UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2014

- or -

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

For the transition period from                            to                         

Commission File Number 0-22981

GEORGIA-CAROLINA BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Georgia	58-2326075
(State or other Jurisdiction of  Incorporation or Organization)	(I.R.S. Employer Identification Number)

3527 Wheeler Road, Augusta, Georgia 30909

(Address of principal executive offices, including zip code)

(706) 731-6600

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES ☒ NO ☐

Indicate by check mark whether the registrant has submitted electronically and has posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES ☒ NO ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	☐	Accelerated filer	☐
Non-accelerated filer	☐	Smaller reporting company	☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES ☐ NO ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at November 7, 2014
Common Stock, $.001 Par Value	3,596,046 shares

GEORGIA-CAROLINA BANCSHARES, INC.

Form 10-Q

Index

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Consolidated Statements of Financial Condition as of September 30, 2014 and December 31, 2013	3
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2014 and 2013	4
	Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2014 and 2013	5
	Consolidated Statements of Shareholders’ Equity for the Three and Nine Months Ended September 30, 2014 and 2013	6
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013	7
	Notes to Consolidated Financial Statements	9
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	39
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	49
Item 4.	Controls and Procedures	49
PART II.	OTHER INFORMATION
Item 6.	Exhibits	50
	SIGNATURES	51
	EXHIBIT INDEX	52

Cautionary Note Regarding Forward-Looking Statements

Certain statements contained in the Company’s filings with the Securities and Exchange Commission (the “SEC”) and its reports to stockholders contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which represent the expectations or beliefs of our management, including, but not limited to, statements concerning the banking industry and our operations, performance, financial condition and growth. For this purpose, any statements contained in this Report that are not statements of historical fact may be deemed forward-looking statements. Without limiting the generality of the foregoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “should,” “can,” “estimate,” or “continue,” or the negative or other variations thereof or comparable terminology, are intended to identify forward-looking statements. These statements by their nature involve substantial risks and uncertainties, certain of which are beyond our control, and actual results may differ materially depending on a variety of important factors, including competition, general economic and market conditions, deposit levels and loan demand, changes in interest rates, changes in the value of real estate and other collateral securing loans, securities portfolio values, interest rate risk management and sensitivity, exposure to regulatory and legislative changes, and other risks and uncertainties described in our periodic reports filed with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2013, and particularly the sections entitled “Risk-Factors” and Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Although we believe that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could prove to be inaccurate. Therefore, we can give no assurance that the results contemplated in the forward-looking statements will be realized. The inclusion of this forward-looking information should not be construed as a representation by us or any person that the future events, plans, or expectations contemplated by us will be achieved. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

Part I - FINANCIAL INFORMATION 

Item 1.     Financial Statements.

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Financial Condition

(dollars in thousands, except share and per share data)

	September 30,			December 31,
	2014			2013
	(Unaudited)
Assets
Cash and due from banks	$	26,881		$	16,828
Securities available-for-sale		134,019			158,439
Loans		302,976			274,747
Allowance for loan losses		(5,256	)		(5,357	)
Loans, net		297,720			269,390
Loans held for sale at fair value		29,694			31,298
Bank-owned life insurance		15,284			14,834
Bank premises and equipment, net		9,244			9,512
Accrued interest receivable		1,729			1,854
Other real estate owned, net		4,738			4,897
Federal Home Loan Bank stock		465			1,606
Other assets		5,807			7,840
Total assets	$	525,581		$	516,498
Liabilities and Shareholders’ Equity
Liabilities
Deposits
Non-interest bearing	$	84,693		$	76,747
Interest-bearing:
NOW accounts		63,106			59,661
Money market accounts		76,908			74,056
Savings		56,777			56,757
Time deposits less than $100,000		51,360			54,859
Time deposits $100,000 or greater		71,818			72,637
Brokered and wholesale deposits		20,661			24,988
Total deposits		425,323			419,705
Short-term debt		-			22,200
Repurchase agreements		30,206			12,111
Other liabilities		7,108			5,593
Total liabilities		462,637			459,609
Shareholders’ equity
Preferred stock, par value $.001; 1,000,000 shares authorized; none issued		-			-
Common stock, par value $.001; 9,000,000 shares authorized; 3,596,046 and 3,572,204 shares issued and outstanding, respectively		4			4
Additional paid-in capital		16,532			16,192
Retained earnings		47,484			44,758
Accumulated other comprehensive income/(loss)		(1,076	)		(4,065	)
Total shareholders’ equity		62,944			56,889
Total liabilities and shareholders’ equity	$	525,581		$	516,498

See notes to the consolidated financial statements.

3

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Income

(Unaudited)

(dollars in thousands, except share and per share data)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2014			2013		2014			2013
Interest income
Interest and fees on loans	$	4,177		$	3,795	$	12,033		$	11,465
Interest on taxable securities		549			635		1,793			1,784
Interest on nontaxable securities		148			143		449			386
Other interest income		6			8		14			42
Total interest income		4,880			4,581		14,289			13,677
Interest expense
Interest on NOW, money market, and savings deposits		127			130		379			422
Interest on time deposits less than $100,000		104			125		323			389
Interest on time deposits $100,000 or greater		143			169		434			509
Interest on brokered and wholesale deposits		48			84		157			292
Interest on funds purchased and other borrowings		22			4		62			14
Total interest expense		444			512		1,355			1,626
Net interest income		4,436			4,069		12,934			12,051
Provision (recapture) for loan losses		(146	)		15		(797	)		(1,787	)
Net interest income after provision for loan losses		4,582			4,054		13,731			13,838
Non-interest income
Service charges on deposits		367			414		1,060			1,174
Mortgage banking activities		1,972			1,765		5,218			6,462
Net gains (losses) on sales of other real estate		4			22		78			181
Net gains on securities available for sale		2			-		53			91
Other		1,224			503		2,099			2,386
Total non-interest income		3,569			2,704		8,508			10,294
Non-interest expense
Salaries and employee benefits		3,434			3,299		10,086			9,664
Occupancy expenses		395			387		1,170			1,122
Other real estate owned expenses		287			351		665			1,053
Other		1,713			1,596		5,532			4,875
Total non-interest expense		5,829			5,633		17,453			16,714
Income before income taxes		2,322			1,125		4,786			7,418
Income tax expense		926			282		1,575			2,149
Net income	$	1,396		$	843	$	3,211		$	5,269
Earnings per common share
Basic	$	0.39		$	0.24	$	0.89		$	1.48
Diluted	$	0.38		$	0.23	$	0.88		$	1.47
Dividends per common share	$	0.045		$	0.045	$	0.135		$	0.130

See notes to the consolidated financial statements. 

4

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Comprehensive Income

(Unaudited)

(dollars in thousands)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2014			2013			2014			2013
Net income	$	1,396		$	843		$	3,211		$	5,269
Other comprehensive income (loss):
Unrealized holding gain (loss) arising during the period		16			(880	)		4,448			(6,379	)
Tax effect of unrealized holding (gain) loss		(4	)		282			(1,423	)		2,117
Reclassification for gain included in net income		(2	)		-			(53	)		(91	)
Tax effect of gain included in net income		-			-			17			31
Total other comprehensive income (loss)		10			(598	)		2,989			(4,322	)
Comprehensive income	$	1,406		$	245		$	6,200		$	947

See notes to the consolidated financial statements.

5

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Shareholders' Equity

(Unaudited)

(dollars in thousands except share data)

	Common Stock Shares		Common Stock Par Value		Additional Paid-in-Capital		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders' Equity
Balance at January 1, 2013		3,528,296	$	4	$	15,687	$	39,177		$	1,457		$	56,325
Net income		-		-		-		5,269			-			5,269
Other comprehensive loss		-		-		-		-			(4,322	)		(4,322	)
Stock-based compensation expense		-		-		70		-			-			70
Issuance of restricted stock for compensation		24,006		-		97		-			-			97
Issuance of stock for directors' fees		12,944		-		188		-			-			188
Dividends		-		-		-		(462	)		-			(462	)
Balance at September 30, 2013		3,565,246	$	4	$	16,042	$	43,984		$	(2,865	)	$	57,165
Balance at January 1, 2014		3,572,204	$	4	$	16,192	$	44,758		$	(4,065	)	$	56,889
Net income		-		-		-		3,211			-			3,211
Other comprehensive income		-		-		-		-			2,989			2,989
Stock-based compensation expense		-		-		66		-			-			66
Issuance of restricted stock for compensation		20,292		-		224		-			-			224
Issuance of stock for directors' fees		3,550		-		50		-			-			50
Dividends		-		-		-		(485	)		-			(485	)
Balance at September 30, 2014		3,596,046	$	4	$	16,532	$	47,484		$	(1,076	)	$	62,944

See notes to the consolidated financial statements.

6

GEORGIA-CAROLINA BANCSHARES, INC.

Consolidated Statements of Cash Flows

(Unaudited)

(dollars in thousands)

	Nine Months Ended September 30,
	2014			2013
Cash flows from operating activities
Net income	$	3,211		$	5,269
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		461			449
Provision (recapture) for loan losses		(797	)		(1,787	)
Write-downs of other real estate owned		199			469
Net gains on sale of other real estate owned		(78	)		(181	)
(Gain) loss on sale of equipment		(1	)		5
Net gains on securities available for sale		(53	)		(91	)
Gain on bank-owned life insurance		-			(806	)
Mortgage banking activities		(5,218	)		(6,462	)
Proceeds from sale of loans held for sale		245,863			311,291
Originations of loans held for sale		(239,041	)		(284,091	)
Increase in cash value of bank-owned life insurance		(450	)		(317	)
Stock-based compensation expense		290			167
Stock issued for directors' fees		50			189
Deferred income taxes		23			(230	)
(Increase) decrease in accrued interest receivable		125			(80	)
Decrease in other assets		524			1,473
Increase in accrued interest payable		-			73
Increase in other liabilities		1,515			2,708
Net cash provided by operating activities		6,623			28,048
Cash flows from investing activities
Loan originations and collections, net		(27,801	)		3,216
Purchases of available-for-sale securities		(14,007	)		(63,025	)
Proceeds from maturities and calls of available-for-sale securities		12,532			20,099
Proceeds from sales of available-for-sale securities		30,344			12,735
Proceeds from redemption of FHLB stock		1,141			1,168
Proceeds from sale of other real estate owned		306			1,259
Proceeds from bank-owned life insurance death benefit		-			1,421
Purchase of bank-owned life insurance		-			(5,000	)
Net additions to bank premises and equipment		(113	)		(1,098	)
Net cash provided by (used in) investing activities		2,402			(29,225	)
Cash flows from financing activities
Net increase in deposits		5,618			12,423
Net proceeds (repayments) of short-term borrowings		(22,200	)		(25,028	)
Increase in repurchase agreements		18,095			2,935
Cash dividends paid		(485	)		(462	)
Net cash provided by (used in) financing activities		1,028			(10,132	)
Net increase (decrease) in cash and due from banks		10,053			(11,309	)
Cash and due from banks at beginning of the period		16,828			30,279
Cash and due from banks at end of the period	$	26,881		$	18,970

See notes to the consolidated financial statements.

7

Supplemental Consolidated Cash Flow Information

The Bank had the following significant transactions during the nine months ended September 30, 2014 and 2013.

	Nine Months Ended September 30,
	2014		2013
	(dollars in thousands)
Supplemental cash flow information:
Interest received	$	14,414	$	13,597
Interest paid		1,355		1,553
Income taxes paid		1,500		2,350
Supplemental noncash information:
Transfers from loans to other real estate owned		268		807
Unrealized gain (loss) on securities, net of tax	$	2,989	$	(4,322	)

See notes to the consolidated financial statements.

8

GEORGIA-CAROLINA BANCSHARES, INC.

Notes to Consolidated Financial Statements

September 30, 2014

(Unaudited)

Note 1 – Basis of Presentation

The accompanying consolidated financial statements include the accounts of Georgia-Carolina Bancshares, Inc. (the “Company”), its wholly owned subsidiary, First Bank of Georgia (the “Bank”), and the wholly owned subsidiary of the Bank, Willhaven Holdings, LLC. All intercompany transactions and accounts have been eliminated in the consolidation of the Company and the Bank.

The consolidated financial statements as of September 30, 2014 and for the three and nine months ended September 30, 2014 and 2013 are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been omitted pursuant to such rules and regulations. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

The financial information included herein reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary to a fair presentation of the financial position and results of operations for interim periods.

