Board semi-annualreports and such additional information as the Federal Reserve Board mayrequire.  The Federal Reserve Board alsomakes examinations of the Corporation.

 

According to Federal ReserveBoard policy, bank holding companies are expected to act as a source offinancial strength to each subsidiary bank and to commit resources to supporteach such subsidiary.  This support maybe required at times when a bank holding company may not be able to providesuch support.  Furthermore, in the eventof a loss suffered or anticipated by the FDIC - either as a result of defaultof a banking or thrift subsidiary of the Corporation or related to FDICassistance provided to a subsidiary in danger of default - the other bankingsubsidiaries of the Corporation may be assessed for the FDIC’s loss, subject tocertain exceptions.

 

Various federal and statestatutory provisions limit the amount of dividends the subsidiary banks can payto their holding companies without regulatory approval.  The payment of dividends by any bank also maybe affected by other factors, such as the maintenance of adequate capital forsuch subsidiary bank.  In addition to theforegoing restrictions, the Federal Reserve Board has the power to prohibitdividends by bank holding companies if their actions constitute unsafe orunsound practices.  The Federal ReserveBoard has issued a policy statement on the payment of cash dividends by bankholding companies, which expresses the Federal Reserve Board’s view that a bankholding company experiencing earnings weaknesses should not pay cash dividendsthat exceed its net income or that could only be funded in ways that weaken thebank holding company’s financial health, such as by borrowing. Furthermore, theTDFI also has authority to prohibit the payment of dividends by a Tennesseebank when it determines such payment to be an unsafe and unsound bankingpractice.

 

 

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A bank holding company andits subsidiaries are also prohibited from acquiring any voting shares of, orinterest in, any banks located outside of the state in which the operations ofthe bank holding company’s subsidiaries are located, unless the acquisition is specificallyauthorized by the statutes of the state in which the target is located.  Further, a bank holding company and itssubsidiaries are prohibited from engaging in certain tie-in arrangements inconnection with the extension of credit or provision of any property orservice.  Thus, an affiliate of a bankholding company may not extend credit, lease or sell property, or furnish anyservices or fix or vary the consideration for these on the condition that (i)the customer must obtain or provide some additional credit, property orservices from or to its bank holding company or subsidiaries thereof or (ii)the customer may not obtain some other credit, property, or services from acompetitor, except to the extent reasonable conditions are imposed to assurethe soundness of the credit extended.

 

In approving acquisitions bybank holding companies of banks and companies engaged in the banking-relatedactivities described above, the Federal Reserve Board considers a number offactors, including the expected benefits to the public such as greaterconvenience, increased competition, or gains in efficiency, as weighed againstthe risks of possible adverse effects such as undue concentration of resources,decreased or unfair competition, conflicts of interest, or unsound bankingpractices.  The Federal Reserve Board isalso empowered to differentiate between new activities and activities commencedthrough the acquisition of a going concern.

 

The Attorney General of theUnited States may, within 30 days after approval by the Federal Reserve Boardof an acquisition, bring an action challenging such acquisition under thefederal antitrust laws, in which case the effectiveness of such approval isstayed pending a final ruling by the courts. Failure of the Attorney General to challenge an acquisition does not,however, exempt the holding company from complying with both state and federalantitrust laws after the acquisition is consummated or immunize the acquisitionfrom future challenge under the anti-monopolization provisions of the ShermanAct.

 

CapitalGuidelines

 

The Federal Reserve Boardhas risk based capital guidelines for bank holding companies and memberbanks.  Under the guidelines, the minimumratio of capital to risk weighted assets (including certain off balance sheetitems, such as standby letters of credit) is 8%.  To be considered a “well capitalized” bank orbank holding company under the guidelines, a bank or bank holding company musthave a total risk based capital ratio in excess of 10%.  At December 31, 2004, on a pro forma basis,the Corporation would have been sufficiently capitalized to be considered “wellcapitalized.”

 

At least half of the totalcapital is to be comprised of common equity, retained earnings, and a limitedamount of perpetual preferred stock, after subtracting goodwill and certainother adjustments (“Tier I capital”). The remainder may consist of perpetual debt, mandatory convertible debtsecurities, a limited amount of subordinated debt, other preferred stock notqualifying for Tier I capital, and a limited amount of loan loss reserves (“TierII capital”).  The Bank is subject tosimilar capital requirements adopted by the FDIC.  In addition, the Federal Reserve Board, andthe FDIC have adopted a minimum leverage ratio (Tier I capital to total assets)of 3%.  Generally, banking organizationsare expected to operate well above the minimum required capital level of 3%unless they meet certain specified criteria, including that they have thehighest regulatory ratings. Most banking organizations are required to maintaina leverage ratio of 3%, plus an additional cushion of at least 1% to 2%.  Most community banks are encouraged tomaintain a leverage ratio of 6.5% to 7.0%; the Bank’s leverage ratio atDecember 31, 2004, was 8.5%.  Theguidelines also provide that banking organizations experiencing internal growthor making acquisitions will be expected to maintain strong capital positionssubstantially above the minimum supervisory levels without significant relianceupon intangible assets.

 

Under the FinancialInstitutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), failureto meet the capital guidelines could subject a banking institution to a varietyof enforcement remedies available to federal regulatory authorities, includingthe termination of deposit insurance by the FDIC.

 

 

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Sarbanes-OxleyAct of 2002 

 

On July 30,2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. Thislegislation represents a comprehensive revision of laws affecting corporategovernance, accounting obligations and corporate reporting. The Sarbanes-Oxley Actis applicable to all companies with equity securities registered, or that filereports under, the Securities Exchange Act of 1934.  In particular, the act establishes (i) newrequirements for audit committees, including independence, expertise andresponsibilities; (ii) additional responsibilities regarding financialstatements for the chief executive officer and chief financial officer of thereporting company and new requirements for them to certify the accuracy ofperiodic reports; (iii) new standards for auditors and regulation of audits;(iv) increased disclosure and reporting obligations for the reporting companyand its directors and executive officers, including an accelerated time framefor reporting of insider transactions; and (v) new and increased civil andcriminal penalties for violations of the federal securities laws. Thelegislation also established a new accounting oversight board to enforceauditing standards and restrict the scope of services that accounting firms mayprovide to their public company audit clients.

 

Because theCorporation’s common stock is registered with the SEC, it is subject to therequirements of this legislation.  At thepresent time, and subject to the final rules and regulations to be adopted andissued by the SEC, management anticipates that the Corporation will incuradditional expense as a result of the act but does not expect that theCorporation’s compliance will have a material impact on its business. To theextent that the Corporation has already implemented the requirements of thislegislation and the related regulations, compliance has been accomplished withexisting Corporation personnel.

 

TheCorporation files periodic reports with the SEC. The public may read and copyany materials the Corporation files with the SEC at the SEC’s Public ReferenceRoom at 450 Fifth Street, N.W., Washington, D.C. 20549.  Information regarding the PublicReference Room may be obtained by calling the SEC at 1-800-SEC-0330.  The SEC also maintains an Internet site thatcontains reports, proxy and information statements, and other informationregarding the Corporation that the Corporation files electronically with theSEC.  This information may be found atwww.sec.gov.

 

Bank Regulation

 

The Bank is aTennessee state-chartered bank and is subject to the regulations of andsupervision by the FDIC as well as the TDFI, Tennessee’s state bankingauthority.  The Bank is also subject tovarious requirements and restrictions under federal and state law, includingrequirements to maintain reserves against deposits, restrictions on the typesand amounts of loans that may be granted and the interest that may be chargedthereon and limitations on the types of investments that may be made and thetypes of services that may be offered. Various consumer laws and regulations also affect the operations of theBank.  In addition to the impact ofregulation, commercial banks are affected significantly by the actions of theBoard of Governors of the Federal Reserve System (the “Federal Reserve Board”)as it attempts to control the money supply and credit availability in order toinfluence the economy.

 

From time totime, legislation is enacted which has the effect of increasing the cost ofdoing business, limiting or expanding permissible activities or affecting thecompetitive balance between banks and other financial institutions.  Proposals to change the laws and regulationsgoverning the operations and taxation of banks, bank holding companies andother financial institutions are frequently made in Congress, in the Tennesseelegislature and before various bank regulatory and other professional agencies.  The likelihood of any major legislativechanges and the impact such changes might have on the Bank are impossible topredict.

 

*General.*The Bank, as a Tennessee statechartered bank, is subject to primary supervision, periodic examination andregulation by the Commissioner of the TDFI (“Commissioner”) and the FDIC.  If, as a result of an examination of a bank,the FDIC should determine that the financial condition, capital resources,asset quality, earnings prospects, management, liquidity or other aspects of theBank’s operations are unsatisfactory or that the Bank or its management isviolating or has violated any law or regulation, various remedies are availableto the FDIC.  Such remedies include thepower to enjoin “unsafe or unsound” practices, to require affirmative action tocorrect any conditions resulting from any violation or practice, to issue anadministrative order that can be judicially enforced, to direct an increase incapital, to restrict the growth of the Bank, to assess civil monetarypenalties, to remove officers and directors and ultimately to terminate a Bank’sdeposit insurance.  The Commissioner hasmany of the same remedial powers, including the power to take possession of abank whose capital becomes impaired.

 

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The depositsof the Bank are insured by the FDIC in the manner and to the extent provided bylaw.  For this protection, the Bank paysa semiannual statutory assessment. Although the Bank is not a member of the Federal Reserve System, it isnevertheless subject to certain regulations of the Federal Reserve Board.

 

Variousrequirements and restrictions under the laws of the State of Tennessee and theUnited States affect the operations of the Bank.  State and federal statutes and regulationsrelate to many aspects of the Bank’s operations, including reserves againstdeposits, interest rates payable on deposits, loans, investments, mergers andacquisitions, borrowings, dividends, locations of branch offices and capitalrequirements.  Further, the Bank isrequired to maintain certain levels of capital.

 

Tennessee lawcontains limitations on the interest rates that may be charged on various typesof loans and restrictions on the nature and amount of loans that may be grantedand on the types of investments which may be made.  The operations of banks are also affected byvarious consumer laws and regulations, including those relating to equal creditopportunity and regulation of consumer lending practices.  All Tennessee banks must become and remaininsured banks under the FDIA. (See 12 U.S.C. §1811, et seq.).

 

*Payment of Dividends*.  The Bank is subject to the Tennessee BankingAct, which limits a bank’s ability to pay dividends.  The payment of dividends by any bank isdependent upon its earnings and financial condition and subject to thestatutory power of certain federal and state regulatory agencies to act toprevent what they deem unsafe or unsound banking practices.  The payment of dividends could, depending uponthe financial condition of the Bank, be deemed to constitute such an unsafe orunsound banking practice.  UnderTennessee law, the board of directors of a state bank may not declare dividendsin any calendar year that exceeds the total of its retained net income of thepreceding two (2) years without the prior approval of the TDFI.  The FDIA prohibits a state bank, the depositsof which are insured by the FDIC, from paying dividends if it is in default inthe payment of any assessments due the FDIC. The Bank is also subject to the minimum capital requirements of the FDICwhich impact the Bank’s ability to pay dividends.  If the Bank fails to meet these standards, itmay not be able to pay dividends or to accept additional deposits because ofregulatory requirements.

 

If, in theopinion of the applicable federal bank regulatory authority, a depositoryinstitution is engaged in or is about to engage in an unsafe or unsoundpractice (which, depending on the financial condition of the depositoryinstitution, could include the payment of dividends), such authority mayrequire that such institution cease and desist from such practice.  The federal banking agencies have indicatedthat paying dividends that deplete a depository institution’s capital base toan inadequate level would be such an unsafe and unsound banking practice.  Moreover, the Federal Reserve Board, theComptroller of the Currency and the FDIC have issued policy statements whichprovide that bank holding companies and insured depository institutionsgenerally should only pay dividends out of current operating earnings.

 

The payment ofdividends by the Bank may also be affected or limited by other factors, such asthe requirement to maintain adequate capital above regulatory guidelines.

 

*FIRREA*. Congress enacted the Financial Institutions Reform, Recovery andEnforcement Act of 1989 (“FIRREA”) on August 9, 1989.  FIRREA provides that a depository institutioninsured by the FDIC can be held liable for any loss incurred by, or reasonableexpected to be incurred by, the FDIC after August 9, 1989 in connection with(i) the default of a commonly controlled FDIC insured depository institution or(ii) any assistance provided by the FDIC to a commonly controlled FDIC insureddepository institution in danger of default. FIRREA provides that certain types of persons affiliated with financialinstitutions can be fined by the federal regulatory agency having jurisdictionover a depository institution with federal deposit insurance (such as the Bank)up to $1 million per day for each violation of certain regulations related(primarily) to lending to and transactions with executive officers, directors,principal shareholders and the interests of these individuals.  Other violations may result in civil moneypenalties of $5,000 to $30,000 per day or in criminal fines and penalties.  In addition, the FDIC has been grantedenhanced authority to withdraw or to suspend deposit insurance in certaincases.

 

 

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*FDICIA*. The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”)which was enacted on December 19, 1991, substantially revised the depositoryinstitution regulatory and funding provisions of the FDIA and made revisions toseveral other federal banking statutes. Among other things, FDICIA requires the federal banking regulators totake “prompt corrective action” in respect of FDIC-insured depositoryinstitutions that do not meet minimum capital requirements. FDICIA establishesfive capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,”“significantly undercapitalized” and “critically undercapitalized.”  Under applicable regulations, a FDIC-insureddepository institution is defined to be well capitalized if it maintains aLeverage Ratio of at least 5%, a risk adjusted Tier 1 Capital Ratio of at least6% and a Total Risk-Based Capital Ratio of at least 10% and is not subject to adirective, order or written agreement to meet and maintain specific capitallevels.  An insured depositoryinstitution is defined to be adequately capitalized if it meets all of itsminimum capital requirements as described above.  In addition, an insured depositoryinstitution will be considered undercapitalized if it fails to meet any minimumrequired measure, significantly undercapitalized if it is significantly belowsuch measure and critically undercapitalized if it fails to maintain a level oftangible equity equal to not less than 2% of total assets.  An insured depository institution may bedeemed to be in a capitalization category that is lower than is indicated byits actual capital position if it receives an unsatisfactory examinationrating.

 

Thecapital-based prompt corrective action provision of FDICIA and theirimplementing regulations apply to FDIC-insured depository institutions and arenot directly applicable to holding companies which control suchinstitutions.  However, the FederalReserve Board has indicated that, in regulating bank holding companies, it willtake appropriate action at the holding company level based on an assessment ofthe effectiveness of supervisory actions imposed upon subsidiary depositoryinstitutions pursuant to such provisions and regulations.

 

FDICIAgenerally prohibits an FDIC-insured depository institution from making anycapital distribution (including payment of dividends) or paying any managementfee to its holding company if the depository institution would thereafter beundercapitalized.  Undercapitalizeddepository institutions are subject to restrictions on borrowing from theFederal Reserve System.  In addition,undercapitalized depository institutions are subject to growth limitations andare required to submit capital restoration plans.  A depository institution’s holding companymust guarantee the capital plan, up to an amount equal to the lesser of 5% ofthe depository institution’s assets at the time it becomes undercapitalized orthe amount of the capital deficiency when the institution fails to comply withthe plan.  The federal banking agenciesmay not accept a capital plan without determining, among other things, that theplan is based on realistic assumptions and is likely to succeed in restoringthe depository institution’s capital.  Ifa depository institution fails to submit an acceptable plan, it is treated asif it is significantly undercapitalized.

 

Significantlyundercapitalized depository institutions may be subject to a number ofrequirements and restrictions, including orders to sell sufficient voting stockto become adequately capitalized, requirements to reduce total assets andcessation of receipt of deposits from correspondent banks.  Critically undercapitalized depositoryinstitutions are subject to appointment of a receiver or conservator generallywithin 90 days of the date on which they became critically undercapitalized.

 

The Bankbelieves that at December 31, 2004, the Bank was well capitalized under thecriteria discussed above.

 

FDICIAcontains numerous other provisions, including accounting, audit and reportingrequirements, termination of the “too big to fail” doctrine except in specialcases, limitations on the FDIC’s payment of deposits at foreign branches, newregulatory standards in such areas as asset quality, earnings and compensationand revised regulatory standards for, among other things, powers of state banks,real estate lending and capital adequacy. FDICIA also requires that a depository institution provide 90 days priornotice of the closing of any branches.

 

Various otherlegislation, including proposals to revise the bank regulatory system and tolimit the investments that a depository institution may make with insuredfunds, is from time to time introduced in Congress.  The TDFI and FDIC will examine the Bankperiodically for compliance with various regulatory requirements.  Such examinations, however, are for theprotection of the Bank Insurance Fund (“BIF”) and for depositors, and not forthe protection of investors and shareholders.

 

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*Interstate Act*.  The Riegle-Neal Interstate Banking andBranching Efficiency Act of 1994 (“Interstate Act”), which was enacted onSeptember 29, 1994, among other things and subject to certain conditions andexceptions, permits on an interstate basis (i) bank holding companyacquisitions commencing one year after enactment of banks of a minimum age ofup to five years as established by state law in any state, (ii) mergers ofnational and state banks after May 31, 1997 unless the home state of eitherbank has opted out of the interstate bank merger provision, (iii) branching denovo by national and state banks if the host state has opted-in to thisprovision of the Interstate Act, and (iv) certain bank agency activities afterone year after enactment.  The InterstateAct contains a 30% intrastate deposit cap, except for the initial acquisitionin the state, restriction that applies to certain interstate acquisitionsunless a different intrastate cap has been adopted by the applicable statepursuant to the provisions of the Interstate Act and a 10% national deposit caprestriction.  Tennessee has opted-in tothe Interstate Act.  Management cannotpredict the extent to which the business of the Bank may be affected.  Tennessee has also adopted legislationallowing banks to acquire branches across state lines subject to certainconditions, including the availability of similar legislation in the otherstate.

 

*Brokered Deposits and Pass-Through Insurance*.  The FDIC has adopted regulations under FDICIAgoverning the receipt of brokered deposits and pass-through insurance.  Under the regulations, a bank cannot acceptor rollover or renew brokered deposits unless (i) it is well capitalized or(ii) it is adequately capitalized and receives a waiver from the FDIC.  A bank that cannot receive brokered depositsalso cannot offer “pass-through” insurance on certain employee benefitaccounts.  Whether or not it has obtainedsuch a waiver, an adequately capitalized bank may not pay an interest rate onany deposits in excess of 75 basis points over certain index prevailing marketrates specified by regulation.  There areno such restrictions on a bank that is well capitalized.  Because it believes that the Bank was wellcapitalized as of December 31, 2004, the Bank believes the brokered depositsregulation will have no material effect on the funding or liquidity of theBank.

 

*FDIC Insurance Premiums*.  The Bank is required to pay semiannual FDICdeposit insurance assessments.  Asrequired by FDICIA, the FDIC adopted a risk-based premium schedule whichincreased the assessment rates for most FDIC-insured depositoryinstitutions.  Under the schedule, thepremiums initially range from $.0 to $.27 for every $100 of deposits.  Each financial institution is assigned to oneof three capital groups - well capitalized, adequately capitalized orundercapitalized - and further assigned to one of three subgroups within acapital group, on the basis of supervisory evaluations by the institution’sprimary federal and, if applicable, state supervisors and other informationrelevant to the institution’s financial condition and the risk posed to theapplicable FDIC deposit insurance fund. The actual assessment rate applicable to a particular institution will,therefore, depend in part upon the risk assessment classification so assignedto the institution by the FDIC.  Recentlythe FDIC has passed a resolution to lower premiums.

 

Under theFDIA, insurance of deposits may be terminated by the FDIC upon a finding thatthe institution has engaged in unsafe and unsound practices, is in an unsafe orunsound condition to continue operations or has violated any applicable law,regulation, rule, order or condition imposed by a federal bank regulatoryagency.

 

G*ramm-Leach-Bliley Act. * The Gramm-Leach-Bliley Act adopted in November1999 has been referred to as the most important banking bill in over 60years.  The most significant provisionsratify new powers for banks and bank holding companies, especially in the areasof securities and insurance.  The Actalso includes requirements regarding the privacy and protection of customerinformation held by financial institutions, as well as many other providers offinancial services.  There are provisionsproviding for functional regulation of the various services provided byinstitutions among different regulators. There are other provisions which limit the future expansion of unitarythrift holding companies which now prevent companies like Wal-Mart from owninga thrift institution.  Finally, amongmany other sections of the Act, there is some relief for small banks from theregulatory burden of the Community Reinvestment Act.  The regulatory agencies have been adoptingmany new regulations to implement the Act.

 

7

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*USA Patriot Act.* On October 26, 2001, thePresident signed the USA PATRIOT Act of 2001 into law.  This act contains the International MoneyLaundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”).The IMLAFA substantially broadens existing anti-money laundering legislationand the extraterritorial jurisdiction of the United States, imposes newcompliance and due diligence obligations, creates new crimes and penalties,compels the production of documents located both inside and outside the UnitedStates, including those of foreign institutions that have a correspondentrelationship in the United States, and clarifies the safe harbor from civil liabilityto customers.  The U.S. TreasuryDepartment has issued a number of regulations implementing the USA PATRIOT Actthat apply certain of its requirements to financial institutions such as ourbanking and broker-dealer subsidiaries. The regulations impose new obligations on financial institutions tomaintain appropriate policies, procedures and controls to detect, prevent andreport money laundering and terrorist financing.  The Treasury Department is expected to issuea number of additional regulations which will further clarify the USA PATRIOTAct’s requirements.

 

The IMLAFArequires all “financial institutions,” as defined, to establish anti-moneylaundering compliance and due diligence programs no later than April 2002.  Such programs must include, among otherthings, adequate policies, the designation of a compliance officer, employeetraining programs, and an independent audit function to review and test theprogram.  The Bank has establishedanti-money laundering compliance and due diligence programs to comply withIMLAFA.

 

*Capital Requirements*.  The federal regulatory agencies use capitaladequacy guidelines in their examination and regulation of banks.  If the capital falls below the minimum levelsestablished by these guidelines, the Bank may (1) be denied approval to acquireor establish additional banks or non-bank businesses or to open facilities, or(2) be subject to other regulatory restrictions or actions.

 

Bankingorganizations historically were required to maintain a minimum ratio of primarycapital to total assets of 5.5%, and a minimum ratio of total capital to totalassets of 6.0%.  The primary and totalcapital ratio requirements have been replaced by the adoption of risk-based andleverage capital requirements.

 

Risk-BasedCapital Requirements

 

The FDICadopted risk-based capital guidelines for banks effective after December 31,1990.  The risk-based capital guidelinesare designed to make regulatory capital requirements more sensitive todifferences in risk profile among banks to account for off-balance sheetexposure and to minimize disincentives for holding liquid assets.  Assets and off-balance sheet items areassigned to broad risk categories each with appropriate weights.  The resulting capital ratios representcapital as a percentage of total risk-weighted assets and off-balance sheetitems.  The ratios are minimums.  The guidelines require all federallyregulated banks to maintain a minimum risk-based total capital ratio of 8%, ofwhich at least 4% must be Tier I capital (see the description of Tier I capitaland Tier II capital below).

