UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2014

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

Commission File Number 0-18832

First Financial Service Corporation

(Exact Name of Registrant as specified in its charter)

Kentucky	61-1168311
(State or other jurisdiction	(IRS Employer Identification No.)
of incorporation or organization)

2323 Ring Road	(270) 765-2131
Elizabethtown, Kentucky 42701	(Registrant's telephone number,
(Address of principal executive offices)	including area code)
(Zip Code)

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 (§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.

Large Accelerated Filer ¨ Accelerated Filer ¨ Non-Accelerated Filer ¨ Smaller Reporting Company x

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class		Outstanding as of August 11, 2014
Common Stock		5,149,855 shares

FIRST FINANCIAL SERVICE CORPORATION

FORM 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION

Preliminary Note Regarding Forward-Looking Statements		3

Item 1.	Consolidated Financial Statements and Notes to Consolidated Financial Statements	4

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	39

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	58

Item 4.	Controls and Procedures	60

PART II – OTHER INFORMATION		60

Item 1.	Legal Proceedings	60

Item 1A.	Risk Factors	60

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	60

Item 3.	Defaults upon Senior Securities	60

Item 4.	Mine Safety Disclosures	61

Item 5.	Other Information	61

Item 6.	Exhibits	61

SIGNATURES		62

PRELIMINARY NOTE REGARDING

FORWARD-LOOKING STATEMENTS

Statements in this report that are not statements of historical fact are forward-looking statements. First Financial Service Corporation (also referred to as “FFKY,” the “Corporation,” “we” or “us”) may make forward-looking statements in future filings with the Securities and Exchange Commission (“SEC”), in press releases, and in oral and written statements made by or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements. Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.

Various risks and uncertainties may cause actual results to differ materially from those indicated by our forward-looking statements. In addition to those risks described under “Item 1A Risk Factors,” of this report and our Annual Report on Form 10-K, the following factors could cause such differences: changes in general economic conditions and economic conditions in Kentucky and the markets we serve, any of which may affect, among other things, our level of non-performing assets, charge-offs, and provision for loan loss expense; changes in interest rates that may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposits; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”); competition with other local and regional commercial banks, savings banks, credit unions and other non-bank financial institutions; our ability to grow core businesses; our ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks.

Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of any such statement.

Item 1.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Balance Sheets

(Unaudited)

	June 30,			December 31,
(Dollars in thousands, except per share data)	2014			2013

ASSETS:
Cash and due from banks	$	16,995		$	13,476
Interest bearing deposits		65,541			52,512
Total cash and cash equivalents		82,536			65,988

Securities available-for-sale		212,231			269,282
Loans held for sale		1,313			470

Loans, net of unearned fees		455,369			466,862
Allowance for loan losses		(9,538	)		(9,576	)
Net loans		445,831			457,286

Federal Home Loan Bank stock		4,080			4,430
Cash surrender value of life insurance		10,606			10,428
Premises and equipment, net		23,307			23,773
Real estate owned:
Acquired through foreclosure, net of valuation allowance of $1,039 Jun (2014) and $581 Dec (2013)		11,243			11,657
Bank lots		1,446			1,469
Other repossessed assets		5			37
Accrued interest receivable		1,752			2,224
Accrued income taxes		3			2,907
Low-income housing investments		6,834			6,965
Other assets		1,134			1,701

TOTAL ASSETS	$	802,321		$	858,617

LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Deposits:
Non-interest bearing	$	89,196		$	78,480
Interest bearing		634,427			705,007
Total deposits		723,623			783,487

Advances from Federal Home Loan Bank		12,320			12,389
Subordinated debentures		18,000			18,000
Accrued interest payable		5,160			4,574
Accrued senior preferred dividend		4,257			3,380
Accounts payable and other liabilities		4,087			3,968

TOTAL LIABILITIES		767,447			825,798

Commitments and contingent liabilities		-			-

STOCKHOLDERS' EQUITY:
Serial preferred stock, $1 par value per share; authorized 5,000,000 shares; issued and outstanding, 20,000 shares with a liquidation preference of $24.3 million June (2014), and $23.5 million Dec (2013)		20,000			19,997
Common stock, $1 par value per share; authorized 35,000,000 shares; issued and outstanding, 5,145,356 shares June (2014), and 4,870,887 shares Dec (2013)		5,145			4,871
Additional paid-in capital		36,978			36,230
Accumulated deficit		(20,661	)		(17,711	)
Accumulated other comprehensive loss		(6,588	)		(10,568	)

TOTAL STOCKHOLDERS' EQUITY		34,874			32,819
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	802,321		$	858,617

See notes to the unuaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Operations

(Unaudited)

	Three Months Ended						Six Months Ended
(Amounts in thousands, except per share data)	June 30,						June 30,
	2014			2013			2014			2013
Interest Income:
Loans, including fees	$	5,627		$	6,603		$	11,380		$	13,421
Taxable securities		1,308			1,541			2,769			3,198
Tax exempt securities		32			67			64			132
Total interest income		6,967			8,211			14,213			16,751

Interest Expense:
Deposits		1,143			1,774			2,416			3,910
Federal Home Loan Bank advances		139			132			275			264
Subordinated debentures		251			341			592			682
Total interest expense		1,533			2,247			3,283			4,856

Net interest income		5,434			5,964			10,930			11,895
Provision for loan losses		100			212			100			(825	)
Net interest income after provision for loan losses		5,334			5,752			10,830			12,720

Non-interest Income:
Customer service fees on deposit accounts		1,350			1,307			2,600			2,498
Gain on sale of mortgage loans		101			161			160			588
Gain on sale of investments		384			334			532			843
Loss on sale of investments		(356	)		(334	)		(567	)		(616	)
Loss on sale and write downs on real estate acquired through foreclosure		(496	)		(532	)		(501	)		(1,592	)
Gain on sale on real estate acquired through foreclosure		1			150			30			207
Other income		510			600			1,033			1,212
Total non-interest income		1,494			1,686			3,287			3,140

Non-interest Expense:
Employee compensation and benefits		4,194			3,757			7,735			7,550
Office occupancy expense and equipment		696			690			1,389			1,398
Outside services and data processing		941			941			1,917			1,804
Bank franchise tax		279			315			594			630
FDIC insurance premiums		454			505			920			1,194
Real estate acquired through foreclosure expense		690			524			776			818
Loan expense		380			385			565			607
Other expense		2,042			1,446			3,258			2,862
Total non-interest expense		9,676			8,563			17,154			16,863

Income (loss) before income taxes		(2,848	)		(1,125	)		(3,037	)		(1,003	)
Income tax expense (benefit)		(879	)		1			(967	)		1
Net Income (Loss)		(1,969	)		(1,126	)		(2,070	)		(1,004	)
Less:
Dividends on preferred stock		(427	)		(250	)		(877	)		(500	)
Accretion on preferred stock		-			(13	)		(3	)		(27	)
Net income (loss) attributable to common shareholders	$	(2,396	)	$	(1,389	)	$	(2,950	)	$	(1,531	)

Shares applicable to basic income (loss) per common share		4,973,513			4,806,444			4,931,837			4,797,259
Basic income (loss) per common share	$	(0.48	)	$	(0.29	)	$	(0.60	)	$	(0.32	)

Shares applicable to diluted income (loss)per common share		4,973,513			4,806,444			4,931,837			4,797,259
Diluted income (loss) per common share	$	(0.48	)	$	(0.29	)	$	(0.60	)	$	(0.32	)

Cash dividends declared per common share	$	-		$	-		$	-		$	-

See notes to the unuaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Comprehensive Income/(Loss)

(Unaudited)

	Three Months Ended						Six Months Ended
(Dollars in thousands)	June 30,						June 30,
	2014			2013			2014			2013
Net Income/(Loss)	$	(1,969	)	$	(1,126	)	$	(2,070	)	$	(1,004	)
Other comprehensive income (loss):
Change in unrealized gain (loss) on securities available-for-sale		2,263			(7,378	)		4,913			(8,328	)
Reclassification of realized amount on securities available-for-sale losses (gains)		(28	)		-			35			(227	)
Net unrealized gain (loss) recognized in comprehensive income		2,235			(7,378	)		4,948			(8,555	)
Tax effect		(880	)		-			(968	)		-
Total other comphrehensive income (loss)		1,355			(7,378	)		3,980			(8,555	)

