Jacksonville Bancorp (JAXB) 10-Q 2013 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended  September 30, 2013

or

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

For the transition period from __________ to ____________.

Commission file number  000-30248

JACKSONVILLE BANCORP, INC.

(Exact name of registrant as specified in its charter)

Florida	59-3472981
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
100 North Laura Street, Suite 1000 Jacksonville, Florida	32202
(Address of principal executive offices)	(Zip Code)

(904) 421-3040

(Registrant’s telephone number,

including area 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 o

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 o

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

Large accelerated filer	o	Accelerated filer	o
Non-accelerated filer	o	Smaller reporting company	x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

As of October 31, 2013, the latest practicable date, there were 3,177,090 shares of the Registrant’s common stock outstanding and 2,618,005 shares of the Registrant’s nonvoting common stock outstanding.

JACKSONVILLE BANCORP, INC.

TABLE OF CONTENTS

Description		Page
Special Cautionary Notice Regarding Forward-Looking Statements		1
PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements	2
	Consolidated Balance Sheets	2
	Consolidated Statements of Operations	3
	Consolidated Statements of Comprehensive Income (Loss)	4
	Consolidated Statements of Changes in Shareholders’ Equity	5
	Consolidated Statements of Cash Flows	6
	Notes to Consolidated Financial Statements	8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	40
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	59
Item 4.	Controls and Procedures	60
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	60
Item 1A.	Risk Factors	61
Item 5.	Other Information	62
Item 6.	Exhibits	63
SIGNATURES		65
EXHIBIT INDEX		66

JACKSONVILLE BANCORP, INC.

SPECIAL CAUTIONARY NOTICE REGARDING

FORWARD-LOOKING STATEMENTS

Various of the statements contained in this Quarterly Report on Form 10-Q, the Annual Report on Form 10-K for the year ended December 31, 2012, Current Reports on Form 8-K, and reports to shareholders are “forward-looking statements” within the meaning and protections of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.

Forward-looking statements include statements with respect to management’s beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions and future performance, and involve known and unknown risks, uncertainties and other factors, including economic and market conditions, which may be beyond our control, and which may cause the actual results, performance or achievements of the Company to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.  Management cautions readers not to place undue reliance on any of the Company’s forward-looking statements, which speak only as of the date made.  The Company has no obligation to and does not undertake to update, revise, or correct any of these forward-looking statements after the date of this report.

All statements other than statements of historical fact are statements that could be forward-looking statements. Words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “evaluate,” “continue,” “further,” “plan,” “point to,” “project,” “could,” “intend,” “target” and other similar words and expressions of the future identify forward-looking statements.  These forward-looking statements may not be realized due to a variety of factors, including, without limitation:

• the effects of future economic, business and market conditions and changes, domestic and foreign, including seasonality;

• governmental monetary and fiscal policies;

• legislative and regulatory changes, including changes in banking, securities and tax laws, regulations and policies and their application by our regulators;

• changes in accounting rules, practices and interpretations;

• the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest-sensitive assets and liabilities;

• changes in borrower credit risks and payment behaviors;

• changes in the availability and cost of credit and capital in the financial markets;

• changes in the prices, values and sales volumes of residential and commercial real estate;

• the effects of concentrations in our loan portfolio;

• our ability to resolve nonperforming assets;

• the failure of assumptions and estimates underlying the establishment of reserves for possible loan losses and other estimates and valuations;

• management’s expectation that measures taken to increase the market price of the Company’s common stock including, but not limited to, a reverse stock split, will result in the intended benefits; or

• management’s expectation that the Company’s recapitalization plan and strategic initiatives will have a sustained positive impact on results of operations and compliance with all regulatory agreements and associated requirements.

All forward-looking statements that are made by or attributable to the Company are qualified in their entirety by and should be read in conjunction with this cautionary notice and the risks described or referred to in Item 1A – Risk Factors of the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 26, 2013, in Item 1A – Risk Factors of this report, and in the Company’s other filings with the SEC.

1

JACKSONVILLE BANCORP, INC.

PART I—FINANCIAL INFORMATION

Item 1.  Financial Statements

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Dollars in thousands, except per share amounts)

	September 30, 2013			December 31, 2012
ASSETS
Cash and due from financial institutions	$	15,384		$	14,587
Federal funds sold		20,542			57,492
Cash and cash equivalents		35,926			72,079
Securities available-for-sale		88,203			83,985
Loans, net of allowance for loan losses of $16,974 and $20,198 as of September 30, 2013 and December 31, 2012, respectively		355,981			377,833
Premises and equipment, net		6,575			6,952
Bank-owned life insurance		12,899			9,797
Federal Home Loan Bank stock, at cost		1,580			1,771
Other real estate owned, net		8,438			6,971
Accrued interest receivable		1,870			2,059
Other intangible assets, net		938			1,260
Other assets		2,137			2,350
Total assets	$	514,547		$	565,057
LIABILITIES
Deposits
Noninterest-bearing demand deposits	$	98,076		$	94,575
Money market, NOW and savings deposits		191,813			198,395
Time deposits		150,465			197,051
Total deposits		440,354			490,021
Loans from related parties		2,200			2,200
Federal Home Loan Bank advances and other borrowings		20,159			20,176
Subordinated debentures		16,138			16,090
Accrued expenses and other liabilities		2,975			2,994
Total liabilities		481,826			531,481
SHAREHOLDERS' EQUITY
Preferred stock		-			18,536
Common stock, $.01 par value, 2,780,713 and 294,544 shares issued and outstanding as of September 30, 2013 and December 31, 2012, respectively(1)		28			3
Nonvoting common stock, $.01 par value, 2,618,000 and noshares issued and outstanding as of September 30, 2013 and December 31, 2012, respectively(1)		26			-
Additional paid–in capital(1)		134,821			83,890
Retained earnings (deficit)		(101,353	)		(70,264	)
Accumulated other comprehensive (loss) income		(801	)		1,411
Total shareholders’ equity		32,721			33,576
Total liabilities and shareholders’ equity	$	514,547		$	565,057

⁽¹⁾ Reflects the 1-for-20 reverse stock split completed in October 2013.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

See accompanying notes to the Consolidated Financial Statements.

2

JACKSONVILLE BANCORP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Dollars in thousands, except per share amounts)

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2013		2012			2013			2012
Interest and dividend income:
Loans, including fees	$	5,127	$	6,102		$	16,323		$	18,233
Taxable securities		300		338			879			931
Tax-exempt securities		129		190			461			570
Federal funds sold and other		49		11			101			52
Total interest income		5,605		6,641			17,764			19,786
Interest expense:
Deposits		704		866			2,257			2,872
Federal Reserve and other borrowings		45		80			152			213
Federal Home Loan Bank advances		75		79			224			248
Subordinated debentures		208		213			621			637
Total interest expense		1,032		1,238			3,254			3,970
Net interest income		4,573		5,403			14,510			15,816
Provision for loan losses		367		5,990			100			17,646
Net interest income (loss) after provision for loan losses		4,206		(587	)		14,410			(1,830	)
Noninterest income:
Service charges on deposit accounts		193		202			588			597
Other income		568		154			974			486
Total noninterest income		761		356			1,562			1,083
Noninterest expense:
Salaries and employee benefits		2,083		2,211			6,136			6,282
Occupancy and equipment		684		611			1,991			1,845
Regulatory assessments		196		227			599			669
Data processing		455		338			1,354			968
Advertising and business development		96		86			270			373
Professional fees		361		265			1,285			737
Telephone expense		103		89			280			275
Other real estate owned expense		182		1,084			1,297			2,798
Goodwill impairment		-		3,137			-			3,137
Other		660		2,512			2,385			3,524
Total noninterest expense		4,820		10,560			15,597			20,608
Net income (loss) before income taxes		147		(10,791	)		375			(21,355	)
Income tax benefit		-		(106	)		-			(136	)
Net income (loss)	$	147	$	(10,685	)	$	375		$	(21,219	)
Noncash, implied preferred stock dividend		-		-			(31,464	)		-
Net income (loss) available to common shareholders	$	147	$	(10,685	)	$	(31,089	)	$	(21,219	)
Weighted average common shares outstanding: (1)
Basic shares		5,307,032		294,544			4,401,317			294,515
Dilutive stock options		10		-			-			-
Diluted shares		5,307,042		294,544			4,401,317			294,515
Earnings (loss) per common share: (1)
Basic	$	0.03	$	(36.27	)	$	(7.06	)	$	(72.05	)
Diluted	$	0.03	$	(36.27	)	$	(7.06	)	$	(72.05	)

⁽¹⁾ Reflects the 1-for-20 reverse stock split completed in October 2013.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

See accompanying notes to Consolidated Financial Statements.

3

JACKSONVILLE BANCORP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(Dollars in thousands)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013			2012			2013			2012
Net income (loss)	$	147		$	(10,685	)	$	375		$	(21,219	)
Other comprehensive (loss) income:
Change in unrealized holding (losses) gains on available-for-sale securities		(15	)		581			(2,197	)		935
Net unrealized derivative gains (losses) on cash flow hedge		(1	)		(69	)		422			(193	)
Reclassification adjustment for net gains on investments realized in earnings		(391	)		-			(437	)		-
Other comprehensive (loss) income		(407	)		512			(2,212	)		742
Tax effect		-			(193	)		-			(279	)
Other comprehensive (loss) income, net of tax effect		(407	)		319			(2,212	)		463
Total comprehensive loss	$	(260	)	$	(10,366	)	$	(1,837	)	$	(20,756	)

See accompanying notes to Consolidated Financial Statements.

4

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

(Dollars in thousands)

					Nonvoting										Additional			Retained			Accumulated Other
	Common Stock (1)				Common Stock (1)				Preferred Stock						Paid-In			Earnings			Comprehensive
	Shares		Amount		Shares		Amount		Shares			Amount			Capital (1)			(Deficit)			Income (Loss)			Total
Balance as of December 31, 2011		294,492	$	3		-	$	-		-		$	-		$	55,439		$	(27,216	)	$	1,118		$	29,344
Net loss																			(43,048	)					(43,048	)
Other comprehensive income																						293			293
Total comprehensive loss																									(42,755	)
Vesting of restricted stock (1)		52		0												0									0
Issuance of preferred stock, Series B, net										5,000			4,863												4,863
Exchange of preferred stock, Series B, for preferred stock, Series A										-			(4,863	)											(4,863	)
Issuance of preferred stock, Series A, net										45,000			50,000			(3,060	)								46,940
Discount on preferred stock, Series A beneficial conversion feature													(31,464	)		31,464									-
Share-based compensation expense																47									47
Balance as of December 31, 2012		294,544	$	3		-	$	-		50,000		$	18,536		$	83,890		$	(70,264	)	$	1,411		$	33,576
Net income																			375						375
Other comprehensive loss																						(2,212	)		(2,212	)
Total comprehensive loss																									(1,837	)
Vesting of restricted stock (1)		38		0												0									0
Accretion of discount on preferred stock, Series A													31,464						(31,464	)					-
Conversion of preferred stock, Series A, to common stock and nonvoting common stock (1)		2,382,000		24		2,618,000		26		(50,000	)		(50,000	)		49,950									-
Issuance of common stock (1)		104,131		1												936									937
Share-based compensation expense																45									45
Balance as of September 30, 2013		2,780,713	$	28		2,618,000	$	26		-		$	-		$	134,821		$	(101,353	)	$	(801	)	$	32,721

⁽¹⁾ Reflects the 1-for-20 reverse stock split completed in October 2013.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

See accompanying notes to Consolidated Financial Statements.

5

JACKSONVILLE BANCORP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 (Unaudited)

(Dollars in thousands)

	Nine Months Ended
	September 30,
	2013			2012
Cash flows from operating activities:
Net income (loss)	$	375		$	(21,219	)
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization		524			429
Net amortization of deferred loan fees		25			(3	)
Provision for loan losses		100			17,646
Goodwill impairment		-			3,137
Premium amortization for securities, net of accretion		763			649
Net realized gain on sale of securities		(437	)		-
Net accretion of purchase accounting adjustments		(1,331	)		(1,128	)
Net gain on sale of other real estate owned		(139	)		(52	)
Write-down of other real estate owned		546			2,291
Earnings on bank-owned life insurance		(102	)		(200	)
Loss on disposal of premises and equipment		3			21
Share-based compensation		45			128
Net change in:
Accrued interest receivable and other assets		391			888
Accrued expenses and other liabilities		403			1,952
Net cash from operating activities		1,166			4,539
Cash flows from investing activities:
Available-for-sale securities:
Sales		14,434			-
Maturities, prepayments and calls		17,421			9,408
Purchases		(39,033	)		(34,821	)
Loan (originations) payments, net		19,221			11,355
Proceeds from sale of other real estate owned		2,273			4,249
Investment in bank-owned life insurance		(3,000	)		-
Additions to premises and equipment, net		(138	)		(342	)
Purchase of Federal Home Loan Bank stock, net of redemptions		191			364
Net cash from (used for) investing activities		11,369			(9,787	)
Cash flows from financing activities:
Net change in deposits		(49,625	)		19,691
Net change in overnight Federal Home Loan Bank advances		-			(18,600	)
Proceeds from issuance of preferred stock, net		-			4,863
Proceeds from issuance of common stock, net		937			-
Proceeds from related party transactions		-			1,000
Proceeds from Federal Home Loan Bank fixed rate advances		-			15,000
Repayment of Federal Home Loan Bank fixed rate advances		-			(13,000	)
Net cash (used for) from financing activities		(48,688	)		8,954
Net change in cash and cash equivalents		(36,153	)		3,706
Cash and cash equivalents at beginning of period		72,079			9,955
Cash and cash equivalents at end of period	$	35,926		$	13,661

See accompanying notes to Consolidated Financial Statements.

6

JACKSONVILLE BANCORP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Cont.)

(Unaudited)

(Dollars in thousands)

	Nine Months Ended
	September 30,
	2013		2012
Supplemental disclosures of cash flow information:
Cash paid during the period for
Interest	$	3,655	$	4,194
Income taxes		-		-
Supplemental schedule of noncash investing activities:
Acquisition of other real estate owned	$	4,310	$	2,873
Supplemental schedule of noncash financing activities:
Implied preferred stock dividend	$	31,464	$	-

See accompanying notes to Consolidated Financial Statements.

7

JACKSONVILLE BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

NOTE 1 – BASIS OF PRESENTATION

Principles of Consolidation

The accounting and reporting policies of the Company reflect banking industry practice and conform to U.S. generally accepted accounting principles (“U.S. GAAP”).  The Consolidated Financial Statements include the accounts of Jacksonville Bancorp, Inc. (“Bancorp”), its wholly owned, primary operating subsidiary The Jacksonville Bank, and The Jacksonville Bank’s wholly owned subsidiary, Fountain Financial, Inc.  The consolidated entity is referred to as the “Company” and The Jacksonville Bank and Fountain Financial, Inc. are collectively referred to as the “Bank.”  The Company’s financial condition and operating results principally reflect those of the Bank.  All intercompany transactions and balances have been eliminated in consolidation.  In preparing the Consolidated Financial Statements, management is required to make estimates and assumptions that affect the reported asset and liability balances and revenue and expense amounts, and the disclosure of contingent assets and liabilities.  Actual results could differ significantly from those estimates and assumptions.

The consolidated financial information included herein as of and for the periods ended September 30, 2013 and 2012 is unaudited.  Accordingly, it does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.  However, such information reflects all adjustments which are, in the opinion of management, necessary for a fair statement of the financial condition and results of operations for the interim periods.  The December 31, 2012 consolidated balance sheet was derived from the Company’s December 31, 2012 audited Consolidated Financial Statements.

Nature of Operations

Bancorp is a financial holding company headquartered in Jacksonville, Florida, that currently provides financial services through eight full-service branches in Jacksonville and Jacksonville Beach, Duval County, Florida, as well as its virtual branch.  The Company’s primary business segment is community banking and consists of attracting deposits from the general public and using such deposits and other sources of funds to originate commercial business loans, commercial real estate loans, residential mortgage loans and a variety of consumer loans.  Substantially all loans are secured by specific items of collateral, including business assets, consumer assets, and commercial and residential real estate.  Commercial loans are expected to be repaid from cash flow from operations of businesses.  There are no significant concentrations of loans to any one industry or customer.  However, the customers’ ability to repay their loans is dependent on the real estate and general economic conditions in the area.  For further information, please refer to the Consolidated Financial Statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the U.S. Securities and Exchange Commission (the “SEC”) on March 26, 2013.

Investment Securities

Debt securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity.  Debt securities are classified as available-for-sale when they might be sold before maturity. Equity securities with readily determinable fair values are classified as available-for-sale.  Available-for-sale securities are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax.  Other securities, such as Federal Home Loan Bank (“FHLB”) stock, are carried at cost.

Interest income includes amortization of purchase premiums and accretion of purchase discounts. Premiums and discounts on securities are amortized on the level yield without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated.  Gains and losses are recorded on the trade date and determined using the specific identification method.

Other-Than-Temporary Impairment

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis and more frequently when economic or market conditions warrant such an evaluation.  In determining OTTI for debt securities, management considers many factors, including:  (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial conditions and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more-likely-than-not will be required to sell the debt security before its anticipated recovery.  The assessment of whether an OTTI decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

8

JACKSONVILLE BANCORP, INC.

NOTE 1 – BASIS OF PRESENTATION (Continued)

In order to determine OTTI for purchased beneficial interests that, on the purchase date, were rated below AA, the Company compares the present value of the remaining cash flows as estimated at the preceding evaluation date to the current expected remaining cash flows.  OTTI is deemed to have occurred if there has been an adverse change in the remaining expected future cash flows.  It is not the Bank’s policy to purchase securities rated below AA.

When OTTI occurs for either debt securities or purchased beneficial interests that, on the purchase date, were rated below AA, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more-likely-than-not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss.  If an entity intends to sell or it is more-likely-than-not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date.  If an entity does not intend to sell the security and it is not more-likely-than-not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors.  The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings.  The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes.  The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.

For the nine months ended September 30, 2013 and 2012, there were no credit losses recognized in earnings related to investment securities.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and allowance for loan losses.  Interest income is accrued on the unpaid principal balance of the loans.  Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level‑yield method without anticipating prepayments.

Interest income on a loan in any of our portfolio segments is discontinued at the time the loan is 90 days delinquent unless the loan is well secured and in process of collection.  Past due status is based on the contractual terms of the loan.  In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.  All unsecured loans in our consumer and other portfolio segment are charged off once they reach 90 days delinquent.  This is the only portfolio segment that the Company charges off loans solely based on the number of days of delinquency.  For real estate mortgage, commercial loan, secured consumer and other portfolio segments, the charge-off policy is that a loan is fully or partially charged off when, based on management’s assessment, it has been determined that it is highly probable that the Company would not collect all principal and interest payments according to the contractual terms of the loan agreement.  This assessment is determined based on a detailed review of all substandard and doubtful loans each month.  This review considers such criteria as the value of the underlying collateral, financial condition and reputation of the borrower and guarantors and the amount of the borrower’s equity in the loan.  The Company’s charge-off policy has remained materially unchanged for all periods presented.

At times, the Company will charge off a portion of a nonperforming or impaired loan versus recording a specific reserve. The decision to charge off a portion of the loan is based on specific facts and circumstances unique to each loan.  General criteria considered are: the probability that the Company will foreclose on the property, the value of the underlying collateral compared to the principal amount outstanding on the loan and the personal guarantees associated with the loan.  For the nine months ended September 30, 2013 and 2012, partial charge-offs were $2,487 and $8,438, respectively, on nonperforming and impaired loans of $6,796 and $23,163, respectively.  For the year ended December 31, 2012, partial charge-offs were $8,984 on nonperforming and impaired loans of $20,446.

Partial charge-offs impact the Company’s credit loss metrics and trends, in particular a reduction in the coverage ratio, by decreasing substandard loan balances, decreasing capital and increasing the historical loss factor used in the calculation of the allowance for loan losses.  However, the impact of the historical loss factor on the allowance for loan losses would be slightly offset by the fact that the charge-off reduces the overall loan balance.

9

JACKSONVILLE BANCORP, INC.

NOTE 1 – BASIS OF PRESENTATION (Continued)

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Overdrawn customer checking accounts are reclassified as commercial loans and are evaluated on an individual basis for collectability.  These balances are included in the estimate of allowance for loan losses and are charged off when collectability is considered doubtful.  As of September 30, 2013 and December 31, 2012, overdrawn customer checking accounts reclassified as commercial loans were $185 and $188, respectively.

Certain Purchased Loans

As part of our merger with Atlantic BancGroup, Inc. (“ABI”) in November 2010, the Company purchased individual loans and groups of loans, some of which have shown evidence of credit deterioration since origination.  These purchased loans were recorded at fair value, such that there is no carryover of the seller’s allowance for loan losses.  Fair values were preliminary and subject to refinement for up to one year after the closing date of the merger as new information relative to the closing date fair value became available.  After acquisition, losses are recognized by an increase in the allowance for loan losses if the reason for the loss was due to events and circumstances that did not exist as of the acquisition date.  If the reason for the loss was due to events and circumstances that existed as of the acquisition date due to new information obtained during the measurement period (i.e., 12 months from date of acquisition), that, if known, would have resulted in the recognition of additional deterioration, the additional deterioration was recorded as additional carrying discount with a corresponding increase to goodwill.

The Company has purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.  Such purchased loans are accounted for individually.  The Company estimates the amount and timing of expected cash flows for each purchased loan, and the expected cash flows in excess of the amount paid are recorded as interest income over the remaining life of the loan (accretable yield).  The excess of the loan’s contractual principal and interest over expected cash flows is not recorded (non-accretable difference).

Over the life of the loan, expected cash flows continue to be estimated.  If the present value of expected cash flows is less than the carrying amount, a loss is recorded.  If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income as earned.

Allowance for Loan Losses

The allowance for loan losses is a valuation allowance for probable incurred credit losses.  Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.  Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is likely.  Subsequent recoveries, if any, are credited to the allowance.

The allowance consists of specific and general components.  The specific components relate to loans that are individually classified as impaired.  The general components relate to all loans not specifically identified as impaired and are modeled on loss by portfolio, weighted by recent historic data and economic factors.

The Company’s policy for assessing loans for impairment is the same for all classes of loans and is included in our allowance for loan losses policy.  The Company classifies a loan as impaired when it is probable that the Company will be unable to collect all amounts due, including both principal and interest, according to the contractual terms of the loan agreement.  An impairment determination is performed utilizing the following general factors:  (i) a risk rating of substandard or doubtful, (ii) a loan amount greater than $100, and/or (iii) a past due aging of 90 days or more.  In addition, the Company also considers the following: the financial condition of the borrower, the Company’s best estimate of the direction and magnitude of any future changes in the borrower’s financial condition, the fair value of collateral if the loan is collateral dependent, the loan’s observable market price, expected future cash flow and, if a purchased loan, the amount of the remaining unaccreted carrying discount.  For loans acquired in the acquisition of ABI, if the loss was attributed to events and circumstances that existed as of the acquisition date as a result of new information obtained during the measurement period (i.e., 12 months from date of acquisition) that, if known, would have resulted in the recognition of additional deterioration, the additional deterioration was recorded as additional carrying discount with a corresponding increase to goodwill.  If not, the additional deterioration was recorded as additional provision expense with a corresponding increase in the allowance for loan losses.  After the measurement period, any additional impairment above the current carrying discount is recorded as additional provision expense with a corresponding increase in the allowance for loan losses.

10

JACKSONVILLE BANCORP, INC.

