10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number 1-5735

Union Financial Bancshares, Inc.

(Exact name of registrant as specified in its charter)

Delaware	57-1001177
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

203 West Main Street, Union, South Carolina	29379
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (864) 429-1864

Securities registered pursuant to Section 12(b) of the Exchange Act: None

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

Common stock, par value $.01 per share

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨    No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(A) of the Act. Yes ¨    No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x    No ¨

Indicate by check mark if disclosure of delinquent filers to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or other information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. x

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

Large accelerated filer ¨                Accelerated filer ¨                Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨    No x

The aggregate market value of the voting stock held by non-affiliates, computed by reference to the average bid and asked price on February 27, 2006, was approximately $29,265,092 (1,672,291 shares at $17.50 per share). Solely for the purposes of this calculation it is assumed that directors and executive officers are affiliates of the registrant.

As of March 13, 2006, there were 1,895,525 shares of the registrant’s common stock issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

1. Portions of the Annual Report to Shareholders for the Fiscal Year Ended December 31, 2005 (Part II).

2. Portions of the Proxy Statement for the 2006 Annual Meeting of Shareholders (Part III).

INDEX

		Page
	Part I
Item 1.	Business	1
Item 1A.	Risk Factors	23
Item 1B.	Unresolved Staff Comments	27
Item 2.	Properties	27
Item 3.	Legal Proceedings	27
Item 4.	Submission of Matters to a Vote of Security Holders	27
	Part II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	27
Item 6.	Selected Financial Data	28
Item 7.	Management’s Discussion and Analysis	28
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	28
Item 8.	Financial Statements and Supplementary Data	28
Item 9.	Changes In and Disagreements with Accountants on Accounting and Financial Disclosure	28
Item 9A.	Controls and Procedures	28
Item 9B.	Other Information	28
	Part III
Item 10.	Directors and Executive Officers of the Registrant	29
Item 11.	Executive Compensation	30
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	30
Item 13.	Certain Relationships and Related Transactions	31
Item 14.	Principal Accountant Fees and Services	31
	Part IV
Item 15.	Exhibits and Financial Statement Schedules	32

PART I

Item 1. Business

General

Union Financial Bancshares, Inc. (“Union Financial”) is the bank holding company for Provident Community Bank, N.A. (the “Bank”). Union Financial has no material assets or liabilities other than its investment in the Bank. Union Financial’s business activity primarily consists of directing the activities of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank. Union Financial and the Bank are collectively referred to as the “Corporation” herein.

The Bank converted from a federal savings bank to a national bank charter in July 2003. The Bank’s operations are conducted through its main office in Union, South Carolina and six full-service banking centers, all of which are located in the upstate area of South Carolina. The Bank is regulated by the Office of the Comptroller of the Currency (the “OCC”), is a member of the Federal Home Loan Bank of Atlanta (the “FHLB”) and its deposits are insured up to applicable limits by the Federal Deposit Insurance Corporation (the “FDIC”). In addition, Union Financial is a bank holding company, subject to regulation by the Federal Reserve Board (the “FRB”).

On October 21, 2003, the Board of Directors of Union Financial changed the fiscal year end of the Corporation from September 30 to December 31, effective December 31, 2003.

The business of the Bank primarily consists of attracting deposits from the general public and originating loans to consumers and businesses. The Bank also maintains a portfolio of investment securities. The principal sources of funds for the Bank’s lending activities include deposits received from the general public, interest and principal repayments on loans and, to a lesser extent, borrowings from the FHLB and other parties. The Bank’s primary source of income is interest earned on loans and investments. The Bank’s principal expense is interest paid on deposit accounts and borrowings and expenses incurred in operating the Bank.

This annual report contains certain “forward-looking statements” within the meaning of the federal securities laws. These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. These forward-looking statements include, but are not limited to, estimates and expectations of future performance with respect to the financial condition and results of operations of the Corporation and other factors. These forward-looking statements are not guarantees of future performance and are subject to various factors that could cause actual results to differ materially from these forward-looking statements. These factors include, but are not limited to: changes in general economic and market conditions and the legal and regulatory environment in which the Corporation operates; the development of an interest rate environment that adversely affects the Corporation’s interest rate spread or other income anticipated from the Corporation’s operations; changes in consumer spending, borrowing and savings habits; adverse changes in the securities markets; changes in accounting policies and practices; and increased competitive pressures among financial services companies. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. The Corporation does not undertake—and specifically disclaims any obligation—to publicly release the results of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

Competition

The Bank faces competition in both the attraction of deposit accounts and in the origination of mortgage, commercial and consumer loans. Its most direct competition for savings deposits historically has been derived from other commercial banks and thrift institutions located in and around Union, Laurens, Fairfield and York Counties, South Carolina. As of June 30, 2005, according to information presented on the Federal Deposit Insurance Corporation’s website, the Corporation held 42.3% of the deposits in Union County, which was the largest share of deposits out of four financial institutions in the county. Additionally, the Corporation held 22.9% of the deposits in Fairfield

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County, which was the third largest out of four financial institutions in the county, 7.4% of the deposits in Laurens County, which was the sixth largest share of deposits out of eight financial institutions in the county and 1.4% of the deposits in York County, which was the ninth largest out of 12 financial institutions in that county. However, the Corporation competes with super-regional banks, such as Wachovia Bank and SunTrust, and large regional banks, such as First-Citizens Bank and Trust Company of South Carolina and Carolina First Bank. These competitors have substantially greater resources and lending limits than does the Corporation and offer services that the Corporation does not provide. The Bank faces additional significant competition for investor funds from money market instruments and mutual funds. It competes for savings by offering depositors a variety of savings accounts, convenient office locations and other services.

The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of the services it provides borrowers, real estate brokers and home builders. The Bank’s competition for real estate loans comes principally from other commercial banks, thrift institutions, and mortgage banking companies.

Competition has increased and is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. The Gramm-Leach-Bliley Act, which permits affiliation among banks, securities firms and insurance companies, also has changed and may continue to change the competitive environment in which the Bank conducts business.

Average Balances, Interest and Average Yields/Cost

The following table sets forth certain information for the periods indicated regarding: (1) average balances of assets and liabilities; (2) the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities; and (3) average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average monthly balance of assets or liabilities, respectively, for the periods presented.

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	Years Ended December 31,														Year Ended September 30, 2003
	2005							2004
	Average Balance		Interest			Average Yield/Cost		Average Balance		Interest			Average Yield/Cost		Average Balance		Interest			Average Yield/Cost
	(Dollars in thousands)
Interest-earning assets:
Loans receivable, net (1)	$	179,844	$	12,666		7.04	%	$	160,131	$	10,399		6.49	%	$	157,265	$	10,914		6.94	%
Mortgage-backed securities		32,860		1,338		4.07			48,216		1,868		3.87			79,104		2,991		3.78
Investment securities:
Taxable		99,404		4,214		4.24			91,630		3,715		4.05			52,459		2,115		4.03
Nontaxable		20,583		869		4.22			21,063		930		4.42			18,490		881		4.77
Total investment securities		119,987		5,083		4.24			112,693		4,645		4.12			70,949		2,996		4.22
Deposits and federal funds sold		6,849		126		1.83			6,434		40		0.62			5,396		23		0.42
Total interest-earning assets		339,540		19,213		5.66			327,474		16,952		5.18			312,714		16,924		5.41
Non-interest-earning assets		23,761							24,803							22,630
Total assets	$	363,301						$	352,277						$	335,344
Interest-bearing liabilities:
Savings accounts		17,678		77		0.43			17,966		72		0.40			15,639		116		0.74
Negotiable order of withdrawal accounts (2)		63,561		1,352		1.75			45,914		436		0.75			33,581		277		0.65
Certificate accounts		138,564		3,819		2.76			144,930		3,395		2.34			149,355		4,267		2.86
FHLB advances and other borrowings		102,099		3,722		3.65			103,639		3,343		3.23			97,900		4,042		4.13
Total interest-bearing liabilities		321,902		8,970		2.67			312,449		7,246		2.23			296,475		8,702		2.85
Non-interest-bearing deposits		13,578							12,146							8,767
Non-interest-bearing liabilities		2,078							2,077							5,400
Total liabilities		337,558							326,672							310,642
Shareholders’ equity		25,743							25,605							24,702
Total liabilities and shareholders’ Equity	$	363,301						$	352,277						$	335,344
Net interest income			$	10,243						$	9,706						$	8,222
Interest rate spread (3)						2.99	%						2.95	%						2.56	%
Net interest margin (4)				3.02	%						2.96	%						2.63	%
Ratio of average interest-earning assets to average interest-bearing liabilities		1.01x							1.01x							1.02x

(1) Average loans receivable includes non-accruing loans. Interest income does not include interest on loans 90 days or more past due.

(2) Average costs include the affects of non-interest bearing deposits.

(3) Represents difference between weighted average yield on all interest-earning assets and weighted average rate on all interest-bearing liabilities.

(4) Represents net interest income before provision for loan losses as a percentage of average interest-earning assets.

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Lending Activities

General. Set forth below is selected data relating to the composition of the Bank’s loan portfolio on the dates indicated (dollars in thousands).

	At December 31,										At September 30,
	2005					2004					2003					2002					2001
	Amount			Percent		Amount			Percent		Amount			Percent		Amount			Percent		Amount			Percent
Real estate loans:
Residential	$	36,560		18.99	%	$	43,556		25.46	%	$	55,647		36.39	%	$	88,746		54.92	%	$	110,109		69.66	%
Commercial		45,665		23.71			43,351		25.34			40,372		26.40			31,465		19.48			16,299		10.31
Multi-family and construction
Loans		4,842		2.51			3,823		2.23			2,170		1.42			5,514		3.41			12,259		7.76
Total real estate loans		87,067		45.21			90,730		53.03			98,189		64.21			125,725		77.81			138,667		87.73
Consumer and installment Loans		39,876		20.71			30,826		18.02			25,445		16.64			25,884		16.02			22,662		14.33
Commercial loans		70,668		36.70			54,796		32.02			33,859		22.14			16,100		9.96			5,593		3.54
Total loans		197,611		102.62			176,352		103.07			157,493		102.99			167,709		103.79			166,922		105.60
Less:
Undisbursed loans in process		(1,980	)	(1.03	)		(2,363	)	(1.38	)		(1,392	)	(0.91	)		(3,204	)	(1.97	)		(6,108	)	(3.86	)
Loan discount Unamortized		(764	)	(0.40	)		(993	)	(0.58	)		(1,448	)	(0.95	)		(1,685	)	(1.04	)		(1,922	)	(1.22	)
Allowance for loan Losses		(2,394	)	(1.24	)		(2,026	)	(1.18	)		(1,842	)	(1.20	)		(1,371	)	(0.85	)		(1,080	)	(0.68	)
Deferred loan fees		104		0.05			124		0.07			110		0.07			127		0.07			251		0.16
Net loans receivable	$	192,577		100.00	%	$	171,094		100.00	%	$	152,921		100.00	%	$	161,576		100.00	%	$	158,063		100.00	%

The following table sets forth, at December 31, 2005, certain information regarding the dollar amount of principal repayments for loans becoming due during the periods indicated (in thousands). Demand loans (loans having no stated schedule of repayments and no stated maturity) and overdrafts are reported as due in one year or less.

	Due Within One Year		Due After 1 Year Through 5 Years		Due After 5 Years		Total
Real estate loans:
Residential loans		60		1,685		34,815	$	36,560
Commercial loans		9,952		29,193		6,520		45,665
Multi-family and construction loans (1)		4,842		—		—		4,842
Consumer and installment loans		3,557		14,368		21,951		39,876
Commercial loans		32,663		33,012		4,993		70,668
Total	$	51,074	$	78,258	$	68,279	$	197,611

(1) Includes construction/permanent loans.

The actual average life of mortgage loans is substantially less than their contractual term because of loan repayments and because of enforcement of due-on-sale clauses that give the Bank the right to declare a loan immediately due and payable if, among other things, the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase, however, when current mortgage loan rates substantially exceed rates on existing mortgage loans.

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The following table sets forth, at December 31, 2005, the dollar amount of loans due after December 31, 2006 which have fixed rates of interest and which have adjustable rates of interest (in thousands).

	Fixed		Adjustable		Total
Real estate loans:
Residential loans	$	23,799	$	12,701	$	36,500
Commercial loans		15,004		20,709		35,713
Consumer and installment loans		14,864		21,455		36,319
Commercial loans		9,808		28,197		38,005
Total	$	63,475	$	83,062	$	146,537

Real Estate Loans. The Bank originates residential mortgage loans to enable borrowers to purchase existing single family homes or to construct new homes. At December 31, 2005, approximately $36.6 million, or 18.9% of the Corporation’s net loan portfolio consisted of loans secured by residential real estate (net of undisbursed principal, excluding construction loans).

Office of the Comptroller of the Currency regulations limit the amount that national banks may lend in relationship to the appraised value of the real estate securing the loan, as determined by an appraisal at the time of loan origination. Federal regulations permit a maximum loan-to-value ratio of 100% for one-to four-family dwellings and 85% for all other real estate loans. The Bank’s lending policies, however, limit the maximum loan-to-value ratio on one-to-four-family real estate mortgage loans to 80% of the lesser of the appraised value or the purchase price. Any single-family loan made in excess of an 80% loan-to-value ratio and any commercial real estate loan in excess of a 75% loan-to-value ratio is required to have private mortgage insurance or additional collateral. In the past, the Bank has originated some commercial real estate loans in excess of a 75% loan-to-value ratio without private mortgage insurance or additional collateral.

The loan-to-value ratio, maturity and other provisions of the loans made by the Bank generally have reflected a policy of making less than the maximum loan permissible under applicable regulations, market conditions, and underwriting standards established by the Bank. Mortgage loans made by the Bank generally are long-term loans (15-30 years), amortized on a monthly basis, with principal and interest due each month. In the Bank’s experience, real estate loans remain outstanding for significantly shorter periods than their contractual terms. Borrowers may refinance or prepay loans, at their option, with no prepayment penalty.

The Bank offers a full complement of mortgage lending products with both fixed and adjustable rates. Due to the nature of the Bank’s marketplace, only a small percentage of residential loans are adjustable-rate mortgage loans (“ARMs”). The Bank offers ARMs tied to U.S. Treasury Bills with a maximum interest rate adjustment of 2% annually and 6% over the life of the loan. At December 31, 2005, the Bank had approximately $12.7 million of ARMs, or 6.6% of the Bank’s total loans receivable. At December 31, 2005, 12.4% of the Bank’s loan portfolio consisted of long-term, fixed-rate residential real estate loans.

Net interest income depends to a large extent on how successful the Bank is in “matching” interest-earning assets and interest-bearing liabilities. The Corporation has taken steps to reduce its exposure to rising interest rates. For a discussion of these steps, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Annual Report to Shareholders (“Annual Report”).

Commercial real estate loans constituted approximately $45.7 million, or 23.7%, of the Bank’s net loan portfolio at December 31, 2005. Commercial real estate loans consist of permanent loans secured by multi-family loans, generally apartment houses, as well as commercial and industrial properties, including office buildings, warehouses, shopping centers, hotels, motels and other special purpose properties. Commercial real estate loans are originated and purchased for inclusion in the Bank’s portfolio. These loans generally have 20 to 30-year amortization schedules and are callable or have balloon payments after five years. Typically, the loan documents provide for adjustment of the interest rate every one to three years. Fixed-rate loans secured by multi-family residential and commercial properties have terms ranging from 20 to 25 years.

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Loans secured by multi-family and commercial real estate properties may involve greater risk than single-family residential loans. Such loans generally are substantially larger than single-family residential loans. Further, the payment experience on loans secured by commercial properties typically depends on the successful operation of the properties, and thus may be subject to a greater extent to adverse conditions in the real estate market or in the economy generally. Our largest commercial loan relationship was a $3.3 million loan secured by real estate located in Rock Hill, South Carolina. This loan was performing according to its original terms at December 31, 2005.

Construction Loans. The Bank engages in construction lending that primarily is secured by single family residential real estate and, to a much lesser extent, commercial real estate. The Bank grants construction loans to individuals with a takeout for permanent financing from one of our correspondent mortgage lenders or another financial institution, and to approved builders on both presold and unsold properties.

Construction loans to individuals are originated for a term of one year or less or are originated to convert to permanent loans at the end of the construction period. Construction loans are originated to builders for a term not to exceed 12 months. Generally, draw inspections are handled by the appraiser who initially appraised the property; however, in some instances the draw inspections are performed by a new appraisal firm.

Construction financing affords the Bank the opportunity to achieve higher interest rates and fees with shorter terms to maturity than do single-family permanent mortgage loans. However, construction loans generally are considered to involve a higher degree of risk than single-family permanent mortgage lending due to: (1) the concentration of principal among relatively few borrowers and development projects; (2) the increased difficulty at the time the loan is made of estimating the building costs and the selling price of the property to be built; (3) the increased difficulty and costs of monitoring the loan; (4) the higher degree of sensitivity to increases in market rates of interest; and (5) the increased difficulty of working out loan problems.

At December 31, 2005, the Bank had approximately $4.8 million outstanding in construction loans, including approximately $2.0 million in undisbursed proceeds. Substantially all of these loans were secured by one- to four-family residences.

Consumer Loans. The Bank’s consumer loan portfolio primarily consists of automobile loans on new and used vehicles, mobile home loans, boat loans, second mortgage loans, loans secured by savings accounts and unsecured loans. The Bank makes consumer loans to serve the needs of its customers and as a way to improve the interest-rate sensitivity of the Bank’s loan portfolio.

Consumer loans tend to bear higher rates of interest and have shorter terms to maturity than residential mortgage loans. However, nationally, consumer loans historically have tended to have a higher rate of default than residential mortgage loans. Additionally, consumer loans entail greater risk than do residential mortgage loans, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected adversely by job loss, divorce, illness or personal bankruptcy.

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Commercial Loans. Commercial business loans are made primarily in our market area to small businesses through its branch network. Each county location of the branch network has an experienced commercial lender that is responsible for the generation of this product. In selective cases, we will enter into a loan participation within our market area to purchase a portion of a commercial loans that meets the Bank’s underwriting criteria. We offer secured commercial loans with maturities of up to 20 years. The term for repayment will normally be limited to the lesser of the expected useful life of the asset being financed or a fixed amount of time, generally less than seven years. These loans have adjustable rates of interest indexed to the prime rate as reported in The Wall Street Journal and are payable on loans not in default, subject to annual review and renewal. When making commercial loans, we consider the financial statements of the borrower, the borrower’s payment history of both corporate and personal debt, the debt service capabilities of the borrower, the projected cash flows of the business, the viability of the industry in which the customer operates and the value of the collateral. Commercial loans generally are secured by a variety of collateral, primarily accounts receivable, inventory and equipment, and generally are supported by personal guarantees. Depending on the collateral used to secure the loans, commercial loans are made in amounts of up to 80% of the value of the collateral securing the loan.

Unlike residential mortgage loans, which are generally made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.

Loan Solicitation and Processing. Loan originations come from walk-in customers, sales and solicitations from loan officers and loan participations. The loan origination process for walk-in customers includes an initial interview with an officer of the Bank for the purpose of obtaining a formal application. Upon receipt of a loan application from a prospective borrower, a credit report is ordered to verify specific information relating to the loan applicant’s employment, income and credit standing. This information may be further verified by personal contacts with other reference sources. An appraisal of the real estate intended to secure the proposed loan is undertaken by pre-approved, independent fee appraisers. As soon as the required information has been obtained and the appraisal completed, the loan is submitted to the authorized officer, loan committees or full Board of Directors for review. The Bank utilizes various officers and loan committees for the approval of real estate loans. The Board of Directors has appointed a Board Loan Committee comprised of two members elected annually from the Board of Directors and four senior executive officers of the Bank. A quorum of three members, including at least one Board member, is required for any action. This Committee has the authority to approve all secured and unsecured loan requests with the exception of a single loan request exceeding $2,000,000 in secured credit and exceeding $1,000,000 in unsecured credit, which require approval of the entire Board of Directors.

Loan applicants are promptly notified of the decision of the Bank by telephone, setting forth the terms and conditions of the decision. If approved, these terms and conditions include the amount of the loan, interest rate, amortization term, and a brief description of the real estate to be mortgaged to the Bank. The Bank also issues a commitment letter to the potential borrower which typically remains in effect for 60 days. The Bank’s experience is that very few commitments go unfunded. See “Loan Commitments.” The borrower is required to pay all origination costs incurred in connection with the particular loan closing.

Loan Originations, Purchases and Sales. During fiscal 2001, we phased out broker loan purchases and originations and reduced our mortgage lending operations to provide an increased capital allocation for consumer and commercial lending. Consequently, the Bank did not securitize any loans in either the 2005, 2004 or 2003 fiscal years. The Bank does not have any current plans to sell a large volume of loans, other than fixed-rate mortgage loans it originates through its retail branch network. The Bank purchases participation interests in loans originated by other institutions. The Bank had total purchases of participation interests of $8 million in fiscal 2005. These participation interests are on both residential and commercial properties and carry either a fixed or adjustable interest rate. The Bank performs its own underwriting analysis on each of its participation interests before purchasing such loans and therefore believes there is no greater risk of default on these obligations. However, in a purchased participation loan, the Bank does not service the loan and thus is subject to the policies and practices of the lead lender with regard to monitoring

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delinquencies, pursuing collections and instituting foreclosure proceedings. The Bank is permitted to review all of the documentation relating to any loan in which the Bank participates, including any annual financial statements provided by a borrower. Additionally, the Bank receives periodic updates on the loan from the lead lender.

The following table sets forth the Bank’s loan origination activity for the periods indicated (in thousands):

	Year Ended December 31,				Year Ended September 30, 2003
	2005		2004
Loans originated:
Real estate loans:
Residential loans	$	5,415	$	6,025	$	7,590
Multi-family and construction loans		1,401		1,411		2,550
Total mortgage loans originated		6,816		7,436		10,140
Consumer and installment loans		17,039		15,166		11,172
Commercial loans		56,469		43,121		41,229
Total loans originated	$	80,324	$	65,723	$	62,541
Loan participations purchased	$	7,987	$	7,798	$	7,085

Loan Commitments. The Bank’s commitments to make conventional mortgage and commercial loans are normally made for periods of up to 60 days from the date of loan approval. See “Financial Condition, Liquidity and Capital Resources” in the Annual Report.

Loan Origination and Other Fees. In addition to interest earned on loans and fees for making loan commitments, the Bank charges origination fees or “points” for originating loans. Loan origination fees usually are a percentage of the principal amount of the loan, typically between 0.5% and 2%, depending on the terms and conditions. Other fees collected include late charges applied to delinquent payments and fees collected in connection with loan modifications. The Bank charges a 5% late charge fee on payments delinquent 15 days or more on new loan originations, loan modifications, loan assumptions and loans currently in the Bank’s portfolio where applicable. Late charges and modification fees do not constitute a material source of income. Accounting standards require fees received (net of certain loan origination costs) for originating loans to be deferred and amortized into interest income over the contractual life of the loan. As of December 31, 2005, the Corporation had net deferred loan costs of approximately $104,000.

Problem Assets. When a borrower fails to make a required payment on a loan, the Bank attempts to cure the default by contacting the borrower. In general, borrowers are contacted after a payment is more than 30 days past due. In most cases, defaults are cured promptly. If the delinquency on a mortgage loan is not cured through the Bank’s normal collection procedures, or an acceptable arrangement is not worked out with the borrower, the Bank will institute measures to remedy the default, including commencing a foreclosure action.

The Bank determines a loan to be delinquent when payments have not been made according to contractual terms, typically evidenced by nonpayment of a monthly installment by the due date. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent. Subsequent payments are either applied to the outstanding principal balance or recorded as interest income, depending on the assessment of the ultimate collectibility of the loan. See Notes 1 and 3 of Notes to Consolidated Financial Statements.

