10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

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

   For the fiscal year ended December 31, 2008

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

   For the transition period from              to             

Commission File No. 001-15571

APPALACHIAN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Georgia	58-2242407
(State of Incorporation)	(I.R.S. Employer Identification Number)
822 Industrial Boulevard Ellijay, Georgia	30540
(Address of Principal Executive Offices)	(Zip Code)

(706) 276-8000

(Registrant’s telephone number, including area code)

Securities registered under Section 12(b) of the Act:

Title of Each Class	Name of each exchange on which registered
Common Stock, $0.01 par value	The NASDAQ Stock Market LLC

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

None

(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 Section 15(d) of the Exchange 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 pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    Yes  ¨    No  x

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

Large accelerated filer ¨	Accelerated filer ¨
Non-accelerated filer ¨ (Do not check if a smaller reporting company)	Smaller Reporting Company 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 common stock held by non-affiliates of the registrant (computed by reference to the closing sales price as reported on the NASDAQ Global Market System) was $68.2 million as of the last business day of the registrant’s most recently completed second fiscal quarter. For the purpose of this response, officers, directors and holders of 5% or more of the registrant’s common stock are considered to be affiliates of the registrant at that date.

There were 5,475,701 shares of the registrant’s common stock outstanding as of March 19, 2009.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement to be delivered to shareholders in connection with the registrant’s 2008 Annual Meeting of Shareholders are incorporated by reference in response to Part III of this report.

APPALACHIAN BANCSHARES, INC.

2008 Form 10-K Annual Report

TABLE OF CONTENTS

Item Number In Form 10-K	Description	Page or Location
Part I
Item 1.	Business	1
Item 1A.	Risk Factors	16
Item 1B.	Unresolved Staff Comments	25
Item 2.	Properties	26
Item 3.	Legal Proceedings	26
Item 4.	Submission of Matters to a Vote of Security Holders	26
PART II
Item 5.	Market for the Registrant’s Common Equity, Related Stockholder Matters and issuer purchases of equity securities	27
Item 6.	Selected Financial Data	29
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operation	31
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	53
Item 8.	Financial Statements and Supplementary Data	53
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	54
Item 9A(T).	Controls and Procedures	54
Item 9B.	Other Information	54
PART III
Item 10.	Directors, Executive Officers and Corporate Governance	55
Item 11.	Executive Compensation	55
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	55
Item 13.	Certain Relationships and Related Transactions, and Director Independence	55
Item 14.	Principal Accountant Fees and Services	55
PART IV
Item 15.	Exhibits and Financial Statement Schedules	56
Signatures		60

PART I

ITEM 1. BUSINESS

This Report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, such as statements relating to future plans and expectations, and are thus prospective. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those projected in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “will,” “expect,” “anticipate,” “believe,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties include, but are not limited to, those described below under Item 1A, entitled “Risk Factors.”

General Overview

We are a Georgia corporation organized in 1996 to serve as the bank holding company for Appalachian Community Bank (formerly Gilmer County Bank), a state-chartered bank located in the foothills of the Blue Ridge Mountains in North Georgia. We are headquartered in Ellijay, Georgia. As of April 2007, we also serve as the bank holding company for Appalachian Community Bank, F.S.B., a federally-chartered thrift headquartered in McCaysville, Georgia with offices in Murphy, North Carolina and Ducktown, Tennessee. We also serve as the bank holding company for Appalachian Real Estate Holdings, Inc., which was formed in June 2008 to hold certain real estate that may be acquired by the Bank and the Thrift through foreclosure.

In 1995, Gilmer County Bank opened its first branch office in Ellijay, Georgia. In November 1998, we acquired a bank with one location in Blairsville, Georgia, and changed its name to Appalachian Community Bank to reflect our strategy to build a community bank franchise in our geographic market area. In May 2000, we opened a branch office in East Ellijay, Georgia, and in August 2001, we opened a loan production office in Blue Ridge, Georgia, which we converted to a full-service branch in February 2002. In August 2001, we merged Appalachian Community Bank into Gilmer County Bank, although we continue to operate our branches in Ellijay and East Ellijay under the trade name “Gilmer County Bank.” During 2006, we opened full-service branches in Chatsworth, McCaysville, Dawsonville, Georgia, a second branch in East Ellijay, Georgia, as well as loan production offices in Murphy, North Carolina and Ducktown, Tennessee. We received our final regulatory approval to form and open a federally-chartered thrift subsidiary on February 16, 2007, which opened and began operating, under the name Appalachian Community Bank, F.S.B., on April 23, 2007. The thrift acquired, as its headquarters, our branch in McCaysville, Georgia and we converted our loan production offices in Murphy, North Carolina, and Ducktown, Tennessee, into full-service branches of the thrift. In 2007, we opened a second bank branch in Dawsonville, Georgia, as well as bank branches in Dahlonega and Dalton, Georgia.

We provide a full range of retail and commercial banking products and services to individuals and small- to medium- sized businesses through our community banking relationship model. Such products and services include the receipt of demand and time deposit accounts, the extension of personal and commercial loans and the furnishing of personal and commercial checking accounts. As of December 31, 2008, we had total assets of approximately $1.2 billion, total loans of approximately $885.4 million, total deposits of approximately $1.0 billion and total shareholders’ equity of approximately $72.4 million. Our website is located at www.apab.com.

Recent Development

As a result of the recently completed examination by the Federal Deposit Insurance Corporation (FDIC), the Board of Directors and management anticipate that the FDIC and the Georgia Department of Banking and Finance (collectively with the FDIC, the “Agencies”) will place the Bank under an administrative action which will contain certain operational and financial restrictions. We are currently in the process of reviewing and negotiating the proposed order of the FDIC and expect that this administrative action will require us, among other things, to assess and potentially modify our management structure, reduce and improve our level of classified assets over designated periods of time, perform internal loan reviews on a more frequent basis, maintain an appropriate allowance for loan and lease losses, implement a commercial real estate lending policy, restrict the use of brokered deposits, maintain a Tier 1 capital ratio equal to or greater than 8% of total assets and a total risk-based capital ratio equal to or greater than 10% of total assets, and to review and, where appropriate, revise various Bank policies on

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matters such as liquidity and funds management, earnings improvement, lending and collection, loan review and underwriting. As with other similarly situated banks, we anticipate that the Bank will be restricted from paying any dividends without the prior written consent of the Agencies. The issuance of such action will also result in the Bank not being considered “well-capitalized” and therefore result in higher FDIC insurance assessments in 2009 and for at least the term of the action.

We further anticipate that the Bank will be required to send periodic written progress reports to the Agencies to show its progress in complying with the restrictions so imposed. These restrictions will remain in place until terminated by the Agencies.

In conjunction with any administrative action placed on the Bank, we anticipate that the Federal Reserve System would impose an administrative action on the Holding Company. We expect that the restrictions imposed by the Federal Reserve would (among other matters): limit the activities of the Holding Company by restricting dividend payments to shareholders without the prior approval of the Federal Reserve Bank and the prior approval of the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve; prohibit any redemption of shares without prior approval of the Reserve Bank; prohibit the appointment of new officers or directors of the Holding Company without prior Reserve Bank approval; and will require the Holding Company to provide quarterly progress reports to the Reserve Bank. These restrictions and requirements would remain in place until terminated by the Federal Reserve.

In anticipation of such actions discussed above, the Company has hired a consulting firm to assist them with raising additional capital in order to meet requirements for additional capital.

Our Market Area

Our market area is located approximately 80 miles north of Atlanta and is primarily comprised of Gilmer, Fannin, Union, Murray, Dawson, Lumpkin and Whitfield Counties in Georgia, as well as Cherokee County North Carolina and Polk County Tennessee. Our market area includes both “North Georgia” and the “Tri-State Area”, the latter consisting of the contiguous three-county area (Fannin, Polk and Cherokee Counties) where Georgia, Tennessee and North Carolina come together. Our market area provides a number of outdoor recreational activities, including hiking, canoeing, fishing, swimming, rafting, hunting and mountain biking. We believe that the natural resources of our market area and its proximity to metropolitan Atlanta are two of the main reasons that our market area has experienced significant population growth in the past. In particular, our market area’s abundant outdoor and recreational activities have historically made it a popular area for second-home buyers and retirees. The current economic downturn, however, has greatly affected the growth in our area as well as this second-home market. However, due to our location and natural resources, we believe that when the economy strengthens, our growth and this market will improve.

Operating and Growth Strategy

Our strategy is to build a community bank franchise servicing real estate developers, small business owners and primary and second home buyers in our market area and surrounding communities. We believe we can execute this strategy and grow our business by building personal relationships with our customers, emphasizing superior customer service and communicating a consistent set of operating principles to our employees.

Lending Activities

General. We offer a variety of loans, including real estate, construction, commercial and consumer loans to individuals and small to mid-size businesses that are located or conduct a substantial portion of their business in our market area. Although we offer a variety of types of loans, we emphasize the use of real estate as collateral and our underwriting standards vary for each type of loan, as described below. As of December 31, 2008, 87.6% of the loans in our loan portfolio were secured by real estate. At December 31, 2008, we had total loans of $885.4 million, representing 74.7% of our total assets. Historically, we have focused our lending activities primarily to small business owners and residential real estate developers. However, due to the current downturn in real estate development and values, our current focus is to develop our commercial and industrial loans as well as consumer type loans. At December 31, 2008, loans to the construction and development industry amounted to $389.3 million,

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or approximately 44.0% of our total loan portfolio, loans to the poultry industry amounted to $19.7 million, or approximately 2.2% of our total loan portfolio and loans to the hospitality (hotel/motel) industry amounted to $8.0 million, or approximately 0.9% of our total loan portfolio.

Our underwriting standards vary for each type of loan. In underwriting all of our real estate related loans, we seek to minimize our risks by giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition. Our underwriting analysis also includes credit checks, reviews of appraisals and environmental hazards and a review of the financial condition of the borrower. We attempt to limit our risk by analyzing our borrowers’ cash flow and collateral value on a regular basis. After a loan is approved, our credit administration group focuses on the loan portfolio, including regularly monitoring the quality of the loan portfolio. Further, we also engage outside firms to evaluate our loan portfolio on a quarterly basis for credit quality and compliance issues.

In addition, we engage in secondary-market mortgage activities by obtaining commitments from secondary mortgage purchasers for loans originated by our bank and thrift. Based on these commitments, we originate mortgage loans on comparable terms and generate fee income and commissions to supplement our non-interest income.

Real Estate Loans. Loans secured by real estate are the primary component of our loan portfolio. To increase the likelihood of the ultimate repayment of the loan, we obtain a security interest in the real estate whenever possible, in addition to the other available collateral. At December 31, 2008, loans primarily secured by real estate amounted to $775.6 million, or 87.6%, of our total loan portfolio.

These loans consist primarily of construction and development loans, commercial real estate loans and residential real estate loans. Interest rates for all categories may be fixed or adjustable. We generally charge an origination fee for each loan and may collect renewal and late charge fees. Real estate loans are subject to the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate. Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a borrower’s cash flow, creditworthiness and ability to repay the loan.

• Construction and Development Real Estate Loans. We offer adjustable and fixed rate real estate residential and commercial loans to builders and developers for both construction and development and to consumers wishing to build their own homes. The duration of our construction and development loans is typically 12 months, although payments may be structured to amortize longer. Construction and development loans generally carry a higher degree of risk than
long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the sale of the property. Specific risks include:

• cost overruns;

• mismanaged construction;

• inferior or improper construction techniques;

• economic changes or downturns during construction;

• a downturn in the real estate market;

• rising interest rates which may prevent sale of the property; and

• failure to sell completed projects in a timely manner.

We attempt to reduce the risk associated with construction and development loans by obtaining personal guarantees where possible and by keeping the loan-to-value ratio of the completed project at or below 80%. At December 31, 2008, total construction and development loans amounted to $389.3 million, or 44.0% of our loan portfolio. Residential construction and development loans totaled $328.5 million, or 37.1% of our loan portfolio, and commercial construction loans represented $60.9 million,

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or 6.9% of our loan portfolio.

• Commercial Real Estate Loans. Our commercial real estate loans generally have terms of five years or less, although payments can be structured to amortize longer. We evaluate each borrower on an individual basis and attempt to determine the business risks and credit profile of each borrower. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on owner-occupied properties where the loan-to-value ratio, established by independent appraisals, does not exceed 80%. We also generally require that a borrower’s cash flow exceeds 110% of monthly debt service obligations. In order to ensure secondary sources of payment and liquidity, we typically review all of the personal financial statements of the principal owners and require their personal guarantees. These commercial real estate loans include various types of business purpose loans secured by farmland and nonresidential commercial real estate. At December 31, 2008, commercial real estate loans (other than commercial construction loans) amounted to $173.6 million, or approximately 19.6% of our loan portfolio.

• Residential Real Estate Loans. At December 31, 2008, our residential real estate loans consisted primarily of loans secured by one- to- four family residences and multi-family (five or more) residences. These loans are generally secured by residential real estate. We also offer, through our mortgage banking department, fixed and adjustable-rate residential real estate loans which we sell under fixed price commitments to third party lenders rather than originating and retaining these loans ourselves. We will not close these residential real estate loans without a fixed price commitment to sell from a correspondent lender, and we do not service these loans. At December 31, 2008, total residential real estate loans amounted to $212.7 million, or 24.0% of our loan portfolio. Loans secured by one-to-four family residences totaled $199.8 million, or 22.6% of our loan portfolio, and loans secured by multi-family residences totaled $12.9 million, or 1.5% of our loan portfolio.

Commercial Business Loans. We make loans for commercial purposes to various lines of businesses. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because commercial loans may be unsecured or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate. At December 31, 2008, commercial business loans amounted to $72.5 million, or 8.2% of our total loan portfolio, excluding for these purposes commercial loans secured by real estate which are included in the real estate category above.

Consumer Loans. We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment and term loans, home equity loans and lines of credit and revolving lines of credit such as credit cards. Consumer loans are underwritten based on the individual borrower’s income, current debt level, past credit history and value of any available collateral. Consumer loan rates are both fixed and variable, with negotiable terms. Our installment loans typically amortize over periods up to 60 months. We will offer consumer loans with a single maturity date when a specific source of repayment is available. We typically require monthly payments of interest and a portion of the principal on our revolving loan products. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate. At December 31, 2008, consumer loans amounted to $28.6 million, or 3.2% of our loan portfolio.

Loan Approval. Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions and risks inherent in dealing with individual borrowers. We attempt to mitigate these risks by adhering to internal credit policies and procedures. Our policies and procedures include officer and client lending limits, a multi-layered approval process for larger loans, documentation examination and follow-up procedures for any exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. We have an officers’ loan committee and a board of directors’ loan committee for each of the bank and the thrift. When the amount of aggregate loans to a single borrower exceeds an individual officer’s lending authority, and is below $500,000, the loan request will be considered by senior lending officers of the bank or thrift. The members of our officers’ loan committee can approve loans up to $1.0 million. If total aggregate loans to a single borrower exceed $1.0 million, then the board of directors’ loan committee may approve the loan. On a monthly basis, any actions of

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the respective board of directors’ loan committee are further ratified by the bank or thrift’s entire board of directors. We do not make any loans to directors or executive officers of the bank or the thrift unless the loan is approved by the board of directors of the bank or the thrift and is on terms not more favorable to such person than would be available to a person not affiliated with the bank or thrift.

Credit Administration and Loan Review. We maintain a continuous loan review system and use an independent consultant to review the loan files on a quarterly basis. Each loan officer is responsible for rating each loan he or she makes and for reviewing those loans on a periodic basis. Our credit underwriting and credit administration groups assist us in strengthening our credit review processes and establishing performance benchmarks in the areas of nonperforming assets, charge-offs, past dues and loan documentation. Our credit administration meets weekly with all loan officers to review the status of all past due loans, nonperforming loans and any relationships placed on our internal watch list. We have recently set up a special assets committee to address issues with classified credits when all account officer collection efforts have been exhausted.

Lending Limits. Our lending activities are subject to a variety of lending limits imposed by state and federal law. In general, the bank and the thrift are subject to a legal limit on loans to a single borrower equal to 15% of the bank’s or thrift’s capital and unimpaired surplus for unsecured loans and 25% of the bank’s or thrift’s capital and unimpaired surplus for fully secured loans. This limit will increase or decrease as the bank’s or thrift’s capital increases or decreases. Based on the capitalization of the bank at December 31, 2008, the bank’s legal lending limits were approximately $18.0 million for secured loans and $10.8 million for unsecured loans. Based on the capitalization of the thrift at December 31, 2008, the thrift’s legal lending limits were approximately $2.1 million for fully secured loans and $1.2 million for unsecured loans. We sell participations in our larger loans to other financial institutions, which allows us to manage the risk involved in these loans and to meet the lending needs of our customers requiring extensions of credit in excess of this limit. At December 31, 2008, we had participations sold totaling $68.4 million.

Deposit Services

Our principal source of funding is core deposits, supplemented by brokered deposits, Federal Home Loan Bank (“FHLB”) advances, federal funds purchased, other borrowings and securities sold under agreements to repurchase. We offer a full range of deposit services, including checking accounts, commercial accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to long-term certificates of deposit. All deposit accounts are insured by the FDIC up to the maximum amount allowed by law.

Other Products and Services

We provide a full range of additional retail and commercial banking products and services, including checking, savings and money market accounts; certificates of deposit; internet banking and bill payment; credit cards; safe-deposit boxes; money orders; cashier’s checks; electronic funds transfer services; travelers’ checks and automatic teller machine access. We are also a member of the STAR ATM network, which permits our customers to perform certain banking transactions, both within and outside of our market area. We currently do not offer trust or fiduciary services.

We are committed to modifying existing, or developing new, products and services that are responsive to the banking demands of our customers. For example, in 2006 we began offering an internet-based cash management system for small businesses, as well as an enhancement to personal checking accounts that improves the overdraft process. In 2007, we added remote deposit capture as an added convenience to our large commercial deposit customers. In the future we intend to upgrade and expand our services to ensure that we remain competitive in our product offerings.

Competition

The banking business is highly competitive, and we experience competition in our market from many other financial institutions. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services offered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative

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lending limits. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions that operate offices within our market area and beyond.

Following is a summary of banks and thrifts in our market areas as of June 30, 2008, the most recent date for deposit data compiled by the Federal Deposit Insurance Corporation (“FDIC”):

County	Number of Locally Owned Banks/Thrifts with Offices	Number of Non-locally Owned Banks/Thrifts with Offices
Gilmer County, Georgia	Three	Three
Union County, Georgia	One	Three
Fannin County, Georgia	One	Six
Murray County, Georgia	One	Four
Dawson County, Georgia	Three	Four
Lumpkin County, Georgia	None	Six
Whitfield County, Georgia	Two	Thirteen
Cherokee County, North Carolina	One	Six
Polk County, Tennessee	Two	Three

Many of our competitors, such as Regions Bank, BB&T and United Community Bank, are well-established, larger financial institutions which have substantially greater resources and lending limits. These institutions offer some services, such as extensive and established branch networks and trust services that we do not provide. We also compete with small banks and thrifts in our markets. In addition, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks and thrifts.

Market Share

As of June 30, 2008, according to the most recent data compiled by the FDIC, our “North Georgia” market area (Gilmer, Fannin, Union, Murray, Dawson, Lumpkin and Whitfield Counties) had total deposits of approximately $5.7 billion, which represented a 4.2% deposit increase from 2007. As of June 30, 2008, we had over 56% market share in Gilmer County, a 21% share in Murray County, a 17% share in Fannin County, a 7% share in Union County, an 8% share in Dawson County, a 4% share in Lumpkin County and a 1% share in Whitfield County. In Polk County, Tennessee, as of June 30, 2008, total deposits amounted to approximately $183.5 million, of which we had $5.1 million, or 3%. In Cherokee County, North Carolina, as of June 30, 2008, total deposits were $489.4 million of which we had $11.9 million or a 2% share of these deposits.

Employees

As of December 31, 2008, we had 288 full-time equivalent employees.

Monetary Policies

The operations of the bank are significantly affected by the credit policies of monetary authorities, particularly the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The instruments of monetary policy employed by the Federal Reserve include open market operations in U.S. government securities, changes in discount rates on member bank borrowings, and changes in reserve requirements against bank deposits. In view of changing conditions in the national economy and in the money markets, as well as the effect of action by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand, or the business and earnings of our banking subsidiaries.

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SUPERVISION AND REGULATION

Our business is subject to extensive state and federal banking laws and regulations that impose restrictions on and provide general regulatory oversight of our operations. These laws and regulations are generally intended to protect depositors and not shareholders. Legislation and regulations authorized by legislation influence, among other things:

• how, when, and where we may expand geographically;

• into what product or service market we may enter;

• how we must manage our assets; and

• under what circumstances money may or must flow between the parent bank holding company and the subsidiary bank.

Set forth below is an explanation of the major pieces of legislation affecting our industry and how that legislation affects our actions. The following summary is qualified by reference to the statutory and regulatory provisions discussed. Changes in applicable laws or regulations may have a material effect on our business and prospects, and legislative changes and the policies of various regulatory authorities may significantly affect our operations. We cannot predict the effect that fiscal or monetary policies, or new federal or state legislation may have on our business and earnings in the future.

Appalachian Bancshares, Inc.

Because the Company owns all of the capital stock of each of Appalachian Community Bank, our bank subsidiary, Appalachian Community Bank, F.S.B., our thrift subsidiary, and Appalachian Real Estate Holdings, Inc, our other real estate subsidiary, it is a bank holding company under the federal Bank Holding Company Act of 1956. As a result, we are primarily subject to the supervision, examination, and reporting requirements of the Bank Holding Company Act and the regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). As a bank holding company located in Georgia, the Georgia Department of Banking and Finance (the “Department”) also regulates and monitors all significant aspects of our operations.

Acquisitions of Banks. The Bank Holding Company Act requires every bank holding company to obtain the Federal Reserve Board’s prior approval before:

• acquiring direct or indirect ownership or control of any voting shares of any bank if, after the acquisition, the bank holding company will directly or indirectly own or control more than 5% of the bank’s voting shares;

• acquiring all or substantially all of the assets of any bank; or

• merging or consolidating with any other bank holding company.

Additionally, the Bank Holding Company Act provides that the Federal Reserve Board may not approve any of these transactions if it would result in or tend to create a monopoly, substantially lessen competition, or otherwise function as a restraint of trade, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve Board is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks concerned and the convenience and needs of the community to be served. The Federal Reserve Board’s consideration of financial resources generally focuses on capital adequacy, which is discussed below.

Under the Bank Holding Company Act, if adequately capitalized and adequately managed, the Company or any other bank holding company located in Georgia may purchase a bank located outside of Georgia. Conversely, an adequately capitalized and adequately managed bank holding company located outside of Georgia may purchase a bank located inside Georgia. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in specified concentrations of deposits. Currently, Georgia law prohibits the acquisition of a bank that has been chartered for less than three years.

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Change in Bank Control. Subject to various exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with related regulations, require Federal Reserve Board approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control is also presumed to exist, although rebuttable, if a person or company acquires 10% or more, but less than 25%, of any class of voting securities and either:

• the bank holding company has registered securities under Section 12 of the Securities Exchange Act of 1934; or

• no other person owns a greater percentage of that class of voting securities immediately after the transaction.

The regulations provide a procedure for challenging the rebuttable presumption of control.

Permitted Activities. The Bank Holding Company Act has generally prohibited a bank holding company from engaging in activities other than banking or managing or controlling banks or other permissible subsidiaries and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those determined by the Federal Reserve to be closely related to banking or managing or controlling banks as to be a proper incident thereto. Provisions of the Gramm-Leach-Bliley Act have expanded the permissible activities of a bank holding company that qualifies as a financial holding company. Under the regulations implementing the Gramm-Leach-Bliley Act, a financial holding company may engage in additional activities that are financial in nature or incidental or complementary to financial activity. Those activities include, among other activities, certain insurance and securities activities.

To qualify to become a financial holding company, the Bank and any other depository institution subsidiary of the Company must be well capitalized and well managed and must have a Community Reinvestment Act rating of at least “satisfactory.” Additionally, the Company must file an election with the Federal Reserve Board to become a financial holding company and must provide the Federal Reserve Board with 30 days’ written notice prior to engaging in a permitted financial activity. While the Company meets the qualification standards applicable to financial holding companies, we have not elected to become a financial holding company at this time.

Support of Subsidiary Institutions. Under Federal Reserve Board policy, we are expected to act as a source of financial strength for both the Bank and the Thrift and to commit resources to support both wholly-owned subsidiaries. This support may be required at times when, without this Federal Reserve Board policy, we might not be inclined to provide it. In addition, any capital loans made by us to the Bank or the Thrift will be repaid only after deposits and various other obligations are repaid in full. In the event of our bankruptcy, any commitment that we give to the respective federal banking regulator to maintain the capital of the Bank or the Thrift will be assumed by the bankruptcy trustee and entitled to a priority of payment.

Appalachian Community Bank and Appalachian Community Bank, F.S.B.

Because the Bank is a commercial bank chartered under the laws of the State of Georgia, it is primarily subject to the supervision, examination, and reporting requirements of the FDIC and the Department. The FDIC and the Department regularly examine the Bank’s operations and have the authority to approve or disapprove mergers, the establishment of branches, and similar corporate actions. Both regulatory agencies also have the power to prevent the continuance or development of unsafe or unsound banking practices or other violations of law. The Bank is also subject to numerous state and federal statutes and regulations that affect the Bank’s business, activities, and operations.

The Thrift, pursuant to the provisions of the Home Owners’ Loan Act of 1933, is subject to the supervision, examination, and reporting requirements of the Office of Thrift Supervision (“OTS”). Pursuant to the provisions of the Home Owners’ Loan Act and the regulations of the OTS promulgated thereunder, the Thrift is required to maintain its status as a “qualified thrift lender” and, additionally, to conduct its lending and investment activities within certain prescribed categories.

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To meet the OTS requirements as a “qualified thrift lender”, a thrift institution is required to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least 65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangibles, including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed securities) in at least 9 months out of each 12 month period. An institution that fails the qualified thrift lender test is subject to certain operating restrictions and may be required to convert to a bank charter. Appalachian Community Bank, F.S.B. met the OTS requirements as a qualified thrift lender throughout 2008. The Thrift will continue to calculate the ratio at least quarterly.

Further, unlike commercial banks, thrifts may generally make the following categories of loans, only to the extent specified:

• Commercial loans up to 20% of assets (50% of which must be in small business loans).

• Nonresidential real property loans up to 400% of capital (the OTS may grant increased authority if it is determined that the increased authority poses no significant threat to the safe and sound operation of the institution and is consistent with prudent operating practices).