Comprehensive Income/(Loss)	$	(614	)	$	(8,504	)	$	1,910		$	(9,559	)

See notes to the unaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Changes in Stockholders' Equity

Six Months Ended June 30, 2014

(Dollars In Thousands, Except Per Share Amounts)

(Unaudited)

	Shares				Amount				Additional Paid-in			Accumulated			Accumulated Other Comprehensive Income (Loss),
	Preferred		Common		Preferred		Common		Capital			Deficit			Net of Tax			Total

Balance, January 1, 2014		20,000		4,870,887	$	19,997	$	4,871	$	36,230		$	(17,711	)	$	(10,568	)	$	32,819
Net loss		-		-		-		-		-			(2,070	)		-			(2,070	)
Stock issued for stock options exercised and employee benefit plans		-		11,756		-		12		21			-			-			33
Issuance of restricted shares		-		262,713		-		262		(262	)		-			-			-
Stock-based compensation expense		-		-		-				989			-			-			989
Total other comprehensive income (loss)		-		-		-		-		-			-			3,980			3,980
Dividends on preferred stock		-		-		-		-		-			(877	)		-			(877	)
Accretion of preferred stock discount		-		-		3		-		-			(3	)		-			-
Balance, June 30, 2014		20,000		5,145,356	$	20,000	$	5,145	$	36,978		$	(20,661	)	$	(6,588	)	$	34,874

See notes to the unaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Cash Flows

(Dollars In Thousands)

(Unaudited)

	Six Months Ended
	June 30,
	2014			2013
Operating Activities:
Net (loss)	$	(2,070	)	$	(1,004	)
Adjustments to reconcile net income/(loss) to net cash provided by operating activities:
Provision for loan losses		100			(825	)
Depreciation on premises and equipment		660			746
Change in real estate acquired through foreclosure valuation allowance		458			221
Loss on low-income housing investments		131			264
Net amortization (accretion) available-for-sale		1,048			3,898
Loss on sale of investments available-for-sale		567			616
Gain on sale of investments available-for-sale		(532	)		(843	)
Gain on sale of mortgage loans		(160	)		(588	)
Gain on sale of real estate acquired through foreclosure		(30	)		(207	)
Loss on sale of real estate acquired through foreclosure		2			-
Write-downs on real estate acquired through foreclosure		499			1,270
Origination of loans held for sale		(10,925	)		(34,589	)
Proceeds on sale of loans held for sale		10,242			35,469
Stock-based compensation expense		989			260
Changes in:
Cash surrender value of life insurance		(178	)		(184	)
Interest receivable		472			300
Other assets		654			179
Interest payable		675			677
Accrued income tax		2,904			21
Accounts payable and other liabilities		(938	)		362
Net cash from operating activities		4,568			6,043

Investing Activities:
Sales of securities available-for-sale		73,081			101,056
Purchases of securities available-for-sale		(26,546	)		(92,922	)
Maturities of securities available-for-sale		14,381			24,639
Net change in loans		10,274			31,802
Redemption of Federal Home Loan Bank stock		350			375
Investment in low-income housing projects		-			(24	)
Net purchases of premises and equipment		(171	)		(440	)
Proceeds from sales of real estate acquired through foreclosure		511			8,577
Net cash from investing activities		71,880			73,063

Financing Activities
Net change in deposits		(59,864	)		(124,243	)
Advance from Federal Home Loan Bank		-			10,000
Repayments to Federal Home Loan Bank		(69	)		(70	)
Issuance of common stock for employee benefit plans and exercise of stock options		33			-29
Net cash from financing activities		(59,900	)		(114,284	)

Increase (decrease) in cash and cash equivalents		16,548			(35,178	)
Cash and cash equivalents, beginning of period		65,988			63,103
Cash and cash equivalents, end of period	$	82,536		$	27,925

Supplemental disclosures
Cash Paid (Received) for:
Interest expense	$	2,697		$	4,179
Income taxes	$	(2,902	)	$	(19	)

Supplemental noncash disclosures:
Transfers from loans to real estate acquired through foreclosure and repossessed assets	$	1,081		$	2,036
Loans to facilitate sales of real estate owned and repossessed assets	$	-		$	82
Dividends accrued not paid on preferred stock	$	877		$	500

See notes to the unaudited consolidated financial statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation (the “Corporation”) and its wholly owned subsidiary, First Federal Savings Bank (the “Bank”). First Federal Savings Bank has two wholly owned subsidiaries, First Service Corporation of Elizabethtown and Heritage Properties, LLC. Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its wholly owned subsidiary, collectively referred to as the “Company”. All significant intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the quarter and six months ended June 30, 2014 are not necessarily indicative of the results that may occur for the year ending December 31, 2014. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2013.

Reclassifications – Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year operations or stockholders’ equity.

Recently Issued Accounting Pronouncement – In January 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects (ASU 2014-01). ASU 2014-01 permits reporting entities to make an accounting policy election to account for investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense. This new guidance also requires new disclosures for all investors in these projects. ASU 2014-01 is effective for interim and annual reporting periods beginning after December 15, 2014. Upon adoption, the guidance must be applied retrospectively to all periods presented. However, entities that use the effective yield method to account for investments in these projects before adoption may continue to do so for these pre-existing investments. The adoption of ASU 2014-01 is not expected to have a material impact on the consolidated financial statements.

In January 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-04, Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40) – Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (ASU 2014-04). ASU 2014-04 provides clarification when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan should be removed from the balance sheet and other real estate owned recognized. These amendments clarify that when an in-substance foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan upon either: (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure, or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. ASU 2014-04 is effective for interim and annual reporting periods beginning after Dec 15, 2014. Early adoption is permitted. The adoption of ASU 2014-04 is not expected to have a material impact on the consolidated financial statements.

In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, Revenue From Contracts With Customers (ASU 2014-09). The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. ASU 2014-09 is effective for interim and annual periods beginning after December 15, 2016. Management is currently evaluating the impact of the adoption of ASU 2014-09 on the consolidated financial statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES –(Continued)

In June 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-12 Compensation - Stock Compensation (Topic 718) - Accounting for Share Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period (ASU 2014-12). ASU 2014-12 requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. ASU 2014-12 is effective for interim and annual periods beginning after December 15, 2015. The amendments can be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented and to all new or modified awards thereafter. Early adoption is permitted. The adoption of ASU 2014-12 is not expected to have a material impact on the consolidated financial statements.

REGULATORY MATTERS

Since January 2011, the Bank has operated under Consent Orders with the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”). The initial Consent Order required the Bank to achieve a total capital to risk-weighted assets ratio of 12% and a Tier 1 capital to average total assets ratio of 9%. It also prohibited the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and has required the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. When the Bank entered into a new Consent Order with the FDIC and KDFI in March 2012, it agreed that should it be unable to reach the required capital levels by June 30, 2012, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date, the Bank has not received such a written direction. The latest Consent Order also includes the same substantive provisions as the initial Consent Order and requires the Bank to continue to adhere to the plans implemented in response to the initial Consent Order.

Copies of the Consent Orders are included as exhibits to our Form 8−K filed on January 27, 2011 and our 2011 Annual Report on Form 10-K filed March 30, 2012.

In April 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval.

The Consent Order and the formal agreement will remain in effect until modified or terminated by the FDIC, KDFI and Federal Reserve Bank of St. Louis.

At June 30, 2014, the Bank’s Tier 1 capital ratio was 8.46% and the total risk-based capital ratio was 14.93% compared to the minimum 9.00% and 12.00% capital ratios required by the Consent Order. Our comparable ratios at December 31, 2013 were 7.96% and 13.48%, respectively. For the seventh consecutive quarter, we have achieved and maintained the required total risk-based capital ratio. Our Tier 1 capital ratio also improved, but has yet to reach the Consent Order minimum. We continue to evaluate strategies to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the Consent Order.

