First Farmers and Merchants 10K 2004 Annual report | FFMH Filing

FORWARD-LOOKING STATEMENTS

Certain statements contained in this report may not be based on historical facts and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may be identified by, among other things, the use of forward-looking terminology such as "believes," "expects," "may," "plans," "will," "pro forma" or "anticipates," or the negatives of such terms. We caution you not to place undue reliance on such forward-looking statements in this report because results could differ materially from those anticipated due to a variety of factors. These factors include, but are not limited to, changes in economic conditions; fluctuations in prevailing interest rates and the effectiveness of our risk monitoring systems; our ability to maintain credit quality; our ability to provide market competitive products and services; laws and regulations affecting financial institutions in general; our ability to operate and integrate new technology; and other factors generally understood to affect the financial results of financial services companies.

EXECUTIVE OVERVIEW

General

First Farmers and Merchants Corporation (the Corporation) was incorporated on March 31, 1982, as a Tennessee corporation. As of December 31, 2004, the only subsidiary of the Corporation was First Farmers and Merchants National Bank (the Bank) which conducts the principal business of the consolidated company. The Bank is a national banking association which was organized in 1954 as a successor to a state bank organized in 1909. The principal executive offices of the Corporation are located at 816 South Garden Street, Columbia, Maury County, Tennessee. The financial condition of the Corporation should be evaluated in terms of the Bank's operations within its service area. All dollar amounts in this report, other than per-share amounts and percentages, are in thousands unless otherwise noted.

Financial Condition

The Corporation's assets consist primarily of its investment in the Bank and other smaller investments. Its primary activities are conducted through the Bank. The Bank is committed to providing quality services in diverse markets and a constantly changing interest rate environment. Management hopes to provide bank customers the quality service of a community bank and the safety and strength of a regional bank.

At December 31, 2004, the Corporation's consolidated total assets were $814,485, its consolidated net loans were $440,544, its total deposits were $693,855, and its total shareholders' equity was $104,188. 2004 ended with the fastest pace of growth seen in the U.S. economy since 1999. The economic climate in the Corporation's market area of Middle Tennessee also showed some improvement in the latter part of 2004. This economic improvement can be seen in the increase in loan volume, net loans were up 6.3%. Another factor in the loan growth was the purchase of a portfolio of single family residential mortgage loans from another bank. Total deposits were down as the Bank decreased its reliance on short term large dollar certificates of deposit. Total shareholders' equity was up 1.9%. Retained earnings, capital stock and additional paid-in capital are up 5.5%. On April 20, 2004, the Corporation's shareholders approved a two-for-one split effected in the form of a 100% stock dividend to shareholders of record on April 20, 2004.

Results of Operations

Consolidated net income in 2004 was up 3.6% compared to 2003. Net interest income was down 6.6% as financial products repriced in the low rate environment and the reduced risk in the credit quality of the increasing loan portfolio resulted in lower yields. In the second quarter of 2004, a reduction (credit) of $677 was made in the allowance for possible loan and lease losses. The amount of the credit was based upon unexpected loss recoveries and substantial reductions in the level of criticized assets. Net income was $8,856 for 2004 compared to $8,550 in 2003 and $8,518 in 2002. On a per common share basis, net income was $1.52 for 2004 versus $1.47 for 2003 and $1.46 for 2002.

The accompanying tables and the discussion and financial information are presented to aid in understanding the Corporation's current financial position and results of operations. The emphasis of this discussion will be on the years 2004, 2003, and 2002; however, financial information for prior years will also be presented where appropriate. This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements included elsewhere in this report.

FINANCIAL CONDITION

First Farmers and Merchants Corporation's financial condition depends on the quality and nature of its assets, its liability and capital structure, the market and economic conditions, and the quality of its personnel.

Net Interest Margin

The net interest margin is defined as the difference between the revenue from earning assets, primarily interest income, and interest expense related to interest-bearing liabilities. The maintenance of the net interest margin at a level which, when coupled with noninterest revenues, exceeds additions to the allowance for loan losses, noninterest expenses and income taxes, and yields an acceptable profit is critical for success in the banking industry. The net interest margin is a function of the average balances of earning assets and interest-bearing liabilities and the yields earned and rates paid on those balances.