A loan is impaired when it is probable, based on current information, the Corporation will be unable to collect all contractual principal and interest payments due in accordance with the terms of the loan agreement. Management has determined that, generally, a failure to make a payment within a 90-day period constitutes a minimum delay or shortfall and generally does not constitute an impaired loan. However, management reviews each past due loan on a loan-by-loan basis and may determine a loan to be impaired prior to the loan becoming over 90 days past due, depending upon the

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circumstances of that particular loan. A loan is classified as non-accrual at the time management believes that the collection of interest is improbable, generally when a loan becomes 90 days past due. The Bank’s policy for charge-off of impaired loans is on a loan-by-loan basis. At the time management believes the collection of interest and principal is remote, the loan is charged off. It is our policy is to evaluate impaired loans based on the fair value of the collateral. Interest income from impaired loans is recorded using the cash method.

Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned. When such property is acquired it is recorded at the lower of the unpaid principal balance of the related loan or its fair market value less selling costs. Any subsequent write-down of the property is charged to income.

It is the policy of the Bank to cease accruing interest on loans 90 days or more past due. As of and for the years ended December 31, 2005 and December 31, 2004, $127,000 and $197,000, respectively, were classified within the meaning of Statement of Financial Accounting Standards (“SFAS”) No. 15. The increase in non-performing assets from $1.1 million at December 31, 2004 to $1.5 million at December 31, 2005 was due to higher loan delinquencies as a result of higher than state average unemployment from plant layoffs and closings in the surrounding communities.

The following table sets forth information with respect to the Bank’s non-performing assets for the periods indicated (dollars in thousands).

	At December 31,						At September 30,
	2005			2004			2003			2002			2001
Loans accounted for on a non-accrual basis:
Real estate	$	461		$	217		$	408		$	916		$	626
Commercial		436			142			2,437			524			160
Consumer		349			391			209			426			9
Total		1,246			750			3,054			1,866			795
Accruing loans which are contractually past due 90 days or more		—			—			—			—			—
Real estate owned, net		224			364			652			356			77
Total non-performing assets	$	1,470		$	1,114		$	3,706		$	2,222		$	872
Percentage of non-performing assets to loans receivable net		0.76	%		0.65	%		2.42	%		1.37	%		0.56	%

Interest income that would have been recorded for the year ended December 31, 2005 had non-accruing loans been current in accordance with their original terms amounted to approximately $92,000. There was no interest included in interest income on such loans for the year ended December 31, 2005.

Allowance for Loan Losses. In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. To cover losses inherent in the portfolio of performing loans, the Bank maintains an allowance for loan losses. Management’s periodic evaluation of the adequacy of the allowance is based on a number of factors, including management’s evaluation of the collectibility of the loan portfolio, the nature and size of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans and economic conditions. The amount of the allowance is based on the estimated value of the collateral securing the loan and other analysis pertinent to each situation.

The Bank increases its allowance for loan losses by charging provisions for loan losses against income. The allowance for loan losses is maintained at an amount management considers adequate to absorb losses inherent in the portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected significantly and adversely if circumstances substantially differ from the assumptions used in making the determinations.

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The provision for loan loss calculation includes a segmentation of loan categories subdivided by residential mortgage, commercial and consumer loans. Each category is rated for all loans including performing groups. The weights assigned to each performing group is developed from previous loan loss experience and as the loss experience changes, the category weight is adjusted accordingly. In addition, as the amount of loans in each category increases and decreases, the provision for loan loss calculation adjusts accordingly.

While we believe that we have established the existing allowance for loan losses in accordance with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the our loan portfolio, will not request the Bank to increase significantly the allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may affect adversely the Corporation’s financial condition and results of operations. See Notes 1 and 3 of Notes to Consolidated Financial Statements for information concerning the Bank’s provision and allowance for possible loan losses.

The following table sets forth an analysis of the Bank’s allowance for loan losses for the periods indicated (dollars in thousands):

	At December 31,						Three Months Ended December 31,			At September 30,
	2005			2004			2003			2003			2002			2001
Balance at beginning of year	$	2,026		$	2,383		$	1,842		$	1,371		$	1,080		$	1,360
Loans charged off:
Real estate		(75	)		(62	)		(47	)		(255	)		(127	)		(180	)
Commercial		(302	)		(1,740	)		(154	)		(11	)		(542	)		(211	)
Consumer		(195	)		(40	)		(39	)		(65	)		(82	)		(176	)
Total charge-offs		(572	)		(1,842	)		(240	)		(331	)		(751	)		(567	)
Recoveries:
Real estate		35			22			1			31			36			4
Commercial		26			192			51			6			—			8
Consumer		10			21			4			40			16			35
Total recoveries		71			235			56			77			52			47
Net charge-offs		(501	)		(1,607	)		(184	)		(254	)		(699	)		(520	)
Provision for loan losses (1)		869			1,250			725			725			990			240
Balance at end of year	$	2,394		$	2,026		$	2,383		$	1,842		$	1,371		$	1,080
Ratio of net charge-offs to average gross loans outstanding during the period		0.27	%		0.91	%		0.12	%		0.16	%		0.42	%		0.32	%

(1) See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Annual Report for a discussion of the factors responsible for changes in the provision for loan losses between the periods.

The Bank experienced bad debt charge-offs, net of recoveries, of approximately $501,000 in fiscal 2005 compared to $1.6 million for fiscal 2004. The loan charge-offs for the previous year included approximately $1.3 million from three commercial loans that were charged-off after the loans were determined to be uncollectable. The allowance for loan losses to total loans ratio at the end of fiscal 2005 was 1.23% compared to 1.17% at the end of fiscal 2004.

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The following table sets forth the breakdown of the allowance for loan losses by loan category and the percentage of loans in each category to total loans for the periods indicated. Management believes that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not necessarily indicative of further losses and does not restrict the use of the allowance to absorb losses in any category (dollars in thousands):

	At December 31,								At September 30,
	2005				2004				2003				2002				2001
	Amount		% of Loans in Each Category to Total Loans		Amount		% of Loans in Each Category to Total Loans		Amount		% of Loans in Each Category to Total Loans		Amount		% of Loans in Each Category to Total Loans		Amount		% of Loans in Each Category to Total Loans
Real estate	$	975	44.06	%	$	984	51.45	%	$	1,078	62.34	%	$	9577	74.97	%	$	831	83.07	%
Commercial		447	20.18			335	17.48			280	16.16			1978	15.43			136	13.58
Consumer		792	35.76			594	31.07			372	21.50			1221	9.60			33	3.35
Unallocated		180	N/A			113	N/A			112	N/A			955	N/A			80	N/A
Total allowance for loan losses	$	2,394	100.00	%	$	2,026	100.00	%	$	1,842	100.00	%	$	1,3711	100.00	%	$	1,080	100.00	%

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The Bank adjusts balances on real estate acquired in settlement of loans to the lower of cost or market based on appraised value when the property is received in settlement. These values reflect current market conditions and sales experience. See Notes 1 and 3 of Notes to Consolidated Financial Statements.

Asset Classification. The Office of the Comptroller of the Currency requires national banks to classify problem assets. Problem assets are classified as “substandard,” “doubtful” or “loss,” depending on the presence of certain characteristics. An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinct possibility” that the institution will sustain some loss if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified as “substandard” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified as “loss” are those considered “uncollectible” and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets that currently do not expose the insured institution to sufficient risk to warrant classification in the above-mentioned categories but possess weaknesses are designated “special mention.”

When an institution classifies problem assets as either substandard or doubtful, it is required to establish general allowances for loan losses in an amount deemed prudent by management. General allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an institution classifies problem assets or a portion of assets as loss, it is required either to establish a specific allowance for losses equal to 100% of the amount of the asset or a portion thereof so classified or to charge-off such amount. An institution’s determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Comptroller of the Currency who can order the establishment of additional general or specific loss allowances.

The following tables set forth the number and amount of classified loans at December 31, 2005 (dollars in thousands):

	Loss			Doubtful			Substandard			Special Mention
	Number	Amount		Number	Amount		Number	Amount		Number	Amount
Real estate	—		—	—		—	15		797	2		133
Commercial	—		—	2		306	6		1,499	9		2,811
Consumer	—		—	—		—	13		562	—		—
Total	—	$	—	2	$	306	34	$	2,858	11	$	2,944

Investment Activities

SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” requires that investments be categorized as “held to maturity,” “trading securities” or “available for sale,” based on management’s intent as to the ultimate disposition of each security. SFAS No. 115 allows debt securities to be classified as “held to maturity” and reported in financial statements at amortized cost only if the reporting entity has the positive intent and ability to hold those securities to maturity. Securities that might be sold in response to changes in market interest rates, changes in the security’s prepayment risk, increases in loan demand, or other similar factors cannot be classified as “held to maturity.” Debt and equity securities held for current resale are classified as “trading securities.” Such securities are reported at fair value, and unrealized gains and losses on such securities would be included in earnings. The Corporation currently does not use or maintain a trading account. Debt and equity securities not classified as either “held to maturity” or “trading securities” are classified as “available for sale.” Such securities are reported at fair value, and unrealized gains and losses on such securities are excluded from earnings and reported net of income taxes in a separate component of shareholders’ equity.

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The following table sets forth the Corporation’s investment and mortgage-backed securities portfolio at the dates indicated (dollars in thousands):

	At December 31,								At September 30,
	2005				2004				2003
	Carrying Value		Percent of Portfolio		Carrying Value		Percent of Portfolio		Carrying Value		Percent of Portfolio
Available for sale:
Investment securities:
U.S. Agency obligations	$	83,443	58.32	%	$	71,548	50.43	%	$	48,596	30.87	%
Municipal securities		18,180	12.71			20,544	14.48			22,334	14.18
Other		14,621	10.22			10,876	7.67			7,860	5.00
Total investment securities		116,244	81.25			102,968	72.58			78,790	50.05
Mortgage-backed and related securities		26,835	18.75			38,896	27.42			78,648	49.95
Total	$	143,079	100.00	%	$	141,864	100.00	%	$	157,438	100.00	%
	At December 31,								At September 30,
	2005				2004				2003
	Carrying Value		Percent of Portfolio		Carrying Value		Percent of Portfolio		Carrying Value		Percent of Portfolio
Held to maturity:
Municipal securities	$	3,204	100.00	%	$	1,630	100.00	%		—	—

The Corporation purchases mortgage-backed securities, both fixed-rate and adjustable-rate, from Freddie Mac, Fannie Mae and Ginnie Mae with maturities from five to 30 years. The Corporation increased its level of agency securities over the previous year to balance the portfolio mix and stabilize interest rate flows as a result of the high loan prepayment speeds experienced with mortgage-backed securities.

The Corporation also purchases mortgage derivative securities in the form of collateralized mortgage obligations (“CMOs”) issued by U.S. government agencies or corporations. While these securities possess minimal credit risk due to the Federal guarantee of collection on the underlying mortgages, they possess liquidity and interest rate risk. The amortized cost and fair value of the CMOs at December 31, 2005 was approximately $5.4 million. See Note 2 of Notes to Consolidated Financial Statements for more information regarding investment and mortgage-backed securities.

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The following table sets forth at amortized cost (held to maturity) and market value (available for sale) the maturities and weighted average yields* of the Corporation’s investment and mortgage-backed securities portfolio at December 31, 2005 (dollars in thousands):

	Amount Due or Repricing within:
	One Year or Less				Over One to Five Years				Over Five to Ten Years				Over Ten Years				Total
	Carrying Value		Weighted Average Yield		Carrying Value		Weighted Average Yield		Carrying Value		Weighted Average Yield		Carrying Value		Weighted Average Yield		Carrying Value		Weighted Average Yield
Available for Sale:
Investment securities:
U.S. Agency obligations	$	31,928	4.16	%	$	36,037	4.08	%	$	15,478	5.08	%	$	—	—	%	$	83,443	4.29	%
Municipal securities		—	—			260	5.00			596	4.40			17,324	4.57			18,180	4.57
Equity securities		—	—			—	—			—	—			1,190	5.81			1,190	5.81
Corporate securities		6,975	6.25			4,452	4.63			—	—			2,004	7.00			13,431	5.82
Total investment securities		38,903	4.53			40,749	4.15			16,074	5.05			20,518	4.88			116,244	4.53
Mortgage-backed and related securities		762	5.68			10,135	4.10			1,970	5.58			13,968	4.22			26,835	4.32
Total available for sale		39,665	4.56			50,884	4.13			18,044	5.11			34,486	4.61			143,079	4.49
Held to Maturity:
Municipal securities	$	—	—	%	$	—	—	%	$	—	—	%	$	3,204	4.12	%	$	3,204	4.12	%

* The weighted average yield is based upon the cost value and the total income received of the instrument.

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At December 31, 2005, approximately $10.8 million of mortgage-backed securities were adjustable-rate securities.

Deposits and Borrowings

General deposits are the major source of our funds for lending and other investment purposes. In addition to deposits, we derive funds from principal repayments and interest payments on loans and investment and mortgage-backed securities. Principal repayments and interest payments are a relatively stable source of funds, although principal prepayments tend to slow when interest rates increase. Deposit inflows and outflows may be influenced significantly by general market interest rates and money market conditions. During fiscal year 2005, the Bank experienced a net increase in deposits of approximately $12.0 million due to various deposit promotion programs with continued emphasis on increasing core deposits. The Bank borrowed funds to support the remaining growth experienced in fiscal 2005.

Deposits. Local deposits are, and traditionally have been, the primary source of the Bank’s funds for use in lending and for other general business purposes. We offer a number of deposit accounts including NOW accounts, money market savings accounts, passbook and statement savings accounts, individual retirement accounts and certificate of deposit accounts. Deposit accounts vary as to terms regarding withdrawal provisions, deposit provisions and interest rates.

We adjust the interest rates offered on our deposit accounts as necessary so as to remain competitive with other financial institutions in Union, Laurens, York and Fairfield Counties.

The following table sets forth the time deposits of the Bank classified by rates as of the dates indicated (in thousands):

	At December 31,				At September 30,
	2005		2004		2003
Up to 2.0%	$	24,568	$	58,034	$	73,282
2.01% to 4.0%		86,570		68,942		57,186
4.01% to 6.0%		26,582		16,089		21,951
6.01% to 8.0%		23		495		823
Total savings certificates	$	137,743	$	143,560	$	153,242

The following table sets forth the maturities of time deposits at December 31, 2005 (in thousands):

	Amount
Within three months	$	28,050
After three months but within six months		29,065
After six months but within one year		46,819
After one year but within three years		32,246
After three years but within five years		1,449
After five years but within ten years		114
Total	$	137,743

Certificates of deposit with maturities of less than one year increased to $103.9 million at December 31, 2005 from $92.3 million at December 31, 2004. Historically, we have been able to retain a significant amount of its deposits as they mature. In addition, we believe that we can adjust the offering rates of savings certificates to retain deposits in changing interest rate environments.

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The following table indicates the amount of the Bank’s jumbo certificates of deposit by time remaining until maturity as of December 31, 2005 (in thousands). Jumbo certificates of deposit are certificates in amounts of $100,000 or more.

Maturity Period	Amount
Three months or less	$	10,518
Over three through six months		10,900
Over six months through twelve months		17,558
Over twelve months		12,682
Total jumbo certificates	$	51,658

See Note 6 of Notes to Consolidated Financial Statements for additional information about deposit accounts.

Borrowings. The Corporation utilizes advances from the FHLB agreements and other borrowings (treasury, tax and loan deposits, security repurchase agreements and trust preferred capital obligations) to supplement its supply of lendable funds for granting loans, making investments and meeting deposit withdrawal requirements. See “Regulation and Supervision — Federal Home Loan Bank System.”

The following tables set forth certain information regarding borrowings by the Bank at the dates and for the periods indicated (dollars in thousands):

	At December 31,						At September 30,
	2005			2004			2003
Balance outstanding at end of period:
FHLB advances	$	75,715		$	63,500		$	74,000
Other borrowings		28,247			32,247			19,247
Weighted average rate paid on:
FHLB advances		3.98	%		3.42	%		3.36	%
Other borrowings		3.91	%		3.09	%		4.33	%
	At December 31,						At September 30,
	2005			2004			2003
Maximum amount of borrowings outstanding at any month end:
FHLB advances	$	75,715		$	76,500		$	79,000
Other borrowings		32,247			37,247			25,247
Approximate average borrowings outstanding :
FHLB advances		77,854			76,997			73,747
Other borrowings		31,036			29,580			24,902
Approximate weighted average rate paid on:
FHLB advances		3.13	%		2.89	%		3.94	%
Other borrowings		2.29	%		2.82	%		4.38	%

At December 31, 2005, the Corporation had unused short-term lines of credit to purchase federal funds from unrelated banks totaling $14.2 million. These lines of credit are available on a one-to-ten day basis for general purposes of the Corporation. All of the lenders have reserved the right to withdraw these lines at their option. At December 31, 2005, the Bank had unused lines of credit for longer term advances totaling $15.0 million.

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Subsidiary Activities

Under OCC regulations, the Bank generally may invest in operating subsidiaries, which may engage in activities permissible for the Bank itself. The Bank currently holds Provident Financial Services, Inc. as a non-active subsidiary.

Union Financial maintains one other subsidiary other than the Bank. In November 2001, Union Financial Statutory Trust I was established as a statutory trust under Connecticut law for the purpose of issuing trust preferred securities. Union Financial Statutory Trust I issued trust preferred securities on December 18, 2001.

Employees

The Corporation has 68 full-time employees and 10 part-time employees. None of the employees are represented by a collective bargaining unit. We believe that relations with our employees are excellent.

REGULATION AND SUPERVISION

General

Union Financial, which is a bank holding company, is required to file certain reports with the Federal Reserve Board and otherwise comply with the Bank Holding Company Act of 1956, as amended (“BHCA”) and the rules and regulations promulgated thereunder.

The Bank, as a national bank, is subject to extensive regulation, examination and supervision by the Office of the Comptroller of the Currency, as its primary regulator, and the Federal Deposit Insurance Corporation, as the deposit insurer. The Bank’s deposit accounts are insured up to applicable limits by the Savings Association Insurance Fund managed by the FDIC. The Bank must file reports with the OCC and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other institutions. The OCC and/or the FDIC conduct periodic examinations to test the Bank’s safety and soundness and compliance with various regulatory requirements. Many aspects of the Bank’s operations are regulated by federal law including allowable activities, reserves against deposits, branching, mergers and investments. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulatory requirements and policies, whether by the OCC, the FDIC, or Congress, could have a material adverse impact on Union Financial or the Bank and their operations.

Certain regulatory requirements applicable to the Bank and Union Financial are referred to below or elsewhere herein. This description of statutory provisions and regulations applicable to national banks and their holding companies does not purport to be a complete description of such statutes and regulations and their effects on the Bank and Union Financial and is qualified in its entirely by reference to the actual statutes and regulations involved.

Holding Company Regulation

Federal Regulation. As a bank holding company, Union Financial is subject to examination, regulation and periodic reporting under the BHCA, as administered by the FRB. Union Financial is required to obtain the prior approval of the FRB to acquire all, or substantially all, of the assets of any bank or bank holding company or merge with another bank holding company. Prior FRB approval is also required for Union Financial to acquire direct or indirect ownership or control of any voting securities of any bank or bank holding company if, after giving effect to such acquisition, Union Financial would, directly or indirectly, own or control more than 5% of any class of voting

17

shares of the bank or bank holding company. In evaluating such transactions, the FRB considers such matters as the financial and managerial resources of and future prospects of the companies and banks involved, competitive factors and the convenience and needs of the communities to be served. Bank holding companies have authority under the BHCA to acquire additional banks in any state, subject to certain restrictions such as deposit concentration limits. In addition to the approval of the FRB, before any bank acquisition can be completed, prior approval may also be required from other agencies having supervisory jurisdiction over the banks to be acquired.

A bank holding company generally is prohibited from engaging in, or acquiring direct or indirect control of more than 5% of the voting securities of any company conducting non-banking activities. One of the principal exceptions to this prohibition is for activities found by the FRB to be so closely related to banking or managing or controlling banks to be a proper incident thereto. Some of the principal activities that the FRB has determined by regulation to be closely related to banking are: (1) making or servicing loans; (2) performing certain data processing services; (3) providing discount brokerage services; (4) acting as fiduciary, investment or financial advisor; (5) finance leasing personal or real property; (6) making investments in corporations or projects designed primarily to promote community welfare; and (7) acquiring a savings association, provided that the savings association only engages in activities permitted by bank holding companies.

The Gramm-Leach-Bliley Act of 1999 authorizes a bank holding company that meets specified conditions, including being “well-capitalized” and “well managed,” to opt to become a “financial holding company” and thereby engage in a broader array of financial activities than previously permitted. Such activities may include insurance underwriting and investment banking. The Gramm-Leach-Bliley Act also authorizes banks to engage through “financial subsidiaries” in certain of the activities permitted for financial holding companies. Financial subsidiaries are generally treated as affiliates for purposes of restrictions on a bank’s transactions with affiliates.

The FRB has adopted capital adequacy guidelines for bank holding companies (on a consolidated basis) substantially similar to those of the OCC for the Bank. See “Capital Requirements.” Union Financial’s total and Tier 1 capital exceed these requirements.

Bank holding companies generally are required to give the FRB prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of their consolidated net worth. The FRB may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe and unsound practice, or would violate any law, regulation, FRB order or directive, or any condition imposed by, or written agreement with, the FRB. There is an exception to this approval requirement for well-capitalized bank holding companies that meet certain other conditions.

The FRB has issued a policy statement regarding the payment of dividends by bank holding companies. In general, the FRB’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the Bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition. The FRB’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary. Furthermore, the FRB has authority to prohibit a bank holding company from paying a capital distribution where a subsidiary bank is undercapitalized. These regulatory policies could affect the ability of Union Financial to pay dividends or otherwise engage in capital distributions.

The FRB has general authority to enforce the BHCA as to Union Financial and may require a bank holding company to cease any activity or terminate control of any subsidiary engaged in an activity that the FRB believes constitutes a serious risk to the safety, soundness or stability of its bank subsidiaries.

Union Financial and its subsidiaries will be affected by the monetary and fiscal policies of various agencies of the United States Government, including the Federal Reserve System. In view of changing conditions in the national economy and money markets, it is impossible for the management of Union Financial accurately to predict

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future changes in monetary policy or the effect of such changes on the business or financial condition of Union Financial or the Bank.

State Regulation. Union Financial is also a “bank holding company” within the meaning of the South Carolina bank holding company laws, which assigns the same definition to “bank holding company” as the meaning set forth in section 2(a) of the BHCA. The prior approval of the South Carolina Board of Financial Institutions is required before Union Financial may merge or consolidate with another bank holding company. Such approval is also necessary for Union Financial to assume direct or indirect ownership or control of more than 5% of any class of voting stock of a bank holding company or bank, or control of substantially all of the assets of a bank holding company or bank.

Acquisition of Union Financial

Federal Regulation. Federal law requires that a notice be submitted to the FRB if any person (including a company), or group acting in concert, seeks to acquire 10% or more of Union Financial’s outstanding voting stock, unless the FRB has found that the acquisition will not result in a change in control of Union Financial. The FRB has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition.

Under the BHCA, any company would be required to obtain prior approval from the FRB before it may obtain “control” of Union Financial within the meaning of the BHCA. “Control” generally is defined to mean the ownership or power to vote 25% or more of any class of voting securities of Union Financial or the ability to control in any manner the election of a majority of Union Financial’s directors. An existing bank holding company would be required to obtain the FRB’s prior approval under the BHCA before acquiring more than 5% of Union Financial’s voting stock. See “Holding Company Regulation.” Approval of the South Carolina Board of Financial Institutions may also be required for acquisition of Union Financial under some circumstances.