NOTE 1 – BASIS OF PRESENTATION (Continued)

If a loan is deemed to be impaired, a portion of the allowance for loan losses may be allocated so that the loan is reported, net, at the present value of estimated expected future cash flows, using the loan’s existing rate, or at the fair value of collateral if repayment is expected solely from the sale of the collateral.  If an impaired loan is on nonaccrual, then recognition of interest income would follow our nonaccrual policy, which is to no longer accrue interest and account for any interest received on the cash-basis or cost-recovery method until qualifying again for interest accrual.  If an impaired loan is not on nonaccrual, then recognition of interest income would accrue on the unpaid principal balance based on the contractual terms of the loan.  All impaired loans are reviewed on at least a quarterly basis for changes in the measurement of impairment.  For impaired loans measured using the present-value-of-expected-cash-flows method, any change to the previously-recognized impairment loss is recognized as a change in the allowance for loan loss account and recorded in the consolidated statement of operations as a component of the provision for loan losses.

Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.  Troubled debt restructurings are measured at the present value of estimated expected future cash flows using the loan’s effective rate at inception.  Key factors that the Company considers at the time a loan is restructured to determine whether the loan should accrue interest include if the loan is less than 90 days past due and if the loan is in compliance with the modified terms of the loan.  The Company determines that the loan has been restructured to be reasonably assured of repayment and of performance according to the modified terms by performing an analysis that documents exactly how the loan is expected to perform under the modified terms.  Once loans become troubled debt restructurings, they remain troubled debt restructurings until they mature or are paid off in the normal course of business.

The general component covers all other loans not identified as impaired and is based on historical losses with consideration given to current factors.  The historical loss component of the allowance is determined by losses recognized by each portfolio segment over the preceding five years with the most recent years carrying more weight.  This is supplemented by the risks for each portfolio segment.  In calculating the historical component ofour allowance, we aggregate as follows:  commercial loans, residential real estate loans, commercial real estate loans, construction and land real estate loans, and consumer and other loans.  Risk factors impacting loans in each of the portfolio segments include broad deterioration of property values, reduced consumer and business spending as a result of continued high unemployment and reduced credit availability and lack of confidence in a sustainable recovery.  Actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment.  These economic factors include consideration of the following:  the concentration of watch and substandard loans as a percentage of total loans, levels of loan concentration within a portfolio segment or division of a portfolio segment and broad economic conditions.

Goodwill and Other Intangible Assets

Goodwill resulting from business combinations after January 1, 2009 is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date.  Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or whenever events or changes in circumstances indicate the carrying amount may be impaired.  The Company has selected September 30^th as the date to perform the annual impairment test.

Goodwill was the only intangible asset with an indefinite life on the Company’s consolidated balance sheets.  The annual impairment analysis as of September 30, 2012 determined that there had been a goodwill impairment of $3,137, which reduced the carrying value of the remaining goodwill balance to zero as of the same date.  The impairment was due to several factors, including the financial performance of the Company during 2012 and the increased provision for loan losses.  The Company recorded a charge to earnings for the same amount of the impairment during the nine months ended September 30, 2012 which contributed to the net loss for the period.

Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values.  Other intangible assets consist of a core deposit intangible asset that arose from the acquisition of ABI which is amortized on an accelerated method over its estimated useful life of eight years.

11

JACKSONVILLE BANCORP, INC.

NOTE 1 – BASIS OF PRESENTATION (Continued)

Convertible Securities

On December 31, 2012, the Company completed a $50,000 private placement capital raise (the “Private Placement”) whereby Bancorp sold a total of 50,000 shares of Mandatorily Convertible, Noncumulative, Nonvoting Perpetual Preferred Stock, Series A, par value $0.01 per share (the “Series A Preferred Stock”) at a purchase price of $1,000 per share.  Please refer to Note 2—Capital Raise Transactions for additional information regarding the Private Placement and Note 10—Shareholders’ Equity for additional information pertaining to the Series A Preferred Stock.

Pursuant to the Series A Preferred Stock designation, the Series A Preferred Stock was mandatorily convertible into shares of the Company’s common stock, par value $0.01 per share, and a new class of nonvoting common stock, par value $0.01 per share, upon receipt of requisite approval by the Company’s shareholders.  As of the date of issuance, the effective conversion price of $9.71 per share was less than the fair value of $16.00 per share of the Company’s common stock.  In accordance with U.S. GAAP, the Series A Preferred Stock was deemed to include a beneficial conversion feature with an intrinsic value of $6.29 per share for a total discount of $31,464.  On the date of conversion, the discount due to the beneficial conversion feature was recognized as an implied preferred stock dividend.  This noncash, implied dividend decreased retained earnings and net income available to common shareholders in the earnings per share calculation.

Share-based Compensation

Compensation cost is recognized for stock options and restricted stock awards issued to employees based on the fair value of these awards at the date of grant.  A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of Bancorp’s common stock at the date of grant is used for restricted stock awards.  Compensation cost is recognized over the required service period, generally defined as the vesting period.  For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

Reclassifications

Certain amounts in the prior year’s financial statements were reclassified to conform to the current year’s presentation.  These reclassifications had no impact on the prior periods’ net income or shareholders’ equity.

In October 2013, Bancorp’s Board of Directors implemented a 1-for-20 reverse stock split of its outstanding shares of common stock and nonvoting common stock effective October 24, 2013.  As a result of the reverse stock split, each 20 shares of issued and outstanding common stock and nonvoting common stock, par value $0.01 per share, respectively, were automatically and without any action on the part of the respective holders combined and reconstituted as one share of the respective class of common equity as of the effective date.  Consequently, the aggregate par value of common stock and nonvoting common stock eliminated in the reverse stock split was reclassed on the Company’s consolidated balance sheets from the respective class of common equity to additional paid-in capital.  Additional adjustments were made to the aforementioned accounts as a result of rounding to avoid the existence of fractional shares.  All share and per share information in the Consolidated Financial Statements and the accompanying notes have been retrospectively adjusted to reflect the 1-for-20 reverse stock split.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

Recently Issued Accounting and Reporting Standards

In February 2013, the Financial Accounting Standards Board (“FASB”) issued an accounting standards update that finalized previously deferred guidance related to the reporting of amounts reclassified out of accumulated other comprehensive income.  The amendments in this update do not alter current requirements for reporting net income or other comprehensive income in the consolidated financial statements.  However, the amendments require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component.  In addition, an entity must present significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income either on the face of the statement where net income is presented or in the accompanying notes to the Consolidated Financial Statements.  This requirement is only applicable if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period.  Alternatively, amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts.  This standard was effective prospectively for reporting periods beginning after December 15, 2012.  Early adoption was permitted.  To comply with the amended guidance, the Company has disclosed additional information pertaining to the components of accumulated other comprehensive income and reclassifications out of accumulated other comprehensive income in Note 10—Shareholders’ Equity in the accompanying notes to the Consolidated Financial Statements.

12

JACKSONVILLE BANCORP, INC.

NOTE 1 – BASIS OF PRESENTATION (Continued)

In July 2013, the FASB issued an accounting standards update that amended existing guidance related to derivatives and hedging.  The amendments in this update permit the use of the Fed Funds Effective Swap Rate (“OIS”) as a benchmark interest rate for hedge accounting purposes, in addition to existing benchmarks based on U.S. Government Treasury obligations (“UST”) and the London Interbank Offered Rate (“LIBOR”).  This standard was effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013.  Early adoption was not permitted.  The Company has evaluated this standard and determined that it will not have a material effect on the Company’s Consolidated Financial Statements.

Also in July 2013, the FASB issued an accounting standards update that requires that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, be presented in the financial statements as a reduction of a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryingforward, with specified exceptions.  To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available as of the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets.  The assessment of whether a deferred tax asset is available is based on the unrecognized tax benefit and deferred tax asset that exist as of the reporting date and should be made presuming disallowance of the tax position at the reporting date. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013.  No new recurring disclosures are required by this update.  The Company is currently evaluating this standard; however, management does not expect this update to have a material impact on the Consolidated Financial Statements.

Other accounting standards that have been issued by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

NOTE 2 – CAPITAL RAISE TRANSACTIONS

2012 Capital Raise Activities

During the year ended December 31, 2012, as part of a bridge financing, Bancorp and CapGen Capital Group IV LP (“CapGen”) entered into a subscription agreement under which Bancorp sold to CapGen 5,000 shares of Bancorp’s newly designated Noncumulative, Nonvoting, Perpetual Preferred Stock, Series B, par value $0.01 per share (“Series B Preferred Stock”) at a purchase price of $1,000 per share for an aggregate of $5,000 (the “Series B Sale”).  In connection with the Series B Sale, Bancorp agreed to exchange shares of Series B Preferred Stock for shares of Series A Preferred Stock concurrently with the issuance of shares of Series A Preferred Stock in the Company’s contemplated Private Placement of up to 50,000 shares of Series A Preferred Stock, unless such shares of Series B Preferred Stock were first redeemed by Bancorp.

On December 31, 2012, Bancorp entered into an amended and restated stock purchase agreement (the “Restated Stock Purchase Agreement”) with CapGen and 29 other accredited investors for the sale of 50,000 shares of Series A Preferred Stock at a price of $1,000 per share, subject to the terms and conditions contained in the Restated Stock Purchase Agreement.  The Private Placement closed on the same date for an aggregate of $50,000.  Included in the 50,000 shares of Series A Preferred Stock sold in the Private Placement were 5,000 shares of Series A Preferred Stock issued to CapGen in exchange for the 5,000 shares of Series B Preferred Stock purchased by CapGen in the Series B Sale, pursuant to an amended and restated exchange agreement between Bancorp and CapGen dated December 31, 2012.  Also included in the shares sold in the Private Placement was an aggregate of 2,265 shares of Series A Preferred Stock sold through individual subscription agreements to certain of Bancorp’s directors, executive officers and other related parties (the “Subscribers”) for consideration of an aggregate of $465 in cash and $1,800 in the cancellation of outstanding debt under the Company’s revolving loan agreements held by certain of the Subscribers and/or their related interests.  As a result of this transaction, no one entity owns more than 50% of Bancorp’s voting equity.

Pursuant to the Series A Preferred Stock designation, the Series A Preferred Stock was mandatorily convertible into shares of Bancorp’s common stock and a new class of nonvoting common stock upon receipt of requisite approvals by Bancorp’s shareholders.  On February 18, 2013, the Company received shareholder approvals to amend its Amended and Restated Articles of Incorporation to (i) increase the number of authorized shares of the Company’s common stock to 20,000,000, and (ii) authorize 5,000,000 shares of a new class of nonvoting common stock, par value $0.01 per share (the “Capital Amendment”).  On the same date, the Company also received shareholder approval to issue an aggregate of 5,000,000 shares of its common stock and nonvoting common stock in the conversion of the 50,000 outstanding shares of the Company’s Series A Preferred Stock.

13

JACKSONVILLE BANCORP, INC.

NOTE 2 – CAPITAL RAISE TRANSACTIONS (Continued)

On February 19, 2013, the Company filed the Capital Amendment with the Florida Secretary of State, and on the same date, all of the outstanding shares of the Company’s Series A Preferred Stock automatically converted into an aggregate of 2,382,000 shares of common stock and 2,618,000 shares of nonvoting common stock (the “Conversion”).  The Conversion was based on a conversion price of $10.00 per share and a conversion rate of 100 shares of common stock and/or nonvoting common stock for each share of Series A Preferred Stock outstanding.  As a result of the Conversion, no shares of the Series A Preferred Stock remain outstanding and an aggregate of 2,676,544 shares of common stock and 2,618,000 shares of nonvoting common stock were outstanding immediately following the Conversion.

Net proceeds from the issuance of preferred stock in the amount of $45,140 were used for general operating expenses, mainly for the subsidiary bank, to improve capital ratios, and will be used to support the Company’s business strategy going forward.  Please refer Note 10—Shareholders’ Equity for additional information pertaining to the Company’s equity securities issued in conjunction with the previously described capital raise transactions.

Immediately prior to the closing of the Private Placement, the Bank sold $25,134 of other real estate owned, nonaccrual loans, loans with a history of being past due, and other loans that were part of an overall customer relationship to a real estate investment firm, who was also an investor in the Private Placement, for a purchase price of $11,705 (the “Asset Sale”).  Total assets sold in the Asset Sale included loans of $24,601 and other real estate owned of $533.  Total proceeds of $11,705 included proceeds from the sale of loans of $11,313 and proceeds from the sale of other real estate owned of $392.  Please refer to Note 4—Loans and Allowance for Loan Losses for additional information related to loans sold in the Asset Sale.

2013 Capital Raise Activities

On August 21, 2013, the Company distributed to its eligible existing shareholders nontransferable subscription rights to purchase shares of the Company’s common stock at a subscription price of $10.00 per share.  The subscription rights entitled the holders of our common stock as of August 20, 2013 (excluding participants in the Private Placement) to purchase an aggregate of approximately 500,000 shares of the Company’s common stock.  The subscription period for the rights offering expired on September 20, 2013 and resulted in the sale of 104,131 shares of the Company’s common stock for an aggregate of $1,041, or $937 net of offering expenses.

Concurrently with the rights offering, the Company initiated a public offering of shares not subscribed for in the rights offering at an equal subscription price of $10.00 per share.  At the completion of the rights offering, 395,869 shares of common stock remained available for sale in the public offering.  The public offering expired on October 4, 2013.  Please refer to Note 14 – Subsequent Events for additional information related to the public offering and net proceeds from the concurrent offerings.

Management’s Plan

The Company’s strategic initiatives address the actions necessary to restore profitability and achieve full compliance with all outstanding regulatory agreements.  In addition to the capital raise transactions and Asset Sale described in the preceding paragraphs, management has also pursued, and will continue to pursue, various options to aid in the steady improvement of the Company’s financial condition and results of operations.

During the second quarter of 2012, the Company adopted a strategy to accelerate the disposition of substandard assets on an individual customer basis.  This strategy materially impacted the Company’s earnings for the year ended December 31, 2012 as a result of the increased provision for loan losses, expenses related to protecting our collateral position, and aggressively pursuing foreclosure actions when necessary.  Additionally, the aggressive pursuit of foreclosure actions resulted in an increase in other real estate owned expenses during the same period.

During the nine months ended September 30, 2013 and looking forward, the Company intends to maintain the quality of its loan portfolio by continuing to improve the overall credit process including, but not limited to, loan origination disciplines, stricter underwriting criteria, and succinct funding and onboarding processes.  In addition, the Company is working to reposition its loan and deposit portfolio mix to better align with our targeted market segment of professional services, wholesalers, distributors and other service industries resulting in greater diversification in our balance sheet.  Such improvements have not yet materially impacted our financial statements; however, these changes have contributed to the current reduction of loan-related expenses and recent improvements in the Company’s overall asset quality.

14

JACKSONVILLE BANCORP, INC.

NOTE 2 – CAPITAL RAISE TRANSACTIONS (Continued)

In October 2013, Bancorp’s Board of Directors implemented a 1-for-20 reverse stock split of the Company’s issued and outstanding shares of common stock and nonvoting common stock in an effort to increase the market price of the Company’s common stock and thereby enhance the overall liquidity of issued and outstanding shares of common stock and nonvoting common stock and regain compliance with NASDAQ continued listing standards.  As of the effective date of the reverse stock split, the Company’s per share market price increased from $0.51 to $10.20.  However, there can be no assurance that the reverse stock split, or any other measures taken by Bancorp’s Board of Directors to increase the market price of the common stock, will result in the intended benefits.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

NOTE 3 - INVESTMENT SECURITIES

The following table summarizes the amortized cost and fair value of the available-for-sale and held-to-maturity investment securities portfolio as of September 30, 2013 and December 31, 2012 and the corresponding amounts of unrealized gains and losses recognized in accumulated other comprehensive income (loss):

(Dollars in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
September 30, 2013
Available-for-sale:
U.S. government-sponsored entities and agencies	$	8,642	$	204	$	(52	)	$	8,794
State and political subdivisions		7,953		384		(61	)		8,276
Mortgage-backed securities - residential		32,707		834		(114	)		33,427
Collateralized mortgage obligations		34,939		183		(546	)		34,576
Corporate bonds		3,040		100		(10	)		3,130
Total available-for-sale securities	$	87,281	$	1,705	$	(783	)	$	88,203

December 31, 2012	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
Available-for-sale:
U.S. government-sponsored entities and agencies	$	10,286	$	205	$	-		$	10,491
State and political subdivisions		16,598		1,568		-			18,166
Mortgage-backed securities - residential		32,148		1,504		(6	)		33,646
Collateralized mortgage obligations		19,349		201		(23	)		19,527
Corporate bonds		2,048		107		-			2,155
Total available-for-sale securities	$	80,429	$	3,585	$	(29	)	$	83,985

As of September 30, 2013 and December 31, 2012, the Company’s investment securities portfolio did not include any held-to-maturity securities.

The following table summarizes the proceeds from sales of available-for-sale securities and the associated gains and losses for the three and nine months ended September 30, 2013 and 2012:

	Three Months Ended September 30,					Nine Months Ended September 30,
(Dollars in thousands)	2013			2012		2013			2012
Gross gains	$	522		$	-	$	601		$	-
Gross losses		(131	)		-		(164	)		-
Net gain	$	391		$	-	$	437		$	-
Proceeds	$	10,267		$	-	$	14,434		$	-

15

JACKSONVILLE BANCORP, INC.

NOTE 3 - INVESTMENT SECURITIES (Continued)

The amortized cost and fair value of the investment securities portfolio are presented below in order of contractual maturity. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.  Securities not due at a single maturity date, primarily mortgage-backed securities – residential and collateralized mortgage obligations, are shown separately.

(Dollars in thousands) September 30, 2013	Amortized Cost		Fair Value
Available-for-sale:
Within one year	$	-	$	-
One to five years		2,770		2,897
Five to ten years		5,342		5,410
Beyond ten years		11,523		11,893
Mortgage-backed securities – residential		32,707		33,427
Collateralized mortgage obligations		34,939		34,576
Total	$	87,281	$	88,203

The following table summarizes the investment securities with unrealized losses as of September 30, 2013 and December 31, 2012 listed by aggregated major security type and length of time in a continuous unrealized loss position:

	Less Than 12 Months						12 Months or Longer					Total
(Dollars in thousands) September 30, 2013	Fair Value			Unrealized losses			Fair Value		Unrealized losses			Fair Value		Unrealized losses
Available-for-sale:
U.S. government-sponsored entities and agencies	$	948	��	$	(52	)	$	-	$	-		$	948	$	(52	)
State and political subdivisions		1,019			(61	)		-		-			1,019		(61	)
Mortgage backed securities – residential		6,096			(114	)		-		-			6,096		(114	)
Collateralized mortgage obligations		19,716			(485	)		2,701		(61	)		22,417		(546	)
Corporate bonds		990			(10	)		-		-			990		(10	)
Total available-for-sale securities	$	28,769		$	(722	)	$	2,701	$	(61	)	$	31,470	$	(783	)

	Less Than 12 Months					12 Months or Longer				Total
December 31, 2012	Fair Value		Unrealized losses			Fair Value		Unrealized losses		Fair Value		Unrealized losses
Available-for-sale:
U.S. government-sponsored entities and agencies	$	-	$	-		$	-	$	-	$	-	$	-
State and political subdivisions		-		-			-		-		-		-
Mortgage backed securities – residential		1,289		(6	)		-		-		1,289		(6	)
Collateralized mortgage obligations		6,821		(23	)		-		-		6,821		(23	)
Corporate bonds		-		-			-		-		-		-
Total available-for-sale securities	$	8,110	$	(29	)	$	-	$	-	$	8,110	$	(29	)

As of September 30, 2013 and December 31, 2012, the Company’s security portfolio consisted of $88,203 and $83,985, respectively, in available-for-sale securities, of which $31,470 and $8,110 were in an unrealized loss position for the related periods.  The unrealized losses as of September 30, 2013 and 2012 were related to all securities types held by the Company, as discussed below.

U.S. Government-Sponsored Entities and Agency Securities (“U.S. Agency Securities”):

All of the U.S. Agency Securities held by the Company were issued by U.S. government-sponsored entities and agencies. As of September 30, 2013 and December 31, 2012, U.S. Agency Securities with unrealized losses were one and none, respectively.  As of September 30, 2013 and December 31, 2012, these securities had depreciated 5.21% and 0.00%, respectively, from the Company’s amortized cost basis.  The decline in fair value was attributable to changes in interest rates, not credit quality.

16

JACKSONVILLE BANCORP, INC.

NOTE 3 - INVESTMENT SECURITIES (Continued)

State and Political Securities (“Municipal Bonds”):

All of the Municipal Bonds held by the Company were issued by a state, city or other local government and represent general obligations of the issuer that are secured by specified revenues.  As of September 30, 2013 and December 31, 2012, Municipal Bonds with unrealized losses were two and none, respectively.  As of September 30, 2013 and December 31, 2012, these securities had depreciated 5.69% and 0.00%, respectively, from the Company’s amortized cost basis. The decline in fair value was primarily attributable to changes in interest rates rather than the ability or willingness of the municipality to repay.

Mortgage-backed Securities – Residential (“Mortgage-backed Securities”):

All of the Mortgage-backed Securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Ginnie Mae and Fannie Mae, institutions which have the full faith and credit of the U.S. government.  As of September 30, 2013 and December 31, 2012, Mortgage-backed Securities with unrealized losses were five and one, respectively.  As of September 30, 2013 and December 31, 2012, these securities had depreciated 1.83% and 0.44%, respectively, from the Company’s amortized cost basis.  The decline in fair value was attributable to changes in interest rates, not credit quality.

Collateralized Mortgage Obligations:

All of the collateralized mortgage obligation securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Ginnie Mae, an institution which has the full faith and credit of the U.S. government.  As of September 30, 2013 and December 31, 2012, collateralized mortgage obligations with unrealized losses were fifteen and five, respectively.  As of September 30, 2013 and December 31, 2012, these securities had depreciated 2.38% and 0.34%, respectively, from the Company’s amortized cost basis.  The decline in fair value was attributable to changes in interest rates, not credit quality.

Corporate Bonds:

All of the corporate bonds held by the Company were debt obligations issued by corporations, with no inherent claim to ownership.  As of September 30, 2013 and December 31, 2012, corporate bonds with unrealized losses were one and none, respectively.  As of September 30, 2013 and December 31, 2012, these securities had depreciated 0.98% and 0.00%, respectively, from the Company’s amortized cost basis.  The decline in fair value was attributable to changes in interest rates, not the credit quality of the issuer.

Other-Than-Temporary Impairment

Because the Company does not have the intent to sell these securities, and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these to be other-than-temporarily impaired as of September 30, 2013 and December 31, 2012.

For the nine months ended September 30, 2013 and 2012, there were no credit losses recognized in earnings related to investment securities.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES

Loans as of September 30, 2013 and December 31, 2012 were as follows:

(Dollars in thousands)	September 30, 2013			December 31, 2012
Commercial loans	$	42,668		$	37,760
Real estate mortgage loans:
Residential		72,208			80,314
Commercial		225,159			239,839
Construction and land		30,982			37,557
Consumer and other loans		2,170			2,768
Loans, gross		373,187			398,238
Less:
Net deferred loan fees		(232	)		(207	)
Allowance for loan losses		(16,974	)		(20,198	)
Loans, net	$	355,981		$	377,833

17

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Loans acquired as a result of the merger with ABI were recorded at fair value on the date of acquisition.  The amounts reported in the table above are net of the fair value adjustments.  The table below reflects the contractual amount of purchased loans less the discount to principal balances remaining from these fair value adjustments by class of loan as of September 30, 2013 and December 31, 2012.  This discount will be accreted into interest income as deemed appropriate over the remaining term of the related loans.

