# Exhibit 13

2005 Annual Report of
HCSB Financial Corporation

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# [GRAPHIC OMITTED]

# HCSB FINANCIAL
CORPORATION

Loris, South Carolina

Annual Report

2005

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# HCSB FINANCIAL CORPORATION
AND SUBSIDIARY

# Contents

Page

|                                                                                      | 
|------------------------------------------------------------------------------------- | 
|Message to Shareholders                                                               | 
|                                                                                      | 
|Ten Year History                                                                      | 
|                                                                                      | 
|Selected Financial Data                                                               | 
|                                                                                      | 
|Description of Company's Business                                                     | 
|                                                                                      | 
|Market for Common Share and Dividends                                                 | 
|                                                                                      | 
|Management's Discussion and Analysis of Financial Condition and Results of Operations | 
|                                                                                      | 
|Report of Independent Registered Public Accounting Firm                               | 
|                                                                                      | 
|Consolidated Balance Sheets                                                           | 
|                                                                                      | 
|Consolidated Statements of Income                                                     | 
|                                                                                      | 
|Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income   | 
|                                                                                      | 
|Consolidated Statements of Cash Flows                                                 | 
|                                                                                      | 
|Notes to Consolidated Financial Statements                                            | 
|                                                                                      | 
|Board of Directors                                                                    | 
|                                                                                      | 
|Corporate Officers                                                                    | 
|                                                                                      | 
|Branch Locations                                                                      | 

Headquarters

| |  | 
| |  | 
| |  | 
| |  | 
| |  | 

Certain statements in this annual
report contain forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995, such as statements relating to the future plans
and expectations, and are thus prospective. Such forward-looking statements are subject to
risks, uncertainties and other factors that could cause actual results to differ
materially from future results expressed or implied by such forward-looking statements.
Please see our annual report filed on Form 10-KSB for further discussion of these risks.

HCSB Financial Corporation will
furnish, free of charge, copies of the Annual Report and the Companys Report to the
Securities and Exchange Commission (Form 10-KSB) upon written request to James R.
Clarkson, President and C.E.O., HCSB Financial Corporation, Post Office Box 218, Loris,
South Carolina 29569.

This Annual Report serves as the
ANNUAL FINANCIAL DISCLOSURE STATEMENT furnished pursuant to Part 350 of the Federal
Deposit Insurance Corporations Rules and Regulations. THIS STATEMENT HAS NOT BEEN
REVIEWED OR CONFIRMED FOR ACCURACY OR RELEVANCE BY THE FEDERAL DEPOSIT INSURANCE
CORPORATION.

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# MESSAGE TO SHAREHOLDERS

I am pleased to present to our
shareholders this Annual Report of the performance of HCSB Financial Corporation and its
subsidiary, Horry County State Bank, for the year 2005. Our eighteenth year proved to be
another successful year in which our overall growth rate exceeded that of the previous
year.

During 2005, total assets increased
by 11.74% and concluded the year at $331.7 million. As a part of this growth in assets,
our loan portfolio grew to $235.1 million at year end, a 10.47% improvement over the prior
year. Funding of this growth was made possible by a 14.28% increase in deposits to a level
of $254.1 million at the end of 2005.

The aforementioned growth enabled us
to improve earnings for the year by 17.18% to $2.4 million. This in turn strengthened our
companys capital by 7.88% over the year 2004, and we concluded the year 2005 with
total capital of $25.3 million. It should also be noted that we achieved our earnings
growth while at the same time increasing our reserve for loan losses to 1.09% of gross
loans at the end of the year 2005 as compared to 1.01% at the end of the previous year.

While our financial performance in
2005 was quite favorable, I am sorry to report on two matters involving two gentlemen who
played instrumental roles in our banks growth and success. First of all, James F.
Frankie Lewis retired during the fourth quarter of 2005 due to health
situations. Frankie did an excellent job of leading our banks expansion into the
Conway market and was largely responsible for the growth that we experienced there.
Frankie in many ways epitomized our motto that Its the little things that make
a little bankBIG!", as he was truly a champion of the little
people. Despite his retirement, however, Frankie continues to be a strong voice for our
bank and is working diligently to help introduce his successor, Richard M. Lane, to the
Conway community.

On a very sad note, Bill G. Page, an
organizer of Horry County State Bank, passed away in December 2005. Bill was a prime
example of the lifeblood of our bank. He operated an independent farm supply business in
Loris for a number of years, successfully competing against larger competitors because of
his knowledge of his products and his commitment to excellence in service. Bill was a
staunch supporter of the agricultural sector of our local economy, but at the same time he
realized the importance of our banks expansion into the coastal markets and readily
endorsed our efforts there. Even though Bill Page retired from active service on our Board
of Directors in 2002, he continued to closely monitor our progress and to offer his advice
and support on a daily basis.

During the third quarter of the year
2006, we expect to open our Carolina Forest office, and we believe this is an excellent
opportunity for us to continue the expansion of our branch network. We are actively
working, also, to expand our presence in the Conway area while at the same time
considering opportunities for additional branches along the Grand Strand.

To support our ability to maximize
our opportunities for success in Myrtle Beach and Carolina Forest, your Board of Directors
has nominated Rachel B. Broadhurst and Michael S. Addy for election to our Board of
Directors this year. Both Rachel and Mike have been active members of our Myrtle Beach
Advisory Board and can truly assist the development of our bank with their service on our
Board of Directors.

We will continue to focus on
attracting and retaining skilled employees who are dedicated to treating our customers as
we would want to be treated and to doing the little things that make a little
bankBIG! And as a shareholder of HCSB Financial Corporation, you, too, should
understand the important role that you may play in the growth of the value of your
investment by readily recommending Horry County State Bank to everyone with whom you come
in contact.

Most respectfully,

/s/ James R. ClarksonJames R. ClarksonPresident/C.E.O.

2

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

Ten Year History(Omit 000s)

|Year | Assets | Deposits | Loans (net) | Capital   | Earnings
|---- | ------ | -------- | ----------- | --------- | --------
|
|1996 |        |          |             | $  49,405 |         
|1997 |        |          |             | 72,156    |         
|1998 |        |          |             | 83,586    |         
|1999 |        |          |             | 114,326   |         
|2000 |        |          |             | 143,718   |         
|2001 |        |          |             | 148,651   |         
|2002 |        |          |             | 211,598   |         
|2003 |        |          |             | 269,714   |         
|2004 |        |          |             | 296,807   |         
|2005 |        |          |             | 331,662   |         

3

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# HCSB FINANCIAL CORPORATION AND SUBSIDIARY

Selected Financial Data

The following  table sets forth certain  selected  financial  data  concerning the Company.  The selected  financial
data has been derived  from the  financial  statements.  This  information  should be read in  conjunction  with the
financial statements of the Company, including the accompanying notes, included elsewhere herein.

|Year Ended December 31,                   | 2005 | 2004 | 2003 | 2002    | 2001
|----------------------------------------- | ---- | ---- | ---- | ------- | ----
|
|Financial Condition:                      |      |      |      |         |     
|Investment securities, available for sale |      |      | $    | 38,233  |     
|Allowance for loan losses                 |      |      |      | 2,569   |     
|Net loans                                 |      |      |      | 232,509 |     
|Premises and equipment, net               |      |      |      | 11,681  |     
|Total assets                              |      |      |      | 331,662 |     
|Noninterest-bearing deposits              |      |      |      | 25,418  |     
|Interest-bearing deposits                 |      |      |      | 228,719 |     
|Total deposits                            |      |      |      | 254,137 |     
|Advances from the Federal Home            |      |      |      |         |     
|Loan Bank                                 |      |      |      | 43,390  |     
|Total liabilities                         |      |      |      | 306,359 |     
|Total shareholders' equity                |      |      |      | 25,303  |     
|                                          |      |      |      |         |     
|Results of Operations:                    |      |      |      |         |     
|Interest income                           |      |      | $    | 19,164  |     
|Interest expense                          |      |      |      | 7,456   |     
|                                          |      |      |      |         |     
|Net interest income                       |      |      |      | 11,708  |     
|Provision for loan losses                 |      |      |      | 1,070   |     
|                                          |      |      |      |         |     
|Net interest income after provision       |      |      |      |         |     
|for loan losses                           |      |      |      | 10,638  |     
|Other income                              |      |      |      | 1,931   |     
|Other expense                             |      |      |      | 8,903   |     
|                                          |      |      |      |         |     
|Income before income taxes                |      |      |      | 3,666   |     
|Income tax expense                        |      |      |      | 1,258   |     
|                                          |      |      |      |         |     
|Net income                                |      |      | $    | 2,408   |     
|                                          |      |      |      |         |     
|Per Share Data (1):                       |      |      |      |         |     
|Net income                                |      |      | $    | 1.36    |     
|                                          |      |      |      |         |     
|Period end book value                     |      |      | $    | 14.15   |     

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(1)    
          Per share data has been adjusted for all prior stock splits and dividends.

4

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Description of
Companys Business

HCSB Financial Corporation (the
Company) was incorporated on June 10, 1999 to become a holding company for Horry County
State Bank. The Companys only significant asset is its wholly owned subsidiary,
Horry County State Bank (the Bank). The Bank is a state-chartered bank incorporated on
December 18, 1987 and located at 5201 Broad Street, Loris, South Carolina. The
Companys primary market includes Horry County in South Carolina and Columbus and
Brunswick Counties in North Carolina. From its 10 branch locations, the Company offers a
full range of deposit services, including checking accounts, savings accounts,
certificates of deposit, money market accounts, and IRAs, as well as a broad range of
non-deposit investment services.

The Company is primarily engaged in
the business of attracting deposits from the general public and using these deposits
together with other funds to make agricultural, commercial, consumer, and real estate
loans. The Companys operating results depend to a substantial extent on the
difference between interest and fees earned on loans and investments and the
Companys interest expense, consisting principally of interest paid on deposits and
borrowings. Unlike most industrial companies, virtually all of the assets and liabilities
of financial institutions are monetary. As a result, interest rates have a greater effect
on the financial institutions performance. In addition to competing with other
traditional financial institutions, the Company also competes for savings dollars with
nontraditional financial intermediaries, such as mutual funds. This has resulted in a
highly competitive market area. The Company attempts to compete in this highly competitive
market by focusing on providing personal service and attention to its customers.

In 1995 the Company opened its first
branch office in the Mt. Olive community of Horry County and has since expanded its branch
network to 10 banking offices located throughout Horry County, as well as an Operation
Center in Loris, South Carolina which houses the Companys executive offices and
support services. This expansion of its branch system has enabled the Company to more
effectively compete for deposits and loans. By expanding into different communities, the
Company has been able to substantially diversify its market place from one of a
predominantly agricultural flavor to one which blends residential developments of retirees
and others, tourism, major employment areas, central county government and the
markets most active overall growth areas. In so doing, the Company has reduced
considerably the seasonality in its loan portfolio as well as the risks that are at times
inherent with concentration of loans in one particular segment of the economy.

In order to support this growth in
its branch network, the Company has undertaken several secondary common stock offerings.
Prior to its reorganization from a bank into the holding company, Horry County State Bank
undertook three such secondary offerings of its common stock in efforts to strengthen the
banks regulatory capital position to support projected future growth in assets.
Since the reorganization was consummated in 1999, the Company committed to another
secondary offering in 2002 whereby the Company issued an additional 365,712 shares of
common stock at a price per share of $22.00, resulting in over $8,000,000 in added
capital.

In December 2004, the Company
participated in the issuance of $6,000,000 of trust preferred securities through its
non-consolidated subsidiary HCSB Financial Trust I (the Trust) to enable the company to
pursue its growth goals and yet maintain a well-capitalized status as defined
by banking regulatory agencies. This method of raising capital only recently became
available to companies such as HCSB Financial Corporation in increments that the Company
could utilize. It allows the Company to continue its growth trends without issuing
additional common stock, and thus there is no dilution of ownership among the
Companys shareholders.

The Company concluded the year 2004
with the purchase of a 2-acre lot at the intersection of Carolina Forest Boulevard and
Gateway Avenue in the Carolina Forest community in Horry County. Construction of a full
service branch on this site is expected to begin during the first quarter of 2006.

5

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Market for Common
Share and Dividends

As of December 31, 2005, there were
1,788,201 shares of our common stock outstanding held by approximately 2,204 shareholders
of record. There is currently no established public trading market in our common stock,
and trading and quotations of our common stock have been limited and sporadic. Because
there has not been an established market for our common stock, we may not be aware of all
prices at which our common stock has been traded. We have not determined whether the
trades of which we are aware were the result of arms-length negotiations between the
parties. Based on information available to us from a limited number of sellers and
purchasers of common stock who have engaged in privately negotiated transactions of which
we are aware, we believe transactions in our common stock can be fairly summarized as
follows for the periods indicated:

|2005           | Low | High
|-------------- | --- | ----
|
|Fourth Quarter |     |     
|Third Quarter  |     |     
|Second Quarter |     |     
|First Quarter  |     |     

|2004           | Low | High
|-------------- | --- | ----
|
|Fourth Quarter |     |     
|Third Quarter  |     |     
|Second Quarter |     |     
|First Quarter  |     |     

All share and per share data in this
report has been adjusted to reflect all stock dividends and splits declared by the
Company.

No cash dividends have ever been
declared or paid by the Company. However, the Board of Directors approved a 10% stock
dividend for each of the five years ended December 31, 1996. The Company also paid a
two-for-one stock split in the form of a 100% stock dividend in 2000, a 5% stock dividend
in each of the years 2001, 2002, and 2003, a 7.5% stock dividend in 2004, and a 3% stock
dividend in 2005. The Board of Directors has declared a 3% stock dividend payable March 3,
2006 to shareholders of record February 10, 2006. Management does not expect the Company
to pay cash dividends in the foreseeable future. The Companys ability to pay
dividends depends on the ability of its subsidiary, Horry County State Bank, to pay
dividends to the Company. As a South Carolina state bank, the Bank may only pay dividends
out of its net profits, after deducting expenses, including losses and bad debts. In
addition, the Bank is prohibited from declaring a dividend on its shares of common stock
until its surplus equals its stated capital.

6

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# INTRODUCTION

The following discussion describes
our results of operations for 2005 as compared to 2004 and also analyzes our financial
condition as of December 31, 2005 as compared to December 31, 2004. Like most community
banks, we derive most of our income from interest we receive on our loans and investments.
Our primary source of funds for making these loans and investments is our deposits, both
interest-bearing and noninterest-bearing. Consequently, one of the key measures of our
success is our amount of net interest income, or the difference between the income on our
interest-earning assets, such as loans and investments, and the expense on our
interest-bearing liabilities, such as deposits and borrowed funds. In order to maximize
our net interest income, we must not only manage the volume of these balance sheet items,
but also the yields that we earn on our interest-earning assets and the rates that we pay
on interest-bearing liabilities.

We have included a number of tables
to assist in our description of these measures. For example, the Average
Balances table shows the average balance during 2005, 2004, and 2003 of each
category of our assets and liabilities, as well as the yield we earned or the rate we paid
with respect to each category. A review of this table shows that our loans typically
provide higher interest yields than do other types of interest earning assets, which is
why we direct a substantial percentage of our earning assets into our loan portfolio.
Similarly, the Rate/Volume Analysis table helps demonstrate the impact of
changing interest rates and changing volume of assets and liabilities during the years
shown. We also track the sensitivity of our various categories of assets and liabilities
to changes in interest rates, and we have included an Interest Rate Sensitivity
Analysis table to help explain this. Finally, we have included a number of tables
that provide details about our investment securities, our loans, and our deposits and
other borrowings.

Of course, there are risks inherent
in all loans, so we maintain an allowance for loan losses to absorb probable losses on
existing loans that may become uncollectible. We establish and maintain this allowance by
charging a provision for loan losses against our operating earnings. In the Loan Portfolio
section we have included a detailed discussion of this process, as well as several tables
describing our allowance for loan losses and the allocation of this allowance among our
various categories of loans.

In addition to earning interest on
our loans and investments, we earn income through fees that we charge to our customers.
Likewise, we incur other operating expenses as well. We describe the various components of
this noninterest income, as well as our noninterest expense, in the Noninterest Income and
Noninterest Expenses sections below.