The Bank is currently designated as a "troubled institution,” which status prohibits the Bank from accepting, renewing or rolling over brokered deposits and restricts the amount of interest the Bank may pay on deposits. Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates .75% above the average rates computed by the FDIC. The Bank has elected not to pursue such a waiver and to adhere to the average rates computed by the FDIC plus the .75% rate cap. Brokered deposits were $22.7 million at June 30, 2014, decreasing by $4.6 million from $27.3 million at December 31, 2013.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

REGULATORY MATTERS – (Continued)

Bank regulatory agencies have discretion when an institution does not meet the terms of a regulatory order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any material failure to comply with our regulatory orders would likely result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business.

On April 21, 2014, we entered into an Agreement and Plan of Share Exchange (the “Agreement”) with Community Bank Shares of Indiana, Inc. (“CBIN”), whereby CBIN will acquire all of the outstanding shares of our common stock pursuant to a statutory share exchange (the “Share Exchange”). It is anticipated that immediately following the Share Exchange, the Corporation will merge into CBIN and the Bank will merge into Your Community Bank, an Indiana chartered commercial bank and wholly owned subsidiary of CBIN (with Your Community Bank as the surviving bank).

The consummation of the Share Exchange is subject to various customary conditions, including receipt of the requisite regulatory approvals and the approval by the shareholders of the Corporation and of CBIN. The parties anticipate completing the Share Exchange in the fourth quarter of 2014. See “Proposed Share Exchange” in the Management’s Discussion and Analysis section of this 10-Q for additional information.

Our plans for 2014 include the following:

Continuing to work towards the completion of the merger and Share Exchange with CBIN.

Continuing to address all requirements of our Consent Order and formal agreement.

Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise.

Continuing to reduce expenses and improve our ability to operate in a profitable manner.

Continuing to reduce our lending concentration in commercial real estate through expected maturities and repayments.

Accelerating our efforts to dispose of problem assets.

Continuing to reduce our inventory of other real estate owned properties.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

SECURITIES

The amortized cost basis and fair values of securities are as follows:

			Gross		Gross
(Dollars in thousands)	Amortized		Unrealized		Unrealized
	Cost		Gains		Losses			Fair Value
Securities available-for-sale:
June 30, 2014:
Government-sponsored collateralized mortgage obligations	$	86,661	$	140	$	(1,904	)	$	84,897
Government-sponsored mortgage-backed residential		83,117		34		(1,631	)		81,520
Asset backed-collateralized loan obligations		14,848		33		(422	)		14,459
Corporate bonds		12,726		213		(15	)		12,924
State and municipal		8,841		476		(8	)		9,309
U.S. Government-sponsored agencies		6,035		1		(4	)		6,032
Commercial mortgage backed		3,065		25		-			3,090

Total	$	215,293	$	922	$	(3,984	)	$	212,231

Securities available-for-sale:
December 31, 2013:
Government-sponsored collateralized mortgage obligations	$	104,390	$	86	$	(3,660	)	$	100,816
Government-sponsored mortgage-backed residential		78,204		4		(3,884	)		74,324
Corporate bonds		43,818		208		(328	)		43,698
Asset backed-collateralized loan obligations		35,113		-		(635	)		34,478
State and municipal		11,670		264		(11	)		11,923
Commercial mortgage backed		4,097		-		(54	)		4,043

Total	$	277,292	$	562	$	(8,572	)	$	269,282

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

SECURITIES – (Continued)

The amortized cost and fair value of securities at June 30, 2014, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.

	Available for Sale
	Amortized		Fair
(Dollars in thousands)	Cost		Value

Due in one year or less	$	855	$	855
Due after one year through five years		14,556		14,737
Due after five years through ten years		5,796		5,853
Due after ten years		6,395		6,820
Investment securities with no single maturity date:
Government-sponsored collateralized mortgage obligations		86,661		84,897
Government-sponsored mortgage-backed residential		83,117		81,520
Asset backed-collateralized loan obligations		14,848		14,459
Commercial mortgage backed		3,065		3,090
	$	215,293	$	212,231

The following schedule shows the proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2014		2013		2014		2013
(Dollars in thousands)

Proceeds from sales	$	36,955	$	25,520	$	73,081	$	101,056
Gross realized gains		384		334		532		843
Gross realized losses		356		334		567		616

Investment securities pledged to secure public deposits and Federal Home Loan Bank (FHLB) advances had an amortized cost of $150.3 million and fair value of $147.4 million at June 30, 2014 and a $193.0 million amortized cost and fair value of $185.8 million at December 31, 2013.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

SECURITIES – (Continued)

Securities with unrealized losses at June 30, 2014 and December 31, 2013 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

June 30, 2014	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss

Government-sponsored collateralized mortgage obligations	$	32,298	$	(259	)	$	37,444	$	(1,645	)	$	69,742	$	(1,904	)
Government-sponsored mortgage-backed residential		8,037		(26	)		67,217		(1,605	)		75,254		(1,631	)
Asset backed-collateralized loan obligations		13,571		(422	)		-		-			13,571		(422	)
Corporate bonds		2,005		(15	)		-		-			2,005		(15	)
State and municipal		307		(1	)		513		(7	)		820		(8	)
U.S. Government-sponsored agencies		5,048		(4	)		-		-			5,048		(4	)

Total temporarily impaired	$	61,266	$	(727	)	$	105,174	$	(3,257	)	$	166,440	$	(3,984	)

December 31, 2013	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss

Government-sponsored collateralized mortgage obligations	$	59,168	$	(2,119	)	$	20,560	$	(1,541	)	$	79,728	$	(3,660	)
Government-sponsored mortgage-backed residential		59,971		(2,864	)		13,215		(1,020	)		73,186		(3,884	)
Corporate bonds		17,578		(328	)		-		-			17,578		(328	)
Asset backed-collateralized loan obligations		34,478		(635	)		-		-			34,478		(635	)
State and municipal		1,865		(11	)		-		-			1,865		(11	)
Commercial mortgage backed		4,043		(54	)		-		-			4,043		(54	)

Total temporarily impaired	$	177,103	$	(6,011	)	$	33,775	$	(2,561	)	$	210,878	$	(8,572	)

We evaluate investment securities with significant declines in fair value on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation, to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary.

In conducting this assessment, the Bank evaluates a number of factors including, but not limited to:

The length of time and the extent to which fair value has been less than the amortized cost basis;

The Bank’s intent to hold until maturity or sell the debt security prior to maturity;

An analysis of whether it is more likely than not that the Bank will be required to sell the debt security before its anticipated recovery;

Adverse conditions specifically related to the security, an industry, or a geographic area;

The historical and implied volatility of the fair value of the security;

The payment structure of the security and the likelihood of the issuer being able to make payments;

Failure of the issuer to make scheduled interest or principal payments;

Any rating changes by a rating agency; and

Recoveries or additional decline in fair value subsequent to the balance sheet date.

Accounting guidance requires entities to split other than temporary impairment charges between credit losses (i.e., the loss based on the entity’s estimate of the decrease in cash flows, including those that result from expected voluntary prepayments), which are charged to earnings, and the remainder of the impairment charge (non-credit component) to accumulated other comprehensive income. This requirement pertains to both debt securities held to maturity and debt securities available for sale.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

SECURITIES – (Continued)

The unrealized losses on our investment securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities. Mortgage backed securities held in our investment portfolio were issued by U.S. government-sponsored entities and agencies, primarily Freddie Mac (“FHLMC”) and Fannie Mae (“FNMA”), institutions that the government has affirmed its commitment to support. Because the decline in market value on our investment securities is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at June 30, 2014.