(Dollars in thousands) September 30, 2013	Gross Contractual Amount Receivable		Discount		Carrying Balance
Commercial loans	$	2,170	$	190	$	1,980
Real estate mortgage loans:
Residential		24,059		1,398		22,661
Commercial		45,775		3,140		42,635
Construction and land		5,681		428		5,253
Consumer and other loans		488		7		481
Total	$	78,173	$	5,163	$	73,010

December 31, 2012	Gross Contractual Amount Receivable		Discount		Carrying Balance
Commercial loans	$	2,592	$	226	$	2,366
Real estate mortgage loans:
Residential		32,383		2,541		29,842
Commercial		52,660		3,833		48,827
Construction and land		13,193		1,753		11,440
Consumer and other loans		662		13		649
Total	$	101,490	$	8,366	$	93,124

The Company has divided the loan portfolio into three portfolio segments, each with different risk characteristics and methodologies for assessing risk.  The three portfolio segments identified by the Company are described below.

Commercial Loans:

Commercial loans are primarily underwritten on the basis of the borrowers’ ability to service such debt from income.  The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value.  As a general practice, we take as collateral a security interest in any available real estate, equipment, or other chattel, although loans may also be made on an unsecured basis.  Collateralized working capital loans typically are secured by short-term assets whereas long-term loans are primarily secured by long-term assets.  Risk is mitigated by the diversity and number of borrowers.

Real Estate Mortgage Loans:

Real estate mortgage loans are typically segmented into three classes:  commercial real estate, residential real estate and construction and land development.  Commercial real estate loans are secured by the subject property and are underwritten based upon standards set forth in the policies approved by the Bank’s Board of Directors (the “Bank’s Board”).  Such standards include, among other factors, loan-to-value limits, cash flow coverage and general credit worthiness of the obligors.  Residential real estate loans are underwritten in accordance with policies set forth and approved by the Bank’s Board, including repayment capacity and source, value of the underlying property, credit history, stability and purchaser guidelines.  Construction loans to borrowers are to finance the construction of owner occupied and lease properties.  These loans are categorized as construction loans during the construction period, later converting to commercial or residential real estate loans after the construction is complete and amortization of the loan begins.  Real estate development and construction loans are approved based on an analysis of the borrower and guarantor, the viability of the project and on an acceptable percentage of the appraised value of the property securing the loan.   Real estate development and construction loan funds are disbursed periodically based on the percentage of construction completed.  The Bank carefully monitors these loans with on-site inspections and requires the receipt of lien waivers prior to advancing funds.  Development and construction loans are typically secured by the properties under development or construction, and personal guarantees are typically obtained.  Further, to assure that reliance is not placed solely on the value of the underlying property, the Bank considers the market conditions and feasibility of proposed projects, the financial condition and reputation of the borrower and guarantors, the amount of the borrower’s equity in the project, independent appraisals, cost estimates and pre-construction sale information.  The Bank also makes loans on occasion for the purchase of land for future development by the borrower.  Land loans are extended for the future development of either commercial or residential use by the borrower.  The Bank carefully analyzes the intended use of the property and the viability thereof.

18

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Repayment of real estate loans is primarily dependent upon the personal income or business income generated by the secured property of the borrowers, which can be impacted by the economic conditions in their market area.  Risk is mitigated by the fact that the properties securing the Company’s real estate loan portfolio are diverse in type and spread over a large number of borrowers.

Consumer and Other Loans:

Consumer and other loans are extended for various purposes, including purchases of automobiles, recreational vehicles, and boats.  We also offer home improvement loans, lines of credit, personal loans, and deposit account collateralized loans.  Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas, such as unemployment levels. Loans to consumers are extended after a credit evaluation, including the credit worthiness of the borrower(s), the purpose of the credit, and the secondary source of repayment. Consumer loans are made at fixed and variable interest rates and may be made on terms of up to ten years. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

Activity in the allowance for loan losses by portfolio segment for the three and nine months ended September 30, 2013 and 2012 was as follows:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(Dollars in thousands)	2013			2012		2013			2012
Allowance at beginning of period	$	17,303		$	20,647	$	20,198		$	13,024
Charge-offs:
Commercial loans		57			401		121			878
Real estate mortgage loans		724			8,289		3,313			12,027
Consumer and other loans		1			98		174			124
Total charge-offs		782			8,788		3,608			13,029
Recoveries:
Commercial loans		11			8		81			13
Real estate mortgage loans		68			164		165			339
Consumer and other loans		7			79		38			107
Total recoveries		86			251		284			459
Net charge-offs		696			8,537		3,324			12,570
Provision for loan losses charged to operating expenses:
Commercial loans		(70	)		153		145			1,148
Real estate mortgage loans		436			5,834		(193	)		16,517
Consumer and other loans		1			3		148			(19	)
Total provision		367			5,990		100			17,646
Allowance at end of period	$	16,974		$	18,100	$	16,974		$	18,100

19

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

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 September 30, 2013 and December 31, 2012:

(Dollars in thousands) September 30, 2013	Commercial Loans		Real Estate Mortgage Loans		Consumer and Other Loans		Total
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	204	$	1,022	$	241	$	1,467
Collectively evaluated for impairment		969		13,486		90		14,545
Loans acquired with deteriorated credit quality		-		962		-		962
Total ending allowance balance	$	1,173	$	15,470	$	331	$	16,974
Loans:
Loans individually evaluated for impairment	$	204	$	15,958	$	241	$	16,403
Loans collectively evaluated for impairment		42,367		291,080		1,927		335,374
Loans acquired with deteriorated credit quality		97		21,311		2		21,410
Total ending loans balance	$	42,668	$	328,349	$	2,170	$	373,187

December 31, 2012	Commercial Loans		Real Estate Mortgage Loans		Consumer and Other Loans		Total
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	29	$	1,168	$	242	$	1,439
Collectively evaluated for impairment		1,039		15,529		77		16,645
Loans acquired with deteriorated credit quality		-		2,114		-		2,114
Total ending allowance balance	$	1,068	$	18,811	$	319	$	20,198
Loans:
Loans individually evaluated for impairment	$	89	$	15,907	$	242	$	16,238
Loans collectively evaluated for impairment		37,574		309,434		2,522		349,530
Loans acquired with deteriorated credit quality		97		32,369		4		32,470
Total ending loans balance	$	37,760	$	357,710	$	2,768	$	398,238

The following table presents loans individually evaluated for impairment, by class of loans as of September 30, 2013 and December 31, 2012:

	September 30, 2013						December 31, 2012
(Dollars in thousands)	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated		Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated
With no related allowance recorded:
Commercial loans	$	-	$	-	$	-	$	159	$	59	$	-
Real estate mortgage loans:
Residential		1,089		849		-		746		402		-
Commercial		7,999		4,858		-		9,669		5,801		-
Construction and land		8,660		4,907		-		11,365		5,270		-
Consumer and other loans		-		-		-		-		-		-
With an allowance recorded:
Commercial loans	$	209	$	205	$	204	$	33	$	30	$	29
Real estate mortgage loans:
Residential		1,773		1,716		363		499		447		297
Commercial		3,604		3,329		453		5,751		3,506		590
Construction and land		298		298		206		500		481		281
Consumer and other loans		253		241		241		242		242		242
Total	$	23,885	$	16,403	$	1,467	$	28,964	$	16,238	$	1,439

20

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

The following table presents the average recorded investment in impaired loans and the related interest income recognized during impairment for the three and nine months ended September 30, 2013 and 2012.

	Three Months Ended September 30, 2013						Nine Months Ended September 30, 2013
(Dollars in thousands)	Average Impaired Loans		Interest Income		Cash- Basis		Average Impaired Loans		Interest Income		Cash- Basis
Commercial loans	$	266	$	-	$	-	$	218	$	-	$	-
Real estate mortgage loans:
Residential		2,735		-		-		2,069		-		-
Commercial		8,675		50		50		9,144		149		150
Construction and land		5,344		6		6		4,609		15		14
Consumer and other loans		232		-		-		240		-		-
Total	$	17,252	$	56	$	56	$	16,280	$	164	$	164

	Three Months Ended September 30, 2012						Nine Months Ended September 30, 2012
	Average Impaired Loans		Interest Income		Cash- Basis		Average Impaired Loans		Interest Income		Cash- Basis
Commercial loans	$	1,359	$	-	$	-	$	1,070	$	-	$	-
Real estate mortgage loans:
Residential		12,046		-		-		12,477		-		-
Commercial		19,611		56		31		20,340		117		97
Construction and land		14,804		-		-		15,923		-		-
Consumer and other loans		27		-		-		22		-		-
Total	$	47,847	$	56	$	31	$	49,832	$	117	$	97

The following table presents the recorded investment in nonaccrual loans by class of loans as of September 30, 2013 and December 31, 2012:

(Dollars in thousands)	September 30, 2013		December 31, 2012
Commercial loans	$	204	$	98
Real estate mortgage loans:
Residential		4,236		4,813
Commercial		5,132		6,151
Construction and land		5,701		11,372
Consumer and other loans		243		247
Total(1)	$	15,516	$	22,681

⁽¹⁾ Includes loans acquired in the merger with ABI.  As of September 30, 2013 and December 31, 2012, these amounts totaled $5,124 and $12,205, respectively.

The number of loans past due over 90 days still on accrual was none and one, as of September 30, 2013 and December 31, 2012, respectively.  As of December 31, 2012, the recorded investment of the loan past due over 90 days still on accrual was $67.

21

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

The following table presents the aging of the recorded investment in past due loans by class of loans as of September 30, 2013 and December 31, 2012:

		Past Due Loans
(Dollars in thousands) September 30, 2013		30-59 Days		60-89 Days		90 Days and Greater		Total		Loans Not Past Due		Total
Commercial loans	$	43	$	13	$	49	$	105	$	42,563	$	42,668
Real estate mortgage loans:
Residential		1,642		93		2,413		4,148		68,060		72,208
Commercial		994		6,570		2,108		9,672		215,487		225,159
Construction and land		712		207		4,706		5,625		25,357		30,982
Consumer and other loans		231		12		-		243		1,927		2,170
Total	$	3,622	$	6,895	$	9,276	$	19,793	$	353,394	$	373,187

	Past Due Loans
December 31, 2012	30-59 Days		60-89 Days		90 Days and Greater		Total		Loans Not Past Due		Total
Commercial loans	$	66	$	8	$	6	$	80	$	37,680	$	37,760
Real estate mortgage loans:
Residential		1,750		825		1,364		3,939		76,375		80,314
Commercial		1,546		1,240		4,685		7,471		232,368		239,839
Construction and land		-		-		10,114		10,114		27,443		37,557
Consumer and other loans		69		244		-		313		2,455		2,768
Total	$	3,431	$	2,317	$	16,169	$	21,917	$	376,321	$	398,238

Included in the past due loan table above are loans acquired in the merger with ABI.  As of September 30, 2013 and December 31, 2012, the amounts of such loans were as follows:

(Dollars in thousands)	September 30, 2013		December 31, 2012
30-59 days past due	$	1,128	$	1,847
60-89 days past due		1,550		676
90 days past due and greater		3,509		6,722
Total past due	$	6,187	$	9,245

The delinquency status of purchased credit impaired loans that resulted from our acquisition of ABI is based on the contractual terms of the loan.  In effect, past due status of an acquired loan is determined in the same manner as loans originated by the Bank.

Troubled Debt Restructurings

During the normal course of business, the Company may restructure or modify the terms of a loan for various reasons.  The restructuring of a loan is considered a troubled debt restructuring if both (i) the borrower is experiencing financial difficulties and (ii) a concession is granted that otherwise would not have occurred under normal circumstances.

The following table presents the recorded investment and specific reserves allocated to loans modified as troubled debt restructurings (“TDRs”) as of September 30, 2013 and December 31, 2012.

(Dollars in thousands)	September 30, 2013		December 31, 2012
Recorded investment(1)	$	11,546	$	10,991
Specific reserves allocated(2)		625		464

⁽¹⁾ Of the total recorded investment in loans modified as TDRs, $4,234 and $6,028, respectively, were for customers whose loans were collateral dependent with collateral shortfalls.

⁽²⁾ Of the specific reserves allocated to customers whose loan terms were modified as TDRs, $531 and $412, respectively, were allocated to customers whose loans were collateral dependent with collateral shortfalls.

22

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

As of September 30, 2013, the Company had extended additional credit of $483 to customers with outstanding loans whose terms have been modified as TDRs, whereas the Company had not committed to lend additional amounts as of December 31, 2012.

The following table represents loans by class modified as troubled debt restructurings that occurred during the three and nine months ended September 30, 2013 and 2012, respectively:

	Three Months Ended							Nine Months Ended
	September 30, 2013							September 30, 2013
(Dollars in thousands)	Number of loans	Pre-Modification Outstanding Recorded Investment			Post-Modification Outstanding Recorded Investment			Number of loans	Pre-Modification Outstanding Recorded Investment			Post-Modification Outstanding Recorded Investment
Commercial loans	-		$	-		$	-	1		$	66		$	66
Real estate mortgage loans:
Residential	-			-			-	2			1,277			1,474
Commercial	1			341			341	1			341			341
Construction and land	2			996			996	4			4,280			4,260
Consumer and other loans	-			-			-	-			-			-
Total	3		$	1,337		$	1,337	8		$	5,964		$	6,141

	Three Months Ended							Nine Months Ended
	September 30, 2012							September 30, 2012
	Number of loans	Pre-Modification Outstanding Recorded Investment			Post-Modification Outstanding Recorded Investment			Number of loans	Pre-Modification Outstanding Recorded Investment			Post-Modification Outstanding Recorded Investment
Commercial loans	-		$	-			-	-		$	-		$	-
Real estate mortgage loans:
Residential	1			29			29	1			29			29
Commercial	2			865			865	3			2,760			2,760
Construction and land	-			-			-	-			-			-
Consumer and other loans	-			-			-	-			-			-
Total	3		$	894		$	894	4		$	2,789		$	2,789

During the three and nine months ended September 30, 2013, the number of loans modified as troubled debt restructurings were three and eight, respectively.  These troubled debt restructurings include several loans modified into a multiple loan structure to accommodate the revised terms and are presented based on the number of loans pre-modification.  The terms of these loans were modified as a troubled debt restructuring because the borrowers were experiencing financial difficulties. The loan modifications allowed the borrowers to make reduced payments, such as (i) forbearance of payments for a limited period of time with revised payment schedules to coordinate with periods of forbearance, (ii) change from principal and interest payments to interest only payments through maturity, (iii) reduced principal and interest payments through maturity, (iv) forgiveness of principal, (v) reduced principal and interest payments through maturity with an assumption of additional debt to protect the Bank’s collateral position, (vi) change from variable rate interest only payments through maturity to fixed rate interest only payments for a limited period of time and reduced principal and interest payments through maturity, or (vii) change from variable rate interest only payments through maturity to fixed rate and reduced principal and interest payments through maturity, or (viii) proposed forgiveness of principal contingent upon the satisfaction of the modified terms.  Principal forgiven in the amount of $565 was offset by existing reserves from purchase accounting adjustments in the amount of $545 which resulted in a net charge-off of $20.  The troubled debt restructurings described above increased the allowance for loan losses by $273 and $400, respectively, and resulted in no charge-offs for the three months ended September 30, 2013 and charge-offs of $233 for the nine months ended September 30, 2013.  For the three and nine months ended September 30, 2013, the number of collateral-impaired loans modified as troubled debt restructurings were one and three, respectively.

23

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

During the three and nine months ended September 30, 2012, there were three and four loans modified as troubled debt restructurings, respectively.  The terms of these loans were modified as a troubled debt restructuring because the borrowers were experiencing financial difficulties. The loan modifications allowed the borrowers to make reduced payments, including (i) interest-only payments through maturity, (ii) interest only payments for a limited period of time, followed by reduced principal and interest payments through maturity, or (iii) reduced principal and interest payments through maturity.  These troubled debt restructurings increased the allowance for loan losses by $180 and $706, respectively, and did not result in any charge-offs for the three and nine months ended September 30, 2012.

There were no TDRs for which there was a payment default within twelve months following the modification during the three and nine months ended September 30, 2013 and 2012, respectively.  A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.

The terms of certain other loans that did not meet the definition of a troubled debt restructuring were modified during the three and nine months ended September 30, 2013 and 2012.  These loans had a total recorded investment of $1,387 and $7,152 for the three and nine months ended September 30, 2013, respectively, and $639 and $17,739 for the three and nine months ended September 30, 2012, respectively.  These modifications involved loans to borrowers who were not experiencing financial difficulties and included (i) allowing the borrowers to make interest-only payments for a limited period of time (generally 18 months or less), (ii) adjusting the interest rate to a market interest rate through maturity, (iii) allowing a delay in payment that was considered to be insignificant, (iv) extension of credit with an additional increase in principal payments, or (v) reduced principal and interest payments with the remaining principal due at maturity.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the Company’s internal underwriting policy.

Credit Quality Indicators

The Company categorizes 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.

The Company analyzes loans individually by classifying the loans as to credit risk.  All loans are graded upon initial issuance.  Loans classified as substandard or special mention are reviewed at least quarterly by the Company for further deterioration or improvement to determine if they are appropriately classified and whether there is any impairment.  Further, commercial loans are typically reviewed at least annually to determine the appropriate loan grading.  In addition, during the renewal process of any loan, as well as if a loan becomes more than 30 days past due, the Company determines the appropriate loan grade.

Loans excluded from the review process above are generally classified as pass credits until:  (i) they become past due; (ii) management becomes aware of a deterioration in the credit worthiness of the borrower; or (iii) the customer contacts the Company for a modification.  In these circumstances, the loan is specifically evaluated for potential classification as to special mention, substandard or doubtful.  The Company uses the following definitions for risk ratings:

Special Mention:

Loans classified as special mention 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 of the institution’s 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.

24

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (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.

Loans not meeting the criteria above that are analyzed individually as part of the above-described process are considered to be pass-rated loans.  As of September 30, 2013 and December 31, 2012, and based on the most recent analysis performed, the risk category of loans by class of loans was as follows:

(Dollars in thousands) September 30, 2013	Pass		Special Mention		Substandard		Doubtful		Total
Commercial loans	$	41,548	$	663	$	457	$	-	$	42,668
Real estate mortgage loans:
Residential		59,761		5,277		7,170		-		72,208
Commercial		203,048		4,689		17,422		-		225,159
Construction and land		21,409		777		8,796		-		30,982
Consumer and other loans		1,867		60		243		-		2,170
Total	$	327,633	$	11,466	$	34,088	$	-	$	373,187

December 31, 2012	Pass		Special Mention		Substandard		Doubtful		Total
Commercial loans	$	37,206	$	415	$	139	$	-	$	37,760
Real estate mortgage loans:
Residential		66,405		6,401		7,508		-		80,314
Commercial		207,674		14,970		17,195		-		239,839
Construction and land		19,229		4,660		13,668		-		37,557
Consumer and other loans		2,507		12		249		-		2,768
Total	$	333,021	$	26,458	$	38,759	$	-	$	398,238

Included in the risk category of loans by class of loans table above are loans acquired in the merger with ABI.  As of September 30, 2013 and December 31, 2012, the amounts of such loans were as follows:

(Dollars in thousands)	September 30, 2013		December 31, 2012
Special mention	$	1,034	$	6,963
Substandard		11,992		20,897
Doubtful		-		-
Total	$	13,026	$	27,860

25

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Loans Sold

On December 28, 2012, the Bank entered into an Asset Purchase Agreement with a real estate investment firm for the sale of $25,134 in assets, including non-accrual loans, loans with a history of being past due, and other loans that were part of an overall customer relationship for a total of $24,601 and other real estate owned (“OREO”) of $533, for a purchase price of $11,705.  The Asset Sale was completed on December 31, 2012, immediately prior to the closing of the Private Placement.  The carrying amount and composition of loans sold in the Asset Sale, as well as total net charge-offs that occurred on the date of sale, were as follows:

(Dollars in thousands)	Recorded Investment		Total Net Charge-Offs(1)
Loans originated by the Company:
Commercial loans	$	113	$	(53	)
Real estate mortgage loans:
Residential		2,584		1,435
Commercial		13,159		7,394
Construction and land		3,162		2,042
Consumer and other loans		-		-
Loans acquired:
Commercial loans	$	111	$	46
Real estate mortgage loans:
Residential		546		185
Commercial		4,926		2,157
Construction and land		-		-
Consumer and other loans		-		-
Total loans:
Commercial loans	$	224	$	(7	)
Real estate mortgage loans:
Residential		3,130		1,620
Commercial		18,085		9,551
Construction and land		3,162		2,042
Consumer and other loans		-		-
Total loans sold	$	24,601	$	13,206

⁽¹⁾ Includes any specific reserve that existed prior to the date of sale (if applicable).

Purchased Loans

The Company has purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.  The carrying amounts of these loans were as follows as of September 30, 2013 and December 31, 2012:

(Dollars in thousands)	September 30, 2013		December 31, 2012
Commercial loans	$	166	$	206
Real estate mortgage loans:
Residential		6,699		10,799
Commercial		14,529		15,709
Construction and land		2,288		10,404
Consumer and other loans		2		5
Unpaid principal balance	$	23,684	$	37,123
Carrying amount	$	21,410	$	32,470

26

JACKSONVILLE BANCORP, INC.

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Accretable yield, or income expected to be collected, from these loans was as follows:

(Dollars in thousands)
Balance as of December 31, 2011	$	16,343
New loans purchased, including loans classified as held-for-sale		-
Accretion of income		(2,593	)
Reduction for loans sold, paid off and other		(1,923	)
Loans charged off		-
Reclassifications from nonaccretable difference		-
Disposals		-
Balance as of December 31, 2012	$	11,827
New loans purchased, including loans classified as held-for-sale		-
Accretion of income		(1,548	)
Reduction for loans sold, paid off and other		(1,018	)
Loans charged off		(935	)
Reclassifications from nonaccretable difference		-
Disposals		-
Balance as of September 30, 2013	$	8,326

For those purchased loans disclosed above, the Company increased the allowance for loan losses to $962 and $2,114 as of September 30, 2013 and December 31, 2012, respectively.  Additionally, no allowance for loan losses related to these loans was reversed during the aforementioned time periods.

NOTE 5 – GOODWILL

The Company had no goodwill on its consolidated balance sheets as of September 30, 2013 and December 31, 2012.  The change in goodwill during the year ended December 31, 2012 is presented in the table below with no activity during the nine months ended September 30, 2013:

(Dollars in thousands)
Balance as of December 31, 2011	$	3,137
Additions		-
Impairment		(3,137	)
Balance as of December 31, 2012	$	-

Impairment exists when the carrying value of goodwill exceeds its fair value, which is determined through a two-step impairment test. Step 1 includes the determination of the carrying value of our single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit.  If the carrying amount exceeds its fair value, we are required to perform a second step to the impairment test.  Step 2 of the impairment test is performed to measure the potential impairment loss, which requires that the implied fair value of goodwill be compared with the carrying amount.  The amount of excess carrying amount over the implied fair value is recognized as an impairment loss.

The Company evaluates goodwill for impairment annually as of September 30^th unless events or changes in circumstances indicate potential impairment has occurred between formal assessments.  A third-party valuation specialist was engaged to assist management in determining the fair value of the Company and whether goodwill was impaired.  The fair value was determined by comparing the output of several different valuation methodologies including:

· Net asset valuation method—this methodology develops a valuation indication in the context of a going concern by adjusting the reported book values of the Company’s assets to their market values and subtracting its liabilities.  The indicated value should not be interpreted as an estimate of liquidation value,

· Guideline public company method—this methodology utilizes the pricing of publicly-traded banks and bank holding companies bearing certain similarities to the Company,

· Guideline transactions method—this methodology utilizes pricing data from change of control transactions involving appropriately comparable banks and bank holding companies, and

· Discounted cash flow method – this methodology relies upon the perception of a future stream of benefits, the present value of which represents the indication of value of the Company.

