8-K/A

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 8-K/A

(Amendment No. 1)

CURRENT REPORT PURSUANT TO

SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

Date of earliest event reported: November 1, 2017

SMARTFINANCIAL, INC.

(Exact Name of Registrant as Specified in its Charter)

Tennessee	333-203449	62-1173944
(State or Other Jurisdiction of Incorporation)	(Commission File Number)	(IRS Employer Identification No.)

5401 Kingston Pike, Suite 600 Knoxville, Tennessee	37919
(Address of Principal Executive Offices)	(Zip Code)

(865) 437-5700

(Registrant’s telephone number, including area code)

Not Applicable

(Former Name or Former Address, if Changed Since Last Report)

Check the appropriate box below if the Form 8-K filing is intended to simultaneously satisfy the filing obligation of the registrant under any of the following provisions (see General Instruction A.2. below):

☐ Written communications pursuant to Rule 425 under the Securities Act (17 CFR 230.425)

☐ Soliciting material pursuant to Rule 14a-12 under the Exchange Act (17 CFR 240.14a-12)

☐ Pre-commencement communications pursuant to Rule 14d-2(b) under the Exchange Act (17 CFR 240.14d-2(b))

☐ Pre-commencement communications pursuant to Rule 13e-4(c) under the Exchange Act (17 CFR 240.13e-4(c))

Indicate by check mark whether the registrant is an emerging growth company as defined in Rule 405 of the Securities Act of 1933 (§230.405 of this chapter) or Rule 12b-2 of the Securities Exchange Act of 1934 (§240.12b-2 of this chapter).

Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

EXPLANATORY NOTE

This Amendment No. 1 on Form 8-K/A (this “Amendment”) amends Item 9.01 of the Current Report on Form 8-K filed by SmartFinancial, Inc., a Tennessee corporation (the “Company”) on November 7, 2017 (the “Original Report”), in which the Company reported, among other events, the completion of its merger (the “Merger”) with Capstone Bancshares, Inc., an Alabama corporation (“Capstone”). This Amendment provides (i) the historical financial statements required by Item 9.01(a) and (ii) the unaudited pro forma financial information required by Item 9.01(b) that were omitted from the Original Report in reliance on Item 9.01(a)(4) and Item 9.01(b)(2), respectively. This Amendment does not amend any other item of the Original Report or purport to provide an update or a discussion of any developments at the Company subsequent to the filing date of the Original Report. All information contained in the Original Report is subject to updating and supplementing as provided in the Company’s reports filed with the Securities and Exchange Commission subsequent to the date on which the Original Report was filed.

Item 9.01. Financial Statements and Exhibits

(a) Financial Statements of Business Acquired.

The audited financial statements of Capstone as of and for the years ended December 31, 2016 and 2015, including the reports of its independent accounting firm, Warren Averett, LLC, and the unaudited financial statements of Capstone as of September 30, 2017 and for the nine months ended September 30, 2017 and 2016 are filed herewith as Exhibit 99.1 and Exhibit 99.2 and incorporated herein by reference.

(b) Pro Forma Financial Information.

The pro forma effect of the Merger on the Company is described in the unaudited pro forma combined condensed balance sheet of the Company at September 30, 2017, the unaudited pro forma combined condensed statements of income of the Company for the nine months ended September 30, 2017 and for the year ended December 31, 2016, and the notes thereto that are filed herewith as Exhibit 99.3 and incorporated herein by reference.

(d) Exhibits.

The exhibits filed with this report are listed in the Exhibit Index that immediately follows the signature hereto, which Exhibit Index is incorporated herein by reference.

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 hereunto duly authorized.

		SMARTFINANCIAL, INC.
Date:	January 17, 2018
			/s/ William Y. Carroll, Jr.
		William Y. Carroll, Jr.
		President & Chief Executive Officer

EXHIBIT INDEX

Exhibit No.	Description
23.1	Consent of Warren Averett, LLC
99.1	Audited financial statements of Capstone Bancshares, Inc. for the years ended December 31, 2016 and 2015
99.2	Unaudited financial statements of Capstone Bancshares, Inc. for the nine months ended September 30, 2017 and 2016
99.3	Unaudited pro forma combined condensed balance sheet of SmartFinancial, Inc. as of September 30, 2017, and the unaudited pro forma combined condensed statements of income of SmartFinancial, Inc. for the nine months ended September 30, 2017 and for the year ended December 31, 2016

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in the registration statements on Form S-3 (No. 333-214802 and 333-208700), Form S-4 (No. 333-219159 and 333-203449), and Form S-8 (No. 333-208819) of SmartFinancial, Inc. of our report dated March 23, 2017, relating to the consolidated financial statements of Capstone Bancshares; Inc. and subsidiary as of and for the years ended December 31, 2016 and 2015, included therein, which report appears in the Form 8-K/A of SmartFinancial, Inc. dated January 17, 2018.

/s/  Warren Averett, LLC

WARREN AVERETT, LLC

Birmingham, Alabama

January 17, 2018

EX-99.1

Exhibit 99.1

CAPSTONE BANCSHARES, INC.

AND SUBSIDIARY

CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

TABLE OF CONTENTS

DECEMBER 31, 2016 AND 2015

INDEPENDENT AUDITORS’ REPORT	1
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Statements of Financial Condition	3
Consolidated Statements of Income	4
Consolidated Statements of Comprehensive Income	5
Consolidated Statements of Changes in Stockholders’ Equity	6
Consolidated Statements of Cash Flows	7
Notes to the Consolidated Financial Statements	8

INDEPENDENT AUDITORS’ REPORT

Board of Directors and Stockholders

Capstone Bancshares, Inc. and Subsidiary

We have audited the accompanying consolidated statements of financial condition of Capstone Bancshares, Inc. and Subsidiary (the Bank) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity and cash flows for the years then ended, and the related notes to the consolidated financial statements.

Management’s Responsibility for the Consolidated Financial Statements

Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.

Auditors’ Responsibility

Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making these risk assessments, the auditors consider internal control relevant to the Bank’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Bank’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

1

Opinion

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Capstone Bancshares, Inc. and Subsidiary as of December 31, 2016 and 2015, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.

/s/ Warren Averett, LLC

Birmingham, Alabama

March 23, 2017

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

DECEMBER 31, 2016 AND 2015

ASSETS
	2016			2015
CASH AND CASH EQUIVALENTS
Cash and due from banks	$	5,852,711		$	5,215,470
Federal funds sold		252,580			3,391,000
TOTAL CASH AND CASH EQUIVALENTS		6,105,291			8,606,470
Securities available-for-sale		43,272,056			35,557,120
Restricted equity securities		1,277,075			985,875
Loans held-for-sale		1,133,300			1,462,550
Loans, net of allowance for loan losses		403,749,009			371,834,150
Premises and equipment, net		13,357,380			13,939,499
Goodwill and other intangible assets		5,776,205			5,922,823
Bank-owned life insurance		9,836,278			9,599,282
Other assets		2,829,880			4,581,423
TOTAL ASSETS	$	487,336,474		$	452,489,192
LIABILITIES AND STOCKHOLDERS’ EQUITY
DEPOSITS
Interest-bearing deposits	$	333,337,175		$	315,686,915
Noninterest-bearing deposits		81,177,278			73,272,799
TOTAL DEPOSITS		414,514,453			388,959,714
FHLB advances		12,218,608			5,805,807
Accounts payable and accrued liabilities		2,703,669			2,361,998
TOTAL LIABILITIES		429,436,730			397,127,519
STOCKHOLDERS’ EQUITY
Common stock, Class A voting, $.01 par value; 30,000,000
shares authorized; 4,349,885 shares issued at December 31,
2016 and 2015; 4,262,388 and 4,260,108 outstanding at
December 31, 2016 and 2015, respectively		43,499			43,499
Common stock, Class B nonvoting, $.01 par value;
15,000,000 shares authorized; none issued		-			-
Common stock, Class C nonvoting, $.01 par value;
15,000,000 shares authorized; none issued		-			-
Treasury stock, 87,497 shares, at cost at December 31,
2016 and 89,777 shares, ‘at cost at December 31, 2015		(874,970	)		(897,770	)
Additional paid-in capital		44,500,768			44,488,351
Retained earnings		14,554,780			11,482,304
Accumulated other comprehensive income (loss)		(324,333	)		245,289
TOTAL STOCKHOLDERS’ EQUITY		57,899,744			55,361,673
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	487,336,474		$	452,489,192

See notes to the consolidated financial statements.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

	2016		2015
INTEREST INCOME
Interest and fees on loans	$	17,793,472	$	17,014,628
Taxable investment securities		803,804		709,281
Nontaxable investment securities		83,048		142,744
Interest on federal funds sold and deposits in banks		21,747		12,411
Total interest income		18,702,071		17,879,064
INTEREST EXPENSE
Interest on deposits		2,205,444		1,962,594
Interest on borrowed funds		133,419		142,820
Total interest expense		2,338,863		2,105,414
PROVISION FOR LOAN LOSSES		1,050,000		1,000,000
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		15,313,208		14,773,650
NONINTEREST INCOME
Service charges on deposit accounts		1,129,118		1,127,933
Mortgage loan origination income		893,841		693,586
ATM fee income		354,879		327,284
Income from bank-owned life insurance		236,997		240,317
Other income		163,861		132,777
Total noninterest income		2,778,696		2,521,897
NONINTEREST EXPENSES
Employee compensation		6,331,676		5,906,179
Occupancy expenses		1,698,091		1,755,642
Employee benefits		1,370,971		1,243,777
Other		3,263,160		3,050,875
Total noninterest expenses		12,663,898		11,956,473
INCOME BEFORE INCOME TAX EXPENSE		5,428,006		5,339,074
INCOME TAX EXPENSE		1,758,796		1,722,351
NET INCOME	$	3,669,210	$	3,616,723

See notes to the consolidated financial statements.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

	2016			2015
NET INCOME	$	3,669,210		$	3,616,723
Other comprehensive loss:
Net change in unrealized losses on available-for-sale securities, net of tax effect of $(299,968) and $(79,809), respectively		(533,276	)		(139,665	)
Reclassification adjustment for net gains on securities available-for-sale realized in net income, net of tax effect of $(20,444) and $(599), respectively		(36,346	)		(1,066	)
COMPREHENSIVE INCOME	$	3,099,588		$	3,475,992

See notes to the consolidated financial statements.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

	Common Stock		Treasury Stock			Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
BALANCE AT DECEMBER 31, 2014	$	43,499	$	(919,370	)	$	44,472,936		$	8,461,997		$	386,020		$	52,445,082
Sale of treasury stock		-		21,600			(3,240	)		-			-			18,360
Payment of dividend ($0.14 per share)		-		-			-			(596,416	)		-			(596,416	)
Stock-based compensation		-		-			18,655			-			-			18,655
Net income		-		-			-			3,616,723			-			3,616,723
Other comprehensive loss		-		-			-			-			(140,731	)		(140,731	)
BALANCE AT DECEMBER 31, 2015		43,499		(897,770	)		44,488,351			11,482,304			245,289			55,361,673
Sale of treasury stock		-		22,800			(590	)		-			-			22,210
Payment of dividend ($0.14 per share)		-		-			-			(596,734	)		-			(596,734	)
Stock-based compensation		-		-			13,007			-			-			13,007
Net income		-		-			-			3,669,210			-			3,669,210
Other comprehensive loss		-		-			-			-			(569,622	)		(569,622	)
BALANCE AT DECEMBER 31, 2016	$	43,499	$	(874,970	)	$	44,500,768		$	14,554,780		$	(324,333	)	$	57,899,744

See notes to the consolidated financial statements.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