At June 30, 2014, we own five collateralized loan obligation (“CLO”) securities subject to the Volcker Rule, with an amortized cost of $14.8 million and a net unrealized loss of $389,000. Absent changes to the Volcker Rule, we would be required to dispose of these securities before July 2017. We believe the unrealized loss reflected results not from credit risk but from interest rate changes and to the uncertainty created by the Volcker Rule. In the first quarter of 2014, we sold four of our CLOs and in the second quarter of 2014 we recorded partial sales on three of our CLOs to confirm their marketability and evaluate our assessment about their market values. We recorded a loss of $286,000 on these sales.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS

Loans are summarized as follows:

	June 30,			December 31,
(Dollars in thousands)	2014			2013

Commercial Real Estate:
Other	$	249,727		$	257,901
Land Development		16,636			20,476
Building Lots		1,480			1,559
Residential mortgage		98,566			99,344
Consumer and home equity		51,473			54,010
Commercial		24,479			20,621
Indirect consumer		13,075			13,041
		455,436			466,952
Less:
Net deferred loan origination fees		(67	)		(90	)
Allowance for loan losses		(9,538	)		(9,576	)
		(9,605	)		(9,666	)

Net Loans	$	445,831		$	457,286

The following tables present the activity in the allowance for loan losses by portfolio segment for the three months ending June 30, 2014 and 2013:

Three Months Ended
June 30, 2014			Commercial			Residential			Consumer &			Indirect
	Commercial		Real Estate			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	549	$	8,378		$	291		$	317		$	73		$	9,608
Provision for loan losses		38		120			-			(20	)		(38	)		100
Charge-offs		-		(268	)		(15	)		(16	)		(10	)		(309	)
Recoveries		25		58			12			15			29			139
Total ending allowance balance	$	612	$	8,288		$	288		$	296		$	54		$	9,538

Six Months Ended
June 30, 2014			Commercial			Residential			Consumer &			Indirect
	Commercial		Real Estate			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	540	$	8,358		$	292		$	309		$	77		$	9,576
Provision for loan losses		38		120			-			(20	)		(38	)		100
Charge-offs		-		(302	)		(19	)		(24	)		(44	)		(389	)
Recoveries		34		112			15			31			59			251
Total ending allowance balance	$	612	$	8,288		$	288		$	296		$	54		$	9,538

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

Three Months Ended
June 30, 2013				Commercial			Residential		Consumer &			Indirect
	Commercial			Real Estate			Mortgage		Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	914		$	13,866		$	371	$	438		$	223		$	15,812
Provision for loan losses		(10	)		229			-		(14	)		7			212
Charge-offs		-			(61	)		-		(51	)		(41	)		(153	)
Recoveries		4			20			4		23			25			76
Total ending allowance balance	$	908		$	14,054		$	375	$	396		$	214		$	15,947

Six Months Ended
June 30, 2013				Commercial			Residential			Consumer &			Indirect
	Commercial			Real Estate			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,236		$	14,815		$	501		$	442		$	271		$	17,265
Provision for loan losses		(272	)		(385	)		(130	)		23			(61	)		(825	)
Charge-offs		(94	)		(452	)		-			(98	)		(57	)		(701	)
Recoveries		38			76			4			29			61			208
Total ending allowance balance	$	908		$	14,054		$	375		$	396		$	214		$	15,947

We did not implement any significant changes to our allowance related accounting policies or methodology during the current period.

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of June 30, 2014 and 2013 and December 31, 2013:

June 30, 2014			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	139	$	3,014	$	4	$	2	$	-	$	3,159
Collectively evaluated for impairment		473		5,274		284		294		54		6,379

Total ending allowance balance	$	612	$	8,288	$	288	$	296	$	54	$	9,538

Loans:
Loans individually evaluated for impairment	$	724	$	30,097	$	2,625	$	401	$	-	$	33,847
Loans collectively evaluated for impairment		23,755		237,746		95,941		51,072		13,075		421,589

Total ending loans balance	$	24,479	$	267,843	$	98,566	$	51,473	$	13,075	$	455,436

December 31, 2013			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	148	$	2,603	$	3	$	32	$	-	$	2,786
Collectively evaluated for impairment		392		5,755		289		277		77		6,790

Total ending allowance balance	$	540	$	8,358	$	292	$	309	$	77	$	9,576

Loans:
Loans individually evaluated for impairment	$	803	$	32,911	$	3,051	$	546	$	-	$	37,311
Loans collectively evaluated for impairment		19,818		247,025		96,293		53,464		13,041		429,641

Total ending loans balance	$	20,621	$	279,936	$	99,344	$	54,010	$	13,041	$	466,952

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

June 30, 2013			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	184	$	6,851	$	31	$	81	$	-	$	7,147
Collectively evaluated for impairment		724		7,203		344		315		214		8,800

Total ending allowance balance	$	908	$	14,054	$	375	$	396	$	214	$	15,947

Loans:
Loans individually evaluated for impairment	$	1,213	$	35,731	$	3,418	$	664	$	-	$	41,026
Loans collectively evaluated for impairment		15,817		268,097		98,863		53,785		13,087		449,649

Total ending loans balance	$	17,030	$	303,828	$	102,281	$	54,449	$	13,087	$	490,675

The following tables’ present loans individually evaluated for impairment by class of loans as of June 30, 2014 and 2013 and December 31, 2013. The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits. The recorded investment and average recorded investment in loans excludes accrued interest receivable and loan origination fees.

							Three Months Ended						Six Months Ended
							June 30, 2014						June 30, 2014
June 30, 2014	Unpaid				Allowance for		Average		Interest		Cash Basis		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest		Recorded		Income		Interest
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized		Investment		Recognized		Recognized

With no related allowance recorded:
Commercial	$	622	$	410	$	-	$	444	$	3	$	3	$	454	$	6	$	6
Commercial Real Estate:
Land Development		1,325		1,325		-		1,382		7		7		1,584		15		15
Building Lots		477		212		-		212		-		-		212		-		-
Other		23,462		19,464		-		20,363		190		190		20,863		403		403
Residential Mortgage		2,558		2,468		-		2,730		18		18		2,817		35		35
Consumer and Home Equity		420		380		-		391		4		4		420		7		7
Indirect Consumer		-		-		-		-		-		-		-		-		-

With an allowance recorded:
Commercial		314		314		139		318		2		2		321		4		4
Commercial Real Estate:
Land Development		2,206		2,198		1,573		2,202		10		10		2,203		22		22
Building Lots		-		-		-		-		-		-		-		-		-
Other		6,914		6,898		1,441		7,205		67		67		7,017		136		136
Residential Mortgage		157		157		4		108		1		1		92		1		1
Consumer and Home Equity		21		21		2		45		-		-		52		1		1
Indirect Consumer		-		-		-		-		-		-		-		-		-

Total	$	38,476	$	33,847	$	3,159	$	35,400	$	302	$	302	$	36,035	$	630	$	630

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

December 31, 2013	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized

With no related allowance recorded:
Commercial	$	679	$	475	$	-	$	747	$	21	$	21
Commercial Real Estate:
Land Development		2,014		1,989		-		2,898		139		139
Building Lots		477		212		-		212		-		-
Other		25,441		21,864		-		17,934		754		754
Residential Mortgage		3,119		2,992		-		2,368		63		63
Consumer and Home Equity		478		478		-		330		10		10
Indirect Consumer		-		-		-		-		-		-

With an allowance recorded:
Commercial		328		328		148		314		9		9
Commercial Real Estate:
Land Development		2,206		2,206		1,581		2,538		121		121
Building Lots		-		-		-		-		-		-
Other		6,640		6,640		1,022		16,512		694		694
Residential Mortgage		59		59		3		312		8		8
Consumer and Home Equity		68		68		32		229		7		7
Indirect Consumer		-		-		-		-		-		-

Total	$	41,509	$	37,311	$	2,786	$	44,394	$	1,826	$	1,826

							Three Months Ended						Six Months Ended
							June 30, 2013						June 30, 2013
June 30, 2013	Unpaid				Allowance for		Average		Interest		Cash Basis		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest		Recorded		Income		Interest
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized		Investment		Recognized		Recognized