Federal Banking Regulations

Capital Requirements. The OCC’s capital regulations require national banks to meet two minimum capital standards: a 4% Tier 1 capital to total adjusted assets ratio for most banks (3% for national banks with the highest examination rating) (the “leverage” ratio) and an 8% risk-based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital to total assets standard, a 4% leverage ratio (3% for institutions receiving the highest rating on the financial institution examination rating system) and, together with the risk-based capital standard itself, a 4% Tier 1 capital to risk-based assets standard. “Tier 1 capital” is generally defined as common stockholders’ equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles (other than certain mortgage servicing rights and credit card relationships), a percentage of certain non-financial equity investments and certain other specified items.

The risk-based capital standard requires the maintenance of Tier 1 and total capital (which is defined as Tier 1 capital plus Tier 2 capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet activities, are multiplied by a risk-weight factor of 0% to 100%, as assigned by the OCC capital regulation based on the risks that the agency believes are inherent in the type of asset. The regulators have recently added a market risk adjustment to cover a bank’s trading account, foreign exchange and commodity positions. Tier 2 capital may include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets, and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of Tier 2 capital included as part of total capital cannot exceed 100% of Tier 1 capital.

The FRB has adopted capital adequacy guidelines for bank holding companies (on a consolidated basis) substantially similar to those of the OCC for the Bank. Union Financial’s total and Tier 1 capital exceed these requirements.

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Both the OCC and the FRB have the discretion to establish higher capital requirements on a case-by-case basis where deemed appropriate in the circumstances of a particular bank or bank holding company.

Prompt Corrective Regulatory Action. Under the prompt corrective action regulations, the OCC is required to take certain supervisory actions against undercapitalized institutions under its jurisdiction, the severity of which depends upon the institution’s degree of undercapitalization. Generally, an institution that has a ratio of total capital to risk weighted assets of less than 8%, a ratio of Tier 1 (core) capital to risk-weighted assets of less than 4% or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be “undercapitalized.” An institution that has a total risk-based capital ratio less than 6%, a Tier 1 capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be “significantly undercapitalized” and an institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be “critically undercapitalized.” Subject to a narrow exception, the OCC is required to appoint a receiver or conservator within specified time frames for an institution that is “critically undercapitalized.” The regulation also provides that a capital restoration plan must be filed with the OCC within 45 days of the date an institution receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the plan must be guaranteed by any parent holding company. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. The OCC could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.

Insurance of Deposit Accounts. Deposits of the Bank are insured by the Savings Association Insurance Fund (“SAIF”) maintained by the FDIC. The FDIC has adopted a risk-based insurance assessment system. The FDIC assigns an institution to one of three capital categories (well capitalized, adequately capitalized or undercapitalized) based on the institution’s financial information as of the reporting period ending seven months before the assessment period. The FDIC also assigns the institution to one of three supervisory subcategories within each capital group, based on a supervisory evaluation provided to the FDIC by the institution’s primary regulator and such other information that the FDIC deems relevant with respect to the financial condition and the risk posed to the deposit insurance funds. An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned. Assessment rates for SAIF deposits are determined semi-annually and currently range from 0 basis points for well-capitalized institutions in the highest supervisory category to 27 basis points for the weakest institutions. The FDIC is authorized to raise the assessment rates in certain circumstances. The FDIC has exercised its authority to raise rates in the past and may raise insurance premiums in the future. If such action is taken by the FDIC, it could have an adverse effect on the earnings of the Bank.

In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation (“FICO”) to recapitalize the predecessor to the SAIF. FICO payments during 2005 approximated 1.39 basis points of assessable deposits.

Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the regulators. Bank management does not know of any practice, condition or violation that might lead to termination of deposit insurance.

Federal Deposit Insurance Reform Act of 2005. The Federal Deposit Insurance Reform Act of 2005 (the “Act”), signed by the President on February 8, 2006, revised the laws governing the federal deposit insurance system. The Act provides for the consolidation of the Bank and Savings Association Insurance Funds into a combined “Deposit Insurance Fund.”

Under the Act, insurance premiums are to be determined by the Federal Deposit Insurance Corporation (“FDIC”) based on a number of factors, primarily the risk of loss that insured institutions pose to the Deposit Insurance Fund. The legislation eliminates the current minimum 1.25% reserve ratio for the insurance funds, the mandatory assessments when the ratio fall below 1.25% and the prohibition on assessing the highest quality banks when the ratio is above 1.25%. The Act provides the FDIC with flexibility to adjust the new insurance fund’s reserve ratio between 1.15% and 1.5%, depending on projected losses, economic changes and assessment rates at the end of a calendar year.

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The Act increased deposit insurance coverage limits from $100,000 to $250,000 for certain types of Individual Retirement Accounts, 401(k) plans and other retirement savings accounts. While it preserved the $100,000 coverage limit for individual accounts and municipal deposits, the FDIC was furnished with the discretion to adjust all coverage levels to keep pace with inflation beginning in 2010. Also, institutions that become undercapitalized will be prohibited from accepting certain employee benefit plan deposits.

The consolidation of the Bank and Savings Association Insurance Funds must occur no later that the first day of the calendar quarter that begins 90-days after the date of the Act’s enactment, i.e., July 1, 2006. The Act also states that the FDIC must promulgate final regulations implanting the remainder of its provisions not later than 270 days after its enactment.

At this time, management cannot predict the effect, if any, that the Act will have on insurance premiums paid by the Bank.

Loans to One Borrower. National banks are subject to limits on the amount that they may lend to single borrowers. Generally, banks may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of its capital and surplus (including Tier 1 capital, Tier 2 capital and the amount of the allowance for loan and lease losses not included in Tier 2 capital). An additional amount may be lent, equal to 10% of capital and surplus, if such loan is secured by readily-marketable collateral, which is defined to include certain financial instruments and bullion. At December 31, 2005, the Bank’s limit on loans to one borrower was $4.7 million and the Bank’s largest aggregate outstanding balance of loans to one borrower was $3.3 million.

Limitation on Capital Distributions. National banks may not pay dividends out of their permanent capital and may not, without OCC approval, pay dividends in excess of the total of the bank’s retained net income for the year combined with retained net income for the prior two years less any transfers to surplus and capital distributions. A national bank may not pay a dividend that would cause it to fall below any applicable regulatory capital standard.

Branching. National banks are authorized to establish branches within the state in which they are headquartered to the extent state law allows branching by state banks. Federal law also provides for interstate branching for national banks. Interstate branching by merger was authorized as of June 1, 1997 unless the state in which the bank is to branch has enacted a law opting out of interstate branching or expedites the effective date by passing legislation. De novo interstate branching is permitted to the extent the state into which the bank is to branch has enacted a law authorizing out-of-state banks to establish de novo branches.

Transactions with Related Parties. The authority of a depository institution to engage in transactions with related parties or “affiliates” (e.g., any company that controls or is under common control with an institution, including Union Financial) is limited by Sections 23A and 23B of the Federal Reserve Act (“FRA”). Section 23A limits the aggregate amount of covered transactions with any individual affiliate to 10% of the capital and surplus of the depository institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the depository institution’s capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in Section 23A and the purchase of low quality assets from affiliates is generally prohibited. Section 23B generally provides that certain transactions with affiliates, including loans and asset purchases, must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies.

The authority of the Bank to extend credit to executive officers, directors and 10% shareholders (“insiders”), as well as entities such persons control, is governed by Sections 22(g) and 22(h) of the FRA and Regulation O thereunder. Among other things, such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and are not to involve more than the normal risk of repayment. There is an exception to this requirement for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. Regulation O also places individual and aggregate limits on the amount of loans that institutions may make to insiders based, in part, on the institution’s capital position and requires certain board approval procedures to be followed.

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Enforcement. The OCC has primary enforcement responsibility over national banks and has the authority to bring actions against such banks and all institution-affiliated parties, including directors, officers, stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors to institution of receivership or conservatorship. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1.0 million per day in especially egregious cases. The FDIC has the authority to recommend to the OCC that it take enforcement action with respect to a national bank. If action is not taken by the agency, the FDIC has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations. The FRB has generally similar enforcement authority with respect to Union Financial. Neither Union Financial nor the Bank are under any enforcement action.

Standards for Safety and Soundness. The federal banking agencies have adopted Interagency Guidelines Prescribing Standards for Safety and Soundness (“Guidelines”) and a final rule to implement safety and soundness standards required under federal law. The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The standards address internal controls and information systems; internal audit system; credit underwriting; loan documentation; interest rate risk exposure; asset growth; and compensation, fees and benefits. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the Guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. The final rule establishes deadlines for the submission and review of such safety and soundness compliance plans when such plans are required.

Community Reinvestment Act. The Community Reinvestment Act, (“CRA”), as implemented by OCC regulations, provides that a national bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the OCC, in connection with its examination of a bank, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain corporate applications by such institution, such as mergers and branching. The Bank’s most recent rating was “satisfactory.”

USA Patriot Act. The USA Patriot Act of 2001 (the “Patriot Act”), designed to deny terrorists and others the ability to obtain anonymous access to the United States financial system, has significant implications for depository institutions, brokers, dealers and other businesses involved in the transfer of money. The Patriot Act mandated that financial institutions to implement additional policies and procedures with respect to, or additional measures designed to address matters such as: money laundering, suspicious activities and currency transaction reporting.

Federal Reserve System

The FRB regulations require savings institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The regulations generally provide that reserves be maintained against aggregate transaction accounts as follows: for accounts aggregating $48.3 million or less (subject to adjustment by the FRB) the reserve requirement is 3%; and for accounts aggregating greater than $48.3 million, a reserve requirement of 10% (subject to adjustment by the FRB between 8% and 14%) is applied against that portion of total transaction accounts in excess of $48.3 million. The first $7.8 million of otherwise reservable balances (subject to adjustments by the FRB) are exempted from the reserve requirements.

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Federal Home Loan Bank System

The Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. The Bank, as a member of the Federal Home Loan Bank of Atlanta, is required to acquire and hold shares of capital stock in the Federal Home Loan Bank of Atlanta. The Bank was in compliance with this requirement with an investment in Federal Home Loan Bank stock at December 31, 2005 of $4.0 million.

The Federal Home Loan Banks are required to provide funds for the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future Federal Home Loan Bank advances increased, the Bank’s net interest income would likely also be reduced. Recent legislation has changed the structure of the Federal Home Loan Banks’ funding obligations for insolvent thrifts, revised the capital structure of the Federal Home Loan Banks and implemented entirely voluntary membership for Federal Home Loan Banks. Management cannot predict the effect that these changes may have with respect to its Federal Home Loan Bank membership.

Item 1A. Risk Factors

An investment in shares of our common stock involves various risks. Before deciding to invest in our common stock, you should carefully consider the risks described below in conjunction with the other information in this offering memorandum, including the items included as exhibits. Our business, financial condition and results of operations could be harmed by any of the following risks or by other risks that have not been identified or that we may believe are immaterial or unlikely. The value or market price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements.

Our increased emphasis on commercial lending may expose us to increased lending risks.

At December 31, 2005, our loan portfolio consisted of $45.7 million, or 23.7%, of commercial real estate loans and $70.7 million, or 35.7%, of commercial business loans. We have increased our emphasis on these types of loans since we converted to a national bank charter in July 2003. These types of loans generally expose a lender to greater risk of non-payment and loss than one- to four-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property and the income stream of the borrowers. Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential mortgage loans. Commercial business loans expose us to additional risks since they typically are made on the basis of the borrower’s ability to make repayments from the cash flow of the borrower’s business and are secured by non-real estate collateral that may depreciate over time. In addition, since such loans generally entail greater risk than one- to four-family residential mortgage loans, we may need to increase our allowance for loan losses in the future to account for the likely increase in probable incurred credit losses associated with the growth of such loans. Also, many of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan.

The unseasoned nature of a significant portion of our commercial loan portfolio may result in errors in judging its collectibility, which may lead to additional loan charge-offs and provisions for loan losses, which would hurt our profits.

Our commercial loan portfolio, which includes loans secured by commercial real estate as well as business assets, has increased from $21.9 million, or 13.9% of total loans, at September 30, 2001 to $116.3 million, or 60.4% of total loans, at December 31, 2005. A large portion of our commercial loan portfolio is unseasoned and does not provide us with a significant payment history pattern with which to judge future collectibility. These loans have also not been subjected to unfavorable economic conditions. As a result, it is difficult to predict the future performance of this part of our loan portfolio. These loans may have delinquency or charge-off levels above our historical experience, which could adversely affect our future performance. Further, commercial loans generally have larger balances and involve a greater risk than one- to four-family residential mortgage loans. Accordingly, if we make any

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errors in judgment in the collectibility of our commercial loans, any resulting charge-offs may be larger on a per loan basis that those incurred with our residential mortgage loan portfolio.

Our market area limits our growth potential.

Some of our offices are located in areas that have experienced population and economic decline. Thus, our ability to originate loans and grow deposits in these areas may be limited. To counter this, we have attempted to expand our operations into communities that are experiencing population growth and economic expansion. This was the impetus for the opening of our banking center in Rock Hill in York County. However, we can provide no assurance that we will be able to successfully enter new markets with similar growth potential. If we are unable to do so, our ability to grow our business and our earnings will be restricted.

Strong competition within our market area could hurt our profits and slow growth.

We face intense competition both in making loans and attracting deposits. This competition has made it more difficult for us to make new loans and has occasionally forced us to offer higher deposit rates. Price competition for loans and deposits might result in us earning less on our loans and paying more on our deposits, which reduces net interest income. According to the Federal Deposit Insurance Corporation, as of June 30, 2005, we held 9.1% of the deposits in Fairfield, Laurens, Union and York counties, South Carolina, which was the third largest market share of deposits out of the 16 financial institutions that held deposits in these counties. Some of the institutions with which we compete have substantially greater resources and lending limits than we have and may offer services that we do not provide. We expect competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Our profitability depends upon our continued ability to compete successfully in our market area.

Certain interest rate movements may hurt our earnings and asset value.

Interest rates have recently been at historically low levels. However, since June 30, 2004, the U.S. Federal Reserve has increased its target for the federal funds rate fourteen times, from 1.00% to 4.50%. While these short-term market interest rates (which we use as a guide to price our deposits) have increased, longer-term market interest rates (which we use as a guide to price our longer-term loans) have not. Although this “flattening” of the market yield curve has not had a negative impact on our interest rate spread and net interest margin to date, if short-term interest rates continue to rise, and if rates on our deposits and borrowings reprice upwards faster than the rates on our long-term loans and investments, we would experience compression of our interest rate spread and net interest margin, which would have a negative effect on our profitability.

Changes in interest rates also affect the value of our interest-earning assets, and, in particular, our securities portfolio. Generally, the value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available-for-sale are reported as a separate component of equity, net of tax. Decreases in the fair value of securities available-for-sale resulting from increases in interest rates could have an adverse effect on shareholders’ equity.

If the value of real estate in northwestern South Carolina were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.

With most of our loans concentrated in the northwestern South Carolina, a decline in local economic conditions could adversely affect the value of the real estate collateral securing our loans. A decline in property values would diminish our ability to recover on defaulted loans by selling the real estate collateral, making it more likely that we would suffer losses on defaulted loans. Additionally, a decrease in asset quality could require additions to our allowance for loan losses through increased provisions for loan losses, which would hurt our profits. Also, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are more geographically diverse. Real estate values are affected by various factors in addition to local economic conditions, including, among other things, changes in general or regional economic conditions, governmental rules or policies and natural disasters.

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Our business is subject to the success of the local economy in which we operate.

Because the majority of our borrowers and depositors are individuals and businesses located and doing business in northwestern South Carolina, our success significantly depends to a significant extent upon economic conditions in northwestern South Carolina. Adverse economic conditions in our market area could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations. Conditions such as inflation, recession, unemployment, high interest rates, short money supply, scarce natural resources, international disorders, terrorism and other factors beyond our control may adversely affect our profitability. We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the State of South Carolina could adversely affect the value of our assets, revenues, results of operations and financial condition. Moreover, we cannot give any assurance we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.

The trading history of our common stock is characterized by low trading volume. Our common stock may be subject to sudden decreases.

Although our common stock trades on Nasdaq National Market, it has not been regularly traded. We cannot predict whether a more active trading market in our common stock will occur or how liquid that market might become. A public trading market having the desired characteristics of depth, liquidity and orderliness depends upon the presence in the marketplace of willing buyers and sellers of our common stock at any given time, which presence is dependent upon the individual decisions of investors, over which we have no control.

The market price of our common stock may be highly volatile and subject to wide fluctuations in response to numerous factors, including, but not limited to, the factors discussed in other risk factors and the following:

• actual or anticipated fluctuations in our operating results;

• changes in interest rates;

• changes in the legal or regulatory environment in which we operate;

• press releases, announcements or publicity relating to us or our competitors or relating to trends in our industry;

• changes in expectations as to our future financial performance, including financial estimates or recommendations by securities analysts and investors;

• future sales of our common stock;

• changes in economic conditions in our marketplace, general conditions in the U.S. economy, financial markets or the banking industry; and

• other developments affecting our competitors or us.

These factors may adversely affect the trading price of our common stock, regardless of our actual operating performance, and could prevent you from selling your common stock at or above the price you desire. In addition, the stock markets, from time to time, experience extreme price and volume fluctuations that may be unrelated or disproportionate to the operating performance of companies. These broad fluctuations may adversely affect the market price of our common stock, regardless of our trading performance.

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We operate in a highly regulated environment and we may be adversely affected by changes in laws and regulations.

Provident Community Bank, N.A. is subject to extensive regulation, supervision and examination by the Office of the Comptroller of the Currency, its chartering authority and federal regulator, and by the Federal Deposit Insurance Corporation, as insurer of its deposits. Union Financial Bancshares is subject to regulation and supervision by the Federal Reserve Board. Such regulation and supervision govern the activities in which an institution and its holding company may engage, and are intended primarily for the protection of the insurance fund and for the depositors and borrowers of Provident Community Bank, N.A. The regulation and supervision by the Office of the Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation are not intended to protect the interests of investors in Union Financial Bancshares common stock. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our operations.

Provisions of our certificate of incorporation, bylaws and Delaware law, as well as federal banking regulations, could delay or prevent a takeover of us by a third party.

Provisions in our certificate of incorporation and bylaws and the corporate law of the State of Delaware could delay, defer or prevent a third party from acquiring us, despite the possible benefit to our shareholders, or otherwise adversely affect the price of our common stock. These provisions include: supermajority voting requirements for certain business combinations; the election of directors to staggered terms of three years; and advance notice requirements for nominations for election to our board of directors and for proposing matters that shareholders may act on at shareholder meetings. In addition, we are subject to Delaware laws, including one that prohibits us from engaging in a business combination with any interested shareholder for a period of three years from the date the person became an interested shareholder unless certain conditions are met. These provisions may discourage potential takeover attempts, discourage bids for our common stock at a premium over market price or adversely affect the market price of, and the voting and other rights of the holders of, our common stock. These provisions could also discourage proxy contests and make it more difficult for you and other shareholders to elect directors other than the candidates nominated by our Board.

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Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

The Corporation owns two banking offices and an operations center in Union, South Carolina, two banking offices in Winnsboro, South Carolina and a banking office in each of Laurens, Jonesville and Rock Hill, South Carolina. The net book value of the Corporation’s investment in premises and equipment totaled approximately $5.1 million at December 31, 2005. See Note 4 of Notes to Consolidated Financial Statements. All property is in good condition and meets the operating needs of the Corporation.

Item 3. Legal Proceedings

Neither Union Financial nor the Bank is engaged in any legal proceedings of a material nature at the present time. From time to time, the Bank is involved in routine legal proceedings occurring in the ordinary course of business wherein it enforces the Bank’s security interest in mortgage loans the Bank has made.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2005.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

For information related to the market for common equity and related stockholder matters, the information contained under the section captioned “Common Stock Market Price and Dividend Information” in the Annual Report is incorporated herein by reference.

Period	Total Number of Shares Purchased	Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Maximum Number of Shares that May Yet be Purchased Under the Plans or Programs
October 1, 2005 through October 31, 2005	—		—	—	127,282
November 1, 2005 through November 30, 2005	27,460	$	18.29	27,460	99,822
December 1, 2005 through December 31, 2005	—		—	—	99,822
Total	27,460	$	18.29	27,460

(1) In November 2004, the Corporation implemented a share repurchase program under which the Corporation may repurchase up to 5% of the outstanding shares or 98,000 shares. In May 2005, the program was expanded by an additional 5% or 95,000 shares. The repurchase program will continue until it is completed or terminated by the Board of Directors.

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Item 6. Selected Financial Data

The information contained in the section captioned “Selected Financial and Other Data” in the Annual Report are incorporated herein by reference.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The information contained in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Annual Report is incorporated herein by reference.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The information contained in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset and Liability Management” in the Annual Report are incorporated herein by reference.

Item 8. Financial Statements and Supplementary Data

The financial statements contained in the Annual Report are incorporated herein by reference.

Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure

No changes in or disagreements with the Corporation’s independent accountants on accounting and financial disclosure has occurred during the two most recent fiscal years.

Item 9A. Controls and Procedures

The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. In addition, based on that evaluation, no change in the Company’s internal control over financial reporting occurred during the quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Item 9B. Other Information

None.

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PART III

Item 10. Directors and Executive Officers of the Registrant

For information concerning the Board of Directors of Union Financial, the information contained under the section captioned “Proposal I — Election of Directors” and “Directors’ Compensation” in the Proxy Statement is incorporated herein by reference. Reference is made to the cover page of this Form 10-K and to the section captioned “Compliance with Section 16(a) of the Exchange Act” for information regarding compliance with section 16(a) of the Exchange Act.

For information concerning the Corporation’s code of ethics, the information contained under the section captioned “Corporate Governance — Code of Business Conduct” in the Proxy Statement is incorporated herein by reference. A copy of the code of ethics is available, without charge, upon written request to Wanda J. Wells, Corporate Secretary, Union Financial Bancshares, Inc., 203 West Main Street, Union, South Carolina 29379.

Executive Officers of the Registrant

Certain executive officers of the Bank also serve as executive officers of Union Financial. The day-to-day management duties of the executive officers of Union Financial and the Bank relate primarily to their duties as to the Bank. The executive officers of Union Financial currently are as follows:

Name	Age(1)	Position as of December 31, 2005
Dwight V. Neese	55	President, Chief Executive Officer and Director
Richard H. Flake	57	Executive Vice President - Chief Financial Officer
Lud W. Vaughn	55	Executive Vice President - Chief Operating Officer
Edward A. Brock	44	Senior Vice President of the Bank
Wanda J. Wells	50	Senior Vice President - Chief Administrative Officer and Corporate Secretary
Mark F. Pack	40	Senior Vice President of the Bank
Henry G. Alexander, Jr.	45	Vice President - Commercial Lending of the Bank
Carolyn H. Belue	49	Vice President - Operations Manager of the Bank
Brenda Billardello	46	Vice President - Marketing Director of the Bank
Lisa G. Morris	33	Vice President - Union Market Executive of the Bank
Lori H. Patrick	38	Vice President - York Market Executive of the Bank
Susan D. Taylor	45	Vice President - Fairfield Market Executive of the Bank
Jeff Thompson	34	Vice President - Laurens Market Executive of the Bank

(1) At December 31, 2005.

Dwight V. Neese was appointed as President and Chief Executive Officer of the Bank effective September 5, 1995. As President and Chief Executive Officer of the Bank and Union Financial, Mr. Neese is responsible for daily operations of the Bank and implementation of the policies and procedures approved by the Board of Directors.

Richard H. Flake joined the Company in September 1995.

Lud W. Vaughn joined the Company in April 2003. Prior to joining the Company, Mr. Vaughn was Senior Vice President for Bank of America in Rock Hill, South Carolina.