Note 2 – Investment Securities

The amortized cost and fair value amounts of securities owned as of September 30, 2014 and December 31, 2013 are shown below:

	September 30, 2014
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(dollars in thousands)
Securities available-for-sale:
U.S. Government and agency	$	44,950	$	27	$	(1,585	)	$	43,392
Mortgage-backed		60,833		537		(762	)		60,608
State and municipal		27,072		610		(373	)		27,309
Corporate bonds		2,747		-		(37	)		2,710
Total	$	135,602	$	1,174	$	(2,757	)	$	134,019

9

Note 2 – Investment Securities (continued)

	December 31, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(dollars in thousands)
Securities available-for-sale:
U.S. Government and agency	$	61,486	$	146	$	(3,351	)	$	58,281
Mortgage-backed		66,095		558		(1,921	)		64,732
State and municipal		32,088		255		(1,592	)		30,751
Corporate bonds		4,749		25		(99	)		4,675
Total	$	164,418	$	984	$	(6,963	)	$	158,439

The amortized cost and fair value of securities as of September 30, 2014 by contractual maturity are as follows. Actual maturities may differ from contractual maturities in mortgage-backed securities, as the mortgages underlying the securities may be called or prepaid without penalty; therefore, these securities are not included in the maturity categories in the following maturity summary.

	Securities Available-for-Sale
	Amortized Cost		Fair Value
	(dollars in thousands)
Less than one year	$	8,725	$	8,278
One to five years		21,756		21,731
Five to ten years		30,971		30,364
Over ten years		13,317		13,038
Mortgage-backed securities		60,833		60,608
Total	$	135,602	$	134,019

Securities with a carrying amount of approximately $80.0 million and $64.1 million were pledged to secure public deposits and for other purposes at September 30, 2014 and December 31, 2013, respectively.

During the nine months ended September 30, 2014, the Bank sold $30.3 million in securities available-for-sale, realizing gains of $374,500 and losses of $297,800 for a net gain of $76,700. During the nine months ended September 30, 2013, the Bank sold $12.7 million in securities available-for-sale, realizing gains of $158,000 and losses of $74,400 for a net gain of $83,600.

For the nine months ended September 30, 2014 and 2013, the Bank reclassified $53,000 and $91,000, respectively, in gains from accumulated other comprehensive income to gain on sale of securities. The tax effect of $17,000 and $31,000 was included in income tax expense for the nine months ended September 30, 2014 and 2013, respectively.

10

Note 2 – Investment Securities (continued)

Information pertaining to securities with gross unrealized losses at September 30, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:

	September 30, 2014
	Less than Twelve Months							Over Twelve Months
	Number of Securities		Fair Value		Gross Unrealized Losses			Number of Securities		Fair Value		Gross Unrealized Losses
	(dollars in thousands)
Securities available-for-sale:
U.S. Government and agency		3	$	6,357	$	(33	)		20	$	30,994	$	(1,552	)
Mortgage-backed		5		5,547		(34	)		17		25,068		(728	)
State and municipal		4		1,846		(9	)		20		8,370		(364	)
Corporate bonds		1		741		(6	)		2		1,968		(31	)
Total		13	$	14,491	$	(82	)		59	$	66,400	$	(2,675	)

	December 31, 2013
	Less than Twelve Months							Over Twelve Months
	Number of Securities		Fair Value		Gross Unrealized Losses			Number of Securities		Fair Value		Gross Unrealized Losses
	(dollars in thousands)
Securities available-for-sale:
U.S. Government and agency		23	$	34,142	$	(1,911	)		7	$	11,759	$	(1,440	)
Mortgage-backed		31		40,852		(1,744	)		3		5,294		(177	)
State and municipal		41		19,934		(1,156	)		8		3,028		(436	)
Corporate bonds		4		3,487		(99	)		-		-		-
Total		99	$	98,415	$	(4,910	)		18	$	20,081	$	(2,053	)

Management evaluates investment securities for other-than-temporary impairment on a periodic basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuers, and (3) the intent and ability of the Bank to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

At September 30, 2014 and December 31, 2013, the gross unrealized losses in securities available-for-sale are primarily the result of changes in market interest rates and not related to the credit quality of the underlying issuer. All of the securities are U.S. agency debt securities, corporate bonds, mortgage-backed securities backed by government-sponsored entities, and municipal securities. Management has determined that no declines in market value are deemed to be other than temporary at September 30, 2014 and December 31, 2013. Securities rated below Moody’s (Baa) or Standard & Poor’s (BBB-) are not purchased.

11

Note 2 – Investment Securities (continued)

Corporate bonds will have a minimum rating at purchase of Moody’s (A3), S&P (A-), or Fitch (A-). The Bank does not intend to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery.

Included in “Other assets” is an investment of approximately $105,000 net of amortization, in a real estate rehabilitation project located in Georgia that will provide the Bank with state tax credits for approximately the next two years.

Note 3 – Loans

The Bank engages in a full complement of lending activities, including commercial, consumer and real estate loans. The composition of loans at September 30, 2014 and December 31, 2013 is summarized as follows:                                                                                           

	September 30,			December 31,
	2014			2013
	(dollars in thousands)
Commercial and industrial	$	27,703		$	18,113
Real estate - construction, land and land development		63,316			60,476
Real estate - residential		65,148			55,792
Real estate - commercial		142,384			136,632
Consumer		4,691			3,931
Total loans		303,242			274,944
Deferred loan fees		(266	)		(197	)
Total loans, net of deferred fees		302,976			274,747
Allowance for loan losses		(5,256	)		(5,357	)
Loans, net of allowance for loan losses	$	297,720		$	269,390

Loan segments

Commercial and industrial loans are directed principally towards individual, partnership or corporate borrowers, for a variety of business purposes.  These loans include short-term lines of credit, short-term to medium-term plant and equipment loans, and loans for general working capital.  Risks associated with this type of lending arise from the impact of economic stresses on the business operations of borrowers. The Bank mitigates such risks to the loan portfolio by diversifying lending across North American Industry Classification System (“NAICS”) codes and has experienced very low levels of loss for this loan type for the past three years.  

Real estate – construction, land and land development loans consist of residential and commercial construction loans as well as land and land development loans.  Land development loans are primarily construction and development loans to builders in the Augusta and Savannah, Georgia markets.  These loan portfolios possess an increased level of risk compared to other types. The Bank’s approach to financing the development, financing the construction and providing the ultimate residential mortgage loans to the residential property purchasers has resulted in less exposure to the effects of declines in property values. These loans include certain real estate – construction loans classified as acquisition, development & construction. The loans are managed by the Bank’s construction division.

12

Note 3 – Loans (continued)

Real estate – residential loans include residential mortgage lending and are primarily single-family residential loans secured by the residential property.  Residential property values have stabilized over the past year, and this loan type has experienced decreases in historical losses over the past three years. Home equity lines are also included in real estate – residential loans.

Real estate – commercial loans include commercial mortgage loans that are generally secured by office buildings, retail establishments and other types of real property, both owner occupied and non-owner occupied. A significant component of this type of lending is to owner occupied borrowers, including churches.

Consumer loans consist primarily of installment loans to individuals for personal, family or household purposes, including automobile loans to individuals and pre-approved lines of credit.  The Bank has experienced low levels of loss for this loan type for the past three years compared to the other loan types.

Loan risk grades

The Company categorizes loans into risk grades based on relevant information about the ability of borrowers to service their debt such as: future repayment ability, financial condition, collateral, administration, management ability of borrower, and history and character of borrower. Grades are assigned at loan origination and may be changed due to the result of a loan review or at the discretion of management. The Company uses the following definitions for risk grades:

Grade 1: Highest quality - Alternate sources of cash exist, such as the commercial paper market, capital market, internal liquidity or other bank lines. These are national or regional companies with excellent cash flow which covers all debt service requirements and a significant portion of capital expenditures. Balance sheet strength and liquidity are excellent and exceed the industry norms. Financial trends are positive. Corporate borrowers are market leaders within the industry and the industry performance is excellent. This grade includes loans which are fully secured by cash or equivalents. This grade includes loans secured by marketable securities with no less than 25% margin. Borrowers are of unquestionable financial strength. Financial standing of borrower is known and borrower exhibits superior liquidity, net worth, cash flow and leverage.

Grade 2: Above average quality - There is minimal risk. Borrowers have strong, stable financial trends. There is strong cash flow covering debt service requirements and some portion of capital expenditures. Alternate sources of repayment are evident and financial ratios are comparable to or exceed the industry norms. Financial trends are positive. Borrower has prominent position within the industry or the local economy and the industry performance is above average. Management is strong in most areas and management depth is good. This grade includes loans secured by marketable securities with a margin less than 25%, and includes borrowers who have stable and reliable cash flow and above average liquidity and cash flow. There is modest risk from exposure to contingent liabilities.

Grade 3: Average quality - Cash flow is adequate to cover all debt service requirements but not capital expenditures. Balance sheet may be leveraged but still comparable to industry norms. Financial trends are stable to mixed over the long term but no significant concerns presently exist. Generally there is a stable industry outlook, although there may be some cyclical characteristics. Borrowers are of average position in the industry or the local economy. The management team is considered capable and stable. This grade includes borrowers with reliable cash flow and alternate sources of repayment which may require the sale of assets. Financial position has been leveraged to a modest degree. However, the borrower has a relatively strong net worth considering income and debt.

13

Note 3 – Loans (continued)

Grade 4: Below average quality – These loans require more frequent monitoring. Stability is lacking in the primary repayment source, cash flow, credit history or liquidity; however, the instability is manageable and considered temporary. Overall trends are not yet adverse. These loans exhibit Grade 3 financial characteristics but may lack proper and complete documentation. Sources of income or cash flow have become unstable or may possibly decline given current business or economic conditions. The borrower has a highly leveraged financial position or limited capital. Speculative construction loans originated by third parties are included in this grade.

Grade 5: Other Assets Especially Mentioned - These loans have potential weaknesses which may inadequately protect the Bank’s position at some future date. Unlike a Grade 4 credit, adverse trends in the borrower’s operations and/or financial position are evident, but have not yet developed into well-defined credit weaknesses. Specific negative events within the borrower or the industry have occurred, which may jeopardize cash flow. Borrower’s operations are highly cyclical or vulnerable to economic or market conditions. Management has potential weaknesses and management depth is lacking. Borrower is taking positive steps to alleviate potential weaknesses and has the potential for improvement and upgrade. Corrective strategy to protect the Bank may be required and active management attention is warranted. Some minor delinquencies may exist from time to time. Borrowers exhibit some degree of weakness in financial condition. This may manifest itself in a reduction of net worth and liquidity.

Grade 6: Substandard - A substandard loan has a well-defined weakness or weaknesses in the primary repayment source and undue reliance is placed on secondary repayment sources (collateral or guarantors). No loss beyond the specific reserves of the allowance for loan losses allocated to these loans is presently expected based on a current assessment of collateral values and guarantor cash flow. However, there is the distinct possibility that the Bank will sustain some future loss if the credit weaknesses are not corrected. Management is inadequate to the extent that the business’s ability to continue operations is in question. Intensive effort to correct the weaknesses and ensure protection against loss of principal (i.e. additional collateral) is mandatory. Delinquency of principal or interest may exist. Net worth, repayment ability, management and collateral protection, all exhibit weakness. In the case of consumer credit, closed end consumer installment loans delinquent between 90 and 119 days (4 monthly payments) will be minimally classified Substandard. Open end consumer credits will be minimally classified substandard if delinquent 90 to 179 days (4 to 6 billing cycles).

Grade 7: Doubtful - A doubtful loan has well-defined weaknesses as in Grade 6 with the added characteristic that collection or liquidation in full, on the basis of currently existing facts, conditions and values, is highly questionable and improbable. The possibility of loss is very high, but because of certain important and reasonably specific pending factors which may work to strengthen the credit, its classification as a loss is deferred until a more exact status can be determined. Pending factors include proposed merger, acquisition, liquidation procedures, capital injection, perfecting liens on additional collateral, and refinancing plans. Borrower is facing extreme financial distress, bankruptcy or liquidation, and prospects for recovery are limited. Loans are seriously in default and should be on non-accrual status. Collateral and guarantor protection are insufficient. Efforts are directed solely at retirement of debt, e.g., asset liquidation. Due to their highly questionable collectability, loans rated doubtful should not remain in this category for an extended period of time.

Grade 8: Loss - Loans classified loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather it is not practical or desirable to defer writing off the asset while pursuing recovery. In the case of consumer credit, closed end consumer installment loans delinquent 120 days or more (5 monthly payments) will be classified Loss. Open end consumer credits will be classified Loss if delinquent 180 days or more (7 or more billing cycles).

14

Note 3 – Loans (continued)

As of September 30, 2014 and December 31, 2013, the Bank had no loans classified as Grade 7 or 8.  It is the Bank’s practice, in most cases, to take a charge-off when a loan or portion of a loan is deemed doubtful or loss.  Consequently, the remaining principal balance, if applicable, which has been evaluated as collectible, is graded accordingly.