 

A bankingorganization’s qualifying total capital consists of two components:  Tier I capital (core capital) and Tier IIcapital (supplementary capital).  Tier Icapital is an amount equal to the sum of: (i) common shareholders’ equity (including adjustments for any surplusor deficit); (ii) non-cumulative perpetual preferred stock; and (iii) thecompany’s minority interests in the equity accounts of consolidatedsubsidiaries.  Intangible assetsgenerally must be deducted from Tier I capital, subject to limited exceptionsfor goodwill arising from certain supervisory acquisitions.  Other intangible assets may be included in anamount up to 25% of Tier I capital, provided that the asset meets each of thefollowing criteria:  (i) the asset mustbe able to be separated and sold apart from the banking organization or the bulkof its assets; (ii) the market value of the asset must be established on anannual basis through an identifiable stream of cash flows and there must be ahigh degree of certainty that the asset will hold this market valuenotwithstanding the future prospects of the banking organization; and (iii) thebanking organization must demonstrate that a liquid market exists for theasset.  Intangible assets in excess of25% of Tier I capital generally are deducted from a banking organization’sregulatory capital.  At least 50% of thebanking organization’s total regulatory capital must consist of Tier I capital.

 

Tier IIcapital is an amount equal to the sum of (i) the allowance for possible creditlosses in an amount up to 1.25% of risk-weighted assets; (ii) cumulativeperpetual preferred stock with an original maturity of 20 years or more andrelated surplus; (iii) hybrid capital instruments (instruments withcharacteristics of both debt and equity), perpetual debt and mandatoryconvertible debt securities; and (iv) in an amount up to 50% of Tier I capital,eligible term subordinated debt and intermediate-term preferred stock with anoriginal maturity of five years or more, including related surplus.  The inclusion of the foregoing elements ofTier II capital are subject to certain requirements and limitations of theFDIC.

 

8

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Investments inunconsolidated banking and finance subsidiaries, investments in securitiessubsidiaries and reciprocal holdings of capital instruments must be deductedfrom capital.  The federal bankingregulators may require other deductions on a case-by-case basis.

 

Under the risk-weightedcapital guidelines, balance sheets assets and certain off-balance sheet items,such as standby letters of credit, are assigned to one of four risk weightcategories (0%, 20%, 50%, or 100%) according to the nature of the asset and itscollateral or the identity of any obligor or guarantor.  For example, cash is assigned to the 0% riskcategory, while loans secured by one-to-four family residences are assigned tothe 50% risk category.  The aggregateamount of such asset and off-balance sheet items in each risk category isadjusted by the risk weight assigned to that category to determine weightedvalues, which are added together to determine the total risk-weighted assetsfor the banking organization. Accordingly, an asset, such as a commercial loan, which is assigned to a100% risk category is included in risk-weighted assets at its nominal facevalue, whereas a loan secured by a single-family home mortgage is included atonly 50% of its nominal face value.  Theapplication ratios are equal to capital, as determined, divided by risk-weightedassets, as determined.

 

LeverageCapital Requirements

 

The FDIC has aregulation requiring certain banking organizations to maintain additionalcapital of 1% to 2% above a 3% minimum Tier I Leverage Capital Ratio (Tier Icapital, less intangible assets, to total assets).  In order for an institution to operate at ornear the minimum Tier I leverage capital requirement of 3%, the FDIC expectsthat such institution would have well-diversified risk, no undue rate riskexposure, excellent asset quality, high liquidity and good earnings.  In general, the Bank would have to beconsidered a strong banking organization, rated in the highest category underthe bank rating system and have no significant plans for expansion.  Higher Tier I leverage capital ratios of upto 5% will generally be required if all of the above characteristics are notexhibited, or if the institution is undertaking expansion, seeking to engage innew activities, or otherwise faces unusual or abnormal risks.

 

The FDIC ruleprovides that institutions not in compliance with the regulation are expectedto be operating in compliance with a capital plan or agreement with theregulator.  If they do not do so, theyare deemed to be engaging in an unsafe and unsound practice and may be subjectto enforcement action.  In addition, failureby an institution to maintain capital of at least 2% of assets constitutes anunsafe and unsound practice and may subject the institution to enforcementaction.  An institution=s failure tomaintain capital of at least 2% of assets constitutes an unsafe and unsoundcondition justifying termination of FDIC insurance.

 

*Depositor Preference*.  The Omnibus Budget Reconciliation Act of 1993provides that deposits and certain claims for administrative expenses andemployee compensation against an insured depositary institution would beafforded a priority over other general unsecured claims against such aninstitution, including federal funds and letters of credit, in the “liquidationor other resolution” of such an institution by any receiver.

 

*Effect of Governmental Policies*.  The Bank is affected by the policies ofregulatory authorities, including the Federal Reserve System.  An important function of the Federal ReserveSystem is to regulate the national money supply.  Among the instruments of monetary policy usedby the Federal Reserve are: purchases and sales of U.S. Government securitiesin the marketplace; changes in the discount rate, which is the rate anydepository institution must pay to borrow from the Federal Reserve; and changesin the reserve requirements of depository institutions.  These instruments are effective in influencingeconomic and monetary growth, interest rate levels and inflation.

 

The monetarypolicies of the Federal Reserve System and other governmental policies have hada significant effect on the operating results of commercial banks in the pastand are expected to continue to do so in the future.  Because of changing conditions in thenational economy and in the money market, as well as the result of actions bymonetary and fiscal authorities, it is not possible to predict with certaintyfuture changes in interest rates, deposit levels, loan demand or the businessand earnings of the Bank or whether the changing economic conditions will havea positive or negative effect on operations and earnings.

 

9

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Bills arepending before the United States Congress and the Tennessee General Assemblywhich could affect the business of the Bank, and there are indications thatother similar bills may be introduced in the future.  It cannot be predicted whether or in whatform any of these proposals will be adopted or the extent to which the businessof the Bank may be affected thereby.

 

InvestmentPolicy

 

The objectiveof the Bank’s investment policy is to invest funds not otherwise needed to meetthe loan demand of its market area to earn the maximum return for the Bank, yetstill maintain sufficient liquidity to meet fluctuations in the Bank’s loandemand and deposit structure.  In doingso, the Bank balances the market and credit risks against the potentialinvestment return, makes investments compatible with the pledge requirements ofthe Bank’s deposits of public funds, maintains compliance with regulatoryinvestment requirements, and assists the various public entities with theirfinancing needs.  The asset liability andinvestment committee has full authority over the investment portfolio and makesdecisions on purchases and sales of securities. The entire portfolio, along with all investment transactions occurringsince the previous Board of Director’s meeting, is reviewed by the Board at itsnext monthly meeting.  The investmentpolicy allows portfolio holdings to include short-term securities purchased toprovide the Bank’s needed liquidity and longer term securities purchased togenerate level income for the Bank over periods of interest rate fluctuations.

 

Loan Policy

 

All lendingactivities of the Bank are under the direct supervision and control of the fullBoard of Directors and Douglas P. Archbold, Chief Credit Officer.  The Board of Directors enforces loan authorizations,decides on loans exceeding such limits, services all requests for officercredits to the extent allowable under current laws and regulations, administersall problem credits, and determines the allocation of funds for each lendingdivision.  The Bank’s established maximumloan volume to deposits is 100%. The loan portfolio consists primarily of realestate, commercial, farming and installment loans.  Commercial loans consist of either realestate loans or term loans.  Maturity ofterm loans is normally limited to five to seven years.  Conventional real estate loans may be made upto 85% of the appraised value or purchase cost of the real estate for no morethan a thirty year term.  Installmentloans are based on the earning capacity and vocational stability of theborrower.

 

The full Boardmakes a monthly review of loans which are 30 days or more past due and the fullBoard of Directors makes a monthly review of loans which are 45 days or morepast due.

 

Management ofthe Bank periodically reviews the loan portfolio, particularly nonaccrual andrenegotiated loans.  The review mayresult in a determination that a loan should be placed on a nonaccrual statusfor income recognition.  In addition, tothe extent that management identifies potential losses in the loan portfolio,it reduces the book value of such loans, through charge-offs, to theirestimated collectible value.  The Bank’spolicy is that accrual of interest is discontinued on a loan when management ofthe Bank determines upon consideration of economic and business factorsaffecting collection efforts that collection of interest is doubtful.  The Bank maintains a specific reserve forimpaired loans.

 

When a loan isclassified as nonaccrual, any unpaid interest is reversed against currentincome.  Interest is included in incomethereafter only to the extent received in cash. The loan remains in a nonaccrual classification until such time as theloan is brought current, when it may be returned to accrualclassification.  When principal orinterest on a nonaccrual loan is brought current, if in management’s opinionfuture payments are questionable, the loan would remain classified asnonaccrual.  After a nonaccrual orrenegotiated loan is charged off, any subsequent payments of either interest orprincipal are applied first to any remaining balance outstanding, then torecoveries and lastly to income.

 

The Bank hadno tax-exempt loans during the period ended December 31, 2004.  The Bank had no loans outstanding to foreignborrowers at December 31, 2004.

 

10

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The Bank’sunderwriting guidelines are applied to four major categories of loans,commercial and industrial, consumer, agricultural and real estate whichincludes residential, construction and development and certain other realestate loans.  The Bank requires its loanofficers and Board to consider the borrower’s character, the borrower’sfinancial condition as reflected in current financial statements, the borrower’smanagement capability, the borrower’s industry and the economic environment inwhich the loan will be repaid.  Beforeapproving a loan, the loan officer or Board must determine that the borrower isbasically honest and creditworthy, determine that the borrower is a capablemanager, understand the specific purpose of the loan, understand the source andplan of repayment, determine that the purpose, plan and source of repayment aswell as collateral are acceptable, reasonable and practical given the normalframework within which the borrower operates.

 

Credit RiskManagement and Reserve for Loan Losses

 

Credit riskand exposure to loss are inherent parts of the banking business.  Management seeks to manage and minimize theserisks through its loan and investment policies and loan review procedures.  Management establishes and continuallyreviews lending and investment criteria and approval procedures that itbelieves reflect the risk sensitive nature of the Bank.  The loan review procedures are set to monitoradherence to the established criteria and to ensure that on a continuing basissuch standards are enforced and maintained. Management’s objective in establishing lending and investment standardsis to manage the risk of loss and provide for income generation through pricingpolicies.

 

The loanportfolio is regularly reviewed and management determines the amount of loansto be charged-off.  In addition, suchfactors as the Bank’s previous loan loss experience, prevailing and anticipatedeconomic conditions, industry concentrations and the overall quality of theloan portfolio are considered.  Whilemanagement uses available information to recognize losses on loans and realestate owned, future additions to the allowance may be necessary based on changesin economic conditions.  In addition,various regulatory agencies, as an integral part of their examination process,periodically review the allowances for losses on loans and real estateowned.  Such agencies may require theBank to recognize additions to the allowances based on their judgments aboutinformation available at the time of their examinations.  In addition, any loan or portion thereofwhich is classified as a “loss” by regulatory examiners is charged-off.

 

CapitalResources/Liquidity

 

*Liquidity*. Of primary importance to depositors,creditors and regulators is the ability to have readily available fundssufficient to repay fully maturing liabilities. The Bank’s liquidity, represented by cash and cash due from banks, is aresult of its operating, investing and financing activities.  In order to insure funds are available at alltimes, the Bank devotes resources to projecting on a monthly basis the amountof funds which will be required and maintains relationships with a diversifiedcustomer base so funds are accessible. Liquidity requirements can also be met through short-term borrowings orthe disposition of short-term assets which are generally matched to correspondto the maturity of liabilities.

 

The Bank has aformal liquidity policy whereby management considers several liquidity ratioson a monthly basis to determine the adequacy of liquidity.  In the opinion of management, its liquiditylevels are considered adequate.   TheBank is subject to general FDIC guidelines which do not require a minimum levelof liquidity.  Management believes itsliquidity ratios meet or exceed these guidelines.  Management does not know of any trends ordemands which are reasonably likely to result in liquidity increasing ordecreasing in any material manner.

 

*Impact of Inflation and Changing Prices*.  The financial statements and relatedfinancial data presented herein have been prepared in accordance with U.S.generally accepted accounting principles which require the measurement offinancial position and operating results in terms of historical dollars withoutconsidering the changes in the relative purchasing power of money over time anddue to inflation.  The impact ofinflation on operations of the Bank is reflected in increased operating costs.  Unlike most industrial companies, virtuallyall of the assets and liabilities of the Bank are monetary in nature.  As a result, interest rates have a moresignificant impact on the Bank’s performance than the effects of general levelsof inflation.  Interest rates do notnecessarily move in the same direction or in the same magnitude as the price ofgoods and services.

 

11

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CapitalAdequacy

 

Capitaladequacy refers to the level of capital required to sustain asset growth overtime and to absorb losses.  The objectiveof the Bank’s management is to maintain a level of capitalization that issufficient to take advantage of profitable growth opportunities while meetingregulatory requirements.  This isachieved by improving profitability through effectively allocating resources tomore profitable businesses, improving asset quality, strengthening servicequality, and streamlining costs.  Theprimary measures used by management to monitor the results of these efforts arethe ratios of average equity to average assets, average tangible equity toaverage tangible assets, and average equity to net loans.

 

The FederalReserve Board has adopted capital guidelines governing the activities of bankholding companies.  These guidelinesrequire the maintenance of an amount of capital based on risk-adjusted assetsso that categories of assets with potentially higher credit risk will requiremore capital backing than assets with lower risk.  In addition, banks and bank holding companiesare required to maintain capital to support, on a risk-adjusted basis, certainoff-balance sheet activities such as loan commitments.

 

The capitalguidelines classify capital into two tiers, referred to as Tier I andTier II.  Under risk-based capitalrequirements, total capital consists of Tier I capital which is generallycommon stockholders’ equity less goodwill and Tier II capital which isprimarily a portion of the allowance for loan losses and certain qualifyingdebt instruments.  In determiningrisk-based capital requirements, assets are assigned risk-weights of 0% to100%, depending primarily on the regulatory assigned levels of credit riskassociated with such assets.  Off-balancesheet items are considered in the calculation of risk-adjusted assets throughconversion factors established by the regulators.  The framework for calculating risk-basedcapital requires banks and bank holding companies to meet the regulatoryminimums of 4% Tier I and 8% total risk-based capital.  In 1990 regulators added a leveragedcomputation to the capital requirements, comparing Tier I capital to totalaverage assets less goodwill.

 

The FederalDeposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) establishedfive capital categories for banks and bank holding companies.  The bank regulators adopted regulationsdefining these five capital categories in September 1992.  Under these new regulations each bank isclassified into one of the five categories based on its level of risk-basedcapital as measured by Tier I capital, total risk-based capital, and Tier Ileverage ratios and its supervisory ratings.

 

The followingtable lists the five categories of capital and each of the minimum requirementsfor the three risk-based capital ratios.

 
| ** **                     | ** ** | **Total Risk-Based  Capital Ratio** | ** ** | **Tier I Risk-Based  Capital Ratio** | ** ** | **Leverage Ratio** |
|--------------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|--------------------|
|                           |       |                                |       |                                 |       |               |
| Well-capitalized               |       | 10% or above                        |       | 6% or above                          |       | 5% or above        |
|                           |       |                                |       |                                 |       |               |
| Adequately capitalized         |       | 8% or above                         |       | 4% or above                          |       | 4% or above        |
|                           |       |                                |       |                                 |       |               |
| Undercapitalized               |       | Less than 8%                        |       | Less than 4%                         |       | Less than 4%       |
|                           |       |                                |       |                                 |       |               |
| Significantly undercapitalized |       | Less than 6%                        |       | Less than 3%                         |       | Less than 3%       |
|                           |       |                                |       |                                 |       |               |
| Critically undercapitalized    |       | —                              |       | —                               |       | 2% or less         |

 

**ITEM 2.**                                                     PROPERTIES

 

The mainoffice of the Corporation is located at 3095 East Andrew Johnson Highway,Greeneville, Greene County, Tennessee, which is also the main office of theBank.  This location is a 2.66 acre lot,on which there is a fully operational modular bank unit.  A full service branch banking office of theBank is located at 506 Asheville 

 

12

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Highway, Greeneville, GreeneCounty, Tennessee.  Both locations arecentrally located and in high traffic/exposure areas.  Automatic teller machines and overnight “depositdrops” are positioned to serve the Bank’s clients.  Additional branches may be established asmarket opportunities surface.

 

**ITEM 3.**                                                     LEGAL PROCEEDINGS

 

To the best ofthe Corporation’s knowledge, there are no pending legal proceedings, other thanroutine litigation incidental to the business, to which the Corporation or theBank is a party or of which any of the Corporation’s or the Bank’s property isthe subject.

 

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

 

No matter wassubmitted to a vote of security holders during the fourth quarter of 2004through the solicitation of proxies or otherwise.

 

PART II

 

**ITEM 5.****                           MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUERPURCHASES OF EQUITY SECURITIES**

 

The commonstock of the Corporation is not traded through an organized exchange nor isthere a known active trading market. The number of shareholders of record atDecember 31, 2004 was 1,697. Holders of the Corporation’s common stock areentitled to receive dividends when declared by the Board of Directors out offunds legally available. Dividends will be affected by other factors includingapplicable government regulations and policies. The following table shows the quarterly range of high and low saleprices for the Corporation’s stock during the fiscal years 2004 and 2003. Allsale prices have been retroactively adjusted to reflect the effects of thestock split on April 25, 2003, and includes information regarding the sale ofBank common stock prior to the Share Exchange. These sale prices representknown transactions and do not necessarily represent all trading transactionsfor the periods.

 
| **Year** | ** ** | ** **     | ** ** | **High**     | ** ** | **Low**                 | ** ** |
|----------|------------|----------------|------------|--------------|------------|-------------------------|------------|
|     |       |           |       |         |       |                    |       |
| 2003:    |       | First Quarter  |       | $ 10.00 |       | $   8.00 |       |
|     |       | Second Quarter |       | $ 13.00 |       | $ 10.00            |       |
|     |       | Third Quarter  |       | $ 14.00 |       | $ 12.00            |       |
|     |       | Fourth Quarter |       | $ 15.00 |       | $ 13.33            |       |
|     |       |           |       |         |       |                    |       |
| 2004:    |       | First  Quarter |       | $ 16.00 |       | $ 15.00            |       |
|     |       | Second Quarter |       | $ 17.00 |       | $ 16.00            |       |
|     |       | Third Quarter  |       | $ 17.00 |       | $ 15.00            |       |
|     |       | Fourth Quarter |       | $ 18.00 |       | $ 15.66            |       |

 

**Dividends**

 

The payment ofcash dividends is subject to the discretion of the Corporation’s Board ofDirectors and the Bank’s ability to pay dividends.  The Bank’s ability to pay dividends isrestricted by applicable regulatory requirements. For more information on theserestrictions, please see PART I, ITEM 1 “DESCRIPTION OF BUSINESS - Payment of Dividends”.  No assurances can be given that any dividendwill be declared or, if declared, what the amount of such dividend would be orwhether such dividends would continue in future periods.

 

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**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

 

The Bankissued Stock Option agreements to certain officers and employees (“Options”),at various times beginning on July 16, 2001. These Options were not approved by the shareholders, as such approval isnot necessary for these non-qualified option agreements.  Upon consummation of the Share Exchange, theCorporation became party to these options issued by the Bank.

 

The followingtable reflects the number of shares to be issued upon the exercise of optionsgranted under the Option agreements, the weighted-average exercise price of allsuch options, and the total number of shares of common stock reserved forissuance upon the exercise of authorized, not-yet-granted options as ofDecember 31, 2004:

 
| **Plan Category**                                           | ** ** | **# of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights  (a)** | ** ** | **Weighted-average  Exercise Price of   Outstanding Options,  Warrants, and Rights  (b)** | ** ** | **# of Equity Securities  Remaining Available for  Future Issuance Under  Equity Compensation  Plans (excluding  securities reflected in   column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity Compensation Plans Approved by  Security Holders     |       | —                                                                                             |       | —                                                                                    |       | —                                                                                                                                                        |       |
| Equity Compensation Plans Not Approved by  Security Holders |       | 246,125                                                                                            |       | $ 5.06                                                                               |       | 74,200                                                                                                                                                        |       |
| Total                                                       |       | 246,125                                                                                            |       | $ 5.06                                                                               |       | 74,200                                                                                                                                                        |       |

 

The maximumnumber of shares of the Corporation’s common stock available for issuancepursuant to stock options is 375,000 shares. As of December 31, 2004 the maximum number of shares available forfuture stock option grants is 74,200 shares. The option exercise price is equal to the fair market value of theCorporation’s common stock at the date of the grant.  The options expire on the tenth anniversaryof the date of the option.  The optionsvest in 20% increments on each of the first five anniversary dates of thespecific option.  Proceeds received bythe Corporation from exercises of the stock options are credited to commonstock and additional paid-in capital.

 

**RecentSales of Unregistered Securities**

 

In July 2001,the Bank issued 750,000 shares of its common stock in an initial offering.  This sale was exempt from registration underthe Securities Act of 1933, as amended, pursuant to Section 3.  Since its initial offering, neither the Bankor the Corporation has sold any additional shares of its common stock, exceptas follows:

 

•                  On December 31,2002, J. Robert Grubbs, exercised the option to purchase 30,000 shares ofcommon stock at an exercise price of $3.33 per share.  On December 31, 2003, J. Robert Grubbs, DonWaddell and Julia Hawk exercised the option to purchase 3,175, 4,500 and 3,000shares of common stock at an exercise price of $3.33 per share,respectively.  On December 31, 2004, DonWaddell, Julia Hawk and Eric Scott exercised the option to purchase 2,000,3,000 and 6,000 shares of common stock at an exercise price of $3.33 per share,respectively.  The Corporation relied onthe exemption provided by Section 4(2) of the Securities Act of 1933 for eachof these transactions.

 

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**Purchases of Equity Securities by theRegistrant and Affiliated Purchasers**

 

TheCorporation made no repurchases of its equity securities, and no AffiliatedPurchasers (as defined in Rule 10b - 18(a)(3) under the Securities Exchange Actof 1934) purchased any shares of the Corporation’s equity securities during thefourth quarter of the fiscal year ended December 31, 2004.