	2016			2015
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	3,669,210		$	3,616,723
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation of premises and equipment		820,429			904,631
Net amortization on securities		327,505			224,979
Amortization of intangibles		146,618			146,618
Provision for loan losses		1,050,000			1,000,000
Net gain on sales of securities available-for-sale		(56,790	)		(1,665	)
Losses and writedowns on foreclosed real estate		28,171			-
Loss on disposal of premises and equipment		-			1,425
Deferred income tax expense (benefit)		(149,226	)		315,374
Stock-based compensation		13,007			18,655
Income from bank-owned life insurance		(236,996	)		(240,317	)
Deferred compensation expense		116,643			113,208
Originations of loans held-for-sale		(35,699,301	)		(29,553,770	)
Proceeds from loans held-for-sale		36,028,551			29,147,203
Increase in interest receivable		(4,881	)		(23,701	)
Decrease in prepaid assets		39,845			21,356
Decrease (increase) in interest payable		23,854			(8,754	)
Net other operating activities		784,031			(1,207,140	)
Net cash provided by operating activities		6,900,670			4,474,825
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities available-for-sale	$	(18,115,019	)	$	(11,491,710	)
Proceeds from maturities and paydowns of securities available-for-sale		7,887,953			7,269,904
Proceeds from sales of securities available-for-sale		1,351,381			1,001,665
Redemption (purchase) of restricted equity securities		(291,200	)		32,500
Net increase in loans		(32,964,859	)		(22,651,527	)
Purchases of premises and equipment		(238,310	)		(85,415	)
Proceeds from the sale of foreclosed real estate		1,575,189			-
Net cash used in investing activities		(40,794,865	)		(25,924,583	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		25,554,739			18,925,281
Sale of treasury stock		22,210			18,360
Dividends declared and paid		(596,734	)		(596,416	)
Net proceeds (repayments) on other borrowings		6,412,801			(836,535	)
Net cash provided by financing activities		31,393,016			17,510,690
DECREASE IN CASH AND CASH EQUIVALENTS		(2,501,179	)		(3,939,068	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		8,606,470			12,545,538
CASH AND CASH EQUIVALENTS AT END OF YEAR	$	6,105,291		$	8,606,470

See notes to the consolidated financial statements.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

1. ORGANIZATION

Capstone Bancshares, Inc. and Subsidiary (the Bank), is a corporation organized under the laws of the State of Alabama for the purposes of owning 100% of the outstanding common stock of Capstone Bank (the Bank). The Bank is a state-chartered bank with its corporate headquarters, main office and one branch location in Tuscaloosa, Alabama and additional branch locations in Northport, McIntosh, Chatom, Jackson, Thomasville, and Fairhope, Alabama. The Bank provides a full range of banking services in its primary market areas.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Cash and Cash Equivalents

For the purpose of cash flows, the Bank considers cash and due from banks and federal funds sold to be cash and cash equivalents. The Bank maintains cash and cash equivalents in various correspondent bank accounts. Total uninsured balances held in these bank accounts amounted to approximately $3,075,000 and $1,577,000 at December 31, 2016 and 2015. Management monitors these banks accounts and does not expect to incur any losses from such bank accounts.

The Bank is required to maintain reserve balance in cash or on deposit with the Federal Reserve Bank, based on a percentage of deposits. The total of those reserve balances was approximately $-0- and $5,740,000 at December 2016 and 2015, respectively.

Supplemental Cash Flow Information

The following is supplemental disclosure to the statements of cash flows for the years ended December 31, 2016 and 2015:

	2016		2015
Cash paid during the year for interest	$	2,315,009	$	2,114,168
Cash paid during the year for income taxes, net Noncash disclosures:		1,108,392		2,070,294
Loans transferred to foreclosed real estate during the year		-		1,681,419
Retirements of premises and equipment		136,758		956,370

Securities Available-for-Sale

Securities available-for-sale represent debt securities which the Bank has designated for sale and include all securities held at December 31, 2016 and 2015. Securities available-for-sale are carried at fair value with unrealized gains and losses, net of taxes, reported as accumulated other comprehensive income (loss) in a separate component of stockholders’ equity until realized. Gains or losses on disposition are based on the net proceeds and the adjusted carrying amount on the securities sold, using the specific identification method. The estimated values are provided by security dealers who have obtained quoted prices.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Loans Held-for-Sale

Loans originated and intended for sale in the secondary market, consisting of mortgage loans, are carried at the lower of cost or estimated fair value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.

The Bank used derivatives to hedge interest rate exposures associated with loans held-for-sale. The Bank regularly enters into derivative financial instruments in the form of forward sales contracts and interest rate lock commitments as part of its normal asset/liability management strategies. The Bank’s obligations under forward sales contracts consist of “best effort” commitments to deliver mortgage loans originated in the secondary market at a future date. Interest rate lock commitments related to loans that are originated for later sale are regularly extended to customers during the loan origination process. These interest rate lock and forward sales commitments qualify as derivatives; however, the fair values and changes in fair values of these derivatives during the years ended December 31, 2016 and 2015, did not have a material impact on the Bank’s consolidated financial position or results of operations and have not been recorded.

Loans and the Allowance for Loan Losses

Loans are stated at unpaid principal balances and reduced by the net deferred loan fees and an allowance for loan losses. Interest on loans is calculated and recognized as income over the terms of the loans using the simple interest method based on daily balances of principal outstanding.

The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is remote. The allowance represents management’s estimate of the amount required to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectability of loans and prior loan loss experience.

As part of management’s assessment of the allowance for loan losses, management segregates the loan portfolio into the following segments: commercial, financial and agricultural; real estate construction; real estate mortgage; and consumer and other. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as information becomes available and as economic conditions change.

The allowance for loan losses consists of specific, general and unallocated components. The specific component relates to loans that are classified. For such loans that are also classified as impaired, an allowance for losses is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

The general component covers nonclassified loans and is based on historical loss experience adjusted for qualitative factors, which includes trend assessments in delinquent and nonaccrual loans, unanticipated charge-offs, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influencing factors.

An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance for loan losses reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

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

Generally, impaired loans include loans on nonaccrual status, loans that have been assigned a specific allowance for credit losses, loans that have been partially charged off and loans designated as a troubled debt restructuring.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

While management believes that it has established the allowance for loan losses in accordance with generally accepted accounting principles and has taken into account the views of its regulators and the current economic environment, there can be no assurance that in the future the Bank’s regulators or its economic environment will not require further increases in the allowance for losses.

Loan origination or commitment fees are deferred and accreted using the interest method over the life of the loan. Direct loan origination costs are capitalized and amortized over the life of the loan as a reduction of the loan yield as an offset to interest and fees on loans. Certain loans, with variable rates, include interest rate floors. The interest rate paid on these loans, typically indexed to the prime interest rate, does not reprice below the predetermined rate floor.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Income Recognition on Impaired and Nonaccrual Loans

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged off, the loan is generally classified as nonaccrual. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, the borrower’s financial condition is such that collection of interest is doubtful.

Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by the borrower, in accordance with the contractual terms of principal and interest.

While a loan is classified as nonaccrual, and the future collectability of the recorded loan balance is doubtful, collections of principal and interest are generally applied as a reduction to principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis.

In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation. Additions and improvements which extend the life of an asset are capitalized. Expenditures for repairs and maintenance are charged against operations when incurred. Depreciation is computed by straight-line and accelerated methods based on the depreciable lives of individual assets, ranging from 3 to 40 years.

Foreclosed Real Estate

Foreclosed real estate includes both formally foreclosed property and in-substance foreclosed property. In-substance foreclosed properties are those properties for which the Bank has taken physical possession, regardless of whether formal foreclosure proceedings have taken place.

At the time of foreclosure, foreclosed real estate is recorded at the fair value less estimated costs to sell, which becomes the property’s new cost basis. Any write-downs based on the asset’s fair value at date of acquisition are charged to the allowance for loan losses. Foreclosed real estate is recorded in other assets in the consolidated statements of financial condition.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Subsequent to foreclosure, valuations are periodically performed by management, and the assets are carried at the lower of carrying value amount or fair value less cost to sell. Costs incurred in maintaining other real estate and subsequent adjustments to the carrying amount of the property are included in income (loss) on other real estate. Costs incurred to complete, repair/renovate or make the property whole are capitalized.

Goodwill and Intangible Assets

Goodwill represents the excess of cost over the fair value of the net assets and liabilities acquired in a business combination. Goodwill is required to be tested annually for impairment, or whenever events occur that may indicate that the recoverability of the carrying amount is not probable. In the event of impairment, the amount by which the carrying amount exceeds the fair value would be charged to earnings.

Intangible assets consist of core deposit premiums paid in connection with business combinations. The core deposit premium is initially recognized based on a valuation performed as of the consummation date. The core deposit premium is amortized over the average remaining life of the acquired customer deposits. Amortization periods are reviewed annually in connection with the annual impairment testing of goodwill.

Advertising

Advertising costs are expensed as incurred.

Income Taxes

The Bank files a federal income tax return and State of Alabama excise tax return. These returns are filed using the accrual basis of accounting. Provisions for income taxes are based on amounts reported in the statements of income (after exclusion of nontaxable income, such as interest on state and municipal securities) and include deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. Such amounts are net of any valuation allowance for deferred tax assets.

Subsequent Events

Management has evaluated subsequent events and their potential effects on these consolidated financial statements through March 23, 2017, the date of the independent auditors’ report (date available for issue).

Reclassifications

Certain amounts in 2015 have been reclassified to conform to the 2016 presentation. These reclassifications had no effect on the financial position, results of operations or cash flows of the Bank as previously presented.

Financial Instruments

The Bank’s financial instruments consist of cash and cash equivalents, securities, loans, deposits, borrowings and related receivables and payables (Note 20). Three categories exist within the fair value hierarchy, which are presented below:

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Level 1 – Valuations based on quoted prices in active markets for identical assets or liabilities that the Bank has the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.

Level 2 – Valuations based on observable inputs, including quoted prices (other than Level 1) in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability, such as interest rates, prepayment speeds, yield curves, volatilities and default rates, and inputs that are derived principally from or corroborated by observable market data.

Level 3 – Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral. The majority of the Bank’s loans are secured by specific collateral, including real property, consumer assets and business assets. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions.

While management uses available information to recognize losses on loans, further reduction in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgments about information available at the time of the examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change in the near term. However, the amount of change that is reasonably possible cannot be estimated.

Recently Adopted and Issued Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09 and in August 2015 issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), a comprehensive new revenue recognition standard that will supersede nearly all existing revenue recognition guidance under U.S. GAAP. The standard’s core principle is that an entity will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. The guidance may be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initial application recognized at the date of initial application for fiscal years beginning after December 15, 2018 and early application is permitted.  The Bank is in the process of reviewing the potential impact the adoption of this guidance will have on its financial statements.

13

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

In January 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.  The amendments in this ASU, among other things: a) requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; b) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; and c) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables.  The effective date of this ASU for the Bank is January 1, 2019.  The new guidance permits early adoption of the own credit provision. In addition, the new guidance permits early adoption of the provision that exempts private companies and not-for-profit organizations from having to disclose fair value information about financial instruments measured at amortized cost.  The Bank is reviewing the impact that the adoption of this ASU may have on its financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842).  The amendments in this ASU, affects all companies and other organizations that lease assets.  This ASU will require organizations that lease assets, referred to as “leases”, to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases.  The accounting by organizations that own the assets leased by the lessee, known as lessor accounting, will remain largely unchanged from current GAAP (Topic 840).  For non-public companies this ASU is effective for fiscal year beginning after December 15, 2019 for January 1, 2020 for the Bank.  The Bank is reviewing the impact that the adoption of this ASU may have on its financial statements.

In March 2016, the FASB issued ASU 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.  The areas for simplification in this ASU involve several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows.  Some of the areas for simplification apply only to nonpublic entities.  For non-public companies, this ASU is effective for annual periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018.  Early adoption is permitted for any entity in any interim or annual period.  The Bank is reviewing the impact that the adoption of this ASU may have on its financial statements.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

In June 2016, the FASB issued ASU 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.  The amendments in this ASU cover two areas:  assets measured at amortized cost and available-for-sale debt securities.  For assets measured at amortized cost, the amendments in this ASU require a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected.  For available-for-sale debt securities, credit losses relating to available-for-sale debt securities should be recorded through an allowance for credit losses.  Available-for-sale accounting recognizes that value may be realized either through collection of contractual cash flows or through sale of the security.  Therefore, the amendments limit the amount of the allowance for credit losses to the amount by which fair value is below amortized cost because the classification as available-for- sale is premised on an investment strategy that recognizes that the investment could be sold at fair value, if cash collection would result in the realization of an amount less than fair value.  For non-public entities, the amendments in this ASU are effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021.  All entities may adopt the amendments in this ASU earlier as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  The Bank is reviewing the impact that the adoption of this ASU may have on its financial statements.