Management activities are planned to maintain a satisfactory spread between the yields on earning assets and the related cost of interest-bearing funds. The gross interest spread is determined by comparing the taxable equivalent gross interest margin to average earning assets before deducting the allowance for loan losses. This ratio reflects the overall profitability of earning assets, including both those funded by interest-bearing sources and those which incur no interest cost (primarily noninterest-bearing demand deposits). This ratio is most often used when analyzing a banking institution's overall gross margin profitability compared to that of other financial institutions. The incremental interest spread compares the difference between the yields on earning assets and the cost of interest-bearing funds. This calculation and similar ratios are used to assist in pricing decisions for interest related products. Table A entitled Distribution of Assets, Liabilities, and Shareholders' Equity, Interest Rates and Interest Differential presents for each of the last three years by major categories of assets and liabilities, the average daily balances, the components of the gross interest margin (on a taxable equivalent basis), the yield or rate, and the incremental and gross interest spread.

Net Interest Margin (Continued)

Table A - Distribution of Assets, Liabilities, and Shareholders' Equity, Interest Rates and Interest Differential

YEAR ENDED DECEMBER 31,


			2004							2003							2002
		Average	Rate/						Average	Rate/						Average	Rate/
		Balance	Yield			Interest			Balance	Yield			Interest			Balance	Yield			Interest
ASSETS
Interest earning assets
Loans, net	$	419,627	5.92	%	$	24,838	*	$	444,942	6.46	%	$	28,735	*	$	513,553	7.28	%	$	37,411
Bank deposits		244	1.23			3			295	1.69			5			273	2.56			7
Taxable securities		266,483	3.93			10,472			259,171	4.33			11,223			210,974	5.49			11,578
Tax exempt securities		53,953	7.32			3,950	*		54,837	7.51			4,117	*		65,173	6.57			4,283
Federal funds sold		7,563	1.15			87			22,922	1.04			239			18,476	1.58			292

TOTAL EARNING ASSETS		747,870	5.26		$	39,350			782,167	5.67		$	44,319			808,449	6.63		$	53,571
Noninterest earning assets
Cash and due from banks		26,604							28,099							28,946
Bank premises and equipment		12,834							12,913							12,781
Other assets		38,159							43,921							40,349

TOTAL ASSETS	$	825,467						$	867,100						$	890,525


LIABILITIES AND SHAREHOLDERS' EQUITY
Interest bearing liabilities
Time and savings deposits:
NOW and money market accounts	$	238,616	0.66	%	$	1,576		$	261,387	0.91	%	$	2,390		$	255,861	1.69	%	$	4,332
Savings		111,730	0.94			1,053			108,799	1.19			1,295			102,735	2.11			2,165
Time		173,376	2.20			3,822			197,759	2.65			5,235			222,206	3.46			7,698
Time over $100,000		72,027	2.75			1,978			80,227	3.08			2,468			97,182	3.68			3,572

TOTAL INTEREST BEARING DEPOSITS		595,749	1.41			8,429			648,172	1.76			11,388			677,984	2.62			17,767
Federal funds purchased and securities
sold under agreements to repurchase		4,056	1.28			52			2,813	0.50			14			2,474	1.01			25
Other short-term debt		385	1.56			6			392	1.79			7			604	2.32			14

TOTAL INTEREST BEARING LIABILITIES		600,190	1.41		$	8,487			651,377	1.75		$	11,409			681,062	2.61		$	17,806
Noninterest bearing liabilities
Demand deposits		115,207							107,537							107,718
Other liabilities		6,248							5,492							6,597

TOTAL LIABILITIES		721,645							764,406							795,377
Shareholders' equity		103,822							102,694							95,148
TOTAL LIABILITIES AND
SHAREHOLDER'S EQUITY	$	825,467						$	867,100						$	890,525


Spread between combined rates earned and
combined rates paid*			3.85	%						3.92	%						4.02	%

Net yield on interest-earning assets*			4.13	%						4.21	%						4.42	%

* Taxable equivalent basis

Notes:

1. U.S. Government, government agency, and corporate debt securities plus equity securities in the available-for-sale and held-to-maturity categories are taxable securities. Municipal debt securities are nontaxable and classified as held-to-maturity.

2. The taxable equivalent adjustment has been computed based on a 34% federal income tax rate and has given effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax-free assets. Loans include nonaccrual loans for all years presented.