As of September 30, 2014 and December 31, 2013, the principal balances of risk grades of loans by loan class, were as follows:

	September 30, 2014
	(dollars in thousands)
	Grades 1 - 4		Grade 5		Grade 6		Total
Commercial and industrial	$	27,658	$	45	$	-	$	27,703
Real estate - construction, land and land development
Acquistion, development, & construction		12,686		171		-		12,857
Other real estate - construction		50,423		-		36		50,459
Real estate - residential
Home equity lines		17,434		-		92		17,526
Other real estate - residential		46,885		575		162		47,622
Real estate - commercial
Owner occupied		55,980		4,199		1,434		61,613
Non-owner occupied		73,638		6,589		544		80,771
Consumer		4,652		-		39		4,691
Total loans receivable	$	289,356	$	11,579	$	2,307	$	303,242

	December 31, 2013
	(dollars in thousands)
	Grades 1 - 4		Grade 5		Grade 6		Total
Commercial and industrial	$	18,010	$	103	$	-	$	18,113
Real estate - construction, land and land development
Acquistion, development, & construction		11,257		49		-		11,306
Other real estate - construction		49,078		-		92		49,170
Real estate - residential
Home equity lines		18,021		-		110		18,131
Other real estate - residential		36,493		612		556		37,661
Real estate - commercial
Owner occupied		54,450		4,845		1,493		60,788
Non-owner occupied		67,989		6,786		1,069		75,844
Consumer		3,910		-		21		3,931
Total loans receivable	$	259,208	$	12,395	$	3,341	$	274,944

The credit risk profile by risk grade category excludes accrued interest receivables of approximately $938,000 and $953,000 as of September 30, 2014 and December 31, 2013, respectively. It also excludes deferred loan fees of approximately $266,000 and $197,000 as of September 30, 2014 and December 31, 2013, respectively.

15

Note 3 – Loans (continued)

The following table presents the activity in the allowance for loan losses by loan segment and the allowance by impairment method as of and for the three and nine months ended September 30, 2014 and 2013:

Allowance for Loan Losses Activity and Allowance by Impairment Method

For the Three and Nine Months Ended September 30, 2014

(dollars in thousands) 

	Commercial and industrial		Real estate - construction, land and land development			Real estate - residential			Real estate - commercial			Consumer			Unallocated			Total
Three Months Ended September 30, 2014
Beginning balance	$	320	$	1,579		$	865		$	2,224		$	214		$	90		$	5,292
Charge offs		-		-			(33	)		-			(22	)		-			(55	)
Recoveries		1		98			47			13			6			-			165
Provisions		25		(79	)		(62	)		(78	)		73			(25	)		(146	)
Ending balance	$	346	$	1,598		$	817		$	2,159		$	271		$	65		$	5,256
Nine Months Ended September 30, 2014
Beginning balance	$	227	$	1,626		$	772		$	2,458		$	210		$	64		$	5,357
Charge offs		-		(37	)		(33	)		-			(65	)		-			(135	)
Recoveries		4		703			50			47			27			-			831
Provisions		115		(694	)		28			(346	)		99			1			(797	)
Ending balance	$	346	$	1,598		$	817		$	2,159		$	271		$	65		$	5,256
Ending balances:
Individually evaluated for impairment	$	-	$	-		$	36		$	227		$	15		$	-		$	278
Collectively evaluated for impairment	$	346	$	1,598		$	781		$	1,932		$	256		$	65		$	4,978

16

Note 3 – Loans (continued)

Allowance for Loan Losses Activity and Allowance by Impairment Method 

For the Three and Nine Months Ended September 30, 2013

(dollars in thousands) 

	Commercial and industrial			Real estate - construction, land and land development			Real estate - residential			Real estate - commercial			Consumer			Unallocated			Total
Three Months Ended September 30, 2013
Beginning balance	$	252		$	1,981		$	719		$	1,805		$	181		$	23		$	4,961
Charge offs		-			-			-			(38	)		(44	)		-			(82	)
Recoveries		1			257			2			10			10			-			280
Provisions		(21	)		(452	)		(10	)		405			52			41			15
Ending balance	$	232		$	1,786		$	711		$	2,182		$	199		$	64		$	5,174
Nine Months Ended September 30, 2013
Beginning balance	$	225		$	2,870		$	794		$	1,872		$	77		$	116		$	5,954
Charge offs		-			-			(54	)		(91	)		(74	)		-			(219	)
Recoveries		3			1,005			10			179			29			-			1,226
Provisions		4			(2,089	)		(39	)		222			167			(52	)		(1,787	)
Ending balance	$	232		$	1,786		$	711		$	2,182		$	199		$	64		$	5,174
Ending balances:
Individually evaluated for impairment	$	13		$	-		$	55		$	63		$	-		$	-		$	131
Collectively evaluated for impairment	$	219		$	1,786		$	656		$	2,119		$	199		$	64		$	5,043

The following table presents the allowance by impairment method as of December 31, 2013:

Allowance by Impairment Method

December 31, 2013

(dollars in thousands) 

	Commercial and industrial		Real estate - construction, land and land development		Real estate - residential		Real estate - commercial		Consumer		Unallocated		Total
Individually evaluated for impairment	$	-	$	37	$	67	$	252	$	2	$	-	$	358
Collectively evaluated for impairment	$	227	$	1,589	$	705	$	2,206	$	208	$	64	$	4,999
Ending balances:	$	227	$	1,626	$	772	$	2,458	$	210	$	64	$	5,357

17

Note 3 – Loans (continued)

The following table presents the recorded investment in loans receivable, including accrued interest and excluding deferred loan fees, by loan segment based on impairment method as of September 30, 2014 and December 31, 2013:

Recorded Investment in Loans Receivable

As of September 30, 2014

(dollars in thousands)

	Commercial and industrial		Real estate - construction, land and land development		Real estate - residential		Real estate - commercial		Consumer		Total
Individually evaluated for impairment	$	-	$	36	$	1,189	$	6,320	$	39	$	7,584
Collectively evaluated for impairment	$	27,769	$	63,576	$	64,184	$	136,396	$	4,671	$	296,596
Ending balance total	$	27,769	$	63,612	$	65,373	$	142,716	$	4,710	$	304,180

Recorded Investment in Loans Receivable

As of December 31, 2013

(dollars in thousands)

	Commercial and industrial		Real estate - construction, land and land development		Real estate - residential		Real estate - commercial		Consumer		Total
Individually evaluated for impairment	$	-	$	92	$	1,695	$	7,053	$	21	$	8,861
Collectively evaluated for impairment	$	18,177	$	60,670	$	54,367	$	129,896	$	3,926	$	267,036
Ending balance total	$	18,177	$	60,762	$	56,062	$	136,949	$	3,947	$	275,897

18

Note 3 – Loans (continued)

Impaired loans

Loans for which it is probable that the payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired, and are individually evaluated for impairment. The following tables present loans individually evaluated for impairment and the related allowance by loan segment as of and for the three and nine month periods ended September 30, 2014 and 2013, and for the year ended December 31, 2013:

Impaired Loans

As of and for the Three Months Ended September 30, 2014

(dollars in thousands) 

	Unpaid Principal Balance		Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		80		36		-		37		-
Real estate - residential
Home equity lines		92		92		-		94		-
Other real estate - residential		1,101		1,017		-		985		12
Real estate - comercial
Owner occupied		5,119		5,080		-		5,110		49
Non-owner occupied		594		594		-		591		15
Consumer		22		10		-		10		-
Total	$	7,008	$	6,829	$	-	$	6,827	$	76
With an allowance recorded:
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		-		-		-		-		-
Real estate - residential
Home equity lines		-		-		-		-		-
Other real estate - residential		80		80		36		79		1
Real estate - comercial
Owner occupied		646		646		227		648		1
Non-owner occupied		-		-		-		-		-
Consumer		29		29		15		31		2
Total	$	755	$	755	$	278	$	758	$	4
Total impaired loans
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		80		36		-		37		-
Real estate - residential
Home equity lines		92		92		-		94		-
Other real estate - residential		1,181		1,097		36		1,064		13
Real estate - comercial
Owner occupied		5,765		5,726		227		5,758		50
Non-owner occupied		594		594		-		591		15
Consumer		51		39		15		41		2
Total	$	7,763	$	7,584	$	278	$	7,585	$	80

19

Note 3 – Loans (continued)

Impaired Loans

As of and for the Nine Months Ended September 30, 2014

(dollars in thousands) 

	Unpaid Principal Balance		Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		80		36		-		38		2
Real estate - residential
Home equity lines		92		92		-		95		2
Other real estate - residential		1,101		1,017		-		1,092		31
Real estate - comercial
Owner occupied		5,119		5,080		-		5,176		156
Non-owner occupied		594		594		-		601		24
Consumer		22		10		-		12		-
Total	$	7,008	$	6,829	$	-	$	7,014	$	215
With an allowance recorded:
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		-		-		-		-		-
Real estate - residential
Home equity lines		-		-		-		-		-
Other real estate - residential		80		80		36		80		3
Real estate - comercial
Owner occupied		646		646		227		657		11
Non-owner occupied		-		-		-		-		-
Consumer		29		29		15		35		2
Total	$	755	$	755	$	278	$	772	$	16
Total impaired loans
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		80		36		-		38		2
Real estate - residential
Home equity lines		92		92		-		95		2
Other real estate - residential		1,181		1,097		36		1,172		34
Real estate - comercial
Owner occupied		5,765		5,726		227		5,833		167
Non-owner occupied		594		594		-		601		24
Consumer		51		39		15		47		2
Total	$	7,763	$	7,584	$	278	$	7,786	$	231

20

Note 3 – Loans (continued)

Impaired Loans

As of and for the Three Months Ended September 30, 2013

(dollars in thousands) 

	Unpaid Principal Balance		Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial and industrial	$	15	$	15	$	-	$	16	$	1
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		1,379		1,184		-		1,355		1
Real estate - residential
Home equity lines		66		66		-		66		-
Other real estate - residential		2,317		2,238		-		2,268		39
Real estate - comercial
Owner occupied		5,276		5,239		-		5,255		68
Non-owner occupied		627		627		-		625		27
Consumer		37		25		-		36		-
Total	$	9,717	$	9,394	$	-	$	9,621	$	136
With an allowance recorded:
Commercial and industrial	$	13	$	13	$	13	$	14	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		-		-		-		-		-
Real estate - residential
Home equity lines		16		16		7		16		-
Other real estate - residential		96		96		48		96		3
Real estate - comercial
Owner occupied		482		482		63		485		13
Non-owner occupied		-		-		-		-		-
Consumer		-		-		-		-		-
Total	$	607	$	607	$	131	$	611	$	16
Total impaired loans
Commercial and industrial	$	28	$	28	$	13	$	30	$	1
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		1,379		1,184		-		1,355		1
Real estate - residential
Home equity lines		82		82		7		82		-
Other real estate - residential		2,413		2,334		48		2,364		42
Real estate - comercial
Owner occupied		5,758		5,721		63		5,740		81
Non-owner occupied		627		627		-		625		27
Consumer		37		25		-		36		-
Total	$	10,324	$	10,001	$	131	$	10,232	$	152

21

Note 3 – Loans (continued)

Impaired Loans

As of and for the Nine Months Ended September 30, 2013

(dollars in thousands) 

	Unpaid Principal Balance		Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial and industrial	$	15	$	15	$	-	$	17	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		1,379		1,184		-		1,379		14
Real estate - residential
Home equity lines		66		66		-		66		2
Other real estate - residential		2,317		2,238		-		2,224		63
Real estate - comercial
Owner occupied		5,276		5,239		-		5,344		172
Non-owner occupied		627		627		-		606		28
Consumer		37		25		-		39		-
Total	$	9,717	$	9,394	$	-	$	9,675	$	279
With an allowance recorded:
Commercial and industrial	$	13	$	13	$	13	$	18	$	1
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		-		-		-		-		-
Real estate - residential
Home equity lines		16		16		7		16		-
Other real estate - residential		96		96		48		96		3
Real estate - comercial
Owner occupied		482		482		63		465		13
Non-owner occupied		-		-		-		-		-
Consumer		-		-		-		-		-
Total	$	607	$	607	$	131	$	595	$	17
Total impaired loans
Commercial and industrial	$	28	$	28	$	13	$	35	$	1
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		1,379		1,184		-		1,379		14
Real estate - residential
Home equity lines		82		82		7		82		2
Other real estate - residential		2,413		2,334		48		2,320		66
Real estate - comercial
Owner occupied		5,758		5,721		63		5,809		185
Non-owner occupied		627		627		-		606		28
Consumer		37		25		-		39		-
Total	$	10,324	$	10,001	$	131	$	10,270	$	296

22

Note 3 – Loans (continued)

Impaired Loans

As of and for the Year Ended December 31, 2013

(dollars in thousands) 

	Unpaid Principal Balance		Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		144		55		-		134		2
Real estate - residential
Home equity lines		162		162		-		162		3
Other real estate - residential		1,342		1,260		-		1,287		69
Real estate - comercial
Owner occupied		5,219		5,184		-		5,192		217
Non-owner occupied		1,060		1,057		-		1,061		37
Consumer		31		19		-		30		-
Total	$	7,958	$	7,737	$	-	$	7,866	$	328
With an allowance recorded:
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		37		37		37		37		-
Real estate - residential
Home equity lines		14		14		7		14		-
Other real estate - residential		259		259		60		259		4
Real estate - comercial
Owner occupied		812		812		252		820		32
Non-owner occupied		-		-		-		-		-
Consumer		2		2		2		2		-
Total	$	1,124	$	1,124	$	358	$	1,132	$	36
Total impaired loans
Commercial and industrial	$	-	$	-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		-
Other real estate - construction		181		92		37		171		2
Real estate - residential
Home equity lines		176		176		7		176		3
Other real estate - residential		1,601		1,519		60		1,546		73
Real estate - comercial
Owner occupied		6,031		5,996		252		6,012		249
Non-owner occupied		1,060		1,057		-		1,061		37
Consumer		33		21		2		32		-
Total	$	9,082	$	8,861	$	358	$	8,998	$	364

For purposes of this disclosure, the unpaid principal balance is not reduced for net charge-offs.