27

JACKSONVILLE BANCORP, INC.

NOTE 5 – GOODWILL (Continued)

The annual impairment analysis as of September 30, 2012 determined that there had been a goodwill impairment of $3,137, which reduced the carrying value of the remaining goodwill balance to zero.  This impairment was due to several factors, including the financial performance of the Company through September 30, 2012 resulting from the increased provision for loan losses.  The Company recorded a charge to earnings for the same amount of the impairment during the nine months ended September 30, 2012 which contributed to the net loss for the period.

NOTE 6 – LOANS FROM RELATED PARTIES

During the year ended December 31, 2011, the Company entered into revolving loan agreements (collectively, the “Revolvers”) with several of its directors and other related parties.  Amounts outstanding under the Revolvers were $2,200 as of September 30, 2013 and December 31, 2012 with no remaining funds available as of September 30, 2013 and $1,800 remaining funds available as of December 31, 2012.  Each Revolver pays an annual rate of interest equal to 8% on a quarterly basis of the Revolver amount outstanding.  To the extent that any Revolver is not fully drawn, an unused revolver fee is calculated and paid quarterly at an annual rate of 2% on the revolving loan commitment less the daily average principal amount outstanding.  The Revolvers mature on January 1, 2015.

In connection with the Private Placement, certain of the Company’s directors, executive officers and other related parties (the “Subscribers”) purchased shares of Series A Preferred Stock through individual subscription agreements.  Consideration for the shares of Series A Preferred Stock sold under the Subscription Agreements included $1,800 in the cancellation of outstanding debt under the Company’s Revolvers held by such Subscribers and/or their related interests.  Funds remaining available under the Revolvers as of December 31, 2012 were a direct result of this transaction.

During the second quarter of 2013, participants in the Private Placement were granted the option to reduce their loan commitments under the Revolvers based on the amount previously utilized to purchase shares of Series A Preferred Stock.  If elected by June 15, 2013, this option would reduce the amount of the loan commitment, as applied to each lender, to zero as of July 1, 2013 and correspondingly reduce the calculation of the unused revolver fee in future periods.  As of June 15, 2013, all such participants in the Private Placement elected to reduce the amount of their loan commitments under the Revolvers resulting in a reduction of the maximum borrowings available to the Company from $4,000 as of December 31, 2012 to $2,200 as of July 1, 2013.  The reduction of loan commitments on these revolving loan agreements impacted only related parties that participated in the Private Placement and did not result in any modifications to the remaining loan agreements.

Please refer to Note 14 – Subsequent Events for additional information regarding recent changes in borrowing capacity under the Revolvers.

NOTE 7 – SHORT-TERM BORROWINGS AND FEDERAL HOME LOAN BANK ADVANCES

As of September 30, 2013and December 31, 2012, advances from the FHLB were as follows:

(Dollars in thousands)	September 30, 2013		December 31, 2012
Overnight advances maturing daily at a daily variable interest rate of 0.36% on September 30, 2013	$	-	$	-
Advances maturing July 15, 2014 at a fixed rate of 2.42%		2,500		2,500
Advance maturing January 9, 2015 at a fixed rate of 0.88%		4,000		4,000
Advances maturing March 2, 2015 at a fixed rate of 0.76%		2,000		2,000
Advances maturing July 15, 2016 at a fixed rate of 2.81%		2,500		2,500
Advances maturing January 9, 2017 at a fixed rate of 1.40%		4,000		4,000
Advances maturing May 30, 2017 at a fixed  rate of 1.23%		5,000		5,000
Total advances from the FHLB	$	20,000	$	20,000

Each advance is payable at its maturity date, with a prepayment penalty for early termination.  The advances are collateralized by a blanket lien arrangement on the Company’s first mortgage loans, second mortgage loans and commercial real estate loans.  Based upon this collateral and the Company’s holdings of FHLB stock, the Company was eligible to borrow up to a total of $26,780 as of September 30, 2013 and had borrowed $20,000, leaving $6,780 available.  As of December 31, 2012, the Company was eligible to borrow up to a total of $35,067 and had borrowed $20,000, leaving $15,067 available as of the same date.

28

JACKSONVILLE BANCORP, INC.

NOTE 7 – SHORT-TERM BORROWINGS AND FEDERAL HOME LOAN BANK ADVANCES (Continued)

The Company also has a “Borrower in Custody” line of credit with the Federal Reserve by pledging collateral.  The amount of this line as of September 30, 2013 and December 31, 2012 was $22,194 and $22,917, respectively, all of which was available as of the respective dates.

Also included in FHLB advances and other borrowings on the Company’s consolidated balance sheets were amounts related to certain loan participation agreements that were classified as secured borrowings as they did not qualify for sale accounting treatment.  As of September 30, 2013 and December 31, 2012, these loan participation agreements were $159 and $176, respectively.  A corresponding amount was recorded as an asset within Loans on the Company’s consolidated balance sheets.

NOTE 8 – SUBORDINATED DEBENTURES

The Company and ABI, which the Company acquired by merger, have participated in four offerings related to debt securities and trust preferred securities, each with 30-year lives.  Interest on all subordinated debentures related to trust preferred securities is payable quarterly.  Under these arrangements, the Company has the right to defer dividend payments to the trust preferred security holders for up to five years.  During the year ended December 31, 2012, the Company exercised its contractual right to defer interest payments with respect to all of the outstanding trust preferred securities.  Under the terms of the related indentures, the Company may defer interest payments for up to 20 consecutive quarters without default or penalty.  Subsequent to their deferral, these payments were periodically evaluated and were reinstated as of March 15, 2013.  Previously deferred payments were paid in full as of the same date.

NOTE 9 – DERIVATIVE FINANCIAL INSTRUMENT

On July 7, 2009, the Company entered into an interest rate swap transaction with SunTrust Bank to mitigate interest rate risk exposure.  Under the terms of the agreement, which relates to the subordinated debt issued to Jacksonville Bancorp, Inc. Statutory Trust III in the amount of $7,550, the Company agreed to pay a fixed rate of 7.53% for a period of ten years in exchange for the original floating-rate contract (90-day LIBOR plus 375 basis points).  The fair value of this derivative instrument was $873 and $1,294 as of September 30, 2013 and December 31, 2012, respectively.  The fair value of the hedged item was $4,857 and $5,531 as of the same dates.

The hedge was designated as a cash flow hedge and was determined to be fully effective during all periods presented.  As such, no amount of ineffectiveness has been included in net income and the aggregate fair value of the swap was recorded in Accrued expenses and other assets on the consolidated balance sheets with changes in fair value recorded in other comprehensive income (“OCI”).  The amount included in accumulated other comprehensive income would be reclassified to current earnings should the hedge no longer be considered effective.  The Company expects the hedge to remain fully effective during the remaining term of the swap.

Credit risk may result from the inability of the counterparties to meet the terms of their contracts.  The Company’s exposure is limited to the replacement value of the contracts rather than the notional amount.

NOTE 10 – SHAREHOLDERS’ EQUITY

Preferred Equity

As of September 30, 2013 and December 31, 2012, Bancorp was authorized to issue up to 10,000,000 shares of preferred stock, par value $0.01 per share.  During the year ended December 31, 2012, Bancorp designated and issued two series of preferred stock in connection with the Company’s capital raise efforts.  The voting and other powers, preferences and relative participating, optional or other rights, and the qualifications, limitations and restrictions of each series of Bancorp’s preferred stock are set forth in the corresponding amendment to Bancorp’s Amended and Restated Articles of Incorporation designating such series of preferred stock.  Material features of each series of preferred stock are discussed below.

If declared by Bancorp’s Board of Directors, dividends on any outstanding shares of Bancorp’s preferred stock would reduce earnings available to common shareholders.  In addition, both new series of preferred stock qualified as Tier 1 capital for regulatory purposes.

29

JACKSONVILLE BANCORP, INC.

NOTE 10 – SHAREHOLDERS’ EQUITY (Continued)

Series B Preferred Stock:

The Series B Preferred Stock, designated as “Noncumulative, Nonvoting, Perpetual Preferred Stock, Series B,” was issued and sold by Bancorp on September 27, 2012 in connection with a bridge financing transaction. The Series B Preferred Stock has a liquidation preference of $1,000 per share and ranks senior to Bancorp’s common stock and equally with the Series A Preferred Stock (described below).  Holders of the outstanding shares of Series B Preferred Stock (if any) are entitled to receive, when and if declared by Bancorp’s Board of Directors, dividends at a rate equal to 10% per share per annum of the Series B liquidation amount of $1,000 (equivalent to $100 per share per annum).  Dividends are payable biannually on June 1^st and December 1^st, beginning June 1, 2013.

In connection with the Private Placement, all of the issued and outstanding shares of Series B Preferred Stock were exchanged, on a one for one basis, for shares of Series A Preferred Stock.  As a result, no shares of Series B Preferred Stock were issued or outstanding as of September 30, 2013 and December 31, 2012, respectively.

Series A Preferred Stock:

The Series A Preferred Stock, designated as “Mandatorily Convertible, Noncumulative, Nonvoting, Perpetual Preferred Stock, Series A,” was issued and sold by Bancorp on December 31, 2012 in the Private Placement.   The Series A Preferred Stock has a liquidation preference of $1,000 per share and ranks senior to Bancorp’s common stock and equally with the Series B Preferred Stock.  Holders of the outstanding shares of Series A Preferred Stock are entitled to receive, when and if declared by Bancorp’s Board of Directors, dividends at a rate equal to 5% per share per annum of the liquidation amount of $1,000 (equivalent to $50 per share per annum).  Dividends are payable biannually on June 15^th and December 15^th, beginning February 15, 2013.

The Series A Preferred Stock was mandatorily convertible into shares of common stock and/or a new class of nonvoting common stock upon receipt of requisite shareholder approvals, including (i) approval of an increase in authorized shares of common stock, (ii) authorization of the new class of nonvoting common stock, and (iii) approval of the issuance of shares of common stock and nonvoting common stock upon conversion of the Series A Preferred Stock.  The initial conversion price was $10.00 per share, with each share of Series A Preferred Stock expected to convert into an aggregate of approximately 100 shares of common stock and/or nonvoting common stock, subject to adjustment as provided in the designation for the Series A Preferred Stock.  The conversion price of the Series A Preferred Stock was subject to certain adjustments, including (i) a 10% decrease if the requisite shareholder approvals were not received within 50 days following the Private Placement, or by February 19, 2013 and (ii) customary anti-dilution adjustments, including in connection with stock dividends or distributions in shares of the common stock or subdivisions, splits and combinations of the common stock.

As of the date of issuance of the Series A Preferred Stock, the effective conversion price of $9.71 per share was less than the fair value of Bancorp’s common stock of $16.00 per share.  In accordance with U.S. GAAP, the Series A Preferred Stock was deemed to include a beneficial conversion feature with an intrinsic value of $6.29 per share for a total discount of $31,464.  This discount was recognized by allocating a portion of the proceeds from the Series A Preferred Stock to additional paid-in capital attributable to common stock on the Company’s consolidated balance sheets as of December 31, 2012.

On February 18, 2013, the Company received shareholder approvals to amend its Amended and Restated Articles of Incorporation to (i) increase the number of authorized shares of the Company’s common stock to 20,000,000, (ii) authorize 5,000,000 shares of a new class of nonvoting common stock, par value $0.01 per share, and (iii) authorize a reverse stock split of the Company’s outstanding Common Stock and Nonvoting Common Stock (if any) at a ratio of up to 1-for-20 to be implemented in the Board’s discretion (the “Capital Amendment”).  On the same date, the Company also received shareholder approval to issue an aggregate of 5,000,000 shares of its common stock and nonvoting common stock in the conversion of the 50,000 outstanding shares of the Company’s Series A Preferred Stock.

On February 19, 2013, the Company filed the Capital Amendment with the Florida Secretary of State, and on the same date, all of the outstanding shares of the Company’s Series A Preferred Stock automatically converted into an aggregate of 2,382,000 shares of common stock and 2,618,000 shares of nonvoting common stock (the “Conversion”).  The Conversion was based on a conversion price of $10 per share and a conversion rate of 100 shares of common stock and/or nonvoting common stock for each share of Series A Preferred Stock outstanding.  In addition, the full balance of the discount due to the beneficial conversion feature was transferred from common stock to preferred stock and recognized as an implied preferred stock dividend, which decreased retained earnings and net income available to common shareholders in the earnings per share calculation.  As a result of the Conversion, no shares of the Series A Preferred Stock remained outstanding and an aggregate of 2,676,544 shares of common stock and 2,618,000 shares of nonvoting common stock were outstanding immediately following the Conversion.

30

JACKSONVILLE BANCORP, INC.

NOTE 10 – SHAREHOLDERS’ EQUITY (Continued)

Common Equity

As a result of the Capital Amendment (described above), the number of authorized shares of the Company’s common stock, par value $0.01 per share, increased from 2,000,000 as of December 31, 2012 to 20,000,000 as of September 30, 2013.  In addition, a new class of nonvoting common stock, par value $0.01 per share, was authorized in the amount of 5,000,000 shares.  Other than voting rights, the common stock and nonvoting common stock have the same rights and privileges, share ratably in all assets of the Company upon its liquidation, dissolution or winding-up, will be entitled to receive dividends in the same amount per share and at the same time when, as and if declared by Bancorp’s Board of Directors, and are identical in all other respects as to all other matters (other than voting).  Holders of the nonvoting common stock are not entitled to vote except as required by the Florida Business Corporation Act.  In addition, holders of the nonvoting common stock have no cumulative voting rights or preemptive rights (other than the limited contractual preemptive rights of certain shareholders) to purchase or subscribe for any additional shares of common stock or nonvoting common stock or other securities, and there are no redemption or sinking fund provisions with respect to the nonvoting common stock.

As provided in the Capital Amendment, each share of nonvoting common stock will automatically convert into one share of common stock in the event of a “permitted transfer” to a transferee.  A “permitted transfer” is a transfer of nonvoting common stock (i) in a widespread public distribution, (ii) in which no transferee (or group of associated transferees) would receive 2% or more of any class of voting securities of the Company, or (iii) to a transferee that would control more than 50% of the voting securities of the Company without any transfer from such holder of nonvoting common stock.

As of September 30, 2013 and December 31, 2012, the carrying amount of common stock outstanding was $28 and $3, respectively.  The carrying amount of nonvoting common stock outstanding was $26 as of September 30, 2013.  As of December 31, 2012, there were no shares of nonvoting common stock authorized or outstanding, and therefore, had no carrying amount as of the same date.

Share amounts related to the Company’s common equity and the respective carrying amount for each class have been adjusted retrospectively for all periods presented to reflect the reverse stock split completed in October 2013.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

Accumulated Other Comprehensive Income

The following table presents information related to changes in accumulated other comprehensive income by component as of September 30, 2013 and December 31, 2012:

(Dollars in thousands)	Change in Unrealized Gains (Losses) on Available-for-Sale Securities			Change in Unrealized Derivative Gains (Losses) on Cash Flow Hedge			Total
Balance as of December 31, 2012	$	2,218		$	(807	)	$	1,411
Other comprehensive (loss) income before reclassifications		(2,196	)		421			(1,775	)
Amounts reclassified from accumulated other comprehensive (loss) income		(437	)		-			(437	)
Other comprehensive (loss) income, net		(2,633	)		421			(2,212	)
Balance as of September 30, 2013	$	(415	)	$	(386	)	$	801

Amounts reclassified from accumulated other comprehensive income during the nine months ended September 30, 2013 resulted from realized gains on the sale of available-for-sale securities presented in Other income on the consolidated statements of operations.

31

JACKSONVILLE BANCORP, INC.

NOTE 11 – FAIR VALUE

Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures defines fair value as the exchange 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.  Assets and liabilities are measured using valuation techniques specific to the following three-tier hierarchy, which prioritizes the inputs used in measuring fair value.

Level I, II and III Valuation Techniques

Level I: Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

Level II: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level III: Unobservable inputs for the asset or liability.

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2013 and December 31, 2012, for which the Company has elected the fair value option, by level within the hierarchy:

(Dollars in thousands) September 30, 2013	Total		Level I		Level II		Level III
Assets:
Securities available-for-sale:
U.S. government-sponsored entities and agencies	$	8,794	$	-	$	8,794	$	-
State and political subdivisions		8,276		-		8,276		-
Mortgage-backed securities - residential		33,427		-		33,427		-
Collateralized mortgage obligations		34,576		-		34,576		-
Corporate bonds		3,130		-		3,130		-
Liabilities:
Derivative liability		873		-		873		-

December 31, 2012	Total		Level I		Level II		Level III
Assets:
Securities available-for-sale:
U.S. government-sponsored entities and agencies	$	10,491	$	-	$	10,491	$	-
State and political subdivisions		18,166		-		18,166		-
Mortgage-backed securities - residential		33,646		-		33,646		-
Collateralized mortgage obligations		19,527		-		19,527		-
Corporate bonds		2,155		-		2,155		-
Liabilities:
Derivative liability		1,294		-		1,294		-

There were no transfers between Level 1 and Level 2 during the three and nine months ended September 30, 2013.

The Company used the following methods and significant assumptions to estimate the fair value of each type of recurring financial instrument:

Securities Available-for-Sale:

The fair values of securities available for sale are determined by obtaining quoted prices on nationally-recognized securities exchanges (Level I inputs) or 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 II inputs).

Derivatives:

The fair value of derivatives is based on valuation models using observable market data as of the measurement date resulting in a Level II classification.

32

JACKSONVILLE BANCORP, INC.

NOTE 11 – FAIR VALUE (Continued)

The following table presents information about our assets measured at fair value on a non-recurring basis as of September 30, 2013 and December 31, 2012, by level within the fair value hierarchy.  The amounts in the tables represent only assets for which the carrying amount has been adjusted for impairment during the period; therefore, these amounts will differ from the total amounts outstanding.

(Dollars in thousands) September 30, 2013	Total		Level I		Level II		Level III
Impaired Loans (Collateral Dependent):
Real estate mortgage loans:
Residential	$	100	$	-	$	-	$	100
Commercial		832		-		-		832
Construction and land		92		-		-		92
Other real estate owned:
Real estate mortgage loans:
Residential		4,652		-		-		4,652
Commercial		309		-		-		309
Construction and land		3,477		-		-		3,477

December 31, 2012	Total		Level I		Level II		Level III
Impaired Loans (Collateral Dependent):
Real estate mortgage loans:
Residential	$	149	$	-	$	-	$	149
Commercial		1,171		-		-		1,171
Construction and land		200		-		-		200
Other real estate owned:
Real estate mortgage loans:
Residential		4,963		-		-		4,963
Commercial		195		-		-		195
Construction and land		1,813		-		-		1,813

The Company used the following methods and significant assumptions to estimate the fair value of each type of non-recurring financial instrument:

Impaired Loans (Collateral Dependent):

Management determined fair value measurements on impaired loans primarily through evaluations of appraisals performed.  The Company considered the appraisal as the starting point for determining fair value and then considered other factors and events in the environment that affected the fair value.  Appraisals for impaired loans are obtained by the Chief Credit Officer and performed by certified general appraisers whose qualifications and licenses have been reviewed and verified by the Company.  Once reviewed, a third-party specialist reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison to independent data sources such as recent market data or industry-wide statistics.  On an annual basis, the Company compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustments, if any, should be made to the appraised value to arrive at fair value.  Adjustments may be made to reflect the age of the appraisal and the type of underlying property.  Certain current appraised values were discounted to estimated fair value based on current market data such as recent sales of similar properties, discussions with potential buyers and negotiations with existing customers.  The Company’s overall strategy is to accelerate the disposition of substandard assets through such arrangements.

Other Real Estate Owned (“OREO”):

Assets acquired as a result of, or in lieu of, loan foreclosure are initially recorded at fair value (based on the lower of the current appraised value or listing price) at the date of foreclosure, establishing a new cost basis.  Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell.  Management has determined fair value measurements on OREO primarily through evaluations of appraisals performed and current and past offers for the OREO under evaluation.  Appraisals of OREO are obtained subsequent to acquisition as deemed necessary by the Chief Credit Officer.  Appraisals are reviewed for accuracy and consistency by a third-party specialist, supervised by the Chief Credit Officer, and are selected from the list of approved appraisers maintained by management.  Certain current appraised values were discounted to estimated fair value based on factors such as sales prices for comparable properties in similar geographic areas and/or assessment through observation of such properties.

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JACKSONVILLE BANCORP, INC.

NOTE 11 – FAIR VALUE (Continued)

Transfers of assets and liabilities between levels within the fair value hierarchy are recognized when an event or change in circumstances occurs.  There were no transfers between fair value levels for September 30, 2013 and December 31, 2012, respectively.

Quantitative Information about Level III Fair Value Measurements

The following table presents quantitative information about unobservable inputs for assets measured on a non-recurring basis using Level III measurements as of September 30, 2013.  This quantitative information is the same for each class of loans.

(Dollars in thousands) September 30, 2013	Fair Value		Valuation Technique	Unobservable Inputs	Weighted Average
Impaired loans (collateral dependent)	$	1,024	Market comparable properties	Marketability discount		0.80	%
Other real estate owned		8,438	Market comparable properties	Comparability adjustments		19.9
December 31, 2012	Fair Value		Valuation Technique	Unobservable Inputs	Weighted Average
Impaired loans (collateral dependent)	$	1,520	Market comparable properties	Marketability discount		9.1	%
Other real estate owned		6,971	Market comparable properties	Comparability adjustments		10.3

The reduced weighted average discount on appraisals of collateral on impaired loans as of September 30, 2013 was the result of updated appraisals, stabilization in the local real estate markets, and disposition values based on offers to purchase and sales of similar properties, among other factors, whereas the weighted average discount on appraisals of collateral on OREO increased due to changes in the property / discount mix during the year-to-date period.

The table below summarizes the outstanding balance, valuation allowance, net carrying amount and period expense related to Level III non-recurring instruments for the nine months ended September 30, 2013 and for the year ended December 31, 2012:

(Dollars in thousands) September 30, 2013	Outstanding Balance		Valuation Allowance		Net Carrying Amount		Period Expense
Impaired loans (collateral dependent)	$	2,406	$	1,382	$	1,024	$	2,471
Other real estate owned		9,077		639		8,438		546

December 31, 2012	Outstanding Balance		Valuation Allowance		Net Carrying Amount		Period Expense
Impaired loans (collateral dependent)	$	2,918	$	1,398	$	1,520	$	8,821
Other real estate owned		7,908		937		6,971		2,789

34

JACKSONVILLE BANCORP, INC.

NOTE 11 – FAIR VALUE (Continued)

Fair Value of Financial Instruments

The carrying amount and estimated fair values of financial instruments as of September 30, 2013 and December 31, 2012 were as follows:

	September 30, 2013				December 31, 2012
(Dollars in thousands)	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash and cash equivalents	$	35,926	$	35,926	$	72,079	$	72,079
Securities available-for-sale		88,203		88,203		83,985		83,985
Loans, net		355,981		363,471		377,833		383,987
Federal Home Loan Bank stock		1,580		N/A		1,771		N/A
Independent Bankers' Bank stock		178		N/A		178		N/A
Accrued interest receivable		1,870		1,870		2,059		2,059
Financial Liabilities:
Deposits	$	440,354	$	430,726	$	490,021	$	494,211
Other borrowings		22,359		22,565		22,376		22,802
Subordinated debentures		16,138		7,506		16,090		8,277
Accrued interest payable		196		196		554		554
Interest rate swap		873		873		1,294		1,294

The methods and assumptions not previously presented, used to estimate fair value are described as follows:

Cash and cash equivalents:

The carrying amounts of cash and cash equivalents approximate the fair value and are classified as either Level I or Level II in the fair value hierarchy.   As of September 30, 2013 and December 31, 2012, respectively, the breakdown of cash and cash equivalents between Level I and Level II were as follows:

	September 30, 2013						December 31, 2012
(Dollars in thousands)	Level I			Level II			Level I			Level II
Cash and cash equivalents		$	29,489		$	6,437		$	70,335		$	1,744

Loans, net:

The fair value of variable-rate loans that re-price frequently and with no significant change in credit risk is based on the carrying value and results in a classification of Level III within the fair value hierarchy.  Fair value for other loans is estimated using discounted cash flow analysis using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level III classification in the fair value hierarchy. The methods used to estimate the fair value of loans do not necessarily represent an exit price.

