UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2012

Commission File No.: 000-52195

BANK OF THE CAROLINAS CORPORATION

(Exact name of registrant as specified in its charter)

NORTH CAROLINA	20-4989192
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)
135 Boxwood Village Drive Mocksville, North Carolina	27028
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (336) 751-5755

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 whether the registrant has submitted electronically and posted on its corporate web site, if any, every interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

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

On November 14, 2012 there were 3,895,840 outstanding shares of the registrant’s common stock.

BANK OF THE CAROLINAS CORPORATION

FORM 10-Q

September 30, 2012

INDEX

Part I. FINANCIAL INFORMATION
Item 1. Financial Statements	3
Consolidated Balance Sheets at September 30, 2012 and December 31, 2011	3
Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2012 and 2011	4
Consolidated Statements of Comprehensive Loss for the Three and Nine Months Ended September 30, 2012 and 2011	5
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011	6
Consolidated Statements of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2012 and 2011	7
Notes to Consolidated Financial Statements	8
Item  2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	28
Item 3. Quantitative and Qualitative Disclosures about Market Risk	37
Item 4. Controls and Procedures	37
Part II. OTHER INFORMATION
Item 1. Legal Proceedings	37
Item 1A. Risk Factors	37
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	37
Item 3. Defaults Upon Senior Securities	37
Item 4. Mine Safety Disclosures	37
Item 5. Other Information	37
Item 6. Exhibits	38
SIGNATURES	39
EXHIBIT INDEX	40

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Bank of the Carolinas Corporation

Consolidated Balance Sheets

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

	September 30 2012			December 31 2011*
	(Unaudited)			(As restated)
Assets:
Cash and due from banks, noninterest-bearing	$	3,987		$	5,044
Interest-bearing deposits in banks		3,843			2,557
Cash and cash equivalents		7,830			7,601
Federal funds sold		13,710			28,165
Investment securities		121,387			112,404
Loans receivable		280,671			307,907
Less: Allowance for loan losses		(7,450	)		(8,101	)
Total loans, net		273,221			299,806
Premises and equipment		11,911			12,229
Other real estate owned		5,424			8,524
Bank owned life insurance		10,447			10,732
Deferred tax assets		—			—
Prepaid FDIC insurance assessment		998			2,200
Accrued interest receivable		1,393			1,503
Other assets		1,952			2,803
Total Assets	$	448,273		$	485,967
Liabilities:
Deposits:
Noninterest-bearing demand deposits	$	34,756		$	34,034
Interest-checking deposits		39,138			37,306
Savings and money market deposits		106,541			106,308
Time deposits		204,095			238,565
Total deposits		384,530			416,213
Securities sold under agreements to repurchase		45,379			45,381
Subordinated debt		7,855			7,855
Other liabilities		1,919			1,903
Total Liabilities		439,683			471,352
Commitments and contingencies (Note 6)		—			—
Stockholders’ Equity:
Preferred stock, no par value		13,179			13,179
Discount on preferred stock		(496	)		(716	)
Common stock, $5 per share par value		19,479			19,479
Additional paid-in capital		12,991			12,991
Retained deficit		(37,463	)		(31,871	)
Accumulated other comprehensive income		900			1,553
Total Stockholders’ Equity		8,590			14,615
Total Liabilities and Stockholders’ Equity	$	448,273		$	485,967
Preferred shares authorized		3,000,000			3,000,000
Preferred shares issued and outstanding		13,179			13,179
Common shares authorized		15,000,000			15,000,000
Common shares issued and outstanding		3,895,840			3,895,840

* Derived from audited consolidated financial statements.

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

3

Bank of the Carolinas Corporation

Consolidated Statements of Operations

(Unaudited)

(dollars in thousands, except per share data)

	Three Months Ended September 30						Nine Months Ended September 30
	2012			2011			2012			2011
Interest income
Interest and fees on loans	$	3,571		$	4,276		$	10,905		$	13,415
Interest on securities		723			823			2,043			2,422
Other interest income		13			16			59			42
Total interest income		4,307			5,115			13,007			15,879
Interest expense
Interest on deposits		779			1,075			2,530			3,405
Interest on borrowed funds		570			571			1,698			2,075
Total interest expense		1,349			1,646			4,228			5,480
Net interest income		2,958			3,469			8,779			10,399
Provision for loan losses		1,471			5,650			2,996			14,567
Net interest income (loss) after provision for loan losses		1,487			(2,181	)		5,783			(4,168	)
Noninterest income
Customer service fees		297			318			867			951
Increase in value of bank owned life insurance		89			91			685			269
Gains on sales of investment securities		—			—			2,147			6
Other income		5			6			20			16
Total noninterest income		391			415			3,719			1,242
Noninterest expense
Salaries and benefits		1,723			1,757			5,266			4,947
Occupancy and equipment		468			502			1,451			1,571
FDIC insurance assessments		405			345			1,225			949
Data processing services		257			218			737			654
Valuation provisions and net operating costs associated with foreclosed real estate		1,324			1,053			2,415			4,050
Other		1,048			1,205			3,371			3,591
Total noninterest expense		5,225			5,080			14,465			15,762
Loss before income taxes		(3,347	)		(6,846	)		(4,963	)		(18,688	)
Provision for income taxes		(383	)		—			409			996
Net loss		(2,964	)		(6,846	)		(5,372	)		(19,684	)
Dividends and accretion on preferred stock		(239	)		(234	)		(714	)		(698	)
Net loss available to common stockholders	$	(3,203	)	$	(7,080	)	$	(6,086	)	$	(20,382	)
Loss per common share:
Basic	$	(0.82	)	$	(1.82	)	$	(1.56	)	$	(5.23	)
Diluted	$	(0.82	)	$	(1.82	)	$	(1.56	)	$	(5.23	)

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

4

Bank of the Carolinas Corporation

Consolidated Statements of Comprehensive Loss

(Unaudited)

(dollars in thousands)

	Three Months Ended September 30						Nine Months Ended September 30
	2012			2011			2012			2011
Net loss	$	(2,964	)	$	(6,846	)	$	(5,372	)	$	(19,684	)
Other comprehensive income (loss):
Unrealized holding gains on securities available-for-sale		996			1,121			1,085			2,125
Reclassification adjustment for gains realized in net loss		—			—			(2,147	)		(6	)
Income tax effect		(383	)		(431	)		409			(815	)
Total other comprehensive income (loss), net of income tax effect		613			690			(653	)		1,304
Total comprehensive loss	$	(2,351	)	$	(6,156	)	$	(6,025	)	$	(18,380	)

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

5

Bank of the Carolinas Corporation

Consolidated Statements of Cash Flows

(Unaudited)

(dollars in thousands)