23

Note 3 – Loans (continued)

The following tables present a summary of current, past due and nonaccrual loans as of September 30, 2014 and December 31, 2013 by loan class:

Analysis of Current, Past Due and Nonaccrual Loans

As of September 30, 2014

(dollars in thousands)

	Accruing
	30-89 Days Past Due		90 Days or more Past Due		Nonaccrual		Total Past Due and Nonaccrual		Current and not Past Due or Nonaccrual		Total Loans
Commercial and industrial	$	55	$	-	$	-	$	55	$	27,648	$	27,703
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		12,857		12,857
Other real estate - construction		13		-		-		13		50,446		50,459
Real estate - residential
Home equity lines		56		-		118		174		17,352		17,526
Other real estate - residential		31		39		162		232		47,390		47,622
Real estate - comercial
Owner occupied		231		-		683		914		60,699		61,613
Non-owner occupied		-		-		-		-		80,771		80,771
Consumer		8		-		39		47		4,644		4,691
Total	$	394	$	39	$	1,002	$	1,435	$	301,807	$	303,242

Analysis of Current, Past Due and Nonaccrual Loans

As of December 31, 2013

(dollars in thousands)

	Accruing
	30-89 Days Past Due		90 Days or more Past Due		Nonaccrual		Total Past Due and Nonaccrual		Current and not Past Due or Nonaccrual		Total Loans
Commercial and industrial	$	59	$	-	$	-	$	59	$	18,054	$	18,113
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-		11,306		11,306
Other real estate - construction		125		31		52		208		48,962		49,170
Real estate - residential
Home equity lines		132		-		110		242		17,889		18,131
Other real estate - residential		468		-		556		1,024		36,637		37,661
Real estate - comercial
Owner occupied		919		-		744		1,663		59,125		60,788
Non-owner occupied		-		-		441		441		75,403		75,844
Consumer		6		-		21		27		3,904		3,931
Total	$	1,709	$	31	$	1,924	$	3,664	$	271,280	$	274,944

24

Note 3 – Loans (continued)

The Bank’s policy is that loans placed on nonaccrual will typically remain on nonaccrual status until all principal and interest payments are brought current and the prospect for future payments in accordance with the loan agreement appear relatively certain. The Bank’s policy generally requires six consecutive months of payment performance to warrant a return to accrual status.

Troubled debt restructurings

Troubled debt restructurings are defined as debt modifications, for economic or legal reasons related to the borrower’s financial difficulties, in which the Bank grants a concession that it would not otherwise consider. Such a concession may stem from an agreement between the Bank and the borrower, or may be imposed by law or a court. Some examples of modifications are as follows:

Rate Modification - A modification in which the interest rate is changed below the current market rate.

Term Modification - A modification in which the maturity date, timing of payments, or frequency of payments is changed.

Interest Only Modification – A modification in which the loan is converted to interest-only payments for a period of time.

Payment Modification – A modification in which the dollar amount of the payment is changed, other than an interest only modification described above.

Transfer of Assets Modification – A modification in which a transfer of assets has occurred to partially satisfy debt, including foreclosure and repossession.

Combination Modification – Any other type of modification, including the use of multiple categories above.

The following tables present the Bank’s loans classified as troubled debt restructurings by loan class as of September 30, 2014 and December 31, 2013:

As of September 30, 2014

(dollars in thousands)

	Number of Contracts		Accrual		Nonaccrual		Total Restructurings
Commercial and industrial		-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-
Other real estate - construction		-		-		-		-
Real estate - residential
Home equity lines		-		-		-		-
Other real estate - residential		10		895		-		895
Real estate - comercial
Owner occupied		10		5,034		327		5,361
Non-owner occupied		2		589		-		589
Consumer		-		-		-		-
Total		22	$	6,518	$	327	$	6,845

25

Note 3 – Loans (continued)

As of December 31, 2013

(dollars in thousands)

	Number of Contracts		Accrual		Nonaccrual		Total Restructurings
Commercial and industrial		-	$	-	$	-	$	-
Real estate - construction, land and land development
Acquistion, development, & construction		-		-		-		-
Other real estate - construction		-		-		-		-
Real estate - residential
Home equity lines		1		66		-		66
Other real estate - residential		10		925		-		925
Real estate - comercial
Owner occupied		13		5,302		473		5,775
Non-owner occupied		1		563		-		563
Consumer		-		-		-		-
Total		25	$	6,856	$	473	$	7,329

At September 30, 2014 and December 31, 2013, there were no outstanding commitments to advance additional funds on troubled debt restructurings.

For the three months ended September 30, 2014, there was one newly restructured loan which totaled $15,000 compared to four newly restructured loans which totaled $1,358,000 for the three months ended September 30, 2013. For the nine months ended September 30, 2014, there were two newly restructured loans that occurred which totaled $32,500 compared to nine newly restructured loans that occurred which totaled $2,212,000 for the nine months ended September 30, 2013. The impact of these modifications was not material to the consolidated financial statements for the three and nine months ended September 30, 2014 and 2013.

Loans receivable modified as troubled debt restructurings and with a payment default, with the payment default occurring within 12 months of the restructure date, for the nine months ended September 30, 2014 and 2013, were $0 and $532,000, respectively.

Note 4 – Stock-Based Compensation

During the nine months ended September 30, 2014 and 2013, the Company made restricted stock awards totaling 20,292 and 24,006, respectively. The awards granted in 2014 which vest fully at the end of three years totaled 15,698. The awards granted in 2014 which immediately vest totaled 4,594. The awards granted in 2013 which vest fully at the end of three years totaled 16,406. The awards granted in 2013 which vest fully at the end of five years totaled 7,600. The Company recorded restricted stock expense of $222,693 and $97,333 during the nine months ended September 30, 2014 and 2013, respectively.

During the nine months ended September 30, 2014 and 2013, the Company recorded stock option expense of $66,390 and $70,391, respectively. The Company did not award any stock options during the nine months ended September 30, 2014 and 2013. Future levels of compensation cost related to share-based compensation awards may be impacted by new awards and/or modifications, repurchases and cancellations of existing awards.

26

Note 5 – Earnings Per Share

Earnings per common share are calculated on the basis of the weighted average number of common shares outstanding. Diluted earnings per share include the effect of outstanding stock options. The following table is a reconciliation of the income amounts and common stock amounts utilized in computing the Company’s earnings per share for the periods then ended:

	For the Three Months Ended September 30, 2014
	Income (Numerator)		Shares (Denominator)		Per Share
	(dollars in thousands, except per share data)
Basic EPS
Net income available to common shareholder	$	1,396		3,596,046	$	0.39
Effect of stock options outstanding		-		80,863		(0.01	)
Diluted EPS
Net income available to common shareholder	$	1,396		3,676,909	$	0.38

	For the Three Months Ended September 30, 2013
	Income (Numerator)		Shares (Denominator)		Per Share
	(dollars in thousands, except per share data)
Basic EPS
Net income available to common shareholder	$	843		3,562,171	$	0.24
Effect of stock options outstanding		-		37,489		(0.01	)
Diluted EPS
Net income available to common shareholder	$	843		3,599,660	$	0.23

	For the Nine Months Ended September 30, 2014
	Income (Numerator)		Shares (Denominator)		Per Share
	(dollars in thousands, except per share data)
Basic EPS
Net income available to common shareholder	$	3,211		3,593,323	$	0.89
Effect of stock options outstanding		-		51,339		(0.01	)
Diluted EPS
Net income available to common shareholder	$	3,211		3,644,662	$	0.88

	For the Nine Months Ended September 30, 2013
	Income (Numerator)		Shares (Denominator)		Per Share
	(dollars in thousands, except per share data)
Basic EPS
Net income available to common shareholder	$	5,269		3,555,293	$	1.48
Effect of stock options outstanding		-		30,338		(0.01	)
Diluted EPS
Net income available to common shareholder	$	5,269		3,585,631	$	1.47

27

Note 5 – Earnings Per Share (continued)

For the three months ended September 30, 2014 and 2013, there were 0 and 34,865 outstanding stock options, respectively, that were antidilutive due to the exercise price exceeding the average market price. For the nine months ended September 30, 2014 and 2013, there were 0 and 47,365 outstanding stock options, respectively, that were antidilutive due to the exercise price exceeding the average market price.

Note 6 – Fair Value Measurement

The Company utilizes fair value measurement to record fair value adjustments to certain assets and liabilities and to determine fair value measurements where required. For assets and liabilities recorded at fair value, it is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements.

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are as follows:

Level 1 – Valuations are readily obtainable because the assets and liabilities are traded on active exchange markets, such as the New York Stock Exchange. At September 30, 2014, the Company had no Level 1 assets.

Level 2 – Valuations are obtained from readily available pricing sources via independent providers for market transactions involving similar assets or liabilities. The Company’s principal markets for these securities are the secondary institutional markets and valuations are based on observable market data in

those markets. At September 30, 2014, the Company’s Level 2 assets included U.S. Government agency obligations, state and municipal bonds, mortgage-backed securities, corporate bonds, and mortgage loans held for sale.

Level 3 – Valuations are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and are not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. Level 3 assets include impaired loans and other real estate owned as discussed below.

Following is a description of valuation methodologies used for determining fair value for assets and liabilities:

Investment Securities Available-for-Sale

Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as present value of future cash flows, adjusted for the securities’ credit rating, prepayment assumptions, and other factors such as credit loss assumptions. Periodically, management compares the fair values obtained through its pricing provider with another independent party to determine reliability. The Company classified $134.0 million and $158.4 million of investment securities available-for-sale subject to recurring fair value adjustments as Level 2 at September 30, 2014 and December 31, 2013, respectively.

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once an individual loan is identified as impaired, management measures the impairment. The fair value of impaired loans is estimated primarily using the collateral value. However, in some cases other methods are used, such as market value of similar debt, enterprise value, liquidation value, and discounted cash flows.

28

Note 6 – Fair Value Measurement (continued)

Those impaired loans not requiring an allowance represent loans with respect to which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2014, substantially all of the impaired loans were evaluated based on the fair value of the collateral less estimated selling costs. Impaired loans where an allowance is established based on the fair value of collateral, or those that have been charged down to the fair value of collateral, require classification in the fair value hierarchy. The fair value of the collateral is generally based on recent third party appraisals, tax valuations, or broker price opinions.

The appraisals may include adjustments by the appraisers for differences between approaches such as the comparable sales approach and the income approach.

As such, the Company records these collateral dependent impaired loans at fair value as nonrecurring Level 3. Collateral dependent impaired loans recorded at fair value totaled $959,000 and $1.4 million at September 30, 2014 and December 31, 2013, respectively. Specific loan loss allowances for these impaired loans totaled $278,000 and $358,000 at September 30, 2014 and December 31, 2013, respectively.

Loans Held for Sale

Loans held for sale are carried at fair value on a recurring basis, as determined by outstanding commitments from third party investors (Level 2). The Company elected the fair value option for loans held for sale on July 1, 2012. These loans are intended for sale and the Company believes that the fair value is the best indicator of the resolution of these loans. Interest income is recorded based on the contractual terms of the loan and in accordance with the Company’s policy on loans held for investment. None of these loans are 90 days or more past due, or on non-accrual as of September 30, 2014 and December 31, 2013. As of September 30, 2014 and December 31, 2013, the aggregate fair value of loans held for sale was $29.7 million and $31.3 million, respectively; the contractual balance including accrued interest was $29.1 million and $30.9 million, respectively.