With no related allowance recorded:
Commercial	$	1,234	$	1,028	$	-	$	850	$	6	$	6	$	763	$	10	$	10
Commercial Real Estate:
Land Development		2,336		2,311		-		2,716		33		33		3,435		84		84
Building Lots		477		212		-		212		-		-		212		-		-
Other		11,042		9,880		-		9,785		99		99		12,023		239		239
Residential Mortgage		2,941		2,941		-		1,691		6		6		3,162		53		53
Consumer and Home Equity		395		395		-		210		1		1		407		7		7
Indirect Consumer		-		-		-		-		-		-		-		-		-

With an allowance recorded:
Commercial		185		185		184		189		1		1		287		4		4
Commercial Real Estate:
Land Development		2,930		2,930		961		2,802		35		35		2,759		67		67
Building Lots		-		-		-		-		-		-		-		-		-
Other		22,609		20,398		5,890		20,350		215		215		19,984		412		412
Residential Mortgage		477		477		31		399		2		2		337		6		6
Consumer and Home Equity		269		269		81		312		1		1		271		5		5
Indirect Consumer		-		-		-		-		-		-		-		-		-

Total	$	44,895	$	41,026	$	7,147	$	39,516	$	399	$	399	$	43,640	$	887	$	887

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

The following tables present the recorded investment in restructured, non-accrual and loans past due over 90 days still on accrual by class of loans as of June 30, 2014 and December 31, 2013.

					Restructured
					Loans Past Due		Loans Past Due
June 30, 2014					Over 90 Days		Over 90 Days		Non-Accrual
	Restructured on		Restructured on		Still		Still		Excluding
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Accruing		Restructured

Commercial	$	-	$	161	$	-	$	-	$	364
Commercial Real Estate:
Land Development		-		1,325		-		-		2,198
Building Lots		-		-		-		-		212
Other		5,493		16,189		-		-		3,135
Residential Mortgage		299		-		-		-		1,112
Consumer and Home Equity		-		71		-		-		139
Indirect Consumer		-		-		-		-		11

Total	$	5,792	$	17,746	$	-	$	-	$	7,171

					Restructured
					Loans Past Due		Loans Past Due
December 31, 2013					Over 90 Days		Over 90 Days		Non-Accrual
	Restructured on		Restructured on		Still		Still		Excluding
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Accruing		Restructured

Commercial	$	-	$	178	$	-	$	-	$	421
Commercial Real Estate:
Land Development		-		1,687		-		-		2,508
Building Lots		-		-		-		-		212
Other		986		17,025		4,780		2,226		4,237
Residential Mortgage		301		-		-		-		1,532
Consumer and Home Equity		23		73		-		-		156
Indirect Consumer		-		-		-		-		30

Total	$	1,310	$	18,963	$	4,780	$	2,226	$	9,096

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

The following tables present the aging of the unpaid principal in past due loans as of June 30, 2014 and December 31, 2013 by class of loans:

June 30, 2014	30-59		60-89		Greater than
	Days		Days		90 Days		Total		Loans Not
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Past Due		Total

Commercial	$	-	$	-	$	364	$	364	$	24,115	$	24,479
Commercial Real Estate:
Land Development		-		-		2,198		2,198		14,438		16,636
Building Lots		-		-		212		212		1,268		1,480
Other		8,297		969		8,628		17,894		231,833		249,727
Residential Mortgage		393		702		274		1,369		97,197		98,566
Consumer and Home Equity		173		67		91		331		51,142		51,473
Indirect Consumer		207		21		11		239		12,836		13,075

Total	$	9,070	$	1,759	$	11,778	$	22,607	$	432,829	$	455,436

December 31, 2013	30-59		60-89		Greater than
	Days		Days		90 Days		Total		Loans Not
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Past Due		Total

Commercial	$	-	$	-	$	421	$	421	$	20,200	$	20,621
Commercial Real Estate:
Land Development		-		-		2,508		2,508		17,968		20,476
Building Lots		-		-		212		212		1,347		1,559
Other		5,250		6,213		11,236		22,699		235,202		257,901
Residential Mortgage		1,446		511		1,053		3,010		96,334		99,344
Consumer and Home Equity		430		23		117		570		53,440		54,010
Indirect Consumer		211		55		22		288		12,753		13,041

Total	$	7,337	$	6,802	$	15,569	$	29,708	$	437,244	$	466,952

Troubled Debt Restructurings:

We have allocated $1.4 million and $1.1 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of June 30, 2014 and December 31, 2013. We are not committed to lend additional funds to debtors whose loans have been modified in a troubled debt restructuring. Specific reserves are generally assessed prior to loans being modified as a TDR, as most of these loans migrate from our internal watch list and have been specifically reserved for as part of our normal reserving methodology.

During the quarter and six month periods ending June 30, 2014, no new loans were modified as troubled debt restructurings. Prior to the 2014 period, the terms of certain loans were modified as troubled debt restructurings and the modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.

Modifications involving a reduction of the stated interest rate of the loan were for periods ranging from six months to one year. Modifications involving an extension of the maturity date were for periods ranging from three to six months.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

The following table presents loans by class modified as troubled debt restructurings that occurred during the periods ending June 30, 2014 and 2013:

	Three Months Ended						Three Months Ended
	June 30, 2014						June 30, 2013
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
			Outstanding		Outstanding				Outstanding		Outstanding
	Number		Recorded		Recorded		Number		Recorded		Recorded
(Dollars in thousands)	of Loans		Investment		Investment		of Loans		Investment		Investment

Troubled Debt Restructurings:
Commercial		-	$	-	$	-		-	$	-	$	-
Commercial Real Estate:
Land Development		-		-		-		-		-		-
Building Lots		-		-		-		-		-		-
Other		-		-		-		2		1,392		1,392
Residential Mortgage		-		-		-		-		-		-
Consumer and Home Equity		-		-		-		1		53		53
Indirect Consumer		-		-		-		-		-		-

Total		-	$	-	$	-		3	$	1,445	$	1,445

	Six Months Ended						Six Months Ended
	June 30, 2014						June 30, 2013
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
			Outstanding		Outstanding				Outstanding		Outstanding
	Number		Recorded		Recorded		Number		Recorded		Recorded
(Dollars in thousands)	of Loans		Investment		Investment		of Loans		Investment		Investment

Troubled Debt Restructurings:
Commercial		-	$	-	$	-		-	$	-	$	-
Commercial Real Estate:
Land Development		-		-		-		-		-		-
Building Lots		-		-		-		-		-		-
Other		-		-		-		5		3,534		3,534
Residential Mortgage		-		-		-		-		-		-
Consumer and Home Equity		-		-		-		2		76		76
Indirect Consumer		-		-		-		-		-		-

Total		-	$	-	$	-		7	$	3,610	$	3,610

The troubled debt restructurings described above increased the allowance for loan losses allocated to troubled debt restructurings by $0 for the three and six months ended June 30, 2014. The troubled debt restructurings described above resulted in a reversal of provision for loan losses allocated to troubled debt restructurings of $11,000 and $164,000 for the three and six months ended June 30, 2013 Typically, these loans had allocated allowance prior to their formal modification. There were no charge-offs recorded on the troubled debt restructurings described above for the 2014 and 2013 periods.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the periods ending June 30, 2014 and 2013:

	Three Months Ended				Three Months Ended
	June 30, 2014				June 30, 2013
	Number		Recorded		Number		Recorded
(Dollars in thousands)	of Loans		Investment		of Loans		Investment

Troubled Debt Restructurings:
Commercial		-	$	-		-	$	-
Commercial Real Estate:
Land Development		-		-		-		-
Building Lots		-		-		-		-
Other		1		806		-		-
Residential Mortgage		-		-		-		-
Consumer and Home Equity		-		-		-		-
Indirect Consumer		-		-		-		-

Total		1	$	806		-	$	-

	Six Months Ended				Six Months Ended
	June 30, 2014				June 30, 2013
	Number		Recorded		Number		Recorded
(Dollars in thousands)	of Loans		Investment		of Loans		Investment

Troubled Debt Restructurings:
Commercial		-	$	-		-	$	-
Commercial Real Estate:
Land Development		-		-		-		-
Building Lots		-		-		-		-
Other		1		806		-		-
Residential Mortgage		-		-		-		-
Consumer and Home Equity		-		-		-		-
Indirect Consumer		-		-		-		-

Total		1	$	806		-	$	-

For disclosure purposes, a loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $0 for the three and six months ended June 30, 2014. The troubled debt restructurings described above resulted in charge-offs of $0 for the three and six month periods ended June 30, 2014. We did not have any troubled debt restructurings for which there was a payment default within twelve months following the modification during the June 30, 2013 three and six month periods.