Edward A. Brock joined the Company in November 2002. Before joining the Company, Mr. Brock was a vice president—commercial banking for First Citizens Bank from December 2001 to November 2002 and a vice president -commercial lender of Bank of America form 1993 until December 2001.

Wanda J. Wells has been employed by the Company since 1975.

29

Mark F. Pack joined the Company in December 2004. Prior to joining the Company, Mr. Pack was Vice President and Senior Commercial Account Manager for SouthTrust Bank in Charlotte, North Carolina.

Henry G. Alexander, Jr. has been employed by the Company since 1983.

Carolyn H. Belue has been employed by the Company since 1979.

Brenda Billardello joined the Company in December 2004. Prior to joining the Company, Ms. Billardello was a vice president of the York County Regional Chamber of Commerce.

Lisa G. Morris has been employed by the Company since 1999.

Lori H. Patrick has been employed by the Company since 1987.

Susan D. Taylor has been employed by the Company since 1995.

Jeff Thompson has been employed by the Company since 2000.

Item 11. Executive Compensation

The information contained under the sections captioned “Executive Compensation” and “Directors’ Compensation” in the Proxy Statement is incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

(a) Security Ownership of Certain Beneficial Owners

Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in the Proxy Statement.

(b) Security Ownership of Management

Information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in the Proxy Statement.

(c) Management of Union Financial knows of no arrangements, including any pledge by any person of securities of Union Financial, the operation of which may at a subsequent date result in a change in control of the registrant.

(d) Equity Compensation Plan Information

30

The following table sets forth information about the Company common stock that may be issued upon the exercise of stock options, warrants and rights under all of the Company’s equity compensation plans as of December 31, 2005.

Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights (a)	Weighted-average exercise price of outstanding options, warrants and rights (b)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
Equity compensation plans approved by security holders	120,966	$	13.30	6,373
Equity compensation plans not approved by security holders	—		—	—
Total	120,966	$	13.30	6,373

Item 13. Certain Relationships and Related Transactions

The information required by this item is incorporated herein by reference to the section captioned “Transactions with Management” in the Proxy Statement.

Item 14. Principal Accountant Fees and Services

The information required by this Item is incorporated herein by reference to the section captioned “Proposal 2-Ratification of Appointment of Auditors” in the Proxy Statement.

31

PART IV

Item 15. Exhibits

Exhibits
3(a)	Certificate of Incorporation(1)
3(b)	Bylaws(2)
3(c)	Certificate of Amendment of Certificate of Incorporation dated January 22, 1997(3)
3(d)	Certificate of Amendment to Certificate of Incorporation dated January 28, 2004(4)
10(a)	Employment Agreement with Dwight V. Neese(5)
10(b)	Employment Agreement with Richard H. Flake(5)
10(c)	Union Financial Bancshares, Inc. 1995 Stock Option Plan(6)
10(d)	Union Financial Bancshares, Inc. 2001 Stock Option Plan(7)
10(e)	Change in Control Agreement with Lud W. Vaughn(5)
10(f)	Change in Control Agreement with Edward A. Brock(8)
13	2005 Annual Report to Shareholders
21	Subsidiaries of the Registrant
23	Consent of Independent Auditor
31(a)	Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31(b)	Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32	Section 1350 Certifications

(1) Incorporated herein by reference to Union Financial’s Registration Statement on Form S-4 (File No. 33-80808) filed with the Securities and Exchange Commission on June 29, 1994.

(2) Incorporated herein by reference to Union Financial’s Form 10-Q for the quarter ended June 30, 2005.

(3) Incorporated herein by reference to Union Financial’s Form 10-KSB for the year ended September 30, 1997.

(4) Incorporated herein by reference to Union Financial’s 10-QSB for the quarter ended December 31, 2003.

(5) Incorporated herein by reference to Union Financial’s Form 10-KSB for the year ended September 30, 2003.

(6) Incorporated herein by reference to Exhibit A to Union Financial’s Proxy Statement for its 1996 Annual Meeting of Stockholders.

(7) Incorporated herein by reference to Appendix A to Union Financial’s Proxy Statement for its 2000 Annual Meeting of Stockholders.

(8) Incorporated herein by reference to Union Financial’s Form 10-KSB for the year ended December 31, 2004.

32

SIGNATURES

In accordance with the requirements of Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	UNION FINANCIAL BANCSHARES, INC.
Date: March 17, 2006		By:	/s/ Dwight V. Neese
			Dwight V. Neese President and Chief Executive Officer

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

By:	/s/ Dwight V. Neese	By:	/s/ Carl L. Mason
	Dwight V. Neese (Principal Executive Officer)		Carl L. Mason Director
Date: March 17, 2006		Date: March 21, 2006
By:	/s/ Richard H. Flake	By:	/s/ Phillip C. Wilkins
	Richard H. Flake (Principal Financial and Accounting Officer)		Phillip C. Wilkins Director
Date: March 21, 2006		Date: March 21, 2006
By:	/s/ Robert H. Breakfield
	Robert H. Breakfield Director
Date: March 21, 2006
By:	/s/ James W. Edwards
	James W. Edwards Director
Date: March 21, 2006
By:	/s/ William M. Graham
	William M. Graham Director
Date: March 21, 2006
By:	/s/ Louis M. Jordan
	Louis M. Jordan Director
Date: March 21, 2006

33

EX-13

EXHIBIT NO. 13

2005 Annual Report to Shareholders

Union Financial Bancshares, Inc.

2005 Supplemental Annual Report

TABLE OF CONTENTS

Business	1
Selected Financial and Other Data	2
Management’s Discussion and Analysis of Financial Condition and Results of Operations	4
Report of Independent Registered Public Accounting Firm	15
Consolidated Financial Statements	15
Notes to Consolidated Financial Statements	21
Directors and Leadership Group	45
Corporate Information	46

BUSINESS

Union Financial Bancshares, Inc. (“Union Financial”) is the bank holding company for Provident Community Bank, N.A., (the “Bank”). Union Financial engages in no significant activity other than holding the stock of the Bank and engaging in certain passive investment activities. Union Financial and the Bank are collectively referred to as the “Corporation” in this annual report.

The Bank is a national bank headquartered in Union, South Carolina. The Bank, originally chartered in 1934, is a member of the Federal Home Loan Bank System (the “FHLB”). Its deposits are insured to the maximum limits allowable by the Federal Deposit Insurance Corporation (the “FDIC”).

The business of the Bank consists primarily of attracting deposits from the general public and originating loans on properties located in South Carolina. The Bank originates consumer and commercial loans, commercial real estate loans, construction loans and residential mortgage loans, invests in federal government and agency obligations and purchases fixed and variable rate mortgage participation certificates. The principal sources of funds for the Bank’s lending and investing activities include deposits received from the general public, advances from the FHLB and other borrowings. The Bank’s principal expenses are interest paid on deposit accounts and other borrowings and expenses incurred in the operation of the Bank. The Bank’s operations are conducted through its main office and six full-service banking centers, all of which are located in the upstate area of South Carolina.

SELECTED FINANCIAL AND OTHER DATA

Operations Data:

	Years Ended December 31						Three Months Ended December 31			Years Ended September 30
	2005			2004			2003			2003			2002			2001
	( In Thousands – Except Share and Per Share Amounts)
Interest income	$	19,213		$	16,952		$	3,787		$	16,924		$	18,361		$	19,018
Interest expense		(8,970	)		(7,246	)		(2,305	)		(8,702	)		(9,775	)		(11,613	)
Net interest income		10,243			9,706			1,482			8,222			8,586			7,405
Provision for loan losses		(869	)		(1,250	)		(725	)		(725	)		(990	)		(240	)
Net interest income after provision for loan losses		9,374			8,456			757			7,497			7,596			7,165
Other income (expense)		2,543			2,561			(283	)		2,533			1,308			1,149
Other expense		(8,537	)		(8,140	)		(2,326	)		(7,600	)		(6,602	)		(6,250	)
Income (loss) before income taxes		3,380			2,877			(1,852	)		2,430			2,302			2,064
Income tax (expense) benefit		(914	)		(721	)		642			(571	)		(558	)		(721	)
Net income (loss)	$	2,466		$	2,156		$	(1,210	)	$	1,859		$	1,744		$	1,343
Net income (loss) per common share (Basic)	$	1.29		$	1.10		$	(0.62	)	$	0.95		$	0.90		$	0.70
Net income (loss) per common share (Diluted)	$	1.26		$	1.05		$	( 0.62	)	$	0.90		$	0.86		$	0.68
Dividends paid per common share	$	0.40		$	0.40		$	0.10		$	0.40		$	0.40		$	0.40
Weighted average number of common shares outstanding (Basic)		1,914,357			1,957,760			1,967,217			1,963,775			1,939,084			1,918,431
Weighted average number of common shares outstanding (Diluted)		1,962,920			2,044,137			1,967,217			2,056,579			2,030,040			1,971,611

UNION FINANCIAL BANCSHARES, INC.

2

Financial Condition:

	At December 31						At September 30,
	2005		2004		2003		2003		2002		2001
	(Dollars In Thousands)
Total amount of:
Assets	$	371,042	$	351,598	$	331,884	$	341,704	$	310,968	$	277,752
Cash and due from banks		8,380		13,197		28,702		3,290		7,385		5,694
Securities		146,283		143,494		123,789		157,438		117,633		89,117
Loans (net)		192,577		171,094		154,501		152,921		161,576		158,063
Deposits		239,603		227,589		223,131		220,232		200,303		194,079
Advances from Federal Home Loan Bank and other borrowings		75,715		63,500		68,500		74,000		57,000		46,007
Securities sold under agreement to repurchase		20,000		24,000		5,000		11,000		17,000		11,000
Floating rate junior subordinated deferrable interest debentures		8,247		8,247		—		—		—		—
Corporate obligated floating rate capital securities		—		—		8,000		8,000		8,000		—
Shareholders’ equity		25,333		26,019		25,507		26,216		27,198		24,376

Other Selected Data:

	Years Ended December 31				Years Ended September 30,
	2005		2004		2003		2002		2001
Average interest rate spread	2.98	%	2.94	%	2.56	%	2.97	%	2.98	%
Net yield on average interest-earning assets	3.02	%	2.96	%	2.63	%	3.08	%	3.08	%
Return on average assets	0.68	%	0.61	%	0.55	%	0.59	%	0.51	%
Return on average shareholders’ equity	9.68	%	8.40	%	6.64	%	7.06	%	6.03	%
Dividend payout ratio	31.26	%	36.32	%	42.29	%	44.55	%	57.03	%
Operating expense to average assets	2.17	%	2.14	%	2.17	%	2.22	%	2.39	%
Ratio of average shareholders’ equity to average assets	7.01	%	7.28	%	8.34	%	8.31	%	8.50	%

Note: In 2003, the Corporation changed its year end from September 30 to December 31.

UNION FINANCIAL BANCSHARES, INC.

3

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Critical Accounting Policies

The Corporation has adopted various accounting policies which govern the application of accounting principles generally accepted in the United States of America in the preparation of financial statements. The significant accounting policies of the Corporation are described in the footnotes to the consolidated financial statements.

Certain accounting policies involve significant judgments and assumptions by management which could have a material impact on the carrying value of certain assets and liabilities. Management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and estimates which could have a material impact on the carrying values of assets and liabilities and the results of operations of the Corporation.

The Corporation believes the allowance for loan losses is a critical accounting policy that requires significant judgments and estimates used in the preparation of consolidated financial statements. Management reviews the level of the allowance on a monthly basis and establishes the provision for loan losses based on the nature and volume of the loan portfolio, overall portfolio quality, delinquency levels, a review of specific problem loans, loss experience, economic conditions, and other factors related to the collectibility of the loan portfolio. A portion of the allowance is established by segregating the loans by residential mortgage, commercial and consumer loans and assigning allocation percentages based on historical loss experience and delinquency trends. The applied allocation percentages are reevaluated at least annually to ensure their relevance in the current economic environment. Accordingly, increases in the size of the loan portfolio and the increased emphasis on commercial real estate and commercial business loans, which carry a higher degree of risk of default and, thus, a higher allocation percentage, increases the allowance. Additionally, a portion of the allowance is established based on the level of specific classified assets.

Although the Corporation believes that it uses the best information available to establish the allowance for loan losses, future additions to the allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions and other factors. In addition, the Office of the Comptroller of the Currency, as an integral part of its examination process, will periodically review the Corporation’s allowance for loan losses. Such agency may require the Corporation to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination. See notes 1 and 3 to the notes to financial statements included in this annual report for a detailed description of the Corporation’s estimation process and methodology related to allowance for loans losses.

Forward-Looking Statements

Management’s Discussion and Analysis of Financial Condition and Results of Operations and other portions of this report contain certain “forward-looking statements” concerning the future operations of Union Financial and the Bank. Management intends to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Corporation of the protections of such safe harbor with respect to all “forward-looking statements” contained in the Annual Report. The Corporation has used “forward-looking statements” to describe future plans and strategies. Forward looking statements are generally preceded by such terms as “expects,” “believes,” “anticipates,” “intends” and similar expressions. Management’s ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could affect actual results include interest rate trends, the general economic climate in the Corporation’s market area and the country as a whole, the ability of the Corporation to control costs and expenses, the products and pricing of its competitors, loan delinquency rates, and changes in federal and state regulation. These factors should be considered in evaluating the “forward-looking statements” and undue reliance should not be placed on such statements. Except as required by applicable law and regulation, the Corporation does not undertake and specifically disclaims any obligation to publicly release the results of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events.

Asset and Liability Management

The Corporation is committed to following a program of asset and liability management in an effort to manage the fluctuations in earnings caused by movements in interest rates. A significant portion of the Corporation’s income results from the spread between the yield realized on its interest-earning assets and the rate of interest paid on its deposits and other borrowings. Differences in the timing

UNION FINANCIAL BANCSHARES, INC.

4

and volume of repricing assets versus the timing and volume of repricing liabilities expose the Corporation to interest rate risk. Management’s policies are directed at minimizing the impact on earnings of movements in interest rates.

The Corporation’s Asset/Liability Committee makes pricing and marketing decisions on deposit and loan products in conjunction with managing the Corporation’s interest rate risk. In addition, the Asset/Liability Committee reviews the Corporation’s securities portfolio, FHLB advances and other borrowings as well as the Corporation’s asset and liability policies.

At December 31, 2005, the Corporation had more interest-rate sensitive assets than liabilities that would reprice over the next twelve months. For the year ended December 31, 2005, the average balance of the loan portfolio increased $19.7 million while the average balance of investment and mortgage-backed securities decreased $7.6 million. Proceeds from the maturation, sale and repayment of investment and mortgage-backed securities were utilized to fund loan growth and resulted in an increase in the average yield on interest-earning assets as the loans originated carried a higher yield than the securities. However, due to the Corporation’s focus on lower cost demand deposit accounts, overall funding costs increased at a slower rate than the increase in yield on earning assets, resulting in a slightly higher interest rate spread. The Corporation expects that its loan portfolio will continue to increase in the future with higher consumer and commercial loan originations, resulting in a higher yield in a rising interest rate environment. The Corporation continues to work to shorten the average life of its assets through the origination of shorter-term variable-rate consumer and commercial loans and the decline in originations of longer-term fixed-rate real estate loans and to extend the term on its liabilities in an effort to provide a better match of repricing for interest earning assets and interest bearing liabilities.

The Corporation has established policies and monitors results to control interest rate sensitivity. While the Corporation utilizes measures such as static gap, which is simply the measurement of the difference between interest-sensitive assets and interest-sensitive liabilities repricing for a particular time period, an equally important process is the evaluation of how particular assets and liabilities are impacted by changes in interest rates or selected indices as they reprice. Asset/liability modeling techniques are utilized by the Corporation to assess varying interest rate and balance sheet mix assumptions.

The primary objective of Asset/Liability management at the Corporation is to manage interest rate risk and achieve reasonable stability in net interest income throughout interest rate cycles in order to maintain adequate liquidity. This is achieved by maintaining the proper balance of rate-sensitive assets and rate-sensitive liabilities. The relationship of rate-sensitive assets to rate-sensitive liabilities is the principal factor in projecting the effect that fluctuating interest rates will have on future net interest income. Rate-sensitive assets and liabilities are those that can be repriced to current market rates within a relatively short time period. Management monitors the rate sensitivity of interest earning assets and interest-bearing liabilities over the entire life of these instruments, but places particular emphasis on the first year. At December 31, 2005, approximately 63% of the Corporation’s interest-earning assets were scheduled to reprice or to mature within one year compared to approximately 61% of interest-bearing liabilities.

The following table shows the Corporation’s rate-sensitive position at December 31, 2005 as measured by gap analysis (the difference between the interest-earning asset and interest-bearing liability amounts scheduled to be repriced to current market rates in subsequent periods). Over the next twelve months, we expect the amount of interest-earning assets to reprice will exceed the amount of interest-bearing liabilities by approximately $10 million. As a result, at December 31, 2005, the ratio of rate-sensitive assets to rate-sensitive liabilities within the one-year time frame was 105%, indicating an “asset-sensitive” position. Companies in an asset sensitive position would expect rising interest rates to have a positive impact on net interest income and falling interest rates to have a negative impact.

UNION FINANCIAL BANCSHARES, INC.

5

The following table sets forth the Corporation’s interest sensitivity position as of December 31, 2005.

Interest Sensitivity Analysis

(dollars in thousands)

	Average Rate	Within 1 Year			1-3 Years			After 3-5 Years			Over 5 Years		Total		Fair Value
INTEREST-EARNING ASSETS
Loans (1)	7.64	$	148,003		$	27,365		$	10,412		$	11,831	$	197,611	$	196,118
Mortgage-backed securities (2)	4.01		11,127			8,974			2,568			4,863		27,532		26,835
Interest-earning deposits, Investments and FHLB/FRB stock	4.46		60,975			20,975			11,507			31,425		124,882		125,579
Total interest-earning assets	6.18		220,105			57,314			24,487			48,119		350,025		348,532
INTEREST-BEARING LIABILITIES
Deposits
Savings accounts (3)	0.43		5,314			6,628			3,456			1,335		16,733		16,188
Checking accounts (3)	1.93		30,549			22,662			5,318			12,184		70,713		71,375
Money market accounts (3)	2.55		2,988			4,310			2,247			4,869		14,414		15,218
Certificate accounts	2.75		103,934			25,386			8,423			—		137,743		136,855
Borrowings (4)	4.06		59,215			18,000			7,500			11,000		95,715		96,311
Floating rate junior subordinated deferrable interest debentures	7.20		8,247			—			—			—		8,247		8,217
Total interest-bearing liabilities	3.03	$	210,247		$	76,986		$	26,944		$	29,388	$	343,565	$	344,164
Interest sensitive gap	3.15		9,858			(19,672	)		(2,457	)	$	18,731
Cumulative interest sensitive gap		$	9,858			($9,814	)	($	12,271	)	$	6,460
Rate Sensitive Assets/ Rate Sensitive Liabilities			105	%

Assumptions:

(1) Fixed-rate loans are shown in the time frame corresponding to contractual principal amortization schedules. Adjustable-rate loans are shown in the time frame corresponding to the next contractual interest rate adjustment date. The fixed and variable rate loans shown also take into account the Company’s estimates of prepayments of fixed and adjustable rate loans.

(2) Mortgage-backed securities are shown at repricing dates but also include prepayment estimates.

(3) Decay rates approximate 30% in the first year and 28% in the second year for checking accounts, 32% in the first year and 30% in the second year for savings accounts and 49% in the first year and 43% in the second year for money market accounts.

(4) Borrowings include fixed-rate FHLB of Atlanta advances at the earlier of maturity date or expected call dates. For purposes of the table above, the Company has assumed under current interest rates that certain advances with call provisions will extend.

Management is not aware of any known events or uncertainties that will have or are reasonably likely to have a material effect on the Corporation’s liquidity, capital resources or results of operations. Management is not aware of any current recommendations by the regulatory authorities which, if they were to be implemented, would have a material effect on the Corporation’s liquidity, capital resources or results of operations.

UNION FINANCIAL BANCSHARES, INC.

6

Yields Earned and Rates Paid

The Corporation’s pretax earnings depend primarily on its net interest income, the difference between the income it receives on its loan portfolio and other investments and its cost of funds, consisting primarily of interest paid on deposits and borrowings. Net interest income is affected by the average yield on interest-earning assets, the average rate on interest-bearing liabilities, and the ratio of interest-earning assets to interest-bearing liabilities.

The following table sets forth, at or for the periods and dates indicated, the weighted average yields earned on the Corporation’s interest-earning assets, the weighted average interest rates paid on the Corporation’s interest-bearing liabilities, the interest rate spread and net yield on interest-earning assets.

	At December 31,		Years Ended December 31,				Three Months Ended December 31,		Year Ended September 30,
	2005		2005		2004		2003		2003
Average yield on earnings assets:
Loans	7.64	%	7.04	%	6.49	%	6.36	%	6.94	%
Investments (1)	4.46	%	4.11	%	3.87	%	3.10	%	3.95	%
Mortgage-backed securities	4.01	%	4.07	%	3.93	%	3.56	%	3.78	%
Total interest-earning assets	6.18	%	5.66	%	5.18	%	4.83	%	5.41	%
Less:
Average rate paid on deposits (2)	2.57	%	2.25	%	1.77	%	1.86	%	2.25	%
Average rate paid on borrowings	4.06	%	3.65	%	3.23	%	5.84	%	4.13	%
Average cost of funds	3.03	%	2.67	%	2.24	%	2.98	%	2.85	%
Average interest rate spread	3.15	%	2.99	%	2.94	%	1.85	%	2.56	%
Net yield on average interest-earning assets	3.15	%	3.02	%	2.96	%	1.89	%	2.63	%

The Corporation’s weighted average yield on earning assets and weighted average cost of interest-bearing liabilities shown above are derived by dividing interest income and expense by the weighted average balances of interest-earning assets or interest-bearing liabilities. During fiscal 2005, the average yield on interest earning assets increased by 48 basis points while the average rate paid on average interest-bearing liabilities increased by 43 basis points. Average interest-earning assets increased $12.1 million in fiscal 2005 while interest-bearing liabilities increased $10.9 million. This, in conjunction with the average yield on interest-earning assets increasing more than the increase in the average rate on interest-bearing liabilities, provided for the increase in gross margin.

(1) Includes investment securities, federal funds sold, interest-bearing time deposits, overnight interest-bearing deposits, Federal Home Loan Bank stock and Federal Reserve stock.

(2) Includes non interest bearing deposits.

UNION FINANCIAL BANCSHARES, INC.

7

Rate/Volume Analysis

The following table sets forth certain information regarding changes in interest income and interest expense of the Corporation for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by prior rate) and (2) changes in rate (changes in rate multiplied by prior volume). The net change attributable to the combined impact of rate and volume has been allocated to rate and volume variances consistently on a proportionate basis.

	Years Ended December 31, 2005 vs. 2004									Years Ended December 31, 2004 vs. September 30, 2003
	Volume			Rate			Total			Volume			Rate			Total
	(Dollars in Thousands)
Change in interest income:
Loans	$	1,280		$	987		$	2,267		$	199			($714	)		($515	)
Mortgage-backed securities		(594	)		65			(529	)		(1,168	)		45			(1,123	)
Investments		303			220			523			1,692			(26	)		1,666
Total interest income		989			1,272			2,261			723			(695	)		28
Change in interest expense:
Deposits		220			1,125			1,345			306			(1,063	)		(757	)
Borrowings and other		(50	)		429			379			237			(936	)		(699	)
Total interest expense		170			1,554			1,724			543			(1,999	)		(1,456	)
Change in net interest income	$	819		($	282	)	$	537		$	180		$	1,304		$	1,484

RESULTS OF OPERATIONS

Comparison of Years Ended December 31, 2005 and December 31, 2004

Net income increased $310,000 or 14.38% from $2,156,000 for the year ended December 31, 2004 to $2,466,000 for the year ended December 31, 2005. Earnings per share were $1.29 per share (basic) and $1.26 per share (diluted) for the year ended December 31, 2005 compared to $1.10 per share (basic) and $1.05 per share (diluted) for the year ended December 31, 2004. Net interest income before the loan loss provision for the year ended December 31, 2005 increased $537,000, or 5.53%, to $10,243,000 compared to $9,706,000 for the same period in the previous year. The increase was due primarily to higher average loan balances over the previous year along with an increase in yield on loans that resulted from a higher concentration of commercial loans. The increase in net interest income was partially offset by higher deposit costs as a result of rising rates.