• Consumer loans up to 35% of assets (all loans in excess of 30% of assets must be direct loans).

• Education loans up to 5% of assets.

• Non-conforming loans up to 5% of assets.

• Construction loans (residential) without security up to 5% of assets.

We received approval from the OTS of our application for permission to organize Appalachian Community Bank, F.S.B. on February 16, 2007, and began operations on April 23, 2007. This approval includes, but is not limited to, the following conditions that must be complied with in a manner satisfactory to the Regional Director of the OTS:

• independent audit reports must be submitted to the Regional Director for the first three years of operations;

• the Thrift must operate within the parameters of the business plan submitted with the application and submit any proposed major deviations or material changes from the plan for the prior, written non-objection of the Regional Director. The request for change must be submitted no later than 60 calendar days prior to the desired implementation date with a copy sent to the FDIC Regional Officer;

• the Thrift must receive prior written non-objection of the Regional Director of the OTS for any proposed new directors or senior executive officers or any significant change in responsibilities of any senior executive officer during the first two years of operation; and

• the Thrift must submit quarterly business plan variance reports, detailing the thrift’s compliance with its business plan and explaining any deviations therein, to the Regional Director of the OTS, within 45 days of the end of each quarter, for the first three years of operations.

Branching. Under Georgia law, the Bank may open branch offices throughout Georgia with the prior approval of its primary bank regulator. In addition, with prior regulatory approval, the Bank may acquire branches of existing banks located in Georgia. Our subsidiaries (subject to the provisions of the Home Owners’ Loan Act, applicable to our Thrift subsidiary), and any other national or state-chartered bank generally may branch across state lines by merging with financial institutions in other states if allowed by the target states’ laws. Georgia’s law, subject to limited exceptions, currently permits branching across state lines through interstate mergers.

Under the Federal Deposit Insurance Act, states may “opt-in” and allow out-of-state banks to branch into their state by establishing a new start-up branch in the state. Currently, Georgia has not opted-in to this provision. Therefore, interstate merger is the only method through which a bank located outside of Georgia may branch into Georgia. This provides a limited barrier of entry into the Georgia banking market, which protects us from an

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important segment of potential competition. However, because Georgia has elected not to opt-in, our ability to establish a new start-up branch in another state may be limited. Consequently, until Georgia changes its election, the only way the Bank will be able to branch into states that have elected to opt-in on a reciprocal basis will be through interstate merger. However, notwithstanding contradictory state law, the Home Owners’ Loan Act permits nationwide interstate branching for federal thrifts, subject to certain approvals and restrictions under federal law and regulations. As a result, branches of the Company’s thrift subsidiary are located in Georgia, Tennessee and North Carolina.

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, the federal banking regulators have established five capital categories, well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, in which all institutions are placed. The federal banking agencies have also specified by regulation the relevant capital levels for each of the other categories.

Federal banking regulators are required to take various mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. The other capital categories are well capitalized, adequately capitalized, and undercapitalized. As of December 31, 2008, the Bank and the Thrift qualified for the well-capitalized category.

A “well-capitalized” bank or thrift is one that significantly exceeds all of its capital requirements, which include maintaining a total risk-based capital ratio of at least 10%, a tier 1 risk-based capital ratio of at least 6%, and a tier 1 leverage ratio of at least 5%. Generally, a classification as well capitalized will place a bank or thrift outside of the regulatory zone for purposes of prompt corrective action. However, a well-capitalized bank or thrift may be reclassified as “adequately capitalized” based on criteria other than capital, if the federal regulator determines that a bank or thrift is in an unsafe or unsound condition, or is engaged in unsafe or unsound practices and has not corrected the deficiency.

FDIC Insurance Assessments. The FDIC is an independent agency of the United States government that uses the Deposit Insurance Fund to protect against the loss of insured deposits if an FDIC-insured bank or savings association fails. The FDIC must maintain the Deposit Insurance Fund within a range between 1.15 percent and 1.50 percent of all insured deposits.

The FDIC has adopted a risk-based assessment system for insured depository institutions that accounts for the risks attributable to different categories and concentrations of assets and liabilities. The system is designed to assess higher rates on those institutions that pose greater risks to the Deposit Insurance Fund. The FDIC places each institution in one of four risk categories using a two-step process based first on capital ratios (the capital group assignment) and then on other relevant information (the supervisory group assignment). Within the lower risk category, Risk Category I, rates will vary based on each institution’s CAMELS component ratings, certain financial ratios, and long-term debt issuer ratings, if any.

Capital group assignments are made quarterly and an institution is assigned to one of three capital categories: (1) well capitalized, (2) adequately capitalized, or (3) undercapitalized. These three categories are substantially similar to the prompt corrective action categories described above, with the “undercapitalized” category including institutions that are undercapitalized, significantly undercapitalized, and critically undercapitalized for prompt corrective action purposes. The FDIC also assigns an institution to one of three supervisory subgroups based on a supervisory evaluation that the institution’s primary federal banking regulator provides to the FDIC and information that the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds.

The FDIC is an independent agency of the United States government that uses the Deposit Insurance Fund to protect against the loss of insured deposits if an FDIC-insured bank or savings association fails. The FDIC must maintain the Deposit Insurance Fund within a range between 1.15 percent and 1.50 percent of all insured deposits.

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Because the Deposit Insurance Fund reserve fell below 1.15 percent as of June 30, 2008, and was expected to remain below 1.15 percent, the Federal Deposit Insurance Reform Act of 2005 required the FDIC to establish and implement a restoration plan to restore the reserve ratio to no less than 1.15 percent within five years, absent extraordinary circumstances.

The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and 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 FDIC.

FDIC Temporary Liquidity Guarantee Program. On October 14, 2008, the FDIC announced that its Board of Directors, under the authority to prevent “systemic risk” in the U.S. banking system, approved the Temporary Liquidity Guarantee Program (“TLGP”). The purpose of the TLGP is to strengthen confidence and encourage liquidity in the banking system. The TLGP is composed of two components, the Debt Guarantee Program and the Transaction Account Guarantee Program, and institutions had the opportunity, prior to December 5, 2008, to opt-out of either or both components of the TLGP.

The Debt Guarantee Program. Under the TLGP, the FDIC is permitted to guarantee certain newly issued senior unsecured debt issued by participating financial institutions. The annualized fee that the FDIC will assess to guarantee the senior unsecured debt varies by the length of maturity of the debt. For debt with a maturity of 180 days or less (excluding overnight debt), the fee is 50 basis points; for debt with a maturity between 181 days and 364 days, the fee is 75 basis points, and for debt with a maturity of 365 days or longer, the fee is 100 basis points. The Bank did not opt-out of the Debt Guarantee component of the TLGP.

The Transaction Account Guarantee Program. Under the TLGP, the FDIC is permitted to fully insure non-interest bearing deposit accounts held at participating FDIC-insured institutions, regardless of dollar amount. The temporary guarantee will expire at the end of 2009. For the eligible noninterest-bearing transaction deposit accounts (including accounts swept from a noninterest bearing transaction account into an noninterest bearing savings deposit account), a 10 basis point annual rate surcharge will be applied to noninterest-bearing transaction deposit amounts over $250,000. Institutions will not be assessed a surcharge on amounts that are otherwise insured. The Bank did not opt-out of the Transaction Account Guarantee component of the TLGP.

Allowance for Loan and Lease Losses. The Allowance for Loan and Lease Losses (the “ALLL”) represents one of the most significant estimates in the financial statements and regulatory reports of the Company’s subsidiaries. Because of its significance, our subsidiaries have developed a system by which they develop, maintain, and document a comprehensive, systematic, and consistently applied process for determining the amounts of the ALLL and the provision for loan and lease losses. The Interagency Policy Statement on the Allowance for Loan and Lease Losses, issued on December 13, 2006 encourages all institutions to ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the institution’s stated policies and procedures, management’s best judgment, and relevant supervisory guidance. Consistent with supervisory guidance, our subsidiaries maintain a prudent and conservative, but not excessive, ALLL, that is at a level that is appropriate to cover estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio. The estimate of the credit losses of our subsidiaries reflects consideration of all significant factors that affect the collectability of the portfolio as of the evaluation date. See “Management’s Discussion and Analysis – Control Accounting Policies.”

Commercial Real Estate Lending. The lending operations of our subsidiaries may be subject to enhanced scrutiny by federal banking regulators based on their concentration of commercial real estate loans. On December 6, 2006, the federal banking regulators issued final guidance to remind financial institutions of the risk posed by commercial real estate (“CRE”) lending concentrations. CRE loans generally include land development, construction loans, and loans secured by multifamily property, and nonfarm, nonresidential real property where the primary source of repayment is derived from rental income associated with the property. The guidance prescribes the following guidelines for its examiners to help identify institutions that are potentially exposed to significant CRE risk and may warrant greater supervisory scrutiny:

• total reported loans for construction, land development and other land represent 100% or more of the institutions total capital, or

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• total commercial real estate loans represent 300% or more of the institution’s total capital, and the outstanding balance of the institution’s commercial real estate loan portfolio has increased by 50% or more.

As of December 31, 2008, the bank’s and thrift’s concentration in construction, land development and other land loans were $709.1 million and $66.5 million, respectively, both of which were in excess of the above stated guidelines. Concentrations in commercial real estate loans for the bank and the thrift were $143.3 million and $30.3 million, respectively, which were also in excess of the above stated guidelines. We are currently making an effort to reduce our exposure to these type loans and our focus has shifted to developing our commercial and industrial loans as well as our consumer loans.

Community Reinvestment Act. The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their respective jurisdictions, the federal banking agencies shall evaluate the record of each financial institution in meeting the credit needs of its local community, including low- and moderate-income neighborhoods. These facts are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on the Company’s subsidiaries. Additionally, our subsidiaries must publicly disclose the terms of various Community Reinvestment Act-related agreements.

Other Regulations. Interest and other charges collected or contracted for by the Bank and the Thrift are subject to state usury laws and federal laws concerning interest rates. The Company’s loan operations as conducted by our subsidiaries are also subject to federal laws applicable to credit transactions, such as the:

• Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

• Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

• Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed, or other prohibited factors in extending credit;

• Fair Credit Reporting Act of 1978, as amended by the Fair and Accurate Credit Transactions Act, governing the use and provision of information to credit reporting agencies, certain identity theft protections, and certain credit and other disclosures;

• Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

• Soldiers’ and Sailors’ Civil Relief Act of 1940, as amended, governing the repayment terms of, and property rights underlying, secured obligations of persons currently on active duty with the United States military;

• Talent Amendment in the 2007 Defense Authorization Act, establishing a 36% annual percentage rate ceiling, which includes a variety of charges including late fees, for certain types of consumer loans to military service members and their dependents; and

• rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

In addition, the deposit operations of the Bank and the Thrift are subject to federal laws applicable to depository accounts, such as the following:

• Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;

• Truth-In-Savings Act, requiring certain disclosures for consumer deposit accounts;

• Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve Board to implement that act, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; and

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• rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

Capital Adequacy

The Company and its subsidiaries are required to comply with the capital adequacy standards established by the Federal Reserve Board, in the case of the Company, the FDIC, in the case of the Bank, and the OTS, in the case of the Thrift. The Federal Reserve Board has established a risk-based and a leverage measure of capital adequacy for bank holding companies. The Company’s subsidiaries are also subject to risk-based and leverage capital requirements adopted by its primary regulator, which are substantially similar to those adopted by the Federal Reserve Board for bank holding companies.

The risk-based capital standards are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance-sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance-sheet items, such as letters of credit and unfunded loan commitments, are assigned to broad risk categories, each with appropriate risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance-sheet items.

The minimum guideline for the ratio of total capital to risk-weighted assets is 8%. Total capital consists of two components:
Tier 1 Capital and Tier 2 Capital. Tier 1 Capital generally consists of common stockholders’ equity, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock, and a limited amount of qualifying cumulative perpetual preferred stock, less goodwill and other specified intangible assets. Tier 1 Capital must equal at least 4% of
risk-weighted assets. Tier 2 Capital generally consists of subordinated debt, other preferred stock and hybrid capital, and a limited amount of loan loss reserves. The total amount of Tier 2 Capital is limited to 100% of Tier 1 Capital. At December 31, 2008 our ratio of total capital to risk-weighted assets was 9.89% and our ratio of Tier 1 Capital to risk-weighted assets was 7.96%.

In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to average assets, less goodwill and other specified intangible assets, of 3% for bank holding companies that meet specified criteria, including having the highest regulatory rating and implementing the Federal Reserve Board’s risk-based capital measure for market risk. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%. At December 31, 2008, our leverage ratio was 6.64%. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without reliance on intangible assets. The Federal Reserve Board considers the leverage ratio and other indicators of capital strength in evaluating proposals for expansion or new activities.

Failure to meet capital guidelines could subject a bank holding company or its subsidiaries to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and certain other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements. See “Prompt Corrective Action” above.

The FDIC approved Appalachian Community Bank, F.S.B.’s application for federal deposit insurance on January 19, 2007, subject to the condition that the Tier 1 capital to assets leverage ratio be maintained at not less than 8%, throughout the first three years of operation, and that an adequate allowance for loan and lease losses be provided.

Payment of Dividends

The Company is a legal entity separate and distinct from its subsidiaries. The principal source of the Company’s cash flow, including cash flow to pay dividends to its shareholders, is dividends that the Bank and the Thrift pay to the Company as the respective subsidiaries’ sole shareholder. Statutory and regulatory limitations apply to the payment of dividends to the Company by its subsidiaries, as well as to the Company’s payment of dividends to its shareholders. If, in the opinion of the federal banking regulator, the Bank or the Thrift were engaged in or about to engage in an unsafe or unsound practice, the respective federal banking regulator could require, after notice and a hearing, that the subsidiary stop or refrain from engaging in the practice. The federal banking agencies

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have indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act of 1991, a depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks and thrifts should generally only pay dividends out of current operating earnings.

The Bank is required to obtain prior approval of the Department if the total of all dividends declared by the Bank in any year will exceed 50% of the Bank’s net income for the prior year. This limitation also applies to a bank holding company’s payment of dividends to its shareholders. The payment of dividends by the Company and its subsidiaries may also be affected by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. At December 31, 2008, due to the Bank’s net loss for the year, cash dividends could not be paid without prior regulatory approval.

Restrictions on Transactions with Affiliates

The Company and its subsidiaries are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:

• an institution’s loans or extensions of credit to affiliates;

• an institution’s investment in affiliates;

• assets a bank may purchase from affiliates, except for real and personal property exempted by the Federal Reserve Board;

• loans or extensions of credit to third parties collateralized by the securities or obligations of affiliates; and

• an institution’s guarantee, acceptance, or letter of credit issued on behalf of an affiliate.

The total amount of the above transactions is limited in amount, as to any one affiliate, to 10% of an institution’s capital and surplus and, as to all affiliates combined, to 20% of an institution’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. The Bank and the Thrift must also comply with other provisions designed to avoid taking low-quality assets.

The Company and its subsidiaries are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibit an institution from engaging in the above transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Our subsidiaries are also subject to restrictions on extensions of credit to its executive officers, directors, principal shareholders, and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

Liability of Commonly Controlled Depository Institutions

Pursuant to Section 5(e) of the Federal Deposit Insurance Act, commonly controlled institutions, such as the Bank and the Thrift, which are controlled by the same company, may be liable for losses incurred or reasonably anticipated by the FDIC in the event of an affiliate financial institution’s default or a rendering of assistance by the FDIC if such institution is in danger of default. The FDIC, however, in its sole discretion, may exempt the Bank, or any insured depository institution, from this liability if it determines that such exemption is in the “best interest of the Bank Insurance Fund or the Savings Association Insurance Fund.” If the FDIC determined that the Bank, or another commonly controlled institution, was not exempt from such liability, the liability would attach at the time of default. Such liability would be superior to any obligation to shareholders and any liability owed to an affiliate of the Bank. On the other hand, such liability would be junior in right and payment to any deposit liability, any

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secured obligation, and any other senior liability or obligation subordinate to depositors or other general creditors, similar to the indebtedness to be represented by the Notes.

Proposed Legislation and Regulatory Action

New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of financial institutions operating and doing business in the United States. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.

Effect of Governmental Monetary Policies

The Company’s earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve Board affect the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks, and its influence over reserve requirements to which member banks are subject. Neither the Company nor its subsidiaries can predict the nature or impact of future changes in monetary and fiscal policies.

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ITEM 1A. RISK FACTORS

The following are certain risks that management believes are specific to our business. This should not be viewed as an all inclusive list or in any particular order.

We could suffer additional loan losses from a continued decline in credit quality.

We could sustain losses if borrowers, guarantors, and related parties fail to perform in accordance with the terms of their loans. We have adopted underwriting and credit monitoring procedures and policies, including the establishment and review of the allowance for credit losses that we believe are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our credit portfolio. These policies and procedures, however, may not prevent unexpected losses that could materially adversely affect our results of operations.

Declines in real estate values have adversely affected our credit quality and profitability.

During 2008, confidence in the credit market for residential housing finance significantly eroded, which resulted in a reduction in financing available to buyers of new homes and borrowers wishing to refinance existing financing terms. The tightening of credit for residential housing led to lower demand for residential housing and more foreclosures, and has reduced the absorption rate for new and existing properties. In turn, this tightening of credit has caused market prices to fall as some property owners, including lenders who acquired property by foreclosure, have accepted lower prices to reduce their exposure to these real estate assets, which has reduced the market values for comparable real estate.

The declines in values and the increased level of marketing required to sell properties has reduced or eliminated the potential profits to many of the builders and developers of properties to whom we have extended loans. As a result, some of these borrowers have been unable to repay their loans in accordance with their terms, which has led to an increase in our past due, impaired and non-performing loans. If these housing trends continue or exacerbate, the Company expects that it will continue to experience increased delinquencies and credit losses. In addition, declining real estate and other asset values may reduce the available equity associated with these assets, which, in turn, would limit the ability of borrowers to use such equity to support borrowings.

Moreover, if the current recession continues, the Company may be required to further increase our loan loss provision, and may experience significantly higher delinquencies and credit losses. An increase in our loan loss provision or increased credit losses would reduce earnings and adversely affect the Company’s financial condition. Furthermore, to the extent that real estate collateral is obtained through foreclosure, the costs of holding and marketing the real estate collateral, as well as the ultimate values obtained from disposition, could reduce the Company’s earnings and adversely affect the Company’s financial condition.

The Company’s business volume and growth is affected by the rate of growth and demand for housing in specific geographic markets. Based on the activity discussed above, the Company’s future rate of growth, if any, could be significantly less than its historical levels and its assets may in fact shrink, depending on the duration and extent of the current disruption in the housing and mortgage markets.

We make and hold in our portfolio a significant number of land acquisition and development and construction loans, which pose more credit risk than other types of loans typically made by financial institutions.

We offer land acquisition and development and construction loans for builders and developers. As of December 31, 2008, approximately $389.3 million, or 44.0%, of our total loan portfolio represented loans for which the related property is neither presold nor preleased. These land acquisition and development and construction loans are considered more risky than other types of loans. The primary credit risks associated with land acquisition and development and construction lending are underwriting, project risks, and market risks. Project risks include cost overruns, borrower credit risk, project completion risk, general contractor credit risk, and environmental and other hazard risks. Market risks are risks associated with the sale of the completed residential units. They include affordability risk, which means the risk that borrowers cannot obtain affordable financing, product design risk, and risks posed by competing projects. There can be no assurance that losses in our land acquisition and development and construction loan portfolio will not exceed our reserves, which could adversely impact our earnings. Given the

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current environment, the non-performing loans in our land acquisition and development and construction portfolio may increase substantially in 2009, and these non-performing loans could result in a material level of charge-offs, which will negatively impact our capital and earnings.

Ongoing deterioration in the housing market and the homebuilding industry may lead to increased losses and further worsening of delinquencies and non-performing assets in our loan portfolios. Consequently, our results of operations may be adversely impacted.

There has been substantial industry concern and publicity over asset quality among financial institutions due in large part to issues related to subprime mortgage lending, declining real estate values and general economic concerns. As of December 31, 2008, our non-performing assets increased significantly to $41.5 million, or 4.62%, of our loan portfolio plus other real estate owned. Furthermore, the housing and the residential mortgage markets recently have experienced a variety of difficulties and changed economic conditions. If market conditions continue to deteriorate, they may lead to additional valuation adjustments on our loan portfolios and real estate owned as we continue to reassess the market value of our loan portfolio, the losses associated with the loans in default, and the net realizable value of real estate owned.

The homebuilding industry has experienced a significant and sustained decline in demand for new homes and an oversupply of new and existing homes available for sale in various markets, including some of the markets in which we lend. Our customers who are builders and developers face greater difficulty in selling their homes in markets where these trends are more pronounced. Consequently, we are facing increased delinquencies and non-performing assets as these builders and developers are forced to default on their loans with us. We do not know when the housing market will improve, and accordingly, additional downgrades, provisions for loan losses, and charge-offs related to our loan portfolio may occur.

Weakness in residential property values and mortgage loan markets could adversely affect us.

Recent weakness in the secondary market for residential lending could have an adverse impact upon our profitability. Pricing may change rapidly impacting the value of loans in our portfolio. This has been most pronounced in residential construction and development loans, and in subprime and Alt-A lending. The turmoil in the mortgage markets, combined with the ongoing correction in real estate markets, could result in further price reductions in single family home prices and lack of liquidity in refinancing markets. These factors could adversely impact the quality of our residential construction and residential mortgage portfolio in various ways, including creating discrepancies in value between the original appraisal and the value at time of sale, and by decreasing the value of the collateral for our mortgage loans. We also have a significant amount of loans on one-to-four family residential properties, which are secured principally by single-family residences. Loans of this type are generally smaller in size and geographically dispersed throughout our market area. Losses on the residential loan portfolio depend to large degree on the level of interest rates, the unemployment rate, economic conditions, and collateral values, and are therefore difficult to predict.

Additionally, we may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of certain borrower defaults, which could harm our liquidity, results of operations, and financial condition. When we sell mortgage loans, whether as whole loans or pursuant to a securitization, we are required to make customary representations and warranties to the purchaser about the mortgage loans and the manner in which the loans were originated. Our whole loan sale agreements sometimes require us to repurchase or substitute mortgage loans in the event we breach any of these representations or warranties. In addition, we may be required to repurchase mortgage loans in the event of early payment default of the borrower on a mortgage loan. While we have taken steps to enhance our underwriting policies and procedures, these steps might not be effective and might not lessen the risks associated with loans sold in the past. If repurchase demands increase, our liquidity, results of operations, and financial condition could be adversely affected.

The amount of “other real estate owned” (“OREO”) may increase significantly, resulting in additional losses, and costs and expenses that will negatively affect our operations

At December 31, 2007, we had a total of $1.5 million of OREO, and at December 31, 2008, we had a total of $13.2 million of OREO, reflecting a $11.7 increase, or 775.7%, from 2007 to 2008. This increase in OREO is due, among other things, to the continued deterioration of the residential real estate market and the tightening of the

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credit market. As the amount of OREO increases, our losses, and the costs and expenses to maintain the real estate likewise increase. Due to the on-going economic crisis, the amount of OREO may continue to increase throughout 2009. Any additional increase in losses, and maintenance costs and expenses due to OREO may have material adverse effects on our business, financial condition, and results of operations. Such effects may be particularly pronounced in a market of reduced real estate values and excess inventory, which may make the disposition of OREO properties more difficult, increase maintenance costs and expenses, and may reduce our ultimate realization from any OREO sales.

Recent negative developments in the financial industry, and the domestic and international credit markets may adversely affect our operations and results.

Negative developments during 2008 in the global credit and derivative markets have resulted in uncertainty in the financial markets in general with the expectation of the general economic downturn continuing in 2009. As a result of this “credit crunch,” commercial as well as consumer loan portfolio performances have deteriorated at many institutions and the competition for deposits and quality loans has increased significantly. In addition, the values of real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline. Global securities markets, and bank holding company stock prices in particular, have been negatively affected, as has the ability of banks and bank holding companies to raise capital or borrow in the debt markets. If these negative trends continue, our business operations and financial results may be negatively affected.

The deterioration in the residential mortgage market may continue to spread to commercial credits, which may result in greater losses and non-performing assets, adversely affecting our business operations.

The losses that were initially associated with subprime residential mortgages rapidly spread into the residential mortgage market generally. If the losses in the residential mortgage market continue to spread to commercial credits, then we may be forced to take greater losses or to hold more non-performing assets. Our business operations and financial results could be adversely affected if we continue to experience losses from our commercial loan portfolio.

The FDIC Deposit Insurance assessments that we are required to pay may materially increase in the future, which would have an adverse effect on our earnings.

As an insured depository institution, we are required to pay quarterly deposit insurance premium assessments to the FDIC. These assessments are required to ensure that FDIC deposit insurance reserve ratio is at least 1.15% of insured deposits. Under the Federal Deposit Insurance Act, the FDIC, absent extraordinary circumstances, must establish and implement a plan to restore the deposit insurance reserve ratio to 1.15% of insured deposits, over a five-year period, when the reserve ratio falls below 1.15%. The recent failures of several financial institutions have significantly increased the Deposit Insurance Fund’s loss provisions, resulting in a decline in the reserve ratio. The FDIC expects a higher rate of insured institution failures in the next few years, which may result in a continued decline in the reserve ratio.

Beginning on January 1, 2009, there is a uniform 7 basis points (annualized) increase to the assessments that banks pay for deposit insurance. The increased assessment rates range from 12 to 50 basis points (annualized) for the first quarter of 2009 assessment. In addition, the FDIC is currently considering a proposal that would increase the assessments that riskier institutions pay, beginning in the second quarter of 2009. As of January 31, 2009, the FDIC had not adopted the proposed increased assessments for riskier institutions, but we cannot predict whether the FDIC will adopt this rule.

During the year ended December 31, 2008, we paid $809,545 in deposit insurance assessments. Due to the recent failure of several unaffiliated FDIC insurance depository institutions and the corresponding increase in assessments, we will be required to pay additional amounts to the Deposit Insurance Fund throughout 2009, which could have an adverse effect on our earnings. If the deposit insurance premium assessment rate applicable to us increases again, either because of our risk classification or because of another uniform increase, our earnings could be further adversely impacted.

18

Future impairment losses could be required on various investment securities, which may materially reduce the Company’s and the Bank’s regulatory capital levels.

The Company establishes fair value estimates of securities available-for-sale in accordance with generally accepted accounting principles. The Company’s estimates can change from reporting period to reporting period, and we cannot provide any assurance that the fair value estimates of our investment securities would be the realizable value in the event of a sale of the securities.