Nonmarketable equity securities:

Nonmarketable equity securities include FHLB stock and other nonmarketable equity securities. It is not practicable to determine the fair value of nonmarketable equity securities due to restrictions placed on their transferability.

Deposits:

The fair value of demand deposits (e.g., interest and noninterest-bearing, savings and certain types of money market accounts) is, by definition, equal to the amount payable in demand at the reporting date (i.e., carrying value) resulting in a Level II classification in the fair value hierarchy.  The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair value at the reporting date resulting in a Level II classification in the fair value hierarchy. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow 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 II classification.

Federal Home Loan advances:

The fair value of FHLB advances is estimated using a discounted cash flow analysis based on the current borrowing rates for similar types of borrowings and is classified as a Level II in the fair value hierarchy.

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JACKSONVILLE BANCORP, INC.

NOTE 11 – FAIR VALUE (Continued)

Accrued interest receivable/payable:

The carrying amounts of accrued interest receivable approximate fair value resulting in a Level III classification. The carrying amounts of accrued interest payable approximate fair value resulting in a Level II classification.

Subordinated debt:

The fair value of subordinated debt, where a market quote is not available, is based on discounted cash flows, using a rate appropriate to the instrument and the term of the issue resulting in a Level II classification.

Off-balance sheet instruments:

The fair value of off-balance sheet instruments is based on the current fees that would be charged to enter into or terminate such arrangements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.  The fair value of these commitments as of September 30, 2013 was not material.

NOTE 12 – CAPITAL ADEQUACY

Banks and bank holding companies 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 initiate regulatory action.

Bank

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among other things, requires the federal banking agencies to take “prompt corrective action” regarding depository institutions that do not meet minimum capital requirements.  FDICIA establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation.

The “prompt corrective action” rules provide that a bank will be: (i) “well capitalized” if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, a leverage capital ratio of 5% or greater and is not subject to certain written agreements, orders, capital directives or prompt corrective action directives by a federal bank regulatory agency to maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if it has a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater, and generally has a leverage capital ratio of 4% or greater; (iii) “undercapitalized” if it has a total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 4% or generally has a leverage capital ratio of less than 4%; (iv) “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3% or a leverage capital ratio of less than 3%; or (v) “critically undercapitalized” if its tangible equity is equal to or less than 2% to total assets.  The federal bank regulatory agencies have authority to require additional capital.

The Bank was well capitalized as of September 30, 2013 and December 31, 2012, respectively.  Depository institutions that are no longer “well capitalized” for bank regulatory purposes must receive a waiver from the Federal Deposit Insurance Corporation (“FDIC”) prior to accepting or renewing brokered deposits.  FDICIA generally prohibits a depository institution from making any capital distribution (including paying dividends) or paying any management fee to its holding company, if the depository institution would thereafter be undercapitalized.

The Bank had a Memorandum of Understanding (“MoU”) with the FDIC and the Florida Office of Financial Regulation (“OFR”) that was entered into in 2008 (the “2008 MoU”), which required the Bank to have a total risk-based capital of at least 10% and a Tier 1 leverage capital ratio of at least 8%.  On July 13, 2012, the 2008 MoU was replaced by a new MoU  (the “2012 MoU”), which, among other things, requires the Bank to have a total risk-based capital of at least 12% and a Tier 1 leverage capital ratio of at least 8%.   The Bank met the minimum capital requirements of the 2012 MoU as of September 30, 2013 and December 31, 2012, when the Bank had total risk-based capital of 14.05% and 12.70%, respectively, and Tier 1 leverage capital of 9.35% and 8.29% as of the same dates.

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JACKSONVILLE BANCORP, INC.

NOTE 12 – CAPITAL ADEQUACY (Continued)

Bancorp

The Federal Reserve requires bank holding companies, including Bancorp, to act as a source of financial strength for their depository institution subsidiaries.

The Federal Reserve has a minimum guideline for bank holding companies of Tier 1 capital to adjusted average quarterly assets (“leverage ratio”) equal to at least 4.00%, and total capital to risk-weighted assets of at least 8.00%, at least half of which must be Tier 1 capital.  As of September 30, 2013 and December 31, 2012, Bancorp met these requirements.

The following table presents the capital ratios and related information for the Company and the Bank as of September 30, 2013 and December 31, 2012, respectively.

(Dollars in thousands)	Actual					For Capital Adequacy Purposes					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
September 30, 2013	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total capital to risk-weighted assets:
Consolidated	$	53,632		14.09	%	$	30,451		8.00	%		N/A		N/A
Bank		53,306		14.05			30,363		8.00		$	37,953		10.00	%
Tier 1 (Core) capital to risk-weighted assets:
Consolidated		43,759		11.50			15,225		4.00			N/A		N/A
Bank		48,411		12.76			15,181		4.00			22,772		6.00
Tier 1 (Core) capital to average assets:
Consolidated		43,759		8.44			20,751		4.00			N/A		N/A
Bank		48,411		9.35			20,707		4.00			25,883		5.00

		Actual				For Capital Adequacy Purposes				Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
December 31, 2012		Amount	Ratio			Amount	Ratio			Amount	Ratio
Total capital to risk-weighted assets:
Consolidated	$	52,194	13.02	%	$	32,080	8.00	%		N/A	N/A
Bank		50,860	12.70			32,047	8.00		$	40,058	10.00	%
Tier 1 (Core) capital to risk-weighted assets:
Consolidated		41,625	10.38			16,040	4.00			N/A	N/A
Bank		45,665	11.40			16,023	4.00			24,035	6.00
Tier 1 (Core) capital to average assets:
Consolidated		41,625	7.54			22,086	4.00			N/A	N/A
Bank		45,665	8.29			22,021	4.00			27,527	5.00

Dividends and Distributions

Prior to October 2009, dividends received from the Bank were Bancorp’s principal source of funds to pay its expenses and interest on and principal of Bancorp’s debt.  Banking regulations and enforcement actions require the maintenance of certain capital levels and restrict the payment of dividends by the Bank to Bancorp or by Bancorp to its shareholders.  Commercial banks generally may only pay dividends without prior regulatory approval out of the total of current net profits plus retained net profits of the preceding two years, and banks and bank holding companies are generally expected to pay dividends from current earnings.  Banks may not pay a dividend if the dividend would result in the bank being “undercapitalized” for prompt corrective action purposes, or would violate any minimum capital requirement specified by law or the Bank’s regulators.  The Bank has not paid dividends since October 2009 and cannot currently pay dividends.  Bancorp cannot currently pay dividends on its capital stock under applicable Federal Reserve policies and enforcement actions.  Bancorp has relied upon revolving loan agreements with certain of its directors and other related parties to pay its expenses during such time.  As of September 30, 2013 there were no remaining funds available under the Revolvers and $1,800 in remaining funds as of December 31, 2012.

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JACKSONVILLE BANCORP, INC.

NOTE 12 – CAPITAL ADEQUACY (Continued)

During the second quarter of 2013, participants in the Private Placement who purchased shares of Series A Preferred Stock through the cancellation of debt under their Revolvers, were given the option and thereby elected to reduce the amount of their loan commitments under the Revolvers resulting in a reduction of the maximum borrowings available to the Company from $4,000 as of December 31, 2012 to $2,200 effective July 1, 2013.  Please refer to Note 5 – Loans from Related Parties and Note 14 – Subsequent Events for additional information related to the Revolvers.

NOTE 13 – SHARE-BASED COMPENSATION

During the year ended December 31, 2012, the Company executed employment agreements with two of its executive officers, Stephen C. Green, then-current President and Chief Executive Officer, and Margaret A. Incandela, Executive Vice President, Chief Operating Officer and Chief Credit Officer, with contemplated equity awards in the form of stock options and/or restricted stock, subject to certain conditions. These conditions included, among other things, (i) the completion and size of the Private Placement and (ii) approval by shareholders of an amendment to the 2008 Amendment and Restatement of the Jacksonville Bancorp, Inc. 2006 Stock Incentive Plan, as amended (“Stock Incentive Plan”), to increase the number of shares of common stock available for issuance.  These contemplated equity awards were also subject to approval by the Compensation Committee of Bancorp’s Board of Directors.

On February 18, 2013, shareholders approved the amendment to the Stock Incentive Plan to increase the number of shares of common stock available for issuance from 9,000 to 350,000, and to eliminate certain minimum vesting conditions for awards of restricted stock and restricted stock units.  This amendment was approved in conjunction with the contemplated equity awards agreed upon in the aforementioned executive employment agreements.

In accordance with their respective executive employment agreements, Mr. Green and Ms. Incandela are entitled to receive stock options exercisable for, or in an amount equal to, 100,000 and 75,000 shares of common stock, respectively.  During the second quarter of 2013, the Compensation Committee of Bancorp’s Board of Directors (“Compensation Committee”) formally approved the stock option grants for Mr. Green.  On June 24, 2013, Mr. Green resigned as President and Chief Executive Officer of the Company, and as Chief Executive Officer of the Bank.  In connection with Mr. Green’s resignation, the aforementioned stock option grants were deemed fully vested as of the grant date and subsequently expired on September 23, 2013.  Subsequent to quarter-end, the Compensation Committee formally approved the grants for Ms. Incandela.

Share amounts have been retrospectively adjusted to reflect the 1-for-20 reverse stock split completed in October 2013.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

NOTE 14 – SUBSEQUENT EVENTS

Subsequent events are events and transactions that occur after the balance sheet date, but before the financial statements are issued.  The effects of subsequent events are recognized in the financial statements when they provide additional evidence about conditions that existed as of the balance sheet date.  The Company has evaluated events and transactions subsequent to September 30, 2013 with the impact of such evaluations set forth below.

Public Offering

Concurrently with the rights offering, previously discussed in Note 2 – Capital Raise Transactions, the Company initiated a public offering of shares of the Company’s common stock not subscribed for in the rights offering at an equal subscription price of $10.00 per share.  At the completion of the rights offering, 395,869 shares of common stock remained available for sale in the public offering.

The public offering expired on October 4, 2013 whereby the Company sold all remaining shares of common stock available for sale for an aggregate of $3,959, or $3,226 net of offering expenses.  As a result of the concurrent offerings, the Company sold a total of 500,000 shares of common stock for aggregate proceeds of $5,000.  Total net proceeds in the amount of $4,163 will be used for general operating expenses.

Reverse Stock Split

On October 8, 2013, Bancorp’s Board of Directors approved a one-for-twenty (1-for-20) reverse stock split of the Company’s common stock and nonvoting common stock, effective at 12:01 a.m. on October 24, 2013.  As a result of the reverse stock split, the stated capital attributable to common stock and nonvoting common stock was reduced by dividing the amount of the stated capital prior to the reverse stock split by 20 (including retroactive adjustment of prior periods) and an equivalent increase to additional paid-in capital.  Additional adjustments were made to the aforementioned accounts as a result of rounding to avoid the existence of fractional shares.   The reverse stock split reduced the number of authorized shares of common stock and nonvoting common stock; however, it did not affect the par value of either class of common stock.  Holders of the Company’s outstanding restricted stock received cash in lieu of fractional shares which was deemed immaterial for disclosure, both individually and in the aggregate.

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JACKSONVILLE BANCORP, INC.

NOTE 14 – SUBSEQUENT EVENTS

The reverse stock split was implemented primarily to regain compliance with NASDAQ continued listing standards.  The Company’s common stock will continue to trade on a post-split basis on the NASDAQ Stock Market under the symbol “JAXB.”  All share and per share amounts disclosed in the Consolidated Financial Statements and the accompanying notes have been retrospectively adjusted to reflect the 1-for-20 reverse stock split, including common shares outstanding, earnings per share and share-based compensation.

Repayment of Loans from Related Parties

On October 22, 2013, the Company repaid in-full amounts outstanding under the Revolvers of $2,200.  The total repayment was made using cash on-hand, including proceeds from recent capital raise activities.  Accordingly, the outstanding balance under the Revolvers as of September 30, 2013 was reduced to zero and the full borrowing capacity of $2,200 was restored as of the repayment date.

Each Revolver pays an annual rate of interest equal to 8% on a quarterly basis of the Revolver amount outstanding.  To the extent that any Revolver is not fully drawn, an unused revolver fee is calculated and paid quarterly at an annual rate of 2% on the revolving loan commitment less the daily average principal amount outstanding.  By reducing amounts outstanding under the Revolvers, the Company will effectively reduce future interest expense related to these loans and improve liquidity going forward until such time when funds available are utilized.

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JACKSONVILLE BANCORP, INC.

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

Management’s discussion and analysis of the financial condition and results of operations represents an overview of the consolidated financial condition as of September 30, 2013 and December 31, 2012 and results of operations for the three and nine months ended September 30, 2013 compared to the same periods in 2012.  This discussion is designed to provide a more comprehensive review of the financial condition and operating results than could be obtained from an examination of the financial statements alone.  This analysis should be read in conjunction with the interim financial statements and related footnotes included herein, and the Company’s audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC on March 26, 2013.

General

Jacksonville Bancorp, Inc. (“Bancorp”) was incorporated on October 24, 1997 and was organized to conduct the operations of The Jacksonville Bank (the “Bank”).  The Bank is a Florida state-chartered commercial bank that opened for business on May 28, 1999, and its deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”).  The Bank provides a variety of community banking services to businesses and individuals in the greater Jacksonville area of Northeast Florida.  During 2000, the Bank formed Fountain Financial, Inc., a wholly owned subsidiary.  Through Fountain Financial, Inc., and our marketing agreement with New England Financial (an affiliate of MetLife), we are able to meet the investment and insurance needs of our customers.  Bancorp, the Bank, and Fountain Financial, Inc. are collectively referred to herein as the “Company.”

Business Strategy

Our primary business segment is community banking and consists of attracting deposits from the general public and using such deposits and other sources of funds to originate commercial business loans, commercial real estate loans, residential mortgage loans and a variety of consumer loans.  We also invest in mortgage-backed securities and securities backed by the United States government, and agencies thereof, as well as other securities.  Our profitability depends primarily on our net interest income, which is the difference between the income we receive from our loan and securities investment portfolios and costs incurred on our deposits, the Federal Home Loan Bank (“FHLB”) advances, Federal Reserve borrowings and other sources of funding.  Net interest income is also affected by the relative amounts of interest-earning assets and interest-bearing liabilities. Net interest income is generated as the relative amounts of interest-earning assets grow in relation to the relative amounts of interest-bearing liabilities.  In addition, the levels of noninterest income earned and noninterest expenses incurred affect profitability.  Included in noninterest income are service charges earned on deposit accounts and increases in cash surrender value of Bank-Owned Life Insurance (“BOLI”).  Included in noninterest expense are costs incurred for salaries and employee benefits, occupancy and equipment expenses, data processing expenses, marketing and advertising expenses, federal deposit insurance premiums, legal and professional fees, loan related expenses, and other real estate owned (“OREO”) expenses.

Our operations are influenced by local economic conditions and by policies of financial institution regulatory authorities.  Fluctuations in interest rates due to factors such as competing financial institutions as well as fiscal policy and the Federal Reserve’s decisions on monetary policies, including interest rate targets, impact interest-earning assets and our cost of funds and, thus, our net interest margin.  In addition, the local economy and real estate market of Northeast Florida, and the demand for our products and loans, impact our margin.  The local economy and viability of local businesses can also impact the ability of our customers to make payments on loans, thus impacting our loan portfolio.  The Company evaluates these factors when valuing its allowance for loan losses. The Company also believes its underwriting procedures are relatively conservative and, as a result, the Company is not being any more affected than the overall market in the current economic downturn.

Our goal is to sustain profitable, controlled growth by focusing on increasing our loan and deposit market share in the Northeast Florida market by developing new financial products, services and delivery channels; closely managing yields on earning assets and rates on interest-bearing liabilities; focusing on noninterest income opportunities; controlling the growth of noninterest expenses; and maintaining strong asset quality.  During the second quarter of 2012, the Company adopted a strategy to accelerate the disposition of substandard assets on an individual customer basis.  This strategy materially impacted the Company’s earnings for the year ended December 31, 2012 as a result of the increased provision for loan losses, expenses related to protecting our collateral position, and aggressively pursuing foreclosure actions when necessary.  Additionally, the aggressive pursuit of foreclosure actions resulted in an increase in other real estate owned expenses during the same period.

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JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

With the initial framework established in the second quarter of 2012, this strategic initiative has been, and continues to be, ongoing.  The collateral for substandard assets that are deemed impaired is evaluated quarterly and an estimate of fair value of the collateral is determined based on appraised values, current market data such as recent sales of similar properties, discussions with potential buyers and negotiations with existing borrowers.  Appraisals are obtained during the regular course of business in accordance with the required appraisal cycle set forth by Bank policy.  Based on specific facts and circumstances surrounding a specific loan, off-cycle appraisals may be obtained when new information becomes available to management.  Additionally, in certain cases, discounts have been applied to appraised values based on the age of the appraisal, type of loan, general market factors and/or market data regarding sales of similar properties.

The Company received updated appraisals on a majority of its substandard assets during the second half of 2012.  As a result of having current appraisals, more modest discounts were required due to the factors noted above.  Appraisals were discounted an average of 9% as of December 31, 2012 compared to 28% as of June 30, 2012.  Likewise, the average discount on OREO appraisals decreased to 10% from 23% as of the same dates.  The discounts applied to appraisals were anticipated to remain at these lower levels for the foreseeable future due to recent indicators of stabilization in the local real estate market; however, discounts applied to appraisals on OREO increased as of September 30, 2013 due to changes in the property / discount mix during the year-to-date period.

For the nine months ended September 30, 2013 and looking forward, the Company intends to maintain the quality of its loan portfolio by continuing to improve the overall credit process including, but not limited to, loan origination disciplines, stricter underwriting criteria, and succinct funding and onboarding processes.  In addition, the Company is working to reposition its loan and deposit portfolio mix to better align with our targeted market segment of professional services, wholesalers, distributors and other service industries resulting in greater diversification in our balance sheet.  Such improvements have not yet materially impacted our financial statements; however, these changes have contributed to the current reduction of loan-related expenses and recent improvements in the Company’s overall asset quality.

To further supplement the Company’s business strategy, the Bank has adopted a philosophy of seeking and retaining the best available personnel for positions of responsibility, whom we believe will provide us with a competitive edge in the local banking market.  Upon the retirement of Mr. Price Schwenck, the Company’s former Chief Executive Officer, the Company appointed Stephen C. Green as President and Chief Executive Officer and Margaret A. Incandela as Chief Operating Officer and Chief Credit Officer during 2012 as a means of adding critical management expertise.  In June of 2013, Mr. Green resigned as President and Chief Executive Officer of the Company, and as Chief Executive Officer of the Bank.  Following his resignation, the Company’s Board of Directors appointed Donald F. Glisson, Jr., Chairman of the Board of the Company, to serve as the Company’s principal executive officer on an interim basis until a new President and Chief Executive Officer is elected.  Please refer to Item 1A. Risk Factors of Part II—Other Information for additional information related to these events and the potential impact on our operating results.

Capital Raise Transactions

During 2012, the Company executed a financial advisory agreement with an investment banking firm to assist in raising capital.  Efforts to secure additional equity capital were realized on December 31, 2012 with the sale of an aggregate of 50,000 shares of the Company’s Mandatorily Convertible, Noncumulative, Nonvoting Perpetual Preferred Stock, Series A (“Series A Preferred Stock”), at a purchase price of $1,000 per share, in the Private Placement.  For the year ended December 31, 2012, gross proceeds from the issuance of preferred stock in the amount of $50.0 million, or $45.1 million net of offering expenses, were used for general operating expenses, mainly for the subsidiary bank, to improve capital ratios, and will be used to support the Company’s business strategy going forward.

During the third quarter of 2013, the Company initiated concurrent offerings: (i) a rights offering to eligible existing shareholders of nontransferable subscription rights to purchase shares of the Company’s common stock at a subscription price of $10.00 per share and (ii) a public offering of shares not subscribed for in the rights offering at an equal subscription price of $10.00 per share.  The subscription period for the rights offering expired on September 20, 2013 and resulted in the sale of 104,131 shares of the Company’s common stock for aggregate proceeds of $1.0 million, or $0.9 million net of offering expenses.  The public offering expired subsequent to quarter-end, on October 4, 2013, whereby the Company sold 395,869 shares for an aggregate of $4.0 million, or $3.2 million net of offering expenses.  Total net proceeds from the concurrent offerings will be used for general operating expenses.

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JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Please refer to Note 2 – Capital Raise Transactions and Note 14 – Subsequent Events in the accompanying notes to the Consolidated Financial Statements for additional information related to the Company’s recent capital raise activities.

Asset Sale

On December 28, 2012, the Bank entered into an Asset Purchase Agreement (the “Asset Purchase Agreement”) with a real estate investment firm (the “Asset Purchaser”) for the purchase by the Asset Purchaser of approximately $25.1 million of the Bank’s loans and other assets for approximately $11.7 million (the “Asset Sale”).  The Asset Sale was consistent with the Company’s strategy to accelerate the disposition of substandard assets. Assets underlying the Asset Sale included OREO, non-accrual loans, loans with a history of being past due, and other loans that were part of an overall customer relationship.  Proceeds from the Asset Sale included $11.3 million from the sale of loans and $0.4 million from the sale of OREO.  The Asset Sale was completed on December 31, 2012 including the immediate transfer of servicing from the Bank.

All assets disposed of in conjunction with the Asset Sale were sold exclusively to the Asset Purchaser due to the relatively small size and composition of the assets being sold, particularly with respect to the current market demand for such loans.  The overall pricing methodology employed by management during the Asset Sale was influenced by several factors including, but not limited to, (i) the engagement of a third-party financial advisor, (ii) management’s experience in loan sale activities and knowledge of the local markets in which the Company operates, and (iii) the pricing expectations of prospective buyers.

Additional discounts (i.e., charge-offs) applied in excess of those assessed in the normal course of business represented a combination of the bulk sale value of the loans and the Asset Purchaser’s assumption of risk and expected rate of return.  Management reviewed information provided by our third-party financial advisor to evaluate the additional discounts applied to the Asset Sale in comparison to similar transactions and to ensure reasonableness.

Of the $13.3 million in charge-offs related to the Asset Sale, $4.5 million was determined to be due to one or a combination of the following factors:  (i) the most recent appraisal (discounted if appropriate), (ii) settlement discussions with the borrower, or (iii) underlying cash flows of the borrower/guarantor as compared to the borrower’s recorded investment.  This amount was included in the historical loss component in determining the appropriateness of the Company’s allowance for loan losses as of December 31, 2012 as it was determined to be indicative of historical loss experience (under the historically determined allowance for loan loss methodology) and, therefore, determined to be part of management’s estimate of the probable incurred losses on the remainder of the portfolio.

The additional $8.8 million of charge-offs required to expedite the disposition through the Asset Sale were not considered indicative of our historical loss experience and, therefore, were excluded in the determination of the appropriateness of our allowance for loan losses for the remaining portfolio as of December 31, 2012.  Asset sales and the respective discounts are not a traditional element of the Company’s normal business activities and, therefore, were excluded in order to properly estimate incurred losses associated with the remainder of the loan portfolio.  Further, management does not anticipate an asset sale in the foreseeable future.