In January 2017, the FASB issued ASU 2017-04, Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendment eliminates the requirement of Step 2 in the current guidance to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value in Step 1 of the current guidance. The amendment is effective December 15, 2021, with early adoption permitted for annual goodwill impairment tests with a measurement date after January 1, 2017. The amendment is to be applied prospectively. Management is reviewing the amendment and the effect on its financial statements.

3. SECURITIES AVAILABLE-FOR-SALE

The carrying amounts of securities available-for-sale and their approximate fair values at December 31, 2016 and 2015, were as follows:

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
As of December 31, 2016:
State and municipal securities	$	3,578,880	$	70,548	$	(32,401	)	$	3,617,027
U.S. Government sponsored mortgage-backed securities		40,199,946		174,336		(719,253	)		39,655,029
	$	43,778,826	$	244,884	$	(751,654	)	$	43,272,056

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

3. SECURITIES AVAILABLE-FOR-SALE – CONTINUED

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
As of December 31, 2015:
U.S. Government sponsored agency securities	$	749,936	$	423	$	(6,890	)	$	743,469
State and municipal securities		2,248,400		120,303		-			2,368,703
U.S. Government sponsored mortgage-backed securities		32,175,520		367,527		(98,099	)		32,444,948
	$	35,173,856	$	488,253	$	(104,989	)	$	35,557,120

The amortized cost and estimated fair value of securities available-for-sale at December 31, 2016, by contractual maturity, are as follows:

	Amortized Cost		Fair Value
Amounts maturing:
After 1 through 5 years	$	90,000	$	90,160
After 5 years through 10 years		700,000		729,529
After 10 years		2,788,880		2,797,338
Mortgage-backed securities		40,199,946		39,655,029
	$	43,778,826	$	43,272,056

Investment securities with an approximate fair value of $15,728,000 and $26,063,000 were pledged as collateral for deposits held under the State of Alabama’s Security for Alabama Funds Enhancement (SAFE) Program as of December 31, 2016 and 2015, respectively.

Restricted equity securities are reported at cost and consist of the following at December 31:

	2016		2015
Freddie Mac stock	$	875	$	875
Federal Home Loan Bank of Atlanta stock		926,200		635,000
First National Banker’s Bank, Inc. stock		350,000		350,000
	$	1,277,075	$	985,875

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

3. SECURITIES AVAILABLE-FOR-SALE – CONTINUED

Temporarily Impaired Securities

At December 31, 2016, the Bank had 38 available-for-sale securities with an amortized cost of $33,136,175 and a fair value of $32,384,521 in an unrealized loss position for less than 12 months, none of which has been deemed by management to be impaired. At December 31, 2015, the Bank had 16 available-for-sale securities with an amortized cost of $13,891,042 and a fair value of $13,813,114 in an unrealized loss position for less than 12 months, none of which has been deemed by management to be impaired.

At December 31, 2016, the Bank had no available-for-sale securities in an unrealized loss position for greater than 12 months. At December 31, 2015, the Bank had two available-for-sale securities with an amortized cost of $1,310,593 and a fair value of $1,283,532 in an unrealized loss position for greater than 12 months, none of which has been deemed by management to be impaired.

These losses are deemed by management to be temporary since the Bank does not intend to sell these securities, and it is not more likely than not that the Bank will be required to sell the securities before recovery of their amortized costs bases, which may be to maturity.

Other-Than-Temporary Impairment

The Bank routinely conducts periodic reviews to identify and evaluate each investment security to determine whether an other-than-temporary impairment has occurred. Inputs included in the evaluation process may include geographic concentrations, credit ratings and other performance indicators of the underlying asset. As of December 31, 2016 and 2015, no securities within the Bank’s investment securities portfolio were considered other-than-temporarily impaired.

4. LOANS

The composition of loans by primary loan classification and by performing and impaired loan status at December 31, 2016 and 2015, are as follows:

	December 31, 2016
	Commercial, Financial and Agricultural		Real Estate		Consumer and Other		Subtotal		Allowance for Loan Losses		Net Loans
Performing loans	$	91,849,964	$	292,252,202	$	19,930,784	$	404,032,950	$	3,506,232	$	400,526,718
Impaired loans		785,171		2,551,625		524,742		3,861,538		639,247		3,222,291
	$	92,635,135	$	294,803,827	$	20,455,526	$	407,894,488	$	4,145,479	$	403,749,009
	December 31, 2015
Performing loans	$	85,795,398	$	262,417,730	$	20,166,245	$	368,379,373	$	3,232,636	$	365,146,737
Impaired loans		1,385,811		5,921,683		356,422		7,663,916		976,503		6,687,413
	$	87,181,209	$	268,339,413	$	20,522,667	$	376,043,289	$	4,209,139	$	371,834,150

The Bank evaluates all loans over 60 days past due or more for impairment.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

4. LOANS – CONTINUED

The changes in the allowance for loan losses for the years ended December 31, 2016 and 2015, are as follows:

	2016			2015
Balance at beginning of year	$	4,209,139		$	5,271,188
Charge-offs		(1,210,473	)		(2,088,244	)
Recoveries		96,813			26,195
Net charge-offs		(1,113,660	)		(2,062,049	)
Provision		1,050,000			1,000,000
Ending balance	$	4,145,479		$	4,209,139

The allocation and changes in the allowance for loan losses, by loan classification, as of and for the years ended December 31, 2016 and 2015, are as follows:

	Commercial, Financial and Agricultural			Real Estate			Consumer and Other			Total
Balance at December 31, 2015	$	1,197,543		$	2,806,664		$	204,932		$	4,209,139
Charge-offs		(395,973	)		(804,404	)		(10,096	)		(1,210,473	)
Recoveries		14,912			60,414			21,487			96,813
Net charge-offs		(381,061	)		(743,990	)		11,391			(1,113,660	)
Provision		53,519			970,210			26,271			1,050,000
Balance at December 31, 2016	$	870,001		$	3,032,884		$	242,594		$	4,145,479
Balance at December 31, 2014	$	977,622		$	4,124,633		$	168,933		$	5,271,188
Charge-offs		(5,679	)		(2,058,164	)		(24,401	)		(2,088,244	)
Recoveries		975			11,765			13,455			26,195
Net charge-offs		(4,704	)		(2,046,399	)		(10,946	)		(2,062,049	)
Provision		224,625			728,430			46,945			1,000,000
Balance at December 31, 2015	$	1,197,543		$	2,806,664		$	204,932		$	4,209,139

The level of the allowance is based upon evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect the borrowers’ ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, historical loss experience, industry and peer bank loan quality indications and other pertinent factors, including regulatory recommendations.

In assessing the adequacy of the allowance for loan losses, management analyzes the allowance for loan losses based on the categories of commercial, financial and agricultural; real estate – construction; real estate – mortgage; and consumer and other.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

4. LOANS – CONTINUED

Risk ratings are categorized as pass, special mention, substandard or doubtful. Management believes that the categories follow those outlined by the primary regulator. Pass rated loans include all risk rated credits other than those included in special mention, substandard and doubtful, which are defined as follows:

· Special mention loans have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date.

· Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize liquidation of the debt. Substandard loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Substandard loans have been placed on nonaccrual status unless it was determined that the loan should remain on accrual status.

· Doubtful loans have all the characteristics of substandard loans with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The Bank considers all doubtful loans to be impaired and places all such loans on nonaccrual status.

The following table outlines the amount of each loan classification based on internally assigned risk ratings as of December 31, 2016 and 2015:

	Commercial, Financial and Agricultural		Real Estate		Consumer and Other		Total
2016
Grade:
Pass	$	91,599,663	$	283,372,553	$	19,864,984	$	394,837,200
Special mention		15,158		6,623,520		65,800		6,704,478
Substandard		235,143		2,256,129		-		2,491,272
Substandard – impaired		669,157		1,400,720		222,378		2,292,255
Doubtful – impaired		116,014		1,150,905		302,364		1,569,283
	$	92,635,135	$	294,803,827	$	20,455,526	$	407,894,488
2015
Grade:
Pass	$	85,709,666	$	252,656,301	$	20,022,884	$	358,388,851
Special mention		85,732		6,035,562		86,039		6,207,333
Substandard		-		3,725,867		57,322		3,783,189
Substandard – impaired		932,452		4,424,197		27,630		5,384,279
Doubtful – impaired		453,359		1,497,486		328,792		2,279,637
	$	87,181,209	$	268,339,413	$	20,522,667	$	376,043,289

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

4. LOANS – CONTINUED

The following tables detail the recorded investments, unpaid principal balance and the related allowance of impaired loans as of December 31, 2016 and 2015, and the average recorded investment of impaired loans, as well as the interest income recognized for the years ended December 31, 2016 and 2015:

	At December 31, 2016						For the Year Ended December 31, 2016
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Impaired loans with no recorded allowance:
Commercial, financial and agricultural	$	609,776	$	609,776	$	-	$	710,150	$	39,757
Real estate		802,767		802,767		-		2,515,705		46,241
Consumer		149,528		149,528		-		237,802		9,125
		1,562,071		1,562,071		-		3,463,657		95,123
Impaired loans with a recorded allowance:
Commercial, financial and agricultural		175,395		175,395		115,177		146,931		10,564
Real estate		1,748,858		1,748,858		451,329		1,487,920		94,275
Consumer		416,089		375,214		72,741		190,042		23,834
		2,340,342		2,299,467		639,247		1,824,893		128,673
Total impaired loans	$	3,902,413	$	3,861,538	$	639,247	$	5,288,550	$	223,796

	At December 31, 2015						For the Year Ended December 31, 2015
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Impaired loans with no recorded allowance:
Commercial, financial and agricultural	$	810,002	$	810,524	$	-	$	654,521	$	42,850
Real estate		4,208,839		4,228,643		-		3,654,065		195,285
Consumer		325,930		326,076		-		11,404		762
		5,344,771		5,365,243		-		4,319,990		238,897
Impaired loans with a recorded allowance:
Commercial, financial and agricultural		575,809		578,331		459,864		186,574		11,905
Real estate		1,712,844		1,714,590		487,608		380,279		12,742
Consumer		30,492		33,900		29,031		32,337		1,477
		2,319,145		2,326,821		976,503		599,190		26,124
Total impaired loans	$	7,663,916	$	7,692,064	$	976,503	$	4,919,180	$	265,021

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

4. LOANS – CONTINUED

Past due balances and loans on nonaccrual status by loan classification are as follows:

2016	Past Due 30-89 Days & Still Accruing		Past Due 90 Days or More & Still Accruing		Total Past Due and Performing		Loans on Nonaccrual Status		Current		Total Loans
Commercial, financial and agricultural	$	296,640	$	-	$	296,640	$	368,037	$	91,970,458	$	92,635,135
Real estate		3,015,415		144,172		3,159,587		1,828,798		289,815,442		294,803,827
Consumer & other		120,000		3,728		123,728		335,767		19,996,031		20,455,526
	$	3,432,055	$	147,900	$	3,579,955	$	2,532,602	$	401,781,931	$	407,894,488
2015
Commercial, financial and agricultural	$	548,875	$	-	$	548,875	$	629,470	$	86,002,864	$	87,181,209
Real estate		948,867		17,000		965,867		1,889,197		265,484,349		268,339,413
Consumer & other		97,074		-		97,074		319,826		20,105,767		20,522,667
	$	1,594,816	$	17,000	$	1,611,816	$	2,838,493	$	371,592,980	$	376,043,289

As of December 31, 2016 and 2015, there were no loans classified as nonaccrual that were not deemed to be impaired, and all impaired loans were on nonaccruing interest status. At the date such loans were placed on nonaccrual status, the Bank reversed all previously accrued interest income against current year earnings. Had nonaccruing loans been on accruing status, interest income would have been greater by $147,489 and $161,504 for the years ended December 31, 2016 and 2015, respectively. The Bank’s policy is that once a loan is classified as impaired and placed on nonaccrual status, future payments of interest will be applied to the principal balance and not to income. There were no loans greater than 90 days past due and still on accrual status for interest at December 31, 2016 and 2015.