	Nine Months Ended September 30
	2012			2011
Cash flows from operating activities:
Net loss	$	(5,372	)	$	(19,684	)
Adjustments to reconcile net loss to net cash provided by operating activitites:
Provision for loan losses		2,996			14,567
Stock based compensation benefit		—			(4	)
Loss on disposal of premises and equipment		—			3
Depreciation and amortization		627			751
Change in valuation allowance on other real estate owned		1,965			3,191
(Gain) loss on sale of other real estate owned		(33	)		125
Gains on sales of investment securities		(2,147	)		(6	)
Decrease (increase) in bank owned life insurance		285			(269	)
Net amortization/accretion of premiums and discounts on investments		464			572
Net change in other assets		1,730			1,361
Net change in other liabilities		16			93
Net cash provided by operating activities		531			700
Cash flows from investing activities:
Net change in federal funds sold		14,455			(13,300	)
Purchases of premises and equipment		(309	)		(96	)
Purchases of securities		(118,959	)		(31,533	)
Proceeds from sales, calls, maturities and principal repayments of securities available for sale		110,597			29,691
Redemption of FHLB stock		842			298
Proceeds from sales of other real estate owned		4,711			2,855
Net decrease in loans		20,046			20,975
Net cash provided by investing activities		31,383			8,890
Cash flows from financing activities:
Net increase (decrease) in deposits		(31,683	)		1,389
Net repayments of other borrowings		—			(12,000	)
Net decrease in repurchase agreements		(2	)		(191	)
Cash dividends paid on preferred stock		—			—
Net cash used by financing activities		(31,685	)		(10,802	)
Net increase (decrease) in cash and cash equivalents		229			(1,212	)
Cash and cash equivalents at beginning of period		7,601			10,565
Cash and cash equivalents at end of period	$	7,830		$	9,353
Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	4,338		$	4,900
Noncash investing and financing activities:
Change in fair value of securities available for sale, net of tax	$	653		$	1,304
Transfer from loans to other real estate owned	$	3,543		$	7,682

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

6

Bank of the Carolinas Corporation

Consolidated Statements of Changes in Stockholders’ Equity

(Unaudited)

(dollars in thousands)

					Discount							Additional						Accumulated Other			Total
	Preferred Stock				on Preferred			Common Stock				Paid-In			Retained			Comprehensive			Stockholders’
	Shares		Amount		Stock			Shares		Amount		Capital			Deficit			Income			Equity
Balance, December 31, 2010		13,179	$	13,179	$	(991	)		3,897,174	$	19,486	$	12,988		$	(3,268	)	$	310		$	41,704
Net loss		—		—		—			—		—		—			(19,684	)		—			(19,684	)
Other comprehensive income		—		—		—			—		—		—			—			1,304			1,304
Total comprehensive loss		—		—		—			—		—		—			—			—			(18,380	)
Stock based compensation benefit		—		—		—			—		—		(4	)		—			—			(4	)
Discount accretion on preferred stock		—		—		204			—		—		—			(204	)		—			—
Dividends accrued on preferred stock		—		—		—			—		—		—			(77	)		—			(77	)
Balance, September 30, 2011		13,179	$	13,179	$	(787	)		3,897,174	$	19,486	$	12,984		$	(23,233	)	$	1,614		$	23,243
Balance, December 31, 2011		13,179	$	13,179	$	(716	)		3,895,840	$	19,479	$	12,991		$	(31,871	)	$	1,553		$	14,615
Net loss		—		—		—			—		—		—			(5,372	)		—			(5,372	)
Other comprehensive loss		—		—		—			—		—		—			—			(653	)		(653	)
Total comprehensive loss		—		—		—			—		—		—			—			—			(6,025	)
Discount accretion on preferred stock		—		—		220			—		—		—			(220	)		—			—
Dividends accrued on preferred stock		—		—		—			—		—		—			—			—			—
Balance, September 30, 2012		13,179	$	13,179	$	(496	)		3,895,840	$	19,479	$	12,991		$	(37,463	)	$	900		$	8,590

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

7

Bank of the Carolinas Corporation

Notes to Consolidated Financial Statements

(Unaudited)

NOTE 1. BASIS OF PRESENTATION

In the opinion of management, the financial information included in these unaudited financial statements reflects all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial information as of September 30, 2012 and December 31, 2011 and for the three- and nine-month periods ended September 30, 2012 and 2011, in conformity with accounting principles generally accepted in the United States of America.

The preparation of financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities at the date of the financial statements, as well as the amounts of income and expense during the reporting period. Actual results could differ from those estimates. Operating results for the three- and nine-month periods ended September 30, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2012.

The results presented here are for Bank of the Carolinas Corporation (“the Company”), the parent company of Bank of the Carolinas (“the Bank”). The organization and business of the Company, accounting policies followed by the Company and other relevant information are contained in the notes to the financial statements filed as part of the Company’s annual report on Form 10-K for the year ended December 31, 2011. This quarterly report should be read in conjunction with the annual report. Because the Company has no separate operations and conducts no business on its own other than owning the Bank, this discussion concerns primarily the business of the Bank. However, because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to as “the Company” unless otherwise noted.

Reclassifications

Certain 2012 and 2011 accounts have been reclassified to conform to the September 30, 2012 presentations. There was no impact on earnings or stockholders’ equity as a result of the reclassifications.

Restatement of Previously Issued Financial Statements

The Corporation has restated its previously issued financial statements to correct the accounting for dividends on preferred stock. The preferred stock issued to the U.S. Treasury pursuant to the Capital Purchase Program has a cumulative dividend rate of 5% per year. Although the Corporation had deferred payment of all dividends, a liability was recorded for each of the quarters in the period March 31, 2011 – June 30, 2012. The accounting guidance for recording dividends prohibits a dividend from being accrued until it has been declared. The Corporation and the Bank are prohibited from declaring dividends as a result of a written agreement between the Corporation and the FDIC and the North Carolina Commissioner of Banks. (See the Corporation’s Management Discussion and Analysis for further discussion.) As a result, since the dividend was never declared, a liability should not have been established and other liabilities was overstated and retained earnings was understated as outlined below. Because of the nature of the misclassification, there was no impact on the net loss available to common shareholders. The following is a summary of the effects of the restatement for December 31, 2011 (dollars in thousands):

	As of December 31, 2011
Consolidated Balance Sheets	As Previously Reported			Preferred Dividend Adjustment			Restated
Other liabilities	$	2,485		$	(582	)	$	1,903
Total Liabilities		471,934			(582	)		471,352
Retained deficit		(32,453	)		582			(31,871	)
Total Stockholders’ Equity		14,033			582			14,615

See Note 13 for the further effects of the restatement on the quarterly financial information.

8

NOTE 2. EARNINGS PER SHARE

Basic earnings (loss) per share represents income (loss) available to common stockholders divided by the weighted average number of common shares outstanding during the period. When applicable, the weighted average shares outstanding for the diluted earnings per share computations are adjusted to reflect the assumed conversion of shares available under stock options using the treasury stock method.

Earnings (loss) per share have been computed based on the following (dollars in thousands):

	Three months ended September 30,						Nine months ended September 30,
	2012			2011			2012			2011
Net loss applicable to common stockholders	($	3,203	)	$	(7,080	)	($	6,086	)	$	(20,382	)
Weighted average number of common shares outstanding		3,895,840			3,897,174			3,895,840			3,897,174
Weighted average number of diluted common shares outstanding		3,895,840			3,897,174			3,895,840			3,897,174
Common stock options and common stock warrants - anti-dilutive		497,605			502,205			497,605			502,205

The common stock warrants referred to above were issued to the United States Treasury in connection with the Company’s April 17, 2009 participation in the Capital Purchase Program, which was authorized as a part of the TARP legislation passed by Congress during 2008.