Credit Quality Indicators:

We categorize loans 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. We analyze loans individually by classifying the loans as to credit risk. This analysis includes commercial and commercial real estate loans. We also evaluate credit quality on residential mortgage, consumer and home equity and indirect consumer loans based on the aging status and payment activity of the loan. This analysis is performed on a monthly basis. We use the following definitions for risk ratings:

Criticized: Loans classified as criticized have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in our credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS – (Continued)

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss: Loans classified as loss are considered non-collectible and their continuance as bankable assets is not warranted.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Loans listed as not rated are included in groups of homogeneous loans. For our residential mortgage, consumer and home equity, and indirect consumer homogeneous loans, we also evaluate credit quality based on the aging status of the loan, which was previously presented, and by payment activity.

As of June 30, 2014 and December 31, 2013, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

June 30, 2014
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total

Commercial	$	-	$	23,231	$	462	$	786	$	-	$	-	$	24,479
Commercial Real Estate:
Land Development		-		12,218		2,212		2,206		-		-		16,636
Building Lots		-		861		407		212		-		-		1,480
Other		-		212,732		9,708		27,287		-		-		249,727
Residential Mortgage		95,045		-		896		2,625		-		-		98,566
Consumer and Home Equity		50,986		-		114		373		-		-		51,473
Indirect Consumer		13,036		-		-		39		-		-		13,075

Total	$	159,067	$	249,042	$	13,799	$	33,528	$	-	$	-	$	455,436

December 31, 2013
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total

Commercial	$	-	$	19,289	$	470	$	862	$	-	$	-	$	20,621
Commercial Real Estate:
Land Development		-		15,484		2,484		2,508		-		-		20,476
Building Lots		-		906		441		212		-		-		1,559
Other		-		213,719		13,920		30,262		-		-		257,901
Residential Mortgage		95,351		-		942		3,051		-		-		99,344
Consumer and Home Equity		53,407		-		72		531		-		-		54,010
Indirect Consumer		12,988		-		-		53		-		-		13,041

Total	$	161,746	$	249,398	$	18,329	$	37,479	$	-	$	-	$	466,952

The following table presents the unpaid principal balance in residential mortgage, consumer and home equity and indirect consumer loans based on payment activity as of June 30, 2014 and December 31, 2013:

June 30, 2014	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer

Performing	$	97,155	$	51,334	$	13,064
Restructured on non-accrual		299		-		-
Non-accrual		1,112		139		11

Total	$	98,566	$	51,473	$	13,075

December 31, 2013	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer

Performing	$	97,511	$	53,831	$	13,011
Restructured on non-accrual		301		23		-
Non-accrual		1,532		156		30

Total	$	99,344	$	54,010	$	13,041

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

REAL ESTATE ACQUIRED THROUGH FORECLOSURE

A summary of the real estate acquired through foreclosure activity is as follows:

	June 30,			December 31,
(Dollars in thousands)	2014			2013

Beginning balance, January 1,	$	11,657		$	22,286
Additions		1,026			8,713
Net proceeds from sale of properties		(483	)		(17,076	)
Writedowns		(499	)		(2,185	)
Change in valuation allowance		(458	)		(81	)
Ending balance	$	11,243		$	11,657

A summary of the real estate acquired through foreclosure valuation allowance activity is as follows:

	Three Months Ended					Six Months Ended
(Dollars in thousands)	June 30,					June 30,
	2014		2013			2014		2013
Beginning balance	$	581	$	972		$	581	$	500
Provision		458		532			458		1,592
Writedowns and loss on sale		-		(783	)		-		(1,371	)
Ending balance	$	1,039	$	721		$	1,039	$	721

Real estate acquired through foreclosure expense which consists primarily of property management expenses and provision expense was $690,000 and $524,000 for the three months ended June 30, 2014 and 2013, and $776,000 and $818,000 for the six months ended June 30, 2014 and 2013, respectively.

INCOME TAXES

The calculation for the income tax provision or benefit generally does not consider the tax effects of changes in other comprehensive income, or OCI, which is a component of stockholders’ equity on the balance sheet. However, an exception is provided in certain circumstances, such as when there is a full valuation allowance against net deferred tax assets, there is a loss from continuing operations and income in other components of the financial statements. In such a case, pre-tax income from other categories, such as changes in OCI, must be considered in determining a tax benefit to be allocated to the loss from continuing operations. An income tax benefit of $879,000 and $967,000 was recorded for the quarter and six month periods ended June 30, 2014 compared to income tax expense of $1,000 recorded for both the quarter and six month 2013 periods.

A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a full valuation allowance, we considered various factors including our five year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and full year operating results in 2013, 2012 and 2011 and the degree of our compliance with the capital requirements of our Consent Order. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at June 30, 2014 and December 31, 2013.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

EARNINGS (LOSS) PER SHARE

The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:

	Three Months Ended						Six Months Ended
(Amounts in thousands,	June 30,						June 30,
except per share data)	2014			2013			2014			2013

Basic:
Net income/(loss)	$	(1,969	)	$	(1,126	)	$	(2,070	)	$	(1,004	)
Less:
Preferred stock dividends		(427	)		(250	)		(877	)		(500	)
Accretion on preferred stock discount		-			(13	)		(3	)		(27	)
Net income (loss) available to common shareholders	$	(2,396	)	$	(1,389	)	$	(2,950	)	$	(1,531	)
Weighted average common shares		4,974			4,806			4,932			4,797

Diluted:
Weighted average common shares		4,974			4,806			4,932			4,797
Dilutive effect of stock options,warrants and restricted share awards		-			-			-			-
Weighted average common and incremental shares		4,974			4,806			4,932			4,797

Earnings (Loss) Per Common Share:
Basic	$	(0.48	)	$	(0.29	)	$	(0.60	)	$	(0.32	)
Diluted	$	(0.48	)	$	(0.29	)	$	(0.60	)	$	(0.32	)

Since the Corporation is reporting a net loss available to common shareholders for all periods presented, no stock options, warrants or restricted share awards were evaluated for dilutive purposes.

STOCK BASED COMPENSATION PLAN

Our 2006 Stock Option and Incentive Compensation Plan, which is stockholder approved, authorizes us to grant restricted stock and incentive or non-qualified stock options to key employees and directors for a total of 763,935 shares of our common stock. We believe that the ability to award stock options and other forms of stock-based incentive compensation can assist us in attracting and retaining key employees. Stock-based incentive compensation is also a means to align the interests of key employees with those of our stockholders by providing awards intended to reward recipients for our long-term growth. Options to purchase shares generally vest over periods of one to five years and expire ten years after the date of grant. We issue new shares of common stock upon the exercise of stock options. If options or awards granted under the 2006 Plan expire or terminate for any reason without having been exercised in full or released from restriction, the corresponding shares shall again be available for option or award for the purposes of the Plan. At June 30, 2014, options and restricted stock available for future grant under the 2006 Plan totaled 56,540.

Under the terms of our 2006 Plan, all outstanding options to purchase shares of our common stock that were not already exercisable become exercisable and the transfer restrictions on restricted stock lapse in the event of a change of control. The events constituting a change of control under the 2006 Plan include, among other things:

shareholders approve a definitive agreement to merge us with or into another company (except if our voting securities outstanding immediately prior to the transaction continue to represent more than 50% of the combined voting power of the voting securities of the surviving entity outstanding immediately after the transaction) or to sell or otherwise transfer all or substantially all of the company’s assets or to adopt a plan of liquidation; or

we enter into an agreement, the consummation of which would result in the occurrence of a change of control.