The following table provides details for the troubled debt restructurings by loan classification:

	At December 31, 2016
	Number of Contracts		Premodification Outstanding Recorded Investment		Postmodification Outstanding Recorded Investment
Troubled Debt Restructurings
Consumer and other		1	$	110,328	$	110,328
Real estate – mortgage		3		378,661		378,661
Commercial, financial and agricultural		1		34,167		34,167
		5	$	523,156	$	523,156

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

4. LOANS – CONTINUED

There were no troubled debt restructurings for 2016 that subsequently defaulted.

	At December 31, 2015
	Number of Contracts		Premodification Outstanding Recorded Investment		Postmodification Outstanding Recorded Investment
Troubled Debt Restructurings
Consumer and other		3	$	471,405	$	471,405
Real estate – mortgage		4		329,485		329,485
Commercial, financial and agricultural		1		48,567		48,567
		8	$	849,457	$	849,457

There was $343,902 in troubled debt restructurings for 2015 that subsequently defaulted.

Impaired loans also include loans that the Bank may elect to formally restructure due to the weakening credit status of a borrower such that the restructuring may facilitate a repayment plan that minimizes the potential losses, if any, that the Bank may have to otherwise incur. These loans are classified as impaired loans and, if on nonaccruing status as of the date of restructuring, the loans are included in the nonperforming loan balances noted above.

Included in impaired loans are loans that have been restructured that were performing as of the restructure date. There were $523,156 and $505,555 of accruing restructured loans as of December 31, 2016 and 2015, respectively.

5. PREMISES, EQUIPMENT AND SOFTWARE

Major classifications of premises, equipment and software are summarized below as of December 31:

	2016		2015
Land and land improvement	$	1,785,911	$	1,785,911
Buildings and improvements		14,258,914		14,255,364
Furniture, fixtures and equipment		4,529,147		4,429,269
		20,573,972		20,470,544
Less accumulated depreciation and amortization		7,216,592		6,531,045
Premises and equipment, net	$	13,357,380	$	13,939,499

Depreciation charged to operating expense for 2016 and 2015 was $820,429 and $904,631, respectively.

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CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

6. GOODWILL AND OTHER INTANGIBLE ASSETS

Goodwill is tested for impairment on an annual basis and as events occur or circumstances change that would more likely than not reduce the fair value of an acquired reporting unit below its carrying amount. No goodwill impairment was recorded during the years ended December 31, 2016 and 2015.

	Core Deposit Intangible			Goodwill		Total
December 31, 2016:
Balance at beginning year	$	729,456		$	5,193,367	$	5,922,823
Amortization expense		(146,618	)		-		(146,618	)
Balance at end of year	$	582,838		$	5,193,367	$	5,776,205
December 31, 2015:
Balance at beginning year	$	876,074		$	5,193,367	$	6,069,441
Amortization expense		(146,618	)		-		(146,618	)
Balance at end of year	$	729,456		$	5,193,367	$	5,922,823

The estimated amortization expense for the core deposit intangible assets for subsequent years is as follows:

2017	$	146,618
2018		91,387
2019		82,760
2020		82,760
2021		82,760
Thereafter		96,553
	$	582,838

The Bank evaluated goodwill for impairment and determined goodwill has not been impaired as of December 31, 2016.

7. TIME DEPOSITS

The Bank had $29,908,161 and $28,673,206 of time deposits outstanding greater than the FDIC insurance limit of $250,000 at December 31, 2016 and 2015, respectively. Interest expense on these time deposits totaled approximately $301,000 and $317,000 for the years ended December 31, 2016 and 2015, respectively. As of December 31, 2016, the Bank had $10,322,000 in brokered time deposits outstanding.

23

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

7. TIME DEPOSITS – CONTINUED

The maturity schedule for all outstanding time deposits as of December 31, 2016, is as follows:

2017	$	67,224,791
2018		30,972,785
2019		23,498,752
2020		7,579,198
2021		7,564,595
	$	136,840,121

8. BORROWINGS

Other borrowings consist of the following at December 31:

	2016		2015
Advances from the Federal Home Loan Bank of Atlanta, payable at various maturity dates from August 3, 2017 through January 31, 2028; interest is payable monthly at variable and fixed rates ranging from 0.80% to 7.22%	$	12,218,608	$	5,805,807

At December 31, 2016 the scheduled maturities of other borrowings are as follows:

2017	$	7,681,818
2018		1,362,456
2019		1,355,268
2020		1,163,823
2021		275,744
Thereafter		379,499
	$	12,218,608

The above advances from the Federal Home Loan Bank of Atlanta are secured by a blanket floating lien on qualifying residential first mortgages of approximately $17.9 million, qualifying home equity lines of credit of approximately $18.1 million and qualifying commercial first mortgages of approximately $15.8 million.

9. OPERATING LEASES

At December 31, 2016, the Bank had entered into agreements for various banking facilities under operating lease agreements. The remaining lease terms vary up to 10 years with various renewal options and generally require fixed monthly lease payments.

24

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

Rental expense for operating leases was $151,530 and $141,067 for the years ended December 31, 2016 and 2015, respectively. In most cases, management expects that, in the ordinary course of business, existing leases will be renewed or replaced by other similar leases.

The future minimum lease payments under operating leases were as follows as of December 31, 2016:

2017	$	144,183
2018		164,183
2019		163,471
2020		146,971
2021		146,971
Thereafter		632,413
	$	1,398,192

10. CONCENTRATION OF CREDIT RISK

The Bank makes commercial, commercial real estate, residential real estate and consumer loans to customers in its primary market areas. The ability of the majority of the Bank’s customers to honor their contractual loan obligations is dependent on the economy in these areas.

Seventy-two percent of the Bank’s loan portfolio is concentrated in real estate. A substantial portion of these loans are secured by real estate in the Bank’s primary market area. In addition, a substantial portion of the foreclosed assets are located in those same markets. Accordingly, the ultimate collectability of the loan portfolio and the recovery of the carrying amount of foreclosed assets are susceptible to changes in market conditions in the Bank’s primary market area. The other significant concentrations of credit by type of loan are set forth in Note 4.

The Bank, according to regulatory restrictions, may not generally extend credit to any single borrower or group of related borrowers on a secured basis in excess of 20% of capital, as defined by banking regulations, or approximately $10,900,000, or on an unsecured basis in excess of 10% of capital, as defined by banking regulations, or approximately $5,400,000.

11. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.

25

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

The outstanding notional amount of off-balance sheet risks at December 31 is as follows:

	2016		2015
Unused commitments and standby letters of credit	$	98,854,451	$	93,823,000

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

12. EMPLOYMENT CONTRACTS

The Bank has change in control agreements with certain senior officers which provide payouts based upon varying multiples of the officers’ salary in the event of a change in control. The maximum aggregate liability to the Bank at December 31, 2016, is approximately $1,611,000 ($1,589,000 at December 31, 2015) for all change in control payouts.

13. CONTINGENCIES

In the normal course of business, the Bank is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings, other than those noted above, would not have a material effect on the Bank’s consolidated financial statements.

14. INCOME TAXES

Provisions for income taxes are based on amounts reported in the consolidated statements of income (after exclusion of nontaxable income items) and include deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. The primary deferred tax differences result from different depreciation methods for book and tax and the allowance for loan losses.

14. INCOME TAXES – CONTINUED

The accounting standard regarding income taxes provides guidance for measuring and recognizing tax positions taken or expected to be taken in a tax return that directly or indirectly affects amounts reported in the Bank’s financial statements. Each company is required to review its income tax positions and determine if each position meets a “more likely than not” threshold of expectation of prevailing. As of December 31, 2016 and 2015, the Bank has no uncertain tax positions that qualify for either recognition or disclosure in the financial statements under the current guidance. Under statute, the Bank is subject to Internal Revenue Service and state taxing authority review for tax years 2014, 2015 and 2016. The Bank has filed tax returns through 2016.

26

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

Federal and state income taxes receivable (payable) were $(55,875) and $(242,985) at December 31, 2016, respectively, and $612,473 and $(111,973) at December 31, 2015, respectively.

The components of income tax expense (benefit) for the years ended December 31, 2016 and 2015, were as follows:

	2016			2015
Current:
Federal	$	1,665,037		$	1,295,004
State		242,985			111,973
Total current		1,908,022			1,406,977
Deferred:
Federal		(133,016	)		276,105
State		(16,210	)		39,269
Total deferred		(149,226	)		315,374
Income tax expense	$	1,758,796		$	1,722,351

27

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

14. INCOME TAXES – CONTINUED

The components of the net deferred tax asset (liability) included in other assets as of December 31, 2016 and 2015, are as follows:

	2016			2015
Deferred tax asset:
Federal	$	1,871,672		$	1,717,712
State		253,358			231,952
Total deferred tax asset		2,125,030			1,949,664
Deferred tax liability:
Federal		(1,158,962	)		(1,419,358	)
State		(150,532	)		(184,408	)
Total deferred tax liability		(1,309,494	)		(1,603,766	)
Net deferred tax asset	$	815,536		$	345,898

The tax effects of each type of income and expense item that gave rise to deferred taxes as of December 31 were as follows:

	2016			2015
Allowance for loan losses	$	1,107,295		$	1,133,352
Deferred compensation		399,109			393,061
Stock-based compensation		190,246			190,246
Net unrealized (gains) losses on securities available-for-sale		182,437			(137,975	)
Deferred loan fees		137,422			124,009
Identifiable intangible assets		(215,068	)		(269,169	)
Premises and equipment		(1,017,037	)		(1,118,232	)
Dividends		(72,398	)		(72,398	)
Other, net		103,530			103,004
Net deferred tax asset	$	815,536		$	345,898

Deferred tax assets are subjected to a “more likely than not” test. If the “more likely than not” test is not met, a valuation allowance must be established against the deferred tax asset. Based on estimated future taxable income, management believes it is more likely than not that the deferred tax assets will be fully utilized.

28

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

14. INCOME TAXES – CONTINUED

Income taxes for financial reporting purposes differ from the amount computed by applying the statutory federal income tax rate of 34% for the years ended December 31, 2016 and 2015, for the reasons below:

	2016			2015
Tax expense on income computed at statutory federal income tax rate	$	1,845,524		$	1,815,285
Increase (decrease) in taxes resulting from:
Tax-exempt interest income		(158,767	)		(131,513	)
Life insurance surrender value increase		(80,579	)		(81,707	)
State income tax, net of federal tax benefit		144,160			113,171
Stock-based compensation		3,090			4,389
Nondeductible expenses and other		5,368			2,726
Income tax expense	$	1,758,796		$	1,722,351

15. RESTRICTIONS ON DIVIDENDS

The Bank may consider paying dividends in the future depending on a number of factors, including current capital levels, the profitability of the Bank, growth expectations and regulatory approval.

16. REGULATORY CAPITAL

The Bank is subject to various regulatory capital requirements administered by its primary federal regulator, Federal Deposit Insurance Corporation (FDIC). Failure to meet the minimum regulatory capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank and these consolidated financial statements.

Under the regulatory capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines involving quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.

The Bank’s capital amounts and classification under the prompt corrective action guidelines are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

29

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

16. REGULATORY CAPITAL – CONTINUED

The FDIC has adopted a new capital rule which is substantively identical to the final rules issued by the Federal Reserve Board and the Office of the Comptroller of the Currency.  The new capital rule implements certain revisions to the regulatory capital framework.  The capital rule allows for a transition period for the implementation of the capital conservation buffer.  The required minimum Conservation Buffer will be phased in incrementally, starting at 0.625% on January 1, 2016 and increasing to 1.25% on January 1, 2017, 1.875% on January 1, 2018 and 2.5% on January 1, 2019.