 

**ITEM 6.**                                                     SELECTED FINANCIAL DATA

 

The followingselected financial data for the years ended December 31, 2004, 2003, 2002,and 2001 should be read in conjunction with the financial statements includedin Item 8:

 
| ** **                                                                 | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                       |       |       |       |       |       |       |       |       |       |
| Income Statement Data:                                                     |       |       |       |       |       |       |       |       |       |
| Total interest income                                                      |       | $          | 5,498,717  |       | $          | 4,308,390  |       | $          | 2,598,782  |   | $ | 658,849 |   |
| Total interest expense                                                     |       | 1,576,080  |       | 1,216,359  |       | 790,959    |       | 222,539    |       |
| Net interest income                                                        |       | 3,922,637  |       | 3,092,031  |       | 1,807,823  |       | 436,310    |       |
| Provision for loan losses                                                  |       | (615,251   | )          | (956,609   | )          | (315,620   | )          | (136,004   | )          |
| Net interest income after provision for  loan losses                       |       | 3,307,386  |       | 2,135,422  |       | 1,492,203  |       | 300,306    |       |
| Noninterest income:                                                        |       |       |       |       |       |       |       |       |       |
| Other income                                                               |       | 531,677    |       | 612,465    |       | 461,892    |       | 122,084    |       |
| Noninterest expenses                                                       |       | (3,107,363 | )          | (2,404,681 | )          | (1,823,986 | )          | (1,761,303 | )          |
| Income before income taxes                                                 |       | 731,700    |       | 343,206    |       | 130,109    |       | (1,338,913 | )          |
| Income tax expense                                                         |       | (227,555   | )          | (89,704    | )          | 510,006    |       | —     |       |
| Net income (loss)                                                          |       | $          | 504,145    |       | $          | 253,502    |       | $          | 640,115    |   | $ | (1,338,913 | ) |
|                                                                       |       |       |       |       |       |       |       |       |       |
| **Per Share Data: (1)**                                                    |       |       |       |       |       |       |       |       |       |
| Net income (loss), basic                                                   |       | $          | 0.22       |       | $          | 0.11       |       | $          | 0.28       |   | $ | (1.79 | ) |
| Net income (loss), assuming dissolution                                    |       | $          | 0.21       |       | $          | 0.11       |       | $          | 0.28       |   | $ | (1.79 | ) |
| Dividends declared                                                         |       | N/A        |       | N/A        |       | N/A        |       | N/A        |       |
| Book value                                                                 |       | $          | 3.36       |       | $          | 3.14       |       | $          | 3.03       |   | $ | 2.74 |   |
|                                                                       |       |       |       |       |       |       |       |       |       |
| **Financial Condition Data:**                                              |       |       |       |       |       |       |       |       |       |
| Total assets                                                               |       | $          | 91,174,368 |       | $          | 85,075,150 |       | $          | 53,045,438 |   | $ | 24,617,801 |   |
| Loans, net                                                                 |       | $          | 72,355,286 |       | $          | 68,539,235 |       | $          | 42,293,917 |   | $ | 17,857,395 |   |
| Federal Home Loan Bank stock                                               |       | $          | 226,500    |       | $          | 171,700    |       | $          | 134,300    |   | $ | — |   |
| Federal funds sold                                                         |       | $          | 7,619,619  |       | $          | 7,244,455  |       | $          | 5,579,365  |   | $ | 2,813,875 |   |
| Deposits                                                                   |       | $          | 78,387,227 |       | $          | 73,461,766 |       | $          | 43,269,854 |   | $ | 18,307,070 |   |
| Federal Home Loan Bank - advances                                          |       | $          | 4,359,346  |       | $          | 4,254,106  |       | $          | 2,672,000  |   | $ | — |   |
| Stockholder’s equity                                                  |       | $          | 7,743,097  |       | $          | 7,207,287  |       | $          | 6,901,202  |   | $ | 6,161,087 |   |
|                                                                       |       |       |       |       |       |       |       |       |       |
| **Selected Ratios:**                                                       |       |       |       |       |       |       |       |       |       |
| Interest rate spread                                                       |       | 4.40       | %          | 4.55       | %          | 4.59       | %          | 3.24       | %          |
| Net yield on interest-earning assets                                       |       | 4.61       | %          | 4.85       | %          | 4.99       | %          | 3.75       | %          |
| Return on average assets                                                   |       | 0.55       | %          | 0.37       | %          | 1.62       | %          | (10.31     | )%         |
| Return on average equity                                                   |       | 6.60       | %          | 3.51       | %          | 10.33      | %          | (49.15     | )%         |
| Average equity to average assets                                           |       | 8.37       | %          | 10.64      | %          | 15.64      | %          | 20.98      | %          |
| Dividend payout ratio                                                      |       | N/A        |       | N/A        |       | N/A        |       | N/A        |       |
| Ratio of nonperforming assets to total  assets                             |       | 0.59       | %          | 0.10       | %          | 0.00       | %          | 0.00       | %          |
| Ratio of allowance for loan losses to  nonperforming assets                |       | 300.79     | %          | 1,626.14   | %          | N/A        |       | N/A        |       |
| Ratio of allowance for loan losses to total  loans, net of unearned income |       | 2.17       | %          | 1.93       | %          | 1.25       | %          | 1.25       | %          |

 

----

(1) Amounts have been restated to reflect the effect of the Company’sthree-for-one stock split effected April 25, 2003.

 

15

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**ITEM 7**.                           MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATION

 

The followingis a discussion of our financial condition and results of operations for theyears ended December 31, 2004, 2003 and 2002. The discussion and analysis should be read in conjunction with ourconsolidated financial statements and related notes in order to obtain a betterunderstanding of the information contained in the financial statements.  The discussions contained herein are for theconsolidated entity BG Financial Group, Inc. (the “Corporation”) and itswholly-owned subsidiary Bank of Greeneville (the “Bank”) collectively referredto herein as the “Company”.  As discussedin the Footnote 1 to the financial statements the financial condition andresults of operations for the year ended December 31, 2004 are for theCorporation and the Bank as a consolidated entity and the financial conditionand results of operations for the years ended December 31, 2003 and 2002 arefor the Bank only.

 

**Overview**

 

The Company’s net income increased to $504,145 in 2004 from $253,502 in2003.  This represents a 98.9% increase**.**  The Company’s rapidgrowth from its inception has had a material impact on the financial conditionand results of operations.

 

Managementbelieves that a rising interest rate environment, which appears to be morelikely than a falling or steady rate environment, should result in greater netinterest income for the Company.  As of December31, 2004 approximately 62% of the Company’s loans are adjustable rate loansthat reprice with prime rate increases. The Company believes that we will continue to place our emphasis onmaking adjustable rate loans to better match corresponding rising costs offunds.

 

**Impact of inflation**

 

The financialstatements and related financial data presented herein have been prepared inaccordance with accounting principles generally accepted in the United Statesand practices within the banking industry which require the measurement offinancial position and operating results in terms of historical dollars withoutconsidering the changes in the relative purchasing power of money over time dueto inflation.  Unlike most industrialcompanies, virtually all the assets and liabilities of a financial institutionare monetary in nature.  As a result,interest rates have a more significant impact on a financial institution’sperformance than the effects of general levels of inflation.

 

**Critical Accounting Estimates**

 

The Company follows generallyaccepted accounting principles that are recognized in the United States, alongwith general practices within the banking industry.  In connection with the application of thoseprinciples and practices, we have made judgments and estimates which, in thecase of our allowance for loan and lease losses (ALLL), are material to thedetermination of our financial position and results of operation.

 

16

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**Recent Accounting Pronouncements**

 

In March 2004,the SEC issued Staff Accounting Bulletin No. 105, *Application of Accounting Principles to Loan Commitments*.  Current accounting guidance requires thecommitment to originate mortgage loans to be held for sale be recognized on thebalance sheet at fair value from inception through expiration or funding.  SAB 105 requires that the fair-valuemeasurement include only differences between the guaranteed interest rate inthe loan commitment and a market interest rate, excluding any expected future cashflows related to the customer relationship or loan servicing.  SAB 105 is effective for commitments tooriginate mortgage loans to be held for sale that are entered into after March31, 2004. Its adoption did not have a material impact on the consolidatedfinancial position or results of operations of the Company.

 

In March 2004,the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Forcereached a consensus on EITF Issue No. 03-1, *TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments. *EITF 03-1provides guidance for determining when an investment is considered impaired,whether impairment is other-than-temporary, and measurement of an impairmentloss.  An investment is consideredimpaired if the fair value of the investment is less than its cost.  Generally, an impairment is consideredother-than temporary unless:  (i) theinvestor has the ability and intent to hold an investment for a reasonableperiod of time sufficient for an anticipated recovery of fair value up to (orbeyond) the cost of the investment; and (ii) evidence indicating that the costof the investment is recoverable within a reasonable period of time outweighsevidence to the contrary.  If impairmentis determined to be other-than-temporary, then an impairment loss should berecognized equal to the difference between the investment’s cost and its fairvalue.  The recognition and measurementprovisions were initially effective for other-than-temporary impairmentevaluations in reporting periods beginning after June 15, 2004.  However, in September 2004, the effectivedate of these provisions was delayed until the finalization of a FASB StaffPosition (FSP) to provide additional implementation guidance.  Due to the recognition and measurementprovisions being suspended and the final rule delayed, the Company is not ableto determine whether the adoption of these new provisions will have a materialimpact on the consolidated financial position or results of income.

 

Statement ofPosition 03-03, *Accounting for Certain Loansor Debt Securities Acquired in a Transfer* (SOP 03-03) addressesaccounting for differences between contractual cash flows and cash flowsexpected to be collected from an investor’s initial investment in loans or debtsecurities (loans) acquired in a transfer if those differences areattributable, at least in part, to credit quality.  It includes loans acquired in purchasebusiness combinations and applies to all nongovernmental entities, includingnot-for-profit organizations.  The SOPdoes not apply to loans originated by the entity.  The SOP is effective for loans acquired infiscal years beginning after December 15, 2004. Early adoption is encouraged. Specific transition guidance applies to certain loans that currently arewithin the scope of Practice Bulletin 6, Amortization of Discounts on CertainAcquired Loans.  Its adoption is notexpected to have material impact on the consolidated financial position orresults of operations of the Company.

 

In December 2004, the FASBissued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised2004), *Share-Based Payment* (“SFASNo. 123R”), which revised SFAS No. 123, “Accounting for Stock-BasedCompensation.  This statement supercedesAPB Opinion No. 25, “Accounting for Stock Issued to Employees.”  The revised statement addresses theaccounting for share-based payment transactions with employees and other thirdparties eliminates the ability to account for share-based compensationtransactions using APB 25 and requires that the compensation costs relating tosuch transactions be recognized in the consolidated statement of income.  The revised statement is effective as of thefirst interim period beginning after June 15, 2005.  The Company is currently evaluating the provisionsof SFAS No. 123R and will adopt it on July 1, 2005 as required.

 

**Forward-Looking Statements**

 

Management’sdiscussion of the Company and management’s analysis of the Company’s operationsand prospects, and other matters, may include forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995 and other 

 

17

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provisions of federal and statesecurities laws.  Although the Companybelieves that the assumptions underlying such forward-looking statementscontained in this Report are reasonable, any of the assumptions could beinaccurate and, accordingly, there can be no assurance that the forward-lookingstatements included herein will prove to be accurate.  The use of such words as “expect,” “anticipate,”“forecast,” and comparable terms should be understood by the reader to indicatethat the statement is “forward-looking” and thus subject to change in a mannerthat can be unpredictable.  Factors thatcould cause actual results to differ from the results anticipated, but notguaranteed, in this Report, include (without limitation) economic and socialconditions, competition for loans, mortgages, and other financial services andproducts, changes in interest rates, unforeseen changes in liquidity, resultsof operations, and financial conditions affecting the Company’s customers, andother risks that cannot be accurately quantified or completely identified.  Many factors affecting the Company’sfinancial condition and profitability, including changes in economicconditions, the volatility of interest rates, political events and competitionfrom other providers of financial services simply cannot be predicted.  Because these factors are unpredictable andbeyond the Company’s control, earnings may fluctuate from period toperiod.  The purpose of this type ofinformation is to provide readers with information relevant to understandingand assessing the financial condition and results of operations of the Company,and not to predict the future or to guarantee results.  The Company is unable to predict the types ofcircumstances, conditions and factors that can cause anticipated results tochange.  The Company undertakes noobligation to publish revised forward-looking statements to reflect theoccurrence of changes or unanticipated events, circumstances, or results.

 

**Results of Operations**

 

The Companyhad net income of $504,145 for the year ended December 31, 2004 or $.22 pershare compared to $253,502 or $.11 per share and $640,115 or $.28 per share forthe years ended December 31, 2003 and 2002 respectively.

 

Net InterestIncome/Margin

 

Net interestincome represents the amount by which interest earned on various assets exceedsinterest paid on deposits and other interest-bearing liabilities and is themost significant component of the Company’s earnings.  Interest income for 2004 was $5,498,717compared to $4,308,390 and $2,598,782 in 2003 and 2002 respectively.  Total interest expense was $1,576,080 in 2004compared to $1,216,359 and $790,959 in 2003 and 2002 respectively.  Average earning assets increased from $36million in 2002 to $64 million in 2003 (78%) and to $85 million in 2004(33%).  Average interest-bearing depositsincreased from $31 million in 2002 to $55 million in 2003 (77%) and to $77million (40%) in 2004.

 

Provision forPossible Loan Losses

 

The provisionfor loan losses represents a charge to operations necessary to establish anallowance for possible loan losses, which in management’s evaluation, isadequate to provide coverage for estimated losses on outstanding loans and toprovide for uncertainties in the economy. The allowance for loan losses in 2004was $1,607,559 as compared to $1,350,266 and $533,819 for the years 2003 and2002 respectively.  Total loans writtenoff, net of recoveries, in 2004 totaled $357,958 compared to $140,162 and$7,825 in 2003 and 2002 respectively. Management believes the allowance for possible loan losses at December31, 2004 to be adequate.

 

Provisions forIncome Taxes

 

Due to theCompany’s bank subsidiary’s loss in 2001, there was no income tax expenseincurred.  Therefore a valuationallowance relating to the net deferred tax asset was necessary.  In 2002, 2003 and 2004, the Company postedpre-tax income of $130,109, $343,206 and $731,700 respectfully; causingmanagement to believe that it is more likely than not that it will generatefuture taxable income to utilize its net deferred tax asset.   As a result, the valuation allowance was eliminatedand a net deferred tax asset was recorded for the deductible temporarydifferences and carryforwards that are expected to be available to reducefuture taxable income.

 

18

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NoninterestIncome

 

The Company’snoninterest income consists of service charges on deposit accounts and otherfees and commissions.  Total noninterestincome for 2004 was $531,677 compared to $612,465 and $461,892 in 2003 and 2002respectively.  The main reasons for thedecrease were the decrease in mortgage banking activities (origination and saleof 1-4 family loans), and the decrease in service charges on deposits.Management projects that other fees and commissions and service charges willincrease in 2005 due to the growth of the Company.

 

NoninterestExpense

 

Noninterestexpenses totaled $3,107,363 in 2004 compared to $2,404,681 and $1,823,986 in2003 and 2002 respectively, and consisted of employee costs, occupancy expenseand other operating expenses.  Salariesand employee benefits (which increased from $989,145 in 2002 to $1,290,696 in2003 and to $1,529,482 in 2004) along with all other noninterest expensecategories increased.

 

**Financial Condition**

 

Total assetsat December 31, 2004, were $91,174,368, an increase of $6,099,218 or 7.2% over2003 year end assets of $85,075,150. Total assets for the 2002 year end were $53,045,438.  Deposits increased to $78,387,227 at December31, 2004, an increase of $4,925,461 or 6.70% from $73,461,766 at December 31,2003.  Total deposits for the year end2002 were $43,269,854.  The increaseddeposits were used for funding growth in the loan portfolio for the most part.Loans increased by $4,073,344, or 5.83%, to $73,962,845 at year end 2004, from$69,889,501 at year-end 2003. Total loans for the year end 2002 were$42,827,736.   Securities were $226,500at December 31, 2004 compared to $171,700 at December 31, 2003.  Securities were $134,300 at year end 2002.

 

The Companyplaces an emphasis on an integrated approach to its balance sheetmanagement.  Significant balance sheet componentsof investment securities, loans and sources of funds are managed in anintegrated manner with the management of interest rate risk, liquidity, andcapital.  These components are discussedbelow.

 

Loans

 

Loansoutstanding totaled $73,962,845 at December 31, 2004 compared to $69,889,501and $42,827,736 at December 31, 2003 and 2002 respectively.  Commercial real estate loan growth increased$6,076,667 while other commercial loans decreased $3,123,031 during 2004.

 

The types ofloans at December 31, 2004 are Installment ($5,522,402), Commercial($20,927,959), Commercial Real Estate ($31,560,010), and Mortgage($15,952,474).

 

Managementfeels the overall quality of loans remains solid.  In the event that a loan is 90 days or morepast due the accrual of income is generally discontinued when the fullcollection of principal or interest is in doubt unless the obligations are bothwell secured and in the process of collection. At December 31, 2004, total loans 90 days or more past due and stillaccruing interest were $13,109 while total loans 90 days or more past due andin non-accrual status equaled $534,442.

 

Securities

 

Federal Home Loan Bank (FHLB) stock at December 31, 2004 had anamortized cost of $226,500 and a market value of $226,500 as compared to anamortized cost of $171,700 and a market value of $171,700 at December 31. 2003.The amortized cost and market value of the FHLB stock for the year end 2002were $134,300. As a member of the Federal Home Loan Bank, the Company isrequired to maintain stock in an amount equal to 0.15% of total assets.  Federal Home Loan Bank stock is maintained bythe Company at par value of one hundred dollars per share.

 

19

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Deposits

 

Totaldeposits, which are the principal source of funds for the Company, were$78,387,227 at December 31, 2004 compared to $73,461,766 and $43,269,854 atDecember 31, 2003 and 2002 respectively. The increase of $4,925,461 from year end 2003 to year end 2004represents an increase of 6.70%.  TheCompany has targeted local consumers, professional and commercial businesses asits central clientele, therefore, deposit instruments in the form of demanddeposits, savings accounts, money market demand accounts, NOW accounts,certificates of deposit and individual retirement accounts are offered tocustomers.   The Company established aline of credit with the Federal Home Loan Bank secured by a blanket-pledge of1-4 family residential mortgage loans. At December 31, 2004, 2003 and 2002 the Company had outstanding advancesof $4,359,346, $4,254,106 and $2,672,000, respectfully, at the Federal HomeLoan Bank.

 

Liquidity

 

At December31, 2004, the Company had liquid assets of $13.4 million in the form of cash,federal funds sold and Federal Home Loan Bank Stock available for sale comparedto $12.5 million and $7.4 million on December 31, 2003 and 2002respectively.  Management believes thatthe liquid assets are adequate at December 31, 2004. Additional liquidity willbe provided by the growth in deposit accounts and loan repayments.  The Company also has the ability to purchasefederal funds and is a member of the Federal Home Loan Bank of Cincinnati thatwill provide an additional credit line if necessary.  Management is not aware of any trends, eventsor uncertainties that are reasonably likely to have a material impact on theCompany’s short term or long term liquidity.

 

Capital

 

Totalshareholders’ equity at December 31, 2004 was $7,743,097, an increase of$535,810 from $7,207,287 at December 31, 2003, due to a profit of $504,145 forthe year and the exercise of 11,000 shares of common stock options to keyofficers of the Company.  Common stockincreased $3,667 and surplus $32,997 from the foregoing sale of commonstock.  The total capital for the year end2002 was $6,901,202.

 

At December31, 2004, capital ratios were in excess of the regulatory minimums with theCompany’s Tier 1, total risk-based and leverage ratio.

 

The Company’sactual capital amounts and ratios are as follows:  

*** ***
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **To Be Well**        | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|-----------------------|------------|-----------------|------------|-----------------------|------------|-----------------------|------------|------------|------------|-----------------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **Capitalized Under** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital** | ** ** | ** **            | ** ** | **Prompt Corrective** | ** ** |
| ** **                                 | ** ** | **Actual** | ** ** | ** ** | ** ** | **Adequacy Purposes** | ** ** | ** **      | ** ** | **Action Provisions** | ** ** |
| ** **                                 | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | ** **            | ** ** | **Amount**      | ** ** | ** **            | ** ** | **Ratio**             | ** ** | ** ** | ** ** | **Amount**            | ** ** | ** ** | ** ** | **Ratio** | ** ** |
|                                       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| As of December 31, 2004 (in  Thousands)    |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Tier 1 Capital (To Average  assets):       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Consolidated                               |       | $          | 7,743      |       | 8.55       | %                     | >       |            | $          | 3,621                 |       | >                  |       | 4.0        |       | >                  |       | N/A |   |   |   | N/A |   |
| Bank of Greeneville                        |       | $          | 7,690      |       | 8.50       | %                     | >       |            | $          | 3,620                 |       | >                  |       | 4.0        |       | >                  |       | $ | 4,525 |   | > |   | 5.0 |   |
| Tier 1 Capital (To Risk  Weighted Assets): |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Consolidated                               |       | $          | 7,743      |       | 9.90       | %                     | >       |            | $          | 3,129                 |       | >                  |       | 4.0        |       | >                  |       | N/A |   |   |   | N/A |   |
| Bank of Greeneville                        |       | $          | 7,690      |       | 10.00      | %                     | >       |            | $          | 3,076                 |       | >                  |       | 4.0        |       | >                  |       | $ | 4,614 |   | > |   | 6.0 |   |
| Total Capital (To Risk Weighted  Assets):  |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Consolidated                               |       | $          | 8,713      |       | 11.14      | %                     | >       |            | $          | 6,258                 |       | >                  |       | 8.0        |       | >                  |       | N/A |   |   |   | N/A |   |
| Bank of Greeneville                        |       | $          | 8,659      |       | 11.26      | %                     | >       |            | $          | 6,152                 |       | >                  |       | 8.0        |       | >                  |       | $ | 7,691 |   | > |   | 10.0 |   |

 

20

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| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **To Be Well**        | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|-----------------------|------------|-----------------|------------|-----------------------|------------|-----------------------|------------|------------|------------|-----------------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **Capitalized Under** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital** | ** ** | ** **            | ** ** | **Prompt Corrective** | ** ** |
| ** **                                 | ** ** | **Actual** | ** ** | ** ** | ** ** | **Adequacy Purposes** | ** ** | ** **      | ** ** | **Action Provisions** | ** ** |
| As of December 31, 2003 (in  Thousands)    |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Tier 1 Capital (To Average  assets):       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 7,207      |       | 8.9        | %                     | >       |            | $          | 3,246                 |       | >                  |       | 4.0        | %          | >                  |       | $ | 4,057 |   | > |   | 5.0 | % |
| Tier 1 Capital (To Risk  Weighted Assets): |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 7,207      |       | 10.2       | %                     | >       |            | $          | 2,821                 |       | >                  |       | 4.0        | %          | >                  |       | $ | 4,231 |   | > |   | 6.0 | % |
| Total Capital (To Risk Weighted  Assets):  |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 8,094      |       | 11.5       | %                     | >       |            | $          | 5,642                 |       | >                  |       | 8.07       | %          | >                  |       | $ | 7,052 |   | > |   | 10.0 | % |
|                                       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| As of December 31, 2002 (in  Thousands)    |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Total Capital (To Risk Weighted  Assets):  |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 7,429      |       | 13.8       | %                     | >       |            | $          | 4,311                 |       |                  |       | 8.0        | %          | >                  |       | $ | 5,389 |   | > |   | 10.0 | % |
| Tier 1 Capital (To Risk  Weighted Assets): |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 6,896      |       | 12.8       | %                     | >       |            | $          | 2,155                 |       | >                  |       | 4.0        | %          | >                  |       | $ | 3,233 |   | > |   | 6.0 | % |
| Tier 1 Capital (To Average  assets):       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 6,896      |       | 14.4       | %                     | >       |            | $          | 1,917                 |       | >                  |       | 4.0        | %          | >                  |       | $ | 2,397 |   | > |   | 5.0 | % |

 

Liability andAsset Management

 

The Company’sAsset/Liability Committee (“ALCO”) actively measures and manages interest raterisk using a process developed by the Company. The ALCO is also responsible for implementing the Company’sasset/liability management policies, overseeing the formulation andimplementation of strategies to improve balance sheet positioning and earnings,and reviewing the Company’s interest rate sensitivity position.

 

The primarytool that management uses to measure short-term interest rate risk is a netinterest income simulation model prepared by an independent correspondentinstitution.  These simulations estimatethe impact that various changes in the overall level of interest rates overone- and two-year time horizons would have on net interest income.  The results help the Company developstrategies for managing exposures to interest rate risk.

 

Like anyforecasting technique, interest rate simulation modeling is based on a largenumber of assumptions.  In this case, theassumptions relate primarily to loan and deposit growth, asset and liabilityprepayments, interest rates and balance sheet management strategies.  Management believes that both individuallyand in the aggregate the assumptions are reasonable.  Nevertheless, the simulation modeling processproduces only a sophisticated estimate, not a precise calculation of exposure.