Interest Income

Total interest income increased $2,261,000, or 13.34%, from $16,952,000 in the year ended December 31, 2004 to $19,213,000 in the year ended December 31, 2005. Interest income on loans increased $2,267,000, or 21.80%, from $10,399,000 in 2004 to $12,666,000 in 2005 due primarily to increasing market interest rates along with higher average balance of loans with a higher average rate due to our increased emphasis on commercial and consumer loan originations. The Corporation’s continued focus on variable and prime-based lending resulted in net growth in consumer/commercial loans of 21.12% while net residential mortgage loans declined 12.61%. Interest income on deposits, federal funds sold and investment securities decreased $6,000, or 0.09%, from $6,553,000 in 2004 to $6,547,000 in 2005. The decrease was due primarily to lower average balances, offset by higher yields. Proceeds from the maturity and sale of investment securities were utilized to fund growth in higher-yielding loans.

UNION FINANCIAL BANCSHARES, INC.

8

Interest Expense

Interest expense increased 23.79% to $8,970,000 in 2005 from $7,246,000 in 2004. Interest expense increased $1,345,000 for deposits and increased $379,000 for other borrowings and floating rate junior subordinated deferrable interest debentures. Interest expense for deposits increased due primarily to higher market rates from a rising interest rate environment. The rate paid was offset by an increase in lower-cost transaction account balances by 21.36% while traditional higher-cost certificate of deposit account balances decreased 4.05%. Interest expense on other borrowings increased due to higher market rates offset somewhat by lower average balances of borrowings.

Provision for Loan Loss

Provisions for loan losses are charges to earnings to bring the total allowance for loan losses to a level considered by management as adequate to provide for estimated loan losses based on management’s evaluation of the collectibility of the loan portfolio. The allowance for loan loss calculation includes a segmentation of loan categories subdivided by residential mortgage, commercial and consumer loans. Each category is risk rated for all loans including performing groups. The weight assigned to each performing group is developed from a three-year historical average loan loss experience ratio and as the loss experience changes, the category weight is adjusted accordingly. In addition to loan loss experience, management’s evaluation of the loan portfolio includes the market value of the underlying collateral, growth and composition of the loan portfolio, delinquency trends and economic conditions. Management evaluates the carrying value of loans periodically, and the allowance for loan losses is adjusted accordingly. Consumer and commercial loans carry higher risk weighted rates in the allowance calculation as compared to residential mortgage loans.

The provision for loan losses decreased from $1,250,000 in 2004 to $869,000 in 2005. The allowance for loan losses increased $368,000 to $2,394,000 as of December 31, 2005 compared to $2,026,000 as of December 31, 2004. Non-performing loans increased $496,000 from $750,000 at December 31, 2004 to $1,246,000 at December 31, 2005. At December 31, 2005, impaired loans totaled $127,000 compared to $197,000 at December 31, 2004.

The Corporation experienced loan charge-offs, net of recoveries, of approximately $501,000 in the year ended December 31, 2005 compared to $1,607,000 for the year ended December 31, 2004. The previous year loan charge-offs included approximately $1,306,000 from three commercial loans that were charged off after the loans were determined to be uncollectible. The allowance for loan losses to total loans at December 31, 2005 was 1.23% compared to 1.18% at December 31, 2004. The allowance for loan losses to non-performing loans at December 31, 2005 was 192.13% compared to 270.13% at December 31, 2004.

Non-Interest Income

Non-interest income decreased 0.70% to $2,543,000 for the year ended December 31, 2005 from $2,561,000 for the year ended December 31, 2004. Fees for financial services increased $61,000 to $2,533,000, primarily due to higher fees as a result of an increase in demand deposit accounts that was offset partially by lower fees generated from third party investment brokerage and financing receivables programs due to a reduction in product volumes.

Non-Interest Expense

Non-interest expense increased 4.88% to $8,537,000 for the year ended December 31, 2005 from $8,140,000 for the year ended December 31, 2004. Compensation and employee benefits increased 8.01%, or $301,000, from the year ended December 31, 2004 compared to the year ended December 31, 2005 due primarily to normal merit salary increases along with higher amortization expense for deferred compensation contracts. Occupancy and equipment expenses decreased 0.84%, or $17,000, to $2,015,000 for the year ended December 31, 2005 from $2,032,000 for the year ended December 31, 2004 due to lower depreciation expense. Professional services expense increased 13.68%, or $42,000, from the year ended December 31, 2004 to the year ended December 31, 2004 due to higher consultant expense utilized to implement improved loan documentation procedures and higher audit fees. Advertising and public relations expense increased 2.45%, or $4,000, from the year ended December 31, 2004 to the year ended December 31, 2005 due to higher advertising expense for deposit product promotions. Loan operations costs increased $66,000, or 48.88%, to $201,000 for the year ended December 31, 2005 from $135,000 for the year ended December 31, 2004, due to higher disposition costs associated with foreclosed real estate properties. Items processing expense decreased $97,000, or 38.65%, to $154,000 for the year ended December 31, 2005 from $251,000 for the year ended December 31, 2004. The Corporation entered into a new items processing contract that was effective January 1, 2005 that reduced the long term expense for processing demand accounts. Telephone expense increased $30,000, or 20.27%, to $178,000 for the year ended December 31, 2005 from $148,000 for the year ended December 31, 2004 due to installation charges incurred for two new banking center systems and prior year expense credits received on the purchase of new equipment. Other operating expense increased 10.03%, or $68,000, for the year ended December 31, 2005 compared to the year ended December 31, 2004 due primarily to higher costs for stock listing services as a result of increasing authorized outstanding shares from 2,500,000 to 5,000,000 and increased courier service expense due to higher fuel costs.

UNION FINANCIAL BANCSHARES, INC.

9

Income Tax Expense

The effective income tax rate for the Corporation was 27.04% for the year ended December 31, 2005 compared to 25.06% for the year ended December 31, 2004. The increase was due to the higher level of taxable versus to non-taxable income for the year ended December 31, 2005 compared to the year ended December 31, 2004.

Comparison of Years Ended December 31, 2004 and September 30, 2003

Net income increased $297,000 or 15.98% from $1,859,000 for the year ended September 30, 2003 to $2,156,000 for the year ended December 31, 2004. Earnings per share were $1.10 per share (basic) and $1.05 per share (diluted) for the year ended December 31, 2004 compared to $.95 per share (basic) and $.90 per share (diluted) for the year ended September 30, 2003. (In 2003, the Corporation changed its year end from September 30 to December 31.)

Interest Income

Total interest income increased $28,000, or 0.17%, from $16,924,000 in year ended September 30, 2003 to $16,952,000 in the year ended December 31, 2004. Interest income on loans decreased $515,000, or 4.72%, from $10,914,000 in 2003 to $10,399,000 in 2004 due primarily to declining market interest rates along with a shift in the loan portfolio toward variable and prime-based loan products. The Corporation’s continued focus on variable and prime-based lending resulted in net growth in consumer and commercial loans of 20.55% while net residential mortgage loans declined 3.76%. Interest income on deposits, federal funds sold and investment securities increased $543,000, or 9.03%, from $6,010,000 in 2003 to $6,553,000 in 2004. The increase was due primarily to increased investments in government agency securities, offset by lower volumes of mortgage-backed securities.

Interest Expense

Interest expense decreased 16.73% to $7,246,000 in 2004 from $8,702,000 in 2003. Interest expense decreased $757,000 for deposits and decreased $699,000 for other borrowings and floating rate junior subordinated deferrable interest debentures. Interest expense for deposits decreased due primarily to lower deposit rates from a declining interest rate environment. In addition, the Corporation increased lower-cost transaction account balances by 29.0% while traditional higher-cost certificate of deposit account balances decreased 4.68%. The overall increase in deposits was primarily from the Rock Hill, South Carolina banking center that was established in late 2003. Interest expense on other borrowings decreased due to lower interest rates during the year, offset by a higher level of borrowings that were utilized to fund growth.

Provision for Loan Loss

Provisions for loan losses are charges to earnings to bring the total allowance for loan losses to a level considered by management as adequate to provide for estimated loan losses based on management’s evaluation of the collectibility of the loan portfolio. The allowance for loan loss calculation included a segmentation of loan categories subdivided by residential mortgage, commercial and consumer loans. Each category was risk rated for all loans including performing groups. The weight assigned to each performing group was developed from a three-year historical average loan loss experience ratio and as the loss experience changes, the category weight was adjusted accordingly. In addition to loan loss experience, management’s evaluation of the loan portfolio included the market value of the underlying collateral, growth and composition of the loan portfolio, delinquency trends and economic conditions. Management evaluated the carrying value of loans periodically, and the allowance for loan losses was adjusted accordingly. The increased allowance reflected the Corporation’s continued movement from longer term, fixed rate residential loans to shorter term, floating rate consumer and commercial loans. Consumer and commercial loans carry higher risk weighted rates in the allowance calculation as compared to residential mortgage loans. The provision for loan losses increased from $725,000 in fiscal 2003 to $1,250,000 in fiscal 2004. The allowance for loan losses increased $184,000 to $2,026,000 as of December 31, 2004 compared to $1,842,000 as of September 30, 2003. Non-performing loans decreased $2,304,000 from $3,054,000 at September 30, 2003 to $750,000 at December 31, 2004. At December 31, 2004, impaired loans totaled $197,000 compared to $718,000 at September 30, 2003.

The Corporation experienced loan charge-offs, net of recoveries, of approximately $1,607,000 in the year ended December 31, 2004 compared to $254,000 for the year ended September 30, 2003. The loan charge-offs in 2004 included approximately $1,306,000 from three commercial loans that were charged off after the loans were determined to be uncollectible. The allowance for loan losses to total loans at December 31, 2004 was 1.18% compared to 1.19% at September 30, 2003. The allowance for loan losses to non-performing loans at December 31, 2004 was 270.13% compared to 60.32% at September 30, 2003.

UNION FINANCIAL BANCSHARES, INC.

10

Non-Interest Income

Non-interest income increased 1.10% to $2,561,000 for the year ended December 31, 2004 from $2,533,000 for the year ended September 30, 2003. Fees for financial services increased $338,000 to $2,472,000, primarily due to higher fees related to checking account products along with the growth of the Rock Hill, South Carolina banking center that was opened in the third quarter of 2003. Other fee income, net increased $277,000 to $65,000 for the year ended December 31, 2004 from $(212,000) for the year ended September 30, 2003. The increase in other fees was due to the amortization of servicing expense with all costs being fully amortized in the previous year. Mortgage banking fees from the gain on sale of loans for the year ended December 31, 2004 was $95,000 compared to $40,000 for the year ended September 30, 2003 as the Corporation sold $10,215,000 in fixed rate mortgage loans during the year as part of its interest rate risk strategies. The sales represented loans funded and sold through a third party on a servicing released basis. Gain on sale of investments was $24,000 for the year ended December 31, 2004 compared to $611,000 for the year ended September 30, 2003. The gain on sale of investments for the previous year was the result of the sale of investments with higher interest rate sensitivity, which helped to improve the interest rate risk exposure for the Corporation.

Non-Interest Expense

Non-interest expense increased 7.10% to $8,140,000 for the year ended December 31, 2004 from $7,600,000 for the year ended September 30, 2003. On June 16, 2003, the Corporation opened its Rock Hill, South Carolina regional banking center and, therefore, expense categories for 2004 reflected additions for the new banking center. Compensation and employee benefits increased 9.12%, or $314,000, from the year ended September 30, 2003 compared to the year ended December 31, 2004 due primarily to the staff additions for the new branch. Occupancy and equipment expenses increased 6.17%, or $118,000, to $2,032,000 for the year ended December 31, 2004 from $1,914,000 for the year ended September 30, 2003 due to higher rent expense for the new branch. Professional services expense decreased 18.57%, or $70,000, from the year ended September 30, 2003 to the year ended December 31, 2004 due to lower legal expense as a result of the previous year’s costs including expenses for the Corporation’s conversion to a national bank charter. Advertising and public relations expense decreased 23.11%, or $49,000, from the year ended September 30, 2003 to the year ended December 31, 2004 due to the previous promotional costs incurred in the previous year related to the new banking center opening. Loan operations costs increased $77,000, or 132.76%, to $135,000 for the year ended December 31, 2004 from $58,000 for the year ended September 30, 2003, due to higher disposition costs associated with foreclosed real estate properties. Items processing expense increased $28,000, or 12.56%, to $251,000 for the year ended December 31, 2004 from $223,000 for the year ended September 30, 2003, due to an increase in demand accounts. Telephone expense increased $26,000, or 21.31%, to $148,000 for the year ended December 31, 2004 from $122,000 for the year ended September 30, 2003 due primarily to the new banking center opening. Other operating expense increased 17.10%, or $99,000, for the year ended December 31, 2004 compared to the year ended September 30, 2003 due primarily to higher general expenses that resulted from the new branch opening in York County.

Income Tax Expense

The effective income tax rate for the Corporation was 25.06% for the twelve month period ended December 31, 2004 compared to 23.50% for the year ended September 30, 2003. The increase was due to the higher level of taxable versus non-taxable income for the year ended December 31, 2004 compared to the year ended September 30, 2003.

Financial Condition, Liquidity and Capital Resources

Financial Condition

Assets

At December 31, 2005, the Corporation’s assets totaled $371,042,000, an increase of $19,444,000, or 5.53%, as compared to $351,598,000 at December 31, 2004. Cash and due from banks decreased $4,817,000 to $8,380,000 from $13,197,000 at December 31, 2004. The reduction was utilized to fund growth in investment securities and loans. Investment and mortgage-backed securities increased $2,789,000 to $146,283,000 from $143,494,000 at December 31, 2004. During 2005, the Corporation reduced its exposure to government equity securities with sales of approximately $1,000,000 that resulted in remaining securities of approximately $1,200,000.

Total loans, net, increased $21,483,000, or 12.56%, to $192,577,000 at December 31, 2005 from $171,094,000 at December 31, 2004. The net change in the loan portfolio balance includes a reduction in residential mortgage loans that reflects the Corporation’s movement toward higher yielding consumer and commercial loans through the use of specialized loan officers and products that are intended to provide improvements in interest rate risk exposure. Consumer and commercial loans during this period increased $27,236,000, or 21.12%, while residential mortgage loans decreased $5,977,000 or 12.61%.

UNION FINANCIAL BANCSHARES, INC.

11

Liabilities

Total liabilities increased $20,130,000, or 6.18%, to $345,709,000 at December 31, 2005 from $325,579,000 at December 31, 2004.

Total deposits increased $12,014,000, or 5.28%, from $227,589,000 at December 31, 2004 to $239,603,000 at December 31, 2005. The increase was due primarily to growth in lower cost demand accounts partially offset by a reduction in higher cost certificates of deposit accounts. The Corporation continues to target lower cost demand deposit accounts through media advertising versus traditional higher cost certificates of deposits. Borrowings from the Federal Home Loan Bank (FHLB) increased $12,215,000, or 19.24%, to $75,715,000 at December 31, 2005 from $63,500,000 at December 31, 2004. Securities sold under agreements to repurchase were $20,000,000 at December 31, 2005 compared to $24,000,000 at December 31, 2004. The increase in deposits and borrowings funded the loan growth and security purchases for the year.

Shareholders’ Equity

Shareholders’ equity decreased $686,000, or 2.64%, to $25,333,000 at December 31, 2005 from $26,019,000 at December 31, 2004 due to the payment of $0.40 per share dividends, a $721,000 increase in unrealized losses on securities available for sale and $1,897,000 used to repurchase 108,568 shares, offset by net income of $2,466,000. During fiscal year 2003, the Corporation implemented a share repurchase program under which the Corporation may repurchase up to 5% of outstanding shares. The program was expanded by an additional 5% in fiscal 2004 and 2005.

The shares will be repurchased either through open market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors. Repurchased shares will be held in treasury and will be available for the Corporation’s benefit plans. The repurchase program is expected to improve the Corporation’s operating performance on a per share basis, and enhance, in the long term, the market price per share of the Corporation’s common stock. During 2005, the Corporation repurchased a total of 108,568 shares at a weighted average cost of $17.47 per share for a total of $1,897,000 compared to a repurchased total of 62,699 shares at a weighted average cost of $17.13 per share for a total of $1,074,000 for 2004.

Liquidity

Liquidity is the ability to meet demand for loan disbursements, deposit withdrawals, repayment of debt, payment of interest on deposits and other operating expenses. The primary sources of liquidity are deposits, loan sales and repayments, borrowings, maturities, prepayment and sales of securities and interest payments.

While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit outflows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The primary investing activities of the Corporation are the origination of commercial and consumer loans and the purchase of investment and mortgage-backed securities. These activities are funded primarily by principal and interest payments on loans and investment securities, deposit growth, securities sold under agreements to repurchase, and the utilization of FHLB advances. During the year ended December 31, 2005, the Corporation’s loan originations totaled $88,311,000. At December 31, 2005, the Corporation’s investment in investment and mortgage-backed securities totaled $146,283,000, $143,079,000 of which was available for sale. Approximately $83,170,000 and $62,396,000 of investment securities at December 31, 2005 and December 31, 2004, respectively, were pledged as collateral to secure deposits of the State of South Carolina, and Union, Laurens and York counties along with additional borrowings and repurchase agreements.

During the year ended December 31, 2005, total deposits increased $12,014,000. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by the Corporation and its local competitors and other factors. The Corporation closely monitors its liquidity position on a daily basis. Certificates of deposit, which are scheduled to mature in one year or less from December 31, 2005, totaled $103,934,000. The Corporation relies primarily on competitive rates, customer service, and long-standing relationships with customers to retain deposits. From time to time, the Corporation will also offer competitive special products to its customers to increase retention and to attract new deposits. Based upon the Corporation’s experience with deposit retention and current retention strategies, management believes that, although it is not possible to predict future terms and conditions upon renewal, a significant portion of such deposits will remain with the Corporation. If the Corporation requires funds beyond its ability to generate them internally, additional sources of funds are available through FHLB advances and lines of credit. At December 31, 2005, the Corporation had outstanding $75,715,000 of FHLB borrowings and $20,000,000 of securities sold under agreements to repurchase. At December 31, 2005, the Corporation had unused short-term lines of credit to purchase federal funds from unrelated banks totaling $14,200,000 and the ability to borrow an additional $15,000,000 from secured borrowing lines. Lines of credit are available on a one-to-ten day basis for general purposes of the Corporation. All of the lenders have reserved the right to withdraw these lines at their option.

See Note 14 to the consolidated financial statements for further information about commitments and contingencies.

UNION FINANCIAL BANCSHARES, INC.

12

Capital Resources

At December 31, 2005, the Bank exceeded the Comptroller of the Currency’s (the “OCC”) and the Federal Reserve Bank’s (the “FRB”) capital requirements. See Note 16 to the consolidated financial statements for further discussion of these capital requirements.

The following table sets forth information relating to the Company’s payments due under contractual obligations at December 31, 2005.

Contractual Obligations	Payments due by period
	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Floating rate junior subordinated deferrable interest debentures	$	8,247,000	$	—	$	—	$	—	$	8,247,000
Advances from the Federal Home Loan Bank		75,715,000		33,215,000		8,000,000		7,500,000		27,000,000
Securities sold under agreements to repurchase		20,000,000		15,000,000		5,000,000		—		—
Facilities lease commitments		4,099,212		293,940		587,880		587,880		2,629,512
Total	$	108,061,212	$	48,508,940	$	13,587,880	$	8,087,880	$	37,876,512

Off-Balance Sheet Risk

In the normal course of operations, the Corporation engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in its financial statements. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are used primarily to manage customer’s requests for funding and take the form of legally binding agreements to lend money to customers at predetermined interest rates for a specified period of time. Outstanding loan commitments (including commitments to fund credit lines) totaled $47,475,000 at December 31, 2005. Management of the Corporation anticipates that it will have sufficient funds available to meet its current loan commitments. Each customer’s credit worthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on the credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, commercial and residential real estate. The credit risk on these commitments is managed by subjecting each customer to normal underwriting and risk management processes.

At December 31, 2005, the undisbursed portion of construction loans was $1,980,000 and the unused portion of credit lines was $42,586,000. Funding for these commitments is expected to be provided from deposits, loan and mortgage-backed securities principal repayments, maturing investments and income generated from operations.

For the year ended December 31, 2005, the Corporation did not engage in any off-balance sheet transactions reasonably likely to have a material effect on its financial condition, results of operation and cash flows.

Impact of Inflation and Changing Prices

The financial statements and related data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. Unlike industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, non-interest expenses do reflect general levels of inflation.

UNION FINANCIAL BANCSHARES, INC.

13

	200 East Broad Street P.O. Box 6286
	Greenville. SC 29606-6286
	Phone 864.242.3370
	Fax 864.232.7161

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors

Union Financial Bancshares, Inc. and Subsidiaries

Union, South Carolina

We have audited the accompanying consolidated balance sheets of Union Financial Bancshares, Inc. and Subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ equity and comprehensive income, and cash flows for the years ended December 31, 2005 and 2004, the three months ended December 31, 2003 and the year ended September 30, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Union Financial Bancshares, Inc. and Subsidiaries as of December 31, 2005 and 2004 and the results of their operations and their cash flows for the years ended December 31, 2005 and 2004, the three months ended December 31, 2003 and the year ended September 30, 2003, in conformity with accounting principles generally accepted in the United States of America.

Greenville, South Carolina

January 13, 2006

UNION FINANCIAL BANCSHARES, INC.

14

UNION FINANCIAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	As of December 31,
	2005			2004
	(In Thousands)
Assets:
Cash and due from banks	$	8,380		$	13,197
Investment and mortgage-backed securities
Held to maturity (market value of $3,247,000 and $1,688,000 at December 31, 2005 and 2004)		3,204			1,630
Available for sale (at fair value)		143,079			141,864
Total investment and mortgage-backed securities		146,283			143,494
Loans, net		192,577			171,094
Federal Home Loan Bank stock, at cost		3,976			3,522
Federal Reserve Bank stock, at cost		539			539
Office properties and equipment, net		5,148			5,635
Accrued interest receivable		2,429			2,068
Intangible assets		3,576			4,212
Cash surrender value of life insurance		5,404			5,206
Other assets		2,730			2,631
Total assets	$	371,042		$	351,598
Liabilities:
Deposits	$	239,603		$	227,589
Advances from the Federal Home Loan Bank		75,715			63,500
Securities sold under agreements to repurchase		20,000			24,000
Floating rate junior subordinated deferrable interest debentures		8,247			8,247
Accrued interest payable		520			333
Other liabilities		1,624			1,910
Total liabilities		345,709			325,579
Commitments and contingencies - note 14
Shareholders’ equity:
Serial preferred stock, no par value, authorized - 500,000 shares, issued and outstanding – None
Common stock - $0.01 par value, authorized - 5,000,000 shares issued and outstanding - 1,905,897 shares at December 31, 2005 and 1,957,989 shares at December 31, 2004		20			20
Additional paid-in capital		12,346			12,109
Accumulated other comprehensive income (loss)		(612	)		109
Retained earnings, substantially restricted		16,916			15,221
Treasury stock, at cost		(3,337	)		(1,440	)
Total shareholders’ equity		25,333			26,019
Total liabilities and shareholders’ equity	$	371,042		$	351,598

See notes to consolidated financial statements.

