Note 1 – Summary of Significant Accounting Policies

Principles of Consolidation: The consolidated financial statements include the accounts of Northern States Financial Corporation (“Company”), its wholly owned subsidiaries, NorStates Bank (“Bank”) and NorProperties, Inc. (“NorProp”) and NorStates Bank's wholly-owned subsidiary, Northern States Community Development Corporation (“NSCDC”). NorProp was formed during the fourth quarter of 2008 to purchase nonperforming assets of the Bank which NorProp manages and disposes. NSCDC was formed in 2002 and the Bank contributed a parcel of the other real estate owned and cash to this entity. Significant intercompany transactions and balances are eliminated in consolidation.

Nature of Operations: The Company's and the Bank's revenues, operating income and assets are primarily from the banking industry. Loan customers are mainly located in Lake County, Illinois and surrounding areas of northeastern Illinois and southeastern Wisconsin and include a wide range of individuals, businesses and other organizations. A major portion of loans are secured by various forms of collateral, including real estate, business assets, consumer property and other items. A portion of the Company's real estate-mortgage commercial loans represents hotel industry loans that totaled $47.0 million at year-end 2011.

Use of Estimates: To prepare financial statements in conformity with accounting principles generally accepted in the United States of America and general banking industry practices, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosure provided, and future results could differ. The allowance for loan and lease losses, fair value of other real estate owned, fair value of financial instruments, valuation of deferred tax assets and status of contingencies are particularly subject to change.

Cash Flow Reporting: Cash and cash equivalents are defined as cash and due from banks, federal funds sold and interest bearing deposits in financial institutions maturing in less than ninety days. Net cash flows are reported for customer loan and deposit transactions, securities sold under repurchase agreements and other short-term borrowings.

Securities: Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported separately as other comprehensive income, net of tax.

Gains and losses on sales are determined using the amortized cost of the specific security sold and recorded on the trade date. Interest income includes amortization of premiums and accretion of discounts. Securities are written down for expected credit losses when a decline in fair value is determined as not being temporary.

Declines in fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other than temporary impairment losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the discounted value of expected future cash flows, and (4) the Company's ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.

Federal Home Loan Bank Stock: The Company as a member of the Federal Home Loan Bank of Chicago (“FHLB”) is required to maintain an investment in the capital stock of the FHLB. There is no ready market for the stock and it does not have any quoted market value. The stock is redeemable at par by the FHLB and is, carried at cost and periodically evaluated for impairment. The Company records dividends in income on the dividend declaration date. During 2011, the Company assessed its FHLB stock for impairment. This assessment reviewed the financial condition and credit rating of the FHLB. This assessment also considered the imputed value of the services available to the Company from the FHLB as the result of the Company's ownership of FHLB stock. During 2011, the FHLB paid dividends on its stock and at year-end 2011, it was concluded that the Company's investment in FHLB was not impaired.

Loans and Leases: Loans and leases are reported at the principal balance outstanding, net of deferred loans fees and costs and the allowance for loan and lease losses. Interest income is reported on the accrual method and includes amortization of deferred loan fees over the loan term

Nonaccrual Loans: Accrual of uncollectible income on problem loans inflates income and if recognized in an untimely fashion can have a dramatic negative impact on earnings. Any loan meeting one of the following criteria is placed in a non-accrual status and all related interest earned but not collected is reversed:

The loan is maintained on a cash basis because of deterioration in the financial condition of the borrower.

The borrower is in bankruptcy and the exposure is not fully secured and in the process of collection.

Full payment of principal or interest is not expected.

The loan has been in default for a period of ninety (90) days or more unless the asset is both well secured and in the process of collection.

Loans meeting any of the criteria above may be exempted from this policy if unanimously agreed upon and duly documented by the Directors' Loan Committee.

Interest received on nonaccrual loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual status. Loans may be returned to accrual status when at least six months of timely payments have been received and there is evidence to support that payments will probably continue.

Troubled Debt Restructuring: Restructuring of loans is undertaken to improve the likelihood that the loan will be repaid in full under the modified terms in accordance with a reasonable repayment schedule. All restructured loans are evaluated to determine whether the loans should be reported as a Troubled Debt Restructure (“TDR”). A loan is a TDR when the Bank, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower by modifying or renewing a loan that the Bank would not otherwise consider. To make this determination the Bank must determine whether (a) the borrower is experiencing financial difficulties and (b) the Bank granted the borrower a concession. This determination requires consideration of all of the facts and circumstances surrounding the modification. An overall general decline in the economy or some deterioration in a borrower's financial condition does not automatically mean the borrower is experiencing financial difficulties.