A number of factors could cause the Company to conclude in one or more future reporting periods that any difference between the fair value and the amortized cost of one or more of the securities that we own constitutes an other-than-temporary impairment. These factors include, but are not limited to, an increase in the severity of the unrealized loss on a particular security, an increase in the length of time unrealized losses continue without an improvement in value, a change in our intent or ability to hold the security for a period of time sufficient to allow for the forecasted recovery, or changes in market conditions or industry or issuer specific factors that would render us unable to forecast a full recovery in value, including adverse developments concerning the financial condition of the companies in which we have invested.

The Company may be required to take other-than-temporary impairment charges on various securities in its investment portfolio. In addition, depending on various factors, including the fair values of other securities that we hold, we may be required to take additional other-than-temporary impairment charges on other investment securities. Any other-than-temporary impairment charges would negatively affect our regulatory capital levels, and may result in a change to our capitalization category, which could limit certain corporate practices and could compel us to take specific actions.

During the third quarter of 2008, the Company recognized an other than temporary impairment charge of $816,000 on its investment in Freddie Mac preferred stock. The value of these securities declined significantly after the U.S. Government placed the company into conservatorship in September 2008. The remaining carrying value of the preferred stock at December 31, 2008 is $6,000.

A reduction in the fair value attributable to recently acquired units of our business may result in the Company having to recognize a non-cash goodwill impairment charge, which would negatively impact our earnings and, consequently, our ability to pay dividends.

In 1998 the Company acquired a bank located in Blairsville, Georgia. We booked $1,991,891 in goodwill as an intangible asset on its balance sheet in connection with this acquisition. Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” requires us to make a periodic assessment of any goodwill we carry on our balance sheet by comparing the current fair value of each unit for which goodwill has been recognized to that unit’s book value. In the event that the assessment shows that the book value of any unit exceeds its fair value, a non-cash, after-tax, we must take a goodwill impairment charge equal to the difference between relevant book and fair values. While such a goodwill impairment charge would have no impact on our regulatory capital ratios or liquidity position, it would result in a reduction of our earnings.

The goodwill impairment assessment must occur on at least an annual basis, or more frequently as changing circumstances would dictate. The Company normally performs its annual assessment on December 31 of each year. After its December 31, 2008 assessment, we determined that no goodwill impairment change was necessary. However, the weakening of real estate markets, both nationally and locally in our primary market area, the tightening of credit, and other events of the past months have generally resulted in the lowered market valuation of financial institutions operating in the southeastern United States and may require that we realize a goodwill impairment charge in 2009.

19

If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease.

Our success depends to a significant extent upon the quality of our assets, particularly loans. In originating loans, there is a substantial likelihood that we will experience credit losses. The risk of loss will vary with, among other things, general economic conditions, the type of loan, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the quality of the collateral for the loan.

Our loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. As a result, we may experience significant loan losses, which could have a material adverse effect on our operating results. Management makes various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses in an attempt to cover any loan losses that may occur. In determining the size of the allowance, we rely on an analysis of our loan portfolio based on historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and non-accruals, national and local economic conditions, and other pertinent information.

If our assumptions are wrong, our current allowance may not be sufficient to cover future loan losses, and we may need to make adjustments to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance would materially decrease our net income. As a result of a difficult real estate market, we have increased our allowance from $9.8 million as of December 31, 2007 to $14.5 million as of December 31, 2008. We expect to continue to increase our allowance in 2009; however, given current and future market conditions, we can make no assurance that our allowance will be adequate to cover future loan losses.

In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs as required by these regulators could have a negative effect on our operating results.

Weakness in the economy and in the real estate market, including specific weakness within our geographic footprint, has adversely affected us and may continue to adversely affect us.

Declines in the U.S. economy and our local real estate markets contributed to our increasing provisions for loan losses during 2008, and may result in additional loan losses and loss provisions for 2009. These factors could result in further increases in loan loss provisions, and additional delinquencies, charge-offs, or both in future periods, any of which may adversely affect our financial condition and results of operations. If the strength of the U.S. economy in general and the strength of the local economies in which we conduct operations continue to decline, this could result in, among other things, further deterioration in credit quality or a reduced demand for credit, including a resultant adverse effect on our loan portfolio and additional increases to our allowance for loan and lease losses.

In addition, deterioration of the U.S. economy may adversely impact our banking business more generally. Economic declines may be accompanied by a decrease in demand for consumer or commercial credit and declining real estate and other asset values. Declining real estate and other asset values may reduce the ability of borrowers to use such equity to support borrowings. Delinquencies, foreclosures and losses generally increase during economic slowdowns or recessions. Additionally, our servicing costs, collection costs, and credit losses may also increase in periods of economic slowdown or recessions. Effects of the current real estate slowdown have not been limited to those directly involved in the real estate construction industry (such as builders and developers). Rather, it has impacted a number of related businesses such as building materials suppliers, equipment leasing firms, and real estate attorneys, among others, and the current recession has negatively impacted businesses of all types. All of these affected businesses have banking relationships, and when their businesses suffer from an economic slowdown or recession, the banking relationship suffers as well.

20

Our net interest income could be negatively affected by the Federal Reserve’s recent interest rate adjustments, as well as by competition in our market area.

As a financial institution, our earnings significantly depend on our net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Therefore, any change in general market interest rates, including changes resulting from changes in the Federal Reserve’s fiscal and monetary policies, affects us more than non-financial institutions and can have a significant effect on our net interest income and total income. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of the assets and liabilities. As a result, an increase or decrease in market interest rates could have material adverse effects on our net interest margin and results of operations.

Since January 2008, in response to the dramatic deterioration of the subprime, mortgage, credit, and liquidity markets, the Federal Reserve has taken action on seven occasions to reduce interest rates by a total of 400 to 425 basis points, which has reduced our net interest income and will likely continue to reduce this income for the foreseeable future. Any reduction in our net interest income will negatively affect our business, financial condition, liquidity, operating results, cash flows and, potentially, the price of our securities. Additionally, in 2009, we expect to have continued margin pressure given these historically low interest rates, along with elevated levels of non-performing assets.

Our access to additional short term funding to meet our liquidity needs is limited.

We must maintain, on a daily basis, sufficient funds to cover withdrawals from depositors’ accounts and to supply new borrowers with funds. We routinely monitor asset and liability maturities in an attempt to match maturities to meet liquidity needs. To meet our cash obligations, we rely on repayments as assets mature, keep cash on hand, maintain account balances with correspondent banks, purchase and sell federal funds, purchase brokered deposits, and maintain a line of credit with the Federal Home Loan Bank. If we are unable to meet our liquidity needs through our cash on hand, and loan and other asset repayments, we may need to borrow additional funds. Currently, our access to additional borrowed funds is limited, and we may be required to pay above market rates for additional borrowed funds, which may adversely affect our results of operations.

As of December 31, 2008, we had approximately $262.7 million in out of market deposits, including brokered deposits, which represented approximately 25.9% of our total deposits. At times, the cost of out of market and brokered deposits exceeds the cost of deposits in our local market. In addition, the cost of out of market and brokered deposits can be volatile, and if we are unable to access these markets or if our costs related to out of market and brokered deposits increases, our liquidity and ability to support demand for loans could be adversely affected.

Our business strategy includes stabilizing growth, preserving market presence and raising capital, and as a result, our financial condition and results of operations could be negatively affected if we fail to effectively stabilize our growth, preserve our market presence or raise capital.

In light of the current adverse economic conditions, expenses, and difficulties currently being experienced in our industry, we intend to stabilize the growth of our business while preserving our market presence. In addition, as a result of the current economic environment, we plan to raise additional capital. We cannot assure you we will be able to stabilize growth and preserve our market presence in our existing markets or successfully raise capital. Failure to manage our growth effectively could have a material adverse effect on our business, financial condition, results of operations, or future prospects, and could adversely affect our ability to successfully implement our business strategy.

Our ability to successfully stabilize our growth and preserve our market presence will depend on a variety of factors including the current economic environment, the availability of desirable business opportunities, and the competitive responses from other financial institutions in our market areas. While we believe we have the management resources and internal systems in place to preserve our market presence, stabilize our growth and raise capital, there can be no assurance that capital will be available or growth, in light of current economic conditions, will be managed successfully.

21

Adverse market conditions and future losses may require us to raise additional capital to support our operations, but that capital may not be available when it is needed, which could adversely affect our financial condition and results of operations.

We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. We anticipate that our current capital resources will satisfy our capital requirements for the foreseeable future. We may at some point, however, need to raise additional capital to support our operations.

Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations could be materially impaired.

Our ability to raise capital could be limited and could be dilutive to existing shareholders.

Current capital markets are such that traditional sources of capital may not be available to us on reasonable terms. If we need to raise capital, there is no guarantee that we will be able to borrow funds or successfully raise additional capital at all or on terms that are favorable or otherwise not dilutive to existing shareholders.

Our directors and executive officers own a significant portion of our common stock and can influence stockholder decisions.

Our directors and executive officers, as a group, beneficially owned approximately 19% of our fully diluted outstanding common stock as of December 31, 2008. As a result of their ownership, the directors and executive officers will have the ability, if they voted their shares in concert, to influence the outcome of all matters submitted to our stockholders for approval, including the election of directors.

We face intense competition in all of our markets.

The financial services industry, including commercial banking, mortgage banking, consumer lending, and home equity lending, is highly competitive, and we encounter strong competition for deposits, loans, and other financial services in all of our market areas in each of our lines of business. Our principal competitors include other commercial banks, savings banks, savings and loan associations, mutual funds, money market funds, finance companies, trust companies, insurers, credit unions, and mortgage companies. Many of our non-bank competitors are not subject to the same degree of regulation as us and have advantages over us in providing certain services. Many of our competitors are significantly larger than us and have greater access to capital and other resources. Also, our ability to compete effectively in our business depends on our ability to adapt successfully to regulatory and technological changes within the banking and financial services industry generally. If we are unable to compete effectively, we will lose market share and our income from loans and other products may diminish.

Our ability to compete successfully depends on a number of factors, including, among other things:

• the ability to develop, maintain, and build upon long-term customer relationships based on top quality service and high ethical standards;

• the scope, relevance, and pricing of products and services offered to meet customer needs and demands;

• the rate at which we introduce new products and services relative to our competitors;

• customer satisfaction with our level of service; and

• industry and general economic trends.

Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.

22

Negative publicity about financial institutions, generally, or about the Company or Bank, specifically, could damage the Company’s reputation and adversely impact its business operations and financial results.

Reputation risk, or the risk to our business from negative publicity, is inherent in our business. Negative publicity can result from the actual or alleged conduct of financial institutions, generally, or the Company or Bank, specifically, in any number of activities, including leasing practices, corporate governance, and actions taken by government regulators in response to those activities. Negative publicity can adversely affect our ability to keep and attract customers and can expose us to litigation and regulatory action, any of which could negatively affect our business operations or financial results.

We are subject to extensive regulation that could limit or restrict our activities and impose financial requirements or limitations on the conduct of our business, which limitations or restrictions could adversely affect our profitability.

As a bank holding company, we are primarily regulated by the Board of Governors of the Federal Reserve System (“Federal Reserve Board”). Our subsidiary bank is primarily regulated by the Federal Deposit Insurance Corporation (the “FDIC”), the State Department of Banking and Finance, and the Office of Thrift Supervision. Our compliance with Federal Reserve Board, FDIC, and Department of Banking and Finance regulations is costly and may limit our growth and restrict certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. We are also subject to capital requirements of our regulators.

The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, our cost of compliance could adversely affect our ability to operate profitably.

The Sarbanes-Oxley Act of 2002, the related rules and regulations promulgated by the SEC that currently apply to us and the related exchange rules and regulations, have increased the scope, complexity and cost of corporate governance, reporting, and disclosure practices. Additional legislation or regulations, or amendments to current legislation or regulations, related to corporate governance, reporting, and disclosure may cause us to experience greater compliance costs.

The Emergency Economic Stabilization Act of 2008 (“EESA”) or other governmental actions may not stabilize the financial services industry.

The EESA, which was signed into law on October 3, 2008, is intended to alleviate the financial crisis affecting the U.S. banking system. A number of programs are being developed and implemented under EESA. The EESA may not have the intended effect, however, and as a result, the condition of the financial services industry could decline instead of improve. The failure of the EESA to improve the condition of the U.S. banking system could significantly adversely affect our access to funding or capital, the trading price of our stock, and other elements of our business, financial condition, and results of operations.

In addition to EESA, a variety of legislative, regulatory, and other proposals have been discussed or may be introduced in an effort to address the financial crisis. Depending on the scope of such proposals, if they are adopted and applied to the Company, our financial condition, results of operations or liquidity could, directly or indirectly, benefit or be adversely affected in a manner that could be material to our business.

Changes in monetary policies may have an adverse effect on our business, financial condition, and results of operations.

Our financial condition and results of operations are affected by credit policies of monetary authorities, particularly the Federal Reserve Board. Actions by monetary and fiscal authorities, including the Federal Reserve Board, could have an adverse effect on our deposit levels, loan demand or business and earnings.

23

Confidential customer information transmitted through the Bank’s online banking service is vulnerable to security breaches and computer viruses, which could expose the Bank to litigation and adversely affect its reputation and ability to generate deposits.

The Bank provides its customers with the ability to bank online. The secure transmission of confidential information over the Internet is a critical element of online banking. The Bank’s network could be vulnerable to unauthorized access, computer viruses, phishing schemes, and other security problems. The Bank may be required to spend significant capital and other resources to protect against the threat of security breaches and computer viruses, or to alleviate problems caused by security breaches or viruses. To the extent that the Bank’s activities or the activities of its clients involve the storage and transmission of confidential information, security breaches and viruses could expose the Bank to claims, litigation and other possible liabilities. Any inability to prevent security breaches or computer viruses could also cause existing clients to lose confidence in the Bank’s systems and could adversely affect its reputation and its ability to generate deposits.

24

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

25

ITEM 2. PROPERTIES

Our executive offices and the operations center for the company, the bank and the thrift are located at 822 Industrial Boulevard, Ellijay, Georgia. We own this property. In addition to this facility, we operate thirteen branch offices, of which nine are owned and four are subject to either building or ground leases. In February 2008, we completed construction on our new Chatsworth location, which replaced a temporary leased facility. Also during 2008, we began construction on new branch offices to replace three other leased facilities. These new facilities are located at Georgia Highway 400 in Dawson County, Georgia, in Dahlonega, Georgia and in Murphy, North Carolina. We began banking operations in the Dawson and Dahlonega facilities in 2008 and we were able to occupy the Murphy location in January 2009.

We also own a building in Ellijay, Georgia, which previously housed our operations center. This building is approximately 14,200 square feet, including approximately 8,000 square feet of commercial space that we have leased to various third parties in the past. We have two tenants occupying sections of this building and at this time we are using the remaining space as a storage facility for all of our branches and operations.

We believe that all of our properties are adequately covered by insurance. Further disclosures pertaining to our properties may be found in the notes to our consolidated financial statements.

ITEM 3. LEGAL PROCEEDINGS

In the ordinary course of operations, we are a party to various legal proceedings from time to time. We do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations or financial condition.

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

No matters were submitted to a vote of shareholders during the fourth quarter of the fiscal year covered by this report.

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PART II

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock trades on the Nasdaq Global Market under the symbol “APAB”. As of March 19, 2009, we had approximately 1,257 shareholders of record.

The following table shows the reported high and low sales prices reported by the Nasdaq Global Market for each of the four quarters in 2008 and 2007.

	Estimated Price Range Per Share
	High		Low
Year End 2008:
First Quarter	$	12.50	$	8.10
Second Quarter		7.50		7.50
Third Quarter		7.71		4.99
Fourth Quarter		5.84		2.50
Year End 2007:
First Quarter	$	21.92	$	18.35
Second Quarter		19.75		17.10
Third Quarter		17.84		13.97
Fourth Quarter		15.24		9.43

To date, we have not paid cash dividends on our common stock. For the foreseeable future we do not intend to declare cash dividends. We intend to retain earnings to grow our business and strengthen our capital base. Our ability to pay cash dividends is dependent upon receiving cash dividends from our subsidiaries. In addition, Georgia and federal banking regulations restrict the amount of cash dividends that can be paid to the company from its subsidiaries. See “Subsidiary Dividends” in the section entitled “Supervision and Regulation.”

27

Unregistered Sales of Equity Securities and Use of Proceeds.

Issuer Repurchases of Equity Securities

Period	Total Number of Shares (or Units) Purchased	Average Price Paid per Share (or Unit)		Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs	Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs(1)
1/1/08 to 1/31/08	0	$	0.00	0	$	1,987,600
2/1/08 to 2/29/08	16,000		11.44	16,000		1,804,560
3/1/08 to 3/31/08	0		0.00	0		—
Total	16,000	$	11.44	16,000	$	—

(1) On March 2, 2007, we announced a program to repurchase up to an aggregate of $2.5 million of our common stock over the twelve month period ending February 27, 2008. This program expired on February 27, 2008.

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ITEM 6. SELECTED FINANCIAL DATA

Our selected consolidated financial data presented below as of and for the years ended December 31, 2004 through 2008 is derived from our audited consolidated financial statements. Our audited consolidated financial statements as of December 31, 2008 and 2007 and for each of the years in the three year period ended December 31, 2008 are included elsewhere in this report.

	At and for the Years Ended December 31,
	2008			2007		2006		2005		2004
	(In thousands, except shares and per share data)
Selected Balance Sheet Data
Assets	$	1,185,678		$	971,200	$	758,214	$	592,606	$	472,811
Investment securities		79,308			76,565		72,413		68,872		61,985
Restricted equity securities		4,932			3,945		2,312		2,698		2,670
Foreclosed assets		13,323			1,573		1,218		147		516
Loans, held for sale		2,783			6,503		733		—		—
Loans		885,374			807,522		631,053		457,418		377,352
Allowance for loan losses		14,510			9,808		7,670		6,059		4,349
Deposits		1,013,276			807,597		651,134		473,310		381,498
Short-term borrowings		10,604			21,048		4,738		24,892		15,470
Accrued interest payable		1,936			2,059		1,454		728		540
FHLB advances		72,000			57,350		25,050		24,950		31,950
Subordinated long-term capital notes		12,511			6,186		6,186		6,186		6,186
Other liabilities		2,913			3,297		2,889		2,715		1,084
Shareholders’ equity		72,438			73,663		66,763		59,825		36,083
Summary Results of Operations Data
Interest income	$	69,005		$	72,127	$	53,193	$	34,750	$	25,736
Interest expense		34,034			34,800		22,494		11,880		7,558
Net interest income		34,971			37,327		30,699		22,870		18,178
Provision for loan losses		12,915			4,726		3,253		2,211		1,235
Net interest income after provision for loan losses		22,056			32,601		27,446		20,659		16,943
Non-interest income		4,247			5,518		3,971		3,303		2,829
Non-interest expense		31,614			29,786		22,561		16,338		13,840
Income (loss) before taxes		(5,311	)		8,333		8,856		7,624		5,932
Income tax expense (benefit)		(2,452	)		2,763		2,852		2,502		1,885
Net income (loss)	$	(2,859	)	$	5,570	$	6,004	$	5,122	$	4,047
Per Share Data
Net income (loss)—basic	$	(0.53	)	$	1.06	$	1.16	$	1.24	$	1.09
Net income (loss)—diluted		(0.53	)		1.06		1.14		1.21		1.04
Book value		13.48			13.94		12.83		11.62		9.58
Cash dividends declared per common share		0.00			0.00		0.00		0.00		0.00
Weighted average number shares outstanding:
Basic		5,366,658			5,265,555		5,170,687		4,123,403		3,724,095
Diluted		5,366,658			5,276,200		5,278,711		4,247,334		3,885,490

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	At and for the Years Ended December 31,
	2008		2007		2006		2005		2004
Performance Ratios
Return on average assets	(0.27	)%	0.65	%	0.91	%	0.99	%	0.91	%
Return on average equity	(3.80	)	7.93		9.57		12.18		12.23
Net interest margin (1)	3.61		4.68		5.04		4.77		4.43
Efficiency ratio (2)	79.05		69.53		65.07		62.42		65.81
Loan to deposit ratio	87.38		99.99		97.03		96.64		98.91
Asset Quality Ratios
Nonperforming loans to total loans	3.18	%	0.57	%	0.55	%	0.24	%	0.41	%
Nonperforming assets to total assets	3.50		0.64		0.62		0.21		0.44
Net charge-offs to average total loans	0.95		0.36		0.30		0.12		0.14
Allowance for loan losses to nonperforming loans	51.51		212.57		220.21		555.36		279.14
Allowance for loan losses to total loans	1.64		1.21		1.21		1.32		1.15
Capital Ratios
Average equity to average assets	7.14	%	8.14	%	9.49	%	8.11	%	7.42	%
Leverage ratio	6.64		8.30		9.55		11.35		8.53
Tier 1 risk-based capital ratio	7.96		9.36		10.69		13.27		10.32
Total risk-based capital ratio	9.89		10.55		11.85		14.52		11.45
Growth Ratios and Other Data
Percentage change in net income (loss)	(151.33	)%	(7.23	)%	17.22	%	26.56	%	31.14	%
Percentage change in diluted net income (loss) per share	(150.00	)	(7.02	)	(5.79	)	16.35		28.40
Percentage change in assets	22.08		28.09		27.95		25.34		15.43
Percentage change in loans	9.64		27.96		38.12		21.22		13.56
Percentage change in deposits	25.47		24.03		37.57		24.07		14.59
Percentage change in equity	(1.66	)	10.34		11.60		65.80		16.09

(1) Taxable Equivalent.

(2) Computed by dividing noninterest expense by the sum of net interest and noninterest income, excluding any realized gains/losses on sales of securities.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion reviews our results of operations and assesses our financial condition. You should read the following discussion and analysis in conjunction with our “Selected Consolidated Financial Data” and our consolidated financial statements and the related notes included elsewhere in this Report.

Overview

We were incorporated in 1996 to serve as the holding company for Gilmer County Bank (now Appalachian Community Bank). As of April 2007, we also serve as the holding company for Appalachian Community Bank, F.S.B.

The following table sets forth selected measures of our financial performance for the periods indicated.

	Years Ended December 31,
	2008			2007		2006
	(In thousands)
Net income (loss)	$	(2,859	)	$	5,570	$	6,004
Total assets		1,185,678			971,200		758,214
Total loans (1)		885,374			807,522		631,053
Total deposits		1,013,276			807,597		651,134
Shareholders’ equity		72,438			73,663		66,763

(1) Loans are net of unearned income

Like most community banks and thrifts, we derive the majority of our income from interest and fees received on our loans. Our primary sources of funds for making these loans and investments are our deposits and advances from the Federal Home Loan Bank of Atlanta (FHLB). Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income earned on our interest-earning assets, such as loans and investments, and the interest paid on our interest-bearing liabilities, such as deposits and advances from the FHLB. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread.

We have included a number of tables to assist in our description of these measures. For example, the “Average Balances, Income and Expense and Rates” tables show for the periods indicated the average balance for each category of our assets and liabilities, as well as the yield we earned or the rate we paid with respect to each category. A review of these tables show that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we intend to channel a substantial percentage of our earning assets into our loan portfolio. Similarly, the “Analysis of Changes in Net Interest Income” table helps demonstrate the impact of changing interest rates and changing volume of assets and liabilities during the periods shown. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included an “Interest Sensitivity Analysis” table to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans, our deposits and other borrowings.

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We maintain this allowance by charging a provision for loan losses against our operating earnings for each period. We have included a detailed discussion of this process, as well as several tables describing our allowance for loan losses.

In addition to earning interest on our loans and investments, we earn income through fees and other charges to our customers. We have also included a discussion of the various components of this noninterest income, as well as of our noninterest expense, included in the “Noninterest Income and Expense” section.

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The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in this Report.

Critical Accounting Policies

In the preparation of our consolidated financial statements, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States as well as the general practices within the banking and thrift industry. Our significant accounting policies are described in the notes to our audited consolidated financial statements included in this Report.

Certain accounting policies involve significant judgments and assumptions by management that may have a material impact on the carrying value of certain assets and liabilities. We consider such accounting policies to be critical accounting policies. The judgments and assumptions we use 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 we make, actual results could differ from these judgments and estimates. These differences could have a material impact on our carrying values of assets and liabilities and our results of operations.

We believe the determination of the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates when preparing our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, cash flow assumptions, determination of loss factors for estimating credit losses, the impact of current events and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the section entitled “Allowance for Loan Losses” for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Results of Operations

Income Statement Review

Overview

For the year ended December 31, 2008, we had a net loss of $2.9 million, or $(0.53) basic net loss per common share, as compared to a net income of $5.6 million, or $1.06 basic net income per common share, for the year ended December 31, 2007, and compared to a net income of $6.0 million, or $1.16 basic net income per common share, for the year ended December 31, 2006.

Our net loss for 2008 is primarily due to the large increase in our provision for loan losses, our decrease to net interest margin, losses on our sales of other real estate (“ORE”), the write-down of our 20,000 shares of Federal Home Loan Mortgage Corporation (“Freddie Mac”) Preferred Stock, our increase in nonaccrual loans, and the increases to other operating expenses necessary to support the Company’s growth.

Net Interest Income

Years Ended December 31, 2008, 2007, and 2006

Our primary source of revenue is net interest income, which represents the difference between the income on interest-earning assets and expense on interest-bearing liabilities. Net interest income decreased $2.4 million, or 6.3%, to $35.0 million for 2008, compared to $37.3 million for 2007. Net interest income increased $6.6 million, or 21.6%, to $37.3 million for 2007, compared to $30.7 million for 2006. During the year ended December 31, 2008, the Prime rate (“Prime”) dropped a total of 4.00%. These decreases lowered the yield on earning assets more rapidly than it lowered the cost of funds. The average maturity of our time deposits at December 31, 2008 was 7.5 months. These time deposits made up 67% of our total deposits at December 31, 2008. Additionally, loans placed on nonaccrual status during 2008 required us to reverse interest income associated with these loans. This interest

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reversal had an effect on our net interest margin for the year ended December 31, 2008 of 22 basis points. Core deposit growth in our newest markets has allowed us to replace alternative funding sources with core deposits. Our core deposits, which exclude national and brokered deposits, have grown $182.8 million since December 31, 2007, of which $50.5 million of this growth is directly related to the opening of our Chatsworth facility in February 2008, and our Dawsonville facility in November 2007. During 2008, we began construction to replace three of our current temporary locations in Dawson County, Georgia, Dahlonega, Georgia and in Murphy, North Carolina. We opened our Dawson County and Dahlonega, Georgia facilities in December 2008 and we moved into our Murphy, North Carolina facility in January 2009. The net interest income increase from 2006 to 2007 was primarily the result of the growth in our loan portfolio during 2007.