3. The average balances of the amortized cost of available-for-sale securities were used in the calculations in this table.

Net Interest Margin (Continued)

Table B sets forth, for the periods indicated, a summary of consolidated changes in interest earned and interest paid separated into the amount generated by volume changes and the amount generated by changes in the yield or rate. Net interest income was down $2,047 for the year ending December 31, 2004 as financial products repriced in the low rate environment and the reduced risk in the credit quality of the loan portfolio resulted in lower yields. Interest paid on interest-bearing deposits was down mainly due to the lower interest rates reducing the impact of revenue declines.

TABLE B - Volume and Yield/Rate Variances

(Taxable Equivalent Basis - In Thousands)

2004 Compared to 2003

2003 Compared to 2002

						Net							Net
				Yield/		Increase				Yield/			Increase
		Volume		Rate		(Decrease)		Volume		Rate			(Decrease)
Revenue earned on
Loans, net	$	(1,635)	$	(2,262)	$	(3,897)	$	(4,995)	$	(3,681)	$	(8,676)
Bank deposits		(1)		(1)		(2)		1		(3)		(2)
Investment securities
Taxable securities		317		(1,068)		(751)		2,646		(3,001)		(355)
Tax-free securities		(66)		(101)		(167)		(679)		513		(166)
Federal funds sold		(160)		8		(152)		70		(123)		(53)

Total interest earning assets		(1,545)		(3,424)		(4,969)		(2,957)		(6,295)		(9,252)
Interest paid on
NOW and money market accounts		(207)		(607)		(814)		93		(2,035)		(1,942)
Savings deposits		35		(277)		(242)		128		(998)		(870)
Time deposits		(646)		(767)		(1,413)		(846)		(1,617)		(2,463)
Time deposits over $100,000		(253)		(237)		(490)		(624)		(480)		(1,104)
Federal funds purchased and securities
sold under agreements to repurchase		6		32		38		3		(14)		(11)
Short term debt		-		(1)		(1)		(5)		(2)		(7)

Total interest-bearing funds		(1,065)		(1,857)		(2,922)		(1,251)		(5,146)		(6,397)

Net interest earnings	$	(481)	$	(1,567)	$	(2,047)	$	(1,706)	$	(1,149)	$	(2,855)

Notes:

1. The change in interest earned or paid resulting from both volume and yield/rate has been allocated to change due to volume and change due to yield/rate in proportion to the relationship of the absolute dollar amounts of the change in each.

2. The computation of the taxable equivalent adjustment has given effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax-free assets.

3. U.S. Government, government agency, and corporate debt securities plus equity securities in the available-for-sale and held-to-maturity categories are taxable securities. Municipal debt securities are nontaxable and classified as held-to-maturity.

Assets and Liabilities

Average earning assets decreased 4.4% in 2004, compared to a 3.3% decrease in 2003. Slow local economic conditions contributed to the small decline in 2003 and the first part of 2004. The economic climate in the Corporation's market area of Middle Tennessee showed some improvement in the latter part of 2004 as healthy loan growth began the reversal of the declining trend. As a financial institution, the Bank's primary earning asset is loans. At December 31, 2004, average net loans represented 56% of average earning assets. Average net loans were down 5.7% in 2004, compared to a 13.4% decrease in 2003.

Average investments, 43% of average earning assets at December 31, 2004, increased 2.0% from year end 2003 compared to a 13.7% increase at the end of 2003 from year end 2002. Maturing securities and other available funds were invested in loans rather than other investments. Average total assets declined 4.8% during 2004 compared to a decrease during 2003 of 2.6%.

The Bank's average deposits declined 5.9% during 2004 as interest rate competition increased from existing banks and non banks as well as the emergence of new banking organizations in our service area. The Bank's average deposits declined 3.8% during 2003. Interest bearing transaction accounts were down 8.7% from the average for 2003. Time deposits under $100,000 declined 12.3% during 2004 and time deposits over $100,000 declined 10.2% as the Bank decreased its reliance on short term large dollar certificates of deposit. Average savings deposits decreased 2.7% during 2004. Savings deposits have been strong historically providing a core, low cost, source of funding.

Customer relationship development resulted in a 7.1% increase in noninterest bearing deposits. The Bank's noninterest-bearing deposits have remained consistently strong and were 16.0% of average total deposits in 2004 and 14.0% of average total deposits in 2003 and 2002. This strong core of noninterest-bearing funds contributed to the decline in deposit cost.