The Bank’s 2016 capital amounts and ratios under the new capital guidance are as follows (2015 was not affected) (dollars in thousands):

	Actual					For Capital Adequacy Purposes (Includes Capital Conservation Buffer)					To Be Well-Capitalized under the Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of December 31, 2016
Total risk capital (to risk-weighted assets):
Consolidated	$	56,992		13.72	%	$	33,220		8.000	%		N/A		N/A
Capstone Bank		54,729		13.19	%		35,815		8.625	%	$	41,496		10.00	%
Tier 1 capital (risk based) (to risk-weighted assets):
Consolidated		52,847		12.73	%		24,915		6.000	%		N/A		N/A
Capstone Bank		50,584		12.19	%		27,491		6.625	%		33,197		8.00	%
Common Equity Tier 1 capital (risk based) (to risk-weighted assets):
Consolidated		52,847		12.73	%		18,686		4.500	%		N/A		N/A
Capstone Bank		50,584		12.19	%		21,267		5.125	%		26,973		6.50	%
Tier 1 capital (leveraged) (to adjusted total assets):
Consolidated		52,847		11.18	%		18,912		4.00	%		N/A		N/A
Capstone Bank		50,584		10.70	%		18,901		4.00	%		23,626		5.00	%

30

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

16. REGULATORY CAPITAL – CONTINUED

	Actual					For Capital Adequacy Purposes (Does not Include Capital Conservation Buffer)					To Be Well-Capitalized under the Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of December 31, 2015
Total risk capital (to risk-weighted assets):
Consolidated	$	54,848		12.53	%	$	35,015		8.00	%		N/A		N/A
Capstone Bank		51,706		13.48	%		30,686		8.00	%	$	38,357		10.00	%
Tier 1 capital (risk based)(to risk-weighted assets):
Consolidated		50,636		11.57	%		26,261		6.00	%		N/A		N/A
Capstone Bank		47,497		12.38	%		23,014		6.00	%		30,686		8.00	%
Common Equity Tier 1 capital (risk based) (to risk-weighted assets):
Consolidated		50,636		11.57	%		19,696		4.50	%		N/A		N/A
Capstone Bank		47,497		12.38	%		17,261		4.50	%		24,932		6.50	%
Tier 1 capital (leveraged) (to adjusted total assets):
Consolidated		50,636		11.19	%		18,100		4.00	%		N/A		N/A
Capstone Bank		47,497		10.66	%		17,820		4.00	%		22,275		5.00	%

17. RELATED PARTY AND PARTY-IN-INTEREST TRANSACTIONS

The Bank holds interest-bearing and noninterest-bearing deposits from executive officers, directors and related companies under common ownership and control of executive officers or directors of approximately $8,935,486 and $9,261,546 as of December 31, 2016 and 2015, respectively.

Certain directors, executive officers and principal stockholders were loan customers of the Bank during 2016 and 2015. A summary of the activity and amounts outstanding are as follows:

	2016			2015
Balance at beginning of year	$	26,032,257		$	23,037,815
New loans or advances		29,789,926			36,267,117
Repayments		(31,818,419	)		(33,078,547	)
Change in related parties		(487,312	)		(194,128	)
Balance at end of year	$	23,516,452		$	26,032,257

In addition, as of December 31, 2016, lines of credit availability exist in the amount of approximately $6,283,000 to related parties.

31

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

18. SHARE-BASED COMPENSATION

The Bank has a stock incentive plan (the Plan), which permits the grant of stock options to its officers, employees, directors and organizers of the Bank for up to 600,000 shares of common stock. Both incentive stock options and nonqualified stock options may be granted under the Plan. Option awards are granted with an exercise price equal to the estimated fair market value of the Bank’s stock at the date of grant; those option awards generally vest based on five years of continuous service and have a 10-year contractual term. Dividends are not paid on unexercised options, and dividends are not subject to vesting. The Plan provides for accelerated vesting if there is a change in control (as defined in the Plan). As of December 31, 2016, there were 327,010 stock options available to be granted under the Plan.

The fair value of each stock option award is estimated on the date of grant using a Black-Scholes-Merton valuation model that uses the weighted-average assumptions noted in the following table. Expected volatilities are based on an index of traded community banks. The expected term of options granted is based on the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

The following table summarizes the weighted-average assumptions used and the weighted-average estimated fair values related to stock options granted during the year ended December 31, 2015:

	2015
Expected volatility		16.06	%
Expected dividends		2.00	%
Expected term	5 years
Risk-free rate		2.96	%
Weighted-average grant date fair value	$	2.12

There were no stock options granted during 2016.

32

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

18. SHARE-BASED COMPENSATION – CONTINUED

A summary of stock option activity is presented below:

	Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Terms (years)
As of December 31, 2016:
Outstanding at beginning of year		262,324	$	10
Granted		-		10
Exercised		-		10
Forfeited or expired		-		10
Outstanding at end of year		262,324	$	10		2.85
Exercisable at end of year		256,324	$	10		2.85
As of December 31, 2015:
Outstanding at beginning of year		259,824	$	10
Granted		2,500		10
Exercised		-		10
Forfeited or expired		-		10
Outstanding at end of year		262,324	$	10		3.09
Exercisable at end of year		251,324	$	10		3.09

The Bank recognized stock-based compensation expense of $13,007 and $18,655 for the years ended December 31, 2016 and 2015, respectively.

As of December 31, 2016, there was $9,370 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted.

Salary Continuation Plan

The Bank sponsors a salary continuation plan providing for death and retirement benefits for certain executive officers, both current and former. The present value of the estimated amounts to be paid under the plan is being accrued over the remaining service period of the executives, both current and former. The expense recognized for the salary continuation plan totaled $116,643 and $113,208 for the years ended December 31, 2016 and 2015, respectively. The balance of the liability for the salary continuation plan included in accounts payable and accrued liabilities, amounted to $1,081,597 and $1,065,205 at December 31, 2016 and 2015, respectively.

33

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

18. SHARE-BASED COMPENSATION – CONTINUED

The expense of the salary continuation plan described above is being offset by the earnings from bank-owned life insurance policies on certain executive officers, both current and former. The balance of the policy surrender values totaled $9,836,278 and $9,599,282 at December 31, 2016 and 2015, respectively. Income recognized from the increase in cash surrender value on these policies totaled $236,996 and $240,317 for the years ended December 31, 2016 and 2015, respectively.

Employee Stock Purchase Plan

The Bank sponsors an employee stock purchase plan which is available to all employees subject to certain minimum service requirements. The plan is administered by a Board appointed committee which designates the offering period in which employees may purchase shares and the offering price which is generally offered at a 15% discount to the Bank’s stock price. All administrative costs are borne by the Bank. During 2016 and 2015, 2,280 and 2,160 shares, respectively, were purchased under the plan for $22,210 and $18,360, respectively.

Profit Sharing Plan

The Bank sponsors a 401(k) profit sharing plan covering substantially all employees subject to certain age and minimum service requirements. Contributions to the plan charged to expense totaled $206,407 and $179,234 for the years ended December 31, 2016 and 2015, respectively.

19. OTHER EXPENSES

Other expenses that exceed 1% of the aggregate of total interest income and other income for the years ended December 31, 2016 and 2015, are as follows:

	2016		2015
Data processing expense	$	1,226,621	$	1,119,589
FDIC Insurance and assessment		323,921		343,843
Professional fees		257,008		254,100
Directors’ fees		219,800		196,150

34

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

20. FAIR VALUE MEASUREMENT AND DISCLOSURES

The fair value hierarchy has designated three categories to determine fair value disclosures (Note 2). The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash Equivalents and Short-Term Investment

For those short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities

Securities available-for-sale consist of U.S. Government and agency securities, mortgage-backed securities and municipal securities. Fair values for the securities available-for-sale are based on quoted market prices or dealer quotes of identical assets on active exchanges, or Level 1 measurements. If such quoted market prices are not available, the Bank utilizes quoted market prices of similar instruments and/or discounted cash flows to estimate a value of these securities, or Level 2 measurements. Level 2 discounted cash flow analyses are typically based on market interest rates, prepayment speeds and/or adjusted spreads.

Loans

For variable rate loans that reprice frequently and with no significant change in credit risk, fair values approximate carrying values. Fair values for certain homogeneous categories of fixed rate loans, are estimated using discounted cash flow analysis, using market interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Loans Held-for-Sale

The fair value of loans held-for-sale is the amount of sales proceeds that have or will be received for the sale of loans held-for-sale; however, sale treatment has been deferred until the warranty period has ended.

Accrued Interest Receivable and Payable

The carrying amount of accrued interest receivable approximates its fair value.

Deposits

The fair value of demand deposits, savings accounts and certain money market deposits are equal to the amount payable on demand at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using the rates currently offered for deposits of similar remaining maturities.

Borrowings

Rates currently available to the Bank for debt with similar terms and remaining maturities are used to estimate fair value of existing borrowings.

Commitments to Extend Credit, Standby Letters of Credit, and Financial Guarantees Written

The fair value of commitments, letters of credit and financial guarantees is estimated to be approximatelythe fees charged for these arrangements.

35

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

20. FAIR VALUE MEASUREMENT AND DISCLOSURES – CONTINUED

Impaired Loans

Nonrecurring fair value adjustments to loans reflect full or partial write-downs that are based on the loan’s observable market price or current appraised value of the collateral. Loans subjected to nonrecurring fair value adjustments based on the current appraised value of the collateral may be classified as Level 2 or Level 3 depending on the type of asset and the inputs to the valuation. When appraisals are used to determine impairment, and these appraisals require significant adjustments to market-based valuation inputs or apply an income approach based on unobservable cash flows to measure fair value, the related loans subjected to nonrecurring fair value adjustments are typically classified as Level 3 due to the fact that Level 3 inputs are significant to the fair value measurement.

Foreclosed Real Estate

Nonrecurring fair value adjustments to other real estate reflect full or partial write-downs that are based on the real estate’s observable market price or current appraised value of the collateral, net of estimated selling costs.

Items Measured at Fair Value on a Recurring Basis

The following fair value hierarchy table presents information about the Bank’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2016 and 2015:

			Fair Value Measurement at Report Date Using
	Fair Value		Quoted Prices In Active Markets Level 1		Significant Other Observable Inputs Level 2		Significant Unobservable Inputs Level 3
December 31, 2016
State and municipal securities	$	3,617,027	$	-	$	3,617,027	$	-
U.S. Government sponsored mortgage-backed securities		39,655,029		-		39,655,029		-
	$	43,272,056	$	-	$	43,272,056	$	-
December 31, 2015
U.S. Government and agency securities	$	743,469	$	-	$	743,469	$	-
State and municipal securities		2,368,703		-		2,368,703		-
U.S. Government sponsored mortgage-backed securities		32,444,948		-		32,444,948		-
	$	35,557,120	$	-	$	35,557,120	$	-

36

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

20. FAIR VALUE MEASUREMENT AND DISCLOSURES – CONTINUED

Items Measured at Fair Value on a Nonrecurring Basis

The following fair value hierarchy table presents information about the Bank’s assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2016 and 2015:

			Fair Value Measurement at Report Date Using
	Fair Value		Quoted Prices In Active Markets Level 1		Significant Other Observable Inputs Level 2		Significant Unobservable Inputs Level 3
December 31, 2016
Impaired loans, net	$	3,222,291	$	-	$	-	$	3,222,291
Foreclosed real estate		243,927		-		-		243,927
	$	3,466,218	$	-	$	-	$	3,466,218
December 31, 2015
Impaired loans, net	$	6,687,413	$	-	$	-	$	6,687,413
Foreclosed real estate		1,847,257		-		-		1,847,257
	$	8,534,670	$	-	$	-	$	8,534,670

No gains or losses have been recorded for impaired loans or foreclosed real estate subsequent to the initial measurement.