# GENERAL

With the rising interest rate
environment, the bank continued to grow throughout 2005. Total assets increased by
$34,855,000, or 11.74%, and net loans increased by $21,860,000, or 10.38%. Much of this
growth is attributable to the success of our branch network, especially the newest offices
in the Myrtle Beach area.

Profitability continued a steady
upward trend in 2005. Net income increased by 17.18%, from $2,055,000 in 2004 to
$2,408,000 in 2005, primarily as a result of increased income from loans and related fees.
The growth of the loan portfolio resulted in a loan to deposit ratio of 92.50%. The
Company will need to attract additional deposits, borrow more money, or a combination of
the two to continue expansion of the loan portfolio. A more detailed discussion of the
factors contributing to growth and the corresponding challenges is presented below.

7

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# RESULTS OF OPERATIONS

The Company experienced an increase
of $2,822,000, or 20.27%, in interest income on loans and related fees for the year ended
December 31, 2005. Because of the rising interest rate environment and increase in growth
in interest-bearing deposits, total interest expense increased $2,520,000, or 51.05%, to
$7,456,000. Although net interest income increased significantly during 2005, the Company
also experienced a significant increase in noninterest expense during 2005. The primary
factor contributing to the increase of noninterest expense was salaries and employee
benefits, which increased $426,000, or 9.31%, from $4,576,000 for the year ended December
31, 2004. This increase was primarily a result of normal salary increases of existing
employees during the year and the additional hiring of employees. We added six full-time
employees in 2005. Overall, the Company had net income for the year ended December 31,
2005 of $2,408,000, compared to $2,055,000 for the year ended December 31, 2004. This
represents an increase in net income of $353,000, or 17.18%.

# ASSETS, LIABILITIES,
AND SHAREHOLDERS EQUITY

During the twelve months ended
December 31, 2005, total assets increased $34,855,000, or 11.74%, when compared to
December 31, 2004. The primary reason for the increase in total assets was an increase in
net loans of $21,860,000, or 10.38%, during 2005 from $210,649,000 at December 31, 2004.
Total deposits increased $31,748,000, or 14.28%, from the December 31, 2004 amount of
$222,389,000. Within the deposit area, interest-bearing deposits increased $34,303,000, or
17.64%, and noninterest-bearing deposits decreased $2,555,000, or 9.13%, during 2005. The
increase in deposits was primarily due to the increase in our Horry Prime Insured
Investment account, which increased $22,821,000, or 116.13%, from $19,651,000 at December
31, 2004 to $42,472,000 at December 31, 2005.

# DISTRIBUTION OF
ASSETS, LIABILITIES, AND SHAREHOLDERS EQUITY

The Company has sought to maintain a
conservative approach in determining the distribution of its assets and liabilities. The
following table presents the percentage relationships of significant components of the
Companys average balance sheets for the last three fiscal years.

8

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

DISTRIBUTION OF ASSETS, LIABILITIES, AND SHAREHOLDERS' EQUITY -
continued

# Balance Sheet Categories
as a Percent of Average Total Assets

|                                           | 2005 | 2004 | 2003
|------------------------------------------ | ---- | ---- | ----
|Assets:                                    |      |      |     
|Interest earning assets:                   |      |      |     
|Federal funds sold                         |      |      |     
|Time deposits with other banks             |      |      |     
|Investment securities                      |      |      |     
|Loans                                      |      |      |     
|                                           |      |      |     
|Total interest earning assets              |      |      |     
|                                           |      |      |     
|Cash and due from banks                    |      |      |     
|Allowance for loan losses                  |      |      |     
|Premises and equipment                     |      |      |     
|Other assets                               |      |      |     
|                                           |      |      |     
|Total assets                               |      |      |     
|                                           |      |      |     
|Liabilities and shareholders equity:      |      |      |     
|Interest-bearing liabilities:              |      |      |     
|Interest-bearing deposits                  |      |      |     
|Federal funds purchased                    |      |      |     
|Advances from the Federal Home Loan Bank   |      |      |     
|Debt due to trust                          |      |      |     
|                                           |      |      |     
|Total interest-bearing liabilities         |      |      |     
|Noninterest-bearing deposits               |      |      |     
|Accrued interest and other liabilities     |      |      |     
|                                           |      |      |     
|Total liabilities                          |      |      |     
|                                           |      |      |     
|Shareholders equity                       |      |      |     
|                                           |      |      |     
|Total liabilities and shareholders' equity |      |      |     
|                                           |      |      |     

# NET INTEREST INCOME

Earnings are dependent to a large
degree on net interest income. Net interest income represents the difference between gross
interest earned on earning assets, primarily loans and investment securities, and interest
paid on deposits and borrowed funds. Net interest income is affected by the interest rates
earned or paid and by volume changes in loans, investment securities, deposits, and
borrowed funds. The interest rate spread and the net yield on earning assets are two
significant elements in analyzing the Companys net interest income. The interest
rate spread is the difference between the yield on average earning assets and the rate on
average interest-bearing liabilities. The net yield on earning assets is computed by
dividing net interest income by the average earning assets.

For the year ended December 31, 2005,
net interest income was $11,708,000, an increase of $1,472,000, or 14.38%, over net
interest income of $10,236,000 in 2004. Interest income from loans, including fees, was
$16,743,000, an increase of $2,822,000, or 20.27%, from 2004 to 2005 as demand for loans
in the Companys marketplace continued to grow and rates continued to rise. Interest
expense for the year ended December 31, 2005 was $7,456,000, compared to $4,936,000 for
2004. This represents an increase of $2,520,000, or 51.05%. The interest rate spread and
net yield on earning assets therefore showed improvement when compared to the previous
year. The net yield realized on earning assets was 4.01% for 2005, compared to 3.97% in
2004. The interest rate spread was 3.77% and 3.75% in 2005 and 2004, respectively.

9

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

NET INTEREST INCOME
 continued

The following table sets forth, for
the periods indicated, the weighted-average yields earned, the weighted-average yields
paid, the interest rate spread, and the net yield on earning assets. The table also
indicates the average daily balance and the interest income or expense by specific
categories.

# Average Balances, Income
and Expenses, and Rates

|Year ended December 31,            | 2005 | 2004 | 2003
|---------------------------------- | ---- | ---- | ----
|
|
|Assets:                            |      |      |     
|Earning Assets:                    |      |      |     
|Securities, taxable                |      |      | $   
|Securities, nontaxable             |      |      |     
|Loans (1)                          |      |      |     
|Federal funds sold                 |      |      |     
|Time deposits with                 |      |      |     
|other banks                        |      |      |     
|Nonmarketable equity               |      |      |     
|securities                         |      |      |     
|                                   |      |      |     
|Total earning assets               |      |      |     
|                                   |      |      |     
|Cash and due from banks            |      |      |     
|Allowance for loan losses          |      |      |     
|Premises and equipment             |      |      |     
|Other assets                       |      |      |     
|                                   |      |      |     
|Total assets                       |      |      | $   
|                                   |      |      |     
|Liabilities:                       |      |      |     
|Interest-Bearing Liabilities:      |      |      |     
|Interest-bearing deposits          |      |      | $   
|Other borrowings                   |      |      |     
|                                   |      |      |     
|Total interest-bearing liabilities |      |      |     
|                                   |      |      |     
|Noninterest-bearing deposits       |      |      |     
|Accrued interest and other         |      |      |     
|liabilities                        |      |      |     
|Shareholders' equity               |      |      |     
|                                   |      |      |     
|Total liabilities and              |      |      |     
|shareholders' equity               |      |      | $   
|                                   |      |      |     
|Net interest income/spread         |      |      |     
|                                   |      |      |     
|Net interest margin                |      |      |     

_______________(1)    
          The effects of loans in nonaccrual status and fees collected are not significant
          to the computations.

10

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# RATE/VOLUME ANALYSIS

Net interest income can also be
analyzed in terms of the impact of changing rates and changing volume. The following table
describes the extent to which changes in interest rates and changes in the volume of
earning assets and interest-bearing liabilities have affected the Companys interest
income and interest expense during the periods indicated. Information on changes in each
category attributable to (i) changes due to volume (change in volume multiplied by prior
period rate), (ii) changes due to rates (changes in rates multiplied by prior period
volume), and (iii) changes in rate and volume (change in rate multiplied by the change in
volume) is provided as follows:

|                                | 2005 compared to 2004
|------------------------------- | ---------------------
|
|
|Interest income:                |                      
|Taxable securities              |                      
|Nontaxable securities           |                      
|Loans                           |                      
|Federal funds sold              |                      
|Time deposits with other banks  |                      
|Nonmarketable equity securities |                      
|                                |                      
|Total interest income           |                      
|                                |                      
|Interest expense:               |                      
|Interest-bearing deposits       |                      
|Other borrowings                |                      
|                                |                      
|Total interest expense          |                      
|                                |                      
|Net interest income             |                      
|                                |                      

|                                | 2004 compared to 2003
|------------------------------- | ---------------------
|
|
|Interest income:                |                      
|Taxable securities              |                      
|Nontaxable securities           |                      
|Loans                           |                      
|Federal funds sold              |                      
|Time deposits with other banks  |                      
|Nonmarketable equity securities |                      
|                                |                      
|Total interest income           |                      
|                                |                      
|Interest expense:               |                      
|Interest-bearing deposits       |                      
|Other borrowings                |                      
|                                |                      
|Total interest expense          |                      
|                                |                      
|Net interest income             |                      
|                                |                      

_______________(1)    
          Volume-rate changes have been allocated to each category based on a
          consistent basis between rate and volume.

11

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# RATE SENSITIVITY

Interest rates paid on deposits and
borrowed funds and interest rates earned on loans and investments have generally followed
the fluctuations in market rates in 2005 and 2004. However, fluctuations in market
interest rates do not necessarily have a significant impact on net interest income,
depending on the Companys interest rate sensitivity position. A rate-sensitive asset
or liability is one that can be repriced either up or down in interest rate within a
certain time interval. When a proper balance exists between rate-sensitive assets and
rate-sensitive liabilities, market interest rate fluctuations should not have a
significant impact on liquidity and earnings. The larger the imbalance, the greater the
interest rate risk assumed and the greater the positive or negative impact of interest
fluctuations on liquidity and earnings.

Interest rate sensitivity management
is concerned with the management of both the timing and the magnitude of repricing
characteristics of interest-earning assets and interest-bearing liabilities and is an
important part of asset/liability management. The objectives of interest rate sensitivity
management are to ensure the adequacy of net interest income and to control the risks to
net interest income associated with movements in interest rates. The following table,
Interest Rate Sensitivity Analysis, indicates that, on a cumulative basis,
after three through twelve months, rate-sensitive liabilities exceeded rate-sensitive
assets, resulting in a twelve month liability sensitive position. For a bank with a
liability-sensitive position, or negative gap, falling interest rates would generally be
expected to have a positive effect on net interest income, and rising interest rates would
generally be expected to have the opposite effect. The following table presents the
Companys rate sensitivity at each of the time intervals indicated as of December 31,
2005 and may not be indicative of the Companys rate-sensitivity position at other
points in time.

# Interest Rate
Sensitivity Analysis

|                                 |  | After One | After Three |         | Greater |  
|-------------------------------- |  | --------- | ----------- | ------- | ------- | -
|
|
|
|
|Assets                           |  |           |             |         |         |  
|Interest-earning assets          |  |           |             |         |         |  
|Federal fund sold                |  |           | $           | 29,262  |         | $
|Loans                            |  |           |             | 15,749  |         |  
|Securities                       |  |           |             | -       |         |  
|                                 |  |           |             |         |         |  
|Total earning assets             |  |           |             | 45,011  |         |  
|                                 |  |           |             |         |         |  
|Liabilities                      |  |           |             |         |         |  
|Interest-bearing liabilities:    |  |           |             |         |         |  
|Interest-bearing deposits:       |  |           |             |         |         |  
|Demand deposits                  |  |           |             | 84,082  |         |  
|Savings deposits                 |  |           |             | 48,588  |         |  
|Time deposits                    |  |           |             | 6,818   |         |  
|                                 |  |           |             |         |         |  
|Total interest-bearing           |  |          
|deposits                         |  |           |             | 139,488 |         |  
|Other borrowings                 |  |           |             | -       |         |  
|Junior subordinated debentures   |  |           |             | -       |         |  
|                                 |  |           |             |         |         |  
|Total interest-bearing           |  |           |             |         |         |  
|liabilities                      |  |           |             | 139,488 |         |  
|                                 |  |           |             |         |         |  
|Period gap                       |  |           | $           | (94,477 | )       | $
|                                 |  |           |             |         |         |  
|Cumulative gap                   |  |           | $           | (94,447 | )       | $
|                                 |  |           |             |         |         |  
|Ratio of cumulative gap to total |  |           |             |         |         |  
|earning assets                   |  |           |             | (30.87  | )%      |  

12

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# PROVISION FOR LOAN
LOSSES

The provision for loan losses is
charged to earnings based upon managements evaluation of specific loans in its
portfolio and general economic conditions and trends in the marketplace. The 2005 and 2004
provisions for loan losses and their related effect of increasing the allowance for loan
losses are related to growth in the loan portfolio. Please refer to the section Loan
Portfolio for a discussion of managements evaluation of the adequacy of the
allowances for loan losses. In 2005 and 2004, the provisions for loan losses were
$1,070,000 and $1,285,000, respectively.

# NONINTEREST INCOME

Noninterest income was $1,931,000 for
the year ended December 31, 2005, a decrease of $225,000, or 10.44%, when compared with
the year ended December 31, 2004. The decrease is primarily a result of a loss on sales of
securities of $52,000 during 2005, versus a gain on sales of securities of $99,000 during
2004. The decrease is also a result of a decrease of $56,000, or 57.73%, in credit life
insurance commissions from $97,000 for the year ended December 31, 2004 to $41,000 for the
year ended December 31, 2005. This trend may continue as the result of a new state
statute, which has eliminated single-premiums on loans, which are collateralized by a
borrowers principal residence. Also, there was a decrease in gains on sale of
mortgage loans of $28,000, or 15.30%, from $183,000 for the year ended December 31, 2004
to $155,000 for the year ended December 31, 2005. However, there was an increase in
brokerage commissions of $35,000, or 26.72% from $131,000 for the year ended December 31,
2004 to $166,000 for the year ended December 31, 2005.

# NONINTEREST EXPENSES

Most categories of noninterest
expenses increased during 2005 due to continued growth of the Company. Salaries and
employee benefits increased $426,000, or 9.31%, due to a normal salary increases among
existing employees as well as a slight increase in the number of employees. Net occupancy
and furniture and equipment expenses also increased $383,000 due mainly to an increase in
depreciation expense and the cost of equipment maintenance associated with the
implementation of our new core processing system in February 2005. Other operating
expenses were $1,955,000 for the year ended December 31, 2005, compared to $1,814,000 for
the year ended December 31, 2004.

# INCOME TAXES

The Companys income tax expense
for 2005 was $1,258,000, an increase of $167,000 from the 2004 expense of $1,091,000. The
increase in the expense resulted from increased income before taxes. The Companys
effective tax rates for the years ended December 31, 2005 and 2004 were 34.32% and 34.68%,
respectively.

# LIQUIDITY

Liquidity is the ability to meet
current and future obligations through liquidation or maturity of existing assets or the
acquisition of additional liabilities. The Company manages both assets and liabilities to
achieve appropriate levels of liquidity. Cash and federal funds sold are the
Companys primary sources of asset liquidity. These funds provide a cushion against
short-term fluctuations in cash flow from both deposits and loans. The investment
securities portfolio is the Companys principal source of secondary asset liquidity.
However, the availability of this source of funds is influenced by market conditions.
Individual and commercial deposits are the Companys primary source of funds for
credit activities. Although not historically used as principal sources of liquidity,
federal funds purchased from correspondent banks and advances from the Federal Home Loan
Bank are other options available to management. As of December 31, 2005, the Company had
unused lines of credit to purchase federal funds from unrelated banks totaling
$14,000,000. These lines of credit are available on a one to fourteen day basis for
general corporate purposes. The lenders have reserved the right not to renew their
respective lines. The Company may also borrow an additional $22,830,000 from the Federal
Home Loan Bank based on a predetermined formula. Securities available-for-sale, which
totaled $38,233,000 at December 31, 2005, also serve as a ready source of liquidity.
Management believes that the Companys liquidity sources are adequate to meet its
operating needs. The level of liquidity is measured by the loans-to-total borrowed funds
ratio, which was at 77.40% and 78.25% at December 31, 2005 and 2004, respectively.