The trend in net interest income is also evaluated in terms of average rates using the net interest margin and the interest rate spread. The net interest margin, or the net yield on earning assets, is computed by dividing fully taxable equivalent net interest income by average earning assets. This ratio represents the difference between the average yield returned on average earning assets and the average rate paid for funds used to support those earning assets, including both interest-bearing and noninterest-bearing sources. The net interest margin for 2008 was 3.61% compared to a net interest margin of 4.68% in 2007 and 5.04% in 2006. Net interest spread, the difference between the average yield on earning assets and the average rate paid on interest-bearing sources of funds, was 3.39% in 2008, compared to 4.25% in 2007, and 4.53% in 2006. During 2008, the prime rate decreased a total of 400 basis points, which decreased the yield on our earning assets more rapidly than our cost of funds. Our certificate of deposit rates for similar maturities did not follow these decreases, yet our prime-based loan portfolio rates decreased immediately. The average maturity of our certificate of deposit portfolio at the end of 2008 was 7.5 months and our loan portfolio is comprised of 62% fixed rate loans. We believe that these factors will be beneficial as we adjust to a lower interest rate environment and continue to manage our margin. Although we continue to confront this margin compression with lower cost alternative funding sources, we must pay competitive rates in order to continue our core deposit growth strategy for liquidity purposes. We believe that, as our current temporary branch locations are converted to permanent banking facilities in our expansion markets, we will continue to grow core deposits and this will allow us to replace alternative funding sources with these core deposits. Until then, we will continue to use alternative funding sources as secondary sources to fund loan growth when necessary. We also believe that the Federal Reserve’s rate drops will dictate much lower competitive deposit rates because this interest margin squeeze is a banking industry concern and not unique to our company.

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Average Balances, Income and Expenses, and Rates. The following table shows, for years ended December 31, 2008, 2007 and 2006, the average daily balances outstanding for the major categories of interest-earning assets and interest-bearing liabilities, and the average interest rate earned or paid. Such yields are calculated by dividing income or expense by the average daily balance of the corresponding assets or liabilities.

Average Balances, Income and Expenses, and Rates

	Years Ended December 31,
	2008						2007						2006
	Average Balance		Income/ Expense		Yields/ Rates		Average Balance		Income/ Expense		Yields/ Rates		Average Balance		Income/ Expense		Yields/ Rates
	(Dollars in thousands)
Earning assets:
Loans, held for sale	$	3,075	$	178	5.79	%	$	3,356	$	205	6.11	%	$	60	$	2	3.33	%
Loans, net of unearned income (1)		856,912		64,481	7.52			716,737		68,035	9.49			537,914		49,869	9.27
Investment securities(2)		80,824		4,178	5.17			77,099		3,839	4.98			72,450		3,338	4.61
Interest-bearing deposits		1,375		16	1.16			1,497		78	5.21			632		30	4.75
Federal funds sold		35,953		513	1.43			6,176		338	5.47			6,539		351	5.37
Total interest-earning assets (3)	$	978,139		69,366	7.09		$	804,865		72,495	9.01		$	617,595		53,590	8.68
Interest-bearing liabilities:
Demand deposits	$	79,322		1,800	2.27		$	62,943		1,389	2.21		$	74,125		1,610	2.17
Savings deposits		183,234		4,774	2.61			185,799		7,992	4.30			105,022		3,544	3.38
Time deposits		579,366		24,419	4.22			431,565		22,986	5.33			315,429		15,197	4.82
Total deposits		841,922		30,993	3.68			680,307		32,367	4.76			494,576		20,351	4.12
Other short-term borrowings		13,858		417	3.01			8,271		283	3.42			12,178		472	3.88
Long-term debt		65,245		2,624	4.02			43,226		2,150	4.97			34,976		1,671	4.78
Total interest-bearing liabilities	$	921,025		34,034	3.70		$	731,804		34,800	4.76		$	541,730		22,494	4.15
Net interest income/net interest spread				35,332	3.39	%				37,695	4.25	%				31,096	4.53	%
Net yield on earning assets					3.61	%					4.68	%					5.04	%
Taxable equivalent adjustment:
Loans				22						27						28
Investment securities				339						341						369
Total taxable equivalent adjustment				361						368						397
Net interest income			$	34,971					$	37,327					$	30,699

(1) Average loans exclude nonaccrual loans of $8.3, $3.2, and $1.6 million for years ended December 31, 2008, 2007 and 2006, respectively. All loans and deposits are domestic.

(2) Average securities exclude average unrealized gains/(losses) of $379,000, $(257,000), and $(839,000) for years ended December 31, 2008, 2007, and 2006, respectively.

(3) Tax equivalent adjustments have been based on an assumed tax rate of 39%.

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Analysis of Changes in Net Interest Income. The following table sets forth a summary of the changes in interest income and interest expense resulting from changes in interest rates and in changes in the volume of earning assets and interest-bearing liabilities, segregated by category. The change due to volume is calculated by multiplying the change in volume by the prior year’s rate. The change due to rate is calculated by multiplying the change in the applicable rate by the prior year’s volume. Figures are presented on a taxable equivalent basis. The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

Analysis of Changes in Net Interest Income

	For the Years Ended December 31, 2008 vs. 2007									For the Years Ended December 31, 2007 vs. 2006
	Volume			Rate			Net Change			Volume			Rate			Net Change
	(In thousands)
Earning assets:
Loans, held for sale	$	(17	)	$	(10	)	$	(27	)	$	200		$	3		$	203
Loans, net of unearned income		11,975			(15,529	)		(3,554	)		16,955			1,211			18,166
Investment securities		189			150			339			222			279			501
Interest bearing deposits		(6	)		(56	)		(62	)		45			3			48
Federal funds sold		585			(410	)		175			(20	)		7			(13	)
Total earning assets		12,726			(15,855	)		(3,129	)		17,402			1,503			18,905
Interest-bearing liabilities:
Demand deposits		371			40			411			(246	)		25			(221	)
Savings deposits		(109	)		(3,109	)		(3,218	)		3,278			1,170			4,448
Time deposits		6,851			(5,418	)		1,433			6,054			1,735			7,789
Total deposits		7,113			(8,487	)		(1,374	)		9,086			2,930			12,016
Other short-term borrowings		172			(38	)		134			(138	)		(51	)		(189	)
Long-term debt		943			(469	)		474			408			71			479
Total interest-bearing liabilities		8,228			(8,994	)		(766	)		9,356			2,950			12,306
Net interest income/net interest spread	$	4,498		$	(6,861	)	$	(2,363	)	$	8,046		$	(1,447	)	$	6,599

Provision for Loan Losses

Years Ended December 31, 2008, 2007 and 2006

The provision for loan losses is based on the growth of the loan portfolio, the amount of net loan losses incurred and management’s estimation of potential future losses based on an evaluation of the risk in the loan portfolio. The provision for loan losses was $12.9 million for 2008, $4.7 million for 2007, and $3.3 million for 2006. Please see the discussion below under “Allowance for Loan Losses” for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

Noninterest Income

Years Ended December 31, 2008, 2007 and 2006

Noninterest income for 2008, 2007 and 2006 totaled $4.2 million, $5.5 million, and $4.0 million, respectively. These amounts are primarily from customer service fees, mortgage origination commissions, insurance commissions, as well as other fees charged to customers such as safe deposit box rental and ATM fees. Customer

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service fees increased from from $1.7 million in 2006, to $2.2 in 2007, and grew to $2.5 million in 2008. The increase in customer service fees for all years is primarily related to deposits growth through our continuing efforts to gain market share in our newly established facilities. We also are continuing our efforts to increase the amount of deposit account charges based on our surveys of competitors. As a result, non-sufficient funds (NSF) and returned check charges increased during 2008. Mortgage origination commissions increased from $1.3 million in 2006 to $2.0 million in 2007 and decreased to $1.4 million in 2008. The increase in mortgage origination commissions from 2006 to 2007 relates primarily to the additional mortgage activity generated from our expansion initiative, however, the economic decline that our area experienced in 2008 greatly reduced mortgage activity. Noninterest income for the year ended December 31, 2008 was offset by net losses on sales of securities in the amount of $776,000, compared to a net gain of $7,000 for the same period in 2007 and $-0- net gains/losses for the year ended December 31, 2006. The 2008 net securities losses include the recognition of the loss on our Freddie Mac Preferred Stock in the amount of $816,000.

Noninterest Expenses

Years Ended December 31, 2008, 2007 and 2006

Noninterest expenses totaled $31.6 million in 2008, up from $29.8 million in 2007, and $22.6 million in 2006. As a percentage of total assets, our total noninterest expenses increased from 3.0% in 2006 to 3.1% in 2007, and decreased to 2.7% in 2008. Salaries and employee benefits increased $233,000, or 1.3%, to $17.7 million in 2008, and increased $4.2 million, or 31.3%, to $17.5 million in 2007. As part of management’s efforts to keep costs at a minimum in 2008, we have reduced our workforce in areas where feasible, however this was the first full year of operations for two of our newly built facilities. Since December 31, 2007, we added only five full time equivalent staff. The increase from 2006 to 2007 in salaries and employee benefits was primarily due to the additional staff necessary to support our existing market growth and our expansion initiative, as well as the addition of several management-level employees necessary to provide the infrastructure to support our continued growth. During 2006, 97 full-time equivalent employees were hired, of which 2007 was the first full year that experienced this staffing increase. In addition, certain of the agreements under our salary continuation plan were amended in May and August of 2006, which caused an increase in noninterest expenses of approximately $153,000 from 2006 to 2007.

Occupancy, furniture and equipment expenses totaled $4.3 million in 2008, $3.7 million in 2007, and $2.7 million in 2006. The 16.5% and 37.0% increases from 2007 to 2008 and from 2006 to 2007, respectively are primarily due to our expansion initiative which increased the number of branches and loan production offices from four locations to 13. As noted earlier, two of our newly built facilities had their first full year of depreciation in 2008. Additionally, we just completed three new branch facilities, two in December 2008 and another in January 2009.

Other operating expenses increased to $9.6 million from $8.6 million in 2007 and from $6.5 million in 2006. The increases for all years is primarily the result of increased losses on sales of ORE and related ORE expenses, increases in state regulatory examination fees and FDIC deposit-assessments, amortization costs, and data processing costs. Net losses on sales of ORE were approximately $764,000 in 2008, an increase of $500,000, compared to $264,000 in 2007 and $32,000 in 2006. ORE related expenses were $347,000 in 2008, compared to $206,000 in 2007 and $32,000 in 2006. Our FDIC deposit insurance and state regulatory examination costs were $927,000 in 2008, an increase of $734,000 compared to $193,000 in 2007 and $109,000 in 2006. These increases were due primarily to the increase in our FDIC deposit-insurance assessments, which occurred in the third quarter of 2007, as well as the increase in premiums relating to our growth in deposits as compared to the prior periods. Data processing fees increased by $104,000, to just over $1.0 million in 2008, compared to $932,000 in 2007 and 776,000 in 2006. Data processing increases were due to our market share growth, as well as the addition of the thrift in 2007. Our director and committee fees and other director compensation expenses increased by $100,000 to $887,000 in 2008, compared to $787,000 in 2007 and $608,000 in 2006. This increase was due in part to an increase in committee fees paid to directors, addition of community directors for our new markets, as well as increased retirement benefit expenses. Also, we had increases in postage, correspondent bank charges, as well as ATM costs and other various expenses which were all necessary to support our new thrift charter, expanded market growth and new branches. In 2008 these costs were offset in part by a decrease in our marketing expenses of $435,000 to $1.3 million in 2008, from $1.7 million in 2007, as well as various other expense decreases resulting from management’s

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efforts keep expenses at a minimum. The $239,000 increase in marketing expenses from 2006 to 2007 was due to the increased advertising and promotional activities necessitated by our expansion initiative.

Balance Sheet Review

General

At December 31, 2008, we had total assets of $1.2 billion, consisting principally of $870.9 million in net loans (net of allowance of $14.5 million), $79.3 million in securities available-for-sale, $146.9 million in cash and cash equivalents, and $39.6 million in net premises and equipment (net of accumulated depreciation of $7.1 million). Our liabilities at December 31, 2008 totaled $1.1 billion, consisting principally of $1.0 billion in deposits, $72.0 million in FHLB advances, $10.6 million of short-term borrowings and $12.5 million of subordinated long-term capital notes. At December 31, 2008, our shareholders’ equity was $72.4 million.

At December 31, 2007, we had total assets of $971.2 million, consisting principally of $797.7 million in net loans (net of allowance of $9.8 million), $76.6 million in securities available-for-sale, $26.5 million in cash and cash equivalents, and $33.0 million in net premises and equipment (net of accumulated depreciation of $5.9 million). Our liabilities at December 31, 2007 totaled $897.5 million, consisting principally of $807.6 million in deposits, $57.4 million in FHLB advances, $21.0 million of short-term borrowings and $6.2 million of subordinated long-term capital notes. At December 31, 2007, our shareholders’ equity was $73.7 million.

Federal Funds Sold

Management maintains federal funds sold as a tool in managing daily cash needs. Federal funds sold at December 31, 2008 and December 31, 2007 were $133.4 million and $12.8 million, respectively. The increase in federal funds sold is the primary result of efforts to improve our liquidity using core deposits and not renew various alternative funding as they mature. Average federal funds sold for the twelve months ended December 31, 2008 and 2007 were approximately $36.0 million or 3.7% of average earning assets, and approximately $6.2 million, or 0.8% of average earning assets, respectively. Although we use federal funds as a source of liquidity, we prefer core deposits to alternative funding.

Securities Portfolio

The primary objectives of our investment strategy are to maintain an appropriate level of liquidity, and to provide a tool with which to control our interest rate position while, at the same time, producing adequate levels of interest income.

The following table presents the carrying amounts of the securities portfolio at December 31 in each of the last three years.

	December 31,
	2008		2007		2006
	(In thousands)
Securities Available-for-Sale:
Government sponsored agencies	$	30,982	$	33,159	$	43,396
State and municipal securities		10,913		14,031		13,148
Mortgage-backed securities		37,215		28,513		14,833
Equity securities		198		862		1,036
Total	$	79,308	$	76,565	$	72,413

Equity securities includes Federal Home Loan Bank preferred stock with a carrying value of $6,000, $671,000 and $850,000 at December 31, 2008, 2007 and 2006, respectively; an investment in Appalachian Capital Trust I in the amount of $186,000 at December 31, 2008, 2007 and 2006; and an investment of $5,500 in a mortgage cooperative at December 31, 2008 and 2007.

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Gross unrealized gains in the portfolio amounted to $1.7 million at year-end 2008 and gross unrealized losses amounted to $274,000. Gross unrealized gains in the portfolio amounted to $847,000 at year-end 2007 and gross unrealized losses amounted to $421,000. Gross unrealized gains in the portfolio amounted to $502,000 at year-end 2006 and gross unrealized losses amounted to $837,000. During the third quarter of 2008, the Company recognized an other than temporary impairment charge of $816,000 on its investment in Freddie Mac preferred stock. The value of these securities declined significantly after the U.S. Government placed the company into conservatorship in September 2008. The remaining carrying value of the preferred stock at December 31, 2008 is $6,000.

At December 31, 2008, 2007 and 2006 the percentage of the total carrying value of the securities portfolio to total assets was 6.7%, 7.9%, and 9.9%, respectively.

The maturities and weighted average yields of our investments in securities (all available for sale) at December 31, 2008 are presented below. Taxable equivalent adjustments (using a 39% tax rate) have been made in calculating yields on tax-exempt obligations.

	Maturing
	Within One Year				After One But Within Five Years				After Five But Within Ten Years				After Ten Years
	Amount		% Yield		Amount		% Yield		Amount		% Yield		Amount		% Yield
	(Dollars in thousands)
Securities Available-for-Sale:
Government sponsored agencies	$	5,108	4.09	%	$	11,059	4.86	%	$	11,256	5.05	%	$	3,559	5.24	%
State and municipal		—	0.00			965	7.82			3,703	8.09			6,245	7.78
Mortgage-backed		—	0.00			468	3.66			2,871	4.13			33,876	5.25
Equity securities		—	0.00			—	0.00			—	0.00			198	15.14
Total Securities	$	5,108	4.09		$	12,492	5.05		$	17,830	5.54		$	43,878	5.63

There were no securities held by us of which the aggregate value by issuer on December 31, 2008 exceeded 10% of shareholders’ equity at that date. Securities which are payable from and secured by the same source of revenue or taxing authority are considered to be securities of a single issuer. Securities of Government agencies and corporations are not included.

Loan Portfolio

Loans make up the largest component of our earning assets. In 2008, average loans (excluding average nonaccrual loans of $8.3 million) represented 88.0%, while in 2007 average loans (excluding average nonaccrual loans of $3.2 million) represented 89.1%. Average loans increased to $856.9 million (excluding average nonaccrual loans of $8.3 million) with a yield of 7.52% in 2008, from $716.7 million (excluding average nonaccrual loans of $3.2 million) with a yield of 9.5% in 2007. The ratio of total loans to total deposits was 87.4% in 2008 and 100.0% in 2007.

Our business model, which includes having strong connected local bankers in each of our geographic markets, gives us a unique ability to monitor loan activity. We continue to see a slowing in the requests for acquisition, development and construction loans. Consistent with much of the country, the residential real estate market in North Georgia has slowed considerably, and it is estimated that there is approximately a 20 to 27 month supply of housing on the market at December 31, 2008. This is an improvement over this same time last year, as it was estimated that we had a 36 to 40 month’s supply at December 31, 2007. In December 2008, we experienced a slight increase in residential real estate loan activity due to the lower mortgage rates, which has continued into 2009. A special assets group was formed in May of 2008 to deal exclusively with real estate related credit issues.

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The following table shows the classification of loans by major category at December 31, 2008, and for each of the preceding four years.

	December 31,
	2008					2007					2006					2005					2004
	Amount			Percent of Total		Amount			Percent of Total		Amount			Percent of Total		Amount			Percent of Total		Amount			Percent of Total
	(Dollars in thousands)
Commercial, financial and agricultural	$	72,543		8.2	%	$	48,749		6.0	%	$	40,491		6.4	%	$	33,778		7.4	%	$	31,920		8.5	%
Real estate - construction (1)		389,339		44.0			389,695		48.3			320,406		50.7			203,538		44.5			145,588		38.6
Real estate - other (2)		386,227		43.6			332,856		41.2			241,569		38.2			193,704		42.3			173,955		46.1
Consumer		28,574		3.2			30,598		3.8			25,386		4.0			21,051		4.6			20,957		5.6
Other loans		8,691		1.0			5,624		0.7			3,934		0.7			5,347		1.2			4,932		1.2
		885,374		100.0	%		807,522		100.0	%		631,786		100.0	%		457,418		100.0	%		377,352		100.0	%
Allowance for loan losses		(14,510	)				(9,808	)				(7,670	)				(6,059	)				(4,349	)
Net loans	$	870,864				$	797,714				$	624,116				$	451,359				$	373,003

(1) The “real estate - construction” category includes residential construction and development loans and commercial construction loans.

(2) The “real estate - other” category includes one-to-four family residential, home equity, multi-family (five or more) residential, commercial real estate and undeveloped agricultural real estate loans.

The following table shows the maturity distribution of selected loan classifications at December 31, 2008, and an analysis of these loan maturities.

	Maturity								Rate Structure for Loans Maturing Over One Year
	One Year or Less		Over One Year Through Five Years		Over Five Years		Total		Predetermined Interest Rate		Floating or Adjustable Rate
	(In thousands)
Commercial, financial and agricultural	$	46,529	$	13,395	$	12,619	$	72,543	$	23,441	$	2,573
Real estate - construction		347,106		41,596		637		389,339		24,032		18,201
Real estate - other		219,670		151,105		15,452		386,227		134,176		32,381
Total	$	613,305	$	206,096	$	28,708	$	848,109	$	181,649	$	53,155

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Allowance for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged as an expense on our statement of operations. The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. Our judgment as to the adequacy of the allowance for loan losses is based on estimated probable losses, which we believe to be reasonable, but which may or may not prove to be accurate. In assessing adequacy, management relies predominantly on its ongoing review of the loan portfolio, which is undertaken both to determine whether there are probable losses that must be charged off and to assess the risk characteristics of the aggregate portfolio. This review takes into consideration the judgments of the responsible lending officers and senior management, and also those of bank regulatory agencies that review the loan portfolio as part of the regular bank examination process. In evaluating the allowance, management also considers our loan loss experience, the amount of past due and nonperforming loans, current economic conditions, lender requirements and other appropriate information. Impaired loans are individually assessed for impairment under Statement of Accounting Financial Accounting Standards (“SFAS”) No. 114 and assigned specific allocations.

Periodically, we adjust the amount of the allowance based on changing circumstances, including changes in general economic conditions, changes in the interest-rate environment, changes in loan concentrations in various areas of our banking activities, changes in identified troubled credits, and economic changes in our market area. We charge recognized losses to the allowance and add subsequent recoveries back to the allowance for loan losses. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.

The allocation of the allowance to the respective loan segments is an approximation and not necessarily indicative of future losses or future allocations. The entire allowance is available to absorb losses occurring in the overall loan portfolio. In addition, the allowance is subject to examination and adequacy testing by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the allowance relative to that of peer institutions, and other adequacy tests. Such regulatory agencies could require us to adjust the allowance based on information available to them at the time of their examination.

At December 31, 2008, our allowance for loan losses was $14.5 million, or 1.64% of total outstanding loans, compared to $9.8 million, or 1.21% of total outstanding loans at December 31, 2007, and $7.7 million, or 1.21% of total outstanding loans, at December 31, 2006.

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The following table sets forth certain information with respect to our loans, net of unearned income, and the allowance for loan losses for the years ended December 31, 2004 to 2008.

	Years ended December 31,
	2008			2007			2006			2005			2004
	(In thousands, except ratios)
Allowance for loan losses, at beginning of period	$	9,808		$	7,670		$	6,059		$	4,349		$	3,610
Loans charged off:
Commercial, financial, and agricultural		643			149			859			359			30
Real estate - construction		3,744			1,254			387			10			240
Real estate - other		3,125			833			317			41			158
Consumer		943			615			263			150			127
Total loans charged off		8,455			2,851			1,826			560			555
Recoveries on loans previously charged off:
Commercial, financial, and agricultural		17			35			75			24			35
Real estate - construction		—			25			1			—			—
Real estate - other		7			16			1			—			2
Consumer		218			187			107			35			22
Total recoveries on loans previously charged off		242			263			184			59			59
Net loans charged off		8,213			2,588			1,642			501			496
Provision for loan losses		12,915			4,726			3,253			2,211			1,235
Allowance for loan losses, at end of period	$	14,510		$	9,808		$	7,670		$	6,059		$	4,349
Loans, net of unearned income, at end of period	$	885,374		$	807,522		$	631,786		$	457,418		$	377,352
Average loans, net of unearned income, outstanding for the period	$	865,225		$	719,926		$	539,577		$	413,561		$	360,261
Ratios:
Allowance at end of period to loans, net of unearned income		1.64	%		1.21	%		1.21	%		1.32	%		1.15	%
Allowance at end of period to average loans, net of unearned income		1.68			1.36			1.42			1.47			1.21
Net charge-offs to average loans, net of unearned income		0.95			0.36			0.30			0.12			0.14
Net charge-offs to allowance at end of period		56.60			26.39			21.41			8.27			11.40
Recoveries to prior year charge-offs		8.52			14.40			32.86			10.63			4.88

Since 2005, economic conditions have worsened considerably and accordingly property values have decreased. During 2008, these adverse conditions negatively impacted our borrowers’ ability to sell property and repay their debts timely. These events caused us to have to foreclose on the real estate collateral and lower market values led to increased charge-offs as compared to prior periods.

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The following table sets forth our estimate of the breakdown of the allowance for loan losses by loan category and the percentage of loans in each category to total loans for the years ended December 31, 2004 to 2008.

Allocation of Allowance for Loan Losses

	At December 31,
	2008				2007				2006				2005				2004
	(Dollars in thousands)
Domestic Loans (1)
Commercial, financial and agricultural	$	1,261	8	%	$	2,392	6	%	$	2,266	6	%	$	3,209	7	%	$	548	8	%
Real estate — construction		6,202	44			3,836	48			1,399	51			271	45			421	39
Real estate — other		6,440	44			1,152	41			3,265	38			1,962	42			2,138	46
Consumer		465	3			1,981	4			199	4			202	5			425	6
Other		142	1			447	1			541	1			415	1			817	1
Total	$	14,510	100	%	$	9,808	100	%	$	7,670	100	%	$	6,059	100	%	$	4,349	100	%

(1) There are no foreign loans.

Nonperforming Assets

Nonperforming assets include nonperforming loans and foreclosed assets. Nonperforming loans include loans classified as nonaccrual and loans past due 90 days or more. Our general practice is to place a loan on nonaccrual status when it is contractually past due 90 days or more as to payment of principal or interest, unless the collateral value is significantly greater than both the principal due and the accrued interest and collection of principal and interest is probable. At the time a loan is placed on nonaccrual status, interest previously accrued but not collected is reversed and charged against current earnings. Recognition of any interest after a loan has been placed on nonaccrual status is accounted for on a cash basis. Nonperforming loans were 3.18% of total loans at December 31, 2008 and 0.57% of total loans at December 31, 2007, compared to 0.55% of total loans at December 31, 2006.

For the year ended December 31, 2008 the difference between gross interest income that would have been recorded in such period, if the non-accruing loans had been current in accordance with their original terms, and the amount of interest income on those loans, that was included in such period’s net income, was $519,000. For each of the four years in the period ended December 31, 2007, that amount was immaterial.

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The following table shows our nonperforming assets as well as the ratio of the allowance for loan losses to total nonperforming assets, the total nonperforming loans to total loans, and the total nonperforming assets to total assets, for the years ended December 31, 2004 to 2008.

	At December 31,
	2008			2007			2006			2005			2004
	(In thousands, except ratios)
Non-accruing loans	$	24,387		$	4,250		$	2,611		$	1,020		$	1,524
Loans past due 90 days or more		3,783			364			871			71			34
Total nonperforming loans		28,170			4,614			3,482			1,091			1,558
Other real estate		13,171			1,504			1,218			147			516
Other repossessed property		151			70			—			—			—
Total nonperforming assets	$	41,492		$	6,188		$	4,700		$	1,238		$	2,074
Ratios:
Allowance to total nonperforming assets		34.97	%		158.50	%		163.19	%		489.42	%		209.69	%
Total nonperforming loans to total loans (net of unearned interest)		3.18	%		0.57	%		0.55	%		0.24	%		0.41	%
Total nonperforming assets to total assets		3.50	%		0.64	%		0.62	%		0.21	%		0.44	%

The $24.4 million in non-accruing loans consist of 63 loans broken down as follows: 26 loans totaling $15.1 million in real estate – construction loans, 25 loans totaling $8.4 million in real estate – other, 7 loans totaling $788,000 in the commercial/financial/agricultural industry and 5 loans totaling $66,000 in consumer loans. Loans past due 90 days or more and still accruing consist of $1.8 million in real estate – construction loans, $1.8 million in real estate – other, $121,000 in commercial/financial/agricultural loans and $93,000 in consumer loans. We have in reserve for the nonaccrual loans approximately $1.3 million at December 31, 2008.