 

At December31, 2004, approximately 62% of the Company’s gross loans had adjustablerates.  Based on the asset/liabilitymodeling management believes that these loans reprice at a faster pace thanliabilities held at the Company.  Becausethe majority of the institutions liabilities are 12 months and under and thegap in repricing is asset sensitive management believes that a rising rateenvironment would have a positive impact on the Company’s net interestmargin.  Floors in the majority of theCompany’s adjustable rate assets also mitigate interest rate sensitivity in adecreasing rate environment. 

 

**Off-Balance Sheet Arrangements**

 

The Company, at December 31, 2004, had outstanding unused lines ofcredit and standby letters of credit that totaled $7,688,771.  These commitments have fixed maturity datesand many will mature without being drawn upon, meaning that the totalcommitment does not necessarily represent the future cash requirements.  The Company has the ability to liquidateFederal funds sold or, on a short-term basis, to purchase Federal funds fromother banks and to borrow from the Federal Home Loan Bank.  At December 31, 2004, the Company hadestablished with correspondent banks the ability to purchase Federal funds ifneeded.

 

21

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I.                     AVERAGEBALANCE SHEETS, NET INTEREST REVENUE AND CHANGES IN INTEREST INCOME ANDINTEREST EXPENSE

 

The followingtable shows the amount of our average balances, interest income or interestexpense for each category of interest-earning assets and interest-bearingliabilities and the average interest rate for total interest-earning assets andtotal interest-bearing liabilities, net interest spread and net yield onaverage interest-earning assets for each of the years in the two-year periodended December 31, 2004.  The table ispresented on taxable equivalent basis, if applicable.

 
| ** **                                      | ** ** | **2004**    | ** ** | **2003**     | ** ** |
|-------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                      | ** ** | ** **  | ** ** | ** **   | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                      | ** ** | **Average** | ** ** | ** **   | ** ** | **Yields/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yields/** | ** ** |
| ** **                                      | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| Assets:                                         |       |        |       |         |       |   |   |   |   |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-earning assets:                        |       |        |       |         |       |   |   |   |   |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Loans                                           |       | $           | 75,435,264 |         | $          | 5,376,509 |   | 7.13% |   | $ | 55,221,961 |   | $ | 4,219,597 |   | 7.64% |   |
| FHLB stock                                      |       | 205,821     |       | 8,578        |       | 4.17% |   | 156,423 |   | 6,554 |   | 4.19% |   |
| Deposits                                        |       | 1,857,123   |       | 19,943       |       | 1.07% |   | 1,793,598 |   | 11,859 |   | 0.66% |   |
| Federal funds sold                              |       | 7,588,098   |       | 93,687       |       | 1.23% |   | 6,624,339 |   | 70,380 |   | 1.06% |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total interest-earning assets                   |       | 85,086,306  |       | 5,498,717    |       | 6.46% |   | 63,796,321 |   | 4,308,390 |   | 6.75% |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Cash and due from banks                         |       | 2,961,599   |       |         |       |   |   | 1,321,609 |   |   |   |   |   |
| Other assets                                    |       | 4,679,699   |       |         |       |   |   | 3,459,424 |   |   |   |   |   |
| Allowance for loan losses                       |       | (1,442,234  | )          |         |       |   |   | (680,604 | ) |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total Assets                                    |       | $           | 91,285,370 |         |       |   |   |   | $ | 67,896,750 |   |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Liabilities and Stockholder’s Equity:      |       |        |       |         |       |   |   |   |   |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Demand deposits                                 |       | $           | 9,686,964  |         | $          | 102,811 |   | 1.06% |   | $ | 8,172,388 |   | $ | 102,315 |   | 1.25% |   |
| Savings deposits                                |       | 4,516,184   |       | 45,658       |       | 1.01% |   | 2,926,223 |   | 32,695 |   | 1.12% |   |
| Other time deposits                             |       | 58,014,179  |       | 1,282,098    |       | 2.21% |   | 40,722,054 |   | 953,591 |   | 2.34% |   |
| FHLB advances                                   |       | 4,409,274   |       | 145,513      |       | 3.30% |   | 3,572,259 |   | 127,758 |   | 3.58% |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities              |       | 76,626,601  |       | 1,576,080    |       | 2.06% |   | 55,392,924 |   | 1,216,359 |   | 2.20% |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Non-interest bearing demand deposits            |       | 6,643,265   |       |         |       |   |   | 5,152,032 |   |   |   |   |   |
| Other liabilities                               |       | 378,163     |       |         |       |   |   | 130,233 |   |   |   |   |   |
| Stockholder’s equity                       |       | 7,637,341   |       |         |       |   |   | 7,221,561 |   |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total liabilities and stockholder’s equity |       |        |       |         |       |   |   |   |   |   |   |   |   |
|                                            |       | $           | 91,285,370 |         |       |   |   |   | $ | 67,896,750 |   |   |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Net interest earnings                           |       |        |       | $            | 3,922,637  |   |   |   |   |   | $ | 3,092,031 |   |   |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Net interest spread                             |       |        |       |         |       | 4.40% |   |   |   |   |   | 4.55% |   |
|                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Net interest  margin                            |       |        |       |         |       | 4.61% |   |   |   |   |   | 4.85% |   |

 

Note:  Average loan balances include nonaccrualloans.  Interest income collected onnonaccrual loans has been included.

 

22

----

 

The netinterest margin for 2004 was 4.61% compared to a net interest margin of 4.85%for the same period in 2003, a decrease of 24 basis points.  The net change in the net interest margin isdue to the rapid growth in interest-bearing liabilities.  The net interest margin for 2002 was 4.98%,compared to the 4.85% margin in 2003, a decrease of 13 basis points.  The net change in the net interest margin wasnot as significant between these two periods because the net decrease in theyield on interest-earning assets between the two periods was 40 basis pointscompared to the net decrease in the rate paid on interest-bearing liabilitiesof 38 basis points.  Other mattersrelated to the changes in net interest income, net yields and rate, and netinterest margin are presented below:

 

•                  Ourloan yields decreased from 2003 to 2004. For asset/liability management purposes, we have emphasized variablerate loans since our inception such that approximately 62.0% of our loans arevariable rate loans at December 31, 2004 compared to 61.0% at December 31, 2003and 67.0% at December 31, 2002.  Variablerate loans generally have lower yields than do fixed rate loans, but bettermatch the cost of funds in a rising rate environment.

 

•                  During2004, we were able to increase our funding base significantly. The averagebalances of noninterest bearing deposits increased by $1,491,233 or 28.9%,while interest bearing deposits increased by $21,233,677 or 38.3%.  Rates began to increase in late 2004 suchthat we anticipate a more rapid increase in funding rates on interest bearingdeposits in 2005.

 

Net interestincome increased by $830,606 between the years ended December 31, 2004 and 2003and by $1,284,208 between the years ended December 31, 2003 and 2002.  The following is an analysis of the changesin our net interest income comparing the changes attributable to rates andthose attributable to volumes:

 
| ** **                         | ** ** | **2004 Compared to 2003**      | ** ** | **2003 Compared to 2002**      | ** ** |
|------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **Increase (Decrease) due to** | ** ** | **Increase (Decrease) due to** | ** ** |
| ** **                         | ** ** | **Rate**                       | ** ** | **Volume**                     | ** ** | **Net** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Net** | ** ** |
|                               |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
| Interest-earning assets:           |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
|                               |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
| Loans                              |       | $                              | (387,384   | )                              | $          | 1,544,296 |   | $ | 1,156,912 |   | $ | (292,025 | ) | $ | 1,999,384 |   | $ | 1,707,359 |   |
| FHLB stock                         |       | (46                            | )          | 2,070                          |       | 2,024 |   | (782 | ) | 6,308 |   | 5,526 |   |
| Deposits                           |       | 7,665                          |       | 419                            |       | 8,084 |   | 10,427 |   | 1,356 |   | 11,783 |   |
| Federal funds sold                 |       | 13,091                         |       | 10,216                         |       | 23,307 |   | (33,432 | ) | 18,372 |   | (15,060 | ) |
|                               |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
| Total interest-earning assets      |       | (366,674                       | )          | 1,557,001                      |       | 1,190,327 |   | (315,812 | ) | 2,025,420 |   | 1,709,608 |   |
|                               |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:      |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
|                               |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
| Demand deposits                    |       | (18,436                        | )          | 18,932                         |       | 496 |   | (37,090 | ) | 11,484 |   | (25,606 | ) |
| Savings deposits                   |       | (4,845                         | )          | 17,808                         |       | 12,963 |   | (16,711 | ) | 19,503 |   | 2,792 |   |
| Other time deposits                |       | (76,129                        | )          | 404,636                        |       | 328,507 |   | (256,386 | ) | 576,980 |   | 320,594 |   |
| FHLB advances                      |       | (12,210                        | )          | 29,965                         |       | 17,755 |   | 122,396 |   | 5,224 |   | 127,620 |   |
|                               |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities |       | (111,620                       | )          | 471,341                        |       | 359,721 |   | (187,791 | ) | 613,191 |   | 425,400 |   |
|                               |       |                           |       |                           |       |   |   |   |   |   |   |   |   |
| Net interest income                |       | $                              | (255,054   | )                              | $          | 1,085,660 |   | $ | 830,606 |   | $ | (128,021 | ) | $ | 1,412,229 |   | $ | 1,284,208 |   |

 

23

----

 

Changes in netinterest income are attributed to either changes in average balances (volumechange) or changes in average rates (rate change) for earning assets andsources of funds on which interest is received or paid.  Volume changes have been determined bymultiplying the prior years’ average rate by the change in average balancesoutstanding.  The rate change is thedifference between the net change and the volume change.

 

II.            INVESTMENTPORTFOLIO

 

The Companyhad no investments as of December 31, 2004 and 2003.

 

III.           LOANPORTFOLIO

 

A.            Loan Types.

 

The followingschedule details the loans of the Company at December 31, 2004 and 2003:

 
| ** **                         | ** ** | **December 31** | ** **       | **December 31** | ** ** |
|------------------------------------|------------|-----------------|------------------|-----------------|------------|
| ** **                         | ** ** | **2004**        | ** **       | **2003**        | ** ** |
|                               |       |            |             |            |       |
| Consumer installment               |       | $               | 5,522,402        |            | $          | 6,011,006 |   |
| Commercial                         |       | 20,874,591      |             | 23,967,041      |       |
| Commercial real estate             |       | 31,560,010      |             | 25,483,343      |       |
| Residential mortgage               |       | 15,952,474      |             | 14,344,162      |       |
| Overdrafts                         |       | 53,368          |             | 83,949          |       |
|                               |       | 73,962,845      |             | 69,889,501      |       |
| Deduct:                            |       |            |             |            |       |
| Allowance for possible loan losses |       | 1,607,559       |             | 1,350,266       |       |
|                               |       |            |             |            |       |
| Loans, net                         |       | $               |  72,355,286 |            | $          |  68,539,235 |   |

 

24

----

 

B.            Maturities and Sensitivities ofLoans to Changes in Interest Rates

 

The following schedule details maturities and sensitivities to interestrate changes for loans as of December 31, 2004: 

 
| ** **                                                    | ** ** | **Within  1 year** | ** **  | **1 to 5  years** | ** ** | **Over 5  years** | ** ** | **Total**  | ** ** |
|---------------------------------------------------------------|------------|--------------------|-------------|-------------------|------------|-------------------|------------|------------|------------|
|                                                          |       |               |        |              |       |              |       |       |       |
| Uses of Funds:                                                |       |               |        |              |       |              |       |       |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Loans                                                         |       |               |        |              |       |              |       |       |       |
| Installment                                                   |       | $                  | 1,589,019   |              | $          | 3,598,002         |       | $          | 335,381    |   | $ | 5,522,402 |   |
| Commercial                                                    |       | 4,545,677          |        | 15,958,798        |       | 370,117           |       | 20,874,592 |       |
| Commercial real estate                                        |       | 8,664,800          |        | 21,455,867        |       | 1,439,343         |       | 31,560,010 |       |
| Mortgage                                                      |       | 4,407,439          |        | 8,014,112         |       | 3,530,923         |       | 15,952,474 |       |
| Overdrafts                                                    |       | 53,367             |        | —            |       | —            |       | 53,367     |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Total Loans                                                   |       | 19,260,302         |        | 49,026,779        |       | 5,675,764         |       | 73,962,845 |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| FHLB stock                                                    |       | 226,500            |        | —            |       | —            |       | 226,500    |       |
| Deposits                                                      |       | 1,724,972          |        | —            |       | —            |       | 1,724,972  |       |
| Federal funds sold                                            |       | 7,619,619          |        | —            |       | —            |       | 7,619,619  |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Total earning assets                                          |       | $                  | 28,831,393  |              | $          | 49,026,779        |       | $          | 5,675,764  |   | $ | 83,533,936 |   |
|                                                          |       |               |        |              |       |              |       |       |       |
| Sources of funds:                                             |       |               |        |              |       |              |       |       |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Deposits:                                                     |       |               |        |              |       |              |       |       |       |
| Interest bearing Money market, interest checking  and savings |       | $                  | 16,046,823  |              | $          | —            |       | $          | —     |   | $ | 16,046,823 |   |
| Time deposits                                                 |       | 51,214,067         |        | 4,370,343         |       | —            |       | 55,584,410 |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Total Deposits                                                |       | 67,260,890         |        | 4,370,343         |       | —            |       | 71,631,233 |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Borrowings                                                    |       | —             |        | 3,633,232         |       | 726,114           |       | 4,359,346  |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Total interest-bearing liabilities                            |       | $                  | 67,260,890  |              | $          | 8,003,575         |       | $          | 726,114    |   | $ | 75,990,579 |   |
|                                                          |       |               |        |              |       |              |       |       |       |
| Net repricing gap                                             |       | $                  | (38,429,497 | )                 | $          | (41,023,204       | )          | $          | 4,949,650  |   | $ | 7,543,357 |   |
|                                                          |       |               |        |              |       |              |       |       |       |
| Rate sensitivity gap:                                         |       |               |        |              |       |              |       |       |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Net repricing gap as a percentage of total  earning assets    |       | (46.00             | )%          | (49.11            | )%         | 5.92              | %          | 9.03       | %          |
| Cumulative Gap                                                |       | $                  | (38,429,497 | )                 | $          | 2,593,707         |       | $          | 7,543,357  |   |   |   |
|                                                          |       |               |        |              |       |              |       |       |       |
| Cumulative gap as a percentage of total  earning assets       |       | (46.00             | )%          | 3.11              | %          | 9.03              | %          |       |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Rate Risk:                                                    |       |               |        |              |       |              |       |       |       |
|                                                          |       |               |        |              |       |              |       |       |       |
| Loans with fixed rates                                        |       | $                  | 6,431,250   |              | $          | 20,355,076        |       | $          | 1,428,109  |   | $ | 28,214,435 |   |
|                                                          |       |               |        |              |       |              |       |       |       |
| Loans with variable/adjusted rate                             |       | 12,829,052         |        | 28,671,703        |       | 4,247,655         |       | 45,748,410 |       |
|                                                          |       |               |        |              |       |              |       |       |       |
|                                                          |       | $                  | 19,260,302  |              | $          | 49,026,779        |       | $          | 5,675,764  |   | $ | 73,962,845 |   |

 

25

----

 

C.            Risk Elements

 

The following table presents information regarding nonaccrual, past dueand restructured  loans at December 31,2004 and 2003:

 
| ** **                                                                                                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Loans accounted for on a non-accrual basis:                                                                                        |       |     |       |     |       |
| Number                                                                                                                             |       | 12       |       | 1        |       |
| Amount                                                                                                                             |       | $        | 534,442    |     | $          | 83,035 |   |
| Accruing loans (including consumer loans)  which are contractually past due 90 days or more as to principal or interest  payments: |       |     |       |     |       |
| Number                                                                                                                             |       | 3        |       | 3        |       |
| Amount                                                                                                                             |       | $        | 13,109     |     | $          | 46,323 |   |
| Loans defined as “troubled debt  restructurings”                                                                         |       |     |       |     |       |
| Number                                                                                                                             |       | —   |       | —   |       |
| Amount                                                                                                                             |       | $        | —     |     | $          | — |   |

 

Accrual ofinterest is discontinued on a loan when management of the Company determinesupon consideration of economic and business factors affecting collectionefforts that collection of interest is doubtful.

 

There are noother loans which are not disclosed above, but where known information aboutpossible credit problems of borrowers causes management to have serious doubtsas to the ability of such borrowers to comply with the present loan repaymentterms.

 

IV.           SUMMARY OF LOAN LOSS EXPERIENCE

 

The followingschedule details selected information related to the allowance for possibleloan loss account of the Company at December 31, 2004 and 2003:

 

26

----

 
| ** **                                                                                 | ** ** | **December 31** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                                                 | ** ** | **2004**        | ** ** | **2003** | ** ** |
|                                                                                       |       |            |       |   |   |
| Balance at beginning of year                                                               |       | $               | 1,350,266  |   | $ | 533,819 |   |
|                                                                                       |       |            |       |   |   |
| Provision charged to expense                                                               |       | 615,251         |       | 956,609 |   |
|                                                                                       |       |            |       |   |   |
| Charge offs:                                                                               |       |            |       |   |   |
| Installment loans                                                                          |       | (82,166         | )          | (17,066 | ) |
| Commercial                                                                                 |       | (373,645        | )          | (103,427 | ) |
| Mortgage                                                                                   |       | (45,968         | )          | (11,773 | ) |
| Overdrafts                                                                                 |       | —          |       | (14,901 | ) |
|                                                                                       |       |            |       |   |   |
| Total Charge Offs                                                                          |       | (501,779        | )          | (147,167 | ) |
|                                                                                       |       |            |       |   |   |
| Recoveries:                                                                                |       |            |       |   |   |
|                                                                                       |       |            |       |   |   |
| Installment loans                                                                          |       | $               | 39,450     |   | $ | 7,005 |   |
| Commercial                                                                                 |       | 77,486          |       | — |   |
| Mortgage                                                                                   |       | 26,885          |       | — |   |
|                                                                                       |       |            |       |   |   |
| Total Loan Recoveries                                                                      |       | 143,821         |       | 7,005 |   |
|                                                                                       |       |            |       |   |   |
| Net Charge Offs                                                                            |       | (357,958        | )          | (140,162 | ) |
|                                                                                       |       |            |       |   |   |
| Balance at end of year                                                                     |       | $               | 1,607,559  |   | $ | 1,350,266 |   |
|                                                                                       |       |            |       |   |   |
| Ratio of net charge offs during the period  to average loans outstanding during the period |       | 0.47            | %          | 0.25 | % |
|                                                                                       |       |            |       |   |   |
| Allowance for loan losses as a percent of  year end loans                                  |       | 2.17            | %          | 1.93 | % |

 

At December31, 2004 and 2003, the allowance for loan losses were allocated as follows:

 
| ** **             | ** ** | **December 31, 2004** | ** ** | **December 31, 2003**  | ** ** |
|------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **             | ** ** | ** **            | ** ** | **Percentage of loan** | ** ** | ** ** | ** ** | **Percentage of loan** | ** ** |
| ** **             | ** ** | ** **            | ** ** | **in each category**   | ** ** | ** ** | ** ** | **in each category** | ** ** |
| ** **             | ** ** | **Amount**            | ** ** | **to total loans**     | ** ** | **Amount** | ** ** | **to total loans** | ** ** |
|                   |       |                  |       |                   |       |   |   |   |   |
| Installment            |       | $                     | 120,604    |                   | 7.50       | % | $ | 116,133 |   | 8.60 | % |
| Commercial             |       | 380,275               |       | 23.66                  | %          | 463,044 |   | 34.29 | % |
| Commercial real estate |       | 741,958               |       | 46.15                  | %          | 492,339 |   | 36.46 | % |
| Mortgage               |       | 350,074               |       | 21.78                  | %          | 277,130 |   | 20.53 | % |
| Overdrafts             |       | 14,648                |       | 0.91                   | %          | 1,620 |   | 0.12 | % |
|                   |       |                  |       |                   |       |   |   |   |   |
|                   |       | $                     | 1,607,559  |                   | 100.00     | % | $ | 1,350,266 |   | 100.00 | % |

 

27

----

 

Nonaccrual and Past Due Loans:

 
| ** **                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Principal:                                         |       |     |       |     |       |
| Nonaccruing loans                                  |       | $        | 534,442    |     | $          | 83,035 |   |
| Loans past due 90 days or more and still  accruing |       | 13,109   |       | 46,323   |       |
|                                               |       | $        | 547,551    |     | $          | 129,358 |   |

 

The allowancefor loan losses is evaluated on a regular basis by management and is based uponmanagement’s periodic review of the collectibility of the loans in light ofhistorical experience, the nature and volume of the loan portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofany underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision as moreinformation becomes available.

 

V.            DEPOSITS

 

The averageamounts and average interest rates for deposits for 2004 and 2003 are detailedin the following schedule:

 
| ** **                 | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------|------------|------------------------------|------------|
| ** **                 | ** ** | **2004**                     | ** ** | **2003** | ** ** |
| **Deposit Category**       | ** ** | **Average  Amount**          | ** ** | **Average Rate  Paid** | ** ** | **Average  Amount** | ** ** | **Average Rate  Paid** | ** ** |
|                       |       |                         |       |   |   |   |   |   |   |
| Noninterest-bearing demand |       | $                            | 6,643,265  |   | N/A |   | $ | 5,152,032 |   | N/A |   |
| NOW deposits               |       | 9,686,964                    |       | 1.06 | % | 8,172,388 |   | 1.25 | % |
| Savings deposits           |       | 4,516,184                    |       | 1.01 | % | 2,926,223 |   | 1.12 | % |
| Time deposits              |       | 58,014,179                   |       | 2.21 | % | 40,722,054 |   | 2.34 | % |
|                            |            |                              |            |  |  |  |  |  |  |  |  |

 

The followingschedule details the amount outstanding of time certificates of deposit of$100,000 or more and respective maturities for the year ended December 31,2004:

 
| ** **       | ** ** | **Certificates of Deposit** | ** ** |
|------------------|------------|-----------------------------|------------|
|             |       |                        |       |
| 3 months or less |       | $                           | 100,816    |   |
| 3-6 months       |       | 503,000                     |       |
| 6-12 months      |       | 1,904,549                   |       |
| Over 12 months   |       | 2,232,042                   |       |
|             |       |                        |       |
| Total            |       | $                           | 4,740,407  |   |

 

28

----

 

VI.           RETURN ON EQUITY AND ASSETS

 

Returns onaverage consolidated assets and average consolidated equity for the periodsindicated are as follows:

 
| ** **                             | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **2004**                    | ** ** | **2003** | ** ** |
|                                   |       |                        |       |   |   |
| Return on average assets               |       | .55%                        |       | .37% |   |
| Return on average equity               |       | 6.60%                       |       | 3.51% |   |
| Average equity to average assets ratio |       | 8.37%                       |       | 10.64% |   |
| Dividend payout ratio                  |       | N/A                         |       | N/A |   |

 

 

VII.          SHORT-TERM BORROWINGS

 

*Federal Home Loan Bank Advances*:

 

Pursuant tocollateral agreements with Federal Home Loan Bank (FHLB), the advances arecollateralized by specific first mortgage loans.  The FHLB’s required unpaid principal balanceof eligible mortgages was $6,198,317 and $5,607,632 at December 31, 2004 and2003, respectively.  The advances atDecember 31, 2004 and 2003, have the maturity dates as follows:

 
| **Maturity Date** | ** ** | **Interest Rate** | ** ** | **December 31, 2004** | ** ** |
|-------------------|------------|-------------------|------------|-----------------------|------------|
|              |       |              |       |                  |       |
| 07/07/06          |       | 3.07              | %          | $                     | 1,600,000  |   |   |
| 08/04/06          |       | 2.99              |       | 100,000               |       |   |
| 03/01/07          |       | 2.91              |       | 265,313               |       |   |
| 12/01/07          |       | 3.11              |       | 25,978                |       |   |
| 12/01/07          |       | 3.83              |       | 520,490               |       |   |
| 12/20/07          |       | 3.60              |       | 30,000                |       |   |
| 01/01/08          |       | 3.50              |       | 17,989                |       |   |
| 05/01/08          |       | 2.64              |       | 63,892                |       |   |
| 06/01/08          |       | 3.28              |       | 782,534               |       |   |
| 08/01/08          |       | 2.85              |       | 44,126                |       |   |
| 08/01/08          |       | 2.99              |       | 69,609                |       |   |
| 11/01/08          |       | 3.54              |       | 113,301               |       |   |
| 04/01/10          |       | 3.56              |       | 726,114               |       |   |
|              |       |              |       | $                     | 4,359,346  |   |   |

 

29

----

 
| **Maturity Date** | ** ** | **Interest Rate** | ** ** | **December 31, 2003** | ** ** |
|-------------------|------------|-------------------|------------|-----------------------|------------|
|              |       |              |       |                  |       |   |
| 07/07/06          |       | 3.07              | %          | $                     | 1,600,000  |   |   |
| 08/04/06          |       | 2.99              |       | 100,000               |       |   |
| 12/01/07          |       | 3.11              |       | 34,114                |       |   |
| 12/01/07          |       | 3.83              |       | 550,814               |       |   |
| 12/20/07          |       | 3.60              |       | 30,000                |       |   |
| 01/01/08          |       | 3.50              |       | 19,055                |       |   |
| 05/01/08          |       | 2.64              |       | 82,592                |       |   |
| 06/01/08          |       | 3.28              |       | 827,879               |       |   |
| 08/01/08          |       | 2.85              |       | 48,552                |       |   |
| 08/01/08          |       | 2.99              |       | 73,672                |       |   |
| 11/01/08          |       | 3.54              |       | 119,494               |       |   |
| 04/01/10          |       | 3.56              |       | 767,934               |       |   |
|              |       |              |       |                  |       |   |
|              |       |              |       | $                     | 4,254,106  |   |   |

 

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

 

Theinformation set forth on pages 16 through 30 of Item 7, “MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS isincorporated herein by reference.