Accordingly, all outstanding options to purchase shares of our common stock that were not already exercisable became exercisable on April 21, 2014, when we entered into the Share Exchange Agreement with Community Bank Shares of Indiana, Inc. Likewise, the transfer restrictions on the shares of our

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

STOCK BASED COMPENSATION PLAN – (Continued)

restricted stock then outstanding terminated on that date. In addition, the transfer restrictions on the shares of restricted stock issued to our non-employee directors on May 21, 2014 will terminate if and when our shareholders approve the Share Exchange Agreement at a special meeting of shareholders expected to be held before the end of 2014.

Stock Options – The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various weighted-average assumptions. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on the fluctuation in the price of a share of stock over the period for which the option is being valued and the expected life of the options granted represents the period of time the options are expected to be outstanding.

The weighted-average assumptions for options granted during the six months ended June 30, 2014 and the resulting estimated weighted average fair value per share is presented below.

	June 30,
	2014
Assumptions:
Risk-free interest rate		2.86	%
Expected dividend yield		-	%
Expected life (years)		10
Expected common stock market price volatility		64	%
Estimated fair value per share	$	3.57

A summary of option activity under the 2006 Plan for the period ended June 30, 2014 is presented below:

						Weighted
				Weighted		Average
	Number			Average		Remaining		Aggregate
	of			Exercise		Contractual		Intrinsic
	Options			Price		Term		Value
								(Dollars In Thousands)
Outstanding, beginning of period		376,300		$	3.13
Granted during period		5,000			4.90
Forfeited during period		(12,000	)		3.81
Exercised during period		(7,500	)		1.69
Outstanding, end of period		361,800		$	3.16		7.7	$	364

Eligible for exercise at period end		361,800		$	3.16		7.7	$	364

The total intrinsic value of options exercised during 2014 was $16,000. The total cash received from options exercised during 2014 was $13,000. There were no options exercised, modified or cash settled during the 2013 period. There was no tax benefit recognized from the option exercises as they are considered incentive stock options.

Compensation cost related to options granted under the 2006 Plan that was charged against earnings for the periods ended June 30, 2014 and 2013 was $443,000 and $73,000. As of June 30, 2014 all previously unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 2006 Plan has been recognized.

Restricted Stock – Our 2012 Non-Employee Director Equity Compensation Program (the “Director Program”) enables us to compensate non-employee directors for their service with stock awards. We currently do not pay cash compensation to non-employee directors pursuant to agreements with bank regulatory agencies. The board has reserved 220,000 of the shares authorized for issuance under our shareholder approved 2006 Stock Option and Incentive Compensation Plan for stock awards under the Director Program.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

STOCK BASED COMPENSATION PLAN – (Continued)

The Director Program provides that each non-employee director elected or continuing in office on the date of each annual meeting of the Corporation’s shareholders will automatically receive an award of restricted stock on that date having a value of $30,000, based on the closing sale price per share of the Corporation’s common stock on the award date, rounded up to the next whole number. Accordingly, on May 21, 2014, the Company’s nine non-employee directors each received an award of 8,310 restricted shares, or 74,790 shares in total, that vest at the close of business on the day immediately preceding the date of the 2015 annual meeting of the Corporation’s shareholders, provided that the recipient has continued to serve as a member of the Board as of the date of vesting. The recipient may not transfer, pledge or dispose of the restricted stock before the date of vesting. The transfer restrictions will also expire upon the occurrence of a Change of Control, as defined in the Plan, or upon the recipient’s death or disability. If a director ceases to serve as a member of the board for any reason, that director will automatically forfeit any unvested shares subject to an award. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date the transfer restrictions expire.

A summary of changes in our non-vested restricted shares for the six months ended June 30, 2014 is presented below:

				Weighted
				Average
	Non-vested			Grant Date
	Shares			Fair Value

Outstanding, beginning of period		63,497		$	3.81
Granted		138,090			4.21
Forfeited		(1,000	)		4.91
Vested		(125,797	)		4.35
Outstanding, end of period		74,790		$	3.61

Compensation cost related to restricted stock granted under the 2006 Plan that was charged against earnings for the periods ended June 30, 2014 and 2013 was $558,000 and $187,000, respectively. As of June 30, 2014 there was $236,000 of total unrecognized compensation cost related to non-vested shares granted under the Plan. That cost is expected to be recognized over the remaining vesting period of .75 years.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FAIR VALUE

U.S. GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

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

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

We used the following methods and significant assumptions to estimate the fair value.

Available-for-sale securities: The fair values of some corporate bonds are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs). For securities where quoted prices are not available, fair values are calculated on market prices of similar securities or determined by a matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

Impaired Loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Once a loan is considered impaired, it is evaluated by a member of the Credit Department on at least a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure and bank lots held for sale are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us. Once received, a member of the Credit Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with via independent data sources such as recent market data or industry-wide statistics.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FAIR VALUE - (Continued)

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets measured at fair value on a recurring basis are summarized below: There were no transfers between Level 1 and Level 2 during the periods presented.

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	June 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2014		(Level 1)		(Level 2)		(Level 3)

Assets:
Government-sponsored collateralized mortgage obligations	$	84,897	$	-	$	84,897	$	-
Government-sponsored mortgage-backed residential		81,520		-		81,520		-
Corporate bonds		12,924		3,377		9,547		-
Asset backed-collateralized loan obligations		14,459		-		14,459		-
State and municipal		9,309		-		9,309		-
U.S. Government-sponsored agencies		6,032		-		6,032		-
Commercial mortgage backed		3,090		-		3,090		-

Total	$	212,231	$	3,377	$	208,854	$	-

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2013		(Level 1)		(Level 2)		(Level 3)

Assets:
Government-sponsored collateralized mortgage obligations	$	100,816	$	-	$	100,816	$	-
Government-sponsored mortgage-backed residential		74,324		-		74,324		-
Corporate bonds		43,698		10,768		32,930		-
Asset backed-collateralized loan obligations		34,478		-		34,478		-
State and municipal		11,923		-		11,923		-
Commercial mortgage backed		4,043		-		4,043		-

Total	$	269,282	$	10,768	$	258,514	$	-

We conduct a review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FAIR VALUE - (Continued)

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Assets measured at fair value on a nonrecurring basis are summarized below:

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	June 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2014		(Level 1)		(Level 2)		(Level 3)

Assets:
Impaired loans:
Commercial Real Estate:
Land Development	$	625	$	-	$	-	$	625
Other		5,457		-		-		5,457
Residential Mortgage		153		-		-		153
Consumer and Home Equity		19		-		-		19
Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		1,003		-		-		1,003
Other		2,190		-		-		2,190
Residential Mortgage		601		-		-		601
Other real estate owned:
Bank Lots		769		-		-		769

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2013		(Level 1)		(Level 2)		(Level 3)

Assets:
Impaired loans:
Commercial Real Estate:
Land Development	$	625	$	-	$	-	$	625
Other		5,618		-		-		5,618
Residential Mortgage		56		-		-		56
Consumer and Home Equity		36		-		-		36
Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		947		-		-		947
Other		2,667		-		-		2,667
Residential Mortgage		634		-		-		634
Other real estate owned:
Bank Lots		792		-		-		792

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $9.2 million, with a valuation allowance of $3.0 million, resulting in an additional provision for loan losses of $288,000 and $412,000 for the quarter and six months ended June 30 2014. Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $24.2 million, with a valuation allowance of $7.1 million, resulting in an additional provision for loan losses of $737,000 and a reversal of provision for loan losses of $342,000 for the quarter and six months ended June 30, 2013.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FAIR VALUE - (Continued)

Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the estimated cost to replace the current property after considering adjustments for depreciation. Values of the market comparison approach evaluate the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investors required return. The final value is a reconciliation of these three approaches and takes into consideration any other factors management deems relevant to arrive at a representative fair value.