Total impaired loans and amounts reserved at December 31 2008 and 2007, respectively, are as follows:

	2008 Impaired		2008 Reserve		2007 Impaired		2007 Reserve
Nonaccrual loans	$	24,387	$	1,342	$	4,250	$	500
Other specifically impaired loans		12,914		1,950		2,733		1,483
Restructured loans		20,306		—		1,248		—
Total impaired loans	$	57,606		3,292	$	8,231		1,983
Reserve on all other loans				11,218				7,825
Total reserve			$	14,510			$	9,808

Deposits and Other Interest-Bearing Liabilities

Deposits are the primary source of funds to support our earning assets. Average deposits increased 21.5%, from $735.8 million in 2007 to $894.2 million in 2008. Average deposits increased 34.5%, from $546.9 million in 2006 to $735.8 million in 2007. At December 31, 2008, total deposits were $1.0 billion, of which $963.2 million or 95.1%, was interest bearing. At December 31, 2007, total deposits were $807.6 million, of which $751.0 million or 93.0%, was interest bearing. Alternative funding sources such as FHLB Advances, national Certificates of DepositCertificates of Deposit and brokered deposits were used to supplement funding sources. These alternative funding sources increased $26.0 million or 11.0% in 2008. National Certificates of Deposit and brokered deposits were $262.7 million at December 31, 2008. At December 31, 2007, national Certificates of Deposit and brokered deposits were $236.7 million. The increase in our national Certificates of Deposit and brokered deposits was

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necessary to fund our growth in loans during the year ended December 31, 2008 at reasonable spreads. Alternative funding sources are a secondary source of funds utilized to fund loan growth. The cost of these alternative funding sources can be less expensive than our local deposits as was the case in 2008.

The average amounts of, and the average rate paid on, each of the following categories of deposits, for the years ended December 31, 2008, 2007, and 2006, are as follows:

	At December 31,
	2008				2007				2006
	Amount		Rate		Amount		Rate		Amount		Rate
	(Dollars in thousands)
Noninterest-bearing demand deposits	$	52,234	0.00	%	$	55,462	0.00	%	$	52,298	0.00	%
Interest-bearing demand deposits		79,322	2.27			62,943	2.21			74,125	2.17
Savings		183,234	2.61			185,799	4.30			105,022	3.37
Time deposits		579,366	4.21			431,565	5.33			315,429	4.82
Total interest-bearing deposits	$	841,922	3.68		$	680,307	4.76		$	494,576	4.11
Total average deposits	$	894,156	3.47		$	735,769	4.40		$	546,874	3.72

Our core deposits, which exclude brokered and national certificates of deposits, were $750.6 million at December 31, 2008, an increase of 31.0% compared to $572.8 million at December 31, 2007. Core deposits as a percentage of total deposits were approximately 74.1% and 70.9% at December 31, 2008 and 2007, respectively. In 2005, we began using the Certificate of Deposit Account Registry Service (CDARS) in order to obtain FDIC insurance on some of our larger customers. Although CDARS are required to be categorized as brokered deposits, these deposits represent deposits greater than $100,000 originated in our local markets that are placed with other institutions that are members in the CDARS network. By placing these deposits in these other institutions, the deposits of our customers are fully insured by the FDIC. In return for the deposits that we place with network institutions, we receive from network institutions, deposits that are approximately equal in amount of what was originated from our customers. In addition, the CDARS are priced at local rates, which generally have lower rates than rates being offered for brokered deposits. At December 31, 2008, CDARS represented $8.8 million of our deposits, or 0.9% and at December 31, 2007, CDARS represented $10.4 million of our deposits, or 1.3%. We continue to focus on increasing our core deposit base. The categories of lowest cost deposits comprised the following percentages of average total deposits during 2008: average noninterest-bearing demand deposits, 5.8%; average interest-bearing demand, 8.9%; and average savings deposits, 20.5%. Of average time deposits, approximately 52.0% were large denomination certificates of deposit.

Noninterest-bearing deposits decreased $6.5 million, or 11.5%, from year-end 2007 to $50.0 million at December 31, 2008, and interest-bearing deposits increased $212.2 million, or 28.3%, during the same period to $963.2 million. The increase in interest-bearing deposits has been the result of our focus on providing excellent customer service, as well as our branch staff’s intensified efforts to obtain a greater deposit share in the newer markets. Our recent transfers from temporary branch locations into permanent facilities, should make it easier for us to continue to grow deposits in those markets.

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The following table sets forth the maturities of our time deposits of $100,000 or more by category at December 31, 2008.

	(In thousands)
Three months or less	$	58,214
Over three through six months		94,333
Over six through twelve months		162,167
Over twelve months		23,331
Total	$	338,045

Borrowings

Short-Term Borrowings

Securities sold under agreements to repurchase amounted to $5.6 million at December 31, 2008, compared to $6.5 million at December 31, 2007, and $4.7 million at December 31, 2006. The weighted average rates were 1.29%, 1.24%, and 1.62% for 2008, 2007 and 2006, respectively. The total amount of securities sold under agreements to repurchase is associated with the cash flow needs of our corporate customers who participate in repurchase agreements. Included in our total FHLB line availability, as detailed under the FHLB Advances section below, is the ability to obtain short-term daily rate credit advances. However there were no such short-term FHLB advances at December 31, 2008, 2007 and 2006. These advance rates float daily based on the overnight funds market. The line of credit has a one year term and matures in May of each year. We have available $33.0 million in lines of credit to purchase federal funds, on an unsecured basis, from commercial banks, of which $33.0 was available at December 31, 2008. We had federal funds purchased that amounted to $-0- at year-end 2008, and $10.0 at year-end 2007, compared to $-0- at year-end 2006. We also have a $10 million line of credit with a third party financial institution that can be utilized to provide additional capital for the bank if deemed necessary. As of December 31, 2008, approximately $5.0 million of this line was available.

Short-term borrowings at December 31, 2008, 2007 and 2006 consisted of the following:

	As of December 31,
	2008		2007		2006
	(In thousands)
Federal funds purchased	$	—	$	10,000	$	—
Securities sold under agreements to repurchase		5,642		6,536		4,738
Other short-term line of credit		4,962		4,512		—
	$	10,604	$	21,048	$	4,738

In connection with the short-term line of credit with the third party financial institution, the Company has agreed, among other things, not to: (1) permit the combined tangible capital of the subsidiary Banks to be less than $60,000,000; (2) permit the Tier 1 leverage ratio to be less than 7.0% and the total risk based ratio to be less than 9.0% at any quarter end; (3) permit the return on average assets to be less than 0.50% for each fiscal quarter; (4) permit the ratio of consolidated loans classified as substandard, doubtful to Tier 1 capital plus its allowance for loan losses to exceed 40%.

The Company was in violation of certain of the above covenants as of December 31, 2008; however, these violations have been waived by the noteholder.

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FHLB Advances

Our total borrowed funds consist primarily of long-term debt with maturities from one to ten years. At December 31, 2008 we were approved to borrow up to approximately $108 million under various short-term and long-term programs offered by the Federal Home Loan Bank of Atlanta. These borrowings are secured under a blanket lien agreement on certain qualifying mortgage instruments in the loan and securities portfolios. At December 31, 2008, the outstanding balance of our credit line was $72.0 million, all of which was accounted for as long-term debt.

Subordinated Long-term Capital Notes

On September 30, 2008 and October 30, 2008, Appalachian Community Bank issued an aggregate of $6,125,000 and $200,000, respectively, in Fixed Rate Subordinated Notes, which will mature on September 30, 2015 (the “Notes”). Interest on the Notes is fixed at 10% per annum. The interest on the Notes is payable semi-annually in arrears on June 30 and December 31 of each year. The bank may redeem all or some of the Notes at anytime beginning on September 30, 2013 at a price equal to 100% of the principal amount of such Notes redeemed plus accrued, but unpaid, interest to the redemption date. Payment of the principal on the Notes may be accelerated by holders of the Notes only in the case of the bank’s insolvency or liquidation. There is no right of acceleration in the case of default in payment of principal of or interest on the Notes. The proceeds will be used for general corporate purposes and to support loan growth. The Notes qualify as Tier II capital under risk-based capital guidelines and will strengthen the bank’s capital position under the federal prompt corrective action guidelines.

On August 28, 2003, Appalachian Capital Trust I (“the Trust”), a Delaware statutory trust established by us, received $6.0 million principal amount of the Trust’s floating rate cumulative trust preferred securities in a trust preferred private placement. The proceeds of that transaction were used by the Trust to purchase an equal amount of our floating rate-subordinated debentures. We have fully and unconditionally guaranteed all obligations of the Trust on a subordinated basis with respect to the trust preferred securities. We account for the trust preferred securities as long-term debt liability in the amount of $6.2 million. Interest only is payable quarterly at a variable per annum rate of interest, reset quarterly, equal to LIBOR plus 3.00 % percent until the debt becomes due on August 8, 2033. The interest rate on the Trust Preferred liability at December 31, 2008 and 2007 was 6.19% and 7.91% respectively. The debt is callable by Appalachian Bancshares, Inc. on August 28, 2008 and every quarter thereafter. Subject to certain limitations, the trust preferred securities qualify as Tier 1 capital and are presented in the consolidated financial statements included elsewhere in this Form 10-K as “subordinated long-term capital notes”.

The sole assets of the Trust are the subordinated debentures issued by us. Both the trust preferred securities and the subordinated debentures have approximately 30-year lives. However, both we and the Trust have options to call our respective securities after five years, subject to regulatory capital requirements.

Capital Resources

Total shareholders’ equity was $72.4 million at December 31, 2008, compared to $73.7 million at December 31, 2007. Our net loss was $2.9 million. We issued 103,479 shares of stock to our 401(k) Plan during 2008 for proceeds of $885,000. We had a $652,000 increase in the accumulated other comprehensive gain on our available-for-sale securities. We purchased 16,000 of our outstanding shares through our stock buy-back program in the amount of $183,000. In addition, the effects of the stock-based compensation expense during 2008 increased equity by $281,000, including the tax benefit.

The Federal Deposit Insurance Corporation Improvement Act establishes risk-based capital guidelines that take into consideration risk factors, as defined by regulators, associated with various categories of assets, both on and off the balance sheet. Under the guidelines, capital strength is measured in two tiers, which are used in conjunction with risk-adjusted assets to determine the risk-based capital ratios. Our Tier 1 capital, which consists of common equity, paid-in capital, retained earnings and qualifying trust preferred securities (less intangible assets and treasury stock), amounted to $73.8 million at December 31, 2008. Tier 2 capital components include supplemental capital components such as qualifying allowance for loan losses and trust preferred securities not qualified for Tier 1 capital. Tier 1 capital, plus the Tier 2 capital components, are referred to as Total Capital and was $91.8 million at year end 2008. The percentage ratios as calculated under regulatory guidelines were 7.96% and 9.89% for Tier 1 and Total Capital, respectively, at year-end 2008. Our Tier 1 Capital and Total Capital exceeded the minimum ratios of 4.00% and 8.00%, respectively.

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Another important indicator of capital adequacy in the banking industry is the leverage ratio. The leverage ratio is defined as the ratio which shareholders’ equity, minus intangibles, bears to total assets minus intangibles. At December 31, 2008, our leverage ratio was 6.64%, exceeding the regulatory minimum requirement of 4.00%.

The table following illustrates our regulatory capital ratios under federal guidelines at December 31, 2008, 2007 and 2006:

	Statutory		Years ended December 31,
	Minimum		2008			2007			2006
	(In thousands, except ratios)
Tier 1 Capital			$	73,827		$	77,180		$	70,730
Tier 2 Capital				17,958			9,808			7,670
Total Qualifying Capital			$	91,785		$	86,988		$	78,400
Risk Adjusted Total Assets (including off-balance sheet exposures)			$	927,732		$	824,834		$	661,431
Tier 1 Risk-Based Capital Ratio	4.00	%		7.96	%		9.36	%		10.69	%
Total Risk-Based Capital Ratio	8.00			9.89			10.55			11.85
Leverage Ratio	4.00			6.64			8.30			9.55

Return on Equity and Assets

The following table summarizes certain of our financial ratios for the years ended December 31, 2008, 2007 and 2006.

	2008		2007		2006
Return on average assets	(0.27	)%	0.65	%	0.91	%
Return on average equity	(3.80	)	7.93		9.57
Dividend payout ratio	0.00		0.00		0.00
Average equity to average assets ratio	7.14		8.14		9.49

The decline in return on average equity and assets from 2007 to 2008 is primarily due to the large increase in our provision for loan losses, increase in nonaccrual loans, our decrease to net interest margin, losses on our sales of other real estate (“ORE”), the write-down of our 20,000 shares of Federal Home Loan Mortgage Corporation (“Freddie Mac”) Preferred Stock, and the increase to other operating expenses necessary to support the Company’s growth. The decline in return on average equity from 2006 to 2007 is primarily due our expansion initiative during the last half of 2006 and in 2007, lower interest margins experienced in 2007, as well as our loan charge-offs in 2007.

Interest Rate Sensitivity Management

Interest rate sensitivity is a function of the repricing characteristics of our portfolios of assets and liabilities. These repricing characteristics are the time frames within which the interest-bearing assets and liabilities are subject to changes in interest rates, either at replacement or maturity during the life of the instruments. Sensitivity is measured as the difference between the volume of assets and liabilities in our current portfolio that is subject to repricing in future time periods. The differences are known as interest rate sensitivity gaps and are usually calculated

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separately for segments of time, ranging from zero to 30 days, 31 to 90 days, 91 days to one year, one to five years, over five years and on a cumulative basis.

The following table indicates that, in a rising interest rate environment, our earnings may be adversely affected in the 0-365 day periods where liabilities will reprice faster than assets, if rates move simultaneously. For purposes of this table, all demand and savings deposits are included in the 0 – 30 day period, but because these deposits are not as sensitive to rate change, we do not anticipate these deposits to mature in this time period. We anticipate that these deposits will mature over all time periods. As seen in the following table, for the first 30 days of repricing opportunity, there is an excess of interest-earning assets over interest-bearing liabilities of approximately $113.9 million. For the first 365 days, interest-bearing liabilities exceed earning assets by approximately $168.8 million. During this one-year time frame, 90.7% of all interest-bearing liabilities will reprice compared to 73.5% of all interest-earning assets. Changes in the mix of earning assets or supporting liabilities can either increase or decrease the net interest margin without affecting interest rate sensitivity. In addition, the interest rate spread between an asset and its supporting liability can vary significantly while the timing of repricing for both the asset and the liability remain the same, thus impacting net interest income. It should be noted, therefore, that a matched interest-sensitive position by itself would not ensure maximum net interest income.

The following table sets forth information regarding our rate sensitivity as of December 31, 2008 for each of the intervals indicated.

	0-30 Days		31-90 Days			91-365 Days			1-5 Years			Over 5 Years	Total
	(In thousands, except ratios)
Interest-earning assets (1)
Loans	$	371,382	$	61,756		$	217,596		$	192,206 $		20,830	$	863,770
Securities (2)		425		13			5,919			12,134		59,403		77,894
Interest-bearing deposits in other banks		731		—			—			—		—		731
Federal funds sold		133,351		—			—			—		—		133,351
		505,889		61,769			223,515			204,340		80,233		1,075,746
Interest-bearing liabilities: (3)
Demand deposits (4)		120,988		—			—			—		—		120,988
Savings deposits (4)		164,156		—			—			—		—		164,156
Time deposits		66,208		81,008			475,824			55,057		—		678,097
Other short-term borrowings		10,604		—			—			—		—		10,604
Long-term debt		30,000		—			5,000			35,000		2,000		72,000
Subordinated long-term capital notes		—		6,186			—			—		6,325		12,511
		391,956		87,194			480,824			90,057		8,325		1,058,356
Interest sensitivity gap	$	113,933	$	(25,425	)	$	(257,309	)	$	114,283 $		71,908	$	17,390
Cumulative interest sensitivity gap	$	113,933	$	88,508		$	(168,801	)	$	(54,518	)$	17,390
Ratio of interest-earning assets to interest-bearing liabilities		1.29		0.71			0.46			2.27		0.00
Cumulative ratio		1.29		1.18			0.82			0.95		1.02
Ratio of cumulative gap to total interest-earning assets		0.11		0.08			(0.16	)		(0.05	)	0.02

(1) Excludes nonaccrual loans. Excludes unrealized gains/losses on securities.

(2) Securities are at book value.

(3) Excludes matured certificates which have not been redeemed by the customer and on which no interest is accruing.

(4) Demand and savings deposits typically reprice simultaneously with market changes.

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Management continually evaluates the condition of the economy, the pattern of market interest rates and other economic data to determine the types of investments that should be made and at what maturities. Using this analysis, management from time to time assumes calculated interest rate sensitivity gap positions to maximize net interest income based upon anticipated movements in the general level of interest rates.

We also use simulation analysis to monitor and manage our interest rate sensitivity. Simulation analysis is the primary method of estimating earnings at risk and capital at risk under varying interest rate conditions. Simulation analysis is used to test the sensitivity of our net interest income and shareholders’ equity to both the level of interest rates and the slope of the yield curve. Simulation analysis accounts for the expected timing and magnitude of assets and liability cash flows, as well as the expected timing and magnitude of deposits that do not reprice on a contractual basis. In addition, simulation analysis includes adjustments for the lag between movements in market interest rates on loans and interest-bearing deposits. These adjustments are made to reflect more accurately possible future cash flows, repricing behavior and ultimately net interest income.

The estimated impact on our net interest income before provision for loan loss sensitivity over a one-year time horizon is shown below. Such analysis assumes a sustained parallel shift in interest rates and our estimate of how interest-bearing transaction accounts will reprice in each scenario. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management’s strategies, among other factors.

	Percentage Increase (Decrease) in Interest Income/Expense Given Interest Rate Shifts
	Down 200 Basis Points		Up 200 Basis Points
For the Twelve Months After December 31, 2008
Projected change in:
Interest income	(18.16	)%	22.23	%
Interest expense	(29.72	)	29.02
Net interest income	(3.71	)	13.73

Market Risk

Market risk is the risk arising from adverse changes in the fair value of financial instruments due to a change in interest rates, exchange rates and equity prices. Our primary market risk is interest rate risk.

The primary objective of asset/liability management is to manage interest rate risk and achieve reasonable stability in net interest income throughout interest rate cycles. This is achieved by maintaining the proper balance of rate sensitive earning assets and rate sensitive liabilities. The relationship of rate sensitive earning 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 earning assets and interest-bearing liabilities are those that can be repriced to current market rates within a relatively short time period. Management monitors the rate sensitivity of earning assets and interest-bearing liabilities over the entire life of these instruments, but places particular emphasis on the first year and through three years.

Management continues to monitor the proper matching of asset/liability repricing to keep our volatility at a low level. However, due to adverse economic conditions that negatively impacted our customers’ ability to repay us, management reversed $2.1 million of previously accrued interest income during 2008. These interest reversals contributed to the unexpected contraction of 30 basis points in our net interest margin in the fourth quarter and 22 basis points for 2008. However, to continue our core deposit growth strategy and increase liquidity, we continued to pay market rates for deposit products.

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Off-Balance Sheet Arrangements

In the normal course of business, we offer a variety of financial products to our customers to aid them in meeting their requirements for liquidity, credit enhancement and interest rate protection. Generally accepted accounting principles recognize these transactions as contingent liabilities and, accordingly, they are not reflected in the consolidated financial statements. Commitments to extend credit, credit card arrangements, commercial letters of credit and standby letters of credit all include exposure to some credit loss in the event of nonperformance of the customer. We use the same credit policies and underwriting procedures for making off-balance sheet credit commitments and financial guarantees as it does for on-balance sheet extensions of credit. Because these instruments have fixed maturity dates, and because many of them expire without being drawn upon, they do not generally present any significant liquidity risk to us. Management conducts regular reviews of these instruments on an individual customer basis, and the results are considered in assessing the adequacy of our allowance for loan losses. Management does not anticipate any material losses as a result of these commitments. The following is a discussion of these commitments:

Standby Letters of Credit. These agreements are used by our customers as a means of improving their credit standings in their dealings with others. Under these agreements, we agree to honor certain financial commitments in the event that its customers are unable to do so. The amount of credit risk involved in issuing letters of credit in the event of nonperformance by the other party is the contract amount. As of December 31, 2008 and 2007, we had issued standby letters of credit of approximately $5.9 million and $5.0 million, respectively. When significant, we record a liability for the estimated fair value of standby letters of credit based on the fees charged.

Loan Commitments. As of December 31, 2008 and 2007, the bank had commitments outstanding to extend credit totaling approximately $77.5 million and $97.0 million, respectively.

Contractual Obligations

We have various contractual obligations that we must fund as part of our normal operations. The following table shows aggregate information about our contractual obligations, and the periods in which payments are due. The amounts and time periods are measured from December 31, 2008.

Payments due by period (in thousands)

	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Long-term debt	$	84,511	$	5,000	$	15,000	$	20,000	$	44,511
Operating lease obligations		1,301		125		135		132		909
Time deposits		678,097		623,040		44,188		10,869		—
Total	$	763,909	$	628,165	$	59,323	$	31,001	$	45,420

Impact of Inflation

The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost basis in accordance with generally accepted accounting principles.

Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate fluctuations, including those resulting from inflation.

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Recent Developments

In September 2006, the EITF reached a consensus on EITF Issue No. 06-4 (EITF 06-4), “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” EITF 06-4 requires an employer to recognize a liability for future benefits based on the substantive agreement with the employee. EITF 06-4 requires a company to use the guidance prescribed in FASB Statement No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and Accounting Principles Board Opinion No. 12, “Omnibus Opinion,” when entering into an endorsement split-dollar life insurance agreement and recognizing the liability. EITF 06-4 is effective for fiscal periods beginning after December 15, 2007. The Company’s adoption of EITF 06-4 did not affect our financial position, results of operations or its cash flows.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159 permits entities to make an irrevocable election, at specified election dates, to measure eligible financial instruments and certain other items at fair value. This statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. The provisions of this statement are effective as of the beginning of the first fiscal year that begins after November 15, 2007. The Company chose not to apply fair value measurements to any financial instruments in accordance with SFAS No. 159, and therefore, the adoption of this standard did not affect our financial position, results of operations or disclosures.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities. SFAS No. 161 is an amendment to SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The objective of SFAS No. 161 is to expand the disclosure requirements of SFAS No. 133 with the intent to improve the financial reporting of how and why an entity uses derivative instruments; how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations; and how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2008. The Company’s adoption of SFAS No. 161 did not affect our financial position or results of operation.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). The current GAAP hierarchy, as set forth in the American Institute of Certified Public Accountants (AICPA) Statement on Auditing Standards No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles, has been criticized because (1) it is directed to the auditor rather than the entity, (2) it is complex, and (3) it ranks FASB Statements of Financial Accounting Concepts, which are subject to the same level of due process as FASB Statements of Financial Accounting Standards, below industry practices that are widely recognized as generally accepted but that are not subject to due process. The FASB believes that the GAAP hierarchy should be directed to entities because it is the entity (not its auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP. Accordingly, the FASB concluded that the GAAP hierarchy should reside in the accounting literature established by the FASB and is issuing this Statement to achieve that result. The Company does not anticipate the new accounting principle to have a material effect on its financial position or results of operation.

In October 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active. This FASB Staff Position clarifies the application of SFAS No. 157, Fair Value Measurements, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 provides guidance on (1) how an entity’s own assumption should be considered when measuring fair value when relevant observable inputs do not exist, (2) how available observable inputs in a market that is not active should be considered when measuring fair value and (3) how the use of market quotes should be considered when assessing the relevance of observable and unobservable inputs available to measure fair value. This FASB Staff Position is effective immediately. The Company does not anticipate the new accounting principle to have a material effect on its financial position or results of operation.

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On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (“EESA”), which creates the Troubled Asset Relief Program (“TARP”) and provides the U.S. Secretary of the Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets. The Capital Purchase Program (the “CPP”) was announced by the U.S. Treasury on October 14, 2008 as part of TARP. Pursuant to the CPP, the U.S. Treasury will purchase up to $250 billion of senior preferred shares on standardized terms from qualifying financial institutions. The purpose of the CPP is to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. The Company will not participate in the CPP.

In December 2008, the FASB issued FASB Staff Position No. 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets” (“FSP 132(R)-1”). This FSP amends FASB Statement No. 132(R), “Employer’s Disclosures about Pensions and Other Postretirement Benefits” (“FAS132(R)”), to require additional disclosures about assets held in an employer’s defined benefit pension or other postretirement plan. This FSP is applicable to an employer that is subject to the disclosure requirements of FAS 132(R) and is generally effective for fiscal years ending after December 15, 2009. We are in the process of reviewing the potential impact of FSP 132(R)-1, however, the adoption of FSP 132(R)-1 is not expected to have a material effect on its financial position or results of operation.

On February 27, 2009, The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) voted to amend the restoration plan for the Deposit Insurance Fund (DIF). The Board also took action to ensure the continued strength of the insurance fund by imposing a special assessment on insured institutions of 20 basis points, implementing changes to the risk-based assessment system, and setting rates beginning the second quarter of 2009. Under the restoration plan approved last October, the Board set a rate schedule to raise the DIF reserve ratio to 1.15 percent within five years. The February 27, 2009 action extends the restoration plan horizon to seven years in recognition of the current significant strains on banks and the financial system and the likelihood of a severe recession. The amended restoration plan was accompanied by a final rule that sets assessment rates and makes adjustments that improve how the assessment system differentiates for risk. Currently, most banks are in the best risk category and pay anywhere from 12 cents per $100 of deposits to 14 cents per $100 for insurance. Under the final rule, banks in this category will pay initial base rates ranging from 12 cents per $100 to 16 cents per $100 on an annual basis, beginning on April 1, 2009. The Board adopted an interim rule imposing a 20 basis point emergency special assessment on the industry on June 30, 2009. The assessment is to be collected on September 30, 2009. The interim rule would also permit the Board to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. Comments on the interim rule on special assessments are due no later than 30 days after publication in the Federal Register. Changes to the assessment system include higher rates for institutions that rely significantly on secured liabilities, which may increase the FDIC’s loss in the event of failure without providing additional assessment revenue. Under the final rule, assessments will be higher for institutions that rely significantly on brokered deposits but, for well-managed and well-capitalized institutions, only when accompanied by rapid asset growth. Brokered deposits combined with rapid asset growth have played a role in a number of costly failures, including some recent ones. The final rule also would provide incentives in the form of a reduction in assessment rates for institutions to hold long-term unsecured debt and, for smaller institutions, high levels of Tier 1 capital. The Company is currently evaluating the effects of these insurance increases to its financial position and results of operation.