Interest Rate Lock Commitments

Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as free standing derivatives (Level 2). Fair values of these mortgage derivatives are estimated based on their values at inception and changes in mortgage interest rates from the date the interest on the loan is locked. The fair value at inception and any changes in the fair values of these derivatives are included in mortgage banking activities. At September 30, 2014 and December 31, 2013, the interest rate lock commitments with a positive fair value totaled $57,000 and $39,000, respectively, and were recorded in other assets. The interest rate lock commitments with a negative fair value at September 30, 2014 and December 31, 2013 totaled $73,000 and $118,000, respectively, and were recorded in other liabilities.

The Company enters into forward commitments for the future delivery of mortgage loans when interest rate locks are entered into, in order to hedge the change in interest rates resulting from its commitments to fund loans. Changes in the fair values of these derivatives are included in mortgage banking activities. At September 30, 2014 and December 31, 2013, the forward commitments for the interest rate lock commitments with a positive fair value totaled $73,000 and $118,000, respectively, and were recorded in other assets. The forward commitments for the interest rate lock commitments with a negative fair value at September 30, 2014 and December 31, 2013 totaled $57,000 and $39,000, respectively, and were recorded in other liabilities.

At September 30, 2014 and December 31, 2013, the forward commitments for loans held for sale with a positive fair value totaled $95,000 and $422,000, respectively, and were recorded in other assets. The forward commitments for loans held for sale with a negative fair value at September 30, 2014 and December 31, 2013 totaled $67,000 and $17,000, respectively, and were recorded in other liabilities.

29

Note 6 – Fair Value Measurement (continued)

Other Real Estate Owned

Foreclosed assets are adjusted to fair value less estimated selling costs upon transfer of the loans to other real estate owned, establishing a new cost basis. Subsequently, other real estate owned is carried at the lower of carrying value or fair value less estimated selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. Most fair values of the collateral are based on an observable market price or a current appraised value; however, in some cases an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price.

Management may apply discount adjustments to the appraised value for estimated selling costs, information from comparable sales, and marketability of the property. As such, the Company records other real estate owned with subsequent write downs after transfer as nonrecurring Level 3. Other real estate owned that has had subsequent write-downs after transfer from loans to other real estate totaled $3.9 million and $3.6 million at September 30, 2014 and December 31, 2013, respectively.

The tables below present information as of September 30, 2014 and December 31, 2013 about assets and liabilities which are measured at fair value on a recurring basis (dollars in thousands):

	Fair Value Measurements at
	September 30, 2014, Using,
	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Other Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
	(dollars in thousands)
U.S. Government and agency	$	-	$	43,392	$	-	$	43,392
Mortgage-backed - residential GSEs		-		60,608		-		60,608
State and municipal		-		27,309		-		27,309
Corporate bonds		-		2,710		-		2,710
Total	$	-	$	134,019	$	-	$	134,019
Loans held for sale	$	-	$	29,694	$	-	$	29,694
Derivative assets (1)	$	-	$	452	$	-	$	452
Derivative liabilities(1)	$	-	$	197	$	-	$	197

(1) This amount includes mortgage related interest rate lock commitments and commitments to sell.

30

Note 6 – Fair Value Measurement (continued)

	Fair Value Measurements at
	December 31, 2013, Using,
	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Other Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
	(dollars in thousands)
U.S. Government and agency	$	-	$	58,281	$	-	$	58,281
Mortgage-backed - residential GSEs		-		64,732		-		64,732
State and municipal		-		30,751		-		30,751
Corporate bonds		-		4,675		-		4,675
Total	$	-	$	158,439	$	-	$	158,439
Loans held for sale	$	-	$	31,298	$	-	$	31,298
Derivative assets (1)	$	-	$	823	$	-	$	823
Derivative liabilities(1)	$	-	$	175	$	-	$	175

(1) This amount includes mortgage related interest rate lock commitments and commitments to sell.

There were no transfers between Level 1, Level 2 or Level 3 during the first nine months of 2014 or 2013.

31

Note 6 – Fair Value Measurement (continued)

Assets measured at fair value on a non-recurring basis as of September 30, 2014 and December 31, 2013 are summarized below:

	Fair Value Measurements at
	September 30, 2014, Using,
	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Other Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
	(dollars in thousands)
Impaired loans, net of allowance
Commercial and industrial	$	-	$	-	$	-	$	-
Real estate - construction		-		-		35		35
Real estate - residential		-		-		73		73
Real estate - commercial		-		-		551		551
Consumer		-		-		22		22
Total impaired loans	$	-	$	-	$	681	$	681
Other real estate owned
Unimproved land	$	-	$	-	$	406	$	406
Real estate - residential		-		-		-		-
Real estate - commercial		-		-		3,532		3,532
Total other real estate owned	$	-	$	-	$	3,938	$	3,938

	Fair Value Measurements at
	December 31, 2013, Using,
	Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Other Unobservable Inputs
	(Level 1)		(Level 2)		(Level 3)		Total
	(dollars in thousands)
Impaired loans, net of allowance
Commercial and industrial	$	-	$	-	$	-	$	-
Real estate - construction		-		-		40		40
Real estate - residential		-		-		249		249
Real estate - commercial		-		-		701		701
Consumer		-		-		11		11
Total impaired loans	$	-	$	-	$	1,001	$	1,001
Other real estate owned
Unimproved land	$	-	$	-	$	471	$	471
Real estate - residential		-		-		144		144
Real estate - commercial		-		-		2,951		2,951
Total other real estate owned	$	-	$	-	$	3,566	$	3,566

32

Note 6 – Fair Value Measurement (continued)

Impaired loans that are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $959,000 with a valuation allowance of $278,000 at September 30, 2014, resulting in an additional provision for loan losses of $278,000 for the nine months ended September 30, 2014. At December 31, 2013, impaired loans had a principal balance of $1,359,000 with a valuation allowance of $358,000, resulting in an additional provision for loan losses of $358,000 for the year ended December 31, 2013.

At September 30, 2014, other real estate owned measured at fair value less costs to sell, had a net carrying amount of $4,738,000 with no valuation allowance and $199,000 in valuation adjustments for the nine months ended September 30, 2014, resulting in a charge of $199,000 for the nine months ended September 30, 2014. At December 31, 2013, other real estate owned had a net carrying amount of $4,897,000 with no valuation allowance and $896,000 in valuation adjustments, resulting in a charge of $896,000 for the year ended December 31, 2013.

The following table presents quantitative information about significant unobservable inputs used in Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2014 for collateral dependent impaired loans and other real estate owned: 

	Fair Value			Valuation Technique	Unobservable Inputs	Range		Weighted Average
Impaired loans:
Real estate – construction	$	35	Sales comparison		Management and appraiser adjustment for difference between comparable sales		45.33%		45.33	%
Real estate – residential		73	Sales comparison		Management and appraiser adjustment for difference between comparable sales		30.64% - 74.77%		46.88	%
Real estate - commercial		551	Sales comparison		Management and appraiser adjustment for difference between comparable sales		5.78% - 44.08%		17.00	%
			Income approach		Capitalization rate		9.50%		9.50	%
Consumer		22	NADA or third party valuation of underlying collateral		Management adjustment for comparable sales		25.46% - 100%		35.92	%
Total	$	681
Other real estate owned:
Unimproved land	$	406	Sales comparison		Management and appraiser adjustment for difference between comparable sales		0.00%-35.42%		3.81	%
Real estate - residential		-	Sales comparison		Management and appraiser adjustment for difference between comparable sales		0.00%		0.00	%
Real estate – commercial		3,532	Sales comparison		Management and appraiser adjustment for difference between comparable sales		0.00% - 23.73%		9.16	%
			Income approach		Capitalization rate		10.00%		10.00	%
Total	$	3,938

33

Note 6 – Fair Value Measurement (continued)

Financial Instruments

Fair value measurements for assets and liabilities where there exists limited or no observable market data and, therefore, are based primarily upon estimates, are often calculated based on the economic and competitive environment, the characteristics of the asset or liability, and other factors. Therefore, the fair value cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect current or future values.

The methods and assumptions, not previously presented, used to estimate the fair value of significant financial instruments are as follows:

Cash and due from banks - The carrying value of cash and due from banks approximates the fair value and these instruments are classified as Level 1.

Federal Home Loan Bank stock - The fair value of Federal Home Loan Bank (“FHLB”) stock is not readily ascertainable since no ready market exists for the stock and there are restrictions on its transferability.

Accrued interest receivable – The carrying value of accrued interest receivable for loans and securities approximates the fair value and is classified consistently with the level of the underlying asset.

Deposits - The fair value of time deposits is estimated using a discounted cash flow calculation that applies current interest rates to a schedule of aggregated expected maturities and these instruments are classified as Level 2. The carrying value of other deposits approximates the fair value and they are classified as Level 1.

Repurchase agreements - The carrying value of repurchase agreements approximates fair value due to their short-term nature and they are classified as Level 1.

Short-term debt – The fair value of short-term debt approximates the carrying value of other borrowings due to their short-term nature and they are classified as Level 1.

Accrued interest payable – The carrying value of accrued interest payable for deposits, repurchase agreements and borrowings approximates the fair value and is classified consistently with the level of the underlying liability.

34

Note 6 – Fair Value Measurement (continued)

The carrying amount and estimated fair values of the Bank’s financial instruments at September 30, 2014 and December 31, 2013 are as follows:

	Fair Value Measurements at
	September 30, 2014
	Carrying Value		Level 1		Level 2		Level 3		Total
	(dollars in thousands)
Financial assets:
Cash and due from banks	$	26,881	$	26,881	$	-	$	-	$	26,881
Securities available for sale		134,019		-		134,019		-		134,019
Loans, net of allowance		297,720		-		-		298,022		298,022
Loans held for sale		29,694		-		29,694		-		29,694
Federal Home Loan Bank stock		465	N/A		N/A		N/A		N/A
Accrued interest receivable, loans		965		-		27		938		965
Accrued interest receivable, securities		764		-		764		-		764
Other derivative assets(1)		452		-		452		-		452
Financial liabilities
Time deposits	$	143,839	$	-	$	144,698	$	-	$	144,698
Other deposits		281,484		281,484		-		-		281,484
Repurchase agreements		30,206		30,206		-		-		30,206
Short-term debt		-		-		-		-		-
Accrued interest payable, deposits		404		4		400		-		404
Accrued interest payable, short-term debt		-		-		-		-		-
Other derivative liabilities(1)		197		-		197		-		197

(1) This amount includes mortgage related interest rate lock commitments and commitments to sell.

35

Note 6 – Fair Value Measurement (continued)

	Fair Value Measurements at
	December 31, 2013
	Carrying Value		Level 1		Level 2		Level 3		Total
	(dollars in thousands)
Financial assets:
Cash and due from banks	$	16,828	$	16,828	$	-	$	-	$	16,828
Securities available for sale		158,439		-		158,439		-		158,439
Loans, net of allowance		269,390		-		-		271,112		271,112
Loans held for sale		31,298		-		31,298		-		31,298
Federal Home Loan Bank stock		1,606	N/A		N/A		N/A		N/A
Accrued interest receivable, loans		974		-		21		953		974
Accrued interest receivable, securities		880		-		880		-		880
Other derivative assets(1)		823		-		823		-		823
Financial liabilities
Time deposits	$	152,484	$	-	$	153,411	$	-	$	153,411
Other deposits		267,221		267,221		-		-		267,221
Repurchase agreements		12,111		12,111		-		-		12,111
Short-term debt		22,200		22,200		-		-		22,200
Accrued interest payable, deposits		398		5		393		-		398
Accrued interest payable, short-term debt		6		6		-		-		6
Other derivative liabilities(1)		175		-		175		-		175

(1) This amount includes mortgage related interest rate lock commitments and commitments to sell.

Note 7 – Commitments and Contingencies

In the ordinary course of business, the Bank may enter into off-balance sheet financial instruments that are not reflected in the consolidated financial statements. These instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the consolidated financial statements when funds are disbursed or the instruments become payable.

The Bank uses the same credit policies for these off-balance sheet financial instruments as it does for other instruments that are recorded in the consolidated financial statements.