UNION FINANCIAL BANCSHARES, INC.

15

UNION FINANCIAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

	Years Ended December 31,					Three Months Ended December 31,			Year Ended September 30,
	2005			2004		2003			2003
	(In Thousands, Except Share Data)
Interest Income:
Loans	$	12,666		$	10,399	$	2,433		$	10,914
Deposits and federal funds sold		126			40		21			23
Securities available for sale:
State and municipal (non taxable)		869			930		251			881
Other investments (taxable)		5,252			5,400		1,052			4,952
Securities held to maturity and FHLB/FRB stock dividends		300			183		30			154
Total interest income		19,213			16,952		3,787			16,924
Interest Expense:
Deposit accounts		5,248			3,903		1,031			4,660
Floating rate junior subordinated deferrable interest debentures		576			426		100			415
Advances from the FHLB and other borrowings		3,146			2,917		1,174			3,627
Total interest expense		8,970			7,246		2,305			8,702
Net Interest Income		10,243			9,706		1,482			8,222
Provision for loan losses		869			1,250		725			725
Net interest income after provision for loan losses		9,374			8,456		757			7,497
Non-Interest Income:
Fees for financial services		2,533			2,472		554			2,134
Other fees, net		58			65		(142	)		(212	)
Net gain (loss) on sale of investments		(48	)		24		(695	)		611
Total non-interest income (loss)		2,543			2,561		(283	)		2,533
Non-Interest Expense:
Compensation and employee benefits		4,059			3,758		1,014			3,444
Occupancy and equipment		2,015			2,032		550			1,914
Deposit insurance premiums		32			32		6			35
Professional services		349			307		92			377
Advertising and public relations		167			163		78			212
Loan operations		201			135		69			58
Telephone		178			148		49			122
Items processing		154			251		59			223
Intangible amortization		636			636		159			636
Other		746			678		250			579
Total non-interest expense		8,537			8,140		2,326			7,600
Income (loss) before income taxes		3,380			2,877		(1,852	)		2,430
Provision (benefit) for income taxes		914			721		(642	)		571
Net income (loss)	$	2,466		$	2,156		($1,210	)	$	1,859
Net income (loss) per common share (basic)	$	1.29		$	1.10		($0.62	)	$	0.95
Net income (loss) per common share (diluted)	$	1.26		$	1.05		($0.62	)	$	0.90
Cash dividends per common share	$	0.40		$	0.40	$	0.10		$	0.40
Weighted average number of common shares outstanding (Basic)		1,914,357			1,957,760		1,967,217			1,963,775
Weighted average number of common shares outstanding (Diluted)		1,962,920			2,044,137		1,967,217			2,056,579

See notes to consolidated financial statements.

UNION FINANCIAL BANCSHARES, INC.

16

UNION FINANCIAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

	Common Stock			Additional Paid-In Capital		Retained Earnings Substantially Restricted		Accumulated Other Comprehensive Income (Loss)		Treasury Stock At Cost		Total Shareholders’ Equity
	Shares	Amount
	(In Thousands, Except Share Data)
Balance at September 30, 2002	1,958,069	$	20	$	11,573	$	14,184	$	1,421	$	—	$	27,198
Net income	—		—		—		1,859		—		—		1,859
Other comprehensive income, net of tax
Unrealized holding losses arising during period	—		—		—		—		(2,443)		—		(2,443)
Less reclassification adjustment for gains included in net income	—		—		—		—		467		—		467
Comprehensive loss													(117)
Stock option activity	19,889		—		179		—		—		—		179
Dividend plan contributions	7,431		—		110		—		—		—		110
Share repurchase program	(20,286)		—		—		—		—		(366)		(366)
Cash dividend ($.40 per share)	—		—		—		(788)		—		—		(788)
Balance at September 30, 2003	1,965,103	$	20	$	11,862	$	15,255		($555)		$(366)	$	26,216
Net loss	—		—		—		(1,210)		—		—		(1,210)
Other comprehensive income, net of tax
Unrealized holding gains arising during period	—		—		—		—		1,108		—		1,108
Less reclassification adjustment for losses included in net income	—		—		—		—		(454)		—		(454)
Comprehensive loss													(654)
Stock option activity	3,006		—		17		—		—		—		17
Dividend plan contributions	1,661		—		27		—		—		—		27
Cash dividend ( $.10 per share)	—		—		—		(197)		—		—		(197)
Balance at December 31, 2003	1,969,770	$	20	$	11,906	$	13,848	$	99		$(366)	$	25,507

UNION FINANCIAL BANCSHARES, INC.

17

UNION FINANCIAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (CONTINUED)

	Common Stock				Additional Paid-In Capital		Retained Earnings Substantially Restricted			Accumulated Other Comprehensive Income (Loss)			Treasury Stock At Cost		Total Shareholders’ Equity
	Shares		Amount
	(In Thousands, Except Share Data)
Balance at December 31, 2003	1,969,770		$	20	$	11,906	$	13,848		$	99		($366	)	$	25,507
Net income	—			—		—		2,156			—		—			2,156
Other comprehensive income, net of tax
Unrealized holding losses arising during period	—			—		—		—			(8	)	—			(8	)
Less reclassification adjustment for gains included in net income	—			—		—		—			18		—			18
Comprehensive income																2,166
Stock option activity, net	44,174			—		93		—			—		—			93
Dividend plan contributions	6,744			—		110		—			—		—			110
Share repurchase program	(62,699	)		—		—		—			—		(1,074	)		(1,074	)
Cash dividend ($.40 per share)	—			—		—		(783	)		—		—			(783	)
Balance at December 31, 2004	1,957,989		$	20	$	12,109	$	15,221		$	109		($1,440	)	$	26,019
Net income	—			—		—		2,466			—		—			2,466
Other comprehensive income, net of tax
Unrealized holding losses arising during period	—			—		—		—			(690	)	—			(690	)
Less reclassification adjustment for losses included in net income	—			—		—		—			(31	)	—			(31	)
Comprehensive income																1,745
Stock option activity, net	50,339			—		129		—			—		—			129
Dividend plan contributions	6,137			—		108		—			—		—			108
Share repurchase program	(108,568	)		—		—		—			—		(1,897	)		(1,897	)
Cash dividend ($.40 per share)	—			—		—		(771	)		—		—			(771	)
Balance at December 31, 2005	1,905,897		$	20	$	12,346	$	16,916			($612)		($3,337)		$	25,333

See notes to consolidated financial statements.

UNION FINANCIAL BANCSHARES, INC.

18

UNION FINANCIAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
	(In Thousands)
Operating activities:
Net income (loss)	$	2,466		$	2,156			($1,210)		$	1,859
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Provision for loan losses		869			1,250			725			725
Amortization expense		636			636			159			1,176
Depreciation expense		824			979			264			1,048
Recognition of deferred income, net of costs		(395	)		(345	)		(37	)		(137	)
Deferral of fee income, net of costs		417			348			22			152
(Gain) loss on investments		48			(24	)		695			(611	)
(Increase) decrease in accrued interest receivable		(361	)		(413	)		272			(199	)
(Increase) decrease in other assets		92			(55	)		1,267			(2,496	)
(Decrease) increase in accrued interest payable		187			48			(79	)		(63	)
(Decrease) increase in other liabilities		(286	)		449			(1,251	)		453
Net cash provided by operating activities	$	4,497		$	5,029		$	827		$	1,907

UNION FINANCIAL BANCSHARES, INC.

19

UNION FINANCIAL BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
	(In Thousands)
Investing activities:
Purchase of investment and mortgage-backed securities:
Held to maturity		($4,574	)		($1,630	)	$	—		$	—
Available for sale		(58,246	)		(109,482	)		(5,654	)		(165,521	)
Proceeds from maturity of investment and mortgage-backed securities:
Held to maturity		3,000			—			—			—
Available for sale		31,708			70,594			91			47,071
Proceeds from sale of investment and mortgage-backed securities:
Available for sale		13,401			4,702			30,187			33,672
Principal repayments on mortgage-backed securities:
Available for sale		10,764			16,240			9,025			42,997
Net (increase) decrease in loans		(22,374	)		(17,941	)		(1,721	)		8,525
(Purchase) redemption of FHLB/FRB stock		(454	)		378			—			(1,539	)
Purchase of office properties and equipment		(337	)		(199	)		(316	)		(890	)
Net cash provided by (used in) investing activities		(27,112	)		(37,338	)		31,612			(35,685	)
Financing activities:
Proceeds from the exercise of stock options		129			93			17			179
Proceeds from dividend reinvestment plan		108			110			27			110
Dividends paid in cash		(771	)		(783	)		(197	)		(788	)
Proceeds (repayment) of term borrowings, net		8,215			14,000			(11,500	)		11,000
Share repurchase program		(1,897	)		(1,074	)		—			(366	)
Increase in deposit accounts		12,014			4,458			2,899			19,929
Net cash provided by (used in) financing activities		17,798			16,804			(8,754	)		30,064
Net (decrease) increase in cash and due from banks		(4,817	)		(15,505	)		23,685			(3,714	)
Cash and due from banks at beginning of period		13,197			28,702			5,017			8,731
Cash and due from banks at end of period	$	8,380		$	13,197		$	28,702		$	5,017

See notes to consolidated financial statements.

UNION FINANCIAL BANCSHARES, INC.

20

UNION FINANCIAL BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

Organization - Union Financial Bancshares, Inc. (“Union Financial”) is the bank holding company for Provident Community Bank, N.A., a national bank (“the Bank”). Union Financial and the Bank are collectively referred to as the “Corporation” in this annual report. The Bank, founded in 1934, offers a complete array of financial services through seven full-service banking centers in four counties in South Carolina, including checking, savings, time deposits, individual retirement accounts (IRAs), investment services, and secured and unsecured consumer loans. The Bank originates and services home loans and provides financing for small businesses and affordable housing. In conjunction with the change from a savings bank charter regulated by the Office of Thrift Supervision (“the OTS”) to a commercial banking charter regulated by the Comptroller of the Currency (“the OCC”) that was granted on July 27, 2003, the Board of Directors of Union Financial Bancshares, Inc. on October 21, 2003, changed the fiscal year end of the Corporation from September 30 to December 31, effective December 31, 2003. Accordingly, the consolidated condensed financial statements are presented for the transition period from October 1, 2003 to December 31, 2003.

Accounting Principles - The accounting and reporting policies of the Corporation conform to accounting principles generally accepted in the United States of America and to general practice within the banking industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of commitments and contingencies. Actual results could differ from those estimates. The following summarizes the more significant policies.

Basis of Consolidation - The accompanying consolidated financial statements include the accounts of Union Financial and the Bank. All inter-company amounts and balances have been eliminated in consolidation.

Disclosure Regarding Segments - The Corporation reports as one operating segment, as the chief operating decision-maker reviews the results of operations of the Corporation as a single enterprise.

Advertising - Advertising, promotional, and other business development costs are generally expensed as incurred. External costs incurred in producing media advertising are expensed the first time the advertising takes place. External costs relating to direct mailing costs are expensed in the period in which the direct mailings are sent.

Cash and Due from Banks - Cash and due from banks include cash on hand and amounts due from depository institutions, federal funds sold and short term, interest-earning deposits. From time to time, the Corporation’s cash deposits with other financial institutions may exceed the FDIC insurance limits.

Investments and Mortgage-backed Securities - The Corporation accounts for investment securities in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” In accordance with SFAS 115, debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as “held to maturity” securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling in the near term are classified as “trading” securities and reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held to maturity or trading securities are classified as “available for sale” securities and reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity. No securities have been classified as trading securities.

Purchases and sales of securities are accounted for on a trade date basis. Premiums and discounts on debt securities are amortized or accreted as adjustments to income over the estimated life of the security using a method approximating the level yield method. Gains or losses on the sale of securities are based on the specific identification method. The fair value of securities is based on quoted market prices or dealer quotes. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loans - Loans are recorded at cost. Mortgage loans consist principally of conventional one-to four-family residential loans and interim and permanent financing of non-residential loans that are secured by real estate. Commercial loans are made primarily on the strength of the borrower’s general credit standing, the ability to generate repayment from income sources

UNION FINANCIAL BANCSHARES, INC.

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1. Summary of Significant Accounting Policies (continued)

and the collateral securing such loans. Consumer loans generally consist of home equity loans, automobile and other personal loans. In many lending transactions, collateral is taken to provide an additional measure of security. Generally, the cash flows or earning power of the borrower represents the primary source of repayment, and collateral liquidation serves as a secondary source of repayment. The Corporation determines the need for collateral on a case-by-case or product-by-product basis. Factors considered include the current and prospective credit worthiness of the customer, terms of the instrument and economic conditions.

The Corporation generally originates single-family residential loans within its primary lending area. The Corporation’s underwriting policies require such loans to be 80% loan to value based upon appraised values unless private mortgage insurance is obtained. These loans are secured by the underlying properties. Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at the amount of unpaid principal, reduced by unearned discount and fees and an allowance for loan losses. Unearned interest on loans is amortized to income over the life of the loan, using the interest method. For all other loans, interest is accrued daily on the outstanding balances.

Loan origination and commitment fees and certain direct loan origination costs are deferred and the net amount amortized as an adjustment of the related loan’s yield. The Corporation is generally amortizing these amounts over the contractual life. Commitment fees and costs are generally based upon a percentage of customers’s unused line of credit and are recognized over the commitment period when the likelihood of exercise is remote. If the commitment is subsequently exercised during the commitment period, the remaining unamortized commitment fee at the time of exercise is recognized over the life of the loan as an adjustment of the yield.

For impaired loans, accrual of interest is discontinued on a loan when management believes, after considering collection efforts and other factors, that the borrower’s financial condition is such that collection of interest is doubtful. Cash collections on impaired loans are credited to the loan receivable balance, and no interest income is recognized on those loans until the principal balance has been collected.

The Corporation determines a loan to be delinquent when payments have not been made according to contractual terms, typically evidenced by nonpayment of a monthly installment by the due date. The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent.

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

Allowance for Loan Losses - The Corporation maintains an allowance for loan losses. 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 collectibility of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance.

The allowance is an amount that management believes will be adequate to absorb estimated losses relating to specifically identified loans, as well as probable credit losses inherent in the balance of the loan portfolio, based on an evaluation of the collectibility of existing loans and prior loss experience. This evaluation also takes into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrower’s ability to pay. The allowance for loan loss calculation includes a segmentation of loan categories by residential mortgage, commercial and consumer loans. Each category is rated for all loans. The weights assigned to each performing group are developed from previous loan loss experience and as the loss experience changes, the category weight is adjusted accordingly. As the loan categories increase and decrease in balance, the provision for loan loss calculation will adjust accordingly. The evaluation also includes a component for expected losses on groups of loans that are related to future events or expected changes in economic conditions. While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses, and may require the Corporation to make additions to the allowance based on their judgment about information available to them at the time of their examinations.

UNION FINANCIAL BANCSHARES, INC.

22

1. Summary of Significant Accounting Policies (continued)

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also accounted for as impaired, an allowance 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. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Recovery of the carrying value of loans is dependent to some extent on the future economic environment and operating and other conditions that may be beyond the Corporation’s control. Unanticipated future adverse changes in such conditions could result in material adjustments to allowances (and future results of operation).

Accounting for Impaired Loans - Impaired loans are accounted for in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan.” SFAS No. 114 requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical matter, at the loan’s observable market value or fair value of the collateral if the loan is collateral dependent. If the resulting value of the impaired loan is less than the recorded balance, the impairment must be recognized by creating a valuation allowance for the difference and recognizing a corresponding bad debt expense. The risk characteristics used to aggregate loans are collateral type, borrower’s financial condition and geographic location. SFAS No. 118, “Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures,” amends SFAS No. 114 to allow a creditor to use existing methods for recognizing interest income on an impaired loan and requires additional disclosures about how a creditor recognizes interest income related to impaired loans.

The Corporation generally determines a loan to be impaired at the time management believes that it is probable that the principal and interest may be uncollectible. Management has determined that, generally, a failure to make a payment within a 90-day period constitutes a minimum delay or shortfall and does not generally constitute an impaired loan. However, management reviews each past due loan and may determine a loan to be impaired prior to the loan becoming over 90 days past due, depending upon the circumstances of that particular loan. The Corporation’s policy for charge-off of impaired loans is on a loan-by-loan basis. The Corporation’s policy is to evaluate impaired loans based on the fair value of the collateral. Interest income from impaired loans is recorded using the cash method. At December 31, 2005 and 2004, impaired loans totaled $127,000 and $197,000 respectively, and the Corporation had recognized no interest income from impaired loans. The average balance in impaired loans was $162,000 for 2005 and $322,000 for 2004.

Office Properties and Equipment - Office properties and equipment are presented at cost less accumulated depreciation. Depreciation is provided on the straight-line basis over the estimated useful lives of the assets. Estimated useful lives are 20-39 years for buildings and improvements and generally five to ten years for furniture, fixtures and equipment.

The cost of maintenance and repairs is charged to expense as incurred, and improvements and other expenditures, which materially increase property lives, are capitalized. The costs and accumulated depreciation applicable to office properties and equipment retired or otherwise disposed of are eliminated from the related accounts, and any resulting gains or losses are credited or charged to income.

Securities Sold Under Agreements to Repurchase - The Corporation enters into sales of securities under agreements to repurchase. Fixed-coupon reverse repurchase agreements are treated as financings, with the obligations to repurchase securities sold being reflected as a liability and the securities underlying the agreements remaining as an asset. The securities are delivered by appropriate entry by the Corporation’s safekeeping agent to the counterparties’ accounts. The dealers may have sold, loaned or otherwise disposed of such securities to other parties in the normal course of their operations, and have agreed to resell to the Corporation substantially identical securities at the maturities of the agreements.

Federal Home Loan Bank Stock - The Bank, as a member institution of Federal Home Loan Bank of Atlanta (“FHLB”) , is required to own capital stock in the FHLB based generally upon the Bank’s balances of residential mortgage loans and FHLB advances. No ready market exists for this stock and it has no quoted market value. However, redemption of this stock historically has been at par value. The Bank carries this investment at its original cost.

UNION FINANCIAL BANCSHARES, INC.

23

1. Summary of Significant Accounting Policies (continued)

Federal Reserve Bank Stock - The Bank, as a member institution of Federal Reserve Bank of Richmond (“FRB”), is required to own capital stock in the FRB based upon the Bank’s capital and surplus. No ready market exists for this stock and it has no quoted market value. However, redemption of this stock historically has been at par value. The Bank carries this investment at its original cost.

Real Estate Acquired Through Foreclosure - Real estate acquired through foreclosure is stated at the lower of cost or estimated fair value less estimated costs to sell. Any accrued interest on the related loan at the date of acquisition is charged to operations. Costs relating to the development and improvement of property are capitalized to the extent that such costs do not exceed the estimated fair value less selling costs of the property, whereas those relating to holding the property are charged to expense. Real estate acquired through foreclosure is included in other assets on the balance sheet.

Intangible Assets - Intangible assets consist of core deposit premiums resulting from Provident Community Bank’s branch acquisitions in 1997 and 1999 and the excess of cost over the fair value of net assets resulting from the acquisition of South Carolina Community Bancshares, Inc. in 1999.

Goodwill and identified intangible assets with indefinite lives related to acquisitions are not subject to amortization. Core deposit intangible assets are amortized over their estimated useful lives using methods that reflect the pattern in which the economic benefits are utilized.

The Corporation’s unamortized goodwill and other intangible assets are reviewed annually to determine whether there have been any events or circumstances to indicate that the recorded amount is not recoverable from projected undiscounted net operating cash flows. If the projected undiscounted net operating cash flows are less than the carrying amount, a loss is recognized to reduce the carrying amount to fair value, and when appropriate, the amortization period is also reduced.

Interest Income - Interest on loans is accrued and credited to income monthly based on the principal balance outstanding and the contractual rate on the loan. The Corporation places loans on non-accrual status when they become greater than 90 days delinquent or when in the opinion of management, full collection of principal or interest is unlikely. All interest that was accrued prior to the loan being placed on non-accrual status is automatically reversed after the 90 delinquency period. The loans are returned to an accrual status when full collection of principal and interest appears likely.

Income Taxes - The Corporation accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes”. Under SFAS No. 109, deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is established for deferred tax assets that may not be realized. Also, SFAS No. 109 eliminates, on a prospective basis, the exception from the requirement to record deferred taxes on tax basis bad debt reserves in excess of the base year amounts. The tax basis bad debt reserve that arose prior to the fiscal year 1988 (the base year amount) is frozen, and the book reserves at that date and all subsequent changes in book and tax basis reserves are included in the determination of deferred taxes.

Per-Share Data - - SFAS No. 128, “Earnings Per Share,” requires the dual presentation of basic and diluted earnings per share on the face of the income statement. Basic earnings per share is computed by dividing net income by the weighted-average number of shares outstanding for the period. Diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. The dilutive effect of options outstanding under Union Financial’s stock option plan is reflected in diluted earnings per share by the application of the treasury stock method. Common stock equivalents included in the diluted earnings per share calculation at December 31, 2005 were 48,563 compared to 86,420 at December 31, 2004.

Fair Values of Financial Instruments - The following methods and assumptions were used by the Corporation in estimating fair values of financial instruments as disclosed herein:

Cash and short-term instruments - The carrying amounts of cash and short-term instruments approximate their fair value.

UNION FINANCIAL BANCSHARES, INC.

24

1. Summary of Significant Accounting Policies (continued)

Available for sale and held to maturity securities - Fair values for securities are based on quoted market prices. The carrying values of restricted equity securities approximate fair values.

Loans - For variable rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans (for example, one-to four-family residential), credit-card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. Fair values for commercial real estate and commercial loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable.

Cash surrender value of life insurance - The carrying amounts of cash surrender values of life insurance approximate their fair value.

Deposit liabilities - The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate, fixed-term money-market accounts and certificates of deposit (CDs) approximate their fair values at the reporting date. Fair values for fixed-rate CDs are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Advances from the FHLB and other borrowings - The fair values of the Corporation’s borrowings are estimated using discounted cash flow analysis based on the Corporation’s current incremental borrowing rates for similar types of borrowing arrangements.

Accrued interest - The carrying amounts of accrued interest approximate their fair values.

Floating rate junior subordinated deferrable interest debentures - The fair values of the Corporation’s floating rate debentures are estimated using discounted cash flow analysis based on the Corporation’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-balance-sheet instruments - Fair values for off-balance-sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter parties’ credit standings.

Risks and Uncertainties - In the normal course of its business, the Corporation encounters two significant types of risk: economic and regulatory. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Corporation is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets.

Credit risk is the risk of default on the Corporation’s loan portfolio that results from the borrowers’ inability or unwillingness to make contractually required payments. Credit risk also applies to investment securities and mortgage-backed securities should the issuer of the security be unable to make principal and interest payments. Market risk reflects changes in the value of collateral underlying loans receivable, the valuation of real estate held by the Corporation and the valuation of investment securities.

The Corporation is subject to the regulations of various government agencies. These regulations can and do change significantly from period to period. The Corporation also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances and operating restrictions resulting from the regulators’ judgments based on information available to them at the time of their examination.

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods covered. Actual results could differ from those estimates and assumptions.

UNION FINANCIAL BANCSHARES, INC.

25

1. Summary of Significant Accounting Policies (continued)

Reclassifications - Certain amounts in prior years’ financial statements have been reclassified to conform with current year classifications. These reclassifications had no effect on previously reported net income (loss) or shareholders’ equity.