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Information in response to this Item 7A is incorporated by reference from the following sections of Item 7 of this report: “Interest Rate Sensitivity Management” and “Market Risk.”

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following consolidated financial statements are included within Exhibit 13.1 of this Annual Report on Form 10-K:

Report of Independent Registered Public Accounting Firm

Consolidated Statements of Financial Condition as of December 31, 2008 and 2007

Consolidated Statements of Operations for the Years Ended December 31, 2008, 2007, and 2006

Consolidated Statements of Shareholders’ Equity for the Years Ended December 3, 2008, 2007 and 2006

Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006

Notes to Consolidated Financial Statements

Quarterly Results (Unaudited)

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A(T). CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Annual Report on Form 10-K, our principal executive officer and principal financial officer have evaluated the effectiveness of our “disclosure controls and procedures” (Disclosure Controls). Disclosure Controls, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act), are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Our management, including the chief executive officer and chief financial officer, does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Based upon their controls evaluation, our chief executive officer and chief financial officer have concluded that our Disclosure Controls are effective at a reasonable assurance level.

Management’s Annual Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s management, including its Principal Executive Officer and Principal Financial Officer, conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, the Company’s management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2008.

This Annual Report on Form 10-K does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation requirements by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this Annual Report.

Changes in Internal Control Over Financial Reporting

During the fourth quarter of 2008, there were no changes in our internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, the our internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

54

PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information appearing under the headings “Election of Directors,” “Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Corporate Governance and Board Matters” in the Proxy Statement (the “2009 Proxy Statement”) relating to our 2009 Annual Meeting of Shareholders is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION

The information appearing under the heading “Compensation of Executive Officers and Directors” in the 2009 Proxy Statement is incorporated herein by reference.

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

The information appearing under the heading “Ownership of Common Stock” in the 2009 Proxy Statement is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information appearing under the caption “Certain Relationships and Related Party Transactions” in the 2009 Proxy Statement is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information appearing under the caption “Independent Public Accountants” in the 2009 Proxy Statement is incorporated herein by reference.

55

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)	1.	Financial Statements.
		The following consolidated financial statements are located in Item 8 of this Report:
		Report of Independent Registered Public Accounting Firm
		Consolidated Statements of Financial Condition as of December 31, 2008 and 2007
		Consolidated Statements of Operations for the Years Ended December 31, 2008, 2007 and 2006
		Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2008, 2007 and 2006
		Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006
		Notes to Consolidated Financial Statements
		Quarterly Results (Unaudited)
	2.	Financial Statement Schedules.
		Schedules to the consolidated financial statements are omitted, as the required information is not applicable.
	3.	Exhibits.
		The following exhibits are filed or incorporated by reference as part of this Report:

Exhibit Number	Description of Exhibit
3.1	Articles of Incorporation of the Company, as Restated (included as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q, dated August 15, 2003 and incorporated herein by reference).
3.2	Bylaws of the Company, as Amended and Restated (included as Exhibit 3.2 to the Company’s Current Report on Form 8-K, dated October 25, 2007 and incorporated herein by reference).
4.1	See Exhibits 3.1 and 3.2 for provisions in the Company’s Articles of Incorporation and Bylaws defining the rights of holders of the common stock
4.2	Form of Certificate of Common Stock (incorporated by reference to Exhibit 4.1 of the Company’s Registration Statement on Form S-2, File No. 333-127898).
4.3	Form of Appalachian Community Bank Fixed Rate Subordinated Debenture (included as Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q, dated November 14, 2008 and incorporated herein by reference).
10.1	1997 Directors’ Non-Qualified Stock Option Plan (included as Exhibit 10.1 to the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996 and incorporated herein by reference).*
10.2	1997 Employee Incentive Stock Incentive Plan (included as Exhibit 10.2 to the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996 and incorporated herein by reference).*

56

Exhibit Number	Description of Exhibit
10.3	Change in Control Agreement (as amended and restated), dated May 1, 2008, by and among Appalachian Community Bank, Appalachian Bancshares, Inc. and Tracy R. Newton (included as Exhibit 10.1 to the Company’s March 31, 2008 10-Q, filed on May 14, 2008 and incorporated herein by reference).*
10.4	Change in Control Agreement (as amended and restated), dated May 1, 2008, by and among Appalachian Community Bank, Appalachian Bancshares, Inc. and J. Keith Hales (included as Exhibit 10.2 to the Company’s March 31, 2008 10-Q, filed on May 14, 2008 and incorporated herein by reference).*
10.5	Form of Salary Continuation Agreement (as amended and restated) for the Directors of Appalachian Community Bank (and description of benefits for each of the Directors) (included as Exhibit 10.3 to the Company’s March 31, 2008 10-Q, filed on May 14, 2008 and incorporated herein by reference).*
10.6	Adoption Agreement for the Appalachian Bancshares, Inc. Employees’ Savings & Profit Sharing Plan Basic Plan Document and related documents (filed as Exhibit 10.2 to the Plan’s Annual Report on Form 11-K for the fiscal year ended December 31, 2002 and incorporated herein by reference).
10.7	Pentegra Services, Inc. Employees’ Savings & Profit Sharing Plan Basic Plan Document and related documents (filed as Exhibit 10.3 to the Plan’s Annual Report on Form 11-K for the fiscal year ended December 31, 2002 and incorporated herein by reference).
10.8	Form of Deferred Fee Agreement between Gilmer County Bank and certain directors and executive officers, with addendum (filed as Exhibit 10.6 to the Company’s Quarterly Report on Form 10-QSB for the period ended June 30, 1997 and incorporated herein by reference).
10.9	Form of Data Processing Agreement by and between Appalachian Community Bank and Fiserv Solutions, Inc., effective as of July 26, 2002 (filed as Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 2003 and incorporated herein by reference).
10.10	2003 Stock Option Plan (included as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2003 and incorporated herein by reference).*
10.11	Form of Stock Option Agreement (included as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 and incorporated herein by reference).*

57

Exhibit Number	Description of Exhibit
10.12	Form of Change in Control Agreement for Named Executive Officers (and description of benefits for each Named Executive Officer) (included as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 and incorporated herein by reference).*
10.13	Form of Salary Continuation Agreement for Named Executive Officers (and description of benefits for each Named Executive Officer) (included as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 and incorporated herein by reference).*
10.14	Form of Salary Continuation Agreement for the Directors of Appalachian Community Bank (and description of benefits for each of the Directors) (included as Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 and incorporated herein by reference).*
10.15	Amended Salary Continuation Agreement dated August 11, 2006 by and among Appalachian Community Bank, Appalachian Bancshares, Inc. and Joseph T. Moss, Jr. (included as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q, dated August 11, 2006 and incorporated herein by reference).*
10.16	Appalachian Bancshares, Inc. 2007 Equity Incentive Plan (included as Exhibit 10.1 to the Company’s Registration Statement on Form S-8, dated October 10, 2007, and incorporated herein by reference) *
10.17	Amended and Restated Salary Continuation Agreement dated March 27, 2008 by and among Appalachian Community Bank, Appalachian Bancshares, Inc. and Tracy R. Newton (included as Exhibit 10.14 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007 and incorporated herein by reference).*
10.18	Appalachian Bancshares, Inc. Amended and Restated Employee Stock Ownership Trust (included as Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2008 and incorporated herein by reference).*
10.19	Appalachian Bancshares, Inc. Employee Stock Ownership Plan with 401(k) Provisions (included as Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2008 and incorporated herein by reference).*
13.1	Consolidated Financial Statements and Supplementary Data
14	Code of Ethics for CEO and Senior Financial Officers (included as Exhibit 14 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003 and incorporated herein by reference).

58

Exhibit Number	Description of Exhibit
21	Subsidiaries of the Registrant
23.1	Consent of Mauldin & Jenkins, LLC
24.1	Power of Attorney (included a part of the signature page).
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
32	Certifications Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

* The referenced exhibit is a compensatory contract, plan or arrangement.

59

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 3rd day of April 2009.

APPALACHIAN BANCSHARES, INC.
By:	/s/ Tracy R. Newton
	Tracy R. Newton
	President and Chief Executive Officer

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Tracy R. Newton, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

/s/ Tracy R. Newton	Date: April 3, 2009
Tracy R. Newton, President, Chief Executive Officer and Director (principal executive officer)
/s/ Danny F. Dukes	Date: April 3, 2009
Danny F. Dukes, Executive Vice President and Chief Financial Officer (principal accounting and financial officer)
	Date: April 3, 2009
Alan S. Dover, Director
/s/ Charles A. Edmondson	Date: April 3, 2009
Charles A. Edmondson, Director
/s/ Roger E. Futch	Date: April 3, 2009
Roger E. Futch, Director
/s/ Joseph C. Hensley	Date: April 3, 2009
Joseph C. Hensley, Director
/s/ Frank E. Jones	Date: April 3, 2009
Frank E. Jones, Director

60

/s/ J. Ronald Knight	Date: April 3, 2009
J. Ronald Knight, Chairman and Director
/s/ Kenneth D. Warren	Date: April 3, 2009
Kenneth D. Warren, Director

61

EXHIBIT INDEX

The following exhibits are filed as part of this report (in addition to those exhibits listed in Item 15 which are filed as a part of this report and incorporated by reference):

Exhibit Number	Description of Exhibit
13.1	Consolidated Financial Statements and Supplementary Data
21	Subsidiaries of the Registrant
23.1	Consent of Mauldin & Jenkins, LLC
31.1	Certification of Principal Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
32	Certifications Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

62

EX-13.1

EXHIBIT 13.1 – CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Financial Statements

	Page(s)
Report of Independent Registered Public Accounting Firm	1
Consolidated Statements of Financial Condition as of December 31, 2008 and 2007	2
Consolidated Statements of Operations for the Years Ended December 31, 2008, 2007 and 2006	3
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2008, 2007 and 2006	4
Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007, and 2006	5
Notes to Consolidated Financial Statements	6
Quarterly Results (Unaudited)	38

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

Appalachian Bancshares, Inc. and Subsidiaries

Ellijay, Georgia

We have audited the consolidated statements of financial condition of Appalachian Bancshares, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Appalachian Bancshares, Inc. and Subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.

We were not engaged to examine management’s assertion about the effectiveness of Appalachian Bancshares, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2008 included under Item 9A(T) “Controls and Procedures” in Appalachian Bancshares, Inc. and Subsidiaries’ Annual Report on Form 10-K and, accordingly, we do not express an opinion thereon.

Atlanta, Georgia

April 2, 2009

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 31, 2008 and 2007

(In thousands)

	2008			2007
Assets
Cash and due from banks	$	12,825		$	13,392
Interest-bearing deposits with other banks		731			310
Federal funds sold		133,351			12,797
Cash and Cash Equivalents		146,907			26,499
Securities available-for-sale		79,308			76,565
Restricted equity securities		4,932			3,945
Loans, held for sale		2,783			6,503
Loans, net of unearned income		885,374			807,522
Allowance for loan losses		(14,510	)		(9,808	)
Net Loans		870,864			797,714
Premises and equipment, net		39,638			32,966
Accrued interest		9,289			9,797
Cash surrender value on life insurance		9,140			8,778
Intangibles, net		1,992			2,179
Foreclosed assets		13,323			1,573
Other assets		7,502			4,681
Total Assets	$	1,185,678		$	971,200
Liabilities and Shareholders’ Equity
Liabilities
Noninterest-bearing deposits	$	50,035		$	56,559
Interest-bearing deposits		963,241			751,038
Total Deposits		1,013,276			807,597
Short-term borrowings		10,604			21,048
Accrued interest		1,936			2,059
FHLB Advances		72,000			57,350
Subordinated long-term capital notes		12,511			6,186
Other liabilities		2,913			3,297
Total Liabilities		1,113,240			897,537
Commitments and Contingencies
Shareholders’ Equity
Preferred stock, 20,000,000 shares authorized, none issued		—			—
Common stock, par value $0.01 per share, 20,000,000 shares authorized, 5,372,505 and 5,285,026 shares issued and outstanding		54			53
Paid-in capital		44,979			43,998
Retained earnings		26,472			29,331
Accumulated other comprehensive income		933			281
Total Shareholders’ Equity		72,438			73,663
Total Liabilities and Shareholders’ Equity	$	1,185,678		$	971,200

See notes to consolidated financial statements.

2

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

Years Ended December 31, 2008, 2007 and 2006

(In thousands, except shares and per share data)

	2008			2007		2006
Interest Income
Interest and fees on loans	$	64,637		$	68,213	$	49,843
Interest on securities:
Taxable securities		3,227			2,859		2,301
Nontaxable securities		612			639		668
Interest on deposits with other banks		16			78		30
Interest on federal funds sold		513			338		351
Total Interest Income		69,005			72,127		53,193
Interest Expense
Interest on deposits		30,993			32,367		20,351
Interest on short-term borrowings		417			283		472
Interest FHLB advances		2,066			1,629		1,180
Interest on subordinated long-term capital notes		558			521		491
Total Interest Expense		34,034			34,800		22,494
Net Interest Income		34,971			37,327		30,699
Provision for loan losses		12,915			4,726		3,253
Net Interest Income After Provision For Loan Losses		22,056			32,601		27,446
Noninterest Income
Customer service fees		2,528			2,235		1,650
Mortgage origination commissions		1,404			1,988		1,348
Net gains (losses) on securities		(776	)		7		—
Other operating income		1,091			1,288		973
Total Noninterest Income		4,247			5,518		3,971
Noninterest Expenses
Salaries and employee benefits		17,743			17,510		13,341
Occupancy, furniture and equipment expense		4,286			3,678		2,685
Other operating expenses		9,585			8,598		6,535
Total Noninterest Expenses		31,614			29,786		22,561
Income (Loss) before income tax expense (benefit)		(5,311	)		8,333		8,856
Income tax expense (benefit)		(2,452	)		2,763		2,852
Net Income (Loss)	$	(2,859	)	$	5,570	$	6,004
Earnings (Losses) Per Common Share
Basic	$	(0.53	)	$	1.06	$	1.16
Diluted		(0.53	)		1.06		1.14
Cash Dividends Declared Per Common Share		0.00			0.00		0.00
Weighted Average Shares Outstanding
Basic		5,366,658			5,265,555		5,170,687
Diluted		5,366,658			5,276,200		5,278,711

See notes to consolidated financial statements.

3

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years Ended December 31, 2008, 2007 and 2006

(In thousands)

	Common Stock			Paid-in Capital			Retained Earnings			Accumulated Other Compre- hensive Income (Loss)			Treasury Stock			Total
Balance at December 31, 2005	$	52		$	43,184		$	17,757		$	(468	)	$	(700	)	$	59,825
Net income 2006		—			—			6,004			—			—			6,004
Unrealized gains on available-for- sale securities, net of tax of $128		—			—			—			247			—			247
Comprehensive income																	6,251
Proceeds from sale of common stock to 401(k) plan		—			50			—			—			—			50
Effect of exercise and issuance of stock options		1			444			—			—			—			445
Stock-based compensation cost		—			204			—			—			—			204
Expense incurred from sale of common stock through stock offering		—			(12	)		—			—			—			(12	)
Balance at December 31, 2006		53			43,870			23,761			(221	)		(700	)		66,763
Net income 2007		—			—			5,570			—			—			5,570
Unrealized gains on available-for- sale securities, net of tax of $252		—			—			—			502			—			502
Comprehensive income		—			—			—			—			—			6,072
Proceeds from sale of common stock to 401(k) plan		—			618			—			—			—			618
Effect of exercise and issuance of stock options		1			1,066			—			—			—			1,067
Stock-based compensation cost		—			327			—			—			—			327
Purchase of treasury stock														(672	)		(672	)
Retirement of treasury stock		(1	)		(1,371	)		—			—			1,372			—
Purchase of stock outstanding		—			(512	)		—			—			—			(512	)
Balance at December 31, 2007		53			43,998			29,331			281			—			73,663
Net loss 2008		—			—			(2,859	)		—			—			(2,859	)
Unrealized gains on available-for- sale securities, net of tax of $336		—			—			—			652			—			652
Comprehensive loss		—			—			—			—			—			(2,207	)
Proceeds from sale of common stock to 401(k) plan		1			884			—			—			—			885
Effect of exercise and issuance of stock options		—			—			—			—			—
Stock-based compensation cost		—			280			—			—			—			280
Purchase of stock outstanding		—			(183	)		—			—			—			(183	)
Balance at December 31, 2008	$	54		$	44,979		$	26,472		$	933		$	—		$	72,438

See notes to consolidated financial statements.

4

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2008, 2007 and 2006

(In thousands)

	2008			2007			2006
Operating Activities
Net income (loss)	$	(2,859	)	$	5,570		$	6,004
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation, amortization, and accretion, net		2,404			558			968
Provision for loan losses		12,915			4,726			3,253
Deferred tax benefit		(1,114	)		(784	)		(1,363	)
Realized security (gains) losses, net		776			(7	)		—
Loss on disposal of premises and equipment		10			39			15
Loss on disposition of other real estate		764			264			32
Increase in cash surrender value on life insurance		(362	)		(340	)		(295	)
(Increase) decrease in accrued interest receivable		508			(1,640	)		(3,406	)
Increase (decrease) in accrued interest payable		(123	)		605			726
Stock-based compensation cost		280			327			204
Excess tax benefits from exercise of stock options		—			(617	)		(88	)
Net (increase) decrease in loans held for sale		3,720			(5,770	)		(733	)
Other, net		(3,229	)		878			(600	)
Net Cash Provided By Operating Activities		13,690			3,809			4,717
Investing Activities
Proceeds from sales of securities available-for-sale		11,457			4,963			2,619
Proceeds from maturity, calls and paydown of securities available-for-sale		18,947			19,389			11,994
Purchase of securities available-for-sale		(34,408	)		(29,275	)		(17,314	)
Net increase in loans		(99,139	)		(179,804	)		(178,002	)
Capital expenditures		(8,431	)		(9,970	)		(7,648	)
Proceeds from disposal of premises and equipment		18			—			12
Proceeds from disposition of other real estate		1,363			225			1,622
Net Cash Used In Investing Activities		(110,193	)		(194,472	)		(186,717	)
Financing Activities
Net increase in demand deposits, NOW accounts, and savings accounts		13,500			71,892			20,132
Net increase in certificates of deposit		192,178			84,571			157,692
Net increase (decrease) in short-term borrowings		(10,444	)		16,310			(20,154	)
Issuance of subordinated debt		6,325			—			—
Proceeds from FHLB advances		40,000			60,000			20,000
Repayment of FHLB advances		(25,350	)		(27,700	)		(19,900	)
Issuance of common stock		885			1,068			394
Purchase of treasury stock		—			(672	)		—
Purchase and retirement of stock		(183	)		(512	)		—
Excess tax benefits from exercise of stock options		—			617			88
Net Cash Provided By Financing Activities		216,911			205,574			158,252
Net Increase (Decrease) in Cash and Cash Equivalents		120,408			14,911			(23,748	)
Cash and Cash Equivalents at Beginning of Year		26,499			11,588			35,336
Cash and Cash Equivalents at End of Year	$	146,907		$	26,499		$	11,588

See notes to consolidated financial statements.

5

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies

The accompanying consolidated financial statements include the accounts of Appalachian Bancshares, Inc. (the “Company”) (a Georgia corporation) and its wholly-owned subsidiaries: Appalachian Community Bank (the “Bank”), Appalachian Community Bank, F.S.B. (the “Thrift”), and Appalachian Real Estate Holdings, Inc. (the “Real Estate Holding Company”). Appalachian Bancshares, Inc. owns 100% of the outstanding stock of each of its subsidiaries, including the Real Estate Holding Company, which was formed in June 2008 to hold certain real estate that may be acquired by the Bank and the Thrift through foreclosure. All significant intercompany transactions and balances have been eliminated in consolidation. Unless otherwise indicated herein, the financial results of the Company refer to the Company, the Bank, the Thrift, and the Real Estate Holding Company on a consolidated basis. The Bank and the Thrift provide a full range of banking services to individual and corporate customers in North Georgia, Murphy, North Carolina, Ducktown, Tennessee and the surrounding areas.

The Company operates predominantly in the domestic commercial banking industry. The accounting and reporting policies of the Company conform to generally accepted accounting principles in the United States and to general practice within the banking industry. The following summarizes the most significant of these policies.

Recent Development

As a result of the recently completed examination by the Federal Deposit Insurance Corporation (FDIC), the Board of Directors and management anticipate that the FDIC and the Georgia Department of Banking and Finance (collectively with the FDIC, the “Agencies”) will place the Bank under an administrative action which will contain certain operational and financial restrictions. We are currently in the process of reviewing and negotiating the proposed order of the FDIC and expect that this administrative action will require us, among other things, to assess and potentially modify our management structure, reduce and improve our level of classified assets over designated periods of time, perform internal loan reviews on a more frequent basis, maintain an appropriate allowance for loan and lease losses, implement a commercial real estate lending policy, restrict the use of brokered deposits, maintain a Tier 1 capital ratio equal to or greater than 8% of total assets and a total risk-based capital ratio equal to or greater than 10% of total assets, and to review and, where appropriate, revise various Bank policies on matters such as liquidity and funds management, earnings improvement, lending and collection, loan review and underwriting. As with other similarly situated banks, we anticipate that the Bank will be restricted from paying any dividends without the prior written consent of the Agencies. The issuance of such action will also result in the Bank not being considered “well-capitalized” and therefore result in higher FDIC insurance assessments in 2009 and for at least the term of the action.

We further anticipate that the Bank will be required to send periodic written progress reports to the Agencies to show its progress in complying with the restrictions so imposed. These restrictions will remain in place until terminated by the Agencies.

In conjunction with any administrative action placed on the Bank, we anticipate that the Federal Reserve System would impose an administrative action on the Holding Company. We expect that the restrictions imposed by the Federal Reserve would (among other matters): limit the activities of the Holding Company by restricting dividend payments to shareholders without the prior approval of the Federal Reserve Bank and the prior approval of the Director of the Division of Banking Supervision and Regulation of the Board of Governors of the Federal Reserve; prohibit any redemption of shares without prior approval of the Reserve Bank; prohibit the appointment of new officers or directors of the Holding Company without prior Reserve Bank approval; and will require the Holding Company to provide quarterly progress reports to the Reserve Bank. These restrictions and requirements would remain in place until terminated by the Federal Reserve.

In anticipation of such actions discussed above, the Company has hired a consulting firm to assist them with raising additional capital in order to meet requirements for additional capital.

6

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

Use of Estimates

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

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management relies on independent appraisals for significant collateral. While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank and Thrift to recognize additional losses based on their judgments about information available to them at the time of their examinations. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term.

Securities

Securities are classified as either held-to-maturity, available-for-sale or trading.

Held-to-maturity securities are securities for which management has the ability and intent to hold until maturity. These securities are carried at amortized cost, adjusted for amortization of premiums and accretion of discount, to the earlier of the maturity or call date.

Securities available-for-sale represent those securities intended to be held for an indefinite period of time, including securities that management intends to use as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, the need to increase regulatory capital, or other similar factors. Securities available-for-sale are recorded at market value with unrealized gains and losses net of any tax effect, added or deducted from shareholders’ equity.

Equity securities without a readily determinable fair value are classified as available for sale and recorded at cost. Restricted equity securities without a readily determinable fair value are recorded at cost.

Securities carried in trading accounts are carried at market value with unrealized gains and losses reflected in income.

Realized gains and losses are recorded on the trade date and are based on the specific identification method.

The amortization of premiums and accretion of discounts are recognized in interest income using the interest method over the life of the securities.

Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in earnings as realized losses.

The Company had no trading or held-to-maturity securities as of December 31, 2008 and 2007.

7

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

Loans Held for Sale

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

Loans

Loans that the Company has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at unpaid principal balances, less the allowance for loan losses and deferred fees and costs on originated loans.

Interest income is accrued on the unpaid principal balance. Loan origination and commitment fees, net of certain origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans.

Allowance for Loan Losses

A loan is generally classified as impaired, based on current information and events, if it is probable that we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the contract interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral less selling costs. Smaller balance homogeneous loans are evaluated collectively for impairment.

The allowance for loan losses is established as losses are estimated to have occurred through charges to earnings in the form of provisions for loan losses. Increases and decreases in the allowance due to changes in the measurement of the impaired loans are included in the provision for loan losses. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable. When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance and subsequent recoveries, if any, are credited to the allowance.

Management determines the allowance for loan losses by first dividing the loan portfolio into two major categories: (1) non-impaired loans and (2) impaired loans. Loan loss reserves are calculated primarily based upon the historical loss experience, by segment for the non-impaired portion of the portfolio adjusted for qualitative factors. Management uses a moving three year average net loan charge off/recovery experience rate (net charge off percentage of total loans) for the various segments in the loan portfolio. This experience rate is applied to the non-impaired loans by segment, in order to determine the reserve amount for non-impaired loans. Impaired loans are evaluated individually for loans over $100,000. Impaired loans $100,000 and under are evaluated for impairment as a group. In management’s opinion, the allowance for loan losses is considered adequate at December 31, 2008 and 2007.

Management’s periodic evaluation of the adequacy of the allowance is based on the past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrowers’ ability to repay, estimated value of any underlying collateral, and current economic conditions. While management believes that it has established the allowance in accordance with generally accepted accounting principles and has taken into account the views of its regulators and the current economic environment, there can be no assurance that in the future the Bank and Thrift’s regulators or the economic environment will not require further increases in the allowance.

8

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

Income Recognition on Impaired and Nonaccrual Loans

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well collateralized and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.

Loans may be returned to accrual status when all principal and interest amounts contractually due are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by the borrower, in accordance with the contractual terms of interest and principal.

While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are applied as regular payments. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge offs have been fully recovered.

Premises and Equipment

Land is carried at cost. Other premises and equipment are carried at cost, net of accumulated depreciation. Depreciation is provided generally by the straight-line method based principally on the estimated useful lives of the respective assets. Estimated lives of premises and equipment are as follows: for buildings and improvements – from ten to fifty years, for furniture and equipment – from three to fifteen years, for computer equipment and software – from three to five years, and for automobiles – five years. Maintenance and repairs are expensed as incurred, while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations.

Foreclosed Assets

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

At the time of foreclosure, foreclosed assets are recorded at fair value less cost to sell, which becomes the property’s new basis. Any write-downs based on the asset’s fair value at date of acquisition are charged to the allowance for loan losses. After foreclosure, these assets are carried at the lower of their new cost basis or fair value less cost to sell.