37

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

20. FAIR VALUE MEASUREMENT AND DISCLOSURES – CONTINUED

The estimated fair values of the Bank’s financial instruments as of December 31 are as follows:

	2016				2015
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
	(in thousands)
Financial assets:
Cash and cash equivalents	$	6,105	$	6,105	$	8,606	$	8,606
Securities available-for-sale		43,272		43,272		35,557		35,557
Restricted equity securities		1,277		1,277		986		986
Loans held-for-sale		1,133		1,132		1,463		1,463
Loans, net		403,749		403,122		371,834		371,867
Bank-owned life insurance		9,836		9,836		9,599		9,599
Accrued interest receivable		1,171		1,171		1,166		1,166
Financial liabilities:
Deposits		414,514		406,612		388,960		381,791
FHLB advances		12,219		12,120		5,806		5,930
Accrued interest payable		232		232		208		208
Unrecognized financial instruments:
Commitments to extend credit		98,854		99		93,823		94

38

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

21. PARENT COMPANY ONLY FINANCIAL INFORMATION

The following information presents the condensed statements of financial condition, income and cash flows of Capstone Bancshares, Inc. as of December 31, 2016 and 2015, and for the years then ended:

CONDENSED STATEMENTS OF FINANCIAL CONDITION

DECEMBER 31, 2016 AND 2015

	2016		2015
ASSETS
Cash	$	1,963,030	$	1,941,302
Investment in subsidiary		55,674,382		53,119,134
Other assets		223,147		729,253
TOTAL ASSETS	$	57,860,559	$	55,789,689
LIABILITIES AND STOCKHOLDERS’ EQUITY
Other liabilities	$	1,000	$	428,016
Stockholders’ equity		57,899,744		55,361,673
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	57,900,744	$	55,789,689

CONDENSED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

	2016			2015
INTEREST INCOME	$	5,414		$	5,808
EXPENSE
Employee benefits		13,008			16,148
Other operating expense		91,984			96,293
Total expense		104,992			112,441
Loss before income tax benefit and equity earnings of subsidiary		(99,578	)		(106,633	)
Income tax benefit		47,187			37,691
Loss before equity in earnings of subsidiary		(52,391	)		(68,942	)
Equity in earnings of subsidiary		3,721,601			3,685,665
NET INCOME	$	3,669,210		$	3,616,723

39

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2016 AND 2015

21. PARENT COMPANY ONLY FINANCIAL INFORMATION – CONTINUED

CONDENSED STATEMENTS OF CASH FLOWS

FOR THE YEARS ENDED DECEMBER 31, 2016 AND 2015

	2016			2015
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	3,669,210		$	3,616,723
Adjustments to reconcile net income to net cash used in operating activities:
Equity in earnings of subsidiary		(3,721,601	)		(3,685,665	)
Deferred income taxes		5,335			(37,691	)
Stock-based compensation		13,007			18,655
Net other operating activities		33,567			29,104
Net cash used in operating activities		(482	)		(58,874	)
CASH FLOWS FROM INVESTING ACTIVITIES
Dividends from subsidiary		596,734			596,416
Net cash provided by investing activities		596,734			596,416
CASH FLOWS FROM FINANCING ACTIVITIES
Sale of treasury stock		22,210			18,360
Dividends declared and paid		(596,734	)		(596,416	)
Net cash used in financing activities		(574,524	)		(578,056	)
NET INCREASE (DECREASE) IN CASH		21,728			(40,514	)
CASH AT BEGINNING OF YEAR		1,941,302			1,981,816
CASH AT END OF YEAR	$	1,963,030		$	1,941,302

40

EX-99.2

Exhibit 99.2

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

	Unaudited September 30, 2017			December 31, 2016
ASSETS
CASH AND CASH EQUIVALENTS
Cash and due from banks	$	6,278,305		$	5,852,711
Federal funds sold		—			252,580
TOTAL CASH AND CASH EQUIVALENTS		6,278,305			6,105,291
Securities available-for-sale		52,539,451			43,272,056
Restricted equity securities		1,049,975			1,277,075
Loans held-for-sale		836,250			1,133,300
Loans, net of allowance for loan losses		418,728,691			403,749,009
Premises and equipment, net		12,882,309			13,357,380
Goodwill and other intangible assets		5,666,241			5,776,205
Bank-owned life insurance		10,011,525			9,836,278
Other assets		3,056,232			2,829,880
TOTAL ASSETS	$	511,048,979		$	487,336,474
LIABILITIES AND STOCKHOLDERS' EQUITY
DEPOSITS	$	352,361,551		$	333,337,175
Interest-bearing deposits		85,566,268			81,177,278
Noninterest-bearing deposits		437,927,819			414,514,453
TOTAL DEPOSITS		8,988,275			12,218,608
FHLB advances & other borrowings		2,631,999			2,703,669
Accounts payable and accrued liabilities		449,548,093			429,436,730
TOTAL LIABILITIES
STOCKHOLDERS’ EQUITY
Common stock, Class A voting, $.01 par value; 30,000,000 shares authorized; 4,349,885 shares issued at September 30,  2017 and 2016; 4,276,726 and 4,261,378 outstanding at September 30, 2017 and 2016, respectively		43,499			43,499
Common stock, Class B nonvoting, $.01 par value; 15,000,000 shares authorized; none issued		—
Common stock, Class C nonvoting, $.01 par value; 15,000,000 shares authorized; none issued		—
Treasury stock, 73,159 shares, at cost at September 30, 2017 and 88,507 shares, at cost at September 30, 2016		(731,590	)		(874,970	)
Additional paid-in capital		44,507,259			44,500,768
Retained earnings		17,487,132			14,554,780
Accumulated other comprehensive income (loss)		194,586			(324,333	)
TOTAL STOCKHOLDERS’ EQUITY		61,500,886			57,899,744
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	511,048,979		$	487,336,474

The Notes to Consolidated Financial Statements are an integral part of these statements.

1

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

	Unaudited Nine Months Ended September 30,
	2017		2016
INTEREST INCOME
Interest and fees on loans	$	14,790,172	$	13,212,351
Taxable investment securities		777,496		603,700
Nontaxable investment securities		71,927		65,586
Interest on federal funds sold and deposits in banks		93,240		19,853
Total interest income		15,732,835		13,901,490
INTEREST EXPENSE
Interest on deposits		2,100,116		1,620,003
Interest on borrowed funds		72,849		96,405
Total interest expense		2,172,965		1,716,408
PROVISION FOR LOAN LOSSES		862,500		785,000
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES		12,697,370		11,400,082
NONINTEREST INCOME
Service charges on deposit accounts		872,235		843,500
Mortgage loan origination income		670,890		724,989
ATM fee income		302,119		259,033
Income from bank-owned life insurance		175,247		177,636
Other income		111,485		162,732
Total noninterest income		2,131,976		2,167,890
NONINTEREST EXPENSES
Employee compensation		5,058,378		4,754,848
Occupancy expenses		1,267,313		1,297,398
Employee benefits		1,137,192		1,050,064
Other		3,028,522		2,543,212
Total noninterest expenses		10,491,405		9,645,522
INCOME BEFORE INCOME TAX EXPENSE		4,337,941		3,922,450
INCOME TAX EXPENSE		1,405,589		1,265,382
NET INCOME	$	2,932,352	$	2,657,068

The Notes to Consolidated Financial Statements are an integral part of these statements.

2

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY - UNAUDITED

For the Nine Months Ended September 30, 2017

	Common Stock		Treasury Stock			Additional Paid-in Capital		Retained Earnings		Accumulated Other Comprehensive Income (Loss)			Total Stockholders' Equity
BALANCE, December 31, 2016	$	43,499	$	(874,970	)	$	44,500,768	$	14,554,780	$	(324,333	)	$	57,899,744
Stock-based compensation		—		—			5,436		—		—			5,436
Sale of treasury stock		—		143,380			1,055		—		—			144,435
Net income		—		—			—		2,932,352		—			2,932,352
Other comprehensive income		—		—			—		—		518,919			518,919
BALANCE, September 30, 2017	$	43,499	$	(731,590	)	$	44,507,259	$	17,487,132	$	194,586		$	61,500,886

The Notes to Consolidated Financial Statements are an integral part of these statements.

3

CAPSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Unaudited Nine Months Ended September 30,
	2017			2016
CASH FLOWS FROM OPERATING ACTIVITIES
Net cash provided by operating activities	$	4,168,574		$	5,212,954
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities available-for-sale		(14,127,647	)		(7,614,654	)
Proceeds from sales of securities available for sale		—			1,351,381
Proceeds from maturities and paydowns of securities available-for-sale		5,521,637			3,452,813
Redemption (purchase) of restricted equity securities		227,100			(395,800	)
Net increase in loans		(15,827,195	)		(21,515,688	)
Purchases of premises and equipment		(116,923	)		(129,848	)
Net cash used in investing activities		(24,323,028	)		(24,851,796	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		23,413,366			7,683,645
Sale of treasury stock		144,435			11,050
Net (repayments) proceeds on other borrowings		(3,230,333	)		11,039,164
Net cash provided by financing activities		20,327,468			18,733,859
INCREASE IN CASH AND CASH EQUIVALENTS		173,014			(904,983	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR		6,105,291			8,606,470
CASH AND CASH EQUIVALENTS AT END OF YEAR	$	6,278,305		$	7,701,487

The Notes to Consolidated Financial Statements are an integral part of these statements.

4

Note 1. Basis of Presentation and Overview

Capstone Bancshares, Inc. and Subsidiary (the Bank), is a corporation organized under the laws of the State of Alabama for the purposes of owning 100% of the outstanding common stock of Capstone Bank (the Bank). The Bank is a state-chartered bank with its corporate headquarters, main office and one branch location in Tuscaloosa, Alabama and additional branch locations in Northport, McIntosh, Chatom, Jackson, Thomasville, and Fairhope, Alabama. The Bank provides a full range of banking services in its primary market areas.

Recently Issued Accounting Pronouncements

During interim periods, the Company follows the accounting policies set forth in its annual audited financial statements for the year ended December 31, 2016 as filed with the Securities and Exchange Commission.  The following is a summary of recent authoritative pronouncements not yet effective that could impact the accounting, reporting, and/or disclosure of financial information by the Company issued since  December 31, 2016.

In January 2017, FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business.  The ASU clarifies the definition of a business to assist with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses.  The amendments in this update are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.  The Company does not expect these amendments to have a material effect on its financial statements.

In January 2017, FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.  The ASU simplifies the subsequent measurement of goodwill and eliminates Step 2 from the goodwill impairment test.  The Company should perform its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount.  An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value.  The impairment charge is limited to the amount of goodwill allocated to that reporting unit.  The amendments in this update are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.   Early adoption is permitted for goodwill impairment tests performed on testing dates after January 1, 2017.  The Company does not expect these amendments to have a material effect on its financial statements.

In March 2017, FASB issued ASU No. 2017-08, Receivables - Nonrefundable Fees and Other Costs (Topic 310-20): Premium Amortization on Purchased Callable Debt Securities.  The ASU shortens the amortization period for certain callable debt securities held at a premium.  The premium on individual callable debt securities shall be amortized to the earliest call date. This guidance does not apply to securities for which prepayments are estimated on a large number of similar loans where prepayments are probable and reasonably estimable. The amendments in this update are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  Early adoption is permitted. This update should be adopted on a modified retrospective basis with a cumulative-effect adjustment to retained earnings on the date of adoption.  The Company does not expect these amendments to have a material effect on its financial statements.

In August 2017, the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities, which amends the hedge accounting recognition and presentation requirements in Accounting Standards Codification (ASC) 815, Derivatives and Hedging. The goals of the ASU are to (1) improve the transparency and understandability of information conveyed to financial statement users about an entity’s risk management activities by better aligning the entity’s financial reporting for hedging relationships with those risk management activities and (2) reduce the complexity of and simplify the application of hedge accounting by preparers. The amendments will be effective for the Company for interim and annual periods beginning after December 15, 2018.  The Company does not expect these amendments to have a material effect on its financial statements.

Note 2. Securities Available for Sale

This note was omitted as the information it would have provided has been superseded by the subsequent event of the merger with SmartFinancial and the liquidation of the securities portfolio as detailed in Pro Forma Financial information included as Exhibit 99.3 in this filing.

5

Note 3. Loans and Allowance for Loan Losses

The composition of loans by primary loan classification and by performing and impaired loan status at September 30, 2017 and December 31, 2016, are as follows:

	September 30, 2017
	Commercial, Financial and Agricultural		Real Estate		Consumer and Other		Subtotal		Allowance for Loan Losses		Net Loans
Performing loans	$	92,527,069	$	306,941,961	$	18,390,326	$	417,859,356	$	3,948,780	$	413,910,576
Impaired loans		759,520		3,899,397		430,947		5,089,864		271,749		4,818,115
Total	$	93,286,589	$	310,841,358	$	18,821,273	$	422,949,220	$	4,220,529	$	418,728,691

	December 31, 2016
	Commercial, Financial and Agricultural		Real Estate		Consumer and Other		Subtotal		Allowance for Loan Losses		Net Loans
Performing loans	$	91,849,964	$	292,252,202	$	19,930,784	$	404,032,950	$	3,506,232	$	400,526,718
Impaired loans		785,171		2,551,625		524,742		3,861,538		639,247		3,222,291
Total loans	$	92,635,135	$	294,803,827	$	20,455,526	$	407,894,488	$	4,145,479	$	403,749,009

The Bank evaluates all loans over 60 days past due or more for impairment.