 

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

 

The report ofIndependent Accountants, Consolidated Financial Statements and supplementarydata required by Item 8 are set forth on pages F-1 through F-29 of this Reportand are incorporated herein by reference.

 

Index toFinancial Statements

 
| **Financial  Statements**                                        | ** ** | **Page** |
|------------------------------------------------------------------|------------|----------|
|                                                             |       |
| Consolidated Statements of Financial  Condition                  | F-1        |
| Consolidated Statements of Income                                | F-2        |
| Consolidated Statements of Changes in  Stockholders’ Equity | F-3        |
| Consolidated Statements of Cash Flows                            | F-4        |
| Notes to Consolidated Financial Statements                       | F5-F29     |

 

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

 

None.

 

**ITEM 9A**.                                            CONTROLS AND PROCEDURES

 

a)             Evaluation of DisclosureControls and Procedures. The Corporation maintains disclosure controls andprocedures, as defined in Rule 13a-15(a) promulgated under the SecuritiesExchange Act of 1934 (the “Exchange Act”), that are designed to ensure thatinformation required to be disclosed by it in the reports that it files orsubmits under the Exchange Act is recorded, processed, summarized and reportedwithin the time period specified in the SEC’s rules and forms and that suchinformation is accumulated and communicated to the Corporation’s management,including its Chief Executive Office and Chief Financial Officer. TheCorporation carried out an evaluation, under the supervision and with theparticipation of its management, including its Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofits disclosure controls and procedures as of the end of the period covered bythis report.  Based on the evaluation ofthese disclosure controls and procedures, the Chief Executive Officer and ChiefFinancial Officer concluded that the Corporation’s disclosure control andprocedures were effective.

 

30

----

 

 

 

b)            Changes in Internal Controls andProcedures. There were no changes in the Corporation’s internal controlover financial reporting during the Corporation’s fiscal quarter ended December31, 2004 that have materially affected, or are reasonably likely to materiallyaffect, its internal control over financial reporting.

 

**ITEM 9B**.                                            OTHER INFORMATION

 

None.

 

PART III

 

**ITEM 10**.                                              DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

 

Informationrelating to our directors and executive officers will be contained in adefinitive Proxy Statement involving the election of directors at the annualmeeting of shareholders to be held May 24, 2005, and such information isincorporated herein by reference.

 

**ITEM 11**.                                              EXECUTIVE COMPENSATION

 

Informationrelating to executive compensation will be contained in the Proxy Statementreferred to above in Item 10, and such information is incorporated herein byreference.

 

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

 

Informationrelating to security ownership of certain beneficial owners and management willbe contained in the Proxy Statement referred to above in Item 10, and suchinformation is incorporated herein by reference.

 

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

 

Informationrelating to certain relationships and related transactions will be contained inthe Proxy Statement referred to above in Item 10, and such information isincorporated herein by reference.

 

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

 

Informationrelating to the principal accountant fees and services will be contained in theProxy Statement referred to above in Item 10, and such information isincorporated herein by reference.

 

31

----

 

PART IV

 

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

 

(a)(1)       Financial Statements:

 

(2)           Schedules required by Article 12 ofRegulation S-X are either omitted because they are not applicable or becausethe required information is shown in the financial statements or the notesthereto.

 

(3)           Exhibits:

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                           |
| 3.1*            |       | Charter of BG Financial Group, Inc.                                                                                            |
| 3.2*            |       | Bylaws of BG Financial Group, Inc.                                                                                             |
| 10.1*           |       | Share Exchange Agreement between BG Financial Group, Inc. and Bank of  Greeneville, effective  January 23, 2004                |
| 10.2**          |       | Stock Option Agreement between Bank of Greeneville and J. Robert  Grubbs                                                       |
| 10.3**          |       | Stock Option Agreement between Bank of Greeneville and T. Don Waddell                                                          |
| 10.4**          |       | Purchase and Assumption Agreement between Bank of Greeneville and  First Community Bank of East Tennessee, dated July 6, 2001; |
| 31.1            |       | Certification pursuant to Rule 13a-14a/15d-14(a)                                                                               |
| 31.2            |       | Certification pursuant to Rule 13a-14a/15d-14(a)                                                                               |
| 32.1            |       | Certification pursuant to Rule 18 USC Section 1350-Sarbanes-Oxley Act  of 2002                                                 |
| 32.2            |       | Certification pursuant to Rule 18 USC Section 1350-Sarbanes-Oxley Act  of 2002                                                 |

 

----

* Previouslyfiled as an exhibit to a Form 8-K filed by BG Financial Group, Inc. with theCommission on May 21, 2004.

 

**  Previously filed as an exhibit to Bank ofGreeneville’s Registration Statement on Form 10-SB, as filed with the FederalDeposit Insurance Corporation on April 27, 2002.

 

32

----

 

**Signatures**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|   | BG FINANCIAL GROUP, INC. |
|--------|--------------------------|
|   |                     |
|   |                     |   |
|   | By:                      |  /s/ J. Robert Grubbs |   |
|   |                     | J. Robert Grubbs, President and Chief |
|   |                     | Executive Officer |
|   |                     |   |
|   | Date:                    | April 14, 2005 |
|        |                          |  |  |  |

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant in theircapacities as directors.

 
| By:    | /s/ Don E. Claiborne  |   | By:              | /s/ William J. Smead |   |
|--------|-----------------------|--------|------------------|----------------------|--------|
|   | Don E. Claiborne      |   | William J. Smead |
|   |                  |   |             |
| Date:  | April 14, 2005        |   | Date:            | April 14, 2005       |   |
|   |                  |   |             |
|   |                  |   |             |
| By:    | /s/ J. Robert Grubbs  |   | By:              | /s/ Wendy C. Warner  |   |
|   | J. Robert Grubbs      |   | Wendy C. Warner  |
|   |                  |   |             |
| Date:  | April 14, 2005        |   | Date:            | Aril 14, 2005        |   |
|   |                  |   |             |
|   |                  |   |             |
| By:    | /s/ Leonard B. Lawson |   | By:              | /s/ Roger A. Woolsey |   |
|   | Leonard B. Lawson     |   | Roger A. Woolsey |
|   |                  |   |             |
| Date:  | April 14, 2005        |   | Date:            | April 14, 2005       |   |
|        |                       |        |                  |                      |        |  |  |  |  |

 

33

----

 

**BGFINANCIAL GROUP, INC. AND SUBSIDIARY (2004)**

**AND BANKOF GREENEVILLE (2003) AND (2002)**

 

**Greeneville,Tennessee**

## ** **

# **AUDITEDFINANCIAL STATEMENTS**

# ** **

## **December31, 2004 and 2003**

## ** **

----

 
|  | One Perkins  Place, 525 Portland Street  Knoxville, TN 37919

 

(p) (865) 673-0844  (f) (865) 673-0173  (w) www.pyapc.com |
|--|---------------------------------------------------------------------------------------------------------------------------------|

 

INDEPENDENT AUDITOR’S REPORT

 

To the Boards of Directors ofBG Financial Group, Inc. and Subsidiary:

 

We have audited the accompanying consolidated statements of financialcondition of BG Financial Group, Inc. and Subsidiary (the Bank) as of December31, 2004 and the related consolidated statements of income, changes instockholders’ equity, and cash flows for the year then ended.  These consolidated financial statements arethe responsibility of the Bank’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audit. The financial statements of the Bank of Greeneville for the year endedDecember 31, 2003 and 2002 were audited by other auditors whose report datedMarch 3, 2004 expressed an unqualified opinion on those statements.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the consolidated financial statements arefree of material misstatement.  An auditincludes consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of the Bank’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the consolidated financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, as wellas evaluating the overall consolidated financial statement presentation.  We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of BG FinancialGroup, Inc. and Subsidiary as of December 31, 2004 and the results of theiroperations and their cash flows for the year then ended in conformity withaccounting principles generally accepted in the United States of America.

 

 

Pershing Yoakley & Associates

Knoxville, Tennessee

March 4, 2005

 

| A T L A N T A | • | C H A R L O T T E | • | K N O X V I L L E | • | T A M P A  B A Y |
|---------------|--------|-------------------|--------|-------------------|--------|-----------------------|

 

----

 

# **CONTENTS**

# ** **

| FINANCIAL STATEMENTS                                             |   |
|------------------------------------------------------------------|--------|
|                                                             |   |
| Consolidated statements of financial  condition                  | F-1    |
| Consolidated statements of income                                | F-2    |
| Consolidated statements of changes in  stockholders’ equity | F-3    |
| Consolidated statements of cash flows                            | F-4    |
| Notes to consolidated financial statements                       | F5-F29 |

 

----

 

**BG FINANCIAL GROUP, INC. AND SUBSIDIARY(2004)**

**AND BANK OF GREENEVILLE (2003) AND (2002)**

**Greeneville, Tennessee**

# **CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

## **December31, 2004 and 2003**

## ** **

| ** **                                                                                                                               | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                                                                                     |       |       |       |       |       |
| Cash and due from banks                                                                                                                  |       | $          | 5,538,897  |       | $          | 5,054,515 |   |
| Federal funds sold                                                                                                                       |       | 7,619,619  |       | 7,244,455  |       |
| Cash and cash equivalents                                                                                                                |       | 13,158,516 |       | 12,298,970 |       |
| Federal Home Loan Bank stock, at cost                                                                                                    |       | 226,500    |       | 171,700    |       |
| Loans, net of allowance for loan losses of  $1,607,559 in 2004 and $1,350,266 in 2003                                               |       | 72,355,286 |       | 68,539,235 |       |
| Premises and equipment, net                                                                                                              |       | 3,895,500  |       | 2,763,153  |       |
| Accrued income receivable                                                                                                                |       | 389,308    |       | 387,258    |       |
| Deferred tax benefit                                                                                                                     |       | 601,307    |       | 603,177    |       |
| Foreclosed assets                                                                                                                        |       | 489,649    |       | 184,127    |       |
| Other assets                                                                                                                             |       | 58,302     |       | 127,530    |       |
| Total Assets                                                                                                                             |       | $          | 91,174,368 |       | $          | 85,075,150 |   |
| ** **                                                                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| **LIABILITIES**                                                                                                                          |       |       |       |       |       |
| Deposits:                                                                                                                                |       |       |       |       |       |
| Noninterest-bearing                                                                                                                      |       |       |       |       |       |
| Demand                                                                                                                                   |       | $          | 6,755,994  |       | $          | 6,193,162 |   |
| Interest-bearing                                                                                                                         |       |       |       |       |       |
| Money market, interest checking and savings                                                                                              |       | 16,046,823 |       | 11,840,876 |       |
| Time deposits                                                                                                                            |       | 55,584,410 |       | 55,427,728 |       |
| Total Deposits                                                                                                                           |       | 78,387,227 |       | 73,461,766 |       |
| Accrued interest                                                                                                                         |       | 202,564    |       | 54,721     |       |
| Other liabilities                                                                                                                        |       | 482,134    |       | 97,270     |       |
| Federal Home Loan Bank advances                                                                                                          |       | 4,359,346  |       | 4,254,106  |       |
| Total Liabilities                                                                                                                        |       | 83,431,271 |       | 77,867,863 |       |
|                                                                                                                                     |       |       |       |       |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock:                                                                                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred stock, no par value; authorized  1,000,000 shares; none issued and outstanding                                                 |       | —     |       | —     |       |
| Common stock, $0.333 par value; authorized  6,000,000 shares; issued and outstanding 2,306,775 shares in 2004; 2,295,775 shares  in 2003 |       | 768,925    |       | 765,258    |       |
| Additional paid-in capital                                                                                                               |       | 6,920,322  |       | 6,887,325  |       |
| Retained earnings (accumulated deficit)                                                                                                  |       | 53,850     |       | (445,296   | )          |
| Total Stockholders’ Equity                                                                                                          |       | 7,743,097  |       | 7,207,287  |       |
| Total Liabilities and Stockholders’ Equity                                                                                          |       | $          | 91,174,368 |       | $          | 85,075,150 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-1

----

 

**BG FINANCIAL GROUP, INC. AND SUBSIDIARY(2004)**

**AND BANK OF GREENEVILLE (2003) AND (2002)**

**Greeneville, Tennessee**

# **CONSOLIDATEDSTATEMENTS OF INCOME**

## **Years EndedDecember 31, 2004, 2003, and 2002**

## ** **

| ** **                                            | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Interest and dividend income:**                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans, including fees                                 |       | $          | 5,376,509  |       | $          | 4,219,597  |       | $ | 2,512,238 |   |
| Dividends on Federal Home Loan Bank stock             |       | 8,578      |       | 6,554      |       | 1,104      |       |
| Federal funds sold and other                          |       | 113,630    |       | 82,239     |       | 85,440     |       |
| Total interest and dividend income                    |       | 5,498,717  |       | 4,308,390  |       | 2,598,782  |       |
|                                                  |       |       |       |       |       |       |       |
| **Interest expense:**                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                              |       | 1,430,567  |       | 1,088,601  |       | 790,821    |       |
| Borrowed funds                                        |       | 145,513    |       | 127,758    |       | 138        |       |
|                                                  |       |       |       |       |       |       |       |
| Total interest expense                                |       | 1,576,080  |       | 1,216,359  |       | 790,959    |       |
| Net interest income before provision for  loan losses |       | 3,922,637  |       | 3,092,031  |       | 1,807,823  |       |
|                                                  |       |       |       |       |       |       |       |
| **Provision for loan losses**                         |       | 615,251    |       | 956,609    |       | 315,620    |       |
| Net interest income after provision for  loan losses  |       | 3,307,386  |       | 2,135,422  |       | 1,492,203  |       |
|                                                  |       |       |       |       |       |       |       |
| **Noninterest income:**                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service charges on deposit accounts                   |       | 272,611    |       | 296,020    |       | 202,538    |       |
| Fees from origination of mortgage loans               |       | 127,417    |       | 154,767    |       | 124,866    |       |
| Investment sales commissions                          |       | 97,313     |       | 97,178     |       | 97,256     |       |
| Other                                                 |       | 34,336     |       | 64,500     |       | 37,232     |       |
| Total noninterest income                              |       | 531,677    |       | 612,465    |       | 461,892    |       |
| ** **                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Noninterest expenses:**                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Compensation and benefits                             |       | 1,529,482  |       | 1,290,696  |       | 989,145    |       |
| Occupancy expenses                                    |       | 400,454    |       | 294,491    |       | 263,013    |       |
| Marketing                                             |       | 170,741    |       | 89,348     |       | 65,923     |       |
| Data processing                                       |       | 191,748    |       | 148,156    |       | 114,041    |       |
| Other operating expenses                              |       | 814,938    |       | 581,990    |       | 391,864    |       |
| Total noninterest expense                             |       | 3,107,363  |       | 2,404,681  |       | 1,823,986  |       |
| **Income****before income taxes**                     |       | 731,700    |       | 343,206    |       | 130,109    |       |
|                                                  |       |       |       |       |       |       |       |
| Income tax expense (benefit)                          |       | 227,555    |       | 89,704     |       | (510,006   | )          |
|                                                  |       |       |       |       |       |       |       |
| **Net income**                                        |       | $          | 504,145    |       | $          | 253,502    |       | $ | 640,115 |   |
|                                                  |       |       |       |       |       |       |       |
| **Per share information:**                            |       |       |       |       |       |       |       |
| Basic net income per common share                     |       | $          | 0.22       |       | $          | 0.11       |       | $ | 0.28 |   |
| Diluted net income per common share                   |       | $          | 0.21       |       | $          | 0.11       |       | $ | 0.28 |   |
| Weighted average basic shares outstanding             |       | 2,299,656  |       | 2,286,844  |       | 2,250,411  |       |
| Weighted average diluted shares outstanding           |       | 2,382,873  |       | 2,333,507  |       | 2,274,390  |       |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-2

----

 

**BG FINANCIAL GROUP, INC. AND SUBSIDIARY(2004)**

**AND BANK OF GREENEVILLE (2003) AND (2002)**

**Greeneville, Tennessee**

**CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**YearsEnded December 31, 2004, 2003, and 2002**

 
| ** **                                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | **Retained**     | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------------|------------|------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                                         | ** ** | **Number** | ** ** | ** ** | ** ** | **Additional** | ** ** | **Earnings**     | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                                                                         | ** ** | **of**     | ** ** | **Common** | ** ** | **Paid-In**    | ** ** | **(Accumulated** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                                                                         | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit)**     | ** ** | **Income (Loss)** | ** ** | **Total**  | ** ** |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Balance, December 31, 2001                                                                                         |       | 2,250,000  |       | $          | 750,000    |           | $          | 6,750,000        |       | $                 | (1,338,913 | )          | $          | — |   | $ | 6,161,087 |   |
| Comprehensive income:                                                                                              |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Net income                                                                                                         |       |       |       | —     |       | —         |       | 640,115          |       | —            |       | 640,115    |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Total comprehensive income                                                                                         |       |       |       |       |       |           |       |             |       |              |       | 640,115    |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Issuance of 30,000 shares of common stock  under stock option plan                                                 |       | 30,000     |       | 10,000     |       | 90,000         |       | —           |       | —            |       | 100,000    |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Balance, December 31, 2002                                                                                         |       | 2,280,000  |       | 760,000    |       | 6,840,000      |       | (698,798         | )          | —            |       | 6,901,202  |       |
| Comprehensive income:                                                                                              |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Net income                                                                                                         |       |       |       | —     |       | —         |       | 253,502          |       | —            |       | 253,502    |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Total comprehensive income                                                                                         |       |       |       |       |       |           |       |             |       |              |       | 253,502    |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Issuance of 15,775 shares of common stock  under stock option plan                                                 |       | 15,775     |       | 5,258      |       | 47,325         |       | —           |       | —            |       | 52,583     |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Balance, December 31, 2003                                                                                         |       | 2,295,775  |       | 765,258    |       | 6,887,325      |       | (445,296         | )          |              |       | 7,207,287  |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Effect of the Plan of Share Exchange and  consolidation of Bank of Greeneville into BG  Financial Group, Inc. |       |       |       | —     |       | —         |       | (4,999           | )          | —            |       | (4,999     | )          |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Comprehensive income:                                                                                              |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Net income                                                                                                         |       |       |       | —     |       | —         |       | 504,145          |       | —            |       | 504,145    |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Total comprehensive income                                                                                         |       |       |       |       |       |           |       |             |       |              |       | 504,145    |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Issuance of 11,000 shares of common stock  under stock option plan                                                 |       | 11,000     |       | 3,667      |       | 32,997         |       | —           |       | —            |       | 36,664     |       |
|                                                                                                               |       |       |       |       |       |           |       |             |       |              |       |       |       |
| Balance, December 31, 2004                                                                                         |       | 2,306,775  |       | $          | 768,925    |           | $          | 6,920,322        |       | $                 | 53,850     |       | $          | — |   | $ | 7,743,097 |   |

 

The accompanying notes are an integral partof these consolidated financial statements

 

F-3

----

 

**BG FINANCIAL GROUP, INC. AND SUBSIDIARY(2004)**

**AND BANK OF GREENEVILLE (2003) AND (2002)**

**Greeneville, Tennessee**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**YearsEnded December 31, 2004, 2003, and 2002**

 
| ** **                                                                                | ** ** | **2004**   | ** ** | **2003**    | ** ** | **2002**    | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------|------------|-------------|------------|-------------|------------|
|                                                                                      |       |       |       |        |       |        |       |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                 | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| Net income                                                                                |       | $          | 504,145    |        | $          | 253,502     |       | $ | 640,115 |   |
| Adjustments to reconcile net income to net  cash provided (used) by operating activities: |       |       |       |        |       |        |       |
| Provision for loan losses                                                                 |       | 615,251    |       | 956,609     |       | 315,620     |       |
| Depreciation                                                                              |       | 259,067    |       | 201,687     |       | 188,062     |       |
| Realized loss (gain) on sales of premises  and equipment                                  |       | —     |       | (8,470      | )          | —      |       |
| Realized gain (loss) on sales of foreclosed  assets                                       |       | (8,919     | )          | —      |       | —      |       |
| Deferred income tax benefit                                                               |       | 4,831      |       | (93,171     | )          | (510,006    | )          |
| Net change in:                                                                            |       |       |       |        |       |        |       |
| Accrued income receivable                                                                 |       | (2,051     | )          | (130,989    | )          | (151,767    | )          |
| Other assets                                                                              |       | (32,218    | )          | (110,399    | )          | (20,838     | )          |
| Other liabilities                                                                         |       | 626,193    |       | (50,388     | )          | 52,737      |       |
| Net cash provided (used) by operating  activities                                         |       | 1,966,299  |       | 1,018,381   |       | 513,923     |       |
|                                                                                      |       |       |       |        |       |        |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                 | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| Federal Home Loan Bank stock purchases                                                    |       | (54,800    | )          | (37,400     | )          | (134,300    | )          |
| Proceeds from sales of premises and equipment                                             |       | —     |       | 14,000      |       | —      |       |
| Proceeds from sales of foreclosed assets                                                  |       | 255,177    |       | —      |       | —      |       |
| Loan originations and principal collections,  net                                         |       | (4,899,698 | )          | (27,201,927 | )          | (24,752,142 | )          |
| Additions to foreclosed assets                                                            |       | (83,383    | )          | (184,127    | )          | —      |       |
| Purchase of land for future development                                                   |       | (563,362   | )          | —      |       | —      |       |
| Additions to premises and equipment                                                       |       | (828,053   | )          | (429,171    | )          | (228,076    | )          |
| Net cash provided (used) by investing  activities                                         |       | (6,174,119 | )          | (27,838,625 | )          | (25,114,518 | )          |
|                                                                                      |       |       |       |        |       |        |       |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                 | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| Net change in deposits                                                                    |       | 4,768,779  |       | 3,866,820   |       | 5,505,063   |       |
| Net change in certificates of deposit                                                     |       | 156,682    |       | 26,325,092  |       | 19,457,721  |       |
| Federal Home Loan Bank advances                                                           |       | 276,462    |       | 3,777,000   |       | 2,804,900   |       |
| Federal Home Loan Bank repayments                                                         |       | (171,221   | )          | (2,194,894  | )          | (132,900    | )          |
| Issuance of stock                                                                         |       | 36,664     |       | 52,583      |       | 100,000     |       |
| Net cash provided (used) by financing  activities                                         |       | 5,067,366  |       | 31,826,601  |       | 27,734,784  |       |
|                                                                                      |       |       |       |        |       |        |       |
| Net change in cash and cash equivalents                                                   |       | 859,546    |       | 5,006,357   |       | 3,134,189   |       |
|                                                                                      |       |       |       |        |       |        |       |
| Cash and cash equivalents at beginning of year                                            |       | 12,298,970 |       | 7,292,613   |       | 4,158,424   |       |
|                                                                                      |       |       |       |        |       |        |       |
| Cash and cash equivalents at end of year                                                  |       | $          | 13,158,516 |        | $          | 12,298,970  |       | $ | 7,292,613 |   |
| ** **                                                                                | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| **SUPPLEMENTARY CASH FLOW INFORMATION:**                                                  | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** |
| Interest paid on deposits and borrowed funds                                              |       | $          | 1,428,238  |        | $          | 1,281,349   |       | $ | 722,188 |   |
| Income taxes paid                                                                         |       | $          | 87,431     |        | $          | 302,340     |       | $ | — |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

F-4

----

 

**BG FINANCIAL GROUP, INC. AND SUBSIDIARY(2004)**

**AND BANK OF GREENEVILLE (2003) AND (2002)**

**Greeneville, Tennessee**

**NOTES TO FINANCIAL STATEMENTS**

 

**Note 1.  ****Summary of Significant Accounting Policies**

 

***Principles of Consolidation***

 

Theconsolidated statements include the accounts of BG Financial Group, Inc. andBank of Greeneville, a wholly owned subsidiary of the BG Financial Group, Inc.collectively referred to herein as the “Company”. All significant intercompanybalances and transactions have been eliminated.