For additional information related to the Asset Sale, please refer to Note 4 – Loans and Allowance for Loan Losses in the accompanying notes to the Consolidated Financial Statements.

Reverse Stock Split

In October 2013, Bancorp’s Board of Directors implemented a 1-for-20 reverse stock split of its outstanding shares of common stock and nonvoting common stock effective October 24, 2013.  As a result of the reverse stock split, each 20 shares of issued and outstanding common stock and nonvoting common stock, par value $0.01 per share, respectively, were automatically and without any action on the part of the respective holders combined and reconstituted as one share of the respective class of common equity as of the effective date.Consequently, the aggregate par value of common stock and nonvoting common stock eliminated in the reverse stock split was reclassed on the Company’s consolidated balance sheets from the respective class of common equity to additional paid-in capital.  Additional adjustments were made to the aforementioned accounts as a result of rounding to avoid the existence of fractional shares.  All share and per share information has been retrospectively adjusted to reflect the 1-for-20 reverse stock split.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

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JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Introduction

The Company’s performance during the periods ended September 30, 2013 and December 31, 2012 is reflective of the Company’s ongoing strategy to accelerate the disposition of substandard assets on an individual customer basis.  As a result of these efforts as well as recent indicators of stabilization in the local real estate markets, the Company recognized reduced provision expense, noninterest expense and a general reduction in substandard assets during the nine months ended September 30, 2013.

Comparison of Financial Condition as of September 30, 2013 and December 31, 2012

Total assets decreased $50.6 million, or 8.9%, from $565.1 million as of December 31, 2012 to $514.5 million as of September 30, 2013.  The Company experienced a significant decrease in cash and cash equivalents as a result of a reduction in federal funds sold in the amount of $37.0 million and a decrease in net loans of $21.9 million as a result of net charge-offs and loan payoffs that outpaced loan originations during the nine months ended September 30, 2013.  These amounts were slightly offset by an increase in securities available-for-sale of $4.2 million, bank-owned life insurance of $3.1 million, and other real estate owned of $1.5 million during the nine months ended September 30, 2013.

Investment securities available-for-sale increased $4.2 million, or 5.0%, from $84.0 million as of December 31, 2012 to $88.2 million as of September 30, 2013.  During the nine months ended September 30, 2013, the Company purchased $39.0 million in securities and received $17.4 million in proceeds from principal repayments, maturities and calls.  In addition, the Company received proceeds of $14.4 million and realized a $0.4 million net gain from the sale of securities during the nine months ended September 30, 2013.  The remaining variance is due to the change in fair market value during the same year-to-date period.

Total deposits decreased by $49.6 million, or 10.1%, during the nine months ended September 30, 2013, from $490.0 million as of December 31, 2012 to $440.4 million as of September 30, 2013.  The following is an explanation of the changes in each of the major deposit categories during the nine months ended September 30, 2013:

· Noninterest-bearing deposits increased $3.5 million, or 3.7%, as a result of a continued emphasis on core deposit growth, especially business relationships with a tendency towards carrying higher account balances;

· Money market, NOW and savings deposits decreased $6.6 million, or 3.3%, due to natural fluctuations in account balances; and

· The time deposit portfolio decreased by $46.6 million, or 23.6%, driven primarily by a $27.9 million reduction in national CDs (the Company is not currently offering or renewing national or brokered CDs).  The remaining variance was due to a decrease in local CDs when compared to the prior year-end.

Loans from related parties and FHLB advances and other borrowings remained substantially unchanged during the nine months ended September 30, 2013, with loans from related parties of $2.2 million as of September 30, 2013 and December 31, 2012, respectively, and FHLB advances and other borrowings of $20.2 million as of the same dates.

Total shareholders’ equity decreased slightly during the nine months ended September 30, 2013, from $33.6 million as of December 31, 2012 to $32.7 million as of September 30, 2013.  This decrease was attributable to a decrease in accumulated comprehensive income of $2.2 million, offset by $0.9 million in additional equity issued in conjunction with the Company’s third quarter rights offering and net income during the nine months ended September 30, 2013 of $375 thousand.  Accumulated comprehensive income decreased based on changes in interest rates during the nine months ended September 30, 2013.  Total shareholders’ equity did not change as a result of the mandatory conversion of the Company’s Series A Preferred Stock into approximately 2.4 million shares of common stock and 2.6 million shares of a new class of nonvoting common stock, each class with a par value of $0.01 per share (the “Conversion”).  The Conversion resulted in (i) the full balance transfer of the discount due to the beneficial conversion feature on the Series A Preferred Stock from common stock additional paid-in capital to preferred stock in the amount of $31.5 million, (ii) the conversion of the outstanding balance of preferred equity to common equity, resulting in an increase in common stock of $24 thousand, nonvoting common stock of $26 thousand and additional paid-in capital of $49.95 million, and (iii) an increase in the retained deficit of $31.5 million due to the noncash, implied preferred stock dividend recognized in conjunction with the transfer of the discount due to the beneficial conversion feature to preferred stock.  In addition to its impact on the retained deficit balance, the noncash, implied preferred stock dividend also reduced net income available to common shareholders in the earnings per share calculation (as discussed below).

43

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Comparison of Operating Results for the Nine Months Ended September 30, 2013 and 2012

Net Income

The Company had net income of $375 thousand for the nine months ended September 30, 2013 compared to $21.2 million of net loss for the nine months ended September 30, 2012.  The year-over-year change from net loss to net income was driven primarily by a decrease in the provision for loan losses from $17.6 million for the nine months ended September 30, 2012 to $100 thousand for the same period in 2013 as well as a decrease in non-interest expense of $5.0 million.

On a diluted per share basis, the Company had a net loss available to common shareholders of $(7.06) for the nine months ended September 30, 2013, compared to net loss of $(72.05) for the same period in the prior year.  The Company experienced a net loss per diluted common share in 2013 due to a reduction of net income in the amount of $31.5 million as a result of the noncash, implied preferred stock dividend recognized in conjunction with the Company’s 2012 capital raise transactions and the previously described Conversion.  This reduction resulted in a net loss available to common shareholders of $31.1 million for the nine months ended September 30, 2013 and an antidilutive impact of stock options as it pertained to the Company’s weighted average common shares outstanding for the same period.

Net Interest Income

Net interest income, the difference between interest earned on interest-earning assets and interest paid on interest-bearing liabilities, was $14.5 million for the nine months ended September 30, 2013, compared to $15.8 million for the same period in 2012.

Total interest income decreased $2.0 million for the nine months ended September 30, 2013 when compared to the same period in 2012.  This decrease was primarily driven by a decrease in average earning assets, in particular, average loan balances which declined by $66.5 million when compared to the same period in the prior year.  The decrease in average loan balances was partially offset by an increase in the average yield on loans to 5.63% for the nine months ended September 30, 2013 compared to 5.36% for the nine months ended September 30, 2012.  The increase in the loan yield was driven by an increase in accretion recognized on acquired loans of approximately $0.5 million as well as a decrease in total nonperforming loans.

The average cost of interest-bearing liabilities decreased 5 basis points to 1.10% for the nine months ended September 30, 2013 compared to 1.15% for the same period in 2012.  The overall decrease in the average cost of interest-bearing deposits reflects an ongoing reduction in interest rates paid on deposits as a result of the re-pricing activities in the current low interest rate environment coupled with an increase in average noninterest-bearing deposits to $94.7 million for the nine months ended September 30, 2013, compared to $86.7 million for the same period in the prior year.

The net interest margin decreased by 1 basis point to 3.84% from 3.85%, when comparing the nine months ended September 30, 2013 to the same period in the prior year.  The Company closely monitors its liquidity needs in conjunction with the cost of its funding sources and evaluates rates paid on its core deposits to ensure they remain competitive in the local market environment.

44

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Average Balance Sheet; Interest Rates and Interest Differential:

The following table sets forth, for the periods indicated, information regarding: (1) the total dollar amount of interest and dividend income from interest-earning assets and the resultant average yield; (2) the total dollar amount of interest expense on interest-bearing liabilities and the resultant average costs; (3) net interest/dividend income; (4) interest rate spread; and (5) net interest margin. Average balances are based on average daily balances.

	Nine Months Ended September 30,
	2013							2012
(Dollars in thousands)	Average Balance		Interest		Average Rate			Average Balance		Interest		Average Rate
Interest-earning assets:
Loans (1)	$	387,739	$	16,323		5.63	%	$	454,195	$	18,233		5.36	%
Securities available-for-sale:
Taxable		74,946		879		1.57			63,556		930		1.95
Tax-exempt(2)		14,345		461		4.30			18,135		570		4.20
Other interest-earning assets(3)		28,087		101		0.48			12,681		52		0.55
Total interest-earning assets		505,117		17,764		4.70			548,567		19,785		4.82
Noninterest-earning assets(4)		20,568							26,905
Total assets	$	525,685						$	575,472
Interest-bearing liabilities:
Savings deposits	$	9,747	$	20		0.27	%	$	10,679	$	31		0.39	%
NOW deposits		22,504		16		0.10			21,746		12		0.07
Money market deposits		160,922		744		0.62			172,416		981		0.76
Time deposits		163,646		1,477		1.21			212,994		1,848		1.16
FHLB advances		20,000		224		1.50			22,333		248		1.48
Federal Reserve and other borrowings(8)		2,204		152		9.22			3,333		213		8.54
Subordinated debt		16,113		621		5.15			16,050		637		5.30
Other interest-bearing liabilities(5)		4		-		-			256		-		-
Total interest-bearing liabilities		395,140		3,254		1.10			459,807		3,970		1.15
Noninterest-bearing liabilities		97,679							89,391
Shareholders' equity		32,866							26,274
Total liabilities and shareholders' equity	$	525,685						$	575,472
Net interest income			$	14,510						$	15,815
Interest rate spread(6)						3.60	%						3.67	%
Net interest margin(7)						3.84	%						3.85	%

⁽¹⁾ Average loans include nonperforming loans.  Interest on loans included loan fees (in thousands) of $180 and $74 for the nine months ended September 30, 2013 and 2012, respectively.

⁽²⁾ Interest income and rates do not include the effects of a tax equivalent adjustment using a federal tax rate of 34% in adjusting tax-exempt interest on tax-exempt investment securities to a fully taxable basis.

⁽³⁾ Includes federal funds sold.

⁽⁴⁾ For presentation purposes, the BOLI acquired by the Bank has been included in noninterest-earning assets.

⁽⁵⁾ Includes federal funds purchased.

⁽⁶⁾ Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

⁽⁷⁾ Net interest margin is net interest income divided by average interest-earning assets.

⁽⁸⁾ Federal Reserve and other borrowings include loans from related parties that pay an annual rate of interest equal to 8% on a quarterly basis of the amount outstanding or an unused revolver fee calculated and paid quarterly at an annual rate of 2% on the revolving loan commitment less the daily average principal amount outstanding.

45

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Rate/Volume Analysis:

The following table sets forth the effect of changes in volumes, changes in rates, and changes in rate/volume on tax-equivalent interest income, interest expense and net interest income.

	Nine Months Ended September 30, 2013 vs. 2012
	Increase (Decrease) Due to(1)
(Dollars in thousands)	Rate			Volume			Total
Interest-earning assets:
Loans	$	855		$	(2,765	)	$	(1,910	)
Securities available-for-sale:
Taxable		(202	)		151			(51	)
Tax-exempt		13			(122	)		(109	)
Other interest-earning assets		(7	)		56			49
Total interest-earning assets	$	659		$	(2,680	)	$	(2,021	)
Interest-bearing liabilities:
Savings deposits	$	(8	)	$	(3	)	$	(11	)
NOW deposits		4			-			4
Money market deposits		(175	)		(62	)		(237	)
Time deposits		72			(443	)		(371	)
FHLB advances		2			(26	)		(24	)
Federal Reserve and other borrowings		16			(77	)		(61	)
Subordinated debt		(18	)		2			(16	)
Other interest-bearing liabilities		-			-			-
Total interest-bearing liabilities	$	(107	)	$	(609	)	$	(716	)
Net change in net interest income	$	766		$	(2,071	)	$	(1,305	)

⁽¹⁾ The change in interest due to both rate and volume has been allocated to the volume and rate components in proportion to the relationship of the dollar amounts of the absolute change in each component.

Noninterest Income, Noninterest Expense and Income Taxes

Noninterest income increased period-over-period, with $1.6 million and $1.1 million in service charges and other income for the nine months ended September 30, 2013 and 2012, respectively.  Included in Other income, the Company recorded a net gain of $0.4 million from the sale of municipal securities, mortgage-backed securities – residential and collateralized mortgage obligations during the nine months ended September 30, 2013.

Noninterest expense decreased to $15.6 million for the nine months ended September 30, 2013, compared to $20.6 million for the same period in 2012.  This decrease was mainly due to nonrecurring goodwill impairment expense of $3.1 million from the prior year and a decrease in OREO expenses of $1.5 million, loan related expenses of $0.6 million, and capital raise and Asset Sale-related expenses of $0.5 million.  These amounts were offset by an increase in professional fees of $0.5 million and data processing of $0.4 million, while the remainder of the components of noninterest expense remained relatively flat period-over-period.

There was no income tax expense/benefit recorded for the nine months ended September 30, 2013, while there was an income tax benefit of $136 thousand for the nine months ended September 30, 2012.  The Company recorded a full valuation allowance against its deferred taxes as of December 31, 2011.  This was substantially due to the fact that it was more-likely-than-not that the benefit would not be realized in future periods due to Section 382 of the Internal Revenue Code.  Based on an analysis performed as of September 30, 2013 and December 31, 2012, it was determined that the need for a full valuation allowance still existed.

46

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Comparison of Operating Results for the Three Months Ended September 30, 2013 and 2012

Net Income

The Company had net income of $147 thousand for the three months ended September 30, 2013, compared to $10.7 million of net loss for the three months ended September 30, 2012.  On a diluted per share basis, the Company had net income of $0.03 for the three months ended September 30, 2013, compared to net loss of $(36.27) for the same period in the prior year.  The net income for the third quarter of 2013 was driven primarily by a decrease in the provision for loan losses as well as total noninterest expense.

Net Interest Income

Net interest income was $4.6 million for the three months ended September 30, 2013, compared to $5.4 million for the same period in 2012.

Total interest income decreased $1.0 million for the three months ended September 30, 2013 when compared to the same period in 2012.  This decrease was primarily driven by a decrease in average earning assets, in particular, average loan balances which declined by $70.3 million when compared to the same period in the prior year.  In addition, the average yield on loans decreased to 5.39% for the three months ended September 30, 2013, compared to 5.42% for the three months ended September 30, 2012.  The decrease in the loan yield was driven by a slight decrease in accretion recognized on acquired loans when compared to the same quarter in the prior year and lower yields on renewed loans and modifications not deemed TDRs to remain competitive with current market rates.

The average cost of interest-bearing liabilities decreased 3 basis points to 1.06% for the three months ended September 30, 2013, compared to 1.09% for the same period in 2012.  The overall decrease in the average cost of interest-bearing deposits reflects an ongoing reduction in interest rates paid on deposits as a result of the re-pricing activities in the current low interest rate environment coupled with an increase in average noninterest-bearing deposits to $98.9 million for the three months ended September 30, 2013, compared to $89.0 million for the same period in the prior year.

The net interest margin decreased by 30 basis points to 3.66% from 3.95%, when comparing the third quarter of 2013 to the same period in the prior year.  The Company closely monitors its liquidity needs in conjunction with the cost of its funding sources and evaluates rates paid on its core deposits to ensure they remain competitive in the local market environment.

Noninterest Income, Noninterest Expense and Income Taxes

Noninterest income increased quarter-over-quarter, with $0.8 million and $0.4 million in service charges and other income for the three months ended September 30, 2013 and 2012, respectively.  Included in Other income, the Company recorded a net gain of $0.4 million from the sale of municipal securities, mortgage-backed securities – residential and collateralized mortgage obligations during the three months ended September 30, 2013.

Noninterest expense decreased to $4.8 million for the three months ended September 30, 2013, compared to $10.6 million for the same period in 2012.  This decrease was mainly due to nonrecurring goodwill impairment expense of $3.1 million from the prior year and a decrease in loan related expenses of $1.3 million, OREO expenses of $0.9 million, and capital raise and Asset Sale-related expenses of $0.5 million.  The remainder of the components of noninterest expense remained relatively flat period-over period.

There was no income tax expense/benefit recorded for the three months ended September 30, 2013, while there was an income tax benefit of $106 thousand for the three months ended September 30, 2012.  As previously discussed, the Company has recorded a full valuation allowance against its deferred taxes.

47

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Asset Quality

The Company has identified certain assets as risk elements.  These assets include nonperforming loans, loans that are contractually past due 90 days or more as to principal or interest payments and still accruing, troubled debt restructurings, and other real estate owned (i.e., foreclosed assets).  Loans are placed on nonaccrual status when management has concerns regarding the Company’s ability to collect the outstanding loan principal and interest amounts and typically when such loans are more than 90 days past due.  These loans present more than the normal risk that the Company will be unable to eventually collect or realize their full carrying value. The Company’s nonperforming loans, foreclosed assets and troubled debt restructurings as of September 30, 2013 and December 31, 2012 were as follows:

(Dollars in thousands)	September 30, 2013			December 31, 2012
Nonperforming loans:
Commercial	$	204		$	98
Real estate mortgage loans
Residential		4,236			4,813
Commercial		5,132			6,151
Construction and land		5,701			11,372
Consumer loans and other		243			246
Loans past due over 90 days still on accrual		-			67
Total nonperforming loans(1)		15,516			22,747
Other real estate owned, net		8,438			6,971
Total nonperforming assets		23,954			29,718
Performing loans classified as troubled debt restructurings		4,957			4,406
Nonperforming loans classified as troubled debt restructurings(1)		6,589			6,585
Total loans classified as troubled debt restructuring	$	11,546		$	10,991
Nonperforming loans as a percent of gross loans		4.16	%		5.71	%
Nonperforming loans and other real estate owned as a percent of total assets		4.66	%		5.26	%

⁽¹⁾ Nonperforming loans classified as troubled debt restructurings are also included in the total nonperforming loans above.

As shown in the table above, nonperforming assets decreased to $24.0 million from $29.7 million as of September 30, 2013 and December 31, 2012, respectively.  Likewise, nonperforming loans decreased to $15.5 million from $22.7 million as of the same dates.  The general reduction of nonperforming loans and nonperforming assets was primarily due to the Company’s strategy to accelerate the disposition of substandard assets on an individual customer basis.

Loans are deemed impaired when it is considered probable that the Company will not collect the outstanding loan principal and interest amounts according to the loan’s contractual terms.  As of September 30, 2013, impaired loans increased by $0.2 million to $16.4 million, compared to $16.2 million as of December 31, 2012.  Of the $16.4 million impaired loans as of September 30, 2013, $1.1 million were loans acquired from the merger with ABI.  Nonperforming impaired loans were $11.4 million as of September 30, 2013.  Specific reserves in the amount of $1.5 million were allocated to impaired loans as of September 30, 2013.

During the normal course of business, the Company may restructure or modify the terms of a loan for various reasons.  The restructuring of a loan is considered a troubled debt restructuring if both (i) the borrower is experiencing financial difficulties and (ii) a concession was granted that otherwise would not have occurred under normal circumstances.  As of September 30, 2013, the Company had loan balances of $11.5 million for customers whose loans were classified as troubled debt restructurings, of which $11.0 million of such loans were included in the impaired loans balance as of the same date.  Of the total loans classified as troubled debt restructurings, $4.2 million were classified as troubled debt restructurings with collateral shortfalls.  The Company has allocated $0.5 million to customers whose loan terms have been modified as troubled debt restructurings with collateral shortfalls and $84 thousand to the remaining troubled debt restructurings included in the impaired loans balance as of September 30, 2013.   An additional allocation in the amount of $9 thousand represented one loan classified as a troubled debt restructuring that was acquired with deteriorated credit quality, and therefore, was excluded from the impaired loans balance as of the same date.

48

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The troubled debt restructurings that occurred during the nine months ended September 30, 2013 allowed the borrowers to make reduced payments, such as (i) forbearance of payments for a limited period of time with revised payment schedules to coordinate with periods of forbearance, (ii) change from principal and interest payments to interest only payments through maturity, (iii) reduced principal and interest payments through maturity, (iv) forgiveness of principal, (v) reduced principal and interest payments through maturity with an assumption of additional debt to protect the Bank’s collateral position, (vi) change from variable rate interest only payments through maturity to fixed rate interest only payments for a limited period of time and reduced principal and interest payments through maturity, or (vii) change from variable rate interest only payments through maturity to fixed rate and reduced principal and interest payments through maturity, or (viii) proposed forgiveness of principal contingent upon the satisfaction of the modified terms.  Principal forgiven in the amount of $565 was offset by existing reserves from purchase accounting adjustments in the amount of $545 which resulted in a net charge-off of $20.  As of September 30, 2013, the Company had extended additional credit of $483 thousand to customers whose loans were classified as troubled debt restructurings.

The terms of certain other loans that did not meet the definition of a troubled debt restructuring were modified during the nine months ended September 30, 2013.  These loans had a total recorded investment of $7.2 million and $17.7 million as of September 30, 2013 and 2012, respectively.  Modifications during the nine months ended September 30, 2013 involved loans to borrowers who were not experiencing financial difficulties and included (i) allowing the borrowers to make interest-only payments for a limited period of time (generally 18 months or less), (ii) adjusting the interest rate to a market interest rate through maturity, (iii) allowing a delay in payment that was considered to be insignificant, (iv) extension of credit with an additional increase in principal payments, or (v) reduced principal and interest payments with the remaining principal due at maturity.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification.  This evaluation is performed under the Company’s internal underwriting policy.

Loans past due still accruing interest as of September 30, 2013 and December 31, 2012 were categorized as follows:

(Dollars in thousands) September 30, 2013	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due Still Accruing Interest
Commercial loans	$	43	$	13	$	-	$	56
Real estate mortgage loans:
Residential		1,615		34		-		1,649
Commercial		994		5,053		-		6,047
Construction and land		222		-		-		222
Consumer and other loans		2		-		-		2
Total	$	2,876	$	5,100	$	-	$	7,976

December 31, 2012	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due Still Accruing Interest
Commercial loans	$	66	$	3	$	-	$	69
Real estate mortgage loans:
Residential		1,750		795		67		2,612
Commercial		699		1,240		-		1,939
Construction and land		-		-		-		-
Consumer and other loans		69		-		-		69
Total	$	2,584	$	2,038	$	67	$	4,689

The increase in total loans past due 30-89 days still accruing interest to $8.0 million as of September 30, 2013 from $4.7 million as of December 31, 2012 was driven primarily by one significant loan currently in forbearance with potential for future modification of loan terms offset by general improvements in asset quality during the nine months ended September 30, 2013.

49

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

General improvements in our credit quality include, but are not limited to, the year-over-year reduction in adversely classified loans to $34.1 million as of September 30, 2013 compared to $38.8 million as of December 31, 2012.  Of the total adversely classified loans of September 30, 2013, $15.5 million of the adversely classified loans were nonperforming and $12.0 million were from the merger with Atlantic BancGroup, Inc. (“ABI”).  The $12.0 million of adversely classified loans from ABI are net of a fair value adjustment of $0.9 million, or 7.00% of the gross contractual amount receivable as of September 30, 2013.

All adversely classified loans are monitored closely and the majority of these loans are collateralized by real estate.  In addition, the Company critically evaluates all requests for additional funding on classified loans to determine whether the borrower has the capacity and willingness to repay.  Any requests of this nature require concurrence by the Director’s Loan Committee of the Bank’s Board of Directors.