Stock-Based Compensation - The Corporation has adopted the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” The statement permits the Corporation to continue accounting for stock-based compensation as set forth in Accounting Principles Board (“APB”) Opinion 25, Accounting for Stock Issued to Employees, provided the Corporation discloses the pro forma effect on net income and earnings per share of adopting the full provisions of SFAS No. 123. Accordingly, the Corporation continues to account for stock based compensation under APB Opinion 25 and has provided the required pro forma disclosures. On January 1, 2006, the Corporation adopted the provisions of SFAS 123 (R). See Note 17 for further discussion

The Corporation has a stock option plan through which the Board of Directors may grant stock options to officers and employees to purchase common stock of the Corporation at prices not less than 100 % of the fair market value on the date of grant. The outstanding options expire ten years from the date of grant. The Corporation has elected the disclosure-only provision of SFAS No. 123. Accordingly, no compensation cost has been charged to operations. Had compensation cost for the plan been determined based on the fair value at the grant dates for awards under the plan consistent with the accounting method available under SFAS No. 123, the Corporation’s net income (loss) and net income (loss) per common share would have been reduced to the pro forma amounts indicated below:

	Years Ended December 31,						Three Months Ended December 31,		Year Ended September 30,
	2005			2004			2003		2003
Net income (loss)(in thousands)
As reported	$	2,466		$	2,156		($1,210	)	$	1,859
Deduct: total stock based employee compensation cost determined under fair value based method, net of related tax effects		(191	)		(77	)	(19	)		(54	)
Pro forma net income (loss)	$	2,275		$	2,079		($1,229	)	$	1,805
Basic net income (loss) per common share
As reported	$	1.29		$	1.10		($0.62	)	$	0.95
Pro forma	$	1.19		$	1.06		($0.62	)	$	0.92
Diluted net income (loss) per common share
As reported	$	1.26		$	1.05		($0.62	)	$	0.90
Pro forma	$	1.16		$	1.02		($0.62	)	$	0.87

UNION FINANCIAL BANCSHARES, INC.

26

1. Summary of Significant Accounting Policies (continued)

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for grants:

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
Weighted average fair value of options granted	$	4.29		$	—		$	5.26		$	3.69
Dividend yield		2.5	%		—	%		2.0	%		4.0	%
Expected volatility		20	%		—	%		25.0	%		25.0	%
Risk-free interest rate		4.5	%		—	%		5.0	%		5.0	%
Expected lives		10 years			—			10 years			10 years

2. Investment and Mortgage-backed Securities

Held to Maturity - - Securities classified as held to maturity consisted of the following (in thousands):

	As of December 31, 2005
	Amortized Cost		Gross Unrealized					Fair Value
			Gains		Losses
Municipal Securities	$	3,204	$	46	$	(3	)	$	3,247

Available for Sale - Securities classified as available for sale consisted of the following (in thousands):

	As of December 31, 2005
	Amortized Cost		Gross Unrealized					Fair Value
			Gains		Losses
Investment Securities:
U.S. Agency Obligations	$	84,631	$	13	$	(1,201	)	$	83,443
Municipal Securities		17,328		854		(2	)		18,180
Other		14,530		153		(62	)		14,621
Total Investment Securities		116,489		1,020		(1,265	)		116,244
Mortgage-backed Securities:
Fannie Mae		17,370		5		(604	)		16,771
Ginnie Mae		67		2		—			69
Freddie Mac		4,572		29		(22	)		4,579
Collateralized Mortgage Obligations		5,523		—		(107	)		5,416
Total Mortgage-backed Securities		27,532		36		(733	)		26,835
Total available for sale	$	144,021	$	1,056	$	(1,998	)	$	143,079

UNION FINANCIAL BANCSHARES, INC.

27

2. Investment and Mortgage-backed Securities (continued)

Held to Maturity - Securities classified as held to maturity consisted of the following (in thousands):

	As of December 31, 2004
	Amortized Cost		Gross Unrealized				Fair Value
			Gains		Losses
Municipal Securities	$	1,630	$	58	$	—	$	1,688

Available for Sale - Securities classified as available for sale consisted of the following (in thousands):

	As of December 31, 2004
	Amortized Cost		Gross Unrealized					Fair Value
			Gains		Losses
Investment Securities:
U.S. Agency Obligations	$	72,202	$	97		($751	)	$	71,548
Municipal Securities		19,471		1,073		—			20,544
Other		10,964		152		(240	)		10,876
Total Investment Securities		102,637		1,322		(991	)		102,968
Mortgage-backed Securities:
Fannie Mae		24,408		117		(313	)		24,212
Ginnie Mae		99		5		—			104
Freddie Mac		7,295		95		(8	)		7,382
Collateralized Mortgage Obligations		7,257		—		(59	)		7,198
Total Mortgage-backed Securities		39,059		217		(380	)		38,896
Total available for sale	$	141,696	$	1,539	($	1,371	)	$	141,864

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

	Less than 12 Months				12 Months or More				Total
Securities Available for Sale	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Agency Obligations	$	31,957	$	206	$	46,482	$	995	$	78,439	$	1,201
Municipal Securities		608		2		—		—		608		2
Other		3,996		30		2,466		32		6,462		62
Mortgage-backed Securities		1		—		23,693		733		23,694		733
Total	$	36,562	$	238	$	72,641	$	1,760	$	109,203	$	1,998

Proceeds, gross gains and gross losses realized from the sales, calls and prepayments of available for sale securities were as follows for the periods ended (in thousands):

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
Proceeds	$	13,401		$	4,702		$	30,187		$	33,672
Gross gains	$	6		$	32		$	—		$	611
Gross losses		(54	)		(8	)		(695	)		—
Net gain (loss) on investment transactions	$	(48	)	$	24			($695)		$	611

UNION FINANCIAL BANCSHARES, INC.

28

2. Investment and Mortgage-backed Securities (continued)

The maturities of securities at December 31, 2005 are as follows (in thousands):

	Held to Maturity				Available for Sale
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less	$	—	$	—	$	—	$	—
Due after one year through five years		—		—		11,395		11,316
Due after five years through ten years		—		—		72,686		71,640
Due after ten years		3,204		3,247		59,940		60,123
Total investment and mortgage-backed securities	$	3,204	$	3,247	$	144,021	$	143,079

The mortgage-backed securities held at December 31, 2005 mature between one and thirty years. The actual lives of those may be significantly shorter as a result of principal payments and prepayments.

At December 31, 2005 and 2004, $83,170,000 and $62,396,000, respectively, of securities were pledged as collateral for certain deposits and borrowings.

At December 31, 2005, approximately $10,801,000 of mortgage-backed securities were adjustable rate securities. The periods range from monthly to annually and rates are adjusted based on the movement of a variety of indices.

Investments in collateralized mortgage obligations (“CMOs”) represent securities issued by agencies of the federal government.

3. Loans, Net

Loans receivable consisted of the following (in thousands):

	As of December 31,
	2005			2004
Mortgage loans:
Fixed-rate residential	$	23,859		$	28,007
Adjustable-rate residential		12,701			15,549
Commercial real estate		45,665			43,351
Construction		4,842			3,823
Total mortgage loans		87,067			90,730
Commercial loans:
Commercial non-real estate		39,453			31,168
Commercial lines of credit		31,215			23,628
Total commercial loans		70,668			54,796
Consumer loans:
Home equity		16,427			14,541
Consumer and installment		23,067			15,879
Consumer lines of credit		382			406
Total consumer loans		39,876			30,826
Total loans		197,611			176,352
Less:
Undisbursed portion of interim construction loans		(1,980	)		(2,363	)
Unamortized loan discount		(764	)		(993	)
Allowance for loan losses		(2,394	)		(2,026	)
Net deferred loan origination costs		104			124
Total, net	$	192,577		$	171,094
Weighted-average interest rate of loans		7.64	%		6.54	%

UNION FINANCIAL BANCSHARES, INC.

29

3. Loans, Net (continued)

Under OCC regulations, the Bank may not make loans to one borrower in excess of 15% of unimpaired capital. This limitation does not apply to loans made before August 9, 1989. At December 31, 2005, the Bank had loans outstanding to one borrower ranging up to $3,270,000.

Adjustable-rate residential real estate loans (approximately $12,701,000 and $15,549,000 at December 31, 2005 and 2004, respectively) are subject to rate adjustments annually and generally are adjusted based on movement of the Federal Home Loan Bank National Monthly Median Cost of Funds rate or the Constant Maturity Treasury index. The maximum loan rates can be adjusted is 200 basis points in any one year with a lifetime cap of 600 basis points.

Non-refundable deferred origination fees and cost and discount points collected at loan closing, net of commitment fees paid, are deferred and recognized at the time of sale of the mortgage loans. Gain or loss on sales of mortgage loans is recognized based upon the difference between the selling price and the carrying amount of the mortgage loans sold. Other fees earned during the loan origination process are also included in net gain or loss on sales of mortgage loans.

Until 2002, the Bank originated both fixed rate and adjustable rate mortgage loans with terms generally ranging from 15 to 30 years and generally sold the loans while retaining servicing on loans originated. The Bank discontinued the origination of loans held for sale in 2002. The underlying value of loans serviced for others were $19,040,000 and $20,654,000 at December 31, 2005 and 2004, respectively.

At December 31, 2005 and 2004, loans which are accounted for on a non-accrual basis or contractually past due ninety days or more totaled approximately $1,246,000 and $750,000, respectively. The amount the Corporation will ultimately realize from these loans could differ materially from their carrying value because of future developments affecting the underlying collateral or the borrower’s ability to repay the loans. During the years ended December 31, 2005 and 2004, the three months ended December 31, 2003 and the year ended September 30, 2003, the Corporation recognized no interest income on loans past due 90 days or more, whereas, under the original terms of these loans, the Corporation would have recognized additional interest income of approximately $92,000, $44,000, $32,000, and $161,000, respectively.

At December 31, 2005 and 2004, impaired loans totaled $127,000 and $197,000 respectively. The average balance in impaired loans was $162,000 for 2005 and $322,000 for 2004.

The changes in the allowance for loan losses consisted of the following (in thousands):

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
Balance at beginning of period	$	2,026		$	2,383		$	1,842		$	1,371
Provision for loan losses		869			1,250			725			725
(Net charge-offs)		(501	)		(1,607	)		(184	)		(254	)
Balance at end of period	$	2,394		$	2,026		$	2,383		$	1,842

Directors and officers of the Corporation are customers of the Corporation in the ordinary course of business. Loans to directors and officers have terms consistent with those offered to other customers. Loans to officers and directors of the Corporation are summarized as follows (in thousands):

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
Balance at beginning of period	$	691		$	644		$	704		$	1,301
Loans originated during the period		145			250			1			38
Loan repayments during the period		(463	)		(203	)		(61	)		(635	)
Balance at end of period	$	373		$	691		$	644		$	704

UNION FINANCIAL BANCSHARES, INC.

30

4. Office Properties and Equipment

Office properties and equipment consisted of the following (in thousands):

	As of December 31,
	2005			2004
Land	$	766		$	766
Building and improvements		4,992			5,015
Office furniture, fixtures and equipment		4,567			5,113
Total		10,325			10,894
Less accumulated depreciation		(5,177	)		(5,259	)
Office properties and equipment , net	$	5,148		$	5,635

Depreciation expense was $824,000, $979,000, $264,000, and $1,048,000 for the years ended December 31, 2005 and 2004, the three months ended December 31, 2003 and the year ended September 30, 2003, respectively.

5. Intangible Assets

Intangible assets consisted of the following (in thousands):

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
Core Deposit Premium
Balance at beginning of year	$	2,684		$	3,320		$	3,479		$	4,115
Amortization		(636	)		(636	)		(159	)		(636	)
Balance at end of year	$	2,048		$	2,684		$	3,320		$	3,479
Goodwill		1,528			1,528			1,528			1,528
Total	$	3,576		$	4,212		$	4,848		$	5,007

6. Deposit Accounts

Deposit accounts at December 31, were as follows (in thousands):

	2005						2004
	Rate		Balance		%		Rate		Balance		%
Account Type
NOW accounts:
Commercial non-interest-bearing			$	14,651	6.11	%			$	13,574	5.96	%
Non-commercial	1.93	%		51,447	21.47	%	0.33	%		22,146	9.73	%
Money market	2.55	%		14,414	6.02	%	1.81	%		26,603	11.69	%
Savings	0.43	%		16,733	6.98	%	0.41	%		17,808	7.83	%
Total demand and savings deposits	1.50	%		97,245	40.58	%	0.71	%		80,131	35.21	%
Savings certificates:
Up to 3.00%				55,105	23.00	%				102,454	45.02	%
3.01 %- 4.00%				56,033	23.38	%				24,522	10.77	%
4.01 %- 5.00%				23,862	9.96	%				12,934	5.68	%
5.01 %- 6.00%				2,720	1.13	%				3,155	1.39	%
6.01 %- 7.00%				23	0.02	%				307	0.14	%
7.01 %- 8.00%				—	0.00	%				188	0.08	%
Total savings certificates	2.75	%		137,743	57.49	%	2.32	%		143,560	63.08	%
Sweep accounts	3.43	%		4,615	1.93	%	1.23	%		3,898	1.71	%
Total deposit accounts	2.57	%	$	239,603	100.00	%	1.87	%	$	227,589	100.00	%

UNION FINANCIAL BANCSHARES, INC.

31

6. Deposit Accounts (continued)

As of December 31, 2005 and 2004, total deposit accounts include approximately $1,722,000 and $1,737,000, respectively, of deposits from the Corporation’s officers, directors, employees or parties related to them.

At December 31, 2005 and 2004, deposit accounts with balances of $100,000 and over totaled approximately $51,658,000 and $51,655,000, respectively.

Savings certificates by maturity were as follows (in thousands):

	As of December 31,
Maturity Date	2005		2004
Within 1 year	$	103,934	$	92,334
After 1 but within 2 years		25,386		42,036
After 2 but within 3 years		6,860		6,508
After 3 but within 4 years		488		1,733
Thereafter		1,075		949
Total savings certificates	$	137,743	$	143,560

Interest expense on deposits consisted of the following (in thousands):

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
Account Type	2005			2004			2003			2003
NOW accounts and money market deposit accounts	$	1,352		$	435		$	71		$	277
Passbook and statement savings accounts		77			72			26			116
Certificate accounts		3,837			3,410			939			4,281
Early withdrawal penalties		(18	)		(14	)		(5	)		(14	)
Total	$	5,248		$	3,903		$	1,031		$	4,660

7. Advances from The Federal Home Loan Bank

At December 31, 2005 and 2004, the Bank had $75,715,000 and $63,500,000, respectively, of advances outstanding from the FHLB. The maturity of the advances from the FHLB is as follows (in thousands):

	As of December 31,
	2005		Wtd Avg Rate		2004		Wtd Avg Rate
Contractual Maturity:
Within one year - fixed rate	$	10,000	2.35	%	$	5,000	2.96	%
Within one year - adjustable rate		23,215	4.08	%		—	—
After one but within three years - fixed rate		3,000	3.35	%		13,000	2.58	%
After one but within three years - adjustable rate		5,000	3.79	%		—	—
After three but within five years - adjustable rate		7,500	5.30	%		23,500	3.04	%
Greater than five years - adjustable rate		27,000	4.24	%		22,000	4.44	%
Total advances	$	75,715	3.98	%	$	63,500	3.42	%

The Bank pledges as collateral to the advances their FHLB stock, investment securities and has entered into a blanket collateral agreement with the FHLB whereby the Bank maintains, free of other encumbrances, qualifying loans (as defined) with unpaid principal balances equal to, when discounted at 50% to 80% of the unpaid principal balances, 100% of total advances. The amount of qualifying loans was $42,721,000 and $37,934,000, respectively, at December 31, 2005 and 2004.

UNION FINANCIAL BANCSHARES, INC.

32

8. Securities Sold Under Agreements to Repurchase

The Company had $20,000,000 and $24,000,000 borrowed under agreements to repurchase at December 31, 2005 and 2004, respectively. The amortized cost of the securities underlying the agreements to repurchase at December 31, 2005 was $23,189,000 and $28,016,000 at December 31, 2004. The maximum amount outstanding at any month end during 2005 was $29,000,000 and $29,000,000 for 2004. The average amount of outstanding agreements for 2005 was $22,789,000 and $21,333,000 for 2004 and the approximate weighted average interest rate was 2.29% in 2005 and 2.82% in 2004.

9. Floating Rate Junior Subordinated Deferrable Interest Debentures

On November 14, 2001, the Corporation sponsored the creation of Union Financial Statutory Trust (“the Trust”). The Corporation is the owner of all of the common securities of the Trust. On December 18, 2001, the Trust issued $8,000,000 in the form of floating rate capital securities through a pooled trust preferred securities offering. The proceeds from this issuance, along with the Corporation’s $247,000 capital contribution for the Trust’s common securities, were used to acquire $8,247,000 aggregate principal amount of the Corporation’s floating rate junior subordinated deferrable interest debentures due December 18, 2031 (the “Debentures”), which constitute the sole asset of the Trust. The interest rate on the Debentures and the capital securities is variable and adjustable quarterly at 3.60% over the three-month LIBOR, with an initial rate of 5.60%. A rate cap of 12.50% is effective through December 18, 2006. The Corporation has, through the Trust agreement establishing the Trust, the Guarantee Agreement, the notes and the related Debenture, taken together, fully irrevocably and unconditionally guaranteed all of the Trust’s obligations under the capital securities. The stated maturity of the Debentures is December 18, 2031. In addition, the Debentures are subject to redemption at par at the option of the Corporation, subject to prior regulatory approval, in whole or in part on any interest payment date after December 18, 2006. The Debentures are also subject to redemption prior to December 18, 2006 at 107.5% of par after the occurrence of certain events that would either have a negative tax effect on the Trust or the Corporation or would result in the Trust being treated as an investment company that is required to be registered under the Investment Company Act of 1940. Upon repayment of the Debentures at their stated maturity or following their redemption, the Trust will use the proceeds of such repayment to redeem an equivalent amount of outstanding trust preferred securities and trust common securities. The Corporation has the right, at one or more times, to defer interest payments on the Debentures for up to twenty consecutive quarterly periods. All deferrals will end on an interest payment date and will not extend beyond December 18, 2031, the stated maturity date of the Debentures. If the Corporation defers interest payments on the Debentures, the Trust will also defer distributions on the capital securities. During any deferral period, each installment of interest that would otherwise have been due and payable will bear additional interest at the applicable distribution rate, compounded quarterly. The Corporation paid $576,000, $426,000, $100,000 and $415,000 in interest for the years ended December 31, 2005 and 2004, the three months ended December 31, 2003, and the year ended September 30, 2003.

10. Income Taxes

Income tax expense (benefit) is summarized as follows (in thousands):

	Years Ended December 31,					Three Months Ended December 31,		Year Ended September 30,
	2005			2004		2003		2003
Current	$	1,426		$	225	($127	)	$	912
Deferred		(512	)		496	(515	)		(341	)
Total income tax expense (benefit)	$	914		$	721	($642	)	$	571

UNION FINANCIAL BANCSHARES, INC.

33

10. Income Taxes (continued)

The provision (benefit) for income taxes differed from amounts computed by applying the statutory federal rate of 34% to income before income taxes as follows (in thousands):

	Years Ended December 31,						Three Months Ended December 31,		Year Ended September 30,
	2005			2004			2003		2003
Tax at federal income tax rate	$	1,149		$	978		($584	)	$	826
Increase (decrease) resulting from:
State income taxes, net of federal benefit		95			81		—			110
Interest on municipal bonds		(329	)		(327	)	(85	)		(300	)
Non-taxable life insurance income		(67	)		(62	)	—			(84	)
Other, net		66			51		27			19
Total	$	914		$	721		($642	)	$	571

The tax effects of significant items comprising the Corporation’s deferred taxes as of December 31, 2005 and 2004 are as follows (in thousands):

	December 31,
	2005		2004
Deferred tax assets:
Book reserves in excess of tax basis bad debt reserves	$	814	$	689
Difference between book and deposit premium basis		258		117
Deferred compensation		244		154
Net operating loss		134		—
SFAS No. 115 mark-to-market adjustment		330		—
Other		70		57
Total deferred tax asset		1,850		1,017
Deferred tax liabilities:
SFAS No. 115 mark-to-market adjustment		—		59
Difference between book and tax property basis		184		264
Difference between book and tax Federal Home Loan Bank stock basis		85		85
Deferred loan fees		35		42
Prepaid expenses		78		—
Total deferred tax liability		382		450
Net deferred tax asset	$	1,468	$	567

The deferred tax assets of $1,468,000 and $567,000 at December 31, 2005 and 2004 are included in other assets in the balance sheet.

Retained earnings at December 31, 2005 includes approximately $1,636,000 representing pre-1988 tax bad debt base year reserve amounts for which no deferred income tax liability has been provided since these reserves are not expected to reverse until indefinite future periods and may never reverse. Circumstances that would require an accrual of a portion or all of this unrecorded tax liability are a reduction in qualifying loan levels relative to the end of 1987, dividend payments in excess of current year or accumulated tax earnings and profits, or other distributions in dissolutions, liquidations or redemption of the Bank’s stock.

11. Employee Benefits

The Corporation has a contributory profit-sharing plan which is available to all eligible employees. Annual employer contributions to the plan consist of an amount which matches participant contributions up to a maximum of 5% of a participant’s compensation and a discretionary amount determined annually by the Corporation’s Board of Directors. The annual contributions to the plan will be 5% of a participant’s compensation. Employer expensed contributions to the plans were $207,000, $240,000, $31,000, and $183,000 for the years ended December 31, 2005 and 2004, for the three months ended December 31, 2003, and the year ended September 30, 2003.

UNION FINANCIAL BANCSHARES, INC.

34

12. Financial Instruments

The Corporation 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 are commitments to extend credit. They involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheets. The contract or notional amounts of those instruments reflect the extent of involvements the Corporation has in particular classes of financial instruments.

The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the counter-party. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties.

The Corporation had loan commitments as follows (in thousands):

	As of December 31,
	2005		2004
Fixed/variable interest rate commitments to fund residential credit	$	2,909	$	2,399
Commitments to fund commercial and construction loans		1,980		2,363
Unused portion of credit lines (principally variable-rate consumer lines secured by real estate)		42,586		35,842
Total	$	47,475	$	40,604

The Corporation has no additional financial instruments with off-balance sheet risk.

The Corporation did not incur any losses on its commitments in the years ended December 31, 2005 and 2004, the three months ended December 31, 2003, or the year ended December 31, 2003.

UNION FINANCIAL BANCSHARES, INC.

35

12. Financial Instruments (continued)

The estimated fair values of the Corporation’s financial instruments were as follows at December 31, 2005 (in thousands):

	December 31, 2005
	Carrying Amount			Fair Value
Financial assets
Cash and due from banks	$	8,380		$	8,380
Securities available for sale		143,079			143,079
Securities held to maturity		3,204			3,247
Federal Home Loan Bank stock, at cost		3,976			3,976
Federal Reserve Bank stock, at cost		539			539
Loans, net		192,577			193,724
Accrued interest receivable		2,429			2,429
Cash surrender value of life insurance		5,404			5,404
Financial liabilities
Deposits	$	239,603		$	238,715
Advances from FHLB and other borrowings		75,715			76,427
Securities sold under agreement to repurchase		20,000			19,884
Floating rate junior subordinated deferrable interest debentures		8,247			8,217
Accrued interest payable		520			520
Off-balance-sheet assets (liabilities)
Commitments to extend credit		($47,475	)		($47,475	)

The estimated fair values of the Corporation’s financial instruments were as follows at December 31, 2004 (in thousands):

	December 31, 2004
	Carrying Amount			Fair Value
Financial assets
Cash and due from banks	$	13,197		$	13,197
Securities available for sale		141,864			141,864
Securities held to maturity		1,630			1,688
Federal Home Loan Bank stock, at cost		3,522			3,522
Federal Reserve Bank stock, at cost		539			539
Loans, net		171,094			171,632
Accrued interest receivable		2,068			2,068
Cash surrender value of life insurance		5,206			5,206
Financial liabilities
Deposits	$	227,589		$	228,415
Advances from FHLB and other borrowings		63,500			64,122
Securities sold under agreement to repurchase		24,000			24,235
Floating rate junior subordinated deferrable interest debentures		8,247			8,328
Accrued interest payable		333			333
Off-balance-sheet asset (liabilities)
Commitments to extend credit		($40,604	)		($40,604	)

UNION FINANCIAL BANCSHARES, INC.