 

***Nature of Business***

 

BG FinancialGroup, Inc. (the “Holding Company”) is a bank holding company whose business isconducted by its wholly-owned subsidiary, Bank of Greeneville (the “Bank”).  Bank of Greeneville is engaged in thebusiness of originating loans within its lending area, Greeneville and GreeneCounty in Tennessee.  The Bank obtainsdeposits both inside and outside of its primary lending area.  The Holding Company was organized in November2003. The Holding Company had minimal assets, liabilities or operations untilJanuary, 2004, when it acquired the Bank in a Plan of Share Exchange wherebythe stockholders exchanged their shares of ownership in the Bank for shares ofownership in the Holding Company on a one-for-one basis.  As a part of the Plan of Share Exchange, theBank became a wholly owned subsidiary of the Holding Company.  As a result of this transaction, thefinancial statements at December 31, 2004 present the Holding Company and theBank as a consolidated entity.  Allsignificant intercompany balances and transactions have been eliminated.  The accompanying 2003 financial statementsare for the Bank only and do not include the minimal assets, liabilities oroperations of the Holding Company as of, and for the year ended, December 31,2003.  Information related to the resultsof operations for the year ended December 31, 2002 are for the Bank ofGreeneville.

 

***Accounting Policies***

 

The followingis a description of the significant accounting policies used in the preparationof the accompanying consolidated financial statements.

 

The accountingand reporting policies of BG Financial Group, Inc. conform to generallyaccepted accounting principles and practices within the banking industry.

 

***Use of Estimates***

 

The preparation of consolidated financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the consolidated financial statements and the reported amountsof revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

F-5

----

 

Materialestimates that are particularly susceptible to significant change relate to thedetermination of the allowance for losses on loans and the valuation of realestate acquired in connection with foreclosures or in satisfaction ofloans.  In connection with the determinationof the allowance for losses on loans and foreclosed real estate, managementobtains independent appraisals for significant properties.

 

A majority ofthe Company’s loan portfolio consists of real estate loans in Greeneville andGreene County in Tennessee.

 

The ultimatecollectibility of a substantial portion of the Company’s loan portfolio and therecovery of a substantial portion of the carrying amount of foreclosed realestate are susceptible to changes in local market conditions.

 

Whilemanagement uses available information to recognize losses on loans andforeclosed real estate, future additions to the allowances may be necessarybased on changes in local economic conditions. In addition, regulatory agencies, as an integral part of theirexamination process, periodically review the Company’s allowances for losses onloans and foreclosed real estate.  Suchagencies may require the Company to recognize additions to the allowances basedon their judgments about information available to them at the time of theirexamination.  Because of these factors,it is reasonably possible that the allowances for losses on loans andforeclosed real estate may change materially in the near term.

 

***Cash and CashEquivalents***

 

For purposesof reporting cash flows, cash and cash equivalents include cash and balancesdue from banks and federal funds sold, all of which mature within ninety days.

 

***Trading Securities***

 

Governmentbonds held principally for resale in the near term, and mortgage-backedsecurities held for sale in conjunction with the Company’s mortgage bankingactivities, are classified as trading account securities and recorded at theirfair values.  Unrealized gains and losseson trading account securities are included immediately in other income.  However, at December 31, 2004 and 2003 theCompany did not have any trading securities.

 

***Securities Held toMaturity***

 

Debtsecurities for which the Company has the positive intent and ability to hold tomaturity are reported at cost, adjusted for premiums and discounts that arerecognized in interest income using the interest method over the period tomaturity.  However, at December 31, 2004and 2003, the Company did not have any held-to-maturity securities.

 

***Securities Availablefor Sale***

 

Available-for-salesecurities consist of bonds, notes, debentures, and certain equity securitiesnot classified as trading securities nor as held-to-maturity securities.

 

Unrealizedholding gains and losses, net of tax, on available-for-sale securities areincluded in other comprehensive income.

 

F-6

----

 

Gains andlosses on the sale of available-for-sale securities are determined using thespecific-identification method.

 

Declines inthe fair value of individual held-to-maturity and available-for-sale securitiesbelow their cost that are other than temporary have resulted in write-downs ofthe individual securities to their fair value. The related write-downs have been included in earnings as realizedlosses.

 

Premiums anddiscounts are recognized in interest income using the interest method over theperiod to maturity.

 

***Loans***

 

Loans thatmanagement has the intent and ability to hold for the foreseeable future oruntil maturity or pay-off generally are reported at their outstanding unpaidprincipal balances adjusted for charge-offs, the allowance for loan losses, andany deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Any loanorigination fees, net of certain direct origination costs, are deferred andrecognized as an adjustment of the related loan yield using the interestmethod.  There were no fees considered tobe material at December 31, 2004 or 2003.

 

The accrual ofinterest on mortgage and commercial loans is discontinued at the time the loanis 90 days past due unless the credit is well-secured and in process ofcollection.  Past due status is based oncontractual terms of the loan.  In allcases, loans are placed on non-accrual or charged-off at an earlier date ifcollection of principal or interest is considered doubtful.

 

All interestaccrued but not collected for loans that are placed on non-accrual or chargedoff is reversed against interest income. The interest on these loans is accounted for on the cash-basis orcost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when allthe principal and interest amounts contractually due are brought current andfuture payments are reasonably assured.

 

***Allowance for LoanLosses***

 

The allowancefor loan losses is established as losses are estimated to have occurred througha provision for loan losses charged to earnings.  Loan losses are charged against the allowancewhen management believes the uncollectibility of a loan balance is confirmed.  Subsequent recoveries, if any, are credited tothe allowance.

 

The allowancefor loan losses is evaluated on a regular basis by management and is based uponmanagement’s periodic review of the collectibility of the loans in light ofhistorical experience, the nature and volume of the loan portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofany underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision as moreinformation becomes available.

 

F-7

----

 

The allowanceconsists of specific and general components. The specific component relates to loans that are classified as eitherdoubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance isestablished when the discounted cash flows (or collateral value or observablemarket price) of the impaired loan is lower than the carrying value of thatloan.

 

A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect the scheduled payments of principal orinterest when due according to the contractual terms of the loan agreement.  Factors considered by management indetermining impairment include payment status, collateral value, and theprobability of collected scheduled principal and interest payments whendue.  Loans that experience insignificantpayment delays and payment shortfalls generally are not classified as impaired.Management determines the significance of payment delays and payment shortfallson a case-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe shortfall in relation to the principal and interest owed.  Impairment is measured on a loan by loanbasis for commercial and construction loans by either the present value ofexpected future cash flows discounted at the loan’s effective interest rate,the loan’s obtainable market price, or the fair value of the collateral if theloan is collateral dependent.

 

Large groupsof smaller balance homogeneous loans are collectively evaluated forimpairment.  Accordingly, the Companydoes not separately identify individual consumer and residential loans forimpairment disclosures, unless principal and interest payments are past due.

 

***Advertising***

 

The Company’spolicy is to expense advertising costs as the costs are incurred.

 

***P******remises and Equipment***

 

Land iscarried at cost.  Company premises andequipment are carried at cost less accumulated depreciation.  Depreciation is computed using thestraight-line method over the following estimated useful lives:

 
| ** **                 | ** ** | **Years** |
|----------------------------|------------|-----------|
|                       |       |      |
| Buildings and improvements |       | 31 1/2    |
| Furniture and equipment    |       | 3-10      |

 

Maintenanceand repairs are expensed as incurred while major additions and improvements arecapitalized.  Gains and losses ondispositions are included in current operations.

 

F-8

----

 

***Foreclosed Assets***

 

Assetsacquired through, or in lieu of, loan foreclosure are held for sale and areinitially recorded at fair value at the date of foreclosure, establishing a newcost basis.  Subsequent to foreclosure,valuations are periodically performed by management and the assets are carriedat the lower of carrying amount or fair value less cost to sell.  Revenue and expenses from operations andchanges in the valuation allowance are included in net expenses from foreclosedassets.  There was no such valuationallowance at December 31, 2004 and 2003.

 

***Income Taxes***

 

Income taxesare provided for the tax effects of the transactions reported in the financialstatements and consist of taxes currently due plus deferred taxes relatedprimarily to differences between the basis of the allowance for loan losses andaccumulated depreciation.  The deferredtax assets and liabilities represent the future tax return consequences ofthose differences, which will either be taxable or deductible when the assetsand liabilities are recovered or settled. Deferred tax assets and liabilities are expected to be realized orsettled.  As changes in tax laws or ratesare enacted, deferred tax assets and liabilities are adjusted through theprovision for income taxes.

 

***Off-Balance SheetCredit Related Financial Instruments***

 

In theordinary course of business, the Company has entered into commitments to extendcredit, including commitments under commercial letters of credit, and standbyletters of credit.  Such financialinstruments are recorded when they are funded.

 

***Stock-BasedCompensation Plan***

 

The Companyaccounts for non-cash stock-based compensation in accordance with theprovisions of Accounting Principles Board Opinion No. 25 (Accounting for StockIssued to Employees), and its related interpretations, which states that nocompensation expense is recognized for stock options or other stock-basedawards to employees that are granted with an exercise price equal to or abovethe estimated fair value per share of the Company’s common stock on the grantdate.  Stock options issued under theCompany’s Stock Option Plan have no intrinsic value at the grant date, andunder Opinion No. 25 no compensation costs are recognized for them.

 

The Companyhas adopted the disclosure requirements of Statement of Financial AccountingStandards No. 123 (Accounting for Stock-Based Compensation), which requirescertain pro forma disclosures as if compensation expense was determined basedon the fair value of the options granted at the date of the grant.  See Note 15 for a further description of theassumptions used for preparing the pro forma disclosures as prescribed by Statement123.

 

F-9

----

 

***Earnings Per CommonShare***

 

Basic earningsper share represents income available to common stockholders divided by theweighted-average number of common shares outstanding during the period.  Diluted earnings per share reflects additionalcommon shares that would have been outstanding if dilutive potential commonshares had been issued, as well as any adjustment to income that would resultfrom the assumed issuance.  Potentialcommon shares that may be issued by the Bank relate solely to outstanding stockoptions and are determined using the treasury stock method.

 

***Recent AccountingPronouncements***

 

In March 2004,the SEC issued Staff Accounting Bulletin No. 105, *Application of Accounting Principles to Loan Commitments*.  Current accounting guidance requires thecommitment to originate mortgage loans to be held for sale be recognized on thebalance sheet at fair value from inception through expiration or funding.  SAB 105 requires that the fair-valuemeasurement include only differences between the guaranteed interest rate inthe loan commitment and a market interest rate, excluding any expected futurecash flows related to the customer relationship or loan servicing.  SAB 105 is effective for commitments tooriginate mortgage loans to be held for sale that are entered into after March31, 2004. Its adoption did not have a material impact on the consolidatedfinancial position or results of operations of the Company.

 

In March 2004,the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Forcereached a consensus on EITF Issue No. 03-1, *TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments. *EITF 03-1provides guidance for determining when an investment is considered impaired,whether impairment is other-than-temporary, and measurement of an impairmentloss.  An investment is consideredimpaired if the fair value of the investment is less than its cost.  Generally, an impairment is consideredother-than temporary unless:  (i) theinvestor has the ability and intent to hold an investment for a reasonableperiod of time sufficient for an anticipated recovery of fair value up to (orbeyond) the cost of the investment; and (ii) evidence indicating that the costof the investment is recoverable within a reasonable period of time outweighsevidence to the contrary.  If impairmentis determined to be other-than-temporary, then an impairment loss should berecognized equal to the difference between the investment’s cost and its fairvalue.  The recognition and measurementprovisions were initially effective for other-than-temporary impairmentevaluations in reporting periods beginning after June 15, 2004.  However, in September 2004, the effectivedate of these provisions was delayed until the finalization of a FASB StaffPosition (FSP) to provide additional implementation guidance.  Due to the recognition and measurementprovisions being suspended and the final rule delayed, the Company is not ableto determine whether the adoption of these new provisions will have a materialimpact on the consolidated financial position or results of income.

 

F-10

----

 

Statement ofPosition 03-03, *Accounting for Certain Loansor Debt Securities Acquired in a Transfer* (SOP 03-03) addressesaccounting for differences between contractual cash flows and cash flowsexpected to be collected from an investor’s initial investment in loans or debtsecurities (loans) acquired in a transfer if those differences areattributable, at least in part, to credit quality.  It includes loans acquired in purchasebusiness combinations and applies to all nongovernmental entities, includingnot-for-profit organizations.  The SOPdoes not apply to loans originated by the entity.  The SOP is effective for loans acquired infiscal years beginning after December 15, 2004. Early adoption is encouraged. Specific transition guidance applies to certain loans that currently arewithin the scope of Practice Bulletin 6, Amortization of Discounts on Certain AcquiredLoans.  Its adoption is not expected tohave material impact on the consolidated financial position or results ofoperations of the Company.

 

In December2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No.123 (revised 2004), *Share-Based Payment*(“SFAS No. 123R”), which revised SFAS No. 123, “Accounting for Stock-BasedCompensation.  This statement supercedesAPB Opinion No. 25, “Accounting for Stock Issued to Employees.”  The revised statement addresses theaccounting for share-based payment transactions with employees and other thirdparties eliminates the ability to account for share-based compensationtransactions using APB 25 and requires that the compensation costs relating tosuch transactions be recognized in the consolidated statement of income.  The revised statement is effective as of thefirst interim period beginning after

 

June 15,2005.  The Company is currentlyevaluating the provisions of SFAS No. 123R and will adopt it on July 1, 2005 asrequired.

 

***Reclassifications***

 

Certain prior year amounts have beenreclassified to conform with present year presentations.

 

**Note 2.**          **RestrictionsOn Cash and Due From Banks**

 

Underagreements with correspondent banks, the Company maintains deposit balanceswith the correspondents to cover various bank processing charges.  At December 31, 2004 and 2003, approximately$1,725,000 and $1,750,000 of the cash and due from banks balance represents thedeposits maintained with the correspondent banks.  In addition, the Company must maintain anaverage reserve balance related to customers’ deposit balances as required bythe Federal Reserve.  At December 31,2004, approximately $25,000 represents the cash reserve balance required to beon hand by the Federal Reserve.

 

**Note3.**          **Federal Home Loan Bank Stock**

 

As a member ofthe Federal Home Loan Bank, the Company is required to maintain stock in anamount equal to.15% of total assets. Federal Home Loan Bank stock is carried at cost. Federal Home Loan Bankstock is maintained by the Company at par value of one hundred dollars pershare.

 

F-11

----

 

**Note4.**          **Loans**

 

The composition of the net loans is as follows:

 
| ** **                | ** ** | **December 31** | ** ** | **December 31** | ** ** |
|---------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                | ** ** | **2004**        | ** ** | **2003**        | ** ** |
|                      |       |            |       |            |       |
| Consumer installment      |       | $               | 5,522,402  |            | $          | 6,011,006 |   |
| Commercial                |       | 20,927,959      |       | 24,050,990      |       |
| Commercial real estate    |       | 31,560,010      |       | 25,483,343      |       |
| Residential mortgage      |       | 15,952,474      |       | 14,344,162      |       |
|                      |       | 73,962,845      |       | 69,889,501      |       |
| Less:                     |       |            |       |            |       |
| Allowance for loan losses |       | 1,607,559       |       | 1,350,266       |       |
|                      |       |            |       |            |       |
| Loans, net                |       | $               | 72,355,286 |            | $          | 68,539,235 |   |

 

The following is a summary of information pertaining to impaired andnon-accrual loans:

 
| ** **                                                    | ** ** | **December 31** | ** ** | **December 31** | ** ** |
|---------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                    | ** ** | **2004**        | ** ** | **2003**        | ** ** |
|                                                          |       |            |       |            |       |
| Impaired loans with a valuation allowance                     |       | $               | 323,446    |            | $          | — |   |
| Total impaired loans                                          |       | $               | 323,446    |            | $          | — |   |
| Valuation allowance related to Impaired  loans                |       | $               | 45,000     |            | $          | — |   |
|                                                          |       |            |       |            |       |
| Past-due loans ninety days or more and  still accruing        |       | $               | 13,109     |            | $          | 46,323 |   |
| Total non-accrual loans                                       |       | $               | 534,442    |            | $          | 83,035 |   |
|                                                          |       |            |       |            |       |
| Average investment in impaired loans                          |       | $               | 27,396     |            | $          | — |   |
| Interest income recognized on impaired  loans                 |       | $               | —     |            | $          | — |   |
| Interest income recognized on a cash basis  on impaired loans |       | $               | —     |            | $          | — |   |

 

Interest income that would have accrued onthese loans if they were on a current basis was approximately $23,645 and$283  in 2004 and 2003, respectively.

 

The following table is a summary of loans asof December 31, 2004:

 
| ** **             | ** ** | ** **     | ** ** | **Variable** | ** ** | ** ** | ** ** |
|------------------------|------------|----------------|------------|--------------|------------|------------|------------|
| ** **             | ** ** | **Fixed Rate** | ** ** | **Rate**     | ** ** | **Total**  | ** ** |
|                   |       |           |       |         |       |       |       |
| Installment            |       | $              | 4,601,727  |         | $          | 920,675    |       | $ | 5,522,402 |   |
| Commercial             |       | 4,769,741      |       | 16,158,218   |       | 20,927,959 |       |
| Commercial real estate |       | 8,692,675      |       | 22,867,335   |       | 31,560,010 |       |
| Mortgage               |       | 10,150,292     |       | 5,802,182    |       | 15,952,474 |       |
|                   |       |           |       |         |       |       |       |
| Total                  |       | $              | 28,214,435 |         | $          | 45,748,410 |       | $ | 73,962,845 |   |

 

F-12

----

 

The schedule of maturities for loans at December 31, 2004 by fixed andvariable rates are shown below:

 
| ** **                            | ** ** | ** **     | ** ** | **Variable** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|----------------|------------|--------------|------------|------------|------------|
| ** **                            | ** ** | **Fixed Rate** | ** ** | **Rate**     | ** ** | **Total**  | ** ** |
|                                  |       |           |       |         |       |       |       |
| Due in one year or less               |       | $              | 6,431,250  |         | $          | 12,829,052 |       | $ | 19,260,302 |   |
| Due after one year through five years |       | 20,355,076     |       | 28,671,703   |       | 49,026,779 |       |
| Due after five years                  |       | 1,428,109      |       | 4,247,655    |       | 5,675,764  |       |
| Total                                 |       | $              | 28,214,435 |         | $          | 45,748,410 |       | $ | 73,962,845 |   |

 

**Note5.**          **Allowance for Loan Losses**

 

Changes in the allowance for loan losses for the bank are as follows:

 
| ** **                                 | ** ** | **December 31** | ** ** | **December 31** | ** ** |
|--------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                 | ** ** | **2004**        | ** ** | **2003**        | ** ** |
| Balance, beginning                         |       | $               | 1,350,266  |            | $          | 533,819 |   |
|                                       |       |            |       |            |       |
| Provision for loan losses                  |       | 615,251         |       | 956,609         |       |
| Recoveries of loans previously charged-off |       | 143,821         |       | 7,005           |       |
|                                       |       | 2,109,338       |       | 1,497,433       |       |
| Loans charged-off                          |       | 501,779         |       | 147,167         |       |
| Balance, ending                            |       | $               | 1,607,559  |            | $          | 1,350,266 |   |

 

**Note6.**          **Premises and Equipment**

 

The major classes of premises and equipment and the total accumulateddepreciation are as follows:

 
| ** **                     | ** ** | **December 31** | ** ** | **December 31** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                     | ** ** | **2004**        | ** ** | **2003**        | ** ** |
|                           |       |            |       |            |       |
| Land                           |       | $               | 1,170,363  |            | $          | 1,170,362 |   |
| Land for future development    |       | 563,362         |       | —          |       |
| Premises and improvements      |       | 1,414,544       |       | 694,924         |       |
| Furniture and equipment        |       | 1,473,463       |       | 1,043,394       |       |
| Construction in process        |       | 5,919           |       | 327,557         |       |
|                           |       | 4,627,651       |       | 3,236,237       |       |
| Less: Accumulated depreciation |       | 732,151         |       | 473,084         |       |
|                           |       |            |       |            |       |
|                           |       | $               | 3,895,500  |            | $          | 2,763,153 |   |

 

Depreciationand amortization expense of premises and equipment for 2004 and 2003 was$259,067 and $201,687, respectively.

 

Rental expenseunder operating leases and data processing fees under operating agreements for2004 and 2003 were $211,294 and $165,105, respectively.