9

NOTE 3. INVESTMENT SECURITIES

The amortized cost, estimated fair values and carrying values of the investment securities portfolios at the indicated dates are summarized as follows (dollars in thousands):

	September 30, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value		Carrying Value
Investment securities available for sale:
U.S. Government agencies securities	$	55,793	$	463	$	19	$	56,237	$	56,237
State and municipal bonds		8,487		3		99		8,391		8,391
Corporate securities		—		—		—		—		—
Mortgage-backed securities		53,686		1,090		4		54,772		54,772
Total investment securities available for sale		117,966		1,556		122		119,400		119,400
Investment securities held to maturity:
Corporate securities		1,987		29		235		1,781		1,987
Total investment securities	$	119,953	$	1,585	$	357	$	121,181	$	121,387
	December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value		Carrying Value
Investment securities available for sale:
U.S. Government agencies securities	$	43,131	$	1,128	$	—	$	44,259	$	44,259
State and municipal bonds		3,433		157		—		3,590		3,590
Corporate securities		963		54		—		1,017		1,017
Mortgage-backed securities		60,415		1,188		32		61,571		61,571
Total investment securities available for sale		107,942		2,527		32		110,437		110,437
Investment securities held to maturity:
Corporate securities		1,967		67		235		1,799		1,967
Total investment securities	$	109,909	$	2,594	$	267	$	112,236	$	112,404

Management of the Bank believes all unrealized losses on available-for-sale securities as of September 30, 2012 represent temporary impairments related to market fluctuations. The unrealized losses on our securities are a nominal portion of the total value of the portfolio. The Bank has no intention of selling these securities before their maturity and has the appropriate sources of liquidity to hold these securities until maturity in order to minimize the likelihood that recognized losses will occur.

10

The fair values of securities with unrealized losses at September 30, 2012 and December 31, 2011 are as follows (dollars in thousands):

September 30, 2012:

	Less than 12 Months				12 Months or More				Total
	Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses
Temporarily impaired securities:
U.S. Government agency securities	$	1,971	$	19	$	—	$	—	$	1,971	$	19
State and municipal securities		7,468		99		—		—		7,468		99
Mortgage-backed securities		1,331		4		—		—		1,331		4
Corporate securities		—		—		1,000		235		1,000		235
Total	$	10,770	$	122	$	1,000	$	235	$	11,770	$	357

December 31, 2011:

	Less than 12 Months				12 Months or More				Total
	Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses		Estimated Fair Value		Unrealized Losses
Temporarily impaired securities:
U.S. Government agency securities	$	—	$	—	$	—	$	—	$	—	$	—
State and municipal securities		—		—		—		—		—		—
Mortgage-backed securities		3,071		32		—		—		3,071		32
Corporate securities		—		—		1,000		235		1,000		235
Total	$	3,071	$	32	$	1,000	$	235	$	4,071	$	267

NOTE 4. LOANS

The loan portfolio as of the dates indicated is summarized below (dollars in thousands):

	September 30, 2012			December 31, 2011
Real estate loans:
1-4 family residential	$	74,033		$	78,631
Commercial real estate		114,502			126,849
Construction and development		30,740			33,081
Home equity		29,417			29,727
Total real estate loans		248,692			268,288
Commercial business and other loans		24,459			34,271
Consumer loans:
Installment		3,373			3,490
Other		4,147			1,858
Total consumer loans		7,520			5,348
Gross loans receivable		280,671			307,907
Allowance for loan losses		(7,450	)		(8,101	)
Loans, net	$	273,221		$	299,806

11

Impaired loans, segregated by class of loans, are summarized as follows as of the dates indicated (dollars in thousands):

	September 30, 2012										December 31, 2011
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized		Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance:
Commercial - Non Real Estate	$	1,190	$	1,469	$	—	$	1,581	$	61	$	1,533	$	2,413	$	—	$	2,518	$	121
Commercial Real Estate
Owner occupied		3,258		3,582		—		3,608		131		4,352		8,513		—		9,402		319
Income producing		3,310		3,412		—		3,431		96		4,226		4,634		—		4,677		279
Multifamily		—		—		—		—		—		708		826		—		829		44
Construction & Development
1 - 4 Family		—		—		—		—		—		387		387		—		393		20
Other		3,581		4,273		—		3,092		118		3,288		3,702		—		3,883		203
Farmland		362		362		—		362		12		—		—		—		—		—
Residential
Equity Lines		140		143		—		237		5		38		39		—		41		2
1 - 4 Family		7,481		8,983		—		9,043		310		7,920		9,491		—		9,577		563
Junior Liens		239		257		—		260		12		58		73		—		75		6
Consumer - Non Real Estate		74		86		—		87		4		58		58		—		59		4
Total loans with no allowance	$	19,635	$	22,567	$	—	$	21,701	$	749	$	22,568	$	30,136	$	—	$	31,454	$	1,561
With an allowance recorded:
Commercial - Non Real Estate	$	2,348	$	2,348	$	52	$	2,416	$	75	$	2,409	$	2,408	$	74	$	2,482	$	105
Commercial Real Estate
Owner occupied		4,207		4,207		173		4,255		164		1,836		1,886		64		1,902		119
Income producing		6,939		6,994		146		7,047		258		6,424		6,479		224		6,586		278
Multifamily		1,319		1,352		50		1,364		38		1,282		1,316		68		1,345		31
Construction & Development
1 - 4 Family		390		397		8		400		15		380		380		9		396		21
Other		3,380		3,382		140		3,446		101		2,920		2,920		91		2,955		130
Farmland		—		—		—		—		—		980		980		—		982		50
Residential
Equity Lines		—		—		—		—		—		—		—		—		—		—
1 - 4 Family		6,329		6,343		203		6,400		193		7,201		7,212		237		7,265		277
Junior Liens		322		324		2		326		13		398		398		3		469		24
Consumer - Non Real Estate		13		13		—		15		1		—		—		—		—		—
Total loans with an allowance	$	25,247	$	25,360	$	774	$	25,669	$	858	$	23,830	$	23,979	$	770	$	24,382	$	1,035
Total:
Commercial - Non Real Estate	$	3,538	$	3,817	$	52	$	3,997	$	136	$	3,942	$	4,821	$	74	$	5,000	$	226
Commercial Real Estate	$	19,033	$	19,547	$	369	$	19,705	$	687	$	18,828	$	23,654	$	356	$	24,741	$	1,070
Construction & Development	$	7,713	$	8,414	$	148	$	7,300	$	246	$	7,955	$	8,369	$	100	$	8,609	$	424
Residential	$	14,511	$	16,050	$	205	$	16,266	$	533	$	15,615	$	17,213	$	240	$	17,427	$	872
Consumer - Non Real Estate	$	87	$	99	$	—	$	102	$	5	$	58	$	58	$	—	$	59	$	4
Totals	$	44,882	$	47,927	$	774	$	47,370	$	1,607	$	46,398	$	54,115	$	770	$	55,836	$	2,596

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Impaired loans include loans whose contractual terms have been restructured in a manner that grants a concession to a borrower experiencing financial difficulties. Troubled debt restructurings (TDRs) are a subset of impaired loans and totaled $41.2 million at September 30, 2012 and $35.6 million at December 31, 2011.