The Company purchased loans in its acquisition of ABI, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually-required payments would not be collected.  Loans acquired with deteriorated credit quality are included in our various disclosures of credit quality, including:  loans on nonaccrual; loans past due; special mention loans; substandard loans; and doubtful loans.  The tables below disclose the total loans for the Company, total loans acquired in the acquisition of ABI, the loans acquired with deteriorated credit quality and the percent of loans acquired with deteriorated credit quality to total loans for the Company for each credit metric.

(Dollars in thousands) September 30, 2013	Total Loans		Loans Acquired from ABI		Loans Acquired from ABI with Deteriorated Credit Quality		% of Total
Nonaccrual	$	15,516	$	5,124	$	4,070		26.2	%
Past Due		19,793		6,187		5,150		26.0
Special Mention		11,466		1,034		1,034		9.0
Substandard		34,088		11,992		7,214		21.2
Doubtful		-		-		-		-
	$	45,554	$	13,026	$	8,248		18.1

December 31, 2012	Total Loans		Loans Acquired from ABI		Loans Acquired from ABI with Deteriorated Credit Quality		% of Total
Nonaccrual	$	22,681	$	12,205	$	10,958		48.3	%
Past Due		21,917		9,245		8,017		36.6
Special Mention		26,458		6,963		5,069		19.2
Substandard		38,759		20,897		16,909		43.6
Doubtful		-		-		-		-
	$	65,217	$	27,860	$	21,978		33.7

During the nine months ended September 30, 2013, the Company experienced an overall reduction in loans acquired from ABI with deteriorated credit quality in terms of the recorded investment in such loans and as a percentage of total loans.  When comparing the total percentage of loans acquired from ABI with deteriorated credit quality for special mention and substandard loans to the total special mention and substandard loans of the Company as of September 30, 2013 and December 31, 2012, the percentages reflect an overall reduction to 18.1% as of September 30, 2013, compared to 33.7% as of December 31, 2012.  A similar reduction was experienced for loans on nonaccrual and loans past due.  This change was primarily due to an increase in the portion of foreclosure activity of ABI loans compared to total loans, loan charge-offs as well as payoffs prior to maturity related to loans acquired with deteriorated credit quality in comparison to total loans.

The same criteria used for all Company loans greater than 90 days past due and still accruing interest applies to loans acquired with deteriorated credit quality.  Loans acquired with deteriorated credit quality will be placed on nonaccrual status if the amount and timing of future cash flows cannot be reasonably estimated or if repayment of the loan is expected to be from collateral that has become deficient.  As of September 30, 2013, we had loans acquired with deteriorated credit quality on nonaccrual in the amount of $4.1 million.

50

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

In comparison to our internally defined peer group, the ratio of nonaccrual loans to total loans remained unfavorable throughout the current year-to-date period.  However, the variance between our ratio and that of our peers has decreased from December 31, 2012 to September 30, 2013 as the Company has shown improvements in our overall asset quality during the nine months ended September 30, 2013.  Also, the Company has historically maintained higher allowance for loan loss reserves as a percentage of total loans when compared to our peers.

Allowance and Provision for Loan Losses

The allowance for loan losses decreased by $3.2 million during the nine months ended September 30, 2013, amounting to $17.0 million as of September 30, 2013 as compared to $20.2 million as of December 31, 2012.  The allowance represented approximately 4.55% and 5.07% of total loans as of September 30, 2013 and December 31, 2012, respectively.

Activity in the allowance for loan losses by portfolio segment for the nine months ended September 30, 2013 and 2012 was as follows:

	Nine Months Ended
	September 30,
(Dollars in thousands)	2013			2012
Allowance at beginning of period	$	20,198		$	13,024
Charge-offs:
Commercial loans		121			878
Real estate mortgage loans		3,313			12,027
Consumer and other loans		174			124
Total charge-offs		3,608			13,029
Recoveries:
Commercial loans		81			13
Real estate mortgage loans		165			339
Consumer and other loans		38			107
Total recoveries		284			459
Net charge-offs		3,324			12,570
Provision for loan losses charged to operating expenses:
Commercial loans		145			1,148
Real estate mortgage loans		(193	)		16,517
Consumer and other loans		148			(19	)
Total provision		100			17,646
Allowance at end of period	$	16,974		$	18,100

The decrease in the allowance for loan losses as of September 30, 2013 compared to December 31, 2012 was driven primarily by a decrease in the amount of allowance needed on loans collectively evaluated for impairment and loans acquired with deteriorated credit quality.  The decrease in the amount of allowance needed on loans collectively evaluated for impairment was due to an overall reduction in the respective loan balances as well as a decrease in net charge-offs that flow into the calculation of the historical look back period, particularly commercial real estate loans.  The decrease in the amount of allowance needed on loans acquired with deteriorated credit quality was due to increased charge-offs related to these loans during the nine months ended September 30, 2013.

The Bank’s identification efforts of potential losses in the portfolio are based on a variety of specific factors, including the Company’s own historical experience as well as industry and economic trends.  In calculating the Company’s allowance for loan losses, the Company’s historical loss experience is supplemented with various current and economic trends.  These current qualitative factors can include any of the following: changes in volume and severity of past due status, special mention, substandard and nonaccrual loans; levels of any trends in charge-offs and recoveries; changes in nature, volume and terms of loans; changes in lending policies and procedures; changes in lending management and quality of loan review; changes in economic and business conditions; and changes in underlying collateral values and effects of concentrations. There were no changes in the current qualitative factors from December 31, 2012 to September 30, 2013.

51

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

As of September 30, 2013, of the $14.5 million of the allowance for loan losses from loans collectively evaluated for impairment, the real estate mortgage loans portfolio segment had total weighted average qualitative factors of 1.26%, or $3.1 million; the commercial loans portfolio segment had total weighted average qualitative factors of 1.30%, or $0.5 million; and the consumer and other loans portfolio segment had total qualitative factors of 0.70%, or $10 thousand.  Impaired loans were $16.4 million as of September 30, 2013, of which $1.5 million was specifically allocated to the allowance for loan losses which was deemed appropriate to absorb probable incurred credit losses.

As part of the Company’s allowance for loan losses policy, loans acquired from ABI with evidence of deteriorated credit quality were included in our evaluation of the allowance for loan losses for each period.  For loans acquired with deteriorated credit quality, if the loss was attributed to events and circumstances that existed as of the acquisition date as a result of new information obtained during the measurement period (i.e., 12 months from date of acquisition) that, if known, would have resulted in the recognition of additional deterioration, the additional deterioration was recorded as additional carrying discount with a corresponding increase to goodwill.  If not, the additional deterioration was recorded as additional provision expense with a corresponding increase to the allowance for loan losses.  After the measurement period, any additional impairment above the current carrying discount was recorded as additional provision for loan loss expense with a corresponding increase to the allowance for loan losses.  As of September 30, 2013, there were $4.1 million in loans acquired with deteriorated credit quality that were included in the evaluation of the allowance for loan losses.

For loans acquired with deteriorated credit quality that were deemed troubled debt restructurings prior to the Company’s acquisition of them, these loans were not considered troubled debt restructurings as they were accounted for under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality.  Subsequent to the acquisition, the same criteria used for all other loans applied to loans acquired with deteriorated credit quality and their treatment as troubled debt restructurings.  As of September 30, 2013, there was one acquired loan with deteriorated credit quality that was deemed a troubled debt restructuring in the amount of $550 thousand.

The allowance for loan losses is a valuation allowance for credit losses in the loan portfolio.  Management adopted a methodology to properly analyze and determine an adequate loan loss allowance.  The analysis is based on sound, reliable and well documented information and is designed to support an allowance that is adequate to absorb probable incurred credit losses in the Company’s loan and lease portfolio.  Due to their similarities, the Company has grouped the loan portfolio as follows: commercial loans, residential real estate loans, commercial real estate loans, and consumer and other loans.  The Company has created a loan classification system to calculate the allowance for loan losses.  Loans are periodically evaluated for impairment.  If a loan is deemed to be impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the sale of the collateral.

It is the Bank’s policy to obtain updated third-party appraisals on all OREO and real estate collateral on substandard loans on, at least, an annual basis.  Value adjustments are often made to appraised values on properties for which the existing appraisal is approximately one year old at period-end.  Occasionally, at period-end, an updated appraisal has been ordered, but not yet received, on a property for which the existing appraisal is approaching one year old.  In this circumstance, an adjustment is typically made to the existing appraised value to reflect the Bank’s best estimate of the change in the value of the property, based on evidence of changes in real estate market values derived by the review of current appraisals received by the Bank on similar properties.  In the current environment, virtually all such adjustments to value are downward due to the overall reduction in real estate values over the last two years in the Bank’s market area.

Real estate values in the Bank’s market area have experienced deterioration over the last several years.  The expectation for further deterioration for all property types appears to be leveling off with recent indicators of stabilization in the market.  On at least a quarterly basis, management reviews several factors, including underlying collateral, and writes down impaired loans to their net realizable value.

52

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

In estimating the overall exposure to loss on impaired loans, the Company has considered a number of factors, including the borrower’s character, overall financial condition, resources and payment record, the prospects for support from any financially responsible guarantors, and the realizable value of any collateral.  The Company also considers other internal and external factors when determining the allowance for loan losses.  These factors include, but are not limited to, changes in national and local economic conditions, commercial lending staff limitations, impact from lengthy commercial loan workout and charge-off periods, loan portfolio concentrations and trends in the loan portfolio.

Based on the results of the analysis performed by management as of September 30, 2013, the allowance for loan losses was considered adequate to absorb probable incurred credit losses in the portfolio as of that date.  As more fully discussed in the “Critical Accounting Policies” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, the process for estimating credit losses and determining the allowance for loan losses as of any balance sheet date is subjective in nature and requires material estimates and judgments.  Actual results may differ significantly from these estimates and judgments.

The amount of future charge-offs and provisions for loan losses could be affected by several factors including, but not limited to, economic conditions in Jacksonville and Jacksonville Beach, Florida, and the surrounding communities.  Such conditions could affect the financial strength of the Company’s borrowers and the value of real estate collateral securing the Company’s mortgage loans.  Future charge-offs and provisions could also be affected by environmental impairment of properties securing the Company’s mortgage loans.  Under the Company’s current policy, an environmental risk assessment is required on the majority of all commercial-type properties that are considered for a mortgage loan.  At the present time, the Company is not aware of any existing loans in the portfolio where there is environmental pollution existing on the mortgaged properties that would materially affect the value of the portfolio.

Liquidity and Capital Resources

Cash Flows

The Company’s primary sources of cash are deposit growth, maturities and amortization of investment securities, FHLB advances, Federal Reserve Bank borrowings and federal funds purchased.  The Company uses cash from these and other sources to fund loans.  Any remaining cash is used primarily to reduce borrowings and to purchase investment securities.

Cash Flows from Operating Activities:

Net cash from operating activities was $1.2 million and $4.5 million for the nine months ended September 30, 2013 and 2012, respectively.  Net cash from operating activities for the nine months ended September 30, 2013 was primarily impacted by net income of $0.4 million, as adjusted for (i) net accretion of purchase accounting adjustments, mainly purchased loans, of $1.3 million, (ii) premium amortization for securities, net of accretion, of $0.8 million, (iii) depreciation and amortization of $0.5 million, (iv) write-down of other real estate owned of $0.5 million, and (v) net realized gains from the sale of securities of $0.4 million.  Net cash from operating activities for the same period in the prior year reflected a net loss of $21.2 million, as adjusted for, among other factors, provision for loan losses of $17.6 million, goodwill impairment of $3.1 million, and the write-down of other real estate owned of $2.3 million.

Cash Flows from Investing Activities:

Net cash from (used for) investing activities was $11.4 million and $9.8 million for the nine months ended September 30, 2013 and 2012, respectively.  The increase in cash flows from investing activities was primarily due to an increase in net loan payments to $19.2 million during the nine months ended September 30, 2013, compared to $11.4 million for the same period in the prior year.  In addition, net cash flows used for activities related to investment securities decreased to $7.2 million, compared to $25.4 million in the prior year.  These amounts were offset by an increase in coverage under the Company’s bank-owned life insurance policy resulting in a $3.0 million investment that did not occur in the prior year and a decrease in proceeds from the sale of other real estate owned of $2.0 million.

Cash Flows from Financing Activities:

Net cash (used for) from financing activities was $48.7 million and $9.0 million for the nine months ended September 30, 2013 and 2012, respectively.  The year-over-year decrease in cash flows was primarily due to $49.6 million in deposit outflows during the nine months ended September 30, 2013, compared to $19.7 million in deposit inflows during the same period in the prior year.  Proceeds from the sale of equity securities included net proceeds from the sale of common stock of $0.9 million during the nine months ended September 30, 2013, compared to $4.9 million in net proceeds from the sale of preferred stock during the nine months ended September 30, 2012.  Prior year factors also included $18.6 million outflow from the net change in overnight Federal Home Loan Bank advances, net proceeds from Federal Home Loan Bank fixed rate advances of $2.0 million and proceeds from related party transactions of $1.0 million.  Such events did not reoccur in the current year.

53

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Capital Resources

The Company has both internal and external sources of near-term liquidity that can be used to fund loan growth and accommodate deposit outflows.  The primary internal sources of liquidity include principal and interest payments on loans, proceeds from maturities and monthly payments on the balance of the investment securities portfolio, and its overnight position with federal funds sold.  As of September 30, 2013, the Company had $88.2 million in available-for-sale securities, $9.6 million of which was pledged to the Federal Reserve Bank for the Borrower-in-Custody Program as well as the State of Florida.  Scheduled maturities and paydowns of the Company’s investment securities are an additional source of liquidity.  The Company also has the ability to convert marketable securities into cash or access new or existing sources of incremental funds if the need should arise.

The Company’s primary external sources of liquidity are customer deposits and borrowings from other commercial banks. The Company’s deposit base consists of both deposits from businesses and consumers in its local market as well as national market deposits.

The Bank has an unsecured federal funds purchased accommodation with its main correspondent bank totaling $10.0 million as of September 30, 2013, all of which was available as of that date.  In the second quarter of 2013, the Bank established an additional unsecured federal funds purchased accommodation with its secondary correspondent bank for $10.0 million, all of which was available as of September 30, 2013.  In addition, the Bank has invested in FHLB stock for the purpose of establishing a line of credit with FHLB.  This line is collateralized by a lien arrangement on the Bank’s first mortgage loans, second mortgage loans and commercial real estate loans.  Based upon this collateral and the Company’s holdings of FHLB stock, the Company is eligible to borrow up to a total of $26.8 million as of September 30, 2013 and had borrowed $20.0 million, leaving $6.8 million available as of the same date.  The Bank also has a “Borrower in Custody” line of credit with the Federal Reserve Bank that utilizes excess loan collateral and pledged municipal securities.  The amount of this line as of September 30, 2013 was $22.2 million, all of which was available as of that date.  While these lines of credit were available to the Company as of September 30, 2013, they do not represent legal commitments to extend credit.

The Bank also has access to the non-brokered national and brokered deposit markets to supplement liquidity needs.  As of September 30, 2013, the Bank had $59.0 million in national CDs and $10.4 million in brokered CDs.  The Bank has historically utilized brokered deposits, but absent a waiver from the FDIC, could not offer brokered CDs during 2012 as it was not well capitalized until December 31, 2012.  Our ability to utilize brokered CDs and the rates we can pay on deposits will be limited if the Bank fails to remain well capitalized for regulatory purposes.

During the year ended December 31, 2011, the Company entered into revolving loan agreements (collectively, the “Revolvers”) with several of its directors and other related parties.  Each Revolver pays an annual rate of interest equal to 8% on a quarterly basis of the Revolver amount outstanding.  To the extent that any Revolver is not fully drawn, an unused revolver fee is calculated and paid quarterly at an annual rate of 2% on the revolving loan commitment less the daily average principal amount outstanding.  The Revolvers mature on January 1, 2015.  Amounts outstanding under the Revolvers were $2.2 million, respectively, with no funds remaining available as of September 30, 2013 and $1.8 million remaining available as of December 31, 2012.  During the second quarter of 2013, participants in the Private Placement who purchased Series A Preferred Stock through the cancellation of debt under their Revolvers, were given the option and thereby elected to reduce their loan commitments under the Revolvers based on the amount previously utilized to purchase shares of Series A Preferred Stock in the Private Placement.  This resulted in a reduction of the maximum borrowings available to the Company from $4.0 million as of December 31, 2012 to $2.2 million effective July 1, 2013.  Please refer to Note 6 – Loans from Related Parties in the accompanying notes to the Consolidated Financial Statements for additional information related to the reduced availability under the Revolvers.  Please refer to Note 14 – Subsequent Events for additional information related to the recent pay down of such borrowings subsequent to period-end.

54

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

In recent years, Bancorp has depended on the Revolvers, in addition to cash on hand and net proceeds from capital raise activities, to pay its operating and interest expenses.  Management believes the maximum borrowings available under the Revolvers as of September 30, 2013 and other sources of liquidity will be sufficient through December 31, 2013.

Historically, the primary source of Bancorp’s income was expected to be dividends from the Bank.  A Florida state-chartered commercial bank may not pay cash dividends that would cause the bank’s capital to fall below the minimum amount required by federal or state law.  Accordingly, commercial banks may only pay dividends out of the total of current net profits plus retained net profits of the preceding two years to the extent it deems expedient, except as follows: No bank may pay a dividend at any time that the total of net income for the current year, when combined with retained net income from the preceding two years, produces a loss.  The Bank met this restriction as of September 30, 2013 as our net income for the nine months ended September 30, 2013 combined with retained earnings from the preceding two years produced a loss.  The future ability of the Bank to pay dividends to Bancorp will also depend in part on the FDIC capital requirements in effect at such time and our ability to comply with such requirements.

Bancorp cannot currently pay dividends on its capital stock under applicable Federal Reserve policies and enforcement actions.  Under Federal Reserve policy, the board of directors of a bank holding company must consider different factors to ensure that its dividend level is prudent relative to maintaining a strong financial position, and is not based on overly optimistic earnings scenarios, such as potential events that could affect its ability to pay dividends, while still maintaining a strong financial position.  As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer or significantly reduce the bank holding company’s dividends if:

• its net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends;

• its prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or

• it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios.

Capital

Banks and bank holding companies are subject to extensive 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 initiate regulatory action.

As of September 30, 2013 and December 31, 2012, Bancorp, the Bank, and the Company met all capital adequacy requirements to which they were subject.  Further, management and the Bank’s Board of Directors have committed to maintain Total Risk-Based Capital of 12% and Tier 1 Capital to Average Assets of 8%.  For additional information related to the Company’s capital adequacy information, please refer to Note 12 – Capital Adequacy in the accompanying notes to the Consolidated Financial Statements.

Bank

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among other things, requires the federal banking agencies to take “prompt corrective action” regarding depository institutions that do not meet minimum capital requirements.  FDICIA establishes five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.”  A depository institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation.

The “prompt corrective action” rules provide that a bank will be: (i) “well capitalized” if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, a leverage capital ratio of 5% or greater and is not subject to certain written agreements, orders, capital directives or prompt corrective action directives by a federal bank regulatory agency to maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if it has a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater, and generally has a leverage capital ratio of 4% or greater; (iii) “undercapitalized” if it has a total risk-based capital ratio of less than 8%, a Tier 1 risk-based capital ratio of less than 4% or generally has a leverage capital ratio of less than 4%; (iv) “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3% or a leverage capital ratio of less than 3%; or (v) “critically undercapitalized” if its tangible equity is equal to or less than 2% to total assets.  The federal bank regulatory agencies have authority to require additional capital.

55

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

The Bank was well capitalized as of September 30, 2013 and December 31, 2012, respectively.  Depository institutions that are no longer “well capitalized” for bank regulatory purposes must receive a waiver from the FDIC prior to accepting or renewing brokered deposits.  FDICIA generally prohibits a depository institution from making any capital distribution (including paying dividends) or paying any management fee to its holding company, if the depository institution would thereafter be undercapitalized.

The Bank had an MoU with the FDIC and the Florida Office of Financial Regulation that was entered into in 2008 (the “2008 MoU”), which required the Bank to have a total risk-based capital of at least 10% and a Tier 1 leverage capital ratio of at least 8%.  On July 13, 2012, the 2008 MoU was replaced by a new MoU (the “2012 MoU”), which, among other things, requires the Bank to have a total risk-based capital of at least 12% and a Tier 1 leverage capital ratio of at least 8%.   The Bank met the minimum capital requirements of these memoranda as of September 30, 2013 and December 31, 2012, when the Bank had total risk-based capital of 14.05% and 12.70% and Tier 1 leverage capital of 9.35% and 8.29%, respectively.

In December 2006, bank regulators issued “Joint Guidance on Concentrations in Commercial Real Estate Lending.”  This document outlines regulators’ concerns regarding the high level of growth in commercial real estate loans on banks’ balance sheets.  Many banks, especially those in Florida, have substantial exposure to commercial real estate loans.  The concentration in this category is considered when analyzing the adequacy of the loan loss allowance based on sound, reliable and well-documented information.  The Bank’s 2012 MoU with the FDIC also requires us to monitor and reduce our commercial real estate (“CRE”) loan concentrations.  As of September 30, 2013 the ratio of total loans secured by non-owner occupied multi-family, nonfarm, and nonresidential properties, as well as construction, land development and other land loans as a percentage of total risk-based capital was 280.00% compared to 315.50% as of December 31, 2012.  While our December 31, 2012 ratio exceeded applicable regulatory guidance of 300%, our September 30, 2013 ratio of total loans secured by non-owner occupied multi-family, nonfarm, and nonresidential properties, as well as construction, land development and other land loans, met this requirement.

Bancorp

The Federal Reserve requires bank holding companies, including Bancorp, to act as a source of financial strength for their depository institution subsidiaries.  The Federal Reserve has a minimum guideline for bank holding companies of Tier 1 capital to adjusted average quarterly assets (“leverage ratio”) equal to at least 4.00%, and total risk-based capital of at least 8.00%, at least half of which must be Tier 1 capital.  As of September 30, 2013 and December 31, 2012, Bancorp met these requirements.

Higher capital may be required in individual cases and depending upon a bank holding company’s risk profile.  All bank holding companies and banks are expected to hold capital commensurate with the level and nature of their risks including the volume and severity of their problem loans. The Federal Reserve will continue to consider a “tangible Tier 1 leverage ratio” (deducting all intangibles) in evaluating proposals for expansion or new activity.  The level of Tier 1 capital to risk-adjusted assets is becoming more widely used by bank regulators to measure capital adequacy.  The Federal Reserve has not advised the Company of any specific minimum capital ratios applicable to it.  Under Federal Reserve policies, bank holding companies are generally expected to operate with capital positions well above the minimum ratios.  The Federal Reserve believes the risk-based ratios do not take into account the quality of capital and interest rate, liquidity, market and operational risks.  Accordingly, supervisory assessments of capital adequacy may differ significantly from conclusions based solely on an organization’s risk-based capital ratios.

Dividends and Distributions

Prior to October 2009, dividends received from the Bank were Bancorp’s principal source of funds to pay its expenses and interest on and principal of Bancorp’s debt.  Banking regulations and enforcement actions require the maintenance of certain capital levels and restrict the payment of dividends by the Bank to Bancorp or by Bancorp to shareholders.  Commercial banks generally may only pay dividends without prior regulatory approval out of the total of current net profits plus retained net profits of the preceding two years, and banks and bank holding companies are generally expected to pay dividends from current earnings.  Banks may not pay a dividend if the dividend would result in the bank being “undercapitalized” for prompt corrective action purposes, or would violate any minimum capital requirement specified by law or the bank’s regulators.  The Bank has not paid dividends to Bancorp since October 2009 and cannot currently pay dividends, and Bancorp cannot currently pay dividends on its capital stock under applicable Federal Reserve policies and enforcement actions.  Bancorp has relied upon revolving loan agreements with certain of its directors and other related parties to pay its expenses during such time.  As of September 30, 2013 there were no funds remaining available under the Revolvers, whereas there was $1,800 in remaining funds available as of December 31, 2012.   During 2013, Bancorp has supplemented borrowings available under the Revolvers with cash on hand and net proceeds from capital raise activities to fund operations.