Following is an analysis of significant off-balance sheet financial instruments as of September 30, 2014 and December 31, 2013:

	September 30, 2014		December 31, 2013
	(dollars in thousands)
Commitments to extend credit	$	84,521	$	74,144
Standby letters of credit		312		472
Total	$	84,833	$	74,616

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Note 7 – Commitments and Contingencies (continued)

Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitment amounts expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. In managing the Bank’s credit and market risk exposure, the Bank may participate these commitments with other institutions when funded. The credit risk involved in issuing these financial instruments is essentially the same as that involved in extending loans to customers. If deemed necessary by the Bank, the amount of collateral obtained upon extension of credit is based on management’s credit evaluation of the customer. Collateral held varies, but may include real estate and improvements, marketable securities, accounts receivable, inventory, equipment and personal property.

Loans sold under our mortgage loans held for sale portfolio contain certain representations and warranties in our loan sale agreements which provide that we repurchase or indemnify the investors for losses or costs on loans we sell under certain limited conditions. Some of these conditions include underwriting errors or omissions, fraud or material misstatements by the borrower in the loan application, or inaccurate market value on the collateral property due to deficiencies in the appraisal. In addition to these representations and warranties, our loan sale contracts define a condition in which the borrower defaults during a short period of time, typically 120 days to one year, as an Early Payment Default (“EPD”).

In the event of an EPD, we are required to return the premium paid by the investor for the loan as well as certain administrative fees, and in some cases repurchase the loan or indemnify the investor. Based on these recourse provisions, the Bank has a recourse liability for mortgage loans sold. During July and August of 2014, the Bank settled with two investors for a total of $740,000 for repurchase demands for mortgage loans which originated during the 2005 to 2008 time period. The Bank had previously set aside $1.0 million in the mortgage recourse liability specifically related to the potential settlement loss as a result of the ongoing settlement discussions with these investors, which have been in process for the last two years. As a result of these settlements, the mortgage recourse liability was reduced by the settlement amount and no additional provision expense was required as the previously established accrual was more than sufficient to cover the amount of the settlement. These settlements are included in the activity for the nine months ended September 30, 2014. The following table presents the activity in the recourse liability for the nine months ended September 30, 2014 and 2013:

	September 30, 2014			September 30, 2013
	(dollars in thousands)
Beginning balance	$	1,090		$	772
Provision		295			374
Losses		(800	)		(196	)
Recoveries		-			15
Ending balance	$	585		$	965

The Bank, as part of its retail mortgage loan production activities, routinely enters into short-term commitments to originate loans. Most of the loans will be sold to third parties upon closing. For those loans, the Bank enters into best efforts forward sales commitments at the same time the commitments to originate are finalized. The Bank has executed best efforts forward sales commitments related to retail mortgage loans, which are classified as loans held for sale. The forward sales commitments on retail mortgage loans function as an economic offset and mitigate the Bank’s market risk on these loans.

The nature of the business of the Bank is such that it ordinarily results in a certain amount of litigation. In the opinion of management, there are no present litigation matters in which the anticipated outcome will have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

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Note 7 – Commitments and Contingencies (continued)

In August 2011, First Bank of Georgia was sued in State Court by a subcontractor related to a residential development project foreclosed upon by First Bank of Georgia. The suit alleged various claims against First Bank of Georgia, all of which First Bank of Georgia denied. Following a mistrial in November 2012 where the jury failed to reach a verdict, a second trial in January 2013 resulted in a verdict against First Bank of Georgia in the amount of $597,500. First Bank of Georgia appealed this verdict.

In July 2014, the Georgia Court of Appeals reversed the judgment in favor of First Bank of Georgia in the foregoing case and has, in rendering its judgment, refused to allow a new trial. The court found that the trial judge should have entered judgment in favor of First Bank of Georgia. The Georgia Supreme Court denied the petition for certiorari by the subcontractor.

A contingent liability of $597,500 was recorded as of December 31, 2012. This contingent liability was fully reversed and recorded as other non-interest income during the third quarter of 2014.

Note 8 – Merger with State Bank Financial Corporation

On June 23, 2014, the Company and State Bank Financial Corporation (“State Bank”), the holding company for State Bank and Trust Company (“SBTC”), entered into an agreement and plan of merger (the “Merger Agreement”), which provides that, subject to the terms and conditions set forth in the Merger Agreement, State Bank will acquire the Company and its wholly-owned subsidiary, First Bank, in a cash and stock transaction with a purchase price of approximately $82 million, or $22.35 per share (the “Merger”). The transaction value at the time of the Merger may change due to fluctuations in the price of State Bank’s common stock. 

Note 9 – Impact of Other Recently Issued Accounting Standards

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies, but not specifically addressed in this report, are not expected to have a material impact on the Company’s financial condition, results of operations, or liquidity.

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Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Overview

Georgia-Carolina Bancshares, Inc. (the “Company”) was incorporated under the laws of the State of Georgia on January 31, 1997 to operate as a bank holding company pursuant to the Federal Bank Holding Company Act of 1956, as amended. The Company is a one-bank holding company and owns 100% of the issued and outstanding stock of First Bank of Georgia (the “Bank”), an independent, state-chartered commercial bank. The Bank operates three offices in Augusta, Georgia, two offices in Martinez, Georgia, one office in Evans, Georgia, and one office in Thomson, Georgia. The Bank opened the branch in Evans, Georgia in May 2013. The Bank also operates non-depository, mortgage origination offices in Augusta, Georgia and Savannah, Georgia. The Bank also has a mortgage production office in Aiken, South Carolina. The Bank is the parent company of Willhaven Holdings, LLC, which held certain other real estate of the Bank.

The Bank targets the banking needs of individuals and small to medium-sized businesses by emphasizing personal service. The Bank offers a full range of deposit and lending services and is a member of an electronic banking network that enables its customers to use the automated teller machines of other financial institutions. In addition, the Bank offers commercial and business credit services, as well as various consumer credit services, including home mortgage loans, automobile loans, lines of credit, home equity loans and home improvement loans. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”).

Merger with State Bank Financial Corporation

On June 23, 2014, the Company and State Bank Financial Corporation (“State Bank”), the holding company for State Bank and Trust Company (“SBTC”), entered into an agreement and plan of merger (the “Merger Agreement”), which provides that, subject to the terms and conditions set forth in the Merger Agreement, State Bank will acquire the Company and its wholly-owned subsidiary, First Bank, in a cash and stock transaction with a purchase price of approximately $82 million, or $22.35 per share (the “Merger”). The transaction value at the time of the Merger may change due to fluctuations in the price of State Bank’s common stock.

Subject to the terms and conditions of the Merger Agreement, each share of the Company’s common stock will be converted into the right to receive $8.85 in cash and a number of shares of State Bank common stock equal to an exchange ratio (described below), subject to the limitations that, if the aggregate value of the stock consideration is less than 40% of the aggregate merger consideration, the exchange ratio will be adjusted such that the aggregate stock consideration is at least 40% of the aggregate merger consideration. Cash will also be paid in lieu of fractional shares.

The exchange ratio will depend on the average closing price of State Bank’s common stock during the twenty trading day period ending five business days before the closing of the transaction (the “Final State Bank Price”). If the Final State Bank Price is above $14.00 but below $17.00, the exchange ratio will be equal to $13.50 divided by the Final State Bank Price. If the Final State Bank Price is at or above $17.00, the exchange ratio will be 0.794. If the Final State Bank Price is at or below $14.00, the exchange ratio will be 0.964.

At the effective time of the Merger, each option granted by the Company to purchase shares of the Company’s common stock will be cancelled immediately prior to completion of the Merger in exchange for a cash payment at closing equal to the product obtained by multiplying (1) the number of shares of the Company’s common stock underlying such person’s options by (2) the Per Share Purchase Price (as defined in the Merger Agreement) less the exercise price per share of such options, by entering into a Stock Option Cash-Out Agreement. In the event that the product obtained by the prior sentence is zero or a negative number, then the options will be cancelled for no consideration. Each option to acquire the Company’s common stock outstanding but unvested on the date of closing will be accelerated to vest prior to the closing of the Merger.

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The boards of directors of the Company and State Bank have approved the Merger Agreement. The Merger Agreement and the transactions contemplated thereby are subject to the approval of the shareholders of the Company, regulatory approvals, and other customary closing conditions. The Merger Agreement provides certain termination rights for both the Company and State Bank, and further provides that upon termination of the Merger Agreement under certain circumstances, the Company will be obligated to pay State Bank a termination fee of $4,500,000. In addition, either the Company or State Bank can terminate the Merger Agreement if the Merger has not been closed by February 28, 2015, if the failure to close is not caused by the breach of the Merger Agreement by the party electing to terminate.

The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the complete text of the Merger Agreement, which is attached as Exhibit 2.1 to the Company’s Current Report on Form 8-K, filed June 24, 2014 with the Securities and Exchange Commission (the “SEC”).

The Merger is expected to be consummated early in the first quarter of 2015.

 Additional Information About the Merger and Where to Find It

In connection with the proposed merger transaction, State Bank Financial Corporation (“State Bank”) has filed a registration statement on Form S-4 with the Securities and Exchange Commission (the “SEC”) to register State Bank’s shares that will be issued to the Company’s shareholders in connection with the transaction, which registration statement has been declared effective by the SEC. The registration statement includes a proxy statement of the Company and a prospectus of State Bank, as well as other relevant documents concerning the proposed transaction. The registration statement and the proxy statement/prospectus related to the proposed transaction contain important information about the Company, State Bank and the proposed transaction and related matters. WE URGE SECURITY HOLDERS TO READ THESE MATERIALS WHEN THEY BECOME AVAILABLE (AND ANY OTHER DOCUMENTS FILED WITH THE SEC IN CONNECTION WITH THE TRANSACTION OR INCORPORATED BY REFERENCE INTO THE REGISTRATION STATEMENT AND PROXY STATEMENT/PROSPECTUS) BECAUSE THOSE DOCUMENTS CONTAIN IMPORTANT INFORMATION. Security holders may obtain free copies of these documents and other documents filed with the SEC on the SEC’s website at http://www.sec.gov. Security holders may obtain free copies of the documents filed with the SEC by the Company at its website at https://www.firstbankofga.com (which website is not incorporated herein by reference) or by contacting Thomas J. Flournoy by telephone at 706.731.6622. Security holders may also obtain free copies of the documents filed with the SEC by State Bank at its website at http://www.statebt.com (which website is not incorporated herein by reference) or by contacting Jeremy Lucas by telephone at 404.239.8626.

 Participants in this Transaction

The Company, State Bank and their respective directors and executive officers may be deemed to be participants in the solicitation of proxies from the shareholders of the Company in connection with the proposed merger. Information regarding these persons who may, under the rules of the SEC, be considered participants in the solicitation of shareholders in connection with the proposed merger is contained in the proxy statement/prospectus described above. Additional information regarding each of the Company’s and State Bank’s respective directors and executive officers, including shareholdings, is included in the Company’s definitive proxy statement for 2014, which was filed with the SEC on April 14, 2014, and State Bank’s definitive proxy statement for 2014, which was filed with the SEC on April 11, 2014. You can obtain free copies of this document from the Company or State Bank, respectively, using the contact information above. You can obtain free copies of this document from the Company or State Bank, respectively, using the contact information above.

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Critical Accounting Policies

The accounting and reporting policies of the Company and Bank are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. Application of these principles requires management to make estimates or judgments that affect the amounts reported in the financial statements and the accompanying notes. These estimates are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates or judgments. Certain policies inherently have a greater reliance on the use of estimates, and as such have a greater possibility of producing results that could be materially different than originally reported.

Estimates or judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or a valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record the valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.

Management views critical accounting policies to be those that are highly dependent on subjective or complex judgments, estimates and assumptions, and where changes in those estimates and assumptions could have a significant impact on the financial statements.

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Estimating the amount of the allowance for loan losses requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on non-impaired loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors.

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is primarily based on the actual loss history experienced by the Bank over the most recent year. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries for the most recent three years; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations.

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There are many factors affecting the allowance for loan losses; some are quantitative while others require qualitative judgment. Although management believes its process for determining the allowance adequately considers all possible factors that could potentially result in credit losses, the process includes subjective elements and may be susceptible to significant change. To the extent actual outcomes differ from management’s estimates, additional provisions for loan losses could be required that could adversely affect the Bank’s earnings or financial position in future periods.

Mortgage Banking Derivatives

Loan commitments, whose underlying mortgage loans at origination will be held for sale upon funding of the loan, are derivative instruments. Loan commitments are recognized on the consolidated balance sheet in other assets and other liabilities at fair value, with changes in their fair values recognized in mortgage banking activities. At the inception of a loan commitment, the Bank generally will simultaneously enter into a best efforts forward commitment to protect the Bank from losses on sales of the loans underlying the loan commitment by securing the ultimate sale price and delivery date of the loan.

Other Real Estate Owned 

Assets acquired through or instead of loan foreclosure are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed. Costs related to the development and improvement of other real estate owned are capitalized.