The following tables illustrate TDR information for the three and nine months ended September 30, 2012 and 2011 (dollars in thousands):

	For the three months ended September 30, 2012						For the nine months ended September 30, 2012
Troubled Debt Restructuring	Number of Contracts		Pre-Modification Recorded Investment		Post-Modification Recorded Investment		Number of Contracts		Pre-Modification Recorded Investment		Post-Modification Recorded Investment
Commercial - Non Real Estate		3	$	82	$	82		13	$	603	$	603
Commercial - Real Estate		4		2,326		2,326		9		5,461		5,461
Construction & Development		2		445		445		8		1,576		1,576
Residential		3		1,293		1,293		22		3,325		3,325
Consumer - Non Real Estate		1		14		14		2		32		32
Totals		13	$	4,160	$	4,160		54	$	10,997	$	10,997
	For the three months ended September 30, 2011						For the nine months ended September 30, 2011
Troubled Debt Restructuring	Number of Contracts		Pre-Modification Recorded Investment		Post-Modification Recorded Investment		Number of Contracts		Pre-Modification Recorded Investment		Post-Modification Recorded Investment
Commercial - Non Real Estate		5	$	315	$	315		18	$	2,195	$	2,195
Commercial - Real Estate		4		693		693		12		3,656		3,656
Construction & Development		1		902		902		6		2,311		2,311
Residential		8		3,891		3,891		25		6,270		6,270
Consumer - Non Real Estate		—		—		—		—		—		—
Totals		18	$	5,801	$	5,801		61	$	14,432	$	14,432

For the purposes of this report, default is defined as being 90-days past due or on non-accrual status without performance. The following tables illustrate loans restructured in the twelve months prior to September 30, 2012 that went into default during the three- and nine-month periods ended September 30, 2012 and 2011 (dollars in thousands).

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	Three months ended September 30, 2012				Nine months ended September 30, 2012
Troubled Debt Restructuring That Subsequently Defaulted	Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment
Commercial - Non Real Estate		—	$	—		—	$	—
Commercial - Real Estate		—		—		—		—
Construction & Development		—		—		—		—
Residential		—		—		1		69
Consumer - Non Real Estate		—		—		—		—
Totals		—	$	—		1	$	69
	Three months ended September 30, 2011				Nine months ended September 30, 2011
Troubled Debt Restructuring That Subsequently Defaulted	Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment
Commercial - Non Real Estate		—	$	—		—	$	—
Commercial - Real Estate		—		—		—		—
Construction & Development		—		—		—		—
Residential		—		—		—		—
Consumer - Non Real Estate		—		—		—		—
Totals		—	$	—		—	$	—

Some loan modifications classified as TDRs may not ultimately result in the full collection of principal and interest, as modified, and may result in potential incremental losses. These potential incremental losses have been factored into our overall allowance for loan losses estimate. The level of any re-defaults will likely be affected by future economic conditions. Once a loan becomes a TDR, it will continue to be reported as a TDR until it is ultimately repaid in full, reclassified to loans held for sale, or foreclosed and sold. Included in the allowance for loan losses at September 30, 2012 and 2011 was an impairment reserve for TDRs in the amount of $774,000 and $443,000, respectively.

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Non-accrual loans and an age analysis of past due loans, segregated by class of loans, were as follows (dollars in thousands):

	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans		90 Days Past Due and Still Accruing		Non-accrual Loans
September 30, 2012:
Commercial - Non Real Estate	$	136	$	30	$	106	$	272	$	24,187	$	24,459	$	—	$	446
Commercial Real Estate
Owner occupied		217		2,466		—		2,683		57,915		60,598		—		358
Income producing		385		—		—		385		46,223		46,608		—		1,443
Multifamily		—		—		—		—		7,296		7,296		—		—
Construction & Development
1 - 4 Family		46		—		—		46		1,816		1,862		—		—
Other		—		433		—		433		28,083		28,516		—		2,004
Farmland		—		—		—		—		362		362		—		—
Residential
Equity Lines		—		35		—		35		29,382		29,417		—		140
1 - 4 Family		1,235		293		1,225		2,753		69,882		72,635		—		3,690
Junior Liens		—		—		—		—		1,398		1,398		—		35
Consumer - Non Real Estate		4		—		9		13		3,360		3,373		—		9
Other		—		—		—		—		4,147		4,147		—		—
Total	$	2,023	$	3,257	$	1,340	$	6,620	$	274,051	$	280,671	$	—	$	8,125
	30 - 59 Days Past Due		60 - 89 Days Past Due		90 Days or More Past Due		Total Past Due		Current		Total Loans		90 Days Past Due and Still Accruing		Non-accrual Loans
December 31, 2011:
Commercial - Non Real Estate	$	785	$	559	$	429	$	1,773	$	32,498	$	34,271	$	—	$	1,246
Commercial Real Estate
Owner occupied		319		270		957		1,546		74,706		76,252		—		4,438
Income producing		2,250		—		2,848		5,098		38,896		43,994		—		4,021
Multifamily		59		708		—		767		5,836		6,603		—		708
Construction & Development
1 - 4 Family		—		—		24		24		3,056		3,080		—		24
Other		—		—		976		976		27,683		28,659		—		1,740
Farmland		—		—		—		—		1,342		1,342		—		—
Residential
Equity Lines		137		99		—		236		29,491		29,727		—		38
1 - 4 Family		1,442		1,458		2,938		5,838		71,182		77,020		—		6,779
Junior Liens		14		—		19		33		1,578		1,611		—		58
Consumer - Non Real Estate		31		5		—		36		3,454		3,490		—		10
Other		—		—		—		—		1,858		1,858		—		—
Total	$	5,037	$	3,099	$	8,191	$	16,327	$	291,580	$	307,907	$	—	$	19,062

The Bank categorizes loans and leases into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. This categorization is made on all commercial, commercial real estate, and construction and development loans. The Bank uses the following definitions for risk ratings:

Special Mention - Loans and leases classified as special mention, while still adequately protected by the borrower’s capital adequacy and payment capability, exhibit distinct weakening trends and/or elevated levels of exposure to external conditions. If left unchecked or uncorrected, these potential weaknesses may result in deteriorated prospects of repayment. These exposures require management’s close attention so as to avoid becoming undue or unwarranted credit exposures.

Substandard - Loans and leases classified as substandard are inadequately protected by the borrower’s current financial condition and payment capability or of the collateral pledged, if any. Loans and leases so classified have a well-defined weakness or weaknesses that jeopardize the orderly repayment of debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

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Doubtful - Loans and leases classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or orderly repayment in full, on the basis of current existing facts, conditions and values, highly questionable and improbable. Possibility of loss is extremely high, but because of certain important and reasonably specific factors that may work to the advantage and strengthening of the exposure, its classification as an estimated loss is deferred until its more exact status may be determined. The Company’s practice is to charge-off the portion of the loan amount determined to be doubtful in the quarter that the determination is made if the repayment of the loan is collateral dependent.