For regulatory purposes, a restructured loan classified as a TDR need not continue to be reported as such in calendar years after the year in which the restructuring took place if the loan yields a market rate and is in compliance with the loan's modified terms. For determining whether the rate is a market rate the Bank considers the risk of the transaction, the structure of the loan, the borrower's financial condition, financial support of the guarantor and protection provided by the collateral. The Bank also considers rates given to other borrowers for similar loans as well as what competitors are offering. To be in compliance with the modified loan terms the borrower should demonstrate the ability to repay under the modified terms for a period of at least six months. TDRs in compliance with their modified terms totaled $51.7 million at year-end 2011 compared with $44.1 million at year-end 2010.

Loan Rating System: Senior management and other lenders use a loan rating system to determine the credit risks of its loan and leases with the following loan ratings:

Pass: A Pass loan has no apparent weaknesses.

Watch: A Watch loan has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank's credit position at some future date. Loan collection is not in jeopardy yet, but continued adverse trends may cause it to be. Typical characteristics of Watch assets include: increasing debt; liquidity problems; negative trends in operating cash flow; collateral dependent with advances outside policy guidelines; and/or sporadic payment performance.

Substandard: A Substandard loan is inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged, if any. These loans have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt and have a distinct possibility that the Bank may sustain some loss if the deficiencies are not corrected.

Nonaccrual: Loans in this category have the same characteristics as those classified Substandard with the added characteristic that further erosion in the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The likelihood of loss is yet to be fully determined due to the borrower's inability or refusal to provide updated financial information, appraisals or additional collateral.

Doubtful: Loans in this category have the weaknesses of those classified Substandard where collection and/or liquidation in full, on the basis of currently existing conditions, is highly questionable or improbable. Specific pending factors may strengthen credit. Treatment as “loss” is deferred until exact status can be determined.

Loss: Loans classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless loan even though partial recovery may be affected in the future.

Allowance for Loan and Lease Losses: The allowance for loan and lease losses (“ALLL”) is a valuation allowance for probable incurred credit losses, increased by the provision for loan and lease losses and decreased by charge-offs net of recoveries. The ALLL represents one of the most significant estimates in the Bank's financial condition. Accordingly, the Bank endeavors to provide a comprehensive and systematic approach for determining management's current judgment about the credit quality of the loan portfolio.

At the end of each quarter, or more frequently if warranted, the Bank analyzes its loan portfolio to determine the level of ALLL needed to be maintained. This analysis results in a prudent, conservative ALLL that falls within an acceptable range of estimated credit losses. The ALLL covers estimated credit losses on individually evaluated loans that are determined to be impaired as well as estimated credit losses inherent in the remainder of the loan portfolio.

Senior management and other lenders review all Watch and Substandard credits to determine if a loan is impaired. A loan is considered impaired if it is probable that full principal and interest will not be collected within the contractual terms of the original note. For loans that are individually evaluated and determined to be impaired the Bank calculates the amount of impairment based on whether repayment of the loan is dependent on operating cash flow or on the underlying collateral. The decision of which method to use is determined by looking at a number of factors, including the size of the loan and other available information. If the loan is to be repaid primarily from the operating cash flow from the borrower, the impairment analysis calculates the present value of the expected future cash flows discounted at the loan's effective interest rate and compares the result to the recorded investment. Collateral-dependent loans are measured against the fair value of the collateral less the costs to sell.

During 2011, management further refined its methodology for calculating the amount in the ALLL by segregating a component of loans considered to be “high risk” but lack sufficient weakness to be considered impaired. These loans are assigned a specific percentage allocation, adjusted by environmental and qualitative factors management believes may affect the repayment of these loans. The impact to the ALLL for the creation of this additional pool of loans was not significant at December 31, 2011.

The remaining unimpaired loan portfolio is segmented into groups based on loan types having similar risk characteristics. Estimated loan losses for these groups are determined using historical loss experience and adjusted for other environmental and qualitative factors the Bank deems significant that would likely cause estimated credit losses to differ from the group's historical loss experience.

Allocations of the ALLL may be made for specific loans and leases, but the entire allowance is available for any loan or lease that, in management's judgment, should be charged-off. Loan and lease losses are charged against the allowance when management believes the uncollectibility of a loan or lease balance is confirmed.

It is the Bank's policy to administer and pursue charged-off borrowers with the same diligence as other loans. Charging off an exposure is an accounting entry and does not affect the borrower's obligation to repay the indebtedness. Administration of charged-off exposure is governed by maximization of recoveries, and borrowers will be pursued until, in the opinion of management, future costs of collection exceed probable future recoveries.

Office Building and Equipment: Land is carried at cost. Building and related components are depreciated using the straight-line method with useful lives ranging from 7 to 40 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 10 years.

Other Real Estate Owned: Real estate acquired in settlement of loans is initially reported at the estimated fair value at transfer less estimated costs to sell. After transfer, the carrying value of the real estate is reduced if the estimated fair value less estimated costs to sell declines below the carrying value of the property. Other real estate is periodically assessed to determine impairment and any such impairment will be recognized in the period identified.