The allocation and changes in the allowance for loan losses, by loan classification, as of and for the periods ended September 30, 2017 and December 31, 2016, are as follows:

	September 30, 2017
	Commercial, Financial and Agricultural			Real Estate			Consumer and Other			Total
Beginning balance	$	870,001		$	3,032,884		$	242,594		$	4,145,479
Loans charged off		(96,000	)		(693,000	)		(63,286	)		(852,286	)
Recoveries of loans charged off		—			31,000			33,836			64,836
Net Charge offs		(96,000	)		(662,000	)		(29,450	)		(787,450	)
Provision (reallocation) charged to operating expense		(48,256	)		976,941			(66,185	)		862,500
Ending balance	$	725,745		$	3,347,825		$	146,959		$	4,220,529

	December 31, 2016
	Commercial, Financial and Agricultural			Real Estate			Consumer and Other			Total
Beginning balance	$	1,197,543		$	2,806,664		$	204,932		$	4,209,139
Loans charged off		(395,973	)		(804,404	)		(10,096	)		(1,210,473	)
Recoveries of loans charged off		14,912			60,414			21,487			96,813
Net Charge offs		(381,061	)		(743,990	)		11,391			(1,113,660	)
Provision (reallocation) charged to operating expense		53,519			970,210			26,271			1,050,000
Ending balance	$	870,001		$	3,032,884		$	242,594		$	4,145,479

6

Note 3. Loans and Allowance for Loan Losses, Continued

The level of the allowance is based upon evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect the borrowers' ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, historical loss experience, industry and peer bank loan quality indications and other pertinent factors, including regulatory recommendations.

In assessing the adequacy of the allowance for loan losses, management analyzes the allowance for loan losses based on the categories of commercial, financial and agricultural; real estate - construction; real estate - mortgage; and consumer and other.

Risk ratings are categorized as pass, special mention, substandard or doubtful. Management believes that the categories follow those outlined by the primary regulator. Pass rated loans include all risk rated credits other than those included in special mention, substandard and doubtful, which are defined as follows:

• Special mention loans have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank's credit position at some future date.

• Substandard loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize liquidation of the debt. Substandard loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Substandard loans have been placed on nonaccrual status unless it was determined that the loan should remain on accrual status.

• Doubtful loans have all the characteristics of substandard loans with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The Bank considers all doubtful loans to be impaired and places all such loans on nonaccrual status.

The following table outlines the amount of each loan classification based on internally assigned risk ratings as of September 30, 2017 and December 31, 2016:

	September 30, 2017
	Commercial, Financial and Agricultural		Real Estate		Consumer and Other		Total
Pass	$	92,458,919	$	300,583,950	$	18,257,769	$	411,300,638
Special mention		68,150		6,358,012		132,557		6,558,719
Substandard		544,712		3,091,284		105,556		3,741,582
Substandard - impaired		198,808		51,232		33,966		284,006
Doubtful - impaired		16,000		756,880		291,395		1,064,275
Total	$	93,286,589	$	310,841,358	$	18,821,273	$	422,949,220

	December 31, 2016
	Commercial, Financial and Agricultural		Real Estate		Consumer and Other		Total
Pass	$	91,599,663	$	283,372,553	$	19,864,984	$	394,837,200
Special mention		15,158		6,623,520		65,800		6,704,478
Substandard		235,143		2,256,129		—		2,491,272
Substandard - impaired		669,157		1,400,720		222,378		2,292,255
Doubtful - impaired		116,014		1,150,905		302,364		1,569,283
Total	$	92,635,135	$	294,803,827	$	20,455,526	$	407,894,488

7

Note 3. Loans and Allowance for Loan Losses, Continued

The following tables detail the recorded investments, unpaid principal balance and the related allowance of impaired loans as of September 30, 2017 and December 31, 2016, and the average recorded investment of impaired loans, as well as the interest income recognized for the periods ended September 30, 2017 and December 31, 2016:

	At September 30, 2017						For the nine months ended September 30, 2017
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Impaired loans without a valuation allowance:
Commercial, financial and agricultural	$	544,712	$	544,712	$	—	$	554,657	$	19,421
Real estate		3,470,645		3,470,645		—		4,163,179		104,511
Consumer		389,815		389,815		—		394,735		4,994
		4,405,172		4,405,172		—		5,112,571		128,926
Impaired loans with a valuation allowance:
Commercial, financial and agricultural		214,808		214,808		138,865		234,596		9,380
Real estate		428,752		428,752		91,752		430,002		12,000
Consumer		41,132		41,132		41,132		44,709		2,454
		684,692		684,692		271,749		709,307		23,834
Total impaired loans	$	5,089,864	$	5,089,864	$	271,749	$	2,821,878	$	152,760

	December 31, 2016						For the Twelve months ended December 31, 2016
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
Impaired loans without a valuation allowance:
Commercial, financial and agricultural	$	609,776	$	609,776	$	—	$	710,150	$	39,757
Real estate		802,767		802,767		—		2,515,705		46,241
Consumer		149,528		149,528		—		237,802		9,125
		1,562,071		1,562,071		—		3,463,657		95,123
Impaired loans with a valuation allowance:
Commercial, financial and agricultural		175,395		175,395		115,177		146,931		10,564
Real estate		1,748,858		1,748,858		451,329		1,487,920		94,275
Consumer		416,089		375,214		72,741		190,042		23,834
		2,340,342		2,299,467		639,247		1,824,893		128,673
Total impaired loans	$	3,902,413	$	3,861,538	$	639,247	$	5,288,550	$	223,796

8

Note 3. Loans and Allowance for Loan Losses, Continued

Past due balances and loans on nonaccrual status by loan classification are as follows:

	September 30, 2017
	30-89 Days Past Due and Accruing		Past Due 90 Days or More and Accruing		Total Past Due and Performing		Loans on Nonaccrual Status		Current Loans		Total Loans
Commercial, financial and agricultural	$	127,000	$	—	$	127,000	$	208,349	$	92,951,240	$	93,286,589
Real estate		1,909,000		108,000		2,017,000		1,244,776		307,579,582		310,841,358
Consumer		139,000		—		139,000		315,861		18,366,412		18,821,273
Total	$	2,175,000	$	108,000	$	2,283,000	$	1,768,986	$	418,897,234	$	422,949,220

	December 31, 2016
	30-89 Days Past Due and Accruing		Past Due 90 Days or More and Accruing		Total Past Due and Performing		Loans on Nonaccrual Status		Current Loans		Total Loans
Commercial, financial and agricultural	$	296,640	$	—	$	296,640	$	368,037	$	91,970,458	$	92,635,135
Real estate		3,015,415		144,172		3,159,587		1,828,798		289,815,442		294,803,827
Consumer		120,000		3,728		123,728		335,767		19,996,031		20,455,526
Total	$	3,432,055	$	147,900	$	3,579,955	$	2,532,602	$	401,781,931	$	407,894,488

As of September 30, 2017 and December 31, 2016, there were no loans classified as nonaccrual that were not deemed to be impaired, and all impaired loans were on nonaccruing interest status. At the date such loans were placed on nonaccrual status, the Bank reversed all previously accrued interest income against current year earnings. The Bank's policy is that once a loan is classified as impaired and placed on nonaccrual status, future payments of interest will be applied to the principal balance and not to income. There were approximately $108,000 and $148,000 in loans greater than 90 days past due and still accruing interest at September 30, 2017 and December 31, 2016, respectively.

The following table provides details for the troubled debt restructurings by loan classification:

September 30, 2017	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Consumer and other		—	$	—	$	—
Real estate - mortgage		2		126,460		126,460
Commercial, financial and agricultural		1		95,008		95,008
Total		3	$	221,468	$	221,468

There was $49,029 in troubled debt restructurings for 2017 that subsequently defaulted.

9

Note 3. Loans and Allowance for Loan Losses, Continued

December 31, 2016	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Consumer and other		1	$	110,328	$	110,328
Real estate - mortgage		3		378,661		378,661
Commercial, financial and agricultural		1		34,167		34,167
Total		5	$	523,156	$	523,156

There were no troubled debt restructurings for 2016 that subsequently defaulted.

Note 4. Financial Instruments with Off Balance Sheet Risk

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.

The outstanding notional amount of off-balance sheet risks at September 30, 2017 and December 31, 2016 is as follows:

	2017		2016
Unused commitments and standby letters of credit	$	107,930,000	$	98,854,451

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Note 5. Contingencies

In the normal course of business, the Bank is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings, other than those noted above, would not have a material effect on the Bank's consolidated financial statements.

Note 6. Fair Value Disclosures

This note was omitted as the information it would have provided has been superseded by the subsequent event of the merger with SmartFinancial and the fair value of the assets and liabilities in accordance with ASC 805 as detailed in the n Pro Forma Financial information included as Exhibit 99.3 in this filing.

10

EX-99.3

Exhibit 99.3

UNAUDITED PRO FORMA COMBINED CONDENSED FINANCIAL INFORMATION

The following unaudited pro forma condensed combined financial information combines the historical financial position and results of operations of SmartFinancial, Inc. ("SmartFinancial")  and Capstone Bancshares Inc. ("Capstone"), after giving effect to the merger of Capstone with and into SmartFinancial,  using the acquisition method of accounting and giving effect to the related pro forma adjustments described in the accompanying explanatory notes.   Under the acquisition method of accounting, the assets and liabilities of Capstone will be recorded by SmartFinancial  at their respective fair values as of November 1, 2017, the date the merger was completed, and the excess of the merger consideration over the fair value of Capstone's net assets will be allocated to goodwill. The unaudited pro forma condensed combined balance sheet gives effect to the merger as if the merger was consummated on September 30, 2017. The unaudited pro forma condensed combined statements of income for the nine months ended September 30, 2017 and for the year ended December 31, 2016 give effect to the merger as if the merger was consummated on January 1, 2017 and January 1, 2016, respectively.

The unaudited pro forma condensed combined financial information should be read together with SmartFinancial's separate audited historical consolidated financial statements and accompanying notes as of and for the year ended December 31, 2016, included in SmartFinancial's Annual Report on Form 10-K for the year ended December 31, 2016; SmartFinancial's separate unaudited historical consolidated financial statements and accompanying notes as of and for the three and nine months ended September 30, 2017, included in SmartFinancial's Quarterly Report on Form 10-Q for the quarter ended September 30, 2017; and other information pertaining to SmartFinancial's contained in previous Securities and Exchange Commission ("SEC") filings.

The unaudited pro forma condensed combined financial information is presented for illustrative purposes only and does not necessarily indicate the financial results of the combined companies had the companies actually been combined at the beginning of the periods presented. The adjustments included in these unaudited pro forma combined financial statements are preliminary and may be revised. The unaudited pro forma condensed combined financial information also does not consider any potential impacts of current market conditions on revenues, potential revenue enhancements, anticipated cost savings and expense efficiencies, or asset dispositions, among other factors. In addition, the purchase price reflected in the unaudited pro forma condensed combined financial information is subject to adjustment. The unaudited pro forma condensed combined balance sheet has also been adjusted to reflect the preliminary allocation of the estimated purchase price to net assets acquired.

The final allocation of the purchase price will be determined after completion of thorough analyses to determine the fair value of Capstone's tangible and identifiable intangible assets and liabilities as of the November 1, 2017 acquisition date. Increases or decreases in the estimated fair values of the net assets of Capstone as compared with the information shown in the unaudited pro forma condensed combined financial information may change the amount of the purchase price allocated to goodwill and may impact the statement of income due to adjustments in yield and/or amortization of the adjusted assets or liabilities. Any changes to Capstone's shareholder’s equity including results of operations through the date the merger is completed will also change the purchase price allocation, which may include the recording of goodwill. The final adjustments may be materially different from the unaudited pro forma adjustments presented herein.