Assets and Liabilities (Continued)

The Corporation and the Bank do not have any long-term debt or other obligations with the exception of certain operating leases that are discussed in Note 7 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS that are included elsewhere in this report.

LIQUIDITY AND CAPITAL RESOURCES

The Bank uses a formal asset and liability management process to ensure adequate liquidity and control interest rate risk. The goal of liquidity management is to provide adequate funds to meet loan demand and any potential unexpected deposit withdrawals. This goal is accomplished by consistent core deposit growth, holding adequate liquid assets, and maintaining unused capacity to borrow funds. The objective of interest rate risk management is maintaining reasonable stability in the gross interest margin as a result of changes in the level of interest rates and/or the spread relationships among interest rates.

Liquidity

At December 31, 2004, the Bank had approximately $98.0 million of cash and due from banks, securities and other short-term investments maturing within one year compared to $88.2 million as of a year earlier. In the normal course of business, the Bank has established lines of credit for short-term borrowings for the management of daily liquidity needs. At December 31, 2004, the unused lines of credit were $37.8 million.

Interest Rate Risk

The Bank uses an earnings simulation model to evaluate the impact of different interest rate scenarios on the gross margin. Each month, the Bank's Asset/Liability Committee monitors the relationship of rate sensitive earning assets to rate sensitive interest-bearing liabilities (interest rate sensitivity) which is the principal factor in determining the effect that fluctuating interest rates will have on future net interest income. Rate sensitive earning assets and interest-bearing liabilities are those which can be repriced to current market rates within a defined time period. The committee measures near-term (next twelve months) risk to net interest income resulting from changes in interest rates. The model incorporates the Bank's assets and liabilities, together with forecasted changes in the balance sheet mix and assumptions that reflect the current interest rate environment to simulate the effect of possible changes in interest rates on net interest income. As a policy, budgeted financial goals are monitored on a monthly basis by the Asset/Liability Committee where the actual dollar change in net interest income given different interest rate movements is reviewed. A negative dollar change in net interest income for a twelve-month period of less than 4.5% of net interest income given a three hundred basis point shift in interest rates is considered an acceptable rate risk position. At December 31, 2004, if interest rates were to fall 300 basis points (3.0%) over the next twelve months, net interest income would be $719,000 less than currently projected without interest rate movements. This would be a decline in net interest income of 2.5% which is within policy guidelines established by the Bank's Board of Directors.

TABLE C - Rate Sensitivity of Earning Assets and Interest-Bearing Liabilities
(Dollars in Thousands)
		3 Months		3-6		6-12			Over 1
As of December 31, 2004		or Less		Months		Months			Year		Total
Earning assets
Bank time deposits	$	48	$		$	-	$			$	48
Taxable investment securities		14,227		15,115		41,468		175,798			246,608
Tax-exempt investment securities		690				1,380		54,381			56,451
Loans and leases, net of deferred fees		90,342		33,916		48,063		276,732			449,053

Total earning assets		105,307		49,031		90,911		506,911			752,160

Interest-bearing liabilities
NOW and money market accounts		169,046		-		-		61,227			230,273
Savings		-		-		-		112,321			112,321
Time		34,369		33,614		50,408		45,699			164,090
Time over $100,000		11,632		19,833		16,103		24,020			71,588
Fed Funds purchased		7,200		-		-		-			7,200
Other short-term debt		2,528		14		-		-			2,542

Total interest bearing liabilities		224,775		53,461		66,511		243,267			588,014

Period gap		(119,468)		(4,430)		24,400		263,644		$	164,146


Cummulative gap	$	(119,468)	$	(123,898)	$	(99,498)	$	164,146

Another tool used to monitor the Bank's overall interest rate sensitivity is a gap analysis. Table C, Rate Sensitivity of Earning Assets and Interest-Bearing Liabilities, shows the Bank's rate sensitive position at December 31, 2004, as measured by gap analysis (the difference between the earning asset and interest-bearing liability amounts scheduled to be repriced to current market rates in subsequent periods). In the short term, deposits are subject to rate changes sooner than loans and investments. Management anticipates rates to increase slowly in 2005 and has determined the Bank to be in an acceptable rate risk position. Table A - Distribution of Assets, Liabilities, and Shareholders' Equity, Interest Rates and Interest Differential provides details of the largest component of interest-bearing liabilities.