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property. Many of the appraisals utilize an income approach, such as the discounted cash flow method, to estimate future income and profits or cash flows. Appraisals may also utilize a single valuation approach or a combination of approaches including a market comparison approach, where prices and other relevant information generated by market transactions involving identical or comparable properties are used to determine fair value. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Fair value adjustments of $954,000 and $957,000 were made to real estate owned during the quarter and six months ended June 30, 2014. Fair value adjustments of $400,000 and $1.5 million were made to real estate owned during the quarter and six months ended June 30, 2013.

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2014.

	Fair	Valuation	Unobservable	Range (Weighted
(Dollars in thousands)	Value	Technique(s)	Input(s)	Average)

Impaired loans:
Commercial Real Estate:
Land Development	625	Sales comparison approach	Adjustment for differences	3.10%-18.00% (15.98%)
			between comparable sales

Other	5,161	Income approach	Discount or capitalization rate	8.50%-9.00% (8.82%)
	296	Sales comparison approach	Adjustment for differences
			between comparable sales	17.00% (1)

Residential Mortgage	153	Sales comparison approach	Adjustment for differences	0.00%-8.00% (3.87%)
			between comparable sales

Consumer and Home Equity	19	Sales comparison approach	Adjustment for differences	0.00% (1)
			between comparable sales

Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development	975	Income approach	Discount or capitalization rate	7.40%-29.00% (20.25%)
	28	Sales comparison approach	Adjustment for differences
			between comparable sales	0.00% (1)

Other	1,522	Income approach	Discount or capitalization rate	9.40%-10.00% (9.79%)
	668	Sales comparison approach	Adjustment for differences
			between comparable sales	20.00%-25.00% (20.97%)

Residential Mortgage	601	Sales comparison approach	Adjustment for differences	0.00%-8.00% (1.40%)
			between comparable sales

Real estate owned:
Bank Lots	769	Sales comparison approach	Adjustment for differences	10.00% (1)
			between comparable sales

(1) Unobservable inputs with a single discount listed include only one property.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FAIR VALUE - (Continued)

Fair Value of Financial Instruments

The estimated fair value of financial instruments, not previously presented, is as follows:

			June 30, 2014
(Dollars in thousands)	Carrying		Fair Value Measurements
	Value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	82,536	$	82,536	$	6,108	$	76,428	$	-
Mortgage loans held for sale		1,313		1,333		-		1,333		-
Loans, net		439,402		440,112		-		-		440,112
Accrued interest receivable		1,752		1,752		-		718		1,034
FHLB stock		4,080		N/A		N/A		N/A		N/A

Financial liabilities:
Deposits		723,623		727,560		-		727,560		-
Advances from Federal Home Loan Bank		12,320		13,232		-		13,232		-
Subordinated debentures		18,000		13,584		-		-		13,584
Accrued interest payable		5,160		5,160		-		5,160		-

			December 31, 2013
(Dollars in thousands)	Carrying		Fair Value Measurements
	Value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	65,988	$	65,988	$	6,596	$	59,392	$	-
Mortgage loans held for sale		470		478		-		478		-
Loans, net		450,771		453,592		-		-		453,592
Accrued interest receivable		2,224		2,224		-		1,136		1,088
FHLB stock		4,430		N/A		N/A		N/A		N/A

Financial liabilities:
Deposits		783,487		788,230		-		788,230		-
Advances from Federal Home Loan Bank		12,389		13,315		-		13,315		-
Subordinated debentures		18,000		13,038		-		-		13,038
Accrued interest payable		4,485		4,485		-		4,485		-

The methods and assumptions, not previously presented, used to estimate fair values are described below:

(a) Cash and due from banks

The carrying amount of cash on hand approximates fair value and is classified as a Level 1. The carrying amount of cash due from bank accounts is classified as a Level 2.

(b) Mortgage loans held for sale

The fair value of mortgage loans held for sale is estimated based upon the binding contracts and quotes from third party investors resulting in a Level 2 classification.

(c) Loans, net

Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

FAIR VALUE - (Continued)

(d) FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

(e) Deposits

The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate interest bearing deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(f) Advances from Federal Home Loan Bank

The fair value of the FHLB advances is obtained from the FHLB and is calculated by discounting contractual cash flow using an estimated interest rate based on the current rates available to us for debt of similar remaining maturities and collateral terms resulting in a Level 2 classification.

(g) Subordinated debentures

The fair value for subordinated debentures is calculated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

(h) Accrued interest receivable/payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the asset or liability with which the accrual is associated.

(i) Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

10.

SUBORDINATED DEBENTURES

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities. Together, the junior subordinated notes had an outstanding principal amount of $18 million. We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of June 30, 2014, we have deferred a total of fifteen quarterly payments and these accrued but unpaid interest payments totaled $5.1 million.

11.

PREFERRED STOCK

On January 9, 2009, we issued $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the United States Treasury under its Capital Purchase Program (“CPP”). The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares paid cumulative dividends quarterly at a rate of 5% per year for the first five years and then reset to 9% per year on January 9, 2014. The Senior Preferred Shares may be redeemed at any time, subject to prior approval from bank regulatory agencies. We also have the ability to defer dividend payments at any time, at our option.

Under the terms of our CPP stock purchase agreement, we also issued the Treasury a warrant to purchase an amount of our common stock equal to 15% of the aggregate amount of the Senior Preferred Shares, or $3 million. The warrant entitles Treasury to purchase 215,983 common shares at a purchase price of $13.89 per share. The initial exercise price for the warrant and the number of shares subject to the warrant were determined by reference to the market price of our common stock calculated on a 20-day trailing average as of December 8, 2008, the date Treasury approved our application. The warrant has a term of 10 years and is potentially dilutive to earnings per share.

Effective with the fourth quarter of 2010, we suspended payment of regular quarterly cash dividends on our Senior Preferred Shares. The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income attributable to common shareholders for financial statement purposes. As of June 30, 2014, we have deferred a total of fifteen quarterly payments and these accrued but unpaid dividends totaled $4.3 million.

The terms of the Senior Preferred Shares restrict our ability to repurchase shares and limit our payment of dividends on our common stock to the most recent quarterly amount we paid prior to October 14, 2008, which was $0.19 per share. These restrictions will remain in effect until the Senior Preferred Shares are fully retired. The restrictions imposed by the terms of the Senior Preferred Shares are in addition to the restrictions imposed by our Consent Order and formal agreement with bank regulatory agencies described in Note 2.

On April 29, 2013, Treasury sold our Senior Preferred Shares to six funds in an auction. Following the sale, the full $20 million stated value of our Senior Preferred Shares remains outstanding and our obligation to pay deferred and future dividends, at the current 9% annual rate, continues until our Senior Preferred Shares are fully retired.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

12.

STOCKHOLDERS’ EQUITY

(a)

Regulatory Capital Requirements – The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can result in regulatory action.

Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined).

As a result of the Consent Order the Bank entered into with the FDIC and KDFI described in greater detail in Note 2, the Bank is categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized".

On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The 2012 Consent Order requires the Bank to achieve the same minimum capital ratios mandated by the January 2011 Consent Order, which are set forth below. See Note 2 for additional information.

Our actual and required capital amounts and ratios are presented below.

(Dollars in thousands)						For Capital					Required by
	Actual					Adequacy Purposes					Consent Order
As of June 30, 2014:	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total risk-based capital (to risk- weighted assets)
Consolidated	$	65,866		12.94	%	$	40,728		8.00	%	$	61,092		12.00	%
Bank		76,163		14.93			40,812		8.00			61,218		12.00
Tier I capital (to risk-weighted assets)
Consolidated		55,284		10.86			20,364		4.00			N/A		N/A
Bank		69,747		13.67			20,406		4.00			N/A		N/A
Tier I capital (to average assets)
Consolidated

FIRST FINANCIAL SERVICE CORP 10-Q