Goodwill and Other Intangible Assets: Goodwill results from prior business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. During 2009, goodwill was assessed and determined to be impaired and written down completely.

The core deposit intangible arising from the First State Bank of Round Lake acquisition was measured at fair value at acquisition and was fully amortized during 2010.

Long-term Assets: These assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future discounted cash flows. If impaired, the assets are written down through earnings to the discounted amounts.

Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance.

Treasury Stock: Treasury stock represents shares of the Company that were repurchased. These shares are carried at cost.

Employee Benefits: A profit sharing plan covers substantially all employees. Contributions are expensed annually and are made at the discretion of the Board of Directors. No contribution was made in 2011, 2010 and 2009. The plan allows employees to make voluntary contributions, although such contributions are not matched by the Company.

At the Company's annual meeting of stockholders held on May 21, 2009, the stockholders approved the 2009 Restricted Stock Plan (“Plan”). The goal of the Plan is to promote the Company's long-term financial success, increase stockholder value and enhance our ability to attract and retain employees and directors. The Plan authorizes the issuance of up to 400,000 shares of the Company's common stock in connection with incentive compensation awards, which is approximately 10 percent of the Company's total shares currently issued and outstanding.

In January 2011, 207,500 shares of restricted stock were issued pursuant to the Plan from the Company's treasury stock. During 2011, employees, who left the Company, forfeited 2,000 shares of restricted stock, which were returned to treasury stock lowering the total shares issued pursuant to the Plan to 205,500 shares. Of the 80,000 shares issued to directors, 70,000 shares vested immediately during January 2011, while the remaining 10,000 shares vest over a two-year period becoming fully vested in January 2013. A total of 125,500 restricted stock shares granted to employees of the Company will fully vest in January 2013. The expense attributable to the restricted stock awards recognized during 2011 totaled $238,000. At year-end 2011, 194,500 shares were available for issuance under the plan.

Income Taxes: Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax basis of assets and liabilities computed using enacted tax rates. A valuation allowance, if needed, based on management's review of positive and negative evidence to determine whether it is more likely than not able to realize the value of the deferred tax asset, is established to the amount expected to be realized. A deferred tax asset or contra-asset associated with an unrealized loss or gain on available for sale investment securities is separately evaluated by management from the Company's other deferred tax assets. Due to the implicit recovery of the book basis of the underlying debt securities along with management's intent and ability to hold the security to recovery or maturity, if necessary, no valuation allowance on the tax effect of the unrealized gain or loss of investment securities has been recorded. At year-end 2011, the deferred tax asset valuation reserve totaled $20.3 million.

Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of on- and off-balance sheet financial instruments does not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments.

Loan Commitments and Related Financial Instruments: Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. Commitments to extend credit and commercial letters of credit are agreements, with fixed expiration dates, to lend to a customer as long as there is no violation of any condition established in the contract. The Bank evaluates each customer's credit worthiness on a case by case basis. The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation of the borrower. The face amount for these items represents possible future loans. Such financial instruments are recorded when they are funded.

Earnings per Share: Basic earnings per share is based on weighted average common shares outstanding. Diluted earnings per share further assumes issue of any dilutive potential common shares.

Comprehensive Income: Comprehensive income consists of results of operations and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale, net of deferred tax, which are also recognized as a separate component of equity.

Reclassification: Some items in the prior year financial statements were reclassified to conform to current presentation.

Recent Accounting Pronouncements:

(ASU No. 2011-2) In April 2011, the FASB issued “Receivables (Topic 310) - A Creditor's Determination of Whether a Restructuring is a Troubled Debt Restructuring.” ASU 2011-2 provides additional guidance to assist creditors in determining whether a restructuring of a receivable meets the criteria to be considered a troubled debt restructuring. The impact of ASU 2011-2 on the Company's disclosure is reflected in Note 4 to the condensed consolidated financial statements.

(ASU 2011-4) In May 2011, the FASB issued an Update related to fair value measurements (Topic 820) and disclosure requirements. The Update results in common fair value measurement and disclosures in U.S. GAAP and IFRS by changing the wording used to describe many of the fair value measurement requirements in U.S. GAAP or to clarify the FASB's intent about the application of existing fair value measurement requirements. The amendments will be adopted beginning in the first quarter of 2012 and applied to the Company's financial statements prospectively.

(ASU 2011-5) In June 2011, the FASB issued an Update on the Presentation of Comprehensive Income (Topic 220), which was amended in October 2011. The Update changes the reporting and presentation of comprehensive income on the face of the financial statements and provides two options of presentation- a single statement including net income and the components of other comprehensive income or two separate statements. The Update eliminates the option of presenting the components of other comprehensive income in the statement of changes in stockholders' equity. The amendments in this Update will be adopted beginning in the first quarter of 2012 and will be applied to the Company's financial statements retrospectively.