Capital

Historically, internal growth has financed the capital needs of the Bank. The Corporation and the Bank do not have any long-term debt and do not have major plans for capital expenditures in the near future. At December 31, 2004, the Corporation had a ratio of Tier 1 capital to average assets of 11.29%. This compares to a ratio of Tier 1 capital to average assets of 10.29% at December 31, 2003. This ratio was up because retained earnings, capital stock, and additional paid in capital are up 5.5% and average total assets declined 4.7% during 2004.

Cash dividends declared in 2004 were 38.9% of net income. The Corporation plans to continue an average annual payout ratio over 20% while continuing to maintain a capital to asset ratio reflecting financial strength and adherence to regulatory guidelines.

Capital (Continued)

As of December 31, 2004, the Corporation's ratios of Tier I capital to risk-weighted assets and total capital to risk-weighted assets were 18.38% and 19.63%, respectively. At December 31, 2003, the comparable ratios were 17.45% and 18.71%, respectively. Please refer to Note 10 in the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS that are included elsewhere in this report for more information on the capital strength of the Corporation and the Bank.

LOANS AND LOAN QUALITY

As with most commercial banking institutions, the Bank's loan portfolio is the largest component of earning assets and consequently provides the highest amount of revenue. The loan portfolio also contains, as a result of credit quality, the highest exposure to risk. When analyzing potential loans, management assesses both interest rate objectives and credit quality objectives in determining whether to make a given loan and the appropriate pricing for that loan. The Bank maintains a diversified portfolio in order to spread its risk and reduce its exposure to economic downturns which may occur in different segments of the economy or in particular industries. The composition of the loan portfolio is disclosed in detail in Note 3 in the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS included elsewhere in this report.

The lending activities of the Bank are subject to written underwriting standards and policies established by the Bank's Board of Directors and management which include loan review procedures and approvals. Applications for loans are taken by designated employees at eighteen of the Bank's offices. Depending primarily on the amount of the loan, there are various approval levels including an Executive Committee of the Board of Directors that meets weekly.

The Bank has a credit administration function which is responsible for assisting loan officers in underwriting new loans, reviewing problem loans, monitoring their status from period to period, and assisting in their resolution. This review process also includes semiannual reviews by an outside party to assess the quality of the loan portfolio independently. Management has concluded that this independent review has served to strengthen underwriting practices. Credit administration's analysis and review also includes a formal review that is prepared quarterly to assess the risk in the loan portfolio and to determine the adequacy of the allowance for loan losses. Loan reviews of all relationships aggregating $250 and greater are completed on an annual schedule. At December 31, 2004 loans totaling $6.6 million, or 1.5% of the portfolio, were classified as other assets especially mentioned. This compares to loans totaling $10.8 million so classified at December 31, 2003. Loans totaling $11.2 million, or 2.5 % of the portfolio, were classified as substandard. This compares to loans totaling $22.0 million so classified at December 31, 2003. Loans totaling $1.0 million, or 0.2 % of the portfolio, were classified as doubtful. This compares to $1.93 million so classified at December 31, 2003. Overall credit quality has improved as problem loans have been resolved and credit underwriting has improved. Delinquency remained at very satisfactory levels throughout 2004, closing at a low point for the year of 1.36% of the portfolio. Loans that are impaired and not accruing interest were more actively monitored to determine those for which more aggressive action plans should be taken. The payoff of several large classified credits was a major contributor to the decline in classified loans. Management believes that the allowance for loan losses was adequate at December 31, 2004.