Loss - Loans and leases classified as loss are considered to be non-collectible and of such little value that their continuance as bankable assets is not warranted. This does not mean the loan has absolutely no recovery value, but rather it is neither practical nor desirable to defer writing off the loan, even though partial recovery may be obtained in the future. Losses are taken in the period in which they surface as uncollectible.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass-rated loans. As of September 30, 2012 and December 31, 2011, and based on the most recent analysis performed, the loans and leases were categorized as follows (dollars in thousands):

	September 30, 2012
Internal Risk Rating Grades	Pass		Special Mention		Substandard		Doubtful		Loss
Commercial - Non Real Estate	$	17,872	$	3,691	$	2,896	$	—	$	—
Commercial Real Estate
Owner occupied		36,390		15,505		8,703		—		—
Income producing		24,873		11,441		10,294		—		—
Multifamily		5,267		710		1,319		—		—
Construction & Development
1 - 4 Family		1,238		255		369		—		—
Other		12,835		12,306		3,375		—		—
Farmland		—		—		362		—		—
Totals	$	98,475	$	43,908	$	27,318	$	—	$	—
Total:
Commercial - Non Real Estate	$	17,872	$	3,691	$	2,896	$	—	$	—
Commercial Real Estate	$	66,530	$	27,656	$	20,316	$	—	$	—
Construction & Development	$	14,073	$	12,561	$	4,106	$	—	$	—
Totals	$	98,475	$	43,908	$	27,318	$	—	$	—
	December 31, 2011
Internal Risk Rating Grades	Pass		Special Mention		Substandard		Doubtful		Loss
Commercial - Non Real Estate	$	26,552	$	3,606	$	3,727	$	386	$	—
Commercial Real Estate
Owner occupied		54,739		8,547		12,854		112		—
Income producing		29,583		3,604		10,807		—		—
Multifamily		3,820		793		1,990		—		—
Construction & Development
1 - 4 Family		1,081		1,255		744		—		—
Other		18,191		8,199		1,988		281		—
Farmland		—		362		980		—		—
Totals	$	133,966	$	26,366	$	33,090	$	779	$	—
Total:
Commercial - Non Real Estate	$	26,552	$	3,606	$	3,727	$	386	$	—
Commercial Real Estate	$	88,142	$	12,944	$	25,651	$	112	$	—
Construction & Development	$	19,272	$	9,816	$	3,712	$	281	$	—
Totals	$	133,966	$	26,366	$	33,090	$	779	$	—

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All consumer-related loans, including residential real estate and non-real estate, are evaluated and monitored based upon payment activity. Once a consumer-related loan becomes past due on a recurring basis, the Company will pull that loan out of the homogenized pool and evaluate it individually for impairment. At this time, the consumer-related loan may be placed on the Company’s internal watch list and risk rated either special mention or substandard, depending upon the individual circumstances. Consumer-related loans at September 30, 2012 and December 31, 2011, segregated by class of loans, were as follows (dollars in thousands):

	September 30, 2012				December 31, 2011
Risk Based on Payment Activity	Performing		Non- Performing		Performing		Non- Performing
Residential
Equity Lines	$	29,277	$	140	$	29,689	$	38
1 - 4 Family		70,758		1,877		73,427		3,593
Junior Liens		1,398		—		1,592		19
Consumer - Non Real Estate
Credit Cards		—		—		—		—
Other		3,373		—		3,480		10
Totals	$	104,806	$	2,017	$	108,188	$	3,660
Total:
Residential	$	101,433	$	2,017	$	104,708	$	3,650
Consumer - Non Real Estate	$	3,373	$	—	$	3,480	$	10
Totals	$	104,806	$	2,017	$	108,188	$	3,660

NOTE 5. ALLOWANCE FOR LOAN LOSSES

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance is necessary to reserve for, in the judgment of management, estimated loan losses and risks inherent in the loan portfolio. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans.

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including, among other things, the performance of the Company’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications.

The Company’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with accounting principles regarding receivables based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with accounting principles regarding contingencies based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with accounting principles regarding contingencies based on general economic conditions and other qualitative risk factors both internal and external to the Company.

17

Historical valuation allowances are calculated based on the historical loss experience of specific types of loans at the time they were charged-off. The Company calculates historical loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical loss ratio and the total dollar amount of the loans in the pool. The Company’s pools of similar loans include commercial and industrial loans, commercial real estate loans, construction and development loans, residential real estate loans, and consumer and other loans. General valuation allowances are based on general economic conditions and other qualitative risk factors both internal and external to the Company. In general, such valuation allowances are determined by evaluating, among other things: (i) levels and trends in delinquencies and impaired loans; (ii) levels of and trends in charge-offs and recoveries; (iii) levels of non-impaired substandard loans; (iv) trends in volume and terms of loans; (v) effects of changes in risk selection and underwriting practices; (vi) experience, ability, and depth of lending management and staff; (vii) national and local economic trends and conditions; (viii) industry conditions; and (ix) effect of changes in credit concentrations. Management evaluates the degree of risk that each one of these components has on the quality of the loan portfolio on a quarterly basis. Loans identified as losses by management, internal loan review and/or regulatory examiners are charged-off.

Changes in the allowance for loan losses by segment, since their respective year-end, are as follows (dollars in thousands):

	September 30, 2012												September 30, 2011
	Beginning Balance		Chargeoffs			Recoveries		Provision			Ending Balance		Beginning Balance		Chargeoffs			Recoveries		Provision		Ending Balance
Commercial - Non Real Estate	$	2,247	$	(382	)	$	306	$	(773	)	$	1,398	$	2,252	$	(4,085	)	$	427	$	4,280	$	2,874
Commercial Real Estate
Owner occupied		1,794		(550	)		67		237			1,548		1,055		(5,731	)		21		6,290		1,635
Income producing		547		(1,170	)		47		1,359			783		99		(101	)		—		190		188
Multifamily		80		—			—		5			85		—		—			—		—		—
Construction & Development
1 - 4 Family		58		(99	)		1		121			81		181		(212	)		4		168		141
Other		661		(1,019	)		166		939			747		486		(492	)		99		785		878
Farmland		—		—			—		—			—		—		—			—		—		—
Residential
Equity Lines		279		(25	)		7		20			281		459		(692	)		2		483		252
1 - 4 Family		1,168		(1,073	)		114		1,073			1,282		1,078		(1,922	)		43		1,902		1,101
Consumer - Non Real Estate		143		(62	)		25		26			132		161		(115	)		15		93		154
Unallocated		1,124		—			—		(11	)		1,113		1,092		—			—		376		1,468
Total	$	8,101	$	(4,380	)	$	733	$	2,996		$	7,450	$	6,863	$	(13,350	)	$	611	$	14,567	$	8,691

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As of September 30, 2012 and December 31, 2011, loans were evaluated for impairment as follows (dollars in thousands):

	Individually Evaluated for Impairment
	September 30, 2012				December 31, 2011
	Allowance		Total Loans		Allowance		Total Loans
Commercial - Non Real Estate	$	52	$	3,538	$	74	$	5,451
Commercial Real Estate
Owner occupied		173		7,465		64		6,188
Income producing		146		10,249		224		10,650
Multifamily		50		1,319		68		1,990
Construction & Development
1 - 4 Family		8		390		9		1,668
Other		140		6,961		91		5,307
Farmland		—		362		—		—
Residential
Equity Lines		—		140		—		38
1 - 4 Family		205		14,371		240		15,048
Consumer - Non Real Estate		—		87		—		58
Unallocated		—		—		—		—
Total	$	774	$	44,882	$	770	$	46,398
	Collectively Evaluated for Impairment
	September 30, 2012				December 31, 2011
	Allowance		Total Loans		Allowance		Total Loans
Commercial - Non Real Estate	$	1,346	$	20,921	$	2,173	$	28,820
Commercial Real Estate
Owner occupied		1,375		53,133		1,730		70,064
Income producing		637		36,359		323		33,344
Multifamily		35		5,977		12		4,613
Construction & Development
1 - 4 Family		73		1,472		49		1,412
Other		607		21,555		570		23,352
Farmland		—		—		—		1,342
Residential
Equity Lines		281		29,277		279		29,689
1 - 4 Family		1,077		59,662		928		63,583
Consumer - Non Real Estate		132		3,286		143		3,432
Unallocated		1,113		4,147		1,124		1,858
Total	$	6,676	$	235,789	$	7,331	$	261,509

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NOTE 6. COMMITMENTS AND CONTINGENCIES

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, lines of credit and standby letters of credit. These instruments involve elements of credit risk in excess of amounts recognized in the accompanying financial statements.