Fair Values of Financial Instruments

Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates.

Results of Operations

Overview

The Company’s net income was $1,396,000 for the quarter ended September 30, 2014, compared to $843,000 for the third quarter of 2013, an increase of 65.6%. The Company’s net income was $3,211,000 for the nine months ended September 30, 2014, compared to net income of $5,269,000 for the nine months ended September 30, 2013, a decrease of 39.1%. The increase in net income for the three month period was primarily due to an increase in net interest income and the reversal of a contingent liability which was recorded in other non-interest income. The decrease in net income for the nine month period was primarily due to a lower negative loan loss provision, a decline in mortgage banking activity and expenses incurred for the Merger. This was partially offset by an increase in net interest income and the reversal of a contingent liability which was recorded in other non-interest income. The increase in net interest income for the quarter and nine month period was due to an increase in interest income on loans coupled with a slight decrease in cost of funds. As noted above, the increase in other non-interest income was due to the reversal of a contingent liability in the amount of $597,500 related to litigation as disclosed in Note 7 – Commitments and Contingencies. Basic and diluted earnings per share were $0.39 and $0.38, respectively, for the quarter ended September 30, 2014 compared to $0.24 and $0.23, respectively, for the quarter ended September 30, 2013. Basic and diluted earnings per share were $0.89 and $0.88, respectively, for the nine months ended September 30, 2014, compared to $1.48 and $1.47, respectively, for the nine months ended September 30, 2013.

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The Company’s return on average assets on an annualized basis was 1.06% for the quarter ended September 30, 2014, compared to 0.68% for the quarter ended September 30, 2013. The Company’s return on average equity on an annualized basis for the quarter ended September 30, 2014 was 8.84% compared to 5.82% for the quarter ended September 30, 2013. The Company’s return on average assets on an annualized basis was 0.83% for the nine months ended September 30, 2014, compared to 1.44% for the nine months ended September 30, 2013. The Company’s return on average equity on an annualized basis for the nine months ended September 30, 2014 was 7.05% compared to 12.13% for the nine months ended September 30, 2013.

Interest Income 

Interest income for the quarter ended September 30, 2014 and 2013 was $4,880,000 and $4,581,000, respectively, which was an increase of $299,000 (6.5%). Interest income for the nine months ended September 30, 2014 and 2013 was $14,289,000 and $13,677,000, respectively, which was an increase of $612,000 (4.5%). The Bank experienced increased loan demand during the fourth quarter of 2013 and through the first nine months of 2014, resulting in growth in volume to offset the overall decline in yield since last year. Therefore, interest and fees on loans are up for both the quarter and nine months ended September 30, 2014 compared to the quarter and nine months ended September 30, 2013. Due to increased loan demand, the Bank sold $30.3 million of investment securities during the first nine months of 2014 at a slight net gain of $77,000. The securities portfolio decreased $22.6 million (14.4%) since September 30, 2013, and the portfolio decreased $24.4 million (15.4%) when compared to December 31, 2013. Net loans, including loans held for sale, were $327,414,000 at September 30, 2014 compared to $300,688,000 at December 31, 2013 and $285,335,000 at September 30, 2013. The overall yield on earning assets decreased slightly from 4.02% to 4.00%, comparing the first nine months of 2013 to the first nine months of 2014. However, earning asset yield increased from 3.97% for the third quarter of 2013 to 4.03% for the third quarter of 2014.

Interest Expense

Interest expense for the quarter ended September 30, 2014 and 2013 was $444,000 and $512,000, respectively, which was a decrease of $68,000 (13.3%). Interest expense for the nine months ended September 30, 2014 and 2013 was $1,355,000 and $1,626,000, respectively, which was a decrease of $271,000 (16.7%). The Company has experienced a decline in interest expense primarily due to the downward repricing in interest rates paid on deposits, as well as a continued shift in the mix of interest-bearing deposits from higher rate time deposits to non-interest bearing demand deposits and lower rate accounts such as NOW and money market accounts.

The Company’s cost of interest-bearing liabilities declined from 0.57% for the third quarter of 2013 to 0.48% for the third quarter of 2014. The Company’s cost of interest-bearing liabilities declined from 0.61% for the first nine months of 2013 to 0.49% for the first nine months of 2014.

Net Interest Income

Net interest income is the difference between the interest and fees earned on loans, securities and other interest-earning assets (interest income), and the interest paid on deposits and borrowed funds (interest expense).

Net interest income was $4,436,000 and $4,069,000 for the three months ended September 30, 2014 and 2013, respectively, which was an increase of $367,000 (9.0%). Net interest income was $12,934,000 and $12,051,000 for the nine months ended September 30, 2014 and 2013, respectively, which was an increase of $883,000 (7.3%). The annualized net interest margin was 3.72% and 3.56% for the quarter ended September 30, 2014 and 2013, respectively. The annualized net interest margin was 3.68% and 3.59% for the nine months ended September 30, 2014 and 2013, respectively.

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As noted above, the increase in net interest income for the quarter and year to date compared to the same periods in the prior year was the result of an increase in interest income on loans, combined with a decline in interest expense due to lower cost of interest-bearing deposits.

Interest-earning assets were $481,709,000 at September 30, 2014 compared to $473,611,000 at September 30, 2013, an increase of $8,098,000 (1.7%). Loans, including loans held for sale, are the highest yielding component of interest-earning assets. Total gross loans, including loans held for sale, were $332,670,000 at September 30, 2014 compared to $290,509,000 at September 30, 2013, an increase of $42,161,000 (14.5%). Mortgage loans held for sale totaled $29,694,000 and $27,694,000 at September 30, 2014 and 2013, respectively, an increase of $2,000,000 (7.2%). Securities available-for-sale were $134,019,000 at September 30, 2014, compared to $156,571,000 at September 30, 2013, a decrease of $22,552,000 (14.4%). Interest bearing deposits with banks totaled $15,020,000 and $11,131,000 at September 30, 2014 and 2013, respectively, an increase of $3,889,000 (34.9%). Interest-bearing customer deposits were $340,630,000 at September 30, 2014 compared to $349,636,000 at September 30, 2013, a decrease of $9,006,000 (2.6%). Noninterest-bearing customer deposits were $84,693,000 at September 30, 2014 compared to $79,743,000 at September 30, 2013, an increase of $4,950,000 (6.2%).

Provision for Loan Losses

Throughout 2013 and 2014, the Bank has continued to experience net recoveries instead of net charge offs, as well as an overall improvement in the quality of the loan portfolio. This resulted in a negative provision to the allowance for loan losses for the third quarter and nine months ended September 30, 2014. During the third quarter of 2014, net recoveries declined, and the balance of the loan portfolio increased when compared to the third quarter of 2013. The Bank recorded a negative provision for loan losses of $146,000 for the three months ended September 30, 2014 compared to a provision of $15,000 for the three months ended September 30, 2013, a decrease of $161,000. The Bank recorded a negative provision for loan losses of $797,000 for the nine months ended September 30, 2014 compared to a negative provision of $1,787,000 for the nine months ended September 30, 2013, an increase of $990,000. The negative provision was the result of decreasing historical loss rates, management’s detailed review of the Bank’s loan portfolio, the level of the Bank’s non-performing loans, net recoveries for the three and nine months ended September 30, 2014, and decreasing loan delinquencies.

Non-performing loans to total loans, excluding loans held for sale, was 0.33% at September 30, 2014 compared to 0.70% at December 31, 2013 and 1.21% at September 30, 2013. As shown in the non-performing assets section below, the Bank has experienced a decrease of $923,000 and $2,168,000 in non-accrual loans compared to December 31, 2013 and September 30, 2013, respectively. Total non-performing assets to total assets ratio has also continued to decrease. The ratio of non-performing assets to total assets was 1.66%, 1.32% and 1.09% as of September 30, 2013, December 31, 2013 and September 30, 2014, respectively. Each loan that the Bank deems impaired is subject to an analysis consisting of an evaluation of the underlying collateral and/or expectation of future cash flows to determine impairment and, if necessary, a specific allowance for loan losses reserve is established. The Bank’s specific reserve was $278,000 at September 30, 2014 compared to $131,000 at September 30, 2013, an increase of $146,000 (111.5%). The ratio of the allowance for loan losses to total loans, excluding loans held for sale, decreased to 1.73% at September 30, 2014 from 1.95% at December 31, 2013, and 1.97% at September 30, 2013. The Bank experienced a net recovery of $110,000 for the third quarter of 2014 compared to net recoveries of $198,000 for the third quarter of 2013, resulting in annualized net charge-off ratios of (-0.14%) and (-0.30%), respectively. The Bank experienced a net recovery of $696,000 for the nine months ended September 30, 2014 compared to net recoveries of $1,007,000 for the nine months ended September 30, 2013, resulting in annualized net charge-off ratios of (-0.32%) and (-0.51%), respectively. Although the Bank’s annualized net charge-off ratios have improved in the last two years, the improved performance of the Bank’s loan portfolio is not necessarily indicative of future performance. Management considers the current allowance for loan losses to be appropriate based upon its detailed analysis of the potential risk in the portfolio; however, there can be no assurance that charge-offs in future periods will not exceed the allowance for loan losses or that additional provisions will not be required.

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Non-interest Income

Non-interest income for the three months ended September 30, 2014 and 2013 was $3,569,000 and $2,704,000, respectively, an increase of $865,000 (32.0%). Service charges on deposit accounts were $367,000 and $414,000 for the three months ended September 30, 2014 and 2013, respectively, a decrease of $47,000 (11.4%). Mortgage banking activities resulted in income of $1,972,000 and $1,765,000 for the three months ended September 30, 2014 and 2013, respectively, an increase of $207,000 (11.7%). Loans sold in the secondary market for the three months ended September 30, 2014 and 2013 were $96,047,000 and $106,740,000, respectively. Substantially all loans originated by the mortgage division are sold in the secondary market with servicing rights released. There has been a decrease in the volume of loans sold when compared to 2013; however, the yields have increased slightly. Industry wide, mortgage banking activities have decreased. Other income was $1,224,000 and $503,000 for the three months ended September 30, 2014 and 2013, respectively, an increase of $721,000 (143.3%). As noted previously, this increase is mainly due to the reversal of a contingent liability of $598,000 recorded during the third quarter of 2014.

Non-interest income for the nine months ended September 30, 2014 and 2013 was $8,508,000 and $10,294,000, respectively, a decrease of $1,786,000 (17.3%). Service charges on deposit accounts were $1,060,000 and $1,174,000 for the nine months ended September 30, 2014 and 2013, respectively, a decrease of $114,000 (9.7%). Mortgage banking activities resulted in income of $5,218,000 and $6,462,000 for the nine months ended September 30, 2014 and 2013, respectively, a decrease of $1,244,000 (19.3%). Loans sold in the secondary market for the nine months ended September 30, 2014 and 2013 were $236,913,000 and $311,281,000, respectively. As noted above, while there has been a decrease in the volume of loans sold when compared to 2013, the yields have increased. Other income was $2,099,000 and $2,386,000 for the nine months ended September 30, 2014 and 2013, respectively, a decrease of $287,000 (12.0%). The decrease is mainly due to death insurance benefits from a Bank owned life insurance policy of $806,000 received in 2013 which is partially offset by the reversal of a contingent liability of $598,000 recorded during the third quarter of 2014.

Non-interest Expense

Non-interest expense for the three months ended September 30, 2014 and 2013 was $5,829,000 and $5,633,000, respectively, an increase of $196,000 (3.5%). Salary and employee benefit costs were $3,434,000 and $3,299,000 for the three months ended September 30, 2014 and 2013, respectively, an increase of $135,000 (4.1%). The increase was primarily due to annual performance incentives and normal salary increases, offset by decreases in incentives for mortgage due to decreased volume. Occupancy expense increased $8,000 (2.1%) from $387,000 to $395,000 comparing the three months ended September 30, 2013 and 2014, respectively. OREO expense decreased $64,000 (18.2%) from $351,000 to $287,000 comparing the three months ended September 30, 2013 and September 30, 2014, respectively. This decrease was due to a decrease in required valuation adjustments and other real estate expenses. Other non-interest expense for the three months ended September 30, 2014 increased by $117,000 (7.3%) to $1,713,000 from $1,596,000 for the three months ended September 30, 2013. This increase was primarily due to Company expenses incurred during the quarter of $154,000 related to the agreement and plan of merger with State Bank.