Costs incurred in maintaining foreclosed assets and subsequent adjustments to the carrying amount of the property are included in other operating expenses.

Income Taxes

Income taxes are provided for the tax effects of the transactions reported in the consolidated financial statements and consist of taxes currently due or refundable plus deferred taxes related primarily to differences between the basis of available-for-sale securities, allowance for loan losses, estimated losses on foreclosed real estate, deferred compensation, and accumulated depreciation for financial and income tax reporting. The deferred

9

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The Company files consolidated income tax returns with its subsidiaries. Management’s determination of the realization of deferred tax assets is based upon management’s judgment of various future events and uncertainties, including the timing, nature and amount of future income earned by certain subsidiaries and the implementation of various plans to maximize realization of deferred tax assets. Management believes that the Company will generate sufficient operating earnings to realize the deferred tax benefits.

Stock-Based Compensation

Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), entitled Share-Based Payment (“SFAS No. 123R”) using the modified-prospective-transition method. Under that transition method, compensation cost recognized in 2006 includes compensation cost for all share-based payments granted prior to but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R.

Employee Benefit Plan

The Company has a 401(k) profit-sharing plan covering substantially all of its employees. Eligible participating employees may elect to contribute tax-deferred contributions. Company contributions to the plan are determined by the board of directors, not to exceed the amount that can be deducted for federal income tax purposes. The Company is presently matching up to 3% of the employee’s salary if the employee contributes at least 10%. The match is prorated if the employee contributes less than 10%.

Intangibles

Intangibles at December 31, 2008 consists of goodwill. Intangibles at December 31, 2007 consists of goodwill and non-compete agreements with two former employees of the Bank. The goodwill represents a premium paid on the purchase of assets and liabilities. Goodwill is stated at cost, net of accumulated amortization, which was provided using the straight-line method over the estimated useful life of 20 years, until the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 142, Goodwill and Other Intangible Assets, in June 2001. The carrying amount of goodwill at December 31, 2008 and 2007 is $1,991,891.

Goodwill is required to be tested annually for impairment, or whenever events occur that may indicate that the recoverability of the carrying amount is not probable. In the event of impairment, the amount by which the carrying amount exceeds the fair value would be charged to earnings. The Company performs its annual test of impairment each December 31st, and as of December 31, 2008 and 2007 the Company determined that there was no impairment of the carrying value.

The noncompete intangible at December 31, 2007 represents agreements with two former employees, one of which was entered into in 2006 and the other in 2007. These employees agreed to certain stipulations concerning future employment. The agreements are stated at cost, net of accumulated amortization, which is provided using the straight-line method over the contract period. Amortization expense incurred from these noncompete agreements for the years ended December 31, 2008 and 2007 was $187,525 and $228,525, respectively.

10

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

Off-Balance Sheet Financial Instruments

In the ordinary course of business the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded in the consolidated financial statements when they are funded.

The Company also has available as a source of short-term financing the purchase of federal funds from other commercial banks from available lines of up to $33.0 million, of which all $33.0 million in funds were available at December 31, 2008. Also, the Company has a line of credit with the Federal Home Loan Bank (the “FHLB”), of up to approximately $108 million, of which approximately $36 million was available, subject to proper collateralization at December 31, 2008. In addition, the Company had a short-term line of credit with another bank in the amount of $10,000,000, of which $5.0 million was available at December 31, 2008.

Earnings (Losses) per Common Share

Basic earnings (losses) per common share are computed by dividing earnings (losses) by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect per share amounts that would have resulted if dilutive potential common stock had been converted to common stock, as prescribed by SFAS No. 128, Earnings per Share.

	Years ended December 31,
	2008	2007	2006
Weighted average of common shares outstanding	5,366,658	5,265,555	5,170,687
Effect of dilutive options	—	10,645	108,024
Weighted average of common shares outstanding effected for dilution	5,366,658	5,276,200	5,278,711
Options not considered in dilutive calculations	273,460	258,000	5,000

Stock Repurchase Plan

In March 2007, the Company announced a stock repurchase program which authorized the repurchase of up to $2.5 million of its shares of common stock over a twelve month period ending on February 27, 2008. During the year ended December 31, 2007, the Company repurchased a total of 35,000 shares at a weighted average repurchase price of $14.64 per share. During 2008, the Company purchased another 16,000 shares at a weighted average price of $11.44 prior to the plan ending date. These shares were retired and available for future issuances.

11

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

Comprehensive Income (Loss)

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income (loss). Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the statement of financial condition, such items, along with net income, are components of comprehensive income (loss).

In the calculation of comprehensive income (loss), certain reclassification adjustments are made to avoid double counting items that are displayed as part of net income for a period that also had been displayed as part of other comprehensive income (loss) in that period or earlier periods. The disclosure of the reclassification amounts and other details of other comprehensive income (loss) are as follows:

	Years ended December 31,
	2008			2007			2006
	(In thousands)
Unrealized gains on securities
Unrealized gains arising during period	$	212		$	761		$	375
Reclassification adjustment for (gains) losses included in net income (loss)		776			(7	)		—
Net unrealized gains		988			754			375
Income tax related to items of other comprehensive income (loss)		(336	)		(252	)		(128	)
Other comprehensive income	$	652		$	502		$	247

12

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

Statements of Cash Flows

The Company includes cash, due from banks, and short-term investments as cash equivalents in preparing the consolidated statements of cash flows. The following is supplemental disclosure to the statements of cash flows for the three years ended December 31, 2008.

	2008		2007		2006
	(In thousands)
Cash paid during the year for interest	$	34,157	$	34,195	$	21,768
Cash paid during the year for income taxes		951		3,240		3,358
Non-cash Disclosures:
Loans transferred to foreclosed assets		20,413		4,556		2,824
Net increase in unrealized gains and losses on securities available-for-sale		988		754		375
Sales of foreclosed assets financed through loans		7,339		3,878		99
Increase in cash surrender value on life insurance		362		340		295

13

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

Recent Developments

In September 2006, the EITF reached a consensus on EITF Issue No. 06-4 (EITF 06-4), “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” EITF 06-4 requires an employer to recognize a liability for future benefits based on the substantive agreement with the employee. EITF 06-4 requires a company to use the guidance prescribed in FASB Statement No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and Accounting Principles Board Opinion No. 12, “Omnibus Opinion,” when entering into an endorsement split-dollar life insurance agreement and recognizing the liability. EITF 06-4 is effective for fiscal periods beginning after December 15, 2007. The Company’s adoption of EITF 06-4 did not affect our financial position, results of operations or its cash flows.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159 permits entities to make an irrevocable election, at specified election dates, to measure eligible financial instruments and certain other items at fair value. This statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. The provisions of this statement are effective as of the beginning of the first fiscal year that begins after November 15, 2007. The Company chose not to apply fair value measurements to any financial instruments in accordance with SFAS No. 159, and therefore, the adoption of this standard did not affect our financial position, results of operations or disclosures.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities. SFAS No. 161 is an amendment to SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The objective of SFAS No. 161 is to expand the disclosure requirements of SFAS No. 133 with the intent to improve the financial reporting of how and why an entity uses derivative instruments; how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations; and how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. The statement is effective for financial statements issued for fiscal years beginning after November 15, 2008. The Company’s adoption of SFAS No. 161 did not affect our financial position or results of operation.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). The current GAAP hierarchy, as set forth in the American Institute of Certified Public Accountants (AICPA) Statement on Auditing Standards No. 69, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles, has been criticized because (1) it is directed to the auditor rather than the entity, (2) it is complex, and (3) it ranks FASB Statements of Financial Accounting Concepts, which are subject to the same level of due process as FASB Statements of Financial Accounting Standards, below industry practices that are widely recognized as generally accepted but that are not subject to due process. The FASB believes that the GAAP hierarchy should be directed to entities because it is the entity (not its auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP. Accordingly, the FASB concluded that the GAAP hierarchy should reside in the accounting literature established by the FASB and is issuing this Statement to achieve that result. The Company does not anticipate the new accounting principle to have a material effect on its financial position or results of operation.

In October 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active. This FASB Staff Position clarifies the application of SFAS No. 157, Fair Value Measurements, in a market that is not active and provides an example to illustrate key considerations in

14

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of Significant Accounting Policies – Continued

determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 provides guidance on (1) how an entity’s own assumption should be considered when measuring fair value when relevant observable inputs do not exist, (2) how available observable inputs in a market that is not active should be considered when measuring fair value and (3) how the use of market quotes should be considered when assessing the relevance of observable and unobservable inputs available to measure fair value. This FASB Staff Position is effective immediately. The Company does not anticipate the new accounting principle to have a material effect on its financial position or results of operation.

On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (“EESA”), which creates the Troubled Asset Relief Program (“TARP”) and provides the U.S. Secretary of the Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets. The Capital Purchase Program (the “CPP”) was announced by the U.S. Treasury on October 14, 2008 as part of TARP. Pursuant to the CPP, the U.S. Treasury will purchase up to $250 billion of senior preferred shares on standardized terms from qualifying financial institutions. The purpose of the CPP is to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy.

In December 2008, the FASB issued FASB Staff Position No. 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets” (“FSP 132(R)-1”). This FSP amends FASB Statement No. 132(R), “Employer’s Disclosures about Pensions and Other Postretirement Benefits” (“FAS132(R)”), to require additional disclosures about assets held in an employer’s defined benefit pension or other postretirement plan. This FSP is applicable to an employer that is subject to the disclosure requirements of FAS 132(R) and is generally effective for fiscal years ending after December 15, 2009. We are in the process of reviewing the potential impact of FSP 132(R)-1, however, the adoption of FSP 132(R)-1 is not expected to have a material effect on its financial position or results of operation.

On February 27, 2009, The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) voted to amend the restoration plan for the Deposit Insurance Fund (DIF). The Board also took action to ensure the continued strength of the insurance fund by imposing a special assessment on insured institutions of 20 basis points, implementing changes to the risk-based assessment system, and setting rates beginning the second quarter of 2009. Under the restoration plan approved last October, the Board set a rate schedule to raise the DIF reserve ratio to 1.15 percent within five years. The February 27, 2009 action extends the restoration plan horizon to seven years in recognition of the current significant strains on banks and the financial system and the likelihood of a severe recession. The amended restoration plan was accompanied by a final rule that sets assessment rates and makes adjustments that improve how the assessment system differentiates for risk. Currently, most banks are in the best risk category and pay anywhere from 12 cents per $100 of deposits to 14 cents per $100 for insurance. Under the final rule, banks in this category will pay initial base rates ranging from 12 cents per $100 to 16 cents per $100 on an annual basis, beginning on April 1, 2009. The Board adopted an interim rule imposing a 20 basis point emergency special assessment on the industry on June 30, 2009. The assessment is to be collected on September 30, 2009. The interim rule would also permit the Board to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. Comments on the interim rule on special assessments are due no later than 30 days after publication in the Federal Register. Changes to the assessment system include higher rates for institutions that rely significantly on secured liabilities, which may increase the FDIC’s loss in the event of failure without providing additional assessment revenue. Under the final rule, assessments will be higher for institutions that rely significantly on brokered deposits but, for well-managed and well-capitalized institutions, only when accompanied by rapid asset growth. Brokered deposits combined with rapid asset growth have played a role in a number of costly failures, including some recent ones. The final rule also would provide incentives in the form of a reduction in assessment rates for institutions to hold long-term unsecured debt and, for smaller institutions, high levels of Tier 1 capital. The Company is currently evaluating the effects of these insurance increases to its financial position and results of operation.

15

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 2 – Restrictions on Cash and Due From Bank Accounts

The Company is required to maintain average reserve balances either in vault cash or on deposit with the Federal Reserve Bank. At December 31, 2008 and 2007, the average amount of the required reserves was $-0- and $-0-, respectively.

Note 3 – Securities

The carrying amounts of securities as shown in the consolidated statements of financial condition of the Company and their approximate fair values at December 31, 2008 and 2007 are presented below.

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
	(In thousands)
December 31, 2008:
Government sponsored agency securities	$	29,993	$	989	$	—	$	30,982
State and municipal securities		10,976		146		209		10,913
Mortgage-backed securities		36,699		553		37		37,215
Equity securities		226		—		28		198
	$	77,894	$	1,688	$	274	$	79,308
December 31, 2007:
Government sponsored agency securities	$	32,964	$	240	$	45	$	33,159
State and municipal securities		13,651		421		41		14,031
Mortgage-backed securities		28,483		186		156		28,513
Equity securities		1,041		—		179		862
	$	76,139	$	847	$	421	$	76,565

At December 31, 2008, the Company’s available-for-sale securities reflected net unrealized gains of $1,413,827 that resulted in an increase in shareholders’ equity of $933,126 net of deferred taxes. At December 31, 2007, the Company’s available-for-sale securities reflected net unrealized gains of $425,566 that resulted in an increase in shareholders’ equity of $280,874 net of deferred taxes.

16

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 – Securities – Continued

The following tables show the Company’s securities’ gross unrealized losses and fair value, aggregated by security category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2008 and 2007.

	Less Than 12 Months				12 Months or More				Total
	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
	(In thousands)
December 31, 2008:
Government sponsored agency securities	$	—	$	—	$	—	$	—	$	—	$	—
State and municipal securities		3,444		210		—		—		3,444		210
Mortgage-backed securities		5,566		23		1,244		13		6,810		36
Equity securities		6		28		—		—		6		28
	$	9,016	$	261	$	1,244	$	13	$	10,260	$	274
December 31, 2007:
Government sponsored agency securities	$	—	$	—	$	8,841	$	45	$	8,841	$	45
State and municipal securities		1,445		30		605		11		2,050		41
Mortgage-backed securities		6,694		77		6,421		79		13,115		156
Equity securities		671		179		—		—		671		179
	$	8,810	$	286	$	15,867	$	135	$	24,677	$	421

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The securities at a loss for 12 months or more at December 31, 2008 are in 2 securities, that are insured agencies of the United States Government and the losses can be attributable to changes in interest rates. Because the declines in value are not attributed to credit quality and the Company has the ability and intent to hold the securities until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.

17

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 – Securities – Continued

The contractual maturities of securities available-for-sale at December 31, 2008 are shown as follows. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized Cost		Estimated Fair Value
	(In thousands)
Due in one year or less	$	5,002	$	5,108
Due after one year through five years		12,134		12,492
Due after five years through ten years		17,289		17,830
Due after ten years		43,243		43,680
Equity securities		226		198
	$	77,894	$	79,308

Mortgage-backed securities have been included in the maturity table based upon the guaranteed payoff date of each security.

Gross realized gains and losses on securities available-for-sale for each of the three years in the period ended December 31, 2008, were as follows:

	2008		2007		2006
	(In thousands)
Gross realized gains	$	67	$	7	$	—
Gross realized losses		843		—		—

During the third quarter of 2008, the Company recognized an other than temporary impairment charge of $816,000 on its investment in Freddie Mac preferred stock. The value of these securities declined significantly after the U.S. Government placed the company into conservatorship in September 2008. The remaining carrying value of the preferred stock at December 31, 2008 is $6,000.

Equity securities includes Federal Home Loan Bank preferred stock with a carrying value of $6,000 and $671,000 at December 31, 2008 and 2007, respectively; an investment in Appalachian Capital Trust I in the amount of $186,000 at December 31, 2008 and 2007; and an investment of $5,500 in a mortgage cooperative at December 31, 2008 and 2007, in order to enable the bank and thrift to participate in larger loan pools to attain preferable rates on certain loans. Restricted equity securities include a restricted investment in Federal Home Loan Bank stock, which must be maintained to secure the available line of credit.

The carrying value of securities pledged to secure public funds on deposit, securities sold under agreements to repurchase, and for other purposes as required by law amounted to $27,184,024 and $35,169,336 at December 31, 2008 and 2007, respectively.

18

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 4 – Loans

The Company grants loans to customers primarily in the North Georgia area. The major classifications of loans as of December 31, 2008 and 2007 were as follows:

	2008			2007
	(In thousands)
Commercial, financial and agricultural	$	72,543		$	48,749
Residential real estate - acquisition and development		328,473			311,099
Commercial real estate - acquisition and development		60,866			78,596
Mortgage real estate - residential		212,661			178,193
Mortgage real estate - commercial		173,566			154,663
Consumer		28,574			30,598
Other loans		8,691			5,624
Total loans (1)		885,374			807,522
Allowance for loan losses		(14,510	)		(9,808	)
Net loans	$	870,864		$	797,714

⁽¹⁾ Total loans are net of deferred fees of $160,540 and $87,070 (not stated in thousands), at December 31, 2008 and 2007, respectively.

Total loans which the Company considered to be impaired at December 31, 2008 and 2007 were $58,139,249 and $8,230,538, respectively. In addition $20,306,129 of the impaired loans represented performing troubled debt restructured loans. Of these loans, $24,386,632 and $4,250,322 were on nonaccrual status at December 31, 2008 and 2007, respectively. Allowances on the impaired loans at December 31, 2008 and 2007 were $3,291,722 and $1,983,084, respectively. Impaired loans consisted primarily of real estate — construction, real estate — commercial and mortgage loans as of December 31, 2008 and 2007. The average recorded investment in impaired loans for the years ended December 31, 2008, 2007 and 2006 was approximately $19,276,768, $7,268,104 and $3,906,000, respectively, excluding restructured loans. Interest income recognized on nonaccrual loans was $16,930 for the year ended December 31, 2008. No material amount of interest income was recognized on nonaccrual loans for the years ended December 31, 2007 and 2006. For other impaired loans, excluding troubled debt restructured loans, we collected approximately $298,035, $226,289 and $184,000 in interest during the years ended December 31, 2008, 2007 and 2006. We collected $1,260,902 in interest on the $20,306,129 troubled debt restructured loans during the year ended December 31, 2008. For the year ended December 31,2008, the difference between gross interest income that would have been recorded in such period if the impaired loans (excluding troubled debt restructured loans) had been current in accordance with their original terms and the amount of interest income on those loans that was included in such period’s net income was $1,330,125. In the years ended December 31, 2007 and 2006, the amounts were $181,665 and $115,480, respectively.

The Company has committed $96,000 in additional loan funds to the borrowers of impaired loans.

At December 31, 2008 and 2007, the Company had loans past due 90 days or more and still accruing interest of $3,782,878 and $364,005, respectively.

Commercial and residential real estate loans pledged to secure Federal Home Loan Bank advances and letters of credit amounted to $108,298,226 and $83,265,638 at December 31, 2008 and 2007, respectively.

19

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 5 – Allowance for Loan Losses

Changes in the allowance for loan losses for each of the three years ended December 31, 2008, 2007 and 2006 are as follows:

	2008			2007			2006
	(In thousands)
Balance at beginning of year	$	9,808		$	7,670		$	6,059
Charge-offs		(8,455	)		(2,851	)		(1,826	)
Recoveries		242			263			184
Net charge-offs		(8,213	)		(2,588	)		(1,642	)
Provision for loan losses		12,915			4,726			3,253
Balance at end of year	$	14,510		$	9,808		$	7,670

Note 6 – Premises and Equipment

Premises and equipment were as follows:

	December 31,
	2008			2007
	(In thousands)
Land	$	11,017		$	8,288
Buildings and improvements		21,492			14,401
Furniture and equipment		6,803			5,873
Computer equipment and software		2,766			2,638
Automobiles		574			451
Construction in progress (estimated cost to complete $982,000)		4,099			7,176
		46,751			38,827
Allowance for depreciation		(7,113	)		(5,861	)
	$	39,638		$	32,966

The provision for depreciation charged to occupancy and furniture and equipment expense for the years ended December 31, 2008, 2007 and 2006 was $1,730,463, $1,369,844, and $1,006,378, respectively.

Leases

The Company has a number of operating lease agreements, involving land, buildings and equipment. These leases are noncancellable and expire on various dates through the year 2028. The leases provide for renewal options and generally require the Company to pay maintenance, insurance and property taxes. For the years ended December 31, 2008, 2007 and 2006, rental expense for operating leases was $322,071, $329,628, and $175,715, respectively.

20

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 6 – Premises and Equipment – Continued

Future minimum lease payments under noncancellable operating leases at December 31, 2008, are as follows:

Years Ending December 31,	(In thousands)
2009	$	125
2010		68
2011		66
2012		66
2013		67
Thereafter		909
Total minimum lease payments	$	1,301

Note 7 – Foreclosed Assets

Changes in foreclosed assets for the years ended December 31, 2008 and 2007 are as follows:

	2008			2007
	(In thousands)
Balance at beginning of year	$	1,573		$	1,218
Property acquired through foreclosure		20,413			4,625
Sales of foreclosed assets		(8,663	)		(4,270	)
Balance at end of year	$	13,323		$	1,573

Note 8 – Deposits

The aggregate amounts of time deposits of $100,000 or more, including certificates of deposit of $100,000 or more at December 31, 2008 and 2007 were $338,044,736 and $264,333,054, respectively. The Company had brokered deposits at December 31, 2008 and 2007 of $79,997,154 and $146,483,110, respectively. Demand deposits reclassified as loan balances as of December 31, 2008 and 2007 amounted to $304,045 and $142,641, respectively.

21

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 8 – Deposits – Continued

The maturities of time certificates of deposit and other time deposits issued by the Company at December 31, 2008, are as follows:

Years ending December 31,	(In thousands)
2009	$	623,040
2010		36,466
2011		7,722
2012		5,333
2013		5,536
	$	678,097

Note 9 – Short-term Borrowings

Short-term borrowings at December 31, 2008 and 2007 consist of the following:

	2008		2007
	(In thousands)
Federal funds purchased	$	—	$	10,000
Securities sold under agreements to repurchase		5,642		6,536
Short-term notes payable		4,962		4,512
	$	10,604	$	21,048

In connection with the short-term note payable the Company has agreed, among other things, not to: (1) permit the combined tangible capital of the subsidiary Banks to be less than $60,000,000; (2) permit the Tier 1 leverage ratio to be less than 7.0% and the total risk based ratio to be less than 9.0% at any quarter end; (3) permit the return on average assets to be less than 0.0% for each fiscal quarter; (4) permit the ratio of consolidated loans classified as substandard, doubtful to Tier 1 capital plus its allowance for loan losses to exceed 60%.

The Company was in violation of certain of the above covenants as of December 31, 2008; however, these violations have been waived by the noteholder.

Securities sold under repurchase agreements, which are secured borrowings, generally mature within one to ninety days from the transaction date. Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transaction. The Company may be required to provide additional collateral based on the fair value of the underlying securities. The Company monitors the fair value of the underlying securities on a daily basis.

22

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 10 – Federal Home Loan Bank Advances

At December 31, 2008 and 2007, the Company had advances from the Federal Home Loan Bank (FHLB) totaling $72,000,000 and $57,350,000, respectively.

FHLB advances consist of the following at December 31:

	2008		2007
	(In thousands)
Notes payable on line of credit at FHLB, with varying maturities from November 2009 through January 2018, interest rates varying from 1.66% to 4.30%, and secured by residential mortgages	$	72,000	$	57,350

The maturities of FHLB advances at December 31, 2008, are as follows:

Years ending December 31,	Fixed		Convertible
	(In thousands)
2009	$	—	$	5,000
2010		10,000		—
2011		5,000		—
2012		5,000		15,000
2013		—		—
Thereafter		—		32,000
	$	20,000	$	52,000

Note 11 – Subordinated Long-term Capital Notes

On September 30, 2008 and October 30, 2008, Appalachian Community Bank issued an aggregate of $6,125,000 and $200,000, respectively, in Fixed Rate Subordinated Notes, which will mature on September 30, 2015 (the “Notes”). Interest on the Notes is fixed at 10% per annum. The interest on the Notes is payable semi-annually in arrears on June 30 and December 31 of each year. The Bank may redeem all or some of the Notes at any time beginning on September 30, 2013 at a price equal to 100% of the principal amount of such Notes redeemed plus accrued, but unpaid, interest to the redemption date. Payment of the principal on the Notes may be accelerated by holders of the Notes only in the case of the Bank’s insolvency or liquidation. There is no right of acceleration in the case of default in payment of principal of or interest on the Notes. The proceeds will be used for general corporate purposes and to support loan growth. The Notes qualify as Tier II capital under risk-based capital guidelines under the federal prompt corrective action guidelines.

23

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 11 – Subordinated Long-term Capital Notes – Continued

On August 28, 2003, Appalachian Capital Trust I (“the Trust”), a Delaware statutory trust established by the Company, received $6,000,000 principal amount of the Trust’s floating rate cumulative trust preferred securities (the “Trust Preferred Securities”) in a trust preferred private placement. The proceeds of that transaction were then used by the Trust to purchase an equal amount of floating rate-subordinated debentures (the “Subordinated Debentures”) of the Company. The Company has fully and unconditionally guaranteed all obligations of the Trust on a subordinated basis with respect to the Trust Preferred Securities. The Company accounts for the Trust Preferred Securities as a long-term debt liability to the Trust in the amount of $6,186,000. Interest only is payable quarterly at a variable per annum rate of interest, reset quarterly, equal to LIBOR plus 3.00% until the debt becomes due on August 8, 2033. The interest rate on the Trust Preferred liability at December 31, 2008 and 2007 was 6.19% and 7.91%, respectively. Subject to certain limitations, the Trust Preferred Securities qualify as Tier 1 capital.

The sole asset of the Trust is the Subordinated Debentures issued by the Company. Both the Trust Preferred Securities and the Subordinated Debentures have stated 30-year lives. However, both the Company and the Trust have options to call their respective securities after five years, subject to regulatory capital requirements.

Note 12 – Other Operating Expenses

Other operating expenses consist of the following:

	Years ended December 31,
	2008		2007		2006
	(In thousands)
Professional fees	$	1,268	$	1,344	$	665
Data processing		1,036		932		776
Director & committee fees		888		787		608
Advertising		800		961		882
Marketing and promotional		500		774		614
Stationary and supplies		459		559		531
Other		4,634		3,241		2,459
	$	9,585	$	8,598	$	6,535

Note 13 – Income Taxes

The components of income tax expense (benefit) for the years ended December 31, 2008, 2007 and 2006 are as follows:

	2008			2007			2006
	(In thousands)
Current
Federal	$	(593	)	$	3,166		$	2,886
State		(327	)		288			468
Deferred
Federal		(1,260	)		(647	)		(343	)
State		(272	)		(44	)		(159	)
	$	(2,452	)	$	2,763		$	2,852

24

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 13 – Income Taxes – Continued

The principal reasons for the difference in the effective tax rate and the federal statutory rate are as follows for the years ended December 31, 2008, 2007 and 2006.