LOANS AND LOAN QUALITY (Continued)

Table D, THE LOAN PORTFOLIO, summarizes average loan balances, and reconciles the allowance for loan losses for each year. Additions to the allowance, which have been included in operating expenses, are also disclosed. Management recognizes that 37.7% of the total loan portfolio is made up of first mortgage loans secured by one to four family residential properties. This is a concentration risk that is acceptable given the quality of underwriting and the low historical loss experience. Within the commercial loan portfolio, the Bank does not have any industry concentrations as measured by regulatory guidelines. However, the Bank does have heavy exposure among four broad industry categories, construction, manufacturing, real estate rental and leasing, other services, and public administration. Given the level of exposure in each of these categories, the particular industries are monitored closely to ensure that underwriting practices and policies, as well as, allowance levels match the level of risk posed. Please refer to Note 9 in NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

TABLE D - THE LOAN PORTFOLIO

						December 31

(Dollars In Thousands)		2004		2003		2002		2001		2000

Average amount of gross loans outstanding	$	428,671	$	456,187	$	524,248	$	468,861	$	354,811

Balance of allowance for possible loan
losses at beginning of year	$	10,123	$	11,375	$	6,707	$	5,322	$	4,818

Balance from acquisition		-		-		536		1,097		-
Loans charged off
Loans secured by real estate		364		958		1,549		21		190
Commercial and industrial loans		1,017		296		580		377		50
Loans to individuals		299		712		1,517		652		475

TOTAL LOANS CHARGED OFF		1,680		1,966		3,646		1,050		715
Recoveries of loans previously charged off
Loans secured by real estate		187		22		3		12		221
Commercial and industrial loans		259		67		54		17		4
Loans to individuals		297		192		271		109		94

TOTAL RECOVERIES		743		281		328		138		319

NET LOANS CHARGED OFF		937		1,685		3,318		912		396

Provision (reduction) charged (credited)
to operating expenses		(677)		433		7,450		1,200		900

BALANCE AT END OF YEAR	$	8,509	$	10,123	$	11,375	$	6,707	$	5,322

Ratio of net charge-offs during the period
to average gross loans outstanding		0.22%		0.37%		0.63%		0.19%		0.11%

RESULTS OF OPERATIONS

Interest Income

Total interest income decreased 11.7% in 2004 as financial products repriced in the low interest rate environment. Interest and fees earned on loans was 65% of gross interest income in 2004 and decreased 14.0% in 2004 over 2003 as the reduced risk in the credit quality of the loan portfolio resulted in lower yields. Interest and fees earned on loans decreased 23.5% in 2003 as a result of low yields and declining loan volume. Interest earned on securities and other investments was 35% of gross interest income in 2004 and was down 6.2% as higher yielding investments were sold or matured and replaced with investments at lower yields. A gain of $917 on the sale of available-for-sale investment securities was realized in the first quarter of 2004. Total interest income decreased 2.2% in 2002.

Interest Expense

Total interest expense decreased 25.6% in 2004, compared to a 35.9% decrease in 2003, and a 25.5% decrease in 2002. The lower interest rate environment contributed these reductions as did a less aggressive appetite for interest bearing public deposits. The cost of interest-bearing deposits is monitored monthly by the Asset/Liability Committee. The net interest margin (tax equivalent net interest income divided by average earning assets) was 4.13% at the end of 2004, 4.21% at the end of 2003, and 4.42% at the end of 2002.

Net interest income on a fully taxable equivalent basis is influenced primarily by changes in: (1) the volume and mix of earning assets and sources of funding; (2) market rates of interest, and (3) income tax rates. The impact of some of these factors can be controlled by management policies and actions. External factors also can have a significant impact on changes in net interest income from one period to another. Some examples of such factors are: (1) the strength of credit demands by customers; (2) Federal Reserve Board monetary policy, and (3) fiscal and debt management policies of the federal government, including changes in tax laws.

Noninterest Income and Expenses

Noninterest income increased 12.75% during 2004 due in part to a gain on the sale of available-for-sale investment securities that offset losses on the sale of other real estate. Income from fiduciary services offered in the Bank's Trust Department was up 15.6%. Noninterest income increased 0.5% in 2003 and 0.9% in 2002. There were losses on the sale of loans and other real estate in 2003 that offset a smaller gain on the sale of available-for-sale investment securities. In 2002 income from fiduciary services offered in the Bank's Trust Department and the gain on the sale of available for sale investment securities were not as high.

Noninterest Income and Expenses (Continued)

Noninterest expenses, excluding the provision for possible loan losses, decreased 0.6% in 2004. Incentive packages and management direction encourage expense control and processing efficiency. These measures resulted in maintenance of the level of noninterest expenses in 2004. Noninterest expenses, excluding the provision for possible loan losses, increased 11.8% in 2003. Increases in salaries and employee benefits contributed to this increase. Organizational restructuring to more effectively manage the lending function and improve processing efficiencies was behind this increase. Noninterest expenses increased 12.8 % in 2002. Acquisition of two more offices in 2002 contributed to this increase.