13

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# IMPACT OF
OFF-BALANCE-SHEET INSTRUMENTS

The Company is a party to financial
instruments with off-balance-sheet risk in the normal course of business to meet the
financing needs of its customers. These financial instruments consist of commitments to
extend credit and standby letters of credit. Commitments to extend credit are legally
binding agreements to lend to a customer at predetermined interest rates as long as there
is no violation of any condition established in the contract. Commitments generally have
fixed expiration dates or other termination clauses and may require payment of a fee. A
commitment involves, to varying degrees, elements of credit and interest rate risk in
excess of the amount recognized in the balance sheets. The Companys exposure to
credit loss in the event of nonperformance by the other party to the instrument is
represented by the contractual notional amount of the instrument. Since certain
commitments are expected to expire without being drawn upon, the total commitment amounts
do not necessarily represent future cash requirements. Letters of credit are conditional
commitments issued to guarantee a customers performance to a third party and have
essentially the same credit risk as other lending facilities. Standby letters of credit
often expire without being used. Management believes that through various sources of
liquidity, the Company has the necessary resources to meet obligations arising from these
financial instruments.

The Company uses the same credit
underwriting procedures for commitments to extend credit and standby letters of credit as
for on-balance-sheet instruments. The credit worthiness of each borrower is evaluated and
the amount of collateral, if deemed necessary, is based on the credit evaluation.
Collateral held for commitments to extend credit and standby letters of credit varies but
may include accounts receivable, inventory, property, plant, equipment, and
income-producing commercial properties, as well as liquid assets such as time deposit
accounts, brokerage accounts, and cash value of life insurance.

The Company is not involved in
off-balance-sheet contractual relationships, other than those disclosed in this report,
which it believes could result in liquidity needs or other commitments or that could
significantly impact earnings.

As of December 31, 2005, commitments
to extend credit totaled $35,134,000 and standby letters of credit totaled $778,000.

The following table sets forth the
length of time until maturity for unused commitments to extend credit and standby letters
of credit at December 31, 2005.

|                          |  | After One | After Three |       |  |  
|------------------------- |  | --------- | ----------- | ----- |  | -
|
|
|
|
|Unused commitments to     |  |           |             |       |  |  
|extend credit             |  |           | $           | 1,600 |  | $
|Standby letters of credit |  |           |             | -     |  |  
|                          |  |           |             |       |  |  
|Totals                    |  |           | $           | 1,600 |  | $
|                          |  |           |             |       |  |  

The Company entered into interest
swap agreements associated with Federal Home Loan Bank advances during the third quarter
of 2003. The interest rate swaps effectively converted the fixed interest rates on the
advances to a variable rate. The notional amount of advances involved in this transaction
totaled $14,600,000. The unrealized gain related to the interest rate swaps was $772,000
at December 31, 2005. The Company believes that the hedging of such debt was very
effective as management protected against further declines in interest rates as well as a
continuation of interest rates at or near their low levels at the time the transaction was
consummated.

14

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# IMPACT OF INFLATION
AND CHANGING PRICES

The financial statements and related
financial data presented herein have been prepared in accordance with generally accepted
accounting principles which require the measurement of financial position and operating
results in terms of historical dollars without considering changes in relative purchasing
power over time due to inflation. Unlike most industrial companies, virtually all of the
assets and liabilities of a financial institution are monetary in nature. As a result,
interest rates generally have a more significant impact on a financial institutions
performance than does the effect of inflation.

While the effect of inflation on a
bank is normally not as significant as its influence on those businesses that have large
investments in plant and inventories, it does have an effect. Interest rates generally
increase as the rate of inflation increases, but the magnitude of the change in rates may
not be the same. While interest rates have traditionally moved with inflation, the effect
on income is diminished because both interest earned on assets and interest paid on
liabilities vary directly with each other unless the Company is in a high liability
sensitive position. Also, general increases in the price of goods and services will result
in increased operating expenses.

# CAPITAL RESOURCES

The Company uses several indicators
of capital strength. The most commonly used measure is average common equity to average
assets, which was 7.66% in 2005 compared to 7.54% in 2004. The change in this ratio
reflects an increase in earnings at a greater rate than the growth in the Companys
assets in 2005.

The Federal Reserve and bank
regulatory agencies require bank holding companies and financial institutions to maintain
capital at adequate levels based on a percentage of assets and off-balance sheet
exposures, adjusted for risk weights ranging from 0% to 100%. The Federal Reserve
guidelines contain an exemption from the capital requirements for small bank holding
companies. On February 27, 2006, the Federal Reserve approved a new rule expanding
the definition of a small bank holding company. The new definition will
include bank holding companies with less than $500 million in total assets. Bank holding
companies will not qualify under the new definition if they (i) are engaged in significant
nonbanking activities either directly or indirectly through a subsidiary, (ii) conduct
significant off-balance sheet activities, including securitizations or managing or
administering assets for third parties, or (iii) have a material amount of debt or equity
securities (including trust preferred securities) outstanding that are registered with the
SEC. The new rule will be effective on March 30, 2006. Although we have less than $500
million in assets, it is unclear at this point whether we otherwise meet the requirements
for qualifying as a small bank holding company. According to the Federal
Reserve Board, the revision of the criterion to exclude any bank holding company that has
outstanding a material amount of SEC-registered debt or equity securities reflects the
fact that SEC registrants typically exhibit a degree of complexity of operations and
access to multiple funding sources that warrants excluding them from the new policy
statement and subjecting them to the capital guidelines. In the adopting release for the
new rule, the Federal Reserve Board stated that what constitutes a material
amount of SEC-registered debt or equity for a particular bank holding company depends on
the size, activities and condition of the relevant bank holding company. In lieu of using
fixed measurable parameters of materiality across all institutions, the rule provides the
Federal Reserve with supervisory flexibility in determining, on a case-by-case basis, the
significance or materiality of activities or securities outstanding such that a bank
holding company should be excluded from the policy statement and subject to the capital
guidelines. Prior to adoption of this new rule, our holding company was subject to these
capital guidelines, as it had more than $150 million in assets. Until the Federal Reserve
provides further guidance on the new rules, it will be unclear whether our holding company
will be subject to the exemption from the capital requirements for small bank holding
companies. Regardless, our bank falls under these minimum capital requirements as set per
bank regulatory agencies.

15

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

CAPITAL RESOURCES continued

Under the capital adequacy
guidelines, regulatory capital is classified into two tiers. These guidelines require an
institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted
assets. Tier 1 capital consists of common shareholders equity, excluding the
unrealized gain or loss on securities available for sale, minus certain intangible assets.
In determining the amount of risk-weighted assets, all assets, including certain
off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on
the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1
capital plus the general reserve for loan losses, subject to certain limitations. We are
also required to maintain capital at a minimum level based on total average assets, which
is known as the Tier 1 leverage ratio. At both the holding company and bank level, we are
subject to various regulatory capital requirements administered by the federal banking
agencies. To be considered well-capitalized, we must maintain total risk-based
capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least
5%.

As of December 31, 2005, the most
recent notifications from the Banks primary regulator categorized the Bank as
well-capitalized under the regulatory framework for prompt corrective action. There are no
conditions or events that management believes have changed the Banks category.

The Company and the Bank are required
to maintain certain risk-based and leverage ratios. The Company and the Bank exceeded
these regulatory capital ratios at December 31, 2005, 2004, and 2003 as set forth in the
following tables.

|December 31,                            | 2005 | 2004 | 2003
|--------------------------------------- | ---- | ---- | ----
|
|The Company                             |      |      |     
|Tier 1 capital                          |      |      | $   
|Tier 2 capital                          |      |      |     
|                                        |      |      |     
|Total qualifying capital                |      |      | $   
|                                        |      |      |     
|Risk-adjusted total assets              |      |      |     
|(including off-balance-sheet exposures) |      |      | $   
|                                        |      |      |     
|Tier 1 risk-based capital ratio         |      |      |     
|Total risk-based capital ratio          |      |      |     
|Tier 1 leverage ratio                   |      |      |     

|December 31,                            | 2005 | 2004 | 2003
|--------------------------------------- | ---- | ---- | ----
|
|The Bank                                |      |      |     
|Tier 1 capital                          |      |      | $   
|Tier 2 capital                          |      |      |     
|                                        |      |      |     
|Total qualifying capital                |      |      | $   
|                                        |      |      |     
|Risk-adjusted total assets              |      |      |     
|(including off-balance-sheet exposures) |      |      | $   
|                                        |      |      |     
|Tier 1 risk-based capital ratio         |      |      |     
|Total risk-based capital ratio          |      |      |     
|Tier 1 leverage ratio                   |      |      |     

The Company does not expect to pay
cash dividends to shareholders during 2006.

16

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# INVESTMENT PORTFOLIO

Management classifies investment
securities as either held-to-maturity or available-for-sale based on their intentions and
the Companys ability to hold them until maturity. In determining such
classifications, securities that management has the positive intent and the Company has
the ability to hold until maturity are classified as held-to-maturity and carried at
amortized cost. All other securities are designated as available-for-sale and carried at
estimated fair value with unrealized gains and losses included in shareholders
equity on an after-tax basis. As of December 31, 2005 and 2004, all securities were
classified as available-for-sale.

The following tables summarize the
carrying value of investment securities as of the indicated dates and the weighted-average
yields of those securities at December 31, 2005.

# Investment Securities
Portfolio Composition

|December 31,                                            | 2005 | 2004 | 2003
|------------------------------------------------------- | ---- | ---- | ----
|
|Securities of U.S. government agencies and corporations |      |      | $   
|Obligations of state and local governments              |      |      |     
|Mortgage-backed securities                              |      |      |     
|Equity securities available-for-sale                    |      |      |     
|Nonmarketable equity securities                         |      |      |     
|                                                        |      |      |     
|Total securities                                        |      |      | $   
|                                                        |      |      |     

# Investment Securities Portfolio
Maturity Schedule

|                                                             | Available-for-Sale
|------------------------------------------------------------ | ------------------
|
|
|Securities of U.S. Government agencies and corporations due: |                   
|Less than one year                                           |                   
|After one year but within five years                         |                   
|Obligations of states and local governments due:             |                   
|After one year but within five years                         |                   
|After five years but within ten years                        |                   
|After ten years                                              |                   
|                                                             |                   
|                                                             |                   
|                                                             |                   
|Mortgage-backed securities                                   |                   
|                                                             |                   
|Equities available-for-sale                                  |                   
|                                                             |                   
|                                                             |                   
|                                                             |                   

17

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# LOAN PORTFOLIO

Management believes the loan
portfolio is adequately diversified. There are no foreign loans, and agricultural loans as
of December 31, 2005 are limited. There are no significant concentrations of loans in any
particular individuals or industry or group of related individuals or industries.

The Company has experienced continued
growth of its loan portfolio throughout 2005 and 2004, resulting in increases of
$22,274,000 and $20,975,000, respectively. Management has concentrated on maintaining
quality in the loan portfolio. The loan-to-deposit ratio is used to monitor a financial
institutions potential profitability and efficiency of asset distribution and
utilization. Generally, a higher loan-to-deposit ratio is indicative of higher interest
income since loans yield a higher return than other interest-earning assets. The
loan-to-deposit ratios were 92.50% and 95.69% at December 31, 2005 and 2004, respectively.
The loans-to-total borrowed funds ratio was 77.40% and 78.25% at December 31, 2005 and
2004, respectively. Management intends to deploy available funds to loans in order to
maximize earnings and achieve its targeted ratio of loans to deposits; however, there can
be no assurance that management will be able to execute its strategy or that loan demand
will continue to support growth.

Loan Portfolio Composition

|December 31,                   | 2005 | 2004 | 2003 | 2002    | 2001
|------------------------------ | ---- | ---- | ---- | ------- | ----
|
|Real estate - construction and |      |      |      |         |     
|land development               |      |      | $    | 18,686  |     
|Real estate - mortgage and     |      |      |      |         |     
|commercial                     |      |      |      | 133,527 |     
|Agricultural                   |      |      |      | 5,141   |     
|Commercial and industrial      |      |      |      | 55,909  |     
|Consumer                       |      |      |      | 21,168  |     
|All other loans (including     |      |      |      |         |     
|overdrafts)                    |      |      |      | 647     |     
|                               |      |      |      |         |     
|Total gross loans              |      |      | $    | 235,078 |     
|                               |      |      |      |         |     

# Credit Risk Management

Credit risk entails both general
risk, which is inherent in the process of lending, and risk that is specific to individual
borrowers. The management of credit risk involves the processes of loan underwriting and
loan administration. The Company manages credit risk through a strategy of making loans
within the Companys primary marketplace and within the Companys limits of
expertise. Although management seeks to avoid concentrations of credit by loan type or
industry through diversification, a substantial portion of the borrowers ability to
honor the terms of their loans is dependent on the business and economic conditions in
Horry and Marion Counties in South Carolina and Columbus and Brunswick Counties in North
Carolina. Additionally, since real estate is considered by the Company as the most
desirable nonmonetary collateral, a significant portion of the Companys loans are
collateralized by real estate; however, the cash flow of the borrower or the business
enterprise is generally considered as the primary source of repayment. Generally, the
value of real estate is not considered by the Company as the primary source of repayment
for performing loans. The Company also seeks to limit total exposure to individual and
affiliated borrowers. The Company manages risk specific to individual borrowers through
the loan underwriting process and through an ongoing analysis of the borrowers
ability to service the debt as well as the value of the pledged collateral.

The Companys loan officers and
loan administration staff are charged with monitoring the Companys loan portfolio
and identifying changes in the economy or in a borrowers circumstances which may
affect the ability to repay the debt or the value of the pledged collateral. In order to
assess and monitor the degree of risk in the Companys loan portfolio, several credit
risk identification and monitoring processes are utilized. The Company assesses credit
risk initially through the assignment of a risk grade to each loan based upon an
assessment of the borrowers financial capacity to service the debt and the presence
and value of any collateral.

18

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

LOAN
PORTFOLIO continued

Credit grading is adjusted during the
life of the loan to reflect economic and individual changes having an impact on the
borrowers abilities to honor the terms of their commitments. Management uses the
risk grades as a tool for identifying known and inherent losses in the loan portfolio and
for determining the adequacy of the allowance for loan losses.

# Maturities and
Sensitivity of Loans to Changes in Interest Rates:

The following table summarizes the
loan maturity distribution, by type, at December 31, 2005 and related interest rate
characteristics:

|                                       |  | Over |   |       
|-------------------------------------- |  | ---- | - | ------
|
|
|
|Real estate - construction             |  |      |   |       
|and land development                   |  |      | $ | 12,877
|Real estate - mortgage and commercial  |  |      |   | 41,791
|Agricultural                           |  |      |   | 2,308 
|Commercial and industrial              |  |      |   | 27,399
|Consumer                               |  |      |   | 6,418 
|All other loans (including overdrafts) |  |      |   | 148   
|                                       |  |      |   |       
|                                       |  |      | $ | 90,941
|                                       |  |      |   |       
|Loans maturing after one year with:    |  |      |   |       
|Fixed interest rates                   |  |      |   |       
|Floating interest rates                |  |      |   |       
|                                       |  |      |   |       
|                                       |  |      |   |       
|                                       |  |      |   |       

# Risk Elements

Loans are defined as impaired when it
is probable that a creditor will be unable to collect all amounts due according to the
contractual terms of the loan agreement. Impairment of a loan is based on the present
value of the expected future cash flows discounted at the loans effective interest
rate or at the fair value of the collateral if the loan is collateral dependent.

Loans on the Companys problem
loan watch list are considered potentially impaired loans. These loans are evaluated in
determining whether all outstanding principal and interest are expected to be collected.
Loans are not considered impaired if a minimal delay occurs and all amounts due, including
accrued interest at the contractual interest rate for the period of delay, are expected to
be collected.

The following table sets forth our
nonperforming assets for the dates indicated.

|Nonperforming Assets           |  |  |   |       |  
|------------------------------ |  |  | - | ----- | -
|
|
|
|Nonaccrual loans               |  |  | $ | 2,044 |  
|Restricted or impaired loans   |  |  |   | -     |  
|                               |  |  |   |       |  
|Total nonperforming loans      |  |  |   | 2,044 |  
|Other real estate owned        |  |  |   | 485   |  
|                               |  |  |   |       |  
|Total nonperforming assets     |  |  | $ | 2,529 |  
|                               |  |  |   |       |  
|Loans 90 days or more past due |  |  |   |       |  
|and still accruing interest    |  |  | $ | 843   |  
|Nonperforming assets to period |  |  |   |       |  
|end loans                      |  |  |   | 1.08  | %

19

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

LOAN PORTFOLIO continued

For loans to be in excess of 90 days delinquent and
still accruing interest, the borrowers must be either remitting payments although not able
to get current, liquidation on loans deemed to be well secured must be near completion, or
the Company must have a reason to believe that correction of the delinquency status by the
borrower is near. The amount of both nonaccrual loans and loans past due 90 days or more
were considered in computing the allowance for loan losses as of December 31, 2005.

# 

|Summary of Loan Loss Experience |  |  |   |         |  
|------------------------------- |  |  | - | ------- | -
|
|Total loans outstanding at      |  |  |   |         |  
|end of period                   |  |  | $ | 235,669 |  
|                                |  |  |   |         |  
|Average loans outstanding       |  |  | $ | 226,528 |  
|                                |  |  |   |         |  
|Balance of allowance for loan   |  | 
|losses at beginning of period   |  |  | $ | 2,155   |  
|                                |  |  |   |         |  
|Charge-offs:                    |  |  |   |         |  
|Real estate                     |  |  |   | 122     |  
|Commercial                      |  |  |   | 382     |  
|Consumer and credit card        |  |  |   | 287     |  
|                                |  |  |   |         |  
|Total charge-offs               |  |  |   | 791     |  
|                                |  |  |   |         |  
|Recoveries of loans previous    |  |  |   |         |  
|charged-off                     |  |  |   | 135     |  
|                                |  |  |   |         |  
|Net charge-offs                 |  |  |   | 656     |  
|                                |  |  |   |         |  
|Provision charged to operations |  |  |   | 1,070   |  
|                                |  |  |   |         |  
|Balance of allowance for loan   |  |  |   |         |  
|losses at end of period         |  |  | $ | 2,569   |  
|                                |  |  |   |         |  
|Ratios:                         |  |  |   |         |  
|Net charge-offs to average      |  |  |   |         |  
|loans outstanding               |  |  |   | 0.29    | %
|Net charge-offs to loans at     |  |  |   |         |  
|end of year                     |  |  |   | 0.28    | %
|Allowance for loan losses to    |  |  |   |         |  
|average loans                   |  |  |   | 1.13    | %
|Allowance for loan losses to    |  |  |   |         |  
|loans at end of year            |  |  |   | 1.09    | %
|Net charge-offs to allowance    |  |  |   |         |  
|for loan losses                 |  |  |   | 25.54   | %
|Net charge-offs to provisions   |  |  |   |         |  
|for loan losses                 |  |  |   | 61.31   | %

20

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

LOAN PORTFOLIO continued

Management has established an
allowance for loan losses through a provision for loan losses charged to expense. The
allowance represents an amount which management believes will be adequate to absorb
probable losses on existing loans that may become uncollectible. Management does not
allocate specific percentages of our allowance for loan losses to the various categories
of loans but evaluates the adequacy on an overall portfolio basis utilizing several
factors. The primary factor considered is the credit risk grading system, which is applied
to each loan. The amount of both nonaccrual loans and loans past due 90 days or more is
also considered. The historical loan loss experience, the size of our lending portfolio,
and current and anticipated economic conditions is also considered in determining the
provision for loan losses. The amount of the allowance is adjusted periodically based on
changing circumstances. Recognized losses are charged to the allowance for loan losses,
while subsequent recoveries are added to the allowance.

Management regularly monitors past
due and classified loans. However, it should be noted that no assurances can be made that
future charges to the allowance for loan losses or provisions for loan losses may not be
significant to a particular accounting period. At December 31, 2005 and 2004, management
considers the allowances for loan losses adequate based on its judgments, evaluations, and
analysis of the loan portfolio.

Managements judgment as to the
adequacy of the allowance is based upon a number of assumptions about future events which
it believes to be reasonable, but which may or may not prove to be accurate. Because of
the inherent uncertainty of assumptions made during the evaluation process, there can be
no assurance that loan losses in future periods will not exceed the allowance for loan
losses or that additional allocations will not be required. Our losses will undoubtedly
vary from our estimates, and there is a possibility that charge-offs in future periods
will exceed the allowance for loan losses as estimated at any point in time.

# AVERAGE DAILY DEPOSITS

The following table summarizes the
Companys average daily deposits during the years ended December 31, 2005, 2004, and
2003. These totals include time deposits $100,000 and over, which at December 31, 2005
totaled $48,424,000. Of this total, scheduled maturities within three months were
$12,645,000; over three through six months were $19,554,000; over six through twelve
months were $13,328,000; and over twelve months were $2,897,000.

|                                      | 2005 | 2004 | 2003
|------------------------------------- | ---- | ---- | ----
|
|
|
|
|Noninterest-bearing demand            |      |      | $   
|Interest-bearing transaction accounts |      |      |     
|Money market savings account          |      |      |     
|Other savings accounts                |      |      |     
|Time deposits                         |      |      |     
|                                      |      |      |     
|Total deposits                        |      |      | $   
|                                      |      |      |     

21

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# ADVANCES FROM THE
FEDERAL HOME LOAN BANK

The following table summarizes the
Companys short-term borrowings for the years ended December 31, 2005, 2004 and 2003.

|                                     | Maximum |  | Weighted |       
|------------------------------------ | ------- |  | -------- | ------
|
|
|
|2005                                 |         |  |          |       
|Advances from Federal Home Loan Bank |         |  | $        | 43,390
|                                     |         |  |          |       
|2004                                 |         |  |          |       
|Advances from Federal Home Loan Bank |         |  | $        | 43,390
|                                     |         |  |          |       
|2003                                 |         |  |          |       
|Advances from Federal Home Loan Bank |         |  | $        | 36,690

Advances from the Federal Home Loan
Bank are collateralized by one-to-four family residential mortgage loans, certain
commercial real estate loans and the Companys investment in Federal Home Loan Bank
stock. Although we expect to continue using Federal Home Loan Bank advances as a secondary
funding source, core deposits will continue to be our primary funding source. Of the
$43,390,000 advances from Federal Home Loan Bank outstanding at December 31, 2005,
$6,700,000 have scheduled principal reductions in 2008 and the remaining balance matures
after five years.

As discussed in the notes to the
financial statements, the Company has entered into interest rate swap agreements
associated with Federal Home Loan Bank advances maturing on March 1, 2010, May 24, 2010
and March 22, 2011. The interest rate swaps effectively converted the fixed interest rates
on the advances to a variable rate. The variable rate was 4.50% at December 31, 2005and is based on the three month LIBOR index.

# JUNIOR SUBORDINATED
DEBENTURES

On December 17, 2005, HCSB Financial
Trust I (the  Trust), a non-consolidated subsidiary of the Company, issued and
sold a total of 6,000 trust preferred securities, with $1,000 liquidation amount per
capital security (the Capital Securities), to institutional buyers in a pooled
trust preferred issue. The Capital Securities, which are reported on the consolidated
balance sheet as junior subordinated debentures, generated proceeds of $6 million. The
Trust loaned these proceeds to the Company to use for general corporate purposes. The
junior subordinated debentures qualify as Tier 1 capital under Federal Reserve Board
guidelines, subject to limitations. See Note 10 to the consolidated financial statements
for more information about the terms of the junior subordinated debentures.

Debt issuance costs, net of
accumulated amortization, from junior subordinated debentures totaled $106,028 and
$109,695 at December 31, 2005, and December 31, 2004, respectively, and are included in
other assets on the consolidated balance sheet. Amortization of debt issuance costs from
junior subordinated debentures totaled $3,667 and $305 for the years ended December 31,
2005 and December 31, 2004, respectively, and are reported in other expenses on the
consolidated income statement for the years ended December 31, 2005 and December 31, 2004.

# RETURN ON EQUITY AND
ASSETS

The following table shows the return
on average assets (net income divided by average total assets), return on average equity
(net income divided by average daily equity), and equity to assets ratio (average daily
equity divided by average total assets) for the period indicated. Since its inception, the
Company has not paid cash dividends.

|                         | 2005 | 2004 | 2003
|------------------------ | ---- | ---- | ----
|
|Return on average assets |      |      |     
|Return on average equity |      |      |     
|Equity to assets ratio   |      |      |     

22

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Managements
Discussion and Analysis ofFinancial Condition and Results of Operations

# ACCOUNTING AND
FINANCIAL REPORTING ISSUES

We have adopted various accounting
policies which govern the application of accounting principles generally accepted in the
United States in the preparation of our financial statements. Our significant accounting
policies are described in the footnotes to the consolidated financial statements at
December 31, 2005, as filed on our annual report on Form 10-KSB. Certain accounting
policies involve significant judgments and assumptions by us which have a material impact
on the carrying value of certain assets and liabilities. We consider these accounting
policies to be critical accounting policies. The judgments and assumptions we use are
based on historical experience and other factors, which we believe to be reasonable under
the circumstances. Because of the nature of the judgments and assumptions we make, actual
results could differ from these judgments and estimates which could have a material impact
on our carrying values of assets and liabilities and our results of operations.

We believe the allowance for loan
losses is a critical accounting policy that requires the most significant judgments and
estimates used in preparation of our consolidated financial statements. Refer to the
portion of this discussion that addresses our allowance for loan losses for a description
of our processes and methodology for determining our allowance for loan losses.

# INDUSTRY DEVELOPMENTS

# Sarbanes-Oxley Act of
2002

The Congress of the United States of
America passed the Sarbanes-Oxley Act in 2002 in the aftermath of corporate scandals among
several major publicly traded corporations. The intent of the Act was to legislate
corporate governance and better ascertain the accuracy of financial reporting by companies
regulated by the Securities and Exchange Commission.

Section 404 of the Sarbanes-Oxley
Act, which becomes effective for the Company in 2007, requires that the Company adopt and
maintain effective internal controls that will, among other things, permit the preparation
of financial statements in conformity with accounting principles generally accepted in the
United States of America. Management of the Company has the responsibility to adopt sound
accounting policies, maintain an adequate and efficient accounting system, safeguard
assets and devise policies to ensure that the Company complies with applicable laws and
regulations.

To assist in this process the company
has purchased software from the national accounting firm of Crowe Chizek and retained the
services of Elliott Davis, LLC and Crowe Chizek to work with management and participate in
the Section 404 process. Elliott Davis, LLC will perform only those services in this
regard that are acceptable by the Public Company Accounting Oversight Board (PCAOB).
Compliance with Section 404 of the Sarbanes-Oxley Act will certainly add to the
Companys operating expenses due to requirements for additional technology, record
keeping, and professional assistance that is necessary.

From time to time, various bills are
introduced in the United States Congress with respect to the regulation of financial
institutions. Certain of these proposals, if adopted, could significantly change the
regulation of banks and the financial services industry. The Company cannot predict
whether any of these proposals will be adopted or, if adopted, how these proposals would
affect the Company.

23

---

# REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM

The Board of DirectorsHCSB
Financial Corporation and SubsidiaryLoris, South Carolina

We have audited the accompanying
consolidated balance sheets of HCSB Financial Corporation and its subsidiary as of
December 31, 2005 and 2004, and the related consolidated statements of income, changes in
shareholders equity and comprehensive income, and cash flows for the years then
ended. These consolidated financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audits to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
the significant estimates made by management as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial
statements present fairly, in all material respects, the consolidated financial position
of HCSB Financial Corporation and its subsidiary as of December 31, 2005 and 2004, and the
consolidated results of their operations and their cash flows for the years then ended, in
conformity with accounting principles generally accepted in the United States of America.

/s/ Elliott Davis, LLCElliott Davis, LLCColumbia,
South Carolina

January 27, 2006

24

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Consolidated Balance
Sheets

|                                                             | December 31,
|------------------------------------------------------------ | ------------
|
|Assets:                                                      |             
|Cash and cash equivalents:                                   |             
|Cash and due from banks                                      |             
|Federal funds sold                                           |             
|Time deposits with other banks                               |             
|                                                             |             
|Total cash and cash equivalents                              |             
|                                                             |             
|Investment securities:                                       |             
|Securities available-for-sale                                |             
|Nonmarketable equity securities                              |             
|                                                             |             
|Total investment securities                                  |             
|                                                             |             
|Loans held for sale                                          |             
|                                                             |             
|Loans receivable                                             |             
|Less allowance for loan losses                               |             
|                                                             |             
|Loans, net                                                   |             
|                                                             |             
|Premises, furniture, and equipment, net                      |             
|Accrued interest receivable                                  |             
|Other assets                                                 |             
|                                                             |             
|Total assets                                                 |             
|                                                             |             
|Liabilities:                                                 |             
|Deposits:                                                    |             
|Noninterest-bearing transaction accounts                     |             
|Interest-bearing transaction accounts                        |             
|Money market savings accounts                                |             
|Other savings accounts                                       |             
|Time deposits $100 and over                                  |             
|Other time deposits                                          |             
|                                                             |             
|Total deposits                                               |             
|Advances from the Federal Home Loan Bank                     |             
|Junior subordinated debentures                               |             
|Accrued interest payable                                     |             
|Other liabilities                                            |             
|                                                             |             
|Total liabilities                                            |             
|                                                             |             
|Commitments and Contingencies (Notes 4, 11 and 12)           |             
|                                                             |             
|Shareholders Equity:                                        |             
|Common stock, $0.01 par value, 10,000,000 shares authorized; |             
|1,788,201 and 1,725,261 shares issued and outstanding        |             
|in 2005 and 2004, respectively                               |             
|Capital surplus                                              |             
|Nonvested restricted stock                                   |             
|Retained earnings                                            |             
|Accumulated other comprehensive loss                         |             
|                                                             |             
|Total shareholders' equity                                   |             
|                                                             |             
|Total liabilities and shareholders' equity                   |             
|                                                             |             

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

25

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Consolidated
Statements of Income

|                                                    | Years ended December 31,
|--------------------------------------------------- | ------------------------
|
|Interest income:                                    |                         
|Loans, including fees                               |                         
|Investment securities:                              |                         
|Taxable                                             |                         
|Tax-exempt                                          |                         
|Nonmarketable equity securities                     |                         
|Federal funds sold and other                        |                         
|                                                    |                         
|Total                                               |                         
|                                                    |                         
|Interest expense:                                   |                         
|Deposits                                            |                         
|Borrowings                                          |                         
|                                                    |                         
|Total                                               |                         
|                                                    |                         
|Net interest income                                 |                         
|                                                    |                         
|Provision for loan losses                           |                         
|                                                    |                         
|Net interest income after provision for loan losses |                         
|                                                    |                         
|Noninterest income:                                 |                         
|Service charges on deposit accounts                 |                         
|Credit life insurance commissions                   |                         
|Gain on sale of residential mortgage loans          |                         
|Brokerage commissions                               |                         
|Other fees and commissions                          |                         
|Gains (losses) on sales of securities               |                         
|Other                                               |                         
|                                                    |                         
|Total                                               |                         
|                                                    |                         
|Noninterest expenses:                               |                         
|Salaries and employee benefits                      |                         
|Net occupancy                                       |                         
|Marketing and advertising                           |                         
|Loss on sale of assets                              |                         
|Furniture and equipment                             |                         
|Other operating                                     |                         
|                                                    |                         
|Total                                               |                         
|                                                    |                         
|Income before income taxes                          |                         
|Income tax provision                                |                         
|                                                    |                         
|Net income                                          |                         
|                                                    |                         
|Net income per common share                         |                         
|Basic                                               |                         
|                                                    |                         
|Diluted                                             |                         
|                                                    |                         
|Average common shares outstanding                   |                         
|Basic                                               |                         
|                                                    |                         
|Diluted                                             |                         
|                                                    |                         

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

26

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

Consolidated
Statements of Changes in Shareholders Equity and Comprehensive Income (Loss)Years
ended December 31, 2005 and 2004

|                               |  |  |  |           |   | Accumulated |   
|------------------------------ |  |  |  | --------- | - | ----------- | --
|
|
|
|
|
|
|Balance,                       |  |  |  |           |   |             |   
|December 31, 2003              |  |  |  | 1,662,473 |   | $           | 16
|                               |  |  |  |           |   |             |   
|Net income                     |  |  |  |           |   |             |   
|Other comprehensive            |  |  |  |           |   |             |   
|income, (loss) net of          |  |  |  |           |   |             |   
|tax benefit of $48             |  |  |  |           |   |             |   
|                               |  |  |  |           |   |             |   
|Comprehensive income           |  |  |  |           |   |             |   
|Payment for fractional shares  |  |  |  |           |   |             |   
|Issuance of restricted stock   |  |  |  | 14,484    |   |             |   
|Forfeiture of restricted stock |  |  |  | (1,946    | ) |             |   
|Declaration of 3.0%            |  |  |  |           |   |             |   
|stock dividend on              |  |  |  |           |   |             |   
|January 26, 2005               |  |  |  | 50,250    |   |             | 1 
|                               |  |  |  |           |   |             |   
|Balance,                       |  |  |  |           |   |             |   
|December 31, 2004              |  |  |  | 1,725,261 |   |             | 17
|Net income                     |  |  |  |           |   |             |   
|Other comprehensive            |  |  |  |           |   |             |   
|income, (loss) net of          |  |  |  |           |   |             |   
|tax benefit of $316            |  |  |  |           |   |             |   
|                               |  |  |  |           |   |             |   
|Comprehensive income           |  |  |  |           |   |             |   
|Payment for fractional shares  |  |  |  | (1,081    | ) |             |   
|Issuance of restricted stock   |  |  |  | 11,470    |   |             |   
|Exercise of stock options      |  |  |  | 468       |   |             |   
|Declaration of 3.0%            |  |  |  |           |   |             |   
|stock dividend on              |  |  |  |           |   |             |   
|January 26, 2006               |  |  |  | 52,083    |   |             | 1 
|                               |  |  |  |           |   |             |   
|Balance,                       |  |  |  |           |   |             |   
|December 31, 2005              |  |  |  | 1,788,201 |   | $           | 18
|                               |  |  |  |           |   |             |   

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

27

---

# Consolidated
Statements of Cash Flows

|(Dollars in thousands)                                   | Years ended December 31,
|-------------------------------------------------------- | ------------------------
|
|Cash flows from operating activities:                    |                         
|Net income                                               |                         
|Adjustments to reconcile net income to                   |                         
|net cash provided by operating activities:               |                         
|Provision for loan losses                                |                         
|Deferred income tax benefit                              |                         
|Depreciation expense                                     |                         
|Premium amortization less discount accretion             |                         
|Amortization of net deferred loan costs                  |                         
|Net gain on sale of securities available-for-sale        |                         
|Loss on sale of other real estate owned                  |                         
|Gain on disposal of premises and equipment               |                         
|Increase in interest receivable                          |                         
|Increase in interest payable                             |                         
|Increase in other assets                                 |                         
|Increase (decrease) in other liabilities                 |                         
|                                                         |                         
|Net cash provided by operating activities                |                         
|                                                         |                         
|Cash flows from investing activities:                    |                         
|Purchases of securities available-for-sale               |                         
|Maturities of securities available-for-sale              |                         
|Proceeds from sales of securities available-for-sale     |                         
|Net increase in loans to customers                       |                         
|Purchase of premises, furniture and equipment            |                         
|Proceeds from sale of premises, furniture and equipment  |                         
|Proceeds from sale of other real estate owned            |                         
|Purchase of nonmarketable equity securities              |                         
|                                                         |                         
|Net cash used by investing activities                    |                         
|                                                         |                         
|Cash flows from financing activities:                    |                         
|Net increase in demand deposits, interest-bearing        |                         
|transaction accounts and savings accounts                |                         
|Net increase (decrease) in time deposits                 |                         
|Net increase in advances from the Federal Home Loan Bank |                         
|Proceeds from stock issuance                             |                         
|Cash paid for fractional shares                          |                         
|Proceeds from junior subordinated debentures             |                         
|                                                         |                         
|Net cash provided by financing activities                |                         
|                                                         |                         
|Net increase (decrease) in cash and cash equivalents     |                         
|                                                         |                         
|Cash and cash equivalents, beginning of year             |                         
|                                                         |                         
|Cash and cash equivalents, end of year                   |                         
|                                                         |                         

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

28

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 1 
ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and
Consolidation  The accompanying consolidated financial statements
include the accounts of HCSB Financial Corporation (the Company) and its wholly owned
subsidiary, Horry County State Bank (the Bank), and all of the stock of HCSB Financial
Trust I (the Trust). The Company was incorporated on June 10, 1999. The Bank was
incorporated on December 18, 1987, and opened for operations on January 4, 1988. The
principal business activity of the Company is to provide commercial banking services in
Horry County, South Carolina, and in Columbus and Brunswick Counties, North Carolina. The
Bank is a state-chartered bank, and its deposits are insured by the Federal Deposit
Insurance Corporation. The Trust is a special purpose subsidiary organized for the sole
purpose of issuing trust preferred securities. The operations of the Trust have not been
consolidated in these financial statements.

Managements
Estimates  In preparing the consolidated financial statements,
management is required to make estimates and assumptions that affect the reported amounts
of assets and liabilities as of the balance sheet date and income and expenses for the
period. Actual results could differ significantly from those estimates.

Material estimates that are
particularly susceptible to significant change relate to the determination of the
allowance for loan losses, including valuation allowances for impaired loans, and the
carrying amount of real estate acquired in connection with foreclosures or in satisfaction
of loans. Management must also make estimates in determining the estimated useful lives
and methods for depreciating premises and equipment.

While management uses available
information to recognize losses on loans and foreclosed real estate, future additions to
the allowance may be necessary based on changes in local economic conditions. In addition,
regulatory agencies, as an integral part of their examination process, periodically review
the Companys allowances for losses on loans and foreclosed real estate. Such
agencies may require the Company to recognize additions to the allowances based on their
judgments about information available to them at the time of their examination. Because of
these factors, it is reasonably possible that the allowances for losses on loans and
foreclosed real estate may change materially in the near term.

Investment
Securities  Investment securities available-for-sale by the Company
are carried at amortized cost and adjusted to their estimated fair value. The unrealized
gain or loss is recorded in shareholders equity net of the deferred tax effects.
Management does not actively trade securities classified as available-for-sale, but
intends to hold these securities for an indefinite period of time and may sell them prior
to maturity to achieve certain objectives. Reductions in fair value considered by
management to be other than temporary are reported as a realized loss and a reduction in
the cost basis in the security. The adjusted cost basis of securities available-for-sale
is determined by specific identification and is used in computing the realized gain or
loss from a sales transaction.

Nonmarketable Equity
Securities  Nonmarketable equity securities include the
Companys investments in the stock of the Federal Home Loan Bank and Community
Financial Services. The stocks are carried at cost because they have no quoted market
value and no ready market exists. Investment in Federal Home Loan Bank stock is a
condition of borrowing from the Federal Home Loan Bank, and the stock is pledged to
collateralize the borrowings. Dividends received on Federal Home Loan Bank stock and
Community Financial Services stock are included as a separate component in interest
income.

At December 31, 2005 and 2004, the
investment in Federal Home Loan Bank stock was $2,544,000 and $2,492,000, respectively,
and the investment in Community Financial Services stock was $112,000 and $60,000,
respectively. The Company also had a $25,000 investment in the holding company of a
community bank at December 31, 2005 and 2004. Also included in nonmarketable equities is
investment in the Trust, which totaled $186,000 at December 31, 2005 and 2004.

29

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 1  ORGANIZATION AND
SIGNIFICANT ACCOUNTING POLICIES  continued

Loans Held for
Sale  Loans held for sale consist of residential mortgage loans the
Company originates for sale to secondary market investors. They are carried at the lower
of aggregate cost or market value. Net unrealized losses, if any, are recognized through a
valuation allowance by charges to income. Fees collected in conjunction with origination
activities are deferred as part of the cost basis of the loan and recognized when the loan
is sold. Gains or losses on sales are recognized when the loans are sold and are
determined as the difference between the sales price and the carrying value of the loans.

The Company issues rate lock
commitments to borrowers based on prices quoted by secondary market investors. When rates
are locked with borrowers, a sales commitment is immediately entered (on a best efforts
basis) at a specified price with a secondary market investor. Accordingly, any potential
liabilities associated with rate lock commitments are offset by sales commitments to
investors.

Loans Receivable
 Loans receivable are stated at their unpaid principal balance. Interest income on
loans is computed based upon the unpaid principal balance. Interest income is recorded in
the period earned.

The accrual of interest income is
generally discontinued when a loan becomes contractually 90 days past due as to principal
or interest. Management may elect to continue the accrual of interest when the estimated
net realizable value of collateral exceeds the principal balance and accrued interest.

Loan origination and commitment fees
and certain direct loan origination costs (principally salaries and employee benefits) are
deferred and amortized to income over the contractual life of the related loans or
commitments, adjusted for prepayments, using the straight-line method.

Under Statement of Financial
Accounting Standards (SFAS) No. 114, Accounting by Creditors for the Impairment of a
Loan,and SFAS No. 118, Accounting by Creditors for Impairment of a Loan 
Income Recognition and Disclosures,loans are defined as impaired when it is probable
that a creditor will be unable to collect all amounts due according to the contractual
terms of the loan agreement. All loans are subject to this criteria except for
smaller balance homogeneous loans that are collectively evaluated for
impairment and loans measured at fair value or at the lower of cost or fair
value. The Company considers its consumer installment portfolio, credit card loans,
and home equity lines as such exceptions. Therefore, the real estate and commercial loan
portfolios are primarily affected by these statements.

Impairment of a loan is measured
based on the present value of expected future cash flows discounted at the loans
effective interest rate or the fair value of the collateral if the loan is collateral
dependent. When management determines that a loan is impaired, the difference between the
Companys investment in the related loan and the present value of the expected future
cash flows, or the fair value of the collateral, is charged to bad debt expense with a
corresponding entry to the allowance for loan losses. The accrual of interest is
discontinued on an impaired loan when management determines the borrower may be unable to
meet payments as they become due. As discussed in Note 4, impaired loans closely
approximated nonaccrual loans at December 31, 2005, and 2004.

Concentrations of Credit
Risk  Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist principally of loans receivable, investment
securities, federal funds sold and amounts due from banks.

The Company makes loans to
individuals and small businesses for various personal and commercial purposes primarily
throughout Horry county in South Carolina and Columbus and Brunswick counties of North
Carolina. The Companys loan portfolio is not concentrated in loans to any single
borrower or a relatively small number of borrowers. Additionally, management is not aware
of any concentrations of loans to classes of borrowers or industries that would be
similarly affected by economic conditions except for loans secured by residential and
commercial real estate and commercial and industrial non-real estate loans. Theses
concentrations of residential and commercial real estate loans and commercial and
industrial non-real estate loans totaled $133,527,000 and $55,909,000, respectively, at
December 31, 2005, representing 528% and 221%, respectively, of total equity and 57% and
24%, respectively, of net loans receivable.

30

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 1  ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES  continued

Concentrations of Credit
Risk (continued)  In addition to monitoring potential
concentrations of loans to particular borrowers or groups of borrowers, industries and
geographic regions, management monitors exposure to credit risk from concentrations of
lending products and practices such as loans that subject borrowers to substantial payment
increases (e.g. principal deferral periods, loans with initial interest-only periods,
etc.), and loans with high loan-to-value ratios. Management has determined that there is
no concentration of credit risk associated with its lending policies or practices.
Additionally, there are industry practices that could subject the Company to increased
credit risk should economic conditions change over the course of a loans life. For
example, the Company makes variable rate loans and fixed rate principal-amortizing loans
with maturities prior to the loan being fully paid (i.e. balloon payment loans). These
loans are underwritten and monitored to manage the associated risks. Therefore, management
believes that these particular practices do not subject the Company to unusual credit
risk.

The Companys investment
portfolio consists principally of obligations of the United States, its agencies or its
corporations and general obligation municipal securities. In the opinion of management,
there is no concentration of credit risk in its investment portfolio. The Company places
its deposits and correspondent accounts with and sells its federal funds to high quality
institutions. Management believes credit risk associated with correspondent accounts is
not significant.

Allowance for Loan
Losses  An allowance for loan losses is maintained at a level deemed
appropriate by management to provide adequately for known and inherent risks in the loan
portfolio. The allowance is based upon a continuing review of past loan loss experience,
current economic conditions which may affect the borrowers ability to pay, and the
underlying collateral value of the loans. Loans deemed uncollectible are charged off and
deducted from the allowance. The provision for loan losses, including provisions for loan
impairment, and recoveries on loans previously charged off, are added to the allowance.

Premises, Furniture and
Equipment  Premises, furniture and equipment are stated at cost less
accumulated depreciation. The provision for depreciation is computed by the straight-line
method. Rates of depreciation are generally based on the following estimated useful lives:
buildings  40 years; furniture and equipment  3 to 25 years. The cost of
assets sold or otherwise disposed of and the related accumulated depreciation is
eliminated from the accounts, and the resulting gains or losses are reflected in the
income statement.

Maintenance and repairs are charged
to current expense as incurred, and the costs of major renewals and improvements are
capitalized.

Other Real Estate
Owned  Other real estate owned includes real estate acquired through
foreclosure. Other real estate owned is initially recorded at the lower of cost (principal
balance of the former loan plus costs of improvements) or fair value, less estimated costs
to sell.

Any write-downs at the dates of
acquisition are charged to the allowance for loan losses. Expenses to maintain such
assets, subsequent write-downs, and gains and losses on disposal are included in other
expenses.

Derivative Financial
Instruments  The Company has entered into certain interest rate swap
agreements which are derivative financial instruments (derivatives). The
derivatives are recognized as other assets on the balance sheet at their fair value. On
the date the derivative contract is entered into, the Company designates the derivative as
a hedge of fair value of a recognized asset or liability (fair value hedge).
Changes in the fair value of a derivative that is highly effective as  and that is
designated and qualifies  as a fair value hedge, along with the loss or gain on the
hedged asset or liability that is attributable to the hedged risk, are recorded in
current-period earnings.

31

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 1  ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES  continued

Derivative Financial
Instruments (continued)  The Company formally documents all
relationships between hedging instruments and hedged items, as well as its risk-management
objective and strategy for undertaking hedged transactions. This process includes linking
all derivatives that are designated as fair value hedges to specific assets and
liabilities on the balance sheet. The derivatives in which the Company is a counterparty
qualify for the shortcut method of assessing the ongoing effectiveness of its
hedging relationship with the underlying hedged item.

The Company discontinues hedge
accounting prospectively when (1) the derivative expires or is sold, terminated, or
exercised; (2) management determines that designation of the derivative as a hedge
instrument is no longer appropriate; or (3) the underlying hedged item is liquidated. When
hedge accounting is discontinued, the derivative is carried at its fair value on the
balance sheet, with changes in its fair value recognized in current-period earnings.

Income and Expense
Recognition  The accrual method of accounting is used for all
significant categories of income and expense. Immaterial amounts of insurance commissions
and other miscellaneous fees are reported when received.

Income Taxes
 Amounts provided for income taxes are based on income reported for financial
statement purposes. Deferred income taxes are provided for the temporary differences
between the financial reporting basis and the tax basis of the Companys assets and
liabilities. Deferred tax assets are reduced by a valuation allowance when, in the opinion
of management, it is more likely than not that some portion or all of the deferred tax
assets will not be realized. Management has determined that it is more likely than not
that the entire deferred tax asset at December 31, 2005, will be realized, and
accordingly, has not established a valuation allowance. Deferred tax assets and
liabilities are adjusted for the effects of changes in tax laws and rates on the date of
enactment.

Advertising
Expense  Advertising and public relations costs are generally
expensed as incurred. External costs incurred in producing media advertising are expensed
the first time the advertising takes place. External costs relating to direct mailing
costs are expensed in the period in which the direct mailings are sent. Advertising and
public relations costs of $235,000 and $270,000 were included in the Companys
results of operations for 2005 and 2004, respectively.

Net Income Per
Share  Basic income per share is calculated by dividing net income by
the weighted-average number of shares outstanding during the year. Diluted net income per
share is computed based on net income divided by the weighted average number of common and
potential common shares. Retroactive recognition has been given for the effects of all
stock dividends in computing the weighted-average number of shares. The only potential
common share equivalents are those related to stock options and restricted stock awards.
Stock options which are anti-dilutive are excluded from the calculation of diluted net
income per share.

Stock-Based
Compensation  The Company adopted a stock-based employee compensation
plan in 2004 which is further described in Note 17. The Company accounts for the plan
under the recognition and measurement principles of Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees, and
related Interpretations. No stock-based employee compensation cost is reflected in net
income, as all stock options granted under these plans had an exercise price equal to the
market value of the underlying common stock on the date of the grant. The following table
illustrates the effect on net income and earnings per share as if the Company had applied
the fair value recognition provisions of Financial Accounting Standards Board
(FASB) Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation, to stock-based employee compensation.

32

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 1  ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES  continued

# Stock-Based Compensation
(continued)

|                                                  | Years ended
|------------------------------------------------- | -----------
|
|
|
|Net income, as reported                           |            
|Deduct: Total stock-based employee compensation   |            
|expense determined under fair value based         |            
|method for all awards, net of related tax effects |            
|                                                  |            
|Pro forma net income                              |            
|                                                  |            
|Earnings per share:                               |            
|Basic - as reported                               |            
|                                                  |            
|Basic - pro forma                                 |            
|                                                  |            
|Diluted - as reported                             |            
|                                                  |            
|Diluted - pro forma                               |            
|                                                  |            

In calculating the pro forma
disclosures, the fair value of options granted is estimated as of the date granted using
the Black-Scholes option pricing model with the following weighted-average assumptions
used for grants in 2005: dividend yield of 0 percent; expected volatility of 63.41
percent; risk-free interest rate of 3.08 percent; and expected life of 7 years.

In calculating the pro forma
disclosures, the fair value of options granted is estimated as of the date granted using
the Black-Scholes option pricing model with the following weighted-average assumptions
used for grants in 2004: dividend yield of 0 percent; expected volatility of 55.57
percent; risk-free interest rate of 2.15 percent; and expected life of 7 years.

Comprehensive
Income  Accounting principles generally require recognized income,
expenses, gains, and losses to be included in net income. Although certain changes in
assets and liabilities, such as unrealized gains and losses on available-for-sale
securities, are reported as a separate component of the equity section of the balance
sheet, such items, along with net income, are components of comprehensive income.

The components of other comprehensive
income and related tax effects are as follows:

|                                        | Years ended December 31,
|--------------------------------------- | ------------------------
|
|Unrealized losses on                    |                         
|securities available-for-sale           |                         
|Reclassification adjustment for (gains) |                         
|losses realized in net income           |                         
|                                        |                         
|Net unrealized losses on securities     |                         
|                                        |                         
|Tax effect                              |                         
|                                        |                         
|Net-of-tax amount                       |                         
|                                        |                         

33

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 1  ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES  continued

Statements of Cash Flows For purposes of reporting cash flows, the Company considers certain highly
liquid debt instruments purchased with a maturity of three months or less to be cash
equivalents. Cash equivalents include amounts due from banks, federal funds sold, and time
deposits with other banks with maturities of three months or less.

The following summarizes supplemental
cash flow information:

|                                                         | Years ended December 31,
|-------------------------------------------------------- | ------------------------
|
|
|Cash paid for interest                                   |                         
|Cash paid for income taxes                               |                         
|Supplemental noncash investing and financing activities: |                         
|Foreclosures on loans                                    |                         

Off-Balance-Sheet Financial Instruments
 In the ordinary course of business, the Company enters into off-balance-sheet
financial instruments consisting of commitments to extend credit and letters of credit.
These financial instruments are recorded in the financial statements when they become
payable by the customer.

Recent Accounting
Pronouncements  The following is a summary of recent authoritative
pronouncements that affect accounting, reporting, and disclosure of financial information
by the Company:

In December 2004, the FASB issued
SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No.
123(R)). SFAS No. 123(R) will require companies to measure all employee stock-based
compensation awards using a fair value method and record such expense in its financial
statements. In addition, the adoption of SFAS No. 123(R) requires additional accounting
and disclosure related to the income tax and cash flow effects resulting from share-based
payment arrangements.SFAS No. 123(R) is effective beginning as of
the first interim or annual reporting period beginning after December 15, 2005. The
Company anticipates using the modified prospective [retrospective] method when this
statement is adopted in the first quarter of 2006. The Company has evaluated the impact
upon adoption of SFAS No. 123 (R) and has concluded that the adoption will result in
additional charges to earnings of approximately $85,000 in 2006.

In April 2005, the Securities and
Exchange Commissions Office of the Chief Accountant and its Division of Corporation
Finance issued Staff Accounting Bulletin (SAB) No. 107 to provide guidance
regarding the application of SFAS No. 123(R). SAB No. 107 provides interpretive guidance
related to the interaction between SFAS No. 123(R) and certain SEC rules and regulations,
as well as the staffs views regarding the valuation of share-based payment
arrangements for public companies. SAB No. 107 also reminds public companies of the
importance of including disclosures within filings made with the SEC relating to the
accounting for share-based payment transactions, particularly during the transition to
SFAS No. 123(R).

In December 2004, the FASB issued
SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No.
29, Accounting for Nonmonetary Transactions. The amendments made by SFAS No. 153
are based on the principle that exchanges of nonmonetary assets should be measured based
on the fair value of the assets exchanged. Further, the amendments eliminate the narrow
exception for nonmonetary exchanges of similar productive assets and replace it with a
broader exception for exchanges of nonmonetary assets that do not have commercial
substance. Previously, Accounting Principles Board (APB) Opinion No. 29
required that the accounting for an exchange of a productive asset for a similar
productive asset or an equivalent interest in the same or similar productive asset should
be based on the recorded amount of the asset relinquished. APB Opinion No. 29 provided an
exception to its basic measurement principle (fair value) for exchanges of similar
productive assets. SFAS No. 153 is effective for nonmonetary asset exchanges occurring in
fiscal periods beginning after June 15, 2005. Earlier application is permitted for
nonmonetary asset exchanges occurring in fiscal periods beginning after the date of
issuance. The provisions of this statement shall be applied prospectively. The adoption of
this statement is not expected to have a material impact on the financial condition or
operating results of the Company.

34

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 1  ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES  continued

Recent Accounting
Pronouncements(continued)  In May 2005, the FASB issued SFAS No.
154, Accounting Changes and Error Corrections  replacement of APB Opinion No.
20 and FASB Statement No. 3". SFAS No. 154 establishes retrospective application as
the required method for reporting a change in accounting principle, unless it is
impracticable, in which case the changes should be applied to the latest practicable date
presented. SFAS No. 154 also requires that a correction of an error be reported as a prior
period adjustment by restating prior period financial statements. SFAS No. 154 is
effective for accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005.

In March 2004, the FASB issued
Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments. This
issue addresses the meaning of other-than-temporary impairment and its application to
investments classified as either available for sale or held to maturity under SFAS No. 115
and it also provides guidance on quantitative and qualitative disclosures. The disclosure
requirements in paragraph 21 of the Issue were effective for annual financial statements
for fiscal years ending after December 15, 2003 and were adopted by the Company effective
December 31, 2003.

The recognition and measurement
guidance in paragraphs 6-20 of this Issue was to be applied to other-than-temporary
impairment evaluations in reporting periods beginning after June 15, 2004, but was delayed
by FASB action in October 2004 through the issuance of a proposed FASB Staff Position
(FSP) on the issue. In July 2005, the FASB issued FSP FAS 115-1 and FAS 124-1
The Meaning of Other-Than-Temporary Impairment and its Application to Certain
Investments. This final guidance eliminated paragraphs 10-18 of EITF-03-1
(paragraphs 19-20 have no material impact on the financial position or results of
operations of the Company) and will be effective for other-than-temporary impairment
analysis conducted in periods beginning after December 15, 2005. The Company has evaluated
the impact that the adoption of FSP FAS 115-1 and FAS 124-1 and has concluded that the
adoption will not have a material impact on financial position and results of operations
upon adoption.

In December 2005, the FASB issued FSP
SOP 94-6-1, Terms of Loan Products that May Give Rise to a Concentration of Credit
Risk. The disclosure guidance in this FSP is effective for interim and annual
periods ending after December 19, 2005. The FSP states that the terms of certain loan
products may increase a reporting entitys exposure to credit risk and thereby may
result in a concentration of credit risk as that term is used in SFAS No. 107, either as
an individual product type or as a group of products with similar features. SFAS No. 107
requires disclosures about each significant concentration, including information
about the (shared) activity, region, or economic characteristic that identifies the
concentration. The FSP suggests possible shared characteristics on which significant
concentrations may be determined which include, but are not limited to: borrowers subject
to significant payment increases, loans with terms that permit negative amortization and
loans with high loan-to-value ratios.

The FSP requires entities to provide
the disclosures required by SFAS No. 107 for loan products that are determined to
represent a concentration of credit risk in accordance with the guidance of this FSP for
all periods presented. The Company adopted this disclosure standard effective December 31,
2005.

Other accounting standards that have
been issued or proposed by the FASB or other standards-setting bodies that do not require
adoption until a future date are not expected to have a material impact on the
consolidated financial statements upon adoption.

Risks and
Uncertainties  In the normal course of its business, the Company
encounters two significant types of risks: economic and regulatory. There are three main
components of economic risk: interest rate risk, credit risk and market risk. The Company
is subject to interest rate risk to the degree that its interest-bearing liabilities
mature or reprice at different speeds, or on different basis, than its interest-earning
assets. Credit risk is the risk of default on the Companys loan portfolio that
results from borrowers inability or unwillingness to make contractually required
payments. Market risk reflects changes in the value of collateral underlying loans
receivable and the valuation of real estate held by the Company.

35

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 1  ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES  continued

Risks and
Uncertainties (continued)  The Company is subject to the
regulations of various governmental agencies. These regulations can and do change
significantly from period to period. The Company also undergoes periodic examinations by
the regulatory agencies, which may subject it to further changes with respect to asset
valuations, amounts of required loss allowances and operating restrictions from the
regulators judgments based on information available to them at the time of their
examination.

Reclassifications
 Certain captions and amounts in the 2004 financial statements were reclassified to
conform with the 2005 presentation.

# NOTE 2  CASH AND
DUE FROM BANKS

The Bank is required by regulation to
maintain an average cash reserve balance based on a percentage of deposits. At December
31, 2005 and 2004, the requirements were satisfied by amounts on deposit with the Federal
Reserve Bank and cash on hand.

# NOTE 3  INVESTMENT
SECURITIES

Securities available-for-sale
consisted of the following:

|                                           | Amortized | Gross Unrealize | Estimated
|------------------------------------------ | --------- | --------------- | ---------
|
|December 31, 2005                          |           |                 |          
|Securities of U.S. government agencies     |           |                 |          
|and corporations                           |           |                 | $        
|Mortgage-backed securities                 |           |                 |          
|Equity securities                          |           |                 |          
|Obligations of state and local governments |           |                 |          
|                                           |           |                 |          
|Total                                      |           |                 | $        
|                                           |           |                 |          
|December 31, 2004                          |           |                 |          
|Securities of U.S. government agencies     |           |                 |          
|and corporations                           |           |                 | $        
|Mortgage-backed securities                 |           |                 |          
|Equity securities                          |           |                 |          
|Obligations of state and local governments |           |                 |          
|                                           |           |                 |          
|Total                                      |           |                 | $        
|                                           |           |                 |          

36

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 3  INVESTMENT
SECURITIES  continued

The following is a summary of
maturities of securities available-for-sale as of December 31, 2005. The amortized cost
and estimated fair values are based on the contractual maturity dates. Actual maturities
may differ from contractual maturities because borrowers may have the right to call or
prepay obligations with or without penalty.

|                                          | Securities
|----------------------------------------- | ----------
|
|
|
|
|Due in less than one year                 |           
|Due after one year but within five years  |           
|Due after five years but within ten years |           
|Due after ten years                       |           
|                                          |           
|                                          |           
|Mortgage-backed securities                |           
|                                          |           
|Total                                     |           
|                                          |           

The following table shows gross
unrealized losses and fair value, aggregated by investment category, and length of time
that individual securities have been in a continuous unrealized loss position, at December
31, 2005.

# Securities Available for
Sale

|                              | Less than | Twelve months |  
|----------------------------- | --------- | ------------- | -
|
|
|
|Securities of U.S. government |           |               |  
|agencies and corporations     |           |               | $
|Mortgage-backed securities    |           |               |  
|Equity securities             |           |               |  
|Obligations of state and      |           |               |  
|local governments             |           |               |  
|                              |           |               |  
|Total                         |           |               | $
|                              |           |               |  

Management evaluates its investment
portfolio periodically to identify any impairment that is other than temporary. At
December 31, 2005, the Company had thirteen individual securities, or 41.18% of the
security portfolio, that have been in an unrealized loss position for more than twelve
months. Management believes these losses are temporary and are a result of the current
interest rate environment.

At December 31, 2005 and 2004,
investment securities with a book value of $31,064,000 and $27,011,000, respectively, and
a market value of $30,299,000 and $27,014,000, respectively, were pledged as collateral to
secure public deposits.

Gross realized gains on sales of
available-for-sale securities were $22,000 and $103,000 in 2005 and 2004, respectively.
Gross realized losses on available-for-sale securities were $74,000 and $4,000 in 2005 and
2004, respectively. Proceeds from the sale of securities totaled $4,237,000 and $9,282,000
in 2005 and 2004, respectively.

37

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 4  LOANS
RECEIVABLE

Loans consisted of the following:

|                                                | December 31,
|----------------------------------------------- | ------------
|
|
|Real estate - construction and land development |             
|Real estate - mortgage and commercial           |             
|Agricultural                                    |             
|Commercial and industrial                       |             
|Consumer                                        |             
|All other loans (including overdrafts)          |             
|                                                |             
|Total gross loans                               |             
|                                                |             

Certain parties (principally certain directors
and officers of the Company, their immediate families, and business interests) were loan
customers and had other transactions in the normal course of business with the Company.
Related party loans are made on substantially the same terms, including interest rates and
collateral, as those prevailing at the time for comparable transactions with unrelated
persons and do not involve more than normal risk of collectibility. The aggregate dollar
amounts of loans to related parties were $3,719,000 and $4,166,000 at December 31, 2005
and 2004, respectively. During 2005, advances to related parties totaled $208,000 and
repayments totaled $655,000.

Transactions in the allowance for
loan losses are summarized below:

|                                           | Years ended December 31,
|------------------------------------------ | ------------------------
|
|
|Balance, beginning of year                 |                         
|Provision charged to operations            |                         
|Recoveries on loans previously charged off |                         
|Loans charged off                          |                         
|                                           |                         
|Balance, end of year                       |                         
|                                           |                         

Loans on the Companys problem
loan watch list are considered potentially impaired loans. These loans are evaluated in
determining whether all outstanding principal and interest are expected to be collected.
Loans are not considered impaired if a minimal delay occurs and all amounts due, including
accrued interest at the contractual interest rate for the period of the delay, are
expected to be collected.

38

---

NOTE 4  LOANS
RECEIVABLE  continued

As of December 31, 2005 and 2004, the
Company had nonaccrual loans of approximately $2,044,000 and $4,295,000, respectively, and
loans that were contractually past due 90 days or more and still accruing interest of
approximately $843,000 and $378,000, respectively, for which impairment had not been
recognized. The additional interest income, which would have been recognized into earnings
if the Companys nonaccrual loans had been current in accordance with their original
terms, was $274,000 and $492,000 during 2005 and 2004, respectively. At December 31, 2005
and 2004, impaired loans closely approximated nonaccrual loans.

Over half the balance of total
nonaccrual loans as of December 31, 2005 relates to loans to one borrower. These loans are
secured by real estate, and management is working to resolve portions of the collateral.
Management believes the allowance for loan losses related to these loans is adequately
funded at December 31, 2005.

The Company is a party to financial
instruments with off-balance-sheet risk in the normal course of business to meet the
financing needs of its customers. These financial instruments include commitments to
extend credit and standby letters of credit. These instruments involve, to varying
degrees, elements of credit and interest rate risk in excess of the amount recognized in
the balance sheets.

The Companys exposure to credit
loss in the event of nonperformance by the other party to the financial instrument for
commitments to extend credit and standby letters of credit is represented by the
contractual or notional amount of those instruments. The Company uses the same credit
policies in making commitments and conditional obligations as it does for on-balance-sheet
instruments.

Standby letters of credit are
conditional commitments issued by the Company to guarantee the performance of a customer
to a third party. The credit risk involved in issuing letters of credit is essentially the
same as that involved in extending loans to customers. The fair value of standby letters
of credit is insignificant.

Commitments to extend credit are
agreements to lend to a customer as long as there is no violation of any condition
established in the contract. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. Since some of the commitments are
expected to expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements. The Company evaluates each customers
creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed
necessary by the Company upon extension of credit, is based on managements credit
evaluation of the counter-party.

Collateral held for commitments to
extend credit and standby letters of credit varies but may include accounts receivable,
inventory, property, plant, equipment, and income-producing commercial properties. The
following table summarizes the Companys off-balance-sheet financial instruments
whose contract amounts represent credit risk:

|                             | December 31,
|---------------------------- | ------------
|
|
|Commitments to extend credit |             
|Standby letters of credit    |             

39

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 5  PREMISES,
FURNITURE AND EQUIPMENT

Premises, furniture and equipment
consisted of the following:

|                                | December 31,
|------------------------------- | ------------
|
|
|Land                            |             
|Buildings and land improvements |             
|Furniture and equipment         |             
|Leasehold improvements          |             
|Construction in progress        |             
|                                |             
|                                |             
|Less accumulated depreciation   |             
|                                |             
|Premises and equipment, net     |             
|                                |             

Depreciation expense for the years
ended December 31, 2005 and 2004 was $619,000 and $485,000, respectively.

The Company had no capitalization of
interest during construction in 2005 compared to $55,000 in 2004.

# NOTE 6  OTHER ASSETS

Other assets consisted of the
following:

|                               | December 31,
|------------------------------ | ------------
|
|
|Cash value of life insurance   |             
|Other real estate owned        |             
|Prepaid expenses and insurance |             
|Unamortized software           |             
|Net deferred tax asset         |             
|Other                          |             
|                               |             
|Total                          |             
|                               |             

# NOTE 7  DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES

The Company maintains an overall
interest-rate risk-management strategy that incorporates the use of derivatives to
minimize significant unplanned fluctuations in earnings that are caused by interest-rate
volatility. As part of this strategy, the Company entered certain interest rate swap
agreements during 2003. Such interest rate swaps are derivative financial instruments
(derivatives). Interest rate swaps generally involve the exchange of fixed and
variable rate interest payments between two parties, based on a common notional amount and
maturity date. The Companys goal is to manage interest-rate sensitivity by modifying
the repricing or maturity characteristics of specific balance-sheet assets and liabilities
so that the net-interest margin is not, on a material basis, adversely affected by
movements in interest rates. The interest-rate swaps entered by the Company converted
certain nonprepayable fixed rate long term debt to floating rates. As a result of
interest-rate fluctuations, hedged assets and liabilities will appreciate or depreciate in
market value. The effect of this unrealized appreciation or depreciation will generally be
offset by income or loss on the derivatives that are linked to the hedged assets and
liabilities. The Company views this strategy as a prudent management of interest-rate
sensitivity, such that earnings are not exposed to undue risk presented by changes in
interest rates.

40

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 7  DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES - continued

By using derivative instruments, the
Company is exposed to credit and market risk. If the counterparty fails to perform, credit
risk is equal to the extent of the fair-value gain in a derivative. When the fair value of
a derivative contract is positive, this generally indicates that the counterparty owes the
Company, and, therefore, creates a repayment risk for the Company. When the fair value of
a derivative contract is negative, the Company owes the counterparty and, therefore, it
has no repayment risk. The Company minimizes the credit (or repayment) risk in derivative
instruments by entering into transactions with high-quality counterparties that are
reviewed by the Companys credit committee.

Market risk is the adverse effect
that a change in interest rates, currency, or implied volatility rates has on the value of
a financial instrument. The Company manages the market risk associated with interest rate
swap contracts by establishing and monitoring limits as to the types and degree of risk
that may be undertaken. The Company periodically measures this risk by using a
value-at-risk methodology.

The Companys derivatives
activities are monitored by its risk-management committee as part of that committees
oversight of the Companys asset/liability and treasury functions. The Companys
asset/liability committee is responsible for implementing various hedging strategies that
are developed through its analysis of data from financial simulation models and other
internal and industry sources. The resulting hedging strategies are then incorporated into
the Companys overall interest-rate risk-management and trading strategies.

The interest rate swap agreements
provide for the Company to make payments at a variable rate determined by a specified
index (three month LIBOR) in exchange for receiving payments at a fixed rate of 3.4%.
During 2005 and 2004, the Company recognized $20,000 and $292,000, respectively, as a
reduction of interest expense on Federal Home Loan Bank Advances as a result of its
interest rate swaps.

At December 31, 2005 and 2004, the
information pertaining to outstanding interest rate swap agreements used to hedge fixed
rate debt is as follows:

|(Dollars in thousands) | 2005 | 2004
|---------------------- | ---- | ----
|
|                       |      |     
|                       |      |     
|                       |      |     
|                       |      |     
|                       |      |     
|                       |      |     

At December 31, 2005 and 2004, the
unrealized gain of $772,000 and $338,000, respectively, related to interest rate swaps
were recorded in derivative assets and other liabilities by the same amount.

Risk management results for the year
ended December 31, 2005 and 2004 related to the balance sheet hedging of long-term debt
indicate that the hedges were 100% effective and that there was no component of the
derivative instruments gain or loss which was excluded from the assessment of hedge
effectiveness.

41

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 8  DEPOSITS

At December 31, 2005, the scheduled
maturities of time deposits were as follows:

|                    | 
|------------------- | 
|
|Maturing In         | 
|2006                | 
|2007                | 
|2008                | 
|2009                | 
|2010 and thereafter | 
|                    | 
|Total               | 
|                    | 

Overdrawn transaction accounts in the
amount of $108,000 and $109,000 were classified as loans as of December 31, 2005 and 2004,
respectively.

Deposits by directors including their
affiliates and executive officers totaled approximately $1,973,000 and $1,172,000 at
December 31, 2005 and 2004, respectively.

# NOTE 9  ADVANCES
FROM THE FEDERAL HOME LOAN BANK

Advances from the Federal Home Loan
Bank consisted of the following:

|                                               | Interest | December 31,
|---------------------------------------------- | -------- | ------------
|
|Convertible advances maturing on:              |          |             
|March 11, 2008                                 |          |             
|December 8, 2008                               |          |             
|March 1, 2010                                  |          |             
|May 24, 2010                                   |          |             
|March 22, 2011                                 |          |             
|January, 17, 2012 (converted to variable rate) |          |             
|July 23, 2012                                  |          |             
|September 4, 2012                              |          |             
|January 30, 2013                               |          |             
|December 8, 2014                               |          |             
|                                               |          |             
|Total                                          |          |             
|                                               |          |             

Interest is payable quarterly.
Initially all advances bear interest at a fixed rate; however, at a certain date for each
of the advances, at the Federal Home Loan Banks option, the rates can be converted
to floating. Also on these dates the Federal Home Loan Bank has the option to call the
advances. As of December 31, 2005, all advances, except for one, were bearing fixed rates
of interest.

As of December 31, 2005, scheduled
principal reductions include $6,700,000 in 2008 and the remainder after five years.

As collateral, the Company has
pledged its portfolio of first mortgage one-to-four family residential loans aggregating
$24,087,000 at December 31, 2005, as well as half of its commercial real estate loan
portfolio, totaling $10,823,000 at December 31, 2005. Also, the Company has pledged half
of its portfolio of HELOCS and second mortgage loans totaling $2,503,000, and its
investment in Federal Home Loan Bank stock with a carrying value of $2,544,000.

As discussed in Note 7, the Company
has entered into interest rate swap agreements associated with Federal Home Loan Bank
advances maturing on March 1, 2010, May 24, 2010 and March 22, 2011. The interest rate
swaps effectively converted the fixed interest rates on the advances to a variable rate.
The variable rate of the swap payable was 3.88% at December 31, 2005 and is based on the
three month LIBOR index.

42

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 10  JUNIOR
SUBORDINATED DEBENTURES

On December 21, 2004, HCSB Financial
Trust I, (a non-consolidated subsidiary) issued $6.0 million floating rate trust preferred
securities with a maturity of December 31, 2034. The rate is adjusted quarterly and was
4.49% at December 31, 2005. In accordance with the revised FIN 46, the trust has not been
consolidated in these financial statements. The Company received from the Trust the $6.0
million proceeds from the issuance of the securities and the $186,000 initial proceeds
from the capital investment in the Trust, and accordingly has shown the funds due to the
trust as a $6,186,000 junior subordinated debenture. The current regulatory rules allow
certain amounts of junior subordinated debentures to be included in the calculation of
regulatory capital. The debenture issuance costs, net of accumulated amortization, totaled
$110,000 at December 31, 2004 and is included in other assets on the consolidated balance
sheet. Amortization of debt issuance costs totaled $3,667 for the year ended December 31,
2005, and $306 for the year ended December 31, 2004 and is included in other borrowings
interest expense.

The Company invested $5,880,000 in
the Companys wholly-owned subsidiary, Horry County State Bank. The remaining balance
will be maintained by the Company to fund operations.

# NOTE 11  LEASE
COMMITMENTS

On May 15, 1997, the Company entered
into a lease agreement for land on which to operate its Tabor City branch. The lease had
an initial five-year term that expired June 5, 2002, and the Company chose to exercise its
option for a five-year renewal of the lease at that time. In December 2002, the Company
and the property owners chose to negotiate a new lease that began January 1, 2003 and ends
January 1, 2008 with the Company having an option for nine additional five-year renewal
periods thereafter. Subsequent to the date of the renegotiated lease, the lease was
amended and resulted in a new rental amount of $1,000 per month through January 1, 2008.
The lease gives the Company the first right of refusal to purchase the property at an
unimproved value if the owners decide to sell. The Company also pays applicable property
taxes on the property.

On February 15, 1999, the Company
entered into an annual lease agreement for use of a parking lot adjacent to the Meeting
Street branch in Loris, S.C. The initial term was for one year with the renewal thereof
renegotiable annually. The lease has subsequently been renewed each year at an annual cost
of $600. The Company expects to renew this lease again in February, 2006.

Expected future minimum lease
payments over the next three years for these long-term operating leases are as follows:

|(Dollars in thousands) | Amount
|---------------------- | ------
|
|2006                   |       
|2007                   |       
|                       |       
|Total                  |       
|                       |       

# NOTE 12 
COMMITMENTS AND CONTINGENCIES

In the ordinary course of business, the
Company may, from time to time, become a party to legal claims and disputes. At December
31, 2005, management was not aware of any pending or threatened litigation or unasserted
claims that could result in losses, if any, that would be material to the financial
statements.

43

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 13 
SHAREHOLDERS EQUITY

Stock Dividends
 In January 2006, the Board of Directors declared a 3.0% stock dividend payable on
March 3, 2006, to shareholders of record at February 10, 2006. As a result of the stock
dividend, 52,083 shares were issued. The financial statements as of December 31, 2005 have
been adjusted to reflect this transaction and resulted in a reclassification of $1,927,000
from retained earnings to common stock and capital surplus. In January 2005, the Board of
Directors declared a 3.0% stock dividend payable on March 14, 2005, to shareholders of
record at February 11, 2005. As a result of the dividend, 50,250 shares were issued. The
financial statements as of December 31, 2004 were adjusted to reflect such transactions
and resulted in a reclassification of $1,608,000 from retained earnings to common stock
and capital surplus. All per share amounts have been adjusted to reflect these dividends.

Restrictions on
Dividends  South Carolina banking regulations restrict the amount of
dividends that can be paid to shareholders. All of the Banks dividends to HCSB
Financial Corporation and Subsidiary are payable only from the undivided profits of the
Bank. At December 31, 2005, the Banks undivided profits were $10,510,896. The Bank
is authorized to pay cash dividends up to 100% of net income in any calendar year without
obtaining the prior approval of the Commissioner of Banking provided that the Bank
received a composite rating of one or two at the last Federal or State regulatory
examination. Under Federal Reserve Board regulations, the amounts of loans or advances
from the Bank to the parent company are also restricted.

# NOTE 14  CAPITAL
REQUIREMENTS

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

Quantitative measures established by
regulation to ensure capital adequacy require the Company and the Bank to maintain minimum
ratios (set forth in the table below) of Tier 1 and total capital as a percentage of
assets and off-balance-sheet exposures, adjusted for risk-weights ranging from 0% to 100%.
Tier 1 capital of the Bank consists of common shareholders equity, excluding the
unrealized gain or loss on securities available for sale, minus certain intangible assets.
Tier 2 capital consists of the allowance for loan losses subject to certain limitations.
Total capital for purposes of computing the capital ratios consists of the sum of Tier 1
and Tier 2 capital.

The Company and the Bank are also
required to maintain capital at a minimum level based on quarterly average assets (as
defined), which is known as the leverage ratio. Only the strongest institutions are
allowed to maintain capital at the minimum requirement of 3%. All others are subject to
maintaining ratios 1% to 2% above the minimum.

44

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 14  CAPITAL
REQUIREMENTS continued

As of the most recent regulatory
examination, the Bank was deemed well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized, the Bank must maintain
total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table
below. There are no conditions or events that management believes have changed the
Companys or the Banks categories.

The following table summarizes the
capital ratios and the regulatory minimum requirements for the Company and the Bank.

|                                         |  |  |   | To Be Well-
|---------------------------------------- |  |  | - | -----------
|
|
|
|
|December 31, 2005                        |  |  |   |            
|The Company                              |  |  |   |            
|Total capital (to risk-weighted assets)  |  |  | $ | 34,424     
|Tier 1 capital (to risk-weighted assets) |  |  |   | 31,855     
|Tier 1 capital (to average assets)       |  |  |   | 31,855     
|                                         |  |  |   |            
|The Bank                                 |  |  |   |            
|Total capital (to risk-weighted assets)  |  |  | $ | 33,233     
|Tier 1 capital (to risk-weighted assets) |  |  |   | 30,664     
|Tier 1 capital (to average assets)       |  |  |   | 30,664     
|                                         |  |  |   |            
|December 31, 2004                        |  |  |   |            
|The Company                              |  |  |   |            
|Total capital (to risk-weighted assets)  |  |  | $ | 31,627     
|Tier 1 capital (to risk-weighted assets) |  |  |   | 29,472     
|Tier 1 capital (to average assets)       |  |  |   | 29,472     
|                                         |  |  |   |            
|The Bank                                 |  |  |   |            
|Total capital (to risk-weighted assets)  |  |  | $ | 30,158     
|Tier 1 capital (to risk-weighted assets) |  |  |   | 28,003     
|Tier 1 capital (to average assets)       |  |  |   | 28,003     

# NOTE 15 
RETIREMENT AND BENEFITS

Trustee Retirement Savings
Plan  The Bank has a trustee retirement savings plan which provides
retirement benefits to substantially all officers and employees who meet certain age and
service requirements. The plan includes a salary reduction feature pursuant to
Section 401(k) of the Internal Revenue Code. Under the plan and present policies,
participants are permitted to contribute up to 15% of their annual compensation. At its
discretion, the Bank can make matching contributions up to 4% of the participants
compensation. The Company charged $128,000 and $129,000 to earnings for the retirement
savings plan in 2005 and 2004, respectively.

Directors Deferred Compensation
Plan  The Company has a deferred compensation plan whereby directors
may elect to defer the payment of their fees. Under the terms of the plan, the Company
accrues an expense equal to the amount deferred plus an interest component based on the
prime rate of interest at the beginning of each year. The Company has also purchased life
insurance contracts on each of the participating directors. At December 31, 2005 and 2004,
$519,000 and $428,000, respectively, of directors fees were deferred and are
included in other liabilities.

Performance Compensation for
Stakeholders Plan  The Company implemented an employee bonus program
in 2003 which it refers to as its Stakeholder Plan. The plan pays employees based on a
schedule of key performance indicators they are required to meet in order to be rewarded.
The plan accrues for its employee bonuses based on a percentage of each employees
annual salary. The plan has a fiscal year ending on December 31, and pays out on January
30 of the following year. At December 31, 2005, the plan had an accrued payout of
$158,000. The Company charged $125,000 and $101,000 to earnings for the stakeholder plan
in 2005 and 2004, respectively.

45

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 16  EARNINGS
PER SHARE

Earnings per share  basic is
computed by dividing net income by the weighted average number of common shares
outstanding. Earnings per share  diluted is computed by dividing net income by the
weighted average number of common shares outstanding and dilutive common share equivalents
using the treasury stock method. Dilutive common share equivalents include common shares
issuable upon exercise of outstanding stock options.

|(Dollars in thousands, except share          | Years ended December 31,
|-------------------------------------------- | ------------------------
|
|
|
|
|Basic earnings per share:                    |                         
|                                             |                         
|Net income available to common shareholders  |                         
|                                             |                         
|Average common shares outstanding - basic    |                         
|                                             |                         
|Basic earnings per share                     |                         
|                                             |                         
|Diluted earnings per share:                  |                         
|                                             |                         
|Net income available to common shareholders  |                         
|                                             |                         
|Average common shares outstanding - basic    |                         
|                                             |                         
|Incremental shares from assumed conversion   |                         
|of stock options and restricted stock awards |                         
|                                             |                         
|Average common shares outstanding - diluted  |                         
|                                             |                         
|Diluted earnings per share                   |                         
|                                             |                         

# NOTE 17  STOCK
COMPENSATION PLAN

In 2004, upon shareholder approval,
the Company adopted an Omnibus Stock Ownership and Long Term Incentive Plan (the
Stock Plan). The Stock Plan authorizes the grant of options and awards of
restricted stock to certain of our employees for up to 200,000 shares of the
Companys common stock from time to time during the term of the Stock Plan, subject
to adjustments upon change in capitalization. The Stock Plan is administered by the
Compensation Committee of the Board of Directors of the Company.

Options granted under the Stock Plan
are incentive stock options, and they are vested over a five year period with none vesting
at the time of the grant. All unexercised incentive stock options expire ten years after
the date of the grant. A summary of the Companys incentive stock options as of
December 31, 2005 and 2004 is as follows, (with adjustments for the 3% stock dividends
for the two periods):

|                                 | 2005 | 2004
|-------------------------------- | ---- | ----
|
|
|
|
|
|Outstanding at beginning of year |      |     
|Granted                          |      |     
|Exercised                        |      |     
|Forfeited                        |      |     
|                                 |      |     
|Outstanding at end of year       |      |     
|                                 |      |     

46

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 17  STOCK
COMPENSATION PLAN  continued

The following table summarizes information
about stock options outstanding under the Companys plan at December 31, 2005(with
adjustments for the 3% stock dividends for the two periods):

|                                | Outstanding | Exercisable
|------------------------------- | ----------- | -----------
|
|Number of options               |             |            
|Weighted average remaining life |             |            
|Weighted average exercise price |             |            
|High exercise price             |             |            
|Low exercise price              |             |            

Restricted stock awards included in
the Stock Plan vest after the first three consecutive periods during which the Banks
return on average assets (ROAA) averages 1.15%. At December 31, 2005 and 2004, none of the
restricted stock had vested; therefore, no compensation expense related to the vesting was
recognized. All ungranted restricted stock awards expire after the date of the award. A
summary of the Companys unrestricted stock awards as of December 31, 2005 and 2004
is as follows (with adjustments for the 3% stock dividends for the two periods):

|                                 | 2005 | 2004
|-------------------------------- | ---- | ----
|
|
|
|
|
|Outstanding at beginning of year |      |     
|Granted                          |      |     
|Exercised                        |      |     
|Forfeited                        |      |     
|                                 |      |     
|Outstanding at end of year       |      |     
|                                 |      |     

# NOTE 18  OTHER
EXPENSES

Other expenses are summarized as follows:

|                                  | Years Ended December 31,
|--------------------------------- | ------------------------
|
|
|Stationery, printing, and postage |                         
|Telephone                         |                         
|Director and advisory fees        |                         
|Insurance                         |                         
|ATM services                      |                         
|Courier services                  |                         
|Other                             |                         
|                                  |                         
|Total                             |                         
|                                  |                         

47

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 19  INCOME
TAXES

Income tax expense is summarized as
follows:

|                                            | Years Ended December 31,
|------------------------------------------- | ------------------------
|
|Currently payable:                          |                         
|Federal                                     |                         
|State                                       |                         
|                                            |                         
|Total current                               |                         
|                                            |                         
|Deferred income taxes                       |                         
|                                            |                         
|Income tax expense                          |                         
|Income tax expense is allocated as follows: |                         
|To continuing operations                    |                         
|To shareholders' equity                     |                         
|                                            |                         
|Total                                       |                         
|                                            |                         

The components of the net deferred
tax asset are as follows:

|                                                     | December 31,
|---------------------------------------------------- | ------------
|
|
|Deferred tax assets:                                 |             
|Allowance for loan losses                            |             
|Net capitalized loan costs                           |             
|State net operating loss                             |             
|Deferred directors' fees                             |             
|Prepaid expenses                                     |             
|Nonaccruing interest                                 |             
|Net unrealized loss on securities available-for-sale |             
|                                                     |             
|Total deferred tax assets                            |             
|                                                     |             
|Deferred tax liabilities:                            |             
|Accumulated depreciation                             |             
|Gain on sale of real estate                          |             
|Software amortization                                |             
|                                                     |             
|Total deferred tax liabilities                       |             
|                                                     |             
|Net deferred tax asset                               |             
|                                                     |             

Deferred tax assets represent the
future tax benefit of future deductible differences and, if it is more likely than not
that a tax asset will not be realized, a valuation allowance is required to reduce the
recorded deferred tax assets to net realizable value. Management has determined that it is
more likely than not that the entire deferred tax asset at December 31, 2005 and 2004 will
be realized and, accordingly, has not established a valuation allowance. Deferred tax
assets are included in other assets.

A reconciliation between the income
tax expense and the amount computed by applying the Federal statutory rates of 34% to
income before income taxes follows:

|                                                    | Years Ended December 31,
|--------------------------------------------------- | ------------------------
|
|
|Tax expense at statutory rate                       |                         
|State income tax, net of federal income tax benefit |                         
|Tax-exempt interest income                          |                         
|Other                                               |                         
|                                                    |                         
|Income tax provision                                |                         
|                                                    |                         

48

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 20  UNUSED
LINES OF CREDIT

As of December 31, 2005, the Company
had unused lines of credit to purchase federal funds from unrelated banks totaling
$14,000,000. These lines of credit are available on a one to fourteen day basis for
general corporate purposes. The lenders have reserved the right not to renew their
respective lines. The Company may also borrow an additional $22,830,000 at December 31,
2005 from the Federal Home Loan Bank based on a predetermined formula. Advances are
subject to approval by the Federal Home Loan Bank and may require the Company to pledge
additional collateral.

# NOTE 21  FAIR
VALUE OF FINANCIAL INSTRUMENTS

The fair value of a financial
instrument is the amount at which the asset or obligation could be exchanged in a current
transaction between willing parties, other than in a forced or liquidation sale. Fair
value estimates are made at a specific point in time based on relevant market information
and information about the financial instruments. Because no market value exists for a
significant portion of the financial instruments, fair value estimates are based on
judgments regarding future expected loss, current economic conditions, risk
characteristics of various financial instruments, and other factors.

The following methods and assumptions
were used to estimate the fair value of significant financial instruments:

Cash and Due from Banks The carrying amount is a reasonable estimate of fair value.

Federal Funds Sold and
Purchased Federal funds sold and purchased are for a term of one day
and the carrying amount approximates the fair value.

Time Deposits with Other
Banks  Time deposits with other banks have a term less than 90 days
and the carrying amount approximates the fair value.

Investment Securities
Available-for-Sale For securities available-for-sale, fair value equals the
carrying amount which is the quoted market price. If quoted market prices are not
available, fair values are based on quoted market prices of comparable securities.

Nonmarketable Equity
Securities The carrying amount is a reasonable estimate of fair value since
no ready market exists for these securities.

Mortgage Loans
Held-for-Sale  Fair values of mortgage loans held for sale are based
on commitments on hand from investors or market prices.

Loans Receivable
For certain categories of loans, such as variable rate loans which are repriced frequently
and have no significant change in credit risk and credit card receivables, fair values are
based on the carrying amounts. The fair value of other types of loans is estimated by
discounting the future cash flows using the current rates at which similar loans would be
made to the borrowers with similar credit ratings and for the same remaining maturities.

Deposits The
fair value of demand deposits, savings, and money market accounts is the amount payable on
demand at the reporting date. The fair values of certificates of deposit are estimated
using a discounted cash flow calculation that applies current interest rates to a schedule
of aggregated expected maturities.

Advances from the Federal Home
Loan Bank For the portion of borrowings immediately callable, fair value is
based on the carrying amount. The fair value of the portion maturing at a later date is
estimated using a discounted cash flow calculation that applies the interest rate of the
immediately callable portion to the portion maturing at the future date.

49

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 21  FAIR
VALUE OF FINANCIAL INSTRUMENTS  continued

Junior Subordinated
Debentures  The carrying value of junior subordinated debentures is a
reasonable estimate of fair value since the debentures were issued at a floating rate.

Accrued Interest Receivable and
Payable The carrying value of these instruments is a reasonable estimate of
fair value.

Commitments to Extend Credit
and Standby Letters of Credit The contractual amount is a reasonable
estimate of fair value for the instruments because commitments to extend credit and
standby letters of credit are issued on a short-term or floating rate basis and include no
unusual credit risks.

Interest Rate
Swaps  Fair values are based on the present value of future cash
flows based on the interest rate spread between the fixed rate and the floating rate.

The carrying values and estimated
fair values of the Companys financial instruments were as follows:

|                                         | December 31,
|---------------------------------------- | ------------
|
|
|
|Financial Assets:                        |             
|Cash and due from banks                  |             
|Federal funds sold                       |             
|Time deposits with other banks           |             
|Investment securities available-for-sale |             
|Nonmarketable equity securities          |             
|Loans and loans held-for-sale            |             
|Other assets - interest rate swaps       |             
|Accrued interest receivable              |             
|                                         |             
|Financial Liabilities:                   |             
|Demand deposit, interest-bearing         |             
|transaction, and savings accounts        |             
|Certificates of deposit                  |             
|Advances from the Federal Home           |             
|Loan Bank                                |             
|Junior subordinated debentures           |             
|Accrued interest payable                 |             
|Other liabilities - interest rate swaps  |             

|                             | Notional | Estimated | Notional | Estimated
|---------------------------- | -------- | --------- | -------- | ---------
|
|Off-Balance Sheet Financial  |          |           |          |          
|Instruments:                 |          |           |          |          
|Commitments to extend credit |          |           | $        | 35,134   
|Standby letters of credit    |          |           |          | 778      
|Interest rate swaps          |          |           |          | 14,600   

50

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

# NOTE 22  HCSB
FINANCIAL CORPORATION (PARENT COMPANY ONLY)

Presented below are the condensed
financial statements for HCSB Financial Corporation and Subsidiary (Parent Company Only).

# Condensed Balance
Sheets

|                                           | December 31,
|------------------------------------------ | ------------
|
|Assets                                     |             
|Cash                                       |             
|Investment in banking subsidiary           |             
|Investment in trust                        |             
|Nonmarketable equity securities            |             
|Land                                       |             
|Other assets                               |             
|                                           |             
|Total assets                               |             
|                                           |             
|Liabilities and shareholders' equity       |             
|Interest payable                           |             
|Junior subordinated debentures             |             
|                                           |             
|Total liabilities                          |             
|                                           |             
|Shareholders' equity                       |             
|                                           |             
|Total liabilities and shareholder's equity |             
|                                           |             

# Condensed Statements
of Income

|                                                       | Years Ended December 31,
|------------------------------------------------------ | ------------------------
|
|Income                                                 |                         
|Dividends from banking subsidiary                      |                         
|                                                       |                         
|Expenses                                               |                         
|Interest expense on junior subordinated debentures     |                         
|Other expenses                                         |                         
|                                                       |                         
|Income (loss) before income taxes and equity in        |                         
|undistributed earnings of banking subsidiary           |                         
|                                                       |                         
|Income tax benefit                                     |                         
|                                                       |                         
|Equity in undistributed earnings of banking subsidiary |                         
|                                                       |                         
|Net income                                             |                         
|                                                       |                         

51

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# Notes to Consolidated
Financial Statements

NOTE 22  HCSB FINANCIAL CORPORATION (PARENT COMPANY ONLY) - continued

# Condensed Statements of
Cash Flows

|                                                            | Years Ended December 31,
|----------------------------------------------------------- | ------------------------
|
|Cash flows from operating activities:                       |                         
|Net income                                                  |                         
|Adjustments to reconcile net income to net cash provided by |                         
|operating activities:                                       |                         
|Equity in undistributed earnings of banking subsidiary      |                         
|Increase in other assets                                    |                         
|Increase in other liabilities                               |                         
|                                                            |                         
|Net cash used by operating activities                       |                         
|                                                            |                         
|Cash flows from investing activities:                       |                         
|Purchase of land                                            |                         
|Proceeds from sale of land and building                     |                         
|                                                            |                         
|Net cash provided (used) from investing activities          |                         
|                                                            |                         
|Cash flows from financing activities:                       |                         
|Proceeds from stock issuance                                |                         
|Transfer of subordinate debentures to the bank              |                         
|Proceeds from junior subordinated debentures                |                         
|Cash paid for fractional shares                             |                         
|                                                            |                         
|Net cash provided (used) by financing activities            |                         
|                                                            |                         
|Increase (decrease) in cash                                 |                         
|                                                            |                         
|Cash and cash equivalents, beginning of year                |                         
|                                                            |                         
|Cash and cash equivalents, end of year                      |                         
|                                                            |                         

52

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# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# BOARD OF DIRECTORS

|                       | 
|---------------------- | 
|Johnny C. Allen        | 
|                       | 
|D. Singleton Bailey    | 
|                       | 
|Franklin C. Blanton    | 
|                       | 
|                       | 
|Clay D. Brittain, III  | 
|                       | 
|Russell R. Burgess, Jr | 
|                       | 
|                       | 
|                       | 
|William H. Caines      | 
|                       | 
|James R. Clarkson      | 
|                       | 
|                       | 
|                       | 
|J. Lavelle Coleman     | 
|                       | 
|Larry G. Floyd         | 
|                       | 
|                       | 
|Boyd R. Ford, Jr       | 
|                       | 
|                       | 
|Tommie W. Grainger     | 
|                       | 
|Randy B. Hardee        | 
|                       | 
|Gwyn G. McCutchen      | 
|                       | 
|T. Freddie Moore       | 
|                       | 
|Carroll D. Padgett, Jr | 

# OFFICERS OF THE BOARD
OF DIRECTORS

| |  | 
| |  | 
| |  | 
| |  | 
| |  | 
| |  | 
| |  | 

53

---

# HCSB FINANCIAL
CORPORATION AND SUBSIDIARY

# HORRY COUNTY STATE BANK CORPORATE OFFICERS

James R. Clarkson, President/CEO
Glenn R. Bullard, Executive Vice President
Denise Floyd, Vice President/Personnel Officer
Margaret H. Fowler, Vice President/Operations Officer
Loretta B. Gerald, Vice President/Cashier/Internal Auditor

# HORRY COUNTY STATE
BANK BRANCHES AND ATM LOCATIONS

|                                | 
|------------------------------- | 
|Broad Street, Loris Office*     | 
|5009 Broad Street               | 
|Loris, SC 29569                 | 
|843-756-6333                    | 
|                                | 
|Mt. Olive Office                | 
|5264 Hwy. 9                     | 
|Green Sea, SC 29545             | 
|843-392-6333                    | 
|                                | 
|Little River Office*            | 
|3187 Hwy. 9 E                   | 
|Little River, SC 29566          | 
|843-399-9523                    | 
|                                | 
|Conway Office*                  | 
|1627-A Church Street (Hwy. 501) | 
|Conway, SC 29526                | 
|843-248-8250                    | 
|                                | 
|Windy Hill Office*              | 
|4400 Hwy. 17 South              | 
|North Myrtle Beach, SC 29582    | 
|843-663-5600                    | 

# www.horrycountystatebank.com

* Denotes ATM Location

54