56

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Recent Updates in Capital Regulation and Supervision

The Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) significantly modified the capital rules applicable to the Company and calls for increased capital, generally.

· The generally applicable prompt corrective action leverage and risk-based capital standards (the “generally applicable standards”), including the types of instruments that may be counted as Tier 1 capital, will be applied on a consolidated basis to depository institution holding companies, as well as their bank and thrift subsidiaries.

· The generally applicable standards in effect prior to the Dodd-Frank Act will be “floors” for the standards to be set by the regulators.

· Bank and thrift holding companies with assets of less than $15 billion as of December 31, 2009, will be permitted to include trust preferred securities that were issued before May 19, 2010, as Tier 1 capital, but trust preferred securities issued by a bank holding company (other than those with assets of less than $500 million) after May 19, 2010, will no longer count as Tier 1 capital.

Under the Basel III capital rules proposed by the Federal Reserve and the FDIC in June 2012, the risk weights of assets, the definitions of capital and the amounts and types of capital will be changed.  Among other things, these proposed rules included the implementation of new capital requirements and the elimination of Tier 1 treatment of trust preferred securities following a phase-in period beginning in 2013.  On November 9, 2012, the Federal Reserve and U.S. bank regulatory agencies announced via press release that the implementation of the proposed Basel III rules would be delayed and, therefore, would not go into effect on January 1, 2013.

On July 2, 2013, the Federal Reserve approved the final rules to implement the Basel III rules in the U.S.  The final rules implemented changes to the regulatory capital framework including, but not limited to, (i) a revised definition of regulatory capital, (ii) a new common equity Tier 1 minimum capital requirement, (iii) a higher minimum Tier 1 capital requirement, (iv) limitations on capital distributions and certain discretionary bonus payments based on various capital requirements, (v) amended methodologies for determining risk-weighted assets, and (vi) new disclosure requirements for top-tier banking organizations with $50.0 billion or more in total assets.  Further, the final rules incorporated these new requirements into the prompt corrective action framework.  Various provisions have been included in the final rules to provide relief to banking organizations under $50.0 billion in assets, such as community banks like ours.  Such provisions include the opportunity for a one-time opt-out from the requirement to include fluctuations in available-for-sale securities as part of regulatory capital and grandfather treatment of trust preferred securities as an element of Tier 1 capital for banking organizations under $15.0 billion.  These new rules will take effect beginning January 1, 2014 with a mandatory compliance deadline of January 1, 2015 for banking organizations with total assets less than $250.0 billion.  The Company is currently evaluating the impact of adoption.

Contractual Obligations, Commitments and Contingent Liabilities

The Company has various financial obligations, including contractual obligations and commitments that are expected to require future cash payments.  Management believes that there have been no material changes in the Company’s overall level of these financial obligations since December 31, 2012 and that any changes in the Company’s obligations which have occurred are routine for the industry.  Further discussion of the nature of each type of obligation is included in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC on March 26, 2013.

57

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Off-Balance Sheet Arrangements

Management believes that there have been no material changes in off-balance sheet arrangements and related risks since the Company’s disclosure in its Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC on March 26, 2013.

Critical Accounting Policies and Estimates

A critical accounting policy is one that is both very important to the portrayal of the Company’s financial condition and requires management’s most difficult, subjective or complex judgments. The circumstances that make these judgments difficult, subjective or complex have to do with the need to make estimates about the effect of matters that are inherently uncertain.  The following is a brief description of the Company’s critical accounting estimates involving significant valuation judgments.

Allowance for Loan Losses

The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb probable incurred credit losses on existing loans that may become uncollectible based on evaluations of the collectability of the loans. The evaluations take into consideration such objective factors as changes in the nature and volume of the loan portfolio and historical loss experience. The evaluation also considers certain subjective factors such as overall portfolio quality, review of specific problem loans and current economic conditions that may affect the borrowers’ ability to pay. The level of allowance for loan losses is also impacted by increases and decreases in loans outstanding, because either more or less allowance is required as the amount of the Company’s credit exposure changes. To the extent actual loan losses differ materially from management’s estimate of these subjective factors, loan growth/run-off accelerates, or the mix of loan types changes, the level of provision for loan losses, and related allowance can, and will, fluctuate.

Other Real Estate Owned (“OREO”)

OREO includes real estate acquired through foreclosure or deed taken in lieu of foreclosure. These amounts are recorded at estimated fair value (based on the lower of current appraised value or listing price), less costs to sell the property, with any difference between the fair value of the property and the carrying value of the loan being charged to the allowance for loan losses.  Subsequent changes in fair value are reported as adjustments to the carrying amount. Those subsequent changes, as well as any gains or losses recognized on the sale of these properties, are included in noninterest expense.  Fair values are preliminary and subject to refinement after the acquisition date as new information relative to the acquisition date fair value becomes available.  Valuation adjustments and gains or losses recognized on the sale of these properties occurring within 90 days of acquisition are charged against, or credited to, the allowance for loan losses.

Deferred Income Taxes

Our net deferred income tax asset arises from differences in the dates that items of income and expense enter into our reported income and taxable income.  From an accounting standpoint, deferred tax assets are reviewed to determine if a valuation allowance is required based on both positive and negative evidence currently available.  Based on these criteria, the Company determined that it was necessary to establish a full valuation allowance against our deferred tax asset as of December 31, 2011 and December 31, 2012.  The Company performed an analysis as of September 30, 2013 and determined the need for a valuation allowance still existed.  To the extent that we generate taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense.  Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once the Company can demonstrate a sustainable return to profitability and conclude that it is more-likely-than-not that the deferred tax asset will be utilized prior to expiration.

Additional information with regard to the Company’s methodology and reporting of its critical accounting policies and associated estimates is included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC on March 26, 2013.

58

JACKSONVILLE BANCORP, INC.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued)

Recently Issued Accounting and Reporting Standards

In February 2013, the Financial Accounting Standards Board (“FASB”) issued an accounting standards update that finalized previously deferred guidance related to the reporting of amounts reclassified out of accumulated other comprehensive income.  The amendments in this update do not alter current requirements for reporting net income or other comprehensive income in the consolidated financial statements.  However, the amendments require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component.  In addition, an entity must present significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income either on the face of the statement where net income is presented or in the accompanying notes to the Consolidated Financial Statements.  This requirement is only applicable if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period.  Alternatively, amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts.  This standard was effective prospectively for reporting periods beginning after December 15, 2012.  Early adoption was permitted.  To comply with the amended guidance, the Company has disclosed additional information pertaining to the components of accumulated other comprehensive income and reclassifications out of accumulated other comprehensive income in Note 10—Shareholders’ Equity in the accompanying notes to the Consolidated Financial Statements.

In July 2013, the FASB issued an accounting standards update that amended existing guidance related to derivatives and hedging.  The amendments in this update permit the use of the Fed Funds Effective Swap Rate (“OIS”) as a benchmark interest rate for hedge accounting purposes, in addition to existing benchmarks based on U.S. Government Treasury obligations (“UST”) and the London Interbank Offered Rate (“LIBOR”).  This standard was effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013.  Early adoption was not permitted.  The Company has evaluated this standard and determined that it will not have a material effect on the Company’s Consolidated Financial Statements.

Also in July 2013, the FASB issued an accounting standards update that requires that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, be presented in the financial statements as a reduction of a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryingforward, with specified exceptions.  To the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available as of the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be combined with deferred tax assets.  The assessment of whether a deferred tax asset is available is based on the unrecognized tax benefit and deferred tax asset that exist as of the reporting date and should be made presuming disallowance of the tax position at the reporting date. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013.  No new recurring disclosures are required by this update.  The Company is currently evaluating this standard; however, management does not expect this update to have a material impact on the Consolidated Financial Statements.

Other accounting standards that have been issued by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Management believes that there have been no material changes in quantitative and qualitative disclosures about market risk since the Company’s disclosure in its Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC on March 26, 2013.

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Item 4. Controls and Procedures

(a)  Evaluation of Disclosure Controls and Procedures

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (the “SEC”).  Based upon management’s evaluation of those controls and procedures as of the end of the fiscal quarter covered by this quarterly report on Form 10-Q, the principal executive officer and Chief Financial Officer of the Company concluded that, subject to the limitations noted below, the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) are effective to ensure that the information required to be disclosed by Bancorp in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Changes in Internal Control over Financial Reporting

In the ordinary course of business, the Company may routinely modify, upgrade and enhance its internal controls and procedures for financial reporting.  In an effort to improve internal control over financial reporting, Bancorp continues to emphasize the importance of identifying areas for improvement and to create and implement new policies and procedures where deficiencies exist.  There have been no changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

(c) Limitations on the Effectiveness of Controls

Bancorp’s management, including our principal executive officer and Chief Financial Officer, does not expect that our disclosure controls and internal controls will prevent all error and all fraud.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management’s override of the control.

The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, as a normal incident of the nature and kind of business in which we are engaged, various claims or charges are asserted against us and/or our directors, officers or affiliates.  In the ordinary course of business, the Company is also subject to regulatory examinations, information gathering requests, inquiries and investigations.  Other than ordinary routine litigation incidental to our business, management believes after consultation with legal counsel that there are no pending legal proceedings against Bancorp or any of its subsidiaries that will, individually or in the aggregate, have a material adverse effect on the consolidated results of operations or financial condition of the Company.

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Item 1A. Risk Factors

Management believes that there have been no material changes from the risk factors disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the SEC on March 26, 2013, other than as set forth below.

The loss of key personnel may adversely affect our operating results.

Our success is, and is expected to remain, highly dependent on our senior management team.  We rely heavily on our senior management because, as a community bank, our management’s extensive knowledge of, and relationships in, the community generates business for us.  Successful execution of our business strategies will continue to place significant demands on our management and the loss of any such person’s services may adversely affect our ability to resolve these problems, recapitalize the Company, resume our growth and return to profitability.  After Mr. Schwenck’s retirement on June 18, 2012, we appointed Stephen C. Green as President and Chief Executive Officer and appointed Margaret A. Incandela as Executive Vice President, Chief Operating Officer and Chief Credit Officer.  Employment contracts were executed with both Mr. Green and Ms. Incandela, with equity awards subject to certain conditions.

On June 24, 2013, Mr. Green resigned as President and Chief Executive Officer of the Company, and as Chief Executive Officer of the Bank.  In connection with his resignation, the Company, the Bank and Mr. Green entered into a separation, release and non-disparagement agreement on June 27, 2013.  Also on June 27, 2013, Donald F. Glisson, Jr., Chairman of the Board of the Company, was appointed to serve as the Company’s principal executive officer on an interim basis until a new President and Chief Executive Officer is elected.  As the Company’s interim principal executive officer, Mr. Glisson plays an active role in facilitating activities within the bounds of our current business strategy and further enhance the organization’s growth potential.  Moving forward, the Company will rely on Mr. Glisson’s knowledge and expertise as he performs the duties and exercises the powers of the President and Chief Executive Officer until such vacancy is filled. If we are unable to attain a new President and Chief Executive Officer in a timely manner our results and financial condition and prospects could be adversely affected.

We also continue to rely upon the services of Scott M. Hall, Executive Vice President and the Bank’s President, and Valerie A. Kendall, Executive Vice President and Chief Financial Officer.  If the services of these individuals were to become unavailable for any reason, or if we were unable to hire highly qualified and experienced personnel to replace them, our results and financial condition and prospects could be adversely affected.

RISKS RELATED TO OUR COMMON STOCK

The market price of our common stock may be volatile, and if we do not maintain a minimum bid price of $1.00, we may be subject to delisting from the NASDAQ Stock Market.

The market price of our common stock is subject to fluctuations as a result of a variety of factors, some of which may be beyond our control. Factors affecting the volatility of the trading price of our common stock include:

· quarterly variations in our operating results or those of other banking institutions;

· changes in local, regional and national economic conditions, financial markets or the banking industry;

· announcements of new products or services by us or our competitors; and

· other developments affecting us or other financial institutions.

The trading volume of our common stock is limited, which may increase the volatility of the market price for our stock. In addition, the stock market has experienced significant price and volume fluctuations in recent years. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons not necessarily related to the operating performance of these companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. For example, the trading price of our common stock could decline in reaction to events that negatively affect other companies in our industry even if these events do not directly affect us at all. In the past, many companies that have experienced volatility in the market price of their stock have been subject to securities class action litigation. We may be a target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns, which could seriously harm our business.

In addition, the NASDAQ Stock Market imposes certain standards that a company must satisfy in order to maintain the listing of its securities on the NASDAQ Stock Market.  Among other things, these standards require that the bid price of the common stock of listed companies be at least $1.00 per share (the “Minimum Bid Price Rule”).  On November 29, 2012, the Company received notice (the “Notice”) from the Listing Qualifications staff of The

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Item 1A. Risk Factors (Continued)

NASDAQ Stock Market stating that the Company no longer complied with the Minimum Bid Price Rule.  Although the Company regained compliance with the Minimum Bid Price Rule within the applicable grace period, during the second quarter of 2013, the bid price of our common stock fell below $1.00 per share for 30 consecutive business days which resulted in a second Notice from the Listing Qualifications staff. 

In October 2013, Bancorp’s Board of Directors implemented a 1-for-20 reverse stock split of the Company’s issued and outstanding shares of common stock and nonvoting common stock in an effort to increase the market price of the Company’s common stock and thereby enhance the overall liquidity of issued and outstanding shares of common stock and nonvoting common stock and regain compliance with NASDAQ continued listing standards.  As of the effective date of the reverse stock split, the Company’s per share market price increased from $0.51 to $10.20.  However, there can be no assurance that the reverse stock split, or any other measures taken by Bancorp’s Board of Directors to increase the market price of the common stock, will result in the intended benefits for the foreseeable future.  Please refer to Note 14 – Subsequent Events for additional information related to the reverse stock split.

Subsequent to quarter-end, on November 7, 2013, the Company received notification that it had regained compliance with the Minimum Bid Price Rule and therefore, was no longer subject to delisting from the NASDAQ Stock Market.

Item 5. Other Information

As previously disclosed, on June 27, 2013, Donald F. Glisson, Jr., Chairman of the Board of the Company, was appointed to serve as the Company’s principal executive officer on an interim basis until a new President and Chief Executive Officer is elected.  On September 26, 2013, the Company’s Board of Directors approved an additional director’s fee payable to Mr. Glisson in the amount of $10 thousand per month to be paid retroactively as of July 1, 2013.  The additional compensation, which Mr. Glisson began receiving on October 15, 2013 and will be paid quarterly thereafter, was approved based on his current role as the interim principal executive officer of the Company.

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Item 6. Exhibits

Exhibit No.	Description of Exhibit
Exhibit No. 2.1	Agreement and Plan of Merger by and between Atlantic BancGroup, Inc. and Jacksonville Bancorp, Inc., dated as of May 10, 2010 (incorporated herein by reference to Exhibit 2.1 of the Registrant’s Form 8-K filed on May 14, 2010, File No. 000-30248).
Exhibit No. 2.1a	First Amendment to Agreement and Plan of Merger by and between Atlantic BancGroup, Inc. and Jacksonville Bancorp, Inc., dated as of September 20, 2010 (incorporated herein by reference to Exhibit 2.1 of the Registrant’s Form 8-K filed on September 20, 2010, File No. 000-30248).
Exhibit No. 3.1	Amended and Restated Articles of Incorporation of Jacksonville Bancorp, Inc., as amended through September 27, 2012 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 10-Q filed on November 14, 2012, File No. 000-30248).
Exhibit No. 3.1a	Articles of Amendment to the Amended and Restated Articles of Incorporation Designating Series B Preferred Stock, effective as of December 27, 2012 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on January 3, 2013, File No. 000-30248).
Exhibit No. 3.1b	Articles of Amendment to the Amended and Restated Articles of Incorporation Designating Series A Preferred Stock, effective as of December 27, 2012 (incorporated herein by reference to Exhibit 3.2 of the Registrant’s Form 8-K filed on January 3, 2013, File No. 000-30248).
Exhibit No. 3.1c	Articles of Amendment to the Amended and Restated Articles of Incorporation, effective as of February 19, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on February 20, 2013, File No. 000-30248).
Exhibit No. 3.1d	Articles of Amendment to the Amended and Restated Articles of Incorporation, effective as of April 23, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on April 24, 2013, File No. 000-30248).
Exhibit No. 3.1e	Articles of Amendment to the Amended and Restated Articles of Incorporation, effective as of October 24, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on October 23, 2013, File No. 000-30248).
Exhibit No. 3.2	Amended and Restated Bylaws of Jacksonville Bancorp, Inc. (incorporated herein by reference to Exhibit 3.2 of the Registrant’s Form 8-K filed on November 17, 2010, File No. 000-30248).
Exhibit No. 3.2a	First Amendment to Amended and Restated Bylaws of Jacksonville Bancorp, Inc., effective as of March 21, 2013 (incorporated herein by reference to Exhibit 3.2a of the Registrant’s Form 10-K filed on March 26, 2013, File No. 000-30248).
Exhibit No. 3.2b	Second Amendment to Amended and Restated Bylaws of Jacksonville Bancorp, Inc., effective as of June 27, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on June 27, 2013, File No. 000-30248).
Exhibit No. 10.1	Separation, Release and Non-Disparagement Agreement by and among Jacksonville Bancorp, Inc., The Jacksonville Bank and Stephen C. Green (incorporated herein by reference to Exhibit 10.1 of the Registrant’s Form 8-K filed on June 27, 2013, File No. 000-30248). †
Exhibit No. 10.2	Election form to reduce commitments under the loan agreements by certain of the directors, their affiliates, entities and family members, effective July 1, 2013 (incorporated herein by reference to Exhibit 10.2 of the Registrant’s Form 10-Q filed on August 9, 2013, File No. 000-30248).
Exhibit No. 31.1	Certification of Chairman of the Board (principal executive officer) required by Rule 13a-14(a)/15d-14(a) of the Exchange Act.*
Exhibit No. 31.2	Certification of Chief Financial Officer (principal financial officer) required by Rule 13a-14(a)/15d-14(a) of the Exchange Act.*
Exhibit No. 32.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes–Oxley Act of 2002 *

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Exhibit No.	Description of Exhibit
Exhibit No. 101.INS	XBRL Instance Document*
Exhibit No. 101.SCH	XBRL Schema Document*
Exhibit No. 101.CAL	XBRL Calculation Linkbase Document*
Exhibit No. 101.DEF	XBRL Definition Linkbase Document*
Exhibit No. 101.LAB	XBRL Label Linkbase Document*
Exhibit No. 101.PRE	XBRL Presentation Linkbase Document*

*Included herewith.

†Identifies management contracts or compensatory plans or arrangements.

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JACKSONVILLE BANCORP, INC.

SIGNATURES

Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	JACKSONVILLE BANCORP, INC.
Date: November 8, 2013	By:	/S/    DONALD F. GLISSON, JR.
		Donald F. Glisson, Jr.
		Chairman of the Board
		(Principal executive officer)
Date: November 8, 2013	By:	/S/    VALERIE A. KENDALL
		Valerie A. Kendall
		Executive Vice President and
		Chief Financial Officer
		(Principal financial officer and
		Chief accounting officer)

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EXHIBIT INDEX

Exhibit No.	Description of Exhibit
Exhibit No. 2.1	Agreement and Plan of Merger by and between Atlantic BancGroup, Inc. and Jacksonville Bancorp, Inc., dated as of May 10, 2010 (incorporated herein by reference to Exhibit 2.1 of the Registrant’s Form 8-K filed on May 14, 2010, File No. 000-30248).
Exhibit No. 2.1a	First Amendment to Agreement and Plan of Merger by and between Atlantic BancGroup, Inc. and Jacksonville Bancorp, Inc., dated as of September 20, 2010 (incorporated herein by reference to Exhibit 2.1 of the Registrant’s Form 8-K filed on September 20, 2010, File No. 000-30248).
Exhibit No. 3.1	Amended and Restated Articles of Incorporation of Jacksonville Bancorp, Inc., as amended through September 27, 2012 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 10-Q filed on November 14, 2012, File No. 000-30248).
Exhibit No. 3.1a	Articles of Amendment to the Amended and Restated Articles of Incorporation Designating Series B Preferred Stock, effective as of December 27, 2012 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on January 3, 2013, File No. 000-30248).
Exhibit No. 3.1b	Articles of Amendment to the Amended and Restated Articles of Incorporation Designating Series A Preferred Stock, effective as of December 27, 2012 (incorporated herein by reference to Exhibit 3.2 of the Registrant’s Form 8-K filed on January 3, 2013, File No. 000-30248).
Exhibit No. 3.1c	Articles of Amendment to the Amended and Restated Articles of Incorporation, effective as of February 19, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on February 20, 2013, File No. 000-30248).
Exhibit No. 3.1d	Articles of Amendment to the Amended and Restated Articles of Incorporation, effective as of April 23, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on April 24, 2013, File No. 000-30248).
Exhibit No. 3.1e	Articles of Amendment to the Amended and Restated Articles of Incorporation, effective as of October 24, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on October 23, 2013, File No. 000-30248).
Exhibit No. 3.2	Amended and Restated Bylaws of Jacksonville Bancorp, Inc. (incorporated herein by reference to Exhibit 3.2 of the Registrant’s Form 8-K filed on November 17, 2010, File No. 000-30248).
Exhibit No. 3.2a	First Amendment to Amended and Restated Bylaws of Jacksonville Bancorp, Inc., effective as of March 21, 2013 (incorporated herein by reference to Exhibit 3.2a of the Registrant’s Form 10-K filed on March 26, 2013, File No. 000-30248).
Exhibit No. 3.2b	Second Amendment to Amended and Restated Bylaws of Jacksonville Bancorp, Inc., effective as of June 27, 2013 (incorporated herein by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on June 27, 2013, File No. 000-30248).
Exhibit No. 10.1	Separation, Release and Non-Disparagement Agreement by and among Jacksonville Bancorp, Inc., The Jacksonville Bank and Stephen C. Green (incorporated herein by reference to Exhibit 10.1 of the Registrant’s Form 8-K filed on June 27, 2013, File No. 000-30248). †
Exhibit No. 10.2	Election form to reduce commitments under the loan agreements by certain of the directors, their affiliates, entities and family members, effective July 1, 2013 (incorporated herein by reference to Exhibit 10.2 of the Registrant’s Form 10-Q filed on August 9, 2013, File No. 000-30248).
Exhibit No. 31.1	Certification of Chairman of the Board (principal executive officer) required by Rule 13a-14(a)/15d-14(a) of the Exchange Act.*
Exhibit No. 31.2	Certification of Chief Financial Officer (principal financial officer) required by Rule 13a-14(a)/15d-14(a) of the Exchange Act.*
Exhibit No. 32.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes–Oxley Act of 2002 *

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Exhibit No.	Description of Exhibit
Exhibit No. 101.INS	XBRL Instance Document*
Exhibit No. 101.SCH	XBRL Schema Document*
Exhibit No. 101.CAL	XBRL Calculation Linkbase Document*
Exhibit No. 101.DEF	XBRL Definition Linkbase Document*
Exhibit No. 101.LAB	XBRL Label Linkbase Document*
Exhibit No. 101.PRE	XBRL Presentation Linkbase Document*

*Included herewith.

†Identifies management contracts or compensatory plans or arrangements.

67