 

F-13

----

 

Future minimumrental payments required under noncancelable operating leases for equipment anddata processing fees under operating agreements were as follows:

 
| 2005           |   | $      | 106,587 |   |
|----------------|--------|--------|---------|--------|
| 2006           |   | 36,279 |    |
| 2007           |   | 11,429 |    |
| 2008           |   | 10,021 |    |
| 2009 and after |   | 13,787 |    |
|           |   | $      | 178,103 |   |

 

**Note7.**          **Federal Home Loan Bank Advance**

 

Pursuant tocollateral agreements with Federal Home Loan Bank (FHLB), the advance iscollateralized by specific first mortgage loans.  The FHLB’s required unpaid principal balanceof eligible mortgages was $6,198,317 at December 31, 2004.  The advances at December 31, 2004, have maturitydates as follow:

 
| **Maturity Date** | ** ** | **Interest Rate** | ** ** | **December 31, 2004**        | ** **                   |
|-------------------|------------|-------------------|------------|------------------------------|------------------------------|
|              |       |              |       |                         |                         |
| 07/07/06          |       | 3.07              | %          |                         | $   1,600,000 |   |   |
| 08/04/06          |       | 2.99              |       |                         | 100,000                      |   |   |
| 03/01/07          |       | 2.91              |       |                         | 265,313                      |   |   |
| 12/01/07          |       | 3.11              |       |                         | 25,978                       |   |   |
| 12/01/07          |       | 3.83              |       |                         | 520,490                      |   |   |
| 12/20/07          |       | 3.60              |       |                         | 30,000                       |   |   |
| 01/01/08          |       | 3.50              |       |                         | 17,989                       |   |   |
| 05/01/08          |       | 2.64              |       |                         | 63,892                       |   |   |
| 06/01/08          |       | 3.28              |       |                         | 782,534                      |   |   |
| 08/01/08          |       | 2.85              |       |                         | 44,126                       |   |   |
| 08/01/08          |       | 2.99              |       |                         | 69,609                       |   |   |
| 11/01/08          |       | 3.54              |       |                         | 113,301                      |   |   |
| 04/01/10          |       | 3.56              |       |                         | 726,114                      |   |   |
|              |       |              |       | $   4,359,346 |                         |   |

 

**Note8.**          **Income Tax Matters**

 

Net deferred tax assets consist of the following components as ofDecember 31, 2004 and 2003:

 

 
| ** **                                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                |       |     |       |     |       |
| Deferred Tax Assets:                                                |       |     |       |     |       |
| Allowance for loan loss                                             |       | $        | 615,534    |     | $          | 517,017 |   |
| Amortization of intangibles start-up cost and  organizational costs |       | 128,493  |       | 187,363  |       |
| Other                                                               |       | —   |       | 84       |       |
|                                                                |       |     |       |     |       |
|                                                                |       | 744,027  |       | 704,464  |       |
| Deferred Tax Liabilities:                                           |       |     |       |     |       |
| Depreciable assets                                                  |       | 142,720  |       | 101,287  |       |
|                                                                |       |     |       |     |       |
| Net deferred tax assets                                             |       | $        | 601,307    |     | $          | 603,177 |   |

 

F-14

----

 

The provisionfor income taxes charged to income from continuing operations for the yearended December 31, 2004, 2003, and 2002 consists of the following:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |     |       |
| Current tax expense            |       | $        | 222,724    |     | $          | 182,875  |       | $ | 6,951 |   |
| Deferred tax expense (benefit) |       | 4,831    |       | (93,171  | )          | (516,957 | )          |
| Total income tax expense       |       | $        | 227,555    |     | $          | 89,704   |       | $ | (510,006 | ) |

 

The income taxprovision differs from the amount of income tax determined by applying the U.S.federal income tax rate to pretax income from continuing operations for theyear ended December 31, 2004, 2003, and 2002, due to the following:

 
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |     |       |
| Computed “expected” tax expense       |       | $        | 248,778    |     | $          | 116,690  |       | $ | 44,237 |   |
| Valuation allowance allowed from previous  year |       | —   |       | —   |       | (526,024 | )          |
| State income tax, net of federal benefits       |       | 31,390   |       | 14,773   |       | 5,582    |       |
| Other, net                                      |       | (52,613  | )          | (41,759  | )          | (33,801  | )          |
|                                            |       |     |       |     |       |     |       |
|                                            |       | $        | 227,555    |     | $          | 89,704   |       | $ | (510,006 | ) |

 

**Note9.****          Deposits**

 

The aggregateamount of time deposits in denominations of $100,000 or more at December 31,2004 and 2003 was $4,740,407 and $11,637,050.

 

At December 31, 2004, the scheduled maturities of time deposits are asfollows:

 
| 2005           |   | $         | 51,214,067 |   |
|----------------|--------|-----------|------------|--------|
| 2006           |   | 2,826,820 |       |
| 2007           |   | 763,385   |       |
| 2008           |   | 780,138   |       |
| 2009 and After |   | —    |       |
|           |   | $         | 55,584,410 |   |

 

F-15

----

 

**Note 10**.   **RegulatoryCapital Requirements**

 

The Company issubject to various regulatory capital requirements administered by the federalbanking agencies.  Failure to meetminimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material affect on the Company and the financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Company must meetspecific capital guidelines that involve quantitative measures of the Company’sassets, liabilities, and certain off-balance sheet items as calculated underregulatory accounting practices.  TheCompany’s capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings, and otherfactors.  Prompt corrective actionprovisions are not applicable to bank holding companies.

 

Quantitativemeasures established by regulation to ensure capital adequacy require theCompany to maintain minimum amounts and ratios (set forth in the table below)of total and Tier I capital (as defined in the regulations) to risk-weightedassets (as defined), and of Tier I capital (as defined) to average assets (asdefined).  Management believes, as ofDecember 31, 2004, that the Company meets all capital adequacy requirements towhich it is subject.

 

As of December31, 2004, the Company was categorized as well capitalized under the regulatoryframework for prompt corrective action according to the most recentnotification dated April 29, 2004, from the Federal Deposit InsuranceCorporation.  To be categorized as wellcapitalized, the Bank must maintain minimum total risk-based, Tier Irisk-based, and Tier I leverage ratios as set forth in the table below.  There are no conditions or events since thenotification that management believes has changed the institution’s category.

 

The Company’s actual capital amounts andratios are as follows:

 
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **To Be Well**        | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|-----------------------|------------|-----------------|------------|-----------------------|------------|-----------------------|------------|------------|------------|-----------------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **            | ** ** | ** **            | ** ** | ** ** | ** ** | **Capitalized Under** | ** ** |
| ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital** | ** ** | ** **            | ** ** | **Prompt Corrective** | ** ** |
| ** **                                 | ** ** | **Actual** | ** ** | ** ** | ** ** | **Adequacy Purposes** | ** ** | ** **      | ** ** | **Action Provisions** | ** ** |
| ** **                                 | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | ** **            | ** ** | **Amount**      | ** ** | ** **            | ** ** | **Ratio**             | ** ** | ** ** | ** ** | **Amount**            | ** ** | ** ** | ** ** | **Ratio** | ** ** |
|                                       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| As of December 31, 2004 (in  Thousands)    |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Tier 1 Capital (To Average  assets):       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Consolidated                               |       | $          | 7,743      |       | 8.55       | %                     | >       |            | $          | 3,621                 |       | >                  |       | 4.0        |       | >                  |       | N/A |   |   |   | N/A |   |
| Bank of Greeneville                        |       | $          | 7,690      |       | 8.50       | %                     | >       |            | $          | 3,620                 |       | >                  |       | 4.0        |       | >                  |       | $ | 4,525 |   | > |   | 5.0 |   |
| Tier 1 Capital (To Risk  Weighted Assets): |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Consolidated                               |       | $          | 7,743      |       | 9.90       | %                     | >       |            | $          | 3,129                 |       | >                  |       | 4.0        |       | >                  |       | N/A |   |   |   | N/A |   |
| Bank of Greeneville                        |       | $          | 7,690      |       | 10.00      | %                     | >       |            | $          | 3,076                 |       | >                  |       | 4.0        |       | >                  |       | $ | 4,614 |   | > |   | 6.0 |   |
| Total Capital (To Risk Weighted  Assets):  |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Consolidated                               |       | $          | 8,713      |       | 11.14      | %                     | >       |            | $          | 6,258                 |       | >                  |       | 8.0        |       | >                  |       | N/A |   |   |   | N/A |   |
| Bank of Greeneville                        |       | $          | 8,659      |       | 11.26      | %                     | >       |            | $          | 6,152                 |       | >                  |       | 8.0        |       | >                  |       | $ | 7,691 |   | > |   | 10.0 |   |
|                                       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| As of December 31, 2003 (in  Thousands)    |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Tier 1 Capital (To Average  assets):       |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 7,207      |       | 8.9        | %                     | >       |            | $          | 3,246                 |       | >                  |       | 4.0        | %          | >                  |       | $ | 4,057 |   | > |   | 5.0 | % |
| Tier 1 Capital (To Risk  Weighted Assets): |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 7,207      |       | 10.2       | %                     | >       |            | $          | 2,821                 |       | >                  |       | 4.0        | %          | >                  |       | $ | 4,231 |   | > |   | 6.0 | % |
| Total Capital (To Risk Weighted  Assets):  |       |       |       |       |       |                  |       |            |       |                  |       |                  |       |       |       |                  |       |   |   |   |   |
| Bank of Greeneville                        |       | $          | 8,094      |       | 11.5       | %                     | >       |            | $          | 5,642                 |       | >                  |       | 8.07       | %          | >                  |       | $ | 7,052 |   | > |   | 10.0 | % |

 

F-16

----

 

**Note 11.**   **Commitments and Contingencies**

 

***Financial Instruments with Off-Balance-SheetRisk***

 

In the normalcourse of business, the Company has entered into off-balance sheet financialinstruments which include commitments to extend credit (i.e., includingunfunded lines of credit) and standby letters of credit.  Commitments to extend credit are usually theresult of lines of credit granted to existing borrowers under agreements thatthe total outstanding indebtedness will not exceed a specific amount during theterm of the indebtedness.  Typicalborrowers are commercial concerns that use lines of credit to supplement theirtreasury management functions, thus their total outstanding indebtedness mayfluctuate during any time period based on the seasonality of their business andthe resultant timing of their cash flows. Other typical lines of credit are related to home equity loans grantedto consumers.  Commitments to extendcredit generally have fixed expiration dates or other termination clauses andmay require payment of a fee.

 

Standbyletters of credit are generally issued on behalf of an applicant (our customer)to a specifically named beneficiary and are the result of a particular businessarrangement that exists between the applicant and the beneficiary.  Standby letters of credit have fixedexpiration dates and are usually for terms of two years or less unlessterminated beforehand due to criteria specified in the standby letter ofcredit.  A typical arrangement involvesthe applicant routinely being indebted to the beneficiary for such items asinventory purchases, insurance, utilities, lease guarantees or other thirdparty commercial transactions.  Thestandby letter of credit would permit the beneficiary to obtain payment fromthe Company under certain prescribed circumstances.  Subsequently, the Company would then seekreimbursement from the applicant pursuant to the terms of the standby letter ofcredit.

 

The Companyfollows the same credit policies and underwriting practices when making thesecommitments as it does for on-balance sheet instruments.  Each customer’s creditworthiness is evaluatedon a case-by-case basis and the amount of collateral obtained, if any, is basedon management’s credit evaluation of the customer.

 

F-17

----

 

Collateralheld varies but may include cash, real estate and improvements, marketablesecurities, accounts receivable, inventory, equipment, and personal property.

 

Thecontractual amounts of these commitments are not reflected in the consolidatedfinancial statements and would only be reflected if drawn upon.  Since many of the commitments are expected toexpire without being drawn upon, the contractual amounts do not necessarilyrepresent future cash requirements. However, should the commitments be drawn upon and should our customersdefault on their resulting obligation to us, the Company’s maximum exposure tocredit loss, without consideration of collateral, is represented by thecontractual amount of those instruments.

 

A summary ofthe Company’s total contractual amount for all off-balance sheet commitments atDecember 31, 2004 is as follows:

 
| Commitments to extend credit |   | $ | 6,416,071 |   |
|------------------------------|--------|---|-----------|--------|
| Standby letters of credit    |   | $ | 1,272,700 |   |

 

At December31, 2004, the fair value of the Company’s standby letters of credit was$1,505.  This amount represents the unamortizedfee associated with these standby letters of credit and is included in theconsolidated balance sheet of the Company. This fair value will decrease over time as the existing standby lettersof credit approach their expiration dates.

 

***Significant Concentrations of Credit Risk***

 

All of theCompany’s loans, commitments to extend credit, and standby letters of credithave been granted to customers in the Company’s market area.  The concentrations of credit by type of loanare set forth in Note 4.  Thedistribution of commitments to extend credit approximates the distribution ofloans outstanding.  Standby letters ofcredit were granted primarily to commercial borrowers.  The Company is not permitted to extend creditto any single borrower or group of related borrowers in excess of 25% ofcapital.

 

***Contingencies***

 

In the normalcourse of business, the Company is involved in various legal proceedings.  In the opinion of management, any liabilityresulting from such proceedings would not have a material adverse effect on theCompany’s financial statements.

 

F-18

----

 

**Note12.**   **Fair Value of Financial Instruments**

 

The fair valueof a financial instrument is the current amount that would be exchanged betweenwilling parties, other than in a forced liquidation.  Fair value is best determined based uponquoted market prices.  However, in manyinstances, there are no quoted market prices for the Company’s variousfinancial instruments.  In cases wherequoted market prices are not available, fair values are based on estimatesusing present value or other valuation techniques.  Those techniques are significantly affectedby the assumptions used, including the discount rate and estimates of futurecash flows.  Accordingly, the fair valueestimates may not be realized in an immediate settlement of theinstrument.  SFAS 107 excludes certainfinancial instruments and all non-financial instruments from its disclosurerequirements.  Accordingly, the aggregatefair value amounts presented may not necessarily represent the underlying fairvalue of the Company.

 

The followingmethods and assumptions were used by the Company in estimating fair valuedisclosures for financial instruments:

 

***Cash and CashEquivalents***

 

The carryingamounts of cash and short-term instruments approximate fair values.

 

***Interest-BearingDeposits in Banks***

 

The carryingamounts of interest-bearing deposits maturing within ninety days approximatetheir fair values.  Fair values of otherinterest-bearing deposits are estimated using discounted cash flow analysesbased on current rates for similar types of deposits.

 

***Trading Assets***

 

Fair valuesfor trading account securities, which also are the amounts recognized in theconsolidated balance sheet, are based on quoted market prices, whereavailable.  If quoted market prices arenot available, fair values are based on quoted market prices of comparableinstruments.

 

***Securities***

 

Fair valuesfor securities, excluding Federal Home Loan Bank stock, are based on quotedmarket prices.  The carrying value ofFederal Home Loan Bank stock approximates fair value based on the redemptionprovisions of the Federal Home Loan Bank.

 

***Loans Receivable***

 

Forvariable-rate loans that reprice frequently and with no significant change incredit risk, fair values are based on carrying values. Fair values for otherloans (e.g., commercial real estate and investment property mortgage loans,commercial and industrial loans) are estimated using discounted cash flowanalyses, using interest rates currently being offered for loans with similarterms to borrowers of similar credit quality. Fair values for non-performing loans are estimated using discounted cashflow analyses or underlying collateral values, where applicable.

 

F-19

----

 

***Deposit Liabilities***

 

The fairvalues disclosed for demand deposits (e.g., interest and non-interest checking,passbook savings, and certain types of money market accounts) are, bydefinition, equal to the amount payable on demand at the reporting date (i.e.,their carrying amounts).  The carryingamounts of variable-rate, fixed-term money market accounts and certificates ofdeposit approximate their fair values at the reporting date.  Fair values for fixed-rate certificates ofdeposit are estimated using a discounted cash flow calculation that appliesinterest rates currently being offered on certificates to a schedule ofaggregated expected monthly maturities on time deposits.

 

***Short-TermBorrowings***

 

The carryingamounts of federal funds purchased, borrowings under repurchase agreements, andother short-term borrowings maturing within ninety days approximate their fairvalues.  Fair values of other short-termborrowings are estimated using discounted cash flow analyses based on theCompany’s current incremental borrowing rates for similar types of borrowingarrangements.

 

***Long-Term Borrowings***

 

The fairvalues of the Company’s long-term borrowings are estimated using discountedcash flow analyses based on the Company’s current incremental borrowing ratesfor similar types of borrowing arrangements.

 

***Accrued Interest***

 

The carrying amounts of accrued interestapproximate fair value.

 

***Off-Balance SheetCredit-Related Instruments***

 

The fairvalues of the Company’s off-balance-sheet financial instruments are based onfees charged to enter into similar agreements. However, commitments to extend credit and standby letters of credit donot represent a significant value to the Company until such commitments arefunded.  The Company has determined thatthe fair value of these instruments is not significant.

 

The estimated fair values of the Company’s financial instruments are asfollows:

 

F-20

----

 
| ** **                                       | ** ** | **2004**     | ** ** | **2003**   | ** ** |
|--------------------------------------------------|------------|--------------|------------|------------|------------|
| ** **                                       | ** ** | **Carrying** | ** ** | **Fair**   | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                       | ** ** | **Amount**   | ** ** | **Value**  | ** ** | **Amount** | ** ** | **Value** | ** ** |
| **Financial Assets:**                            |       |         |       |       |       |   |   |   |   |
| Cash and federal funds sold                      |       | $            | 13,158,516 |       | $          | 13,158,516 |   | $ | 12,298,970 |   | $ | 12,298,970 |   |
| Federal Home Loan Bank Stock                     |       | 226,500      |       | 226,500    |       | 171,700 |   | 171,700 |   |
|                                             |       |         |       |       |       |   |   |   |   |
| Loans, net:                                      |       |         |       |       |       |   |   |   |   |
| Held for investment                              |       | 72,355,286   |       | 72,235,046 |       | 68,539,235 |   | 68,612,204 |   |
| Total financial assets                           |       | 85,740,302   |       | $          | 85,620,062 |   | 81,009,905 |   | $ | 81,082,874 |   |
|                                             |       |         |       |       |       |   |   |   |   |
| **Nonfinancial Assets:**                         |       |         |       |       |       |   |   |   |   |
| Other assets                                     |       | 5,434,066    |       |       |       | 4,065,245 |   |   |   |
| Total assets                                     |       | $            | 91,174,368 |       |       |   | $ | 85,075,150 |   |   |   |
|                                             |       |         |       |       |       |   |   |   |   |
| **Financial Liabilities:**                       |       |         |       |       |       |   |   |   |   |
| Deposits                                         |       |         |       |       |       |   |   |   |   |
| Without stated maturities                        |       | $            | 22,802,817 |       | 22,802,817 |   | $ | 18,032,000 |   | $ | 18,032,000 |   |
| With stated maturities                           |       | 55,584,410   |       | 55,653,487 |       | 55,429,766 |   | 55,780,505 |   |
| Federal Home Loan Bank advances                  |       | 4,359,346    |       | 4,291,977  |       | 4,254,106 |   | 4,208,360 |   |
|                                             |       |         |       |       |       |   |   |   |   |
| Total financial liabilities                      |       | 82,746,573   |       | $          | 82,748,281 |   | 77,715,872 |   | $ | 78,020,865 |   |
|                                             |       |         |       |       |       |   |   |   |   |
| **Other Nonfinancial Liabilities**               |       | 684,698      |       |       |       | 151,991 |   |   |   |
| Shareholder’s Equity                        |       | 7,743,097    |       |       |       | 7,207,287 |   |   |   |
|                                             |       |         |       |       |       |   |   |   |   |
| Total liabilities and shareholders’  equity |       | $            | 91,174,368 |       |       |   | $ | 85,075,150 |   |   |   |

 
| ** **                      | ** ** | **Notional** | ** ** | ** ** | ** ** | **Notional** | ** ** | ** ** | ** ** |
|---------------------------------|------------|--------------|------------|------------|------------|--------------|------------|------------|------------|
| ** **                      | ** ** | **Amounts**  | ** ** | ** ** | ** ** | **Amounts**  | ** ** | ** ** | ** ** |
| **Off-balance sheet financial** |       |         |       |       |       |         |       |       |       |
| **Instruments:**                |       |         |       |       |       |         |       |       |       |
| Loan commitments                |       | $            | 6,416,071  |       | $          | —       |       | $          | 8,768,188  |   | $ | — |   |
| Letters of credit               |       | $            | 1,272,700  |       | $          | —       |       | $          | 55,000     |   | $ | — |   |

 

The carryingamounts in the table above are the amounts at which the financial instrumentsare reported in the financial statements.

 

**Note13.**   **Transactions With Related Parties**

 

The Companyhas had, and may be expected to have in the future, banking transactions in theordinary course of business with directors, principal officers, their immediatefamilies and affiliated companies in which they are principal stockholders(commonly referred to as related parties), all of which have been, in theopinion of management, on the same terms, including interest rates andcollateral, as those prevailing at the time for comparable transactions withothers.

 

F-21

----

 

The amounts ofloans due directly from officers and directors of the Company or indirectlyfrom corporations, partnerships of ventures in which these individuals have aninterest were approximately $667,673 and $1,206,063 and at December 31, 2004and 2003, respectively.  During the yearsended December 31, 2004 and 2003, total principal additions were $128,073 and$615,894, respectively and total principal payments were $666,463 and$1,950,492, respectively.

 

**Note14.**   **Employee Benefit Plans**

 

The Companyhas a retirement savings 401(k) plan in which all employees mayparticipate.  To be eligible, an employeemust complete (6) months of service and reach their entry date.  An entry date is the first day of the PlanYear quarter coinciding with or next following the date that satisfies the Plan’seligibility requirements.  For 2004,employees may make, pretax, voluntary contributions in amounts up to $13,000(age 49 or less) and $16,000 (age 50 and older).  The Company may make discretionary matchingcontributions equal to a uniform percentage of tiered salary deferrals.  This percentage will be determined eachyear.  The Company’s expense for the planwas $ 53,470 and $110,298 at December 31, 2004 and 2003, respectively.

 

**Note15.**   **Stock Compensation Plan**

 

The Companyhas an employee Stock Option Plan (Plan) under which certain employees may begranted options to purchase shares of the Company’s authorized but unissuedcommon stock.  The maximum number ofshares of the Company’s common stock available for issuance under the Plan is375,000 shares.  As of December 31, 2004and 2003 the maximum number of shares available for future grants under the Planis 74,200 shares and 91,300 shares, respectively.  Under the Plan, the option exercise price isequal to the fair market value of the Company’s common stock at the date of thegrant.  The options expire on the tenthanniversary of the date of the option. The options vest in 20% increments on each of the first five anniversarydates of the option.  Proceeds receivedby the Company from exercises of the stock options are credited to common stockand additional paid-in capital.