The Company’s risk of loss related to unfunded loan commitments and lines of credit or standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments under such instruments as it does for on-balance sheet instruments. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The following table presents a summary of outstanding financial instruments whose contract amounts represent credit risk as of September 30, 2012 (dollars in thousands):

Unfunded loan commitments	$	28,060
Financial standby letters of credit		212
Total unused commitments	$	28,272

NOTE 7. RECENT ACCOUNTING PRONOUNCEMENTS

In January 2011, the FASB (also referred to in this note as the “Board”) issued Accounting Standards Update 2011-01, Receivables: Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. Under the existing effective date in Update 2010-20, public-entity creditors would have provided disclosures about troubled debt restructurings for periods beginning on or after December 15, 2010. The amendments in this Update temporarily deferred the effective date for interim and annual periods ending after June 15, 2011, enabling public-entity creditors to provide those disclosures after the Board clarifies the guidance for determining what constitutes a troubled debt restructuring. The deferral in this Update will result in more consistent disclosures about troubled debt restructurings. This amendment does not defer the effective date of the other disclosure requirements in Update 2010-20. The deferral in this amendment was effective upon issuance and did have a significant impact on the Company.

In April 2011, the FASB issued Accounting Standards Update 2011-02, Receivables: A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. This update provides additional guidance and amendments to Subtopic 310-40, Receivables – Troubled Debt Restructurings by Creditors. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: the restructuring constitutes a concession, and the debtor is experiencing financial difficulties. The amendments clarify the guidance on a creditor’s evaluation of whether it has granted a concession, and on a creditor’s evaluation of whether a debtor is experiencing financial difficulties.

The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. As a result of applying these amendments, an entity may identify receivables that are newly considered impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. An entity should disclose the total amount of receivables and the allowance for credit losses as of the end of the period of adoption related to those receivables that are newly considered impaired under Section 310-10-35 for which impairment was previously measured under Subtopic 450-20, Contingencies—Loss Contingencies. An entity should disclose the information required by paragraphs 310-10-50-33 through 50-34, which was deferred by Accounting Standards Update No. 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20. The amendments in this update are for interim and annual periods beginning on or after June 15, 2011. The amendments did not have a significant impact on the Company.

In April 2011, the FASB issued Accounting Standards Update 2011-03, Transfers and Servicing: Reconsideration of Effective Control for Repurchase Agreements. The amendments in this Update remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that

20

criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this Update.

Those criteria indicate that the transferor is deemed to have maintained effective control over the financial assets transferred (and thus must account for the transaction as a secured borrowing) for agreements that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity when all of the listed conditions have been met. The amendments in this Update are effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2011. The amendments did not have a significant impact on the Company.

In May 2011, the FASB issued Accounting Standards Update 2011-04, Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this Update result in common fair value measurement and disclosure requirements in U.S. GAAP and IFRSs. Consequently, the amendments change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. For many of the requirements, the Board does not intend for the amendments in this Update to result in a change in the application of the requirements in Topic 820.

Some of the amendments clarify the Board’s intent about the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this Update are effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2011. The amendments did not have a significant impact on the Company.

In June 2011, the FASB issued Accounting Standards Update 2011-05, Comprehensive Income: Presentation of Comprehensive Income. Under the amendments to Topic 220, Comprehensive Income, in this Update, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income.

Regardless of whether an entity chooses to present comprehensive income in a single continuous statement or in two separate but consecutive statements, the entity is required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented.

The amendments in this Update do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The amendments do not change the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, with one amount shown for the aggregate income tax expense or benefit related to the total of other comprehensive income items. In both cases, the tax effect for each component must be disclosed in the notes to the financial statements or presented in the statement in which other comprehensive income is presented. The amendments do not affect how earnings per share is calculated or presented. The amendments in this Update are effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2011. The amendments did not have a significant impact on the Company.

In December 2011, the FASB issued Accounting Standards Update 2011-12, Comprehensive Income: Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05. Under the amendments in Update 2011-05, entities are required to present reclassification adjustments and the effect of those reclassification adjustments on the face of the financial statements where net income is presented, by component of net income, and on the face of the financial statements where other comprehensive income is presented, by component of other comprehensive income. In addition, the amendments in Update 2011-05 require that reclassification adjustments be presented in interim financial periods.

The amendments in this Update supersede changes to those paragraphs in Update 2011-05 that pertain to how, when, and where reclassification adjustments are presented.

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The objective of Update 2011-05 was to help financial statement users better understand the causes of an entity’s change in financial position and results of operations. However, it is important that the benefits of improving the usefulness of financial statement information to users of financial statements be justified by the related costs. The Board received more information about the systems challenges for preparers to comply with the presentation requirements for reclassifications out of accumulated other comprehensive income by the effective date since the issuance of Update 2011-05. The information received caused the Board to reassess the costs and benefits of those provisions in Update 2011-05 related to reclassifications out of accumulated other comprehensive income. Due to the time required to properly make such a reassessment and to evaluate alternative presentation formats, the Board decided that it is necessary to reinstate the requirements for the presentation of reclassifications out of accumulated other comprehensive income that were in place before the issuance of Update 2011-05. The amendments in this Update are effective for public entities for fiscal years, and interim periods within those years, beginning after December 15, 2011. The amendments did not have a significant impact on the Company.

In July 2012, the FASB issued Accounting Standards Update 2012-02, Intangibles – Goodwill and Other (Topic 350). The amendments in this Update are intended to reduce cost and complexity by providing an entity with the option to make a qualitative assessment about the likelihood that an indefinite-lived intangible asset is impaired to determine whether it should perform a quantitative impairment test. The amendments also enhance the consistency of impairment testing guidance among long-lived asset categories by permitting an entity to assess qualitative factors to determine whether it is necessary to calculate the asset’s fair value when testing an indefinite-lived intangible asset for impairment, which is equivalent to the impairment testing requirements for other long-lived assets. The amendments are not expected to have a significant impact on the Company.

From time to time the FASB issues Proposed Accounting Standards Updates. Such proposed updates are subject to comment from the public, to revisions by the FASB and to final issuance by the FASB as Accounting Standards Updates. Management considers the effect of the proposed updates on the consolidated financial statements of the Company and monitors the status of changes to and proposed effective dates of proposed updates.

NOTE 8. FAIR VALUE

Accounting principles generally accepted in the United States of America require that companies measure and record certain assets and liabilities at fair value and record any adjustments to the fair value of those assets. Securities are recorded at fair value on a recurring basis while other assets, such as impaired loans, are recorded at fair value on a non-recurring basis.

The Company uses three levels of measurement to group those assets measured at fair value. These groupings are made based on the markets the assets are traded in and the reliability of the assumptions used to determine fair value. The groupings include:

• Level 1 pricing for an asset or liability is derived from the most likely actively traded markets and considered very reliable. Quoted prices on actively traded equities, for example, fall into this category.

• Level 2 pricing is derived from observable data including market spreads, current and projected rates, prepayment data and credit quality. Our bond price adjustments fall into this category as well as impaired loans and other real estate owned that use appraisals or brokered price opinions to determine fair value.

• Level 3 pricing is derived without observable data. In such cases, mark-to-market strategies are typically employed. These types of instruments often have no active market, possess unique characteristics and are thinly traded.

The Company’s investment securities are measured on a recurring basis through a model used by our bond agent. All of our bond price adjustments meet Level 2 criteria. Prices are derived from a model which uses actively quoted rates, prepayment models and other underlying credit and collateral data.

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The following table summarizes the Company’s assets measured at fair value at the dates indicated (dollars in thousands):

	At September 30, 2012
	Total		Level 1		Level 2		Level 3
Assets valued on a recurring basis
Investment securities:
U.S. government and agency	$	56,237	$	—	$	56,237	$	—
State and municipals		8,391		—		8,391		—
Mortgage-backed		54,772		—		54,772		—
Assets valued on a non-recurring basis
Impaired loans		44,108		—		44,108		—
Other real estate owned		5,424		—		5,424		—
Total	$	168,932	$	—	$	168,932	$	—
	At December 31, 2011
	Total		Level 1		Level 2		Level 3
Assets valued on a recurring basis
Investment securities:
U.S. government and agency	$	44,259	$	—	$	44,259	$	—
State and municipals		3,590		—		3,590		—
Corporate		1,017		—		1,017		—
Mortgage-backed		61,571		—		61,571		—
Assets valued on a non-recurring basis
Impaired loans		45,628		—		45,628		—
Other real estate owned		8,524		—		8,524		—
Total	$	164,589	$	—	$	164,589	$	—

NOTE 9. BORROWED FUNDS

A summary of the Company’s outstanding borrowings and the annual rate of interest currently payable on each category is presented in the following table at the dates indicated (dollars in thousands):

	September 30, 2012					December 31, 2011
	Outstanding Balance		Annual Interest Rate			Outstanding Balance		Annual Interest Rate
Securities sold under overnight repurchase agreements	$	379		0.10	%	$	381		0.10	%
Securities sold under term repurchase agreements		45,000		4.38			45,000		4.38
Trust preferred securities		5,155		3.29			5,155		3.49
Subordinated debt		2,700		4.00			2,700		4.00
Total borrowed funds	$	53,234		4.22	%	$	53,236		4.24	%

The Bank engages from time-to-time in federal funds purchases from upstream correspondent institutions to meet temporary funding needs. There were none of these transactions outstanding at the close of either period presented in the above table.

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The Bank had a total of $45.0 million of borrowings in the form of securities sold under term repurchase agreements that were entered into during 2008. These borrowings are secured by marketable investment securities equal to approximately 109.5% of the principal balances outstanding plus accrued interest and the value of an imbedded interest rate cap. The following table contains certain pertinent information with respect to these agreements at September 30, 2012 (dollars in thousands):

	Outstanding Principal Balance		Annual Effective Interest Rate			Final Maturity Date		Beginning Quarterly Call Dates		Collateral Requirement
Agreement dated 7/8/2008	$	25,000		4.85	%		7/8/2018		7/8/2013	$	8,796
Agreement dated 8/20/2008		20,000		3.78			8/20/2015		8/20/2011		4,356
Total	$	45,000		4.38	%					$	13,152

The Bank utilizes borrowings from the Federal Home Loan Bank (“FHLB”) as a source of liquidity. At September 30, 2012, the Bank had immediately available credit of $8.4 million. There were no advances from the FHLB at quarter-end.

During 2008, the Company issued $5.2 million of junior subordinated debentures to its wholly owned capital trust, Bank of the Carolinas Trust I (the “Trust”), which, in turn, issued $5.0 million in trust preferred securities having a like liquidation amount and $155,000 in common securities (all common securities are owned by the Company). The Company has fully and unconditionally guaranteed the Trust’s obligations related to the trust preferred securities. The Trust has the right to redeem the trust preferred securities in whole or in part, on or after June 15, 2013 at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest.

In addition, the Trust may redeem the trust preferred securities in whole (but not in part) at any time within 90 days following the occurrence of a tax event, an investment company event, or a capital treatment event at a special redemption price (as defined in the debenture). Interest is payable quarterly on the trust preferred securities at the annual rate of 90-day LIBOR plus 300 basis points. In February 2011, the Company announced its election to defer its regularly scheduled interest payments on the junior subordinated debentures related to the trust preferred securities. Furthermore, the Company is now party to a written agreement with the Federal Reserve, which restricts the Company’s ability to make interest payments on subordinated debt, as described below.

The Company also has issued $2.7 million of subordinated debt in a private transaction with another financial institution. This subordinated note has a floating interest rate equal to 75 basis points over the Prime Rate published by Wall Street Journal and a maturity date of August 13, 2018. This debt can be repaid in full at any time with no penalty.

Under the terms of a written agreement between the Company and the Federal Reserve Bank of Richmond, the Company and the Trust may not make any distributions of interest, principal, or other sums on subordinated debentures or trust preferred securities without the prior written approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors.

NOTE 10. STOCKHOLDERS’ EQUITY

Preferred Stock:

The Company has 3.0 million shares of preferred stock authorized. There were 13,179 shares of preferred stock issued and outstanding with a $1,000 per share liquidation preference on September 30, 2012 and December 31, 2011. All of the shares were issued on April 17, 2009 in connection with the Company’s participation in the U.S. Treasury’s TARP Capital Purchase Program.

In February 2011, the Company notified the Treasury of its intent to defer the payment of its regular quarterly cash dividend on its Series A Preferred Stock sold to the Treasury. In addition, the Company has entered into a written agreement with the Federal Reserve Bank of Richmond, which prohibits the Company’s payment of any dividends without the prior approval of the Federal Reserve Bank of Richmond and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Board of Governors.

At September 30, 2012 and December 31, 2011, the cumulative amount of dividends in arrears not declared was $1.1 million and $582,000, respectively.

Common Stock:

The Company has 15.0 million shares of $5 par value common stock authorized. There were 3,895,840 shares of common stock issued and outstanding at September 30, 2012 and December 31, 2011, respectively.

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Warrants:

In connection with the issuance of the preferred shares under the U.S. Treasury’s TARP Capital Purchase Program, the Company issued the U.S. Treasury a warrant to purchase 475,204 shares of its common stock for $4.16 per share. The warrant expires April 17, 2019.

NOTE 11. INCOME TAXES

The Company utilizes the liability method of computing income taxes. Under the liability method, deferred tax liabilities and assets are established for future tax return effects of the temporary differences between the stated value of assets and liabilities for financial reporting purposes and their tax bases. The focus is on accruing the appropriate balance sheet deferred tax amount, with the statement of income effect being the result of the changes in the balance sheet amounts from period to period. The current portion of income tax expense is provided based upon the actual tax liability incurred for tax return purposes.

An evaluation of the probability of being able to realize the future benefits of deferred tax assets is made. A valuation allowance is provided for the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. Management has established a deferred tax asset valuation allowance as of September 30, 2012 of $15.0 million. There was a $12.7 million valuation allowance as of December 31, 2011. The valuation allowance has been established because management believes current overall credit trends, as well as actual and forecasted performance, raise significant concern over the ability of the Company to realize the components of its deferred tax assets relating to net operating losses and the allowances for losses on loans and OREO.