Non-interest expense for the nine months ended September 30, 2014 and 2013 was $17,453,000 and $16,714,000, respectively, an increase of $739,000 (4.4%). Salary and employee benefit costs were $10,086,000 and $9,664,000 for the nine months ended September 30, 2014 and 2013, respectively, an increase of $422,000 (4.4%). As noted above, the increase was primarily due to annual performance incentives and normal salary increases, including an increase in salary expense due to the new Evans, Georgia branch which opened in May 2013, offset by decreases in incentives for mortgage due to decreased volume. Occupancy expense increased $48,000 (4.3%) from $1,122,000 to $1,170,000 comparing the nine months ended September 30, 2013 and 2014, respectively. OREO expense decreased $388,000 (36.8%) from $1,053,000 to $665,000 comparing the nine months ended September 30, 2013 and September 30, 2014, respectively. This decrease was due to a decrease in required valuation adjustments and other real estate expenses. Other non-interest expense for the nine months ended September 30, 2014 increased by $657,000 (13.5%) to $5,532,000 from $4,875,000 for the nine months ended September 30, 2013. As noted above, this increase is mainly due to expenses of $794,000 incurred related to the agreement and plan of merger with State Bank.

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Income Taxes

The Company recorded income tax expense of $926,000 and $282,000 for the three months ended September 30, 2014 and 2013, respectively. The increase in 2014 resulted from the increase in net income before taxes. The effective tax rate was 39.8% and 25.1% for the three months ended September 30, 2014 and 2013, respectively.

The Company recorded income tax expense of $1,575,000 and $2,149,000 for the nine months ended September 30, 2014 and 2013, respectively. The decrease in 2014 resulted from the decrease in net income before taxes. The effective tax rate was 32.9% and 29.0% for the nine months ended September 30, 2014 and 2013, respectively.

The effective tax rate for the Company has increased in 2014 due to increased non-deductible expenses incurred related to the agreement and plan of merger with State Bank.

Financial Condition

Overview

Total consolidated assets at September 30, 2014 were $525,581,000, an increase of $9,083,000 (1.8%) from December 31, 2013 total consolidated assets of $516,498,000. Cash and due from banks totaled $26,881,000 at September 30, 2014, and $16,828,000 at December 31, 2013, an increase of $10,053,000 (59.7%). Investments in securities at September 30, 2014 were $134,019,000 compared to $158,439,000 at December 31, 2013, a decrease of $24,420,000 (15.4%). Gross loans, excluding loans held for sale, were $302,976,000 at September 30, 2014, an increase of $28,229,000 (10.3%) from $274,747,000 at December 31, 2013. The Bank experienced an increase in loan demand beginning in the fourth quarter of 2013 and continuing through the third quarter of 2014. As previously noted, the Bank sold some securities during the first nine months of 2014 to manage the increased loan demand and to improve yields on interest earning assets. Loans held for sale decreased $1,604,000 (5.1%) from $31,298,000 at December 31, 2013 to $29,694,000 at September 30, 2014. Demand for mortgage loans began to decrease somewhat during the second half of 2013 and through the first quarter of 2014. This industry wide decreased demand was driven mostly by an increasing rate environment coupled with certain regulatory changes related to qualified mortgages. Cash and due from banks at September 30, 2014 and December 31, 2013 included $5,700,000 and $1,300,000, respectively, of interest-bearing balances with the Federal Reserve Bank, at a minimal interest rate. This was included in interest-earning assets. Other assets decreased $2,033,000 (25.9%) mainly due to a decrease of $1,430,000 in deferred tax assets driven by changes in the fair value of securities available for sale, and a decrease of $371,000 in the derivatives recorded for the forward commitments for loans held for sale and interest rate lock commitments.

Total deposits at September 30, 2014 were $425,323,000, an increase of $5,618,000 (1.3%) from the December 31, 2013 balance of $419,705,000. Interest-bearing customer deposits at September 30, 2014 were $340,630,000, a decrease of $2,328,000 (0.7%) from the December 31, 2013 balance of $342,958,000. Total time deposits, including brokered and wholesale, decreased $8,645,000 (5.7%). Money market accounts increased $2,852,000 (3.9%) and NOW and savings accounts increased $3,465,000 (3.0%). Non-interest bearing deposits increased $7,946,000 (10.4%) from $76,747,000 at December 31, 2013 to $84,693,000 at September 30, 2014. The Bank’s repurchase agreements totaled $30,206,000 at September 30, 2014, an increase of $18,095,000 (149.4%) from the December 31, 2013 balance of $12,111,000. This is mainly due to two customers who have utilized the repurchase agreement deposit product.

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Management continuously monitors the financial condition of the Bank in order to protect depositors, increase retained earnings and protect current and future earnings. Further discussion of significant items affecting the Bank’s financial condition is presented in detail below.

Nonperforming Assets

A major key to long-term earnings growth is the maintenance of a high-quality loan portfolio. The Bank’s directive in this regard is carried out through its policies and procedures for extending credit to the Bank’s customers. The goals of these policies and procedures are to provide a sound basis for new credit extensions and early recognition of problem assets to allow the most flexibility in their timely disposition.

The composition of non-performing assets for each reportable date is shown in the table below.

	September 30, 2014		December 31, 2013		September 30, 2013
	(dollars in thousands)
Non-accrual loans	$	1,002	$	1,924	$	3,169
Other real estate owned		4,738		4,897		5,136
	$	5,740	$	6,821	$	8,305

The Bank’s non-accrual loans decreased $922,000 (48.0%) during the first nine months of 2014. This decrease is due to various factors, including minimal charge-offs and transfers to OREO as well as pay-downs and movement to accrual status. The Bank’s OREO decreased $159,000 (3.2%) during that same period. Since September 30, 2013, non-accrual loans have decreased $2,167,000 (68.4%) and OREO decreased $398,000 (7.7%). The ratio of non-performing assets to total loans and OREO, excluding loans held for sale, was 1.87% at September 30, 2014, 2.44% at December 31, 2013, and 3.10% at September 30, 2013. The continued reduction and disposition of non-performing assets is a management priority.

Troubled Debt Restructurings

As of September 30, 2014, the Bank had 22 loans totaling $6,845,000 classified as troubled debt restructurings. As of December 31, 2013, the Bank had 25 loans totaling $7,329,000 classified as troubled debt restructurings. Included in troubled debt restructurings were loans totaling $327,000 and $473,000 on nonaccrual as of September 30, 2014 and December 31, 2013, respectively. As of September 30, 2014, one loan totaling $28,000 classified as a troubled debt restructuring was in default. As of September 30, 2013, two loans totaling $532,000 classified as troubled debt restructurings were in default.

Allowance for Loan Losses

Additions to the allowance for loan losses are made periodically to maintain the allowance at an appropriate level based upon management’s analysis of probable risk in the loan portfolio, as described above under the heading “Critical Accounting Policies.” The allowance for loan losses was $5,256,000, $5,357,000, and $5,174,000 as of September 30, 2014, December 31, 2013, and September 30, 2013, respectively. The slight decrease of $101,000 from December 31, 2013 to September 30, 2014 is the result of several factors, including improving historical loss ratios and improving credit quality. The Bank also experienced net recoveries of $696,000 during the nine months ended September 30, 2014 as noted in the provision for loan losses discussion above. The ratio of the allowance for loan losses to total loans, excluding loans held for sale, decreased to 1.73% at September 30, 2014 from 1.95% at December 31, 2013, and 1.97% at September 30, 2013. For the three months ended September 30, 2014, there was a net recovery of 0.14% annualized compared to net recoveries of 0.30% annualized for the same period in 2013. For the nine months ended September 30, 2014, there was a net recovery of 0.32% annualized compared to net recoveries of 0.51% annualized for the same period in 2013. Management considers the current allowance for loan losses to be appropriate based upon its detailed analysis of the potential risk in the Bank’s portfolio; however, there can be no assurance that charge-offs in future periods will not exceed the allowance for loan losses or that additional provisions will not be required.

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Liquidity and Capital Resources

Liquidity is the ability of an organization to meet its financial commitments and obligations on a timely basis. These commitments and obligations include credit needs of customers, withdrawals by depositors, and payment of operating expenses and dividends. Management does not anticipate any events which would require liquidity beyond that which is available through deposit growth, investment maturities, federal funds lines, and other lines of credit and funding sources. Management actively monitors and manages the levels, types and maturities of earning assets, in relation to the sources available to fund current and future needs, to ensure that adequate funding will be available at all times.

The Bank’s liquidity remains adequate to meet operating and loan funding requirements. The Bank’s liquidity ratio at September 30, 2014 was 30.8% compared to 38.4% at December 31, 2013.

Management is committed to maintaining capital at a level sufficient to protect depositors, provide for reasonable growth, and fully comply with all regulatory requirements. Management’s strategy to achieve this goal is to retain sufficient earnings while providing a reasonable return on equity. Federal banking regulations establish certain capital adequacy standards required to be maintained by banks.

The table below reflects the Bank’s current regulatory capital ratios, including comparisons to December 31, 2013 and current regulatory minimums:

	September 30, 2014		December 31, 2013		Minimum Regulatory Requirement
Total risk-based capital ratio	16.37	%	17.25	%	8.00	%
Tier 1 risk-based capital ratio	15.12	%	15.99	%	4.00	%
Tier 1 leverage ratio	12.04	%	11.93	%	4.00	%

On October 20, 2014, the Company declared a cash dividend of $0.045 per share of common stock to all shareholders of record as of November 4, 2014, payable on November 11, 2014.

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Item 3.     Quantitative and Qualitative Disclosures About Market Risk.

There have been no material changes in the Company’s quantitative and qualitative disclosures about market risk as of September 30, 2014 from that presented under the heading “Liquidity and Interest Rate Sensitivity” and “Market Risk” in Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

Management has developed and implemented policies and procedures for reviewing disclosure controls and procedures and internal control over financial reporting on a quarterly basis. Management, including the Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the design and operation of disclosure controls and procedures as of September 30, 2014 and, based on such evaluation, has concluded that these controls and procedures are effective. Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

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Part II - OTHER INFORMATION

Item 6. Exhibits.

The following exhibits are filed with this Report:

Exhibit No.	Description
2.1	Agreement and Plan of Merger, dated as of June 23, 2014, by and between State Bank Financial Corporation and Georgia-Carolina Bancshares, Inc. (incorporated herein by reference to Exhibit 2.1 of the Company’s Form 8-K filed on June 24, 2014).
3.1	Articles of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1 of the Company’s Registration Statement on Form SB-2 under the Securities Act of 1933, as amended, Registration No. 333-69763).
3.1.1	Articles of Amendment to the Articles of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1.1 of the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2000).
3.2	By-Laws of the Company (incorporated herein by reference to Exhibit 3.2 of the Company’s Registration Statement on Form SB-2 under the Securities Act of 1933, as amended, Registration No. 333-69763).
31.1^	Certification of President and Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2^	Certification of Senior Vice President and Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1^	Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS*^	XBRL Instance Document.
101.SCH*^	XBRL Taxonomy Extension Schema Document.
101.CAL*^	XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF*^	XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB*^	XBRL Taxonomy Extension Label Linkbase Document.
101.PRE*^	XBRL Taxonomy Extension Presentation Linkbase Document.

* - In accordance with Regulation S-T, XBRL (Extensible Business Reporting Language) related information in Exhibit No. (101) to this Quarterly Report on Form 10-Q shall be deemed “furnished” and not “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that section, and shall not be incorporated by reference into any registration statement pursuant to the Securities Act of 1933, as amended; except as shall be expressly set forth by specific reference in such filing.

^ - Filed herewith.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	GEORGIA-CAROLINA BANCSHARES, INC.
November 7, 2014	By:	/s/ Remer Y. Brinson, III
	Remer Y. Brinson, III
	President and Chief Executive Officer (principal executive officer)
November 7, 2014	By:	/s/ Thomas J. Flournoy
	Thomas J. Flournoy
	Senior Vice President and Chief Financial Officer (principal financial and accounting officer)

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EXHIBIT INDEX

Exhibit No.	Description of Exhibit
Exhibit 31.1^	Certification of President and Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 31.2^	Certification of Senior Vice President and Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1^	Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 101.INS*^	XBRL Instance Document
Exhibit 101.SCH*^	XBRL Taxonomy Extension Schema Document
Exhibit 101.CAL*^	XBRL Taxonomy Extension Calculation Linkbase Document
Exhibit 101.DEF*^	XBRL Taxonomy Extension Definition Linkbase Document
Exhibit 101.LAB*^	XBRL Taxonomy Extension Label Linkbase Document
Exhibit 101.PRE*^	XBRL Taxonomy Extension Presentation Linkbase Document

* - In accordance with Regulation S-T, XBRL (Extensible Business Reporting Language) related information in Exhibit No. (101) to this Quarterly Report on Form 10-Q shall be deemed “furnished” and not “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that section, and shall not be incorporated by reference into any registration statement pursuant to the Securities Act of 1933, as amended; except as shall be expressly set forth by specific reference in such filing.

^ - Filed herewith.

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