Net Income

Net income was 3.6% higher in 2004 than in 2003. In the second quarter of 2004, a reduction (credit) of $677 was made in the allowance for possible loan and lease losses. The amount of the credit was based upon unexpected loss recoveries and substantial reductions in the level of criticized assets. The increase in noninterest income and no increase in noninterest expenses offset the decline in net interest income. Net income was 0.38% higher in 2003 than in 2002. A reduction in provisions for possible loan losses during 2003 was a contributing factor. During the first quarter of 2002, the Bank changed the accounting estimate of the allowance for possible loan losses which decreased income before provision for income taxes by $4.4 million, or $2.6 million, net of tax for the year ended December 31, 2002.

Off-Balance Sheet Arrangements

As of December 31, 2004, the Bank was a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Please refer to Note 9 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS that are included elsewhere in this report for more information on the Bank's commitments and contingencies. Please refer to Table C in this material for a summary of our earning assets and interest-bearing liabilities by maturities that are included in the CONSOLIDATED BALANCE SHEETS.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS ON THE FINANCIAL STATEMENTS

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS ON THE FINANCIAL STATEMENTS (Continued)

guaranteed interest rate in the loan commitment and a market interest rate, excluding any expected future cash flows related to the customer relationship or loan servicing. The adoption of this bulletin did not have a material impact on the consolidated financial position or results of operations of the Corporation.

In March 2004, the Financial Accounting Standards Board's ("FASB") Emerging Issues Task Force ("ETIF") reached a consensus on EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. Generally, an impairment is considered other-than-temporary unless: (i) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for an anticipated recovery of fair value up to (or beyond) the cost of the investment; and (ii) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. If impairment is determined to be other-than-temporary, then an impairment loss should be recognized equal to the difference between the investment's cost and its fair value. The recognition and measurement provisions were initially effective for other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. However, in September 2004, the effective date of these provisions was delayed until the finalization of a FASB Staff Position ("FSP") to provide additional implementation guidance. Due to the recognition and measurement provisions being suspended and the final rule delayed, management was not able to determine whether the adoption of these new provisions will have a material impact on the consolidated financial position or results of operations of the Corporation.

Statement of Position 03-03, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (the "SOP") addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans acquired in purchase business combinations and applies to all nongovernmental entities, including not-for-profit organizations. The SOP does not apply to loans originated by the entity. The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. Early adoption is encouraged. Specific transition guidance applies to certain loans that currently are within the scope of Practice Bulletin 6, Amortization of Discounts on Certain Acquired loans. Its adoption is not expected to have a material impact on the consolidated financial position or results of operations of the Corporation.

In December 2004, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), Share-Based Payment ("SFAS No.123R"), which revised SFAS No. 123, Accounting for Stock-Based Compensations. This statement supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees. The revised statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based compensation transactions using APB 25 and requires that the compensation costs relating to such transactions be recognized in the consolidated statement of income. Its adoption is not expected to have a material impact on the consolidated financial position or results of operations of the Corporation.

CRITICAL ACCOUNTING POLICIES

The accounting principles the Bank follows and the methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices within the banking industry. In connection with the application of those principles, Bank management has made judgments and estimates which, in the case of the determination of the allowance for loan losses ("ALLL") and the recognition of deferred income tax assets, have been critical to the determination of the Bank's financial position, results of operations, and cash flows.

Allowance for Loan Losses

Management assesses the adequacy of the ALLL prior to the end of each month and prepares a more formal review quarterly to assess the risk in the Bank's loan portfolio. This assessment includes procedures to estimate the allowance and test the adequacy and appropriateness of the resulting balance. The ALLL represents calculated amounts for specifically identified credit exposure and exposures readily predictable by historical or comparative experience. Even though this calculation considers specific credits, the entire allowance is available to absorb any credit losses.

These calculated amounts are determined by assessing loans identified as not in compliance with loan agreements. These loans are generally in two different risk groups. One group is unique loans (commercial loans, including those loans considered impaired). The second group is homogenous loans (generally retail and mortgage loans). The calculation for unique loans is based primarily on risk rating grades assigned to each of these loans as a result of our loan management and review processes. Each risk-rating grade is assