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 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 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 $45.7 million at year-end 2012.

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 with an original maturity of less than ninety days.

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.

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.

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 accretion of net deferred loan fees over the loan term.

Nonaccrual Loans: Accrual of uncollectible income on problem loans inflates income and, when reversed, can have a dramatic negative impact on earnings. Any loan meeting one of the following criteria is placed in a nonaccrual 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. In general, all accrued interest on an exposure placed on nonaccrual status is charged-off to income. Interest received on nonaccrual loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual status. A loan may be returned to accrual status if the borrower demonstrates repayment performance for a reasonable period prior to the date the loan is returned to accrual status and there is evidence to support that payments will continue. A reasonable period of repayment performance would be a period of at least six months, but may be less depending on the particular circumstances.

Troubled Debt Restructuring: Restructuring of a loan 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 TDR. A loan is a TDR when the Company, 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 Company would not otherwise consider. To make this determination the Company must determine whether (a) the borrower is experiencing financial difficulties and (b) the Company 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.

Some of the factors reviewed to determine whether the borrower is experiencing financial difficulties are: 1) is the borrower currently in default on any of its debts; 2) has the borrower declared or in the process of declaring bankruptcy; or 3) absent the current modification, would the borrower more than likely default. Factors to consider in determining whether the Company has granted a concession include: lowering the interest rate, extending the maturity date, forgiving debt, reducing accrued interest or changing the payment to interest only for an extended period of time.

A restructured loan classified as a TDR may not need to 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. In determining whether the rate is a market rate the Company considers the riskiness 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 Company 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 normally demonstrate the ability to repay under the modified terms for a period of at least six months and provide evidence to support that payments will continue.

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 net 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 Company 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. 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. 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. Management believes 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. The recorded investment of collateral dependent loans are measured against the fair value of the collateral less the costs to sell.

Management further segregates a component of loans considered to be "high risk" but lacking 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 remaining 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 Company'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.

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 2012, 2011 and 2010. 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 2009 Restricted Stock Plan from the Company's treasury stock. During 2012 and 2011, employees, who left the Company, forfeited 9,000 shares of restricted stock which were returned to treasury stock, and 80,500 shares of restricted stock issued to directors and employees vested. Subsequently on January 15, 2013, the remaining 118,000 restricted stock shares vested in accordance with the award agreement. The expense attributable to the restricted stock awards totaled $106,000 and $238,000 during 2012 and 2011, respectively. At year-end 2012, 201,500 shares were available for issuance under the plan.

On March 7, 2013, the Company filed a post-effective amendment to its Registration Statement on Form S-8 to deregister all shares of the Company's common stock covered by the Form S-8 Registration Statement that remained unsold under the Plan.

Income Taxes: Income tax expense is the sum of the current year income tax due 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 currently enacted tax rates. 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, a valuation allowance may be established. A deferred tax asset or liability 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. No valuation allowance on the tax effect of the unrealized gain or loss of investment securities or has been recorded. At year-end 2012, the deferred tax asset valuation reserve totaled $25.1 million.

Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 16. 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 face amount for these items represents possible future loans. Such financial instruments are recorded when they are funded.

Earnings per Share: A basic earnings per share is based on weighted average common shares outstanding. Diluted earnings per share assumes the issuance of any potential dilutive common shares.

Comprehensive Income: Comprehensive income consists of results of operations and 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: In 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The amendments in this Update supersede the presentation requirements for reclassifications out of accumulated other comprehensive income in Accounting Standards Updates No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, and No. 2011-12, Comprehensive Income (Topic 220): 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, for all entities. The objective of this Update is to improve the reporting requirements for reclassifications out of accumulated other comprehensive income in a manner that balances the benefits to users with the costs to preparers of financial statements. The amendments in this Update are effective prospectively for the Company beginning with its March 31, 2013 quarterly financial statements. Early adoption is permitted and the adoption of this standard is not anticipated to have a significant impact on the financial statements.

During 2012, the Company adopted new guidance related to the presentation of comprehensive income in the financial statements. Among other changes, the new guidance eliminated the option to only present comprehensive income in the statement of equity. The Company has elected to report comprehensive income in a separate statement of comprehensive income that begins with net loss. The new guidance did not have a material effect on the financial statements.

In 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. This update to Fair Value Measurement (Topic 820) results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRS. The amendments in this update explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. However, this update does require expanded disclosure related to the nature and significance of inputs that are used in estimating and measuring the fair value of financial instruments. The amendments in this Update have been disclosed and did not have a material effect on the financial statements.