Unaudited Proforma Consolidated Balance Sheet

September 30, 2017

(in thousands)

	SmartFinancial			Capstone			Pro Forma Adjustments, Net				Pro Forma Combined
ASSETS
Cash and due from banks	$	40,867		$	6,278		$	(5,825	)	a,b	$	41,320
Interest-bearing deposits at other financial institutions		24,833			—			—				24,833
Federal funds sold		18,398						—				18,398
Total cash and cash equivalents		84,098			6,278			(5,825	)			84,551
Securities available for sale		115,535			52,540			91		c		168,166
Restricted investments, at cost		6,081			1,050			—				7,131
Loans, net of deferred fees		871,679			423,786			(12,007	)	d		1,283,458
Allowance for loan losses		(5,393	)		(4,221	)		4,221		e		(5,393	)
Loans, net of allowance for loan losses		866,286			419,565			(7,786	)			1,278,065
Bank premises and equipment, net		33,778			12,882			(4,070	)	f,g		42,590
Cash surrender value of life insurance		2,888			10,012							12,900
Foreclosed assets		7,414			168			242		g, h		7,824
Goodwill and core deposit intangible, net		11,484			5,666			37,911		i,j,k		55,061
Other assets		8,258			2,888			3,252		l,m		14,398
Total assets	$	1,135,822		$	511,049		$	23,815			$	1,670,686
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits	$	185,386		$	85,566		$	—			$	270,952
Interest-bearing demand deposits		156,953			13,725			—				170,678
Money market and savings deposits		306,357			190,724			—				497,081
Time deposits		311,490			147,913			1,102		n		460,505
Total deposits		960,187			437,928			1,102				1,399,217
Securities sold under agreement to repurchase		26,542			—			—				26,542
Federal Home Loan Bank advances and other borrowings		6,000			8,988			10,038		a,o		25,026
Accrued expenses and other liabilities		6,505			2,632			5,147		p,q		14,284
Total liabilities		999,234			449,548			16,287				1,465,069
Stockholders' equity:
Preferred stock		—			—			—				—
Common stock		8,243			43			2,865		r,s		11,151
Additional paid-in capital		107,065			43,776			22,346		r,s		173,187
Retained earnings		21,653			17,487			(17,487	)	r		21,653
Accumulated other comprehensive loss		(374	)		195			(195	)	r		(374	)
Total stockholders' equity		136,588			61,501			7,529				205,618
Total liabilities and stockholders' equity	$	1,135,822		$	511,049		$	23,816			$	1,670,687

See accompanying notes to unaudited pro forma combined consolidated financial information.

Unaudited Proforma Consolidated Income Statement

For the Nine Months Ended September 30, 2017

(in thousands)

	SmartFinancial			Capstone		Pro Forma Adjustments, Net				Pro Forma Combined
INTEREST INCOME
Loans, including fees	$	32,449		$	14,790	$	542		t	$	47,781
Securities and interest bearing deposits at other financial institutions		2,093			850		—				2,943
Federal funds sold and other earning assets		237			93		—				330
Total interest income		34,779			15,733		542				51,054
INTEREST EXPENSE
Deposits		3,712			2,100		(592	)	u		5,220
Securities sold under agreements to repurchase		47			—		—				47
Federal Home Loan Bank advances and other borrowings		32			73		337		v		442
Total interest expense		3,791			2,173		(255	)			5,709
Net interest income before provision for loan losses		30,988			13,560		797				45,345
Provision for loan losses		341			863		—				1,204
Net interest income after provision for loan losses		30,647			12,697		797				44,141
NONINTEREST INCOME
Customer service fees		850			872		—				1,722
Gain on sale of securities		143			—		—				143
Gain on sale of loans and other assets		910			671		—				1,581
Gain (loss) on sale of foreclosed assets		(42	)		—		—				(42	)
Other noninterest income		1,543			589		—				2,132
Total noninterest income		3,404			2,132		—				5,536
NONINTEREST EXPENSES
Salaries and employee benefits		14,472			6,196		—				20,668
Net occupancy and equipment expense		3,054			1,267		(160	)	w		4,161
Depository insurance		316			180		—				496
Foreclosed assets		30			11		—				41
Advertising		471			96		—				567
Data processing		1,292			967		—				2,259
Professional services		1,483			148		—				1,631
Amortization of intangible assets		192			109		235		x,y		536
Service contracts		972			43		—				1,015
Other operating expenses		4,239			1,474		(1,040	)	z		4,673
Total noninterest expenses		26,521			10,491		(965	)			36,047
Income before income tax expense		7,530			4,338		1,762				13,630
Income tax expense		2,553			1,406		675				4,634
Net income		4,977			2,932		1,087				8,996
Preferred stock dividends		195			—		—				195
Net income available to common stockholders	$	4,782		$	2,932	$	1,087			$	8,801
EARNINGS PER COMMON SHARE
Basic	$	0.60		$	0.69					$	0.81
Diluted	$	0.59		$	0.67					$	0.80
Weighted average common shares outstanding
Basic		7,994,661			4,269,557						10,902,755
Diluted		8,086,346			4,346,189						11,059,577
Dividends per common share		—			—						—

See accompanying notes to unaudited pro forma combined consolidated financial information.

Unaudited Proforma Consolidated Income Statement

For the Year Ended December 31, 2016

(in thousands)

	SmartFinancial		Capstone		Pro Forma Adjustments, Net				Pro Forma Combined
INTEREST INCOME
Loans, including fees	$	39,764	$	17,793	$	723		t	$	58,280
Securities and interest bearing deposits at other financial institutions		2,554		887		—				3,441
Federal funds sold and other earning assets		247		22		—				269
Total interest income		42,564		18,702		723				61,989
INTEREST EXPENSE
Deposits		4,106		2,206		(789	)	u		5,523
Securities sold under agreements to repurchase		65		—		—				65
Federal Home Loan Bank advances and other borrowings		129		133		450		v		712
Total interest expense		4,300		2,339		(339	)			6,300
Net interest income before provision for loan losses		38,265		16,363		1,062				55,690
Provision for loan losses		788		1,050		—				1,838
Net interest income after provision for loan losses		37,477		15,313		1,062				53,852
NONINTEREST INCOME
Customer service fees		1,128		1,129		—				2,257
Gain on sale of securities		199		—		—				199
Gain on sale of loans and other assets		948		894		—				1,842
Gain (loss) on sale of foreclosed assets		191		—		—				191
Other noninterest income		1,717		756		—				2,473
Total noninterest income		4,183		2,779		—				6,962
NONINTEREST EXPENSES
Salaries and employee benefits		17,715		7,703		—				25,418
Net occupancy and equipment expense		3,996		1,698		(214	)	w		5,480
Depository insurance		606		283		—				889
Foreclosed assets		236		56		—				292
Advertising		616		153		—				769
Data processing		1,893		1,263		—				3,156
Professional services		2,123		271		—				2,394
Amortization of intangible assets		305		147		313		x,y		765
Service contracts		1,154		54		—				1,208
Other operating expenses		3,855		1,036		—				4,891
Total noninterest expenses		32,409		12,664		99				45,172
Income before income tax expense		9,161		5,428		963				15,642
Income tax expense		3,362		1,759		369				5,490
Net income		5,799		3,669		594				10,062
Preferred stock dividends		1,022		—		—				1,022
Net income available to common stockholders	$	4,777	$	3,669	$	594			$	9,040
EARNINGS PER COMMON SHARE
Basic	$	0.82	$	0.86					$	1.03
Diluted	$	0.78	$	0.85					$	1.00
Weighted average common shares outstanding
Basic		5,838,574		4,261,248						8,736,998
Diluted		6,118,943		4,337,880						9,082,504
Dividends per common share		—		—						—

See accompanying notes to unaudited pro forma combined consolidated financial information.

NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS

(all amounts are in thousands, except per share data, unless otherwise indicated)

Note 1 — Basis of Pro Forma Presentation

The unaudited pro forma condensed combined financial information has been prepared pursuant to the rules and regulations of the SEC. Certain information and certain footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted pursuant to such rules and regulations. However, management believes that the disclosures are adequate to make the information presented not misleading.

Note 2 — Preliminary Unaudited Pro Forma and Acquisition Accounting Adjustments

The following pro forma adjustments have been reflected in the unaudited pro forma condensed combined financial information. All adjustments are based on current assumptions and valuations, which are subject to change.

a. Adjustment reflects cash payments to Capstone shareholders of $15.8 million.

b. Adjustment reflects a holding company loan of $10.0 million.

c. Adjustment reflects fair value adjustment of the acquired securities portfolio, the value of which was determined by liquidation within a week of the merger date.

d. Adjustment to the acquired loan portfolio which includes a fair value component and a credit component.  The estimated fair value adjustment is $3.6 million and the credit adjustment is estimated to be $8.4 million.

e. Adjustment to allowance for loan losses to reflect the reversal of Capstone's allowance for loan and lease losses.

f. Adjustment reflects fair value adjustment of the acquired plant, property, and equipment.

g. Adjustment reflects a reclassification of $448 thousand from plant, property, and equipment to foreclosed assets.

h. Adjustment reflects fair value adjustment of the acquired foreclosed assets.

i. Adjustment to reflect the reversal of Capstone's intangible assets.

j. Adjustment reflects the estimated fair value of the acquired core deposit intangible of $5.5 million.

k. Adjustment to record the estimated goodwill of $38.0 million as a result of consideration paid in excess of  the fair value of net assets acquired.

l. Adjustment reflects the reversal of Capstone's deferred tax asset and to record the estimated deferred tax asset post-merger.

m. Adjustment to write off a prepaid asset from Capstone's previous core conversion of $275 thousand.

n. Adjustment reflects the estimated fair value adjustment to the acquired time deposit portfolio.

o. Adjustment reflects the fair value adjustment to FHLB borrowings, the value of which was determined by repaying the borrowings within a week of the merger date.

p. Adjustment to reflect the estimated cost of a change in control liability created by merger.

q. Adjustment to reflect estimated additional merger costs, after tax, of $4.8 million.

r. Adjustment to reflect the reversal of Capstone's common equity.

s. To record the acquisition consideration paid in stock and the fair value of options assumed of $69.9 million.

t. Adjustment reflects the difference between the recorded interest earned on loans and the estimated incremental income accretion of the acquired loans.

u. Adjustment reflects the amortization of the premium on acquired time deposits.

v. Adjustment reflects the interest cost of the holding company loan.

w. Adjustment reflects the reduction in depreciation due to the lower book value of acquired plant, property, and equipment.

x. Adjustment reflects the elimination of Capstone's core deposit intangible amortization.

y. Adjustment reflects the amortization for the core deposit intangible over 13 years.

z. Adjustment reflects the elimination of historical nonrecurring transaction costs incurred during nine months ended September 30, 2017 that directly related to the Capstone acquisition.

Note 3 — Preliminary Estimated Acquisition Consideration and Allocation

Measurement of the acquisition consideration was based on the estimated fair value of SmartFinanical common stock, which was more clearly evident than the fair value of the net assets acquired. Based on the estimate of value of the shares of SmartFinancial common stock outstanding as of October 31, 2017, the preliminary estimated acquisition consideration is as follows (numbers in thousands, with the exception of per share figures):

	Acquisition Price
Capstone common shares outstanding		4,276,726
% Shares to be converted to stock		80	%
Shares to be converted into stock (including fractional shares)		3,421,380
Conversion Ratio		0.85
Pro forma shares of SmartFinancial stock		2,908,094
Multiplied by SmartFinancial common stock market price on March 31, 2017	$	23.49
Estimated fair value of SmartFinancial common stock issued		68,311
Preliminary fair value estimate of Capstone stock options		1,585
Estimated cash consideration paid		15,826
Total preliminary estimated acquisition consideration	$	85,722

The total preliminary acquisition consideration has been allocated to Capstone tangible and intangible assets and liabilities as of November 1, 2017, based on their preliminary estimated fair values as follows:

	Allocation of Acquisition Consideration
Total preliminary estimated acquisition consideration				$	85,722
Fair value of assets assumed
Cash and cash equivalents	$	6,278
Investment securities available for sale		52,631
Restricted investments		1,050
Loans		411,779
Bank premises and equipment		8,813
Bank owned life insurance		10,012
Other real estate owned		410
Deferred tax asset		5,273
Other assets		867
Core deposits intangibles		5,530
Total fair value of assets acquired		502,643
Fair value of liabilities assumed
Deposits		(439,030	)
FHLB advances and other borrowings		(9,026	)
Payables and other liabilities		(6,912	)
Total fair value of liabilities assumed	$	(454,968	)
Net assets acquired		47,675		$	47,675
Excess of cost over fair value of net assets acquired-goodwill				$	38,047