	2008		2007		2006
Statutory federal income tax rate	34.0	%	34.0	%	34.0	%
Effect on rate of:
Tax-exempt securities	(11.4	)	(2.6	)	(2.6	)
Tax-exempt loans	(0.7	)	(0.2	)	(0.2	)
Interest expense disallowance	1.6		0.5		0.4
State income tax, net of federal tax	21.6		1.9		2.3
Other	1.1		(0.3	)	(1.7	)
Effective income tax rate	46.2	%	33.3	%	32.2	%

The tax effects of each type of income and expense item that gave rise to deferred taxes are:

	2008			2007
	(In thousands)
Net unrealized gains on securities available-for-sale	$	(481	)	$	(145	)
Depreciation		(1,777	)		(1,116	)
Allowance for loan losses		5,467			3,457
Deferred compensation		650			446
Other		475			160
	$	4,334		$	2,802

Note 14 – Commitments and Contingencies

In the normal course of business, the Bank and Thrift offer a variety of financial products to their customers to aid them in meeting their requirements for liquidity, credit enhancement, and interest rate protection. Generally accepted accounting principles recognize these transactions as contingent liabilities and, accordingly, they are not reflected in the consolidated financial statements. Commitments to extend credit, credit card arrangements, commercial letters of credit, and standby letters of credit all include exposure to some credit loss in the event of nonperformance of the customer. The Bank and Thrift use the same credit policies and underwriting procedures for making off-balance sheet credit commitments and financial guarantees as they do for on-balance sheet extensions of credit. Because these instruments have fixed maturity dates, and because many of them expire without being drawn upon, they do not generally present any significant liquidity risk to the Bank and Thrift. Management does not anticipate any material losses as a result of these commitments.

Following is a discussion of these commitments:

Standby Letters of Credit: These agreements are used by the Bank and Thrift customers as a means of improving their credit standings in their dealings with others. Under these agreements, the Bank and the Thrift agree to honor certain financial commitments in the event that its customers are unable to do so. The amount of credit risk involved in issuing letters of credit in the event of nonperformance by the other party is the contract amount. As of December 31, 2008 and 2007, the Bank and the Thrift have issued standby letters of credit of approximately $5,941,863 and $5,025,314. When significant, we record a liability for the estimated fair value of standby letters of credit based on the fees charged.

25

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 14 – Commitments and Contingencies – Continued

Loan Commitments: As of December 31, 2008 and 2007, the Bank and Thrift had commitments outstanding to extend credit totaling approximately $77,501,922 and $97,006,761, respectively. These commitments generally require the customers to maintain certain credit standards. Management does not anticipate any material losses as a result of these commitments.

Litigation: The Company is party to litigation and claims arising in the normal course of business. Management believes that the liabilities, if any, arising from such litigation and claims are not material to the consolidated financial statements.

Note 15 – Concentrations of Credit

Substantially all of the Bank and Thrift’s loans, commitments and standby letters of credit have been granted to customers in their market areas. The concentrations of credit by type of loan are set forth in Note 5 and include a concentration on loans secured by real estate. The commitments to extend credit relate primarily to unused real estate draw lines. Commercial and standby letters of credit were granted primarily to commercial borrowers.

During 2008, the declining confidence in the real estate market led to falling prices, lower demand for real estate and, due to the reduction in sales, more foreclosures. Since December 31, 2007, real estate inventory levels have come down with approximately a 20 to 27 month supply of homes on the market at year-end. This is an improvement over December 31, 2007 in which we had a 36 to 40 month’s supply of homes on the market. We are hopeful that real estate sales will improve over the next twelve months, and are encouraged by the activity we have seen in 2009. Historically, a large portion of our lending activities has been to residential real estate developers. However, due to the current downturn in real estate development and values, we are currently focusing on development of our commercial and industrial loan portfolio as well as on consumer type loans.

Note 16 – Stock Based Compensation

The Company has a 1997 Employee Stock Incentive Plan and a Directors’ Nonqualified Stock Option Plan (“the 1997 Plan”), a 2003 Stock Option Plan (“the 2003 Plan”) and a 2007 Equity Incentive Plan (“the 2007 Plan”) under which it has granted statutory and nonstatutory stock options to certain directors and employees. The Plans provide for up to 880,000 stock option awards granted under the 1997 Employee and Director Plans, 165,000 stock option awards for the 2003 Plan, and 300,000 stock option awards for the 2007 Plan. The options granted provide for directors and employees the opportunity to purchase shares of the Company’s $0.01 par value common stock at the market value at the dates of grant. Market value is determined by the closing price for the 1997 and the 2007 Plans and by averaging the high/low prices as of the date of grant for the 2003 Plan. The options granted generally vest over five years of continuous service and must be exercised within ten years from the date of grant. Either at the Board’s discretion or as stated under the plans, in the event of a change in control, any outstanding options covered by such an agreement shall be fully vested, nonforfeitable and become exercisable as of the date of the change in control. At December 31, 2008, there were outstanding 148,220, 125,240 and -0- stock option awards issued from the 1997 Plan, the 2003 Plan and the 2007 Plan, respectively. Shares available for future grants to employees and directors under the 1997 Plan, the 2003 Plan and the 2007 Plan were -0-, 39,760, and 300,000 shares, respectively.

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option valuation model that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Company’s stock. The Company uses historical data to estimate option exercises, employee terminations and forfeitures within the valuation model; separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected term of options granted is estimated based on the short-cut method. The risk-free rate for periods within the estimated life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

26

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 16 – Stock Based Compensation – Continued

The following assumptions were used for the years ended December 31, 2007, and 2006. There were no options granted during the year ended December 31, 2008.

	2007			2006
Dividend Yield		0.00	%		0.00	%
Expected volatility		17.59 – 21.06	%		15.52 – 19.21	%
Risk-free interest rate		3.71 – 5.04	%		4.11 – 5.03	%
Annual forfeiture rate		1.20 – 3.88	%		0.00 – 3.42	%
Expected life of options (in years)		7.50 years			7.50 years
Weighted-average grant-date fair value	$	6.08		$	6.81

The following table represents stock option activity for the year ended December 31, 2008.

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contract Life (Years)	Aggregate Intrinsic Value ($000)
Outstanding at January 1, 2008	307,460		$	16.33
Granted
Exercised	—
Forfeited	(27,600	)		18.43
Expired	(6,400	)		17.78
Outstanding at December 31, 2008	273,460		$	16.08	5.4	$	—
Exercisable at December 31, 2008	164,180		$	13.94	4.1	$	—

There were no options exercised during the year ended December 31, 2008. Total intrinsic value of options exercised was $1,672,069 and $788,574 for the years ended December 31, 2007 and 2006, respectively. Cash received for the exercise of options was $450,965 and the tax benefit realized related to those exercises of options was $616,852 for the year ended December 31, 2007. The total fair value of options vested during the years ended December 31, 2008, 2007 and 2006 was $112,650, $514,269 and $355,163, respectively.

The compensation cost charged against income for the years ended December 31, 2008, 2007, and 2006 was $280,530, $326,966 and $204,392, respectively. Income tax benefits recognized for the respective years were $43,759, $52,988 and $27,557.

As of December 31, 2008, there was $589,390 of total unrecognized compensation cost related to the nonvested share-based compensation arrangements granted under the option plan. That cost is expected to be recognized over a weighted-average period of 2.5 years.

27

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 17 – Regulatory Matters

Dividends

Bank. The board of directors of any state-chartered bank in Georgia may declare and pay cash dividends on its outstanding capital stock without any request for approval of the Bank’s regulatory agency if the following conditions are met:

1. Total classified assets at the most recent examination of the Bank do not exceed 80% of equity capital.

2. The aggregate amount of dividends declared in the calendar year does not exceed 50% of the prior year’s net income.

3. The ratio of equity capital to adjusted assets shall not be less than 6%.

As of December 31, 2008, the Bank could not declare dividends without regulatory consent, since the Bank had a net loss for the prior year. Even if the Bank were able to declare dividends, management expects that any capital available to pay dividends would be retained by the Company in order to maintain a well capitalized position.

Thrift. Federal regulations impose certain limitations on the payment of dividends and other capital distributions by the Thrift. Under these regulations, a savings institution, such as the Thrift, that will meet capital requirements (as defined by OTS regulations) subsequent to a capital distribution is generally permitted to make such a capital distribution without OTS approval, subject to certain limitations and restrictions as described in the regulations. A savings institution with total capital in excess of current minimum capital requirements is permitted to make, without OTS approval, capital distributions of between 25% and 75% of its net earnings for the previous four quarters less dividends already paid for such period. A savings institution that fails to meet current minimum capital requirements is prohibited from making any capital distributions without prior approval from the OTS.

Capital Adequacy

The Company, Bank and Thrift are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company, Bank and Thrift and the consolidated financial statements. Under capital adequacy guidelines and the regulatory framework from prompt corrective action, the Company, Bank and Thrift must meet specific capital guidelines that involve quantitative measures of their 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 regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 Capital (as defined in the regulations) to risk weighted assets (as defined), and of Tier 1 Capital (as defined) to average assets (as defined). The minimum capital standards of the OTS generally require the Thrift to maintain minimum amounts and ratios (set forth in the table below) of Tangible capital (as defined in the regulations), Core capital (as defined) and Risk-Based capital (as defined). Management believes, as of December 31, 2008 and 2007, that the Company, Bank and Thrift met all capital adequacy requirements to which they are subject.

As of December 31, 2008, the most recent notification from the applicable regulatory agencies categorized the Bank and the Thrift as well capitalized under the regulatory framework for prompt corrective action. To become well capitalized the Bank and Thrift must maintain minimum ratios as set forth in the following table and also must not be subject to any written agreement, order, capital directive, or prompt corrective action directive issued by federal banking regulators. Prompt corrective action provisions are not applicable to bank holding companies.

28

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 17 – Regulatory Matters – Continued

The Company’s, Bank’s, and Thrift’s actual capital amounts and ratios are presented in the table below.

	Actual				For Capital Adequacy Purposes				To be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
	(Dollars in thousands)
As of December 31, 2008:
Total Capital
Consolidated	$	91,785	9.89	%	$	74,219	8.00	%	$	N/A	N/A	%
Appalachian Community Bank		86,472	10.08			68,648	8.00			85,809	10.00
Appalachian Community Bank, F.S.B.		5,254	13.93			5,254	8.00			6,568	10.00
Tier 1 Capital
Consolidated		73,827	7.96			37,109	4.00			N/A	N/A
Appalachian Community Bank		69,385	8.09			34,324	4.00			51,486	6.00
Appalachian Community Bank, F.S.B.		9,150	12.68			2,627	4.00			3,941	6.00
Tier 1 Leverage
Consolidated		73,827	6.64			44,573	4.00			N/A	N/A
Appalachian Community Bank		69,385	6.73			41,222	4.00			51,528	5.00
Core Capital
Appalachian Community Bank, F.S.B.		8,328	9.95			3,347	4.00			5,020	6.00
Tangible Capital
Appalachian Community Bank, F.S.B.		8,328	9.95			1,255	1.50			4,184	5.00
As of December 31, 2007:
Total Capital
Consolidated	$	86,988	10.55	%	$	74,433	8.00	%	$	N/A	N/A	%
Appalachian Community Bank		81,787	10.41			62,853	8.00			78,566	10.00
Appalachian Community Bank, F.S.B.		8,434	20.81			3,423	8.00			4,054	10.00
Tier 1 Capital
Consolidated		77,180	9.36			32,993	4.00			N/A	N/A
Appalachian Community Bank		72,538	9.23			31,426	4.00			47,140	6.00
Appalachian Community Bank, F.S.B.		7,927	19.56			1,374	4.00			2,061	6.00
Tier 1 Leverage
Consolidated		77,180	8.30			37,217	4.00			N/A	N/A
Appalachian Community Bank		72,538	8.05			36,035	4.00			45,043	5.00
Core Capital
Appalachian Community Bank, F.S.B.		7,927	16.91			1,875	4.00			2,813	6.00
Tangible Capital
Appalachian Community Bank, F.S.B.		7,927	16.91			703	1.50			2,344	5.00

29

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 18 – Employee Benefit Plan

On July 31, 2008 we amended our 401(k) plan known as the Appalachian Bancshares, Inc. Employees’ Savings and Profit Sharing Plan to be known as the Appalachian Bancshares, Inc. Employee Stock Ownership Plan with 401(k) Provisions (effective January 1, 2008). This amended plan qualifies under Section 401(a), 401(k) and 401(m) of the Internal Revenue Code (The “Code”) and also qualifies as an employee stock ownership plan under Section 4975(e)(7) of the Code and United States Department of Labor Regulation Section 2550.408b-3. Under the provisions of the plan, eligible participating employees may elect to contribute up to the maximum amount of tax deferred contribution allowed by the Internal Revenue Code. Employer and employee contributions may be made in the form of cash or Company stock. The Company’s contribution to the plan is determined by its board of directors. The Company made discretionary cash contributions to the plan of $423,883 in 2008, $866,785 in 2007, and $563,518 in 2006.

The Company has various deferred compensation plans providing for death and retirement benefits for certain officers and directors. Expenses recognized for the years ended December 31, 2008, 2007, and 2006 related to these plans were $516,246, $665,369 and $336,946, respectively. The estimated amounts to be paid under the compensation plan have been partially provided for through the purchase of life insurance policies on certain officers and directors. Accrued deferred compensation of $1,725,536 and $1,191,289 is included in other liabilities as of December 31, 2008 and 2007, respectively. Cash surrender values of $9,139,906 and $8,778,080 on the insurance policies is included in other assets at December 31, 2008 and 2007, respectively.

Note 19 – Related Party Transactions

Loans: Certain directors, executive officers and principal shareholders, including their immediate families and associates were loan customers of the Bank during 2008 and 2007. There were no such relationships with the Thrift at December 31, 2008 or 2007. Such loans are made in the ordinary course of business at normal credit terms, including interest rates and collateral and do not represent more than a normal risk of collection. A summary of activity and amounts outstanding are as follows:

	(In thousands)
Balance at beginning of year	$	29,828
New loans		15,417
Repayments		(9,764	)
Change in related parties		(20	)
Balance at end of year	$	35,461

Deposits: Deposits held from related parties were $2,358,826 and $7,206,701 at December 31, 2008 and 2007, respectively.

Fixed Rate Subordinated Notes: As discussed previously, on September 30, 2008 and October 30, 2008, Appalachian Community Bank issued an aggregate of $6,125,000 and $200,000, respectively, in Fixed Rate Subordinated Notes, which will mature on September 30, 2015 (the “Notes”). A portion of these notes were issued to Company Directors. In September 2008, seven of the directors formed a limited liability company and purchased $4.0 million of these notes. In addition, one of these same directors individually purchased $200,000 of these notes. Interest on the Notes is fixed at 10% per annum. The interest on the Notes is payable semi-annually in arrears on June 30 and December 31 of each year. The Bank paid $105,000 in interest payments on these notes to the directors during the year ended December 31, 2008.

30

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 19 – Related Party Transactions – Continued

Purchases: The Bank and the Thrift purchase telecommunication, internet, cable and advertising services from a local telecommunications company. One of the directors of the Company, Bank and the Thrift, serves as executive vice president and chief operations officer of this telecommunications company. Amounts paid to the telecommunication company in 2008 and 2007 amounted to $511,870 and $493,345, respectively, which represented the fair market price for the services provided. Other services are provided by Directors to the Company at prices that are considered fair market rates.

Note 20 – Fair Value Disclosures

Fair Value Measurements

In September 2006 the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but applies under other accounting pronouncements. FASB previously concluded in such accounting pronouncements that fair value is the relevant measurement attribute.

The Company adopted the provisions of SFAS 157 on January 1, 2008. In February 2008 the FASB issued Staff Position No. FAS 157-2 which permits delayed application of the provisions of SFAS 157 to nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the financial statements on a nonrecurring basis to fiscal years beginning after November 15, 2008. Since the Company has elected to delay application of the provisions of SFAS 157 to nonfinancial assets and liabilities in scope of this staff position, the information disclosed below does not consider the impact that SFAS 157 would have on such nonfinancial assets and liabilities. The major categories of assets and liabilities that are recognized or disclosed at fair value, for which the provisions of SFAS 157 have not been applied, include reporting units measured at fair value in the first step of a goodwill impairment test under SFAS 142 and nonfinancial long-lived assets measured at fair value for an impairment assessment under SFAS 144.

SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1 – Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 – Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3 – Generated from model-based techniques that use at least one significant assumption based on unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

31

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 20 – Fair Value Disclosures – Continued

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Securities Available-for-Sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans Held for Sale: Loans held for sale are carried at the lower of cost or fair value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, management classifies loans subjected to recurring fair value adjustments as Level 2.

Impaired Loans: Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan,” (SFAS 114). The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2008, substantially all of the impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

Foreclosed Assets: Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

32

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 20 – Fair Value Disclosures – Continued

The table below presents the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.

	Balance at December 31, 2008		(Level 1)		(Level 2)		(Level 3)
	(In thousands)
Assets
Securities	$	79,308	$	––	$	79,308	$	––
Loans held for sale		2,783		––		2,783		––

The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. Generally Accepted Accounting Principles. These include assets that are measured at the lower of cost or fair value. The table below presents the Company’s assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.

	Balance at December 31, 2008		(Level 1)		(Level 2)		(Level 3)
	(In thousands)
Assets
Impaired loans	$	34,009	$	—	$	—	$	34,009
Foreclosed assets		13,323		—		—		13,323

For the year ended December 31, 2008, the Company recognized adjustments related to impaired loans and foreclosed assets that are measured at fair value on a nonrecurring basis. Approximately $11.7 million of losses related to impaired loans and foreclosed assets were recognized as either charge-offs or specific allocations within the allowance for loan losses for the year ended December 31, 2008.

Fair Value of Financial Instruments

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Short-term Investments: For those short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities: For securities and marketable equity securities, fair values are 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.

33

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 20 – Fair Value Disclosures – Continued

Loans: For certain homogeneous categories of loans, such as some residential mortgages, credit card receivables, and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Accrued Interest Receivable: The carrying amount of accrued interest receivable approximates its fair value.

Deposits: The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Accrued Interest Payable: The carrying amount of accrued interest payable approximates its fair value.

Short-term Borrowings: The fair value of short-term borrowings, including securities sold under agreements to repurchase, is estimated to be approximately the same as the carrying amount.

FHLB Advances and Subordinated Debt: Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.

Commitments to Extend Credit, Letters of Credit, and Financial Guarantees Written: The fair value of commitments and letters of credit is estimated to be approximately the fees charged for these arrangements.

34

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 20 – Fair Value Disclosures – Continued

The estimated fair values of the Company’s financial instruments as of December 31, 2008 and 2007 are as follows:

	2008				2007
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
	(In thousands)
Financial assets
Cash and short-term investments	$	146,907	$	146,907	$	26,499	$	26,499
Restricted equity securities		4,932		4,932		3,945		3,945
Loans held for sale		2,783		2,783		6,503		6,503
Loans		870,864		872,780		797,714		797,957
Accrued interest receivable		9,289		9,289		9,797		9,797
Total Financial Assets	$	1,034,775	$	1,036,691	$	844,458	$	844,701
Financial Liabilities
Deposits	$	1,013,276	$	1,013,175	$	807,597	$	809,455
Short-term borrowings		10,604		10,604		21,048		21,048
Accrued interest payable		1,936		1,936		2,059		2,059
Long-term debt		84,511		86,700		63,536		63,455
Total Financial Liabilities	$	1,110,327	$	1,112,415	$	894,240	$	896,017
Unrecognized financial instruments
Commitments to extend credit	$	77,502	$	389	$	97,007	$	567
Standby letters of credit		5,942		30		5,025		29
Total Unrecognized Financial Instruments	$	83,444	$	419	$	102,032	$	596

35

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 21 – Condensed Parent Information

Statements of Financial Condition

	December 31,
	2008		2007
	(In thousands)
Assets
Cash and due from banks	$	744	$	38
Investment in subsidiaries		82,183		82,926
Securities available for sale		186		186
Income taxes receivable		713		1,440
Other assets		3		49
Total Assets	$	83,829	$	84,639
Liabilities and Shareholders’ Equity
Note payable	$	4,962	$	4,512
Guaranteed preferred beneficial interest in the Company’s subordinated debentures		6,186		6,186
Accrued interest payable		87		94
Other liabilities		156		184
Total Liabilities		11,391		10,976
Total Shareholders’ Equity		72,438		73,663
Total Liabilities and Shareholders’ Equity	$	83,829	$	84,639

Statements of Operations

	Years ended December 31,
	2008			2007			2006
	(In thousands)
Income
Other income	$	12		$	19		$	15
Expenses
Interest		665			602			491
Other expenses		829			1,185			1,250
		1,494			1,787			1,741
Loss before income tax benefits and equity in undistributed Earnings (losses) of subsidiaries		(1,482	)		(1,768	)		(1,726	)
Income tax benefits		559			667			596
Loss before equity in undistributed earnings (losses) of subsidiaries		(923	)		(1,101	)		(1,130	)
Equity in undistributed earnings (losses) of subsidiaries		(1,936	)		6,671			7,134
Net Income (Loss)	$	(2,859	)	$	5,570		$	6,004

36

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 21 – Condensed Parent Information – Continued

Statements of Cash Flow

	Years ended December 31,
	2008			2007			2006
	(In thousands)
Operating Activities
Net income (loss)	$	(2,859	)	$	5,570		$	6,004
Adjustments to reconcile net income (loss) to net cash used in operating activities
Equity in undistributed (earnings) losses of subsidiaries		1,936			(6,671	)		(7,134	)
Increase (decrease) in accrued interest payable		(7	)		19			(4	)
Compensation associated with issuance of options		—			—			48
Excess tax benefits from exercise of stock options		—			(617	)		(88	)
Other		744			76			(195	)
Net Cash Used In Operating Activities		(186	)		(1,623	)		(1,369	)
Investing Activities
Capital injection in subsidiaries		(260	)		(13,850	)		(5,750	)
Other adjustments to equity capital		—			—			(156	)
Net Cash Used In Investing Activities		(260	)		(13,850	)		(5,906	)
Financing Activities
Net increase in notes payable		450			4,512			—
Issuance of common stock		885			1,068			—
Purchase and retirement of stock		(183	)		(512	)		—
Purchase of treasury stock		—			(672	)		394
Excess tax benefits from exercise of stock options		—			617			88
Net Cash Provided By Financing Activities		1,152			5,013			482
Net Increase (Decrease) in Cash and Cash Equivalents		706			(10,460	)		(6,793	)
Cash & Cash Equivalents at Beginning of Year		38			10,498			17,291
Cash and Cash Equivalents at End of Year	$	744		$	38		$	10,498
Cash paid during the year for interest	$	672		$	583		$	495

37

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 22 – Quarterly Results of Operations (Unaudited)

Selected quarterly results of operations for the four quarters of each of the years ended December 31, 2008 and 2007 are as follows:

	First Quarter		Second Quarter		Third Quarter			Fourth Quarter
	(In thousands, except per share data)
2008:
Total interest income	$	18,643	$	17,400	$	16,871		$	16,091
Total interest expense		8,929		7,864		8,465			8,776
Provision for loan losses		955		1,496		4,665			5,799
Net interest income after provision for loan losses		8,759		8,040		3,741			1,516
Total noninterest income		1,265		1,342		453			1,187
Total noninterest expense		8,362		8,426		8,558			6,268
Income tax expense (benefit)		525		255		(1,744	)		(1,488	)
Net income (loss)	$	1,137	$	701	$	(2,620	)	$	(2,077	)
Per Common Share:
Basic earnings (losses)	$	0.21	$	0.13	$	(0.49	)	$	(0.39	)
Diluted earnings (losses)		0.21		0.13		(0.49	)		(0.39	)
2007:
Total interest income	$	16,564	$	17,966	$	18,529		$	19,068
Total interest expense		7,694		8,532		9,154			9,420
Provision for loan losses		636		947		677			2,466
Net interest income after provision for loan losses		8,234		8,487		8,698			7,182
Total noninterest income		1,372		1,260		1,499			1,387
Total noninterest expense		7,297		7,435		8,085			6,969
Income tax expense		750		811		705			497
Net income	$	1,559	$	1,501	$	1,407		$	1,103
Per Common Share:
Basic earnings	$	0.30	$	0.29	$	0.27		$	0.21
Diluted earnings		0.30		0.29		0.27			0.21

38

EX-21

EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT

Subsidiaries – Direct/Wholly-owned	State of Incorporation
Appalachian Capital Trust I	Delaware
Appalachian Community Bank Also doing business under the registered trade name “Gilmer County Bank”	Georgia
Appalachian Community Bank, FSB	United States (thrift charter)
Appalachian Real Estate Holdings, Inc.	Georgia
Subsidiaries – Indirect/wholly-owned by Appalachian Community Bank
Appalachian Information Management, Inc.	Georgia

EX-23.1

EXHIBIT 23.1 - CONSENT OF MAULDIN & JENKINS, LLC

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statements (File Numbers 333-149987, 333-111706 and 333-27127) on Form S-8 of Appalachian Bancshares, Inc. of our report dated April 3, 2009 relating to our audit of the consolidated financial statements, which appears in this Annual Report on Form 10-K of Appalachian Bancshares, Inc. for the year ended December 31, 2008.

/s/ Mauldin & Jenkins, LLC

Atlanta, Georgia

April 3, 2009

EX-31.1

EXHIBIT 31.1

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER

I, Tracy R. Newton, certify that:

1. I have reviewed this Annual Report on Form 10-K of Appalachian 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 officers 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)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we 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) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

c) 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

d) 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.

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

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: April 3, 2009

/s/ Tracy R. Newton

Tracy R. Newton

President and Chief Executive Officer (principal executive officer)

EX-31.2

EXHIBIT 31.2

CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER

I, Danny F. Dukes., certify that:

1. I have reviewed this Annual Report on Form 10-K of Appalachian 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 officers 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)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we 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) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

c) 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

d) 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.

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

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: April 3, 2009

/s/ Danny F. Dukes

Danny F. Dukes

Executive Vice President and Chief Financial Officer (Principal Financial Officer)

EX-32

EXHIBIT 32

CERTIFICATIONS PURSUANT TO

18 U.S.C. SECTION 1350

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Appalachian Bancshares, Inc. (the “Company”) on Form 10-K for the year ended December 31, 2008 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, Tracy R. Newton, President and Chief Executive Officer of the Company, and Danny F. Dukes., Executive Vice President and Chief Financial Officer, do hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to the best of our knowledge:

(1) The Report fully complies with the requirements of section 13(a) 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.

By:

/s/ Tracy R. Newton

Tracy R. Newton

President and Chief Executive Officer

April 3, 2009

/s/ Danny F. Dukes

Danny F. Dukes

Executive Vice President and Chief Financial Officer

April 3, 2009