NOTE 12. GOING CONCERN

Going Concern Considerations

The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future. It is the responsibility of management to assess the Company’s ability to continue as a going concern. In making this assessment, the Company has taken into account all available information about the future, which is at least, but is not limited to, twelve months from the balance sheet date of September 30, 2012. The Company had a history of profitable operations prior to 2008 and sufficient sources of liquidity to meet its short-term and long-term funding needs.

The effects of the current economic environment are being felt across many industries, with financial services and real estate being particularly hard-hit, and have been particularly severe during the last 45 months. The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, including residential construction and development loans, has seen a decline in the value of the collateral securing its portfolio as well as rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans made by the Bank. As a result, the Bank’s level of nonperforming assets increased substantially during 2010 and 2011. The significant losses in 2010, 2011, and the first nine months of 2012, which were primarily related to credit losses and the valuation allowance on deferred tax assets, reduced the Company’s capital levels. In order to again become well capitalized under federal banking agencies’ guidelines, management believes that the Company will need to raise additional capital to recapitalize the Bank and to absorb the potential future credit losses associated with the disposition of its nonperforming assets. Accordingly, management is in the process of evaluating various alternatives to increase tangible common equity and regulatory capital through the issuance of additional equity in public or private offerings. Management is actively evaluating a number of potential capital sources, asset reductions, and other balance sheet management strategies with the goal of increasing its level of regulatory capital to support its balance sheet long-term. Management is currently attempting to reduce and otherwise restructure the Company’s balance sheet to improve capital ratios.

Current market conditions for banking institutions, the overall uncertainty in financial markets, and a depressed stock price are significant barriers to the success of any plan to issue additional equity in public or private offerings. An equity financing transaction would result in substantial dilution to the Company’s current stockholders and could adversely affect the market price of the Company’s common stock. There can be no assurance as to whether these efforts will be successful, either on a short-term or long-term basis. Should these efforts be unsuccessful, due to existing regulatory restrictions on cash payments and dividends between the Bank and the holding company, the Company may be unable to discharge its liabilities in the normal course of business. There can be no assurance that the Company will be successful in any efforts to raise additional capital.

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Both the Company and the Bank actively manage liquidity and cash flow needs. The Bank is prohibited from declaring or paying dividends without prior approval of the FDIC or the North Carolina Commissioner of Banks and the Company is prohibited from declaring or paying dividends without the prior approval from the Federal Reserve. Even if these requirements were not in place, the Company does not intend to declare or pay dividends to shareholders at any time in the foreseeable future. At September 30, 2012, the Company had $7.8 million of cash and cash equivalents. The Company has no long-term debt maturing in 2012 or 2013.

Based on current capital levels and continued operating losses, management believes the Company will require additional capital to be able to remain viable. Management has implemented various strategies to provide this needed capital. In spite of management’s best efforts, there is no assurance management will be successful in raising additional capital. The accompanying consolidated financial statements for the Company have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets.

Management’s Plans and Intentions

The Company incurred significant net losses in 2010 and 2011, which have continued in 2012, primarily from the higher provisions for loan losses due to the significant level of nonperforming assets and increases in foreclosed real estate. The FDIC and the Commissioner issued the Consent Order in April 2011. The Company entered into a written agreement with the FRB in August 2011. The Company’s independent registered public accounting firm issued a report with respect to the Company’s audited financial statements for the fiscal year ended December 31, 2011, which contained an explanatory paragraph indicating that there is substantial doubt about the Company’s ability to continue as a going concern. The Company is attempting to implement the following strategies to improve its financial condition:

Deferring Preferred Stock and Trust Preferred Securities Payments – The Company began deferring the payment of cash dividends on its outstanding Fixed Rate Cumulative Perpetual Preferred Stock, Series A, in February 2011, as well as the payment of interest on the junior subordinated notes related to its outstanding trust preferred securities to enhance the Company’s liquidity. The expense associated with trust preferred securities continues to accrue and is reflected in the Company’s Consolidated Statements of Operations. Accrued but unpaid dividends on preferred stock are shown as an increase to net loss to derive net loss to common shareholders in the Consolidated Statements of Operations.

Balance Sheet Reduction – Management currently is implementing strategies to improve capital ratios through the reduction of assets and off-balance sheet commitments. At September 30, 2012, risk-weighted assets had been reduced by $103.4 million since December 31, 2010. Reductions occurred primarily in the commercial loan portfolio. Management expects future reductions in risk-weighted assets to be moderate and occur primarily in the loan portfolio. To offset the majority of asset reductions, liabilities declined primarily through reductions in other borrowings by $22.0 million and non-core deposits by $9.6 million.

Earnings – In June 2011, the Bank retired $10.0 million in FHLB advances and paid an early redemption penalty of $273,000 to the FHLB for the retirement of these advances. In November 2011, the Bank retired an additional advance of $10.0 million due to the FHLB and paid an early redemption penalty of $7,000. The advances had a remaining average life of 1.0 year and an average interest rate of 1.21%. The Bank is prohibited from accepting or rolling over any brokered certificates of deposit. Since April 2011, the brokered certificates of deposit had maturities ranging from 2 months to 27 months with interest rates ranging from 0.75% to 2.40%. As these matured and continue to mature, the Bank replaced and will continue to replace these funds with institutional certificates of deposit with average interest rates of 0.50%. As a result of these changes, the interest expense savings during 2012 should have a positive impact on net interest margin.

Additional Capital – The Company has engaged investment banking firms and is working to secure investors in a capital raise plan that may include issuing common stock, preferred stock or a combination of both, debt, or other financing alternatives that may be treated as capital for capital adequacy ratio purposes. Currently, the Company is working diligently to raise additional capital; however, there are no assurances that an offering will be completed or that the Company will succeed in this endeavor. In addition, a transaction would more likely than not involve equity financing, resulting in substantial dilution to current shareholders and an adverse effect on the price of the Company’s common stock. The Company’s ability to raise capital depends to a large degree on the current capital markets and on its financial performance. Available capital markets are not currently favorable, and the Company can offer no assurance that it will be able to raise capital on terms that are acceptable, if at all.

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NOTE 13. SELECTED QUARTERLY FINANCIAL INFORMATION (Unaudited)

	September 30, 2012			June 30, 2012 (As  Restated)			March 31, 2012 (As  Restated)			December 31, 2011 (As Restated)			September 30, 2011 (As Restated)			June 30, 2011 (As  Restated)			March 31, 2011 (As  Restated)
	(in thousands)
Assets:
Cash and due from banks, noninterest-bearing	$	3,987		$	3,884		$	4,674		$	5,044		$	4,922		$	10,172		$	4,174
Interest-bearing deposits in banks		3,843			3,226			2,562			2,557			4,431			4,256			4,208
Cash and cash equivalents		7,830			7,110			7,236			7,601			9,353			14,428			8,382
Federal funds sold		13,710			48,465			44,245			28,165			22,630			8,175			14,985
Investment securities		121,387			105,609			103,682			112,404			113,768			118,534			116,879
Loans receivable		280,671			285,186			296,092			307,907			324,757			345,617			359,561
Less: Allowance for loan losses		(7,450	)		(7,541	)		(8,048	)		(8,101	)		(8,691	)		(6,685	)		(8,314	)
Total loans, net		273,221			277,645			288,044			299,806			316,066			338,932			351,247
Premises and equipment		11,911			12,091			12,256			12,229			12,448			12,681			12,859
Other real estate owned