 

Additional information with respect to the Plan’s stock option activityis as follows:

 
| ** **                               | ** ** | **Number of** | ** ** | **Weighted Average** | ** ** |
|------------------------------------------|------------|---------------|------------|----------------------|------------|
| ** **                               | ** ** | **Shares**    | ** ** | **Exercise Price**   | ** ** |
|                                     |       |          |       |                 |       |
| Outstanding at December 31, 2002         |       | 261,300       |       | $                    | 3.99       |   |
| Granted                                  |       | 1,400         |       | 14.00                |       |
| Exercised                                |       | (13,675       | )          | 3.33                 |       |
| Outstanding at December 31, 2003         |       | 249,025       |       | 4.08                 |       |
| Granted                                  |       | 17,100        |       | 17.00                |       |
| Forfeited                                |       | (9,000        | )          | 3.33                 |       |
| Exercised                                |       | (11,000       | )          | 3.33                 |       |
| Outstanding at December 31, 2004         |       | 246,125       |       | $                    | 5.06       |   |
| Options exercisable at December 31, 2003 |       | 63,005        |       | $                    | 3.88       |   |
| Options exercisable at December 31, 2004 |       | 106,765       |       | $                    | 3.99       |   |

 

F-22

----

 

The following tables summarize theinformation about the stock options outstanding and exercisable at December 31,2004:

 
| ** **         | ** ** | **Stock Options Outstanding** | ** ** |
|--------------------|------------|-------------------------------|------------|
| ** **         | ** ** | ** **                    | ** ** | **Weighted Average** | ** ** |
| ** **         | ** ** | **Number of**                 | ** ** | **Remaining** | ** ** |
| ** **         | ** ** | **Options**                   | ** ** | **Contractual** | ** ** |
| **Exercise Price** | ** ** | **Outstanding**               | ** ** | **Life in Years** | ** ** |
|               | $          | 3.33                          |       | 178,425 |   |   | 6.5 |   |   |
|               | $          | 5.33                          |       | 15,000 |   |   | 7.0 |   |   |
|               | $          | 7.33                          |       | 15,300 |   |   | 7.7 |   |   |
|               | $          | 7.67                          |       | 3,900 |   |   | 7.8 |   |   |
|               | $          | 8.00                          |       | 15,000 |   |   | 7.9 |   |   |
|               | $          | 14.00                         |       | 1,400 |   |   | 8.8 |   |   |
|               | $          | 17.00                         |       | 1,000 |   |   | 9.6 |   |   |
|               | $          | 17.00                         |       | 1,100 |   |   | 9.7 |   |   |
|               | $          | 17.00                         |       | 15,000 |   |   | 9.7 |   |   |
|               |       | 246,125                       |       |   | 6.9 |   |   |

 
| ** ** | ** ** | **Stock Options Exercisable** | ** ** |
|------------|------------|-------------------------------|------------|
| ** ** | ** ** | **Number of**                 | ** ** | ** ** | ** ** |
| ** ** | ** ** | **Options**                   | ** ** | **Weighted Average** | ** ** |
| ** ** | ** ** | **Exercisable**               | ** ** | **Exercise Price** | ** ** |
|       |       | 87,585                        |       | $ | 3.33 |   |
|       |       | 6,000                         |       | 5.33 |   |
|       |       | 6,120                         |       | 7.33 |   |
|       |       | 780                           |       | 7.67 |   |
|       |       | 6,000                         |       | 8.00 |   |
|       |       | 280                           |       | 13.00 |   |
|       |       | 106,765                       |       | $ | 3.99 |   |

 

The following tables summarize theinformation about the stock options outstanding and exercisable at December 31,2003:

 
| ** **         | ** ** | **Stock Options Outstanding** | ** ** |
|--------------------|------------|-------------------------------|------------|
| ** **         | ** ** | ** **                    | ** ** | **Weighted Average** | ** ** |
| ** **         | ** ** | **Number of**                 | ** ** | **Remaining** | ** ** |
| ** **         | ** ** | **Options**                   | ** ** | **Contractual** | ** ** |
| **Exercise Price** | ** ** | **Outstanding**               | ** ** | **Life in Years** | ** ** |
|               | $          | 3.33                          |       | 198,425 |   |   | 7.5 |   |   |
|               | $          | 5.33                          |       | 15,000 |   |   | 8.0 |   |   |
|               | $          | 7.33                          |       | 15,300 |   |   | 8.7 |   |   |
|               | $          | 7.67                          |       | 3,900 |   |   | 8.8 |   |   |
|               | $          | 7.67                          |       | 15,000 |   |   | 8.9 |   |   |
|               | $          | 14.00                         |       | 1,400 |   |   | 9.8 |   |   |
|               |       |                          | 249,025    |   |   | 7.7 |   |   |

 
| ** ** | ** ** | **Stock Options Exercisable** | ** ** |
|------------|------------|-------------------------------|------------|
| ** ** | ** ** | **Number of**                 | ** ** | ** ** | ** ** |
| ** ** | ** ** | **Options**                   | ** ** | **Weighted Average** | ** ** |
| ** ** | ** ** | **Exercisable**               | ** ** | **Exercise Price** | ** ** |
|       |       | 53,165                        |       | $ | 3.33 |   |
|       |       | 3,000                         |       | 5.33 |   |
|       |       | 3,060                         |       | 7.33 |   |
|       |       | 780                           |       | 7.67 |   |
|       |       | 3,000                         |       | 7.67 |   |
|       |       | 63,005                        |       | $ | 3.88 |   |

 

F-23

----

 

The Companyhas elected to follow APB Opinion No. 25 (Accounting for Stock Issued toEmployees) in accounting for its employee stock options.  Accordingly, no compensation expense isrecognized in the Company’s financial statements because the exercise price ofthe Company’s employee stock option equals the market price of the Company’scommon stock on the date of the grant. If under the Financial Accounting Standards Board Statement No. 123(Accounting for Stock-Based Compensation), the Company determined compensationcosts based on the fair value at the grant date for its stock options, netearnings and earnings per share would have been reduced to the following proforma amounts:

 
| ** **                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
|                               |       |     |       |     |       |
| Net earnings (loss):               |       |     |       |     |       |
| As reported                        |       | $        | 504,145    |     | $          | 248,503 |   |
| Pro forma, net of related taxes    |       | $        | 366,672    |     | $          | 126,301 |   |
|                               |       |     |       |     |       |
| Basic earnings (loss) per share:   |       |     |       |     |       |
| As reported                        |       | $        | 0.22       |     | $          | 0.11 |   |
| Pro forma, net of related taxes    |       | $        | 0.16       |     | $          | 0.06 |   |
|                               |       |     |       |     |       |
| Diluted earnings (loss) per share: |       |     |       |     |       |
| As reported                        |       | $        | 0.21       |     | $          | 0.11 |   |
| Pro forma, net of related taxes    |       | $        | 0.15       |     | $          | 0.05 |   |
|                               |       |     |       |     |       |

 

 

Theweighted-average estimated fair value of stock options granted during 2004 and2003 was $13.98 and $12.27 per share, respectively.  These amounts were determined using theBlack-Scholes option-pricing model, which values options based on the stockprice at the grant date, the expected life of the option, the estimatedvolatility of the stock, the expected dividend payments, and the risk-freeinterest rate over the expected life of the option.  The assumptions used in the Black-Scholesmodel were as follows for the stock options granted in 2004 and 2003:

 
| ** **                          | ** ** | **2004**   | ** ** | **2003**        | ** ** |
|-------------------------------------|------------|------------|------------|-----------------|------------|
|                                |       |       |       |            |       |
| Risk-free interest rate             |       | 4.00       | %          | 4.27            | %          |
| Expected volatility of common stock |       | 27.45      | %          | 40.00           | %          |
| Dividend yield                      |       | 0.00       | %          | 0.00            | %          |
| Expected life of options            |       | 6.7   | years      | 7.7   | years      |

 

TheBlack-Scholes option valuation model was developed for estimating the fair valueof traded options that have no vesting restrictions and are fullytransferable.  Because option valuationmodels require the use of subjective assumptions, changes in these assumptionscan materially affect the fair value of the options, and the Company’s optionsdo not have the characteristics of traded options, the option valuation modelsdo not necessarily provide a reliable measure of the fair value of its options.

 

F-24

----

 

**Note 16.****   Stock Split**

 

On March 31, 2003, theBank’s Board of Directors approved a three-for-one stock split effective April25, 2003. Shareholders’ equity, common stock, and stock option activity for allperiods presented have been restated to give retroactive recognition to thestock split.  In addition, all referencesin the financial statements and notes to financial statements, to weightedaverage number of shares, per share amounts, and market prices of the Bank’scommon stock have been restated to give retroactive recognition to the stocksplit.

 

**Note 17.****   Restrictions on Payment ofDividends**

 

The Company is subject tothe Tennessee Banking Act, which provides that dividends will be paid out ofundivided profits.  The payment ofdividends by any bank is dependent upon its earnings and financial conditionand subject to the statutory power of certain federal and state regulatoryagencies to act to prevent what they deem unsafe or unsound bankingpractices.  Moreover, the Federal ReserveBoard, the Comptroller of the Currency and the FDIC have issued policystatements which provide that bank holding companies and insured depositoryinstitutions generally should only pay dividends out of current operatingearnings.  Under Tennessee law, the boardof directors of a state bank may not declare dividends in any calendar yearthat exceeds the total of its retained net income of the preceding two (2)years without prior approval of the TDFI. The payment of dividends by the Company may also be affected or limitedby other factors, such as the requirement to maintain adequate capital aboveregulatory guidelines.

 

**Note 18.****   Condensed Financial Statementsof Parent Company**

 

Financial information pertaining only to BG FinancialGroup, Inc. is as follows:

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|------------------|------------|
| ** **                                      | ** ** | **2004**         | ** ** |
| **Balance Sheets**                              | ** ** | ** **       | ** ** |
| **Assets**                                      |       |             |       |
|                                            |       |             |       |
| Cash and due from banks                         |       | $                | 31,553     |   |
| Investment in Bank of Greeneville               |       | 7,690,685        |       |
| Other assets                                    |       | 20,959           |       |
| Total assets                                    |       | $                | 7,743,197  |   |
|                                            |       |             |       |
| **Liabilities and Stockholders’ Equity**   |       |             |       |
|                                            |       |             |       |
| Accrued expenses                                |       | $                | 100        |   |
| Other liabilities                               |       | —           |       |
| Total liabilities                               |       | 100              |       |
| Stockholders’ equity                       |       | 7,743,097        |       |
| Total liabilities and stockholders’ equity |       | $                | 7,743,197  |   |

 

F-25

----

 
| ** **                                                                                       | ** ** | **Year Ended**   | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                       | ** ** | **December 31,** | ** ** |
| ** **                                                                                       | ** ** | **2004**         | ** ** |
| **Statement  of Income**                                                                         |       |             |       |
| **Income**                                                                                       |       |             |       |
|                                                                                             |       |             |       |
| Dividends from Bank of Greeneville                                                               |       | $                | 49,000     |   |
|                                                                                             |       |             |       |
| Total income                                                                                     |       | 49,000           |       |
| **Operating expenses**                                                                           |       | 45,621           |       |
|                                                                                             |       |             |       |
| Income (loss) before income taxes and  equity in undistributed net income of Bank of Greeneville |       | 3,379            |       |
| Applicable income tax provision (benefit)                                                        |       | (17,368          | )          |
|                                                                                             |       | 20,747           |       |
| Equity in undistributed net income (loss)                                                        |       | 483,398          |       |
| ** **                                                                                       | ** ** | ** **       | ** ** |
| **Net income**                                                                                   |       | $                | 504,145    |   |

 
| ** **                                                                        | ** ** | **Year Ended**   | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                        | ** ** | **December 31,** | ** ** |
| ** **                                                                        | ** ** | **2004**         | ** ** |
| **Statement  of Cash Flows**                                                      |       |             |       |
| Cash flows from operating activities Net  income (loss)                           |       | $                | 504,145    |   |
|                                                                              |       |             |       |
| Adjustments to reconcile net income to net cash  provided by operating activities |       |             |       |
| Equity in undistributed net loss (income) of  Bank of Greeneville                 |       | (483,398         | )          |
| Depreciation                                                                      |       | 49               |       |
| Deferred income tax expense(benefit)                                              |       | (2,903           | )          |
| Increase (decrease) in other liabilities                                          |       | (14,565          | )          |
| ** **                                                                        | ** ** | ** **       | ** ** |
| Net cash provided (used) by operating activities                                  |       | 3,328            |       |
| ** **                                                                        | ** ** | ** **       | ** ** |
| Cash flows from investing activities                                              | ** ** | ** **       | ** ** |
| Purchase of equipment                                                             |       | (439             | )          |
| Net cash used for investing activities                                            |       | (439             | )          |
| ** **                                                                        | ** ** | ** **       | ** ** |
| Cash flows from financing activities                                              | ** ** | ** **       | ** ** |
| Issuance of stock                                                                 |       | 36,664           |       |
| Increase(decrease) in short-term notes                                            |       | (8,000           | )          |
| ** **                                                                        | ** ** | ** **       | ** ** |
| Net cash provided for financing activities                                        |       | 28,664           |       |
| ** **                                                                        | ** ** | ** **       | ** ** |
| Net increase (decrease) in cash and cash equivalents                              |       | 31,553           |       |
| Cash and cash equivalents at beginning of  year                                   |       | —           |       |
| Cash and cash equivalents at end of year                                          |       | $                | 31,553     |   |

 

F-26

----

 

**Note 19. SubsidiaryBank Only Financial Information**

 

Financial information pertaining only to Bank of Greeneville is asfollows:

 

**Balance Sheets**

** **
| ** **                                                                                                                                                        | ** ** | **As of**             | ** ** | **As of**             | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                        | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
| **ASSETS**                                                                                                                                                        |       |                  |       |                  |       |
|                                                                                                                                                              |       |                  |       |                  |       |
| Cash and due from banks                                                                                                                                           |       | $                     | 5,538,897  |                  | $          | 5,054,515 |   |
| Federal funds sold                                                                                                                                                |       | 7,619,619             |       | 7,244,455             |       |
| Cash and cash equivalents                                                                                                                                         |       | 13,158,516            |       | 12,298,970            |       |
| Federal Home Loan Bank stock, at cost                                                                                                                             |       | 226,500               |       | 171,700               |       |
| Loans, net of allowance for loan losses  $1,607,559 in 2004 and $1,350,266 in  2003                                                                     |       | 72,355,286            |       | 68,539,235            |       |
| Premises and equipment, net                                                                                                                                       |       | 3,895,110             |       | 2,763,153             |       |
| Accrued income receivable                                                                                                                                         |       | 389,308               |       | 387,258               |       |
| Deferred tax benefit                                                                                                                                              |       | 595,443               |       | 603,177               |       |
| Foreclosed assets                                                                                                                                                 |       | 489,649               |       | 184,127               |       |
| Other assets                                                                                                                                                      |       | 58,302                |       | 127,530               |       |
| Total Assets                                                                                                                                                      |       | $                     | 91,168,114 |                  | $          | 85,075,150 |   |
|                                                                                                                                                              |       |                  |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                     |       |                  |       |                  |       |
|                                                                                                                                                              |       |                  |       |                  |       |
| **LIABILITIES**                                                                                                                                                   |       |                  |       |                  |       |
| Deposits:                                                                                                                                                         |       |                  |       |                  |       |
| Noninterest-bearing                                                                                                                                               |       |                  |       |                  |       |
| Demand                                                                                                                                                            |       | $                     | 6,787,547  |                  | $          | 6,193,162 |   |
| Interest-bearing                                                                                                                                                  |       |                  |       |                  |       |
| Money market, interest checking and savings                                                                                                                       |       | 16,046,823            |       | 11,840,876            |       |
| Time deposits                                                                                                                                                     |       | 55,584,410            |       | 55,427,728            |       |
| Total Deposits                                                                                                                                                    |       | 78,418,780            |       | 73,461,766            |       |
| Accrued interest                                                                                                                                                  |       | 202,564               |       | 54,721                |       |
| Other liabilities                                                                                                                                                 |       | 496,739               |       | 97,270                |       |
| Federal Home Loan Bank - advances                                                                                                                                 |       | 4,359,346             |       | 4,254,106             |       |
| Total Liabilities                                                                                                                                                 |       | 83,477,429            |       | 77,867,863            |       |
|                                                                                                                                                              |       |                  |       |                  |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                     |       |                  |       |                  |       |
| Stock:                                                                                                                                                            |       |                  |       |                  |       |
| Preferred stock, no par value; authorized  1,000,000 shares; none issued and outstanding                                                                          |       | —                |       | —                |       |
| Common stock, $.333 par value; authorized  6,000,000 shares; issued and outstanding 2,306,775 shares at December 31,  2004; 2,295,775 shares at December 31, 2003 |       | 765,258               |       | 765,258               |       |
| Additional paid-in capital                                                                                                                                        |       | 6,838,325             |       | 6,887,325             |       |
| Retained earnings (accumulated deficit)                                                                                                                           |       | 87,102                |       | (445,296              | )          |
| Total Stockholders’ Equity                                                                                                                                   |       | 7,690,685             |       | 7,207,287             |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                   |       | $                     | 91,168,114 |                  | $          | 85,075,150 |   |

 

F-27

----

 

**Statements of Income**

 
| ** **                                            | ** ** | **Twelve Months Ended December 31** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                            | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Interest and dividend income:**                     | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans, including fees                                 |       | $                                   | 5,376,509  |   | $ | 4,219,597 |   | $ | 2,512,238 |   |
| Dividends on Federal Home Loan Bank stock             |       | 8,578                               |       | 6,554 |   | 1,104 |   |
| Federal funds sold and other                          |       | 113,630                             |       | 82,239 |   | 85,440 |   |
| Total interest and dividend income                    |       | 5,498,717                           |       | 4,308,390 |   | 2,598,782 |   |
|                                                  |       |                                |       |   |   |   |   |
| **Interest expense:**                                 | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                              |       | 1,430,567                           |       | 1,088,601 |   | 790,821 |   |
| Borrowed funds                                        |       | 144,632                             |       | 127,758 |   | 138 |   |
|                                                  |       |                                |       |   |   |   |   |
| Total interest expense                                |       | 1,575,199                           |       | 1,216,359 |   | 790,959 |   |
| Net interest income before provision for  loan losses |       | 3,923,518                           |       | 3,092,031 |   | 1,807,823 |   |
|                                                  |       |                                |       |   |   |   |   |
| **Provision for loan losses**                         |       | 615,251                             |       | 956,609 |   | 315,620 |   |
| Net interest income after provision for  loan losses  |       | 3,308,267                           |       | 2,135,422 |   | 1,492,203 |   |
|                                                  |       |                                |       |   |   |   |   |
| **Noninterest income:**                               | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service charges on deposit accounts                   |       | 272,611                             |       | 296,020 |   | 202,538 |   |
| Fees from origination of mortgage loans               |       | 127,417                             |       | 154,767 |   | 124,866 |   |
| Investment sales commissions                          |       | 97,313                              |       | 97,178 |   | 97,256 |   |
| Other                                                 |       | 34,336                              |       | 64,500 |   | 37,232 |   |
| Total noninterest income                              |       | 531,677                             |       | 612,465 |   | 461,892 |   |
| ** **                                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Noninterest expenses:**                             | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Compensation and benefits                             |       | 1,529,482                           |       | 1,290,696 |   | 989,145 |   |
| Occupancy expenses                                    |       | 400,405                             |       | 294,491 |   | 263,013 |   |
| Marketing                                             |       | 143,267                             |       | 89,348 |   | 65,923 |   |
| Data processing                                       |       | 191,748                             |       | 148,156 |   | 114,041 |   |
| Other operating expenses                              |       | 797,721                             |       | 581,990 |   | 391,864 |   |
| Total noninterest expense                             |       | 3,062,623                           |       | 2,404,681 |   | 1,823,986 |   |
| **Income****before income taxes**                     |       | 777,321                             |       | 343,206 |   | 130,109 |   |
|                                                  |       |                                |       |   |   |   |   |
| Income tax expense(benefit)                           |       | 244,923                             |       | 89,704 |   | (510,006 | ) |
|                                                  |       |                                |       |   |   |   |   |
| **Net income**                                        |       | $                                   | 532,398    |   | $ | 253,502 |   | $ | 640,115 |   |

 

F-28

----

 

**Statementsof Cash Flows**

 
| ** **                                                                                | ** ** | **Twelve Months Ended December 31** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                                      |       |                                |       |   |   |   |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                 | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                                |       | $                                   | 532,398    |   | $ | 253,502 |   | $ | 640,115 |   |
| Adjustments to reconcile net income to net  cash provided (used) by operating activities: |       |                                |       |   |   |   |   |
| Provision for loan losses                                                                 |       | 615,251                             |       | 956,609 |   | 315,620 |   |
| Depreciation                                                                              |       | 259,018                             |       | 201,687 |   | 188,062 |   |
| Realized loss (gain) on sales of premises  and equipment                                  |       | —                              |       | (8,470 | ) | — |   |
| Realized gain (loss) on sales of foreclosed  assets                                       |       | (8,919                              | )          | — |   | — |   |
| Deferred income tax benefit                                                               |       | 7,734                               |       | (93,171 | ) | (510,006 | ) |
| Net change in:                                                                            |       |                                |       |   |   |   |   |
| Accrued income receivable                                                                 |       | (2,051                              | )          | (130,989 | ) | (151,767 | ) |
| Other assets                                                                              |       | (32,218                             | )          | (110,399 | ) | (20,838 | ) |
| Other liabilities                                                                         |       | 648,758                             |       | (50,388 | ) | 52,737 |   |
| Net cash provided (used) by operating  activities                                         |       | 2,019,971                           |       | 1,018,381 |   | 513,923 |   |
|                                                                                      |       |                                |       |   |   |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                 | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal Home Loan Bank stock purchases                                                    |       | (54,800                             | )          | (37,400 | ) | (134,300 | ) |
| Proceeds from sales of premises and equipment                                             |       | —                              |       | 14,000 |   | — |   |
| Proceeds from sales of foreclosed assets                                                  |       | 255,177                             |       | — |   | — |   |
| Loan originations and principal collections,  net                                         |       | (4,899,698                          | )          | (27,201,927 | ) | (24,752,142 | ) |
| Additions to foreclosed assets                                                            |       | (83,383                             | )          | (184,127 | ) | — |   |
| Purchase of land for future development                                                   |       | (563,362                            | )          | — |   | — |   |
| Additions to premises and equipment                                                       |       | (827,614                            | )          | (429,171 | ) | (228,076 | ) |
| Net cash provided (used) by investing  activities                                         |       | (6,173,680                          | )          | (27,838,625 | ) | (25,114,518 | ) |
|                                                                                      |       |                                |       |   |   |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                 | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net change in deposits                                                                    |       | 4,800,332                           |       | 3,866,820 |   | 5,505,063 |   |
| Net change in certificates of deposit                                                     |       | 156,682                             |       | 26,325,092 |   | 19,457,721 |   |
| Federal Home Loan Bank advances                                                           |       | 276,462                             |       | 3,777,000 |   | 2,804,900 |   |
| Federal Home Loan Ban repayments                                                          |       | (171,221                            | )          | (2,194,894 | ) | (132,900 | ) |
| Dividends paid                                                                            |       | (49,000                             | )          | 52,583 |   | 100,000 |   |
| Net cash provided (used) by financing  activities                                         |       | 5,013,255                           |       | 31,826,601 |   | 27,734,784 |   |
|                                                                                      |       |                                |       |   |   |   |   |
| Net change in cash and cash equivalents                                                   |       | 859,546                             |       | 5,006,357 |   | 3,134,189 |   |
|                                                                                      |       |                                |       |   |   |   |   |
| Cash and cash equivalents at beginning of year                                            |       | 12,298,970                          |       | 7,292,613 |   | 4,158,424 |   |
|                                                                                      |       |                                |       |   |   |   |   |
| Cash and cash equivalents at end of year                                                  |       | $                                   | 13,158,516 |   | $ | 12,298,970 |   | $ | 7,292,613 |   |

 

F-29

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