36

13. Supplemental Cash Flow Disclosures

	Years Ended December 31,					Three Months Ended December 31,		Year Ended September 30,
	2005			2004		2003		2003
Cash paid for:
Income taxes	$	1,652		$	120	$	59	$	488
Interest		8,783			7,198		2,384		8,702
Non-cash transactions:
Loans foreclosed		229			757		295		296
Unrealized gain (loss) on securities available for sale	$	(942	)	$	168	$	152	$	(853	)

14. Commitments And Contingencies

Lease commitments -The Corporation leases certain Bank facilities under rental agreements that have expiration dates between 2018 and 2025. Future minimum rental payments due under these leases are as follows:

Years Ended
2006	$	293,940
2007		293,940
2008		293,940
2009		293,940
2010		293,940
Thereafter	$	2,629,512

Total rent expense for the years ended December 31, 2005 and 2004, for the three months ended December 31, 2003, and the year ended September 30, 2003 were $197,000, $186,000, $41,000 and $34,000, respectively.

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

The Corporation makes loans to individuals and small businesses for various personal and commercial purposes primarily in the piedmont region of South Carolina and North Carolina. The Corporation’s loan portfolio is not concentrated in loans to any single borrower or a relatively small number of borrowers. Additionally, management is not aware of any concentrations of loans to classes of borrowers or industries that would be similarly affected by economic conditions. Management has identified a concentration of a type of lending that it is monitoring. This concentration of commercial non-mortgage loans totaled $70.7 million at December 31, 2005 representing 279% of total equity and 36% of loans receivable. At December 31, 2004 this concentration totaled $54.8 million representing 210.6% of total equity and 31.1% of net loans receivable. Commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business and are generally secured by a variety of collateral types, primarily accounts receivable, inventory and equipment.

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios. Management has determined that the Corporation has a concentration of loans that exceed one of the regulatory guidelines for loan to value ratios. This particular guideline states that the total amount by which commercial, agricultural, and multifamily and other non-residential properties exceed the regulatory maximum loan to value ratio limits should not exceed 30% of a bank’s total risk-based capital. The excess over regulatory guidelines for these types of loans totaled $16.4 million at December 31, 2005 representing 51.6% of the Bank’s total risk-based capital. These amounts exceeded regulatory guidelines by $6.8 million and 21.6%, respectively. At December 31, 2004, the Corporation did not exceed the guideline.

Additionally, there are industry practices that could subject the Corporation to increased credit risk should economic conditions change over the course of a loan’s life. For example, the Corporation makes variable rate loans and fixed rate principal-amortizing loans with maturities prior to the loan being fully paid (i.e. balloon payment loans). These loans are underwritten and monitored to manage the associated risks. Therefore, management believes that these particular practices do not subject the Corporation to unusual credit risk.

UNION FINANCIAL BANCSHARES, INC.

37

14. Commitments And Contingencies (continued)

The Corporation’s investment portfolio consists principally of obligations of the United States, its agencies or its corporations and general obligation municipal securities. In the opinion of management, there is no concentration of credit risk in its investment portfolio.

The Corporation places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.

Litigation - The Corporation is involved in legal actions in the normal course of business. In the opinion of management, based on the advice of its general counsel, the resolution of these matters will not have a material adverse impact on future results of operations or the financial position of the Corporation.

Potential Impact of Changes in Interest Rates - The Corporation’s profitability depends to a large extent on its net interest income, which is the difference between interest income from loans and investments and interest expense on deposits and borrowings. Like most financial institutions, the Corporation’s interest income and interest expense are significantly affected by changes in market interest rates and other economic factors beyond its control. Management seeks to manage the relationships between interest-sensitive assets and liabilities in order to protect against wide interest rate fluctuations.

15. Stock Option Plans

At December 31, 2005, the Corporation had the following stock options outstanding.

Grant Date	Shares Granted	Average Exercise Price Per Share	Expiration Date	Earliest Date Exercisable
May, 1998	23,888	15.83	May, 2008	May, 1998
October, 2000	1,700	8.75	October, 2010	October, 2000
January, 2001	23,190	9.06	January, 2011	January, 2001
January, 2002	18,235	10.36	January, 2012	January, 2002
April, 2002	1,000	13.00	April, 2012	April, 2002
November, 2002	1,000	13.25	November, 2012	November, 2002
December, 2003	42,000	16.75	December, 2013	December, 2003
January, 2005	1,500	16.60	January, 2015	January, 2005
March, 2005	25,750	17.26	March, 2015	March, 2005
Total shares granted	138,263

At December 31, 2005, the Corporation had the following options exercisable:

Fiscal Year	Range of exercise price		Weighted Average Remaining Contractual Life	Number Options Exercisable	Average Exercise Price
1998	$	15.83	4.3 years	23,891		15.83
2000	$	8.75	4.8 years	1,700		8.75
2001	$	9.06	6 years	23,190		9.06
2002	$	10.36 - $13.25	6.6 years	20,235		10.96
2003	$	16.75	8 years	25,200		16.75
2005	$	16.60	9 years	1,000		16.60
2005	$	17.26	8.9 years	25,750		17.26
	$	8.75 - $17.26	6.8 years	120,966	$	13.30

UNION FINANCIAL BANCSHARES, INC.

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Stock Option Plans (continued)

Options for the three previous fiscal years were forfeited and exercised as follows (adjusted for stock splits and dividends):

	Stock options		Weighted average exercise
Outstanding at September 30, 2002	225,912		$	8.43
Granted	4,000			13.00
Forfeited	(6,087	)		11.54
Exercised	(19,888	)		8.95
Outstanding at September 30, 2003	203,937			8.35
Granted	43,000			16.75
Forfeited	—			—
Exercised	(3,006	)		5.79
Outstanding at December 31, 2003	243,931			10.35
Granted	—			—
Forfeited	(500	)		9.06
Exercised	(60,635	)		8.95
Outstanding at December 31, 2004	182,796			11.13
Granted	27,250			17.22
Forfeited	(1,525	)		16.43
Exercised	(70,258	)		6.94
Outstanding at December 31, 2005	138,263		$	14.40

16. Liquidation Account, Dividend Restrictions and Regulatory Matters

On August 7, 1987, the Bank completed its conversion from a federally chartered mutual savings and loan association to a federally chartered stock savings and loan association. A special liquidation account was established by the Bank for the pre-conversion retained earnings of approximately $3,718,000. The liquidation account is maintained for the benefit of depositors who held a savings or demand account as of the March 31, 1986 eligibility or the June 30, 1987 supplemental eligibility record dates who continue to maintain their deposits at the Bank after the conversion. In the event of a future liquidation (and only in such an event), each eligible and supplemental eligible account holder who continues to maintain his or her deposit account will be entitled to receive a distribution from the liquidation account. The total amount of the liquidation account will be decreased in an amount proportionately corresponding to decreases in the deposit account balances of eligible and supplemental eligible account holders on each subsequent annual determination date. Except for payment of dividends by the Bank to Union Financial and repurchase of the Bank’s stock, the existence of the liquidation account will not restrict the use or application of such net worth.

The Bank is prohibited from declaring cash dividends on its common stock or repurchasing its common stock if the effect thereof would cause its net worth to be reduced below either the amount required for the liquidation account or the minimum regulatory capital requirement. In addition, the Bank is also prohibited from declaring cash dividends and repurchasing its own stock without prior regulatory approval if the total amount of all dividends and stock repurchases (including any proposed dividends and stock repurchases) for the applicable calendar year exceeds its current year’s net income plus its retained net income for the preceding two years. Under current OCC regulations the Bank is limited in the amount it may loan to affiliates, including the Corporation. Loans to a single affiliate may not exceed 10%, and the aggregate of loans to all affiliates may not exceed 20% of bank capital and surplus.

The Bank and the Corporation are subject to various regulatory capital requirements administered by banking regulators. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s financial statements.

Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulations to ensure capital adequacy require the Bank and the Corporation to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to average assets (as defined in the regulations). Management believes, as of December 31, 2005, that the Bank and the Corporation meet the capital adequacy requirements to which they are subject.

As of December 31, 2005 and 2004, the Bank was “well capitalized” under the regulatory framework for prompt corrective action based on its capital ratio calculations. In order to be “well capitalized”, the bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since December 31, 2005 that management believes have changed the bank’s classification.

UNION FINANCIAL BANCSHARES, INC.

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16. Liquidation Account, Dividend Restrictions and Regulatory Matters (continued)

Under present regulations of the OCC, the Bank must have core capital (leverage requirement) equal to 4.0% of assets, of which 1.5% must be tangible capital, excluding intangible assets. The Bank must also maintain risk-based regulatory capital as a percent of risk weighted assets at least equal to 8.0%. In measuring compliance with capital standards, certain adjustments must be made to capital and total assets.

The following tables present the total risk-based, Tier 1 risk-based and Tier 1 leverage requirements for the Corporation and the Bank (in thousands).

	December 31, 2005
	Actual				Regulatory Minimum				“Well Capitalized”
	Amount		Ratio		Amount		Ratio		Amount		Ratio
Leverage ratio
Corporation	$	30,369	8.47	%	$	14,348	4	%		n/a	n/a
Bank		29,465	8.21	%		14,348	4	%	$	17,935	5	%
Tier 1 capital ratio
Corporation		30,369	12.97	%		9,363	4	%		n/a	n/a
Bank		29,465	12.58	%		9,370	4	%		14,055	6	%
Total risk-based capital ratio
Corporation		32,764	14.00	%		18,727	8	%		n/a	n/a
Bank		31,859	13.60	%		18,740	8	%		23,425	10	%
	December 31, 2004
	Actual				Regulatory Minimum				“Well Capitalized”
	Amount		Ratio		Amount		Ratio		Amount		Ratio
Leverage ratio
Corporation	$	29,510	8.42	%	$	14,012	4	%		n/a	n/a
Bank		28,958	8.27	%		14,012	4	%	$	17,516	5	%
Tier 1 capital ratio
Corporation		29,510	14.61	%		8,078	4	%		n/a	n/a
Bank		28,958	14.33	%		8,083	4	%		12,124	6	%
Total risk-based capital ratio
Corporation		31,536	15.62	%		16,156	8	%		n/a	n/a
Bank		30,984	15.33	%		16,165	8	%		20,207	10	%

Under current Federal Reserve guidelines, the Corporation includes trust preferred securities in Tier 1 capital. The Bank is required to maintain reserves, in the form of cash and balances with the Federal Reserve Bank, against its deposit liabilities. The amounts of such reserves totaled $1,300,000 at December 31, 2005 and $858,000 at December 31, 2004.

17. Recently Issued Accounting Standards

The following is a summary of recent authoritative pronouncements that affect accounting, reporting, and disclosure of financial information by the Corporation:

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) will require companies to measure all employee stock-based compensation awards using a fair value method and record such expense in its financial statements. In addition, the adoption of SFAS No. 123(R) requires additional accounting and disclosure related to the income tax and cash flow effects resulting from share-based payment arrangements. SFAS No. 123(R) is effective beginning as of the first annual reporting period beginning after December 15, 2005. SFAS No. 123(R) allows for adoption using either the modified prospective or modified retrospective methods. The Company anticipates using the modified prospective method when this statement is adopted in the first quarter of 2006. The Company has evaluated the impact upon adoption of SFAS No. 123(R) and related guidance and has concluded that the adoption will not have a material impact on financial position or results of operations upon adoption.

UNION FINANCIAL BANCSHARES, INC.

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17. Recently Issued Accounting Standards (continued)

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets – an amendment of APB Opinion No. 29.” The standard is based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged and eliminates the exception under ABP Opinion No. 29 for an exchange of similar productive assets and replaces it with an exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The standard is effective for non-monetary exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of SFAS 153 is not expected to have a material impact on the Company’s financial position or results of operations.

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

In March 2005 the FASB issued FIN No. 47, “Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143.” This Interpretation clarifies that the term conditional asset retirement obligation as used in SFAS No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Thus, the timing and (or) method of settlement may be conditional on a future event. Accordingly, an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation should be recognized when incurred—generally upon acquisition, construction, or development and (or) through the normal operation of the asset. Uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists.

FIN No. 47 is effective no later than the end of fiscal years ending after December 15, 2005. The Company adopted FIN No. 47 in 2005 and its adoption had no material effect on financial position or results of operations.

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

The recognition and measurement guidance in paragraphs 6-20 of this Issue was to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004, but was delayed by FASB action in October 2004 through the issuance of a proposed FASB Staff Position (“FSP”) on the issue. In July 2005, the FASB issued FSP FAS 115-1 and FSP FAS 124-1—”The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” This FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. This FSP will be effective for other-than-temporary impairment analysis conducted in periods beginning after December 15, 2005. The Company has evaluated the impact that the adoption of FSP FAS 115-1 and FSP FAS 124-1 and has concluded that the adoption will not have a material impact on financial position and results of operations upon adoption.

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

a. Borrowers subject to significant payment increases

b. Loans with terms that permit negative amortization

c. Loans with high loan-to-value ratios.

UNION FINANCIAL BANCSHARES, INC.

41

17. Recently Issued Accounting Standards (continued)

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

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

18. Union Financial Bancshares, Inc. Financial Information

(Parent Corporation Only)

Condensed financial information for Union Financial is presented as follows (in thousands):

Condensed Balance Sheets	As of December 31,
	2005		2004
Assets:
Cash and due from banks	$	874	$	468
Investment in subsidiary		32,428		33,467
Other		303		351
Total assets	$	33,605	$	34,286
Liabilities and Shareholders’ Equity:
Accrued interest payable	$	25	$	20
Floating rate junior subordinated deferrable interest debentures		8,247		8,247
Shareholders’ equity		25,333		26,019
Total liabilities and shareholders’ equity	$	33,605	$	34,286

UNION FINANCIAL BANCSHARES, INC.

42

18. Union Financial Bancshares, Inc. Financial Information (continued)

(Parent Corporation Only)

	Years Ended December 31,						Three Months Ended December 31,			Year Ended September 30,
	2005			2004			2003			2003
Condensed Statements of Income
Equity in undistributed earnings (loss) of subsidiary	$	3,183		$	2,714			($1,077	)	$	2,399
Interest expense		(576	)		(426	)		(100	)		(415	)
Other expense, net		(141	)		(132	)		(33	)		(125	)
Net income(loss)	$	2,466		$	2,156			($1,210	)	$	1,859
Condensed Statements of Cash Flows
Operating Activities:
Net income(loss)	$	2,466		$	2,156			($1,210	)	$	1,859
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Equity in undistributed earnings (loss) of subsidiary		(3,183	)		(2,714	)		1,077			(2,399	)
Decrease in other assets		54			56			26			54
Net cash used in operating activities		(663	)		(502	)		(107	)		(486	)
Financing Activities:
Dividends received from subsidiary		3,500			2,000			—			—
Dividend reinvestment plan contributions		108			110			27			110
Dividends paid		(771	)		(783	)		(197	)		(788	)
Share repurchase program		(1,897	)		(1,074	)		—			(366	)
Proceeds from the exercise of stock options		129			93			17			179
Net cash provided by (used in) financing activities		1,069			346			(153	)		(865	)
Net increase (decrease) in cash and due from banks		406			(156	)		(260	)		(1,351	)
Cash and due from banks at beginning of period		468			624			884			2,235
Cash and due from banks at end of period	$	874		$	468		$	624		$	884

UNION FINANCIAL BANCSHARES, INC.

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19. Quarterly Financial Data

The tables set forth below summarize selected financial data regarding results of operations for the periods indicated (in thousands, except common share data).

	For the year ended December 31, 2005
	First quarter		Second quarter	Third quarter	Fourth quarter	Total
Net interest income	$	2,450	2,500	2,578	2,715	10,243
Provision for loan losses		208	341	220	100	869
Non-interest income		577	673	692	601	2,543
Non-interest expense		2,102	2,090	2,170	2,175	8,537
Provision for income taxes		178	193	242	301	914
Net income	$	539	549	638	740	2,466
Net income per common share—Basic	$	0.28	0.29	0.33	0.39	1.29
Net income per common share—Diluted	$	0.27	0.28	0.33	0.38	1.26
	For the year ended December 31, 2004
	First quarter		Second quarter	Third quarter	Fourth quarter	Total
Net interest income	$	2,260	2,416	2,469	2,561	9,706
Provision for loan losses		135	250	390	475	1,250
Non-interest income		627	657	639	638	2,561
Non-interest expense		2,080	2,087	2,051	1,922	8,140
Provision for income taxes		163	188	159	211	721
Net income	$	509	548	508	591	2,156
Net income per common share—Basic	$	0.26	0.28	0.26	0.30	1.10
Net income per common share—Diluted	$	0.25	0.27	0.25	0.28	1.05

UNION FINANCIAL BANCSHARES, INC.

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BOARD OF DIRECTORS

UNION FINANCIAL BANCSHARES AND SUBSIDIARIES

Robert H. Breakfield

Attorney

James W. Edwards

Dean of Academics, USC-Union

William M. Graham

Owner, Graham’s Flowers

Louis M. Jordan

President, Jordan’s Ace Hardware, Inc.

Carl L. Mason

Chairman

Retired

Dwight V. Neese

President and Chief Executive Officer

Provident Community Bank

Philip C. Wilkins, DMD

Dentist

LEADERSHIP GROUP

PROVIDENT COMMUNITY BANK

Henry G. Alexander, Jr.

Vice President

Commercial Lending Specialist

Carolyn H. Belue

Vice President

Operations Manager

Brenda T. Billardello

Vice President

Marketing Director

Edward A. Brock

Senior Vice President

York Market Executive

Richard H. Flake

Executive Vice President

Chief Financial Officer

Lisa G. Morris

Vice President

Union Market Executive

Dwight V. Neese

President

Chief Executive Officer

Mark F. Pack

Senior Vice President

Commercial Administration Manager

Lori H. Patrick

Vice President

York County Consumer Market Executive

Susan D. Taylor

Vice President

Fairfield Market Executive

Jeffrey M. Thompson

Vice President

Laurens Market Executive

Lud W. Vaughn

Executive Vice President

Chief Operating Officer

Wanda J. Wells

Senior Vice President

Chief Administrative Officer

UNION FINANCIAL BANCSHARES, INC.

45

CORPORATE INFORMATION

Common Stock Information

Union Financial Bancshares, Inc.’s common stock is quoted on the Nasdaq National Market under the symbol UFBS. As of January 31, 2006, there were 731 shareholders of record and 1,893,897 shares of common stock issued and outstanding. The following table contains the range of high and low bid information of Union Financial’s common stock as reported by the Nasdaq Stock Market and per share dividend as declared during each quarter of the last two calendar years. Union Financial is subject to the requirements of Delaware law, which generally limits dividends to an amount equal to the excess of the net assets of Union Financial (the amount by which total assets exceed total liabilities) over its statutory capital or, if there is no excess, to its net profits for the current year and the immediately preceding fiscal year. See Note 16 to the financial statements for information regarding certain limitations imposed on the Bank’s ability to pay cash dividends to the holding company.

Calendar Year 2005	High		Low		Dividend
Fourth Quarter	$	19.00	$	16.92	$	.10
Third Quarter	$	18.25	$	16.75	$	.10
Second Quarter	$	17.50	$	16.17	$	.10
First Quarter	$	18.30	$	16.50	$	.10
Calendar Year 2004	High		Low		Dividend
Fourth Quarter	$	18.13	$	16.40	$	.10
Third Quarter	$	17.12	$	15.46	$	.10
Second Quarter	$	17.55	$	16.74	$	.10
First Quarter	$	17.26	$	16.68	$	.10

Dividend Reinvestment Plan

The Corporation has a dividend reinvestment program that allows shareholders to purchase additional shares with corporate dividends. Details of the program are outlined in the dividend reinvestment prospectus. To receive more information, please contact the Shareholder Relations Officer at the corporate address.

10-K Information

A copy of the Form 10-K filed with the Securities and Exchange Commission, will be furnished to shareholders, without charge, upon written request to the Corporate Secretary, Union Financial Bancshares, Inc., 203 West Main Street, Union, South Carolina 29379.

Annual Meeting of Shareholders

The Annual Meeting of Shareholders will convene at the Main Street Auditorium of the University of South Carolina, Union Campus, Union, South Carolina on April 19, 2006 at 2:00 p.m.

Additional Information

If you are receiving duplicate mailings of shareholder reports due to multiple accounts, we can consolidate the mailings without affecting your account registration. To do this, or for additional information, contact our Shareholder Relations Officer at the corporate address shown below.

Corporate Offices

203 West Main Street

Union, South Carolina 29379

(888) 427-9002

Transfer Agent

Registrar & Transfer Company

10 Commerce Drive

Cranford, New Jersey 07016

(800) 456-0596

Independent Registered Public Accounting Firm

Elliott Davis, LLC

200 East Broad Street

Greenville, SC 29601

Special Counsel

Muldoon Murphy & Aguggia LLP

5101 Wisconsin Avenue, N.W.

Washington, D.C. 20016

General Counsel

Nelson Mullins Riley & Scarborough

104 South Main Street, Suite 900

Greenville, South Carolina 29601

Shareholder Relations Officer

Wanda J. Wells

Union Financial Bancshares, Inc.

203 West Main Street

Union, SC 29379

(864) 429-1861

Website

www.providentonline.com

UNION FINANCIAL BANCSHARES, INC.

46

EX-21

EXHIBIT NO. 21

Subsidiaries of Registrant

Subsidiaries	Percentage Owned		Jurisdiction or State of Incorporation
Union Financial Statutory Trust I	100	%	Connecticut
Provident Community Bank	100	%	United States

EX-23

EXHIBIT NO. 23

Consent of Independent Certified Public Accountants

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in the Registration Statement on Form S-8 pertaining to the 1995 Stock Option Plan and the 2001 Stock Option Plan of Union Financial Bancshares, Inc. and in the Post Effective Amendment No. 2 to the Registration Statement on Form S-3 (No. 333-35319) pertaining to the Dividend Reinvestment Plan of Union Financial Bancshares, Inc. of our report dated January 13, 2006, with respect to the consolidated financial statements of Union Financial Bancshares, Inc. and Subsidiaries incorporated by reference in the Annual Report on Form 10-K for the year ended December 31, 2005.

/s/ Elliott Davis, LLC

March 21, 2006

Greenville, South Carolina

EX-31.(A)

EXHIBIT 31(a)

Exhibit 31(a)

CERTIFICATION

I, Dwight V. Neese, certify that:

1. I have reviewed this annual report on Form 10-K of Union Financial Bancshares, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 17, 2006	/s/ Dwight V. Neese
	Dwight V. Neese President and Chief Executive Officer

EX-31.(B)

EXHIBIT 31(b)

Exhibit 31(b)

CERTIFICATION

I, Richard H. Flake, certify that:

1. I have reviewed this annual report on Form 10-K of Union Financial Bancshares, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 17, 2006	/s/ Richard H. Flake
	Richard H. Flake Chief Financial Officer

EX-32

EXHIBIT 32

Exhibit 32

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADDED BY

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Union Financial Bancshares, Inc. (the “Company”) on Form 10-K for the fiscal year ended December 31, 2005 as filed with the Securities and Exchange Commission (the “Report”), the undersigned certify, pursuant to 18 U.S.C. §1350, as added by Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of and for the period covered by the Report.

/s/ Dwight V. Neese

Dwight V. Neese

President and Chief Executive Officer

/s/ Richard H. Flake

Richard H. Flake

Chief Financial Officer

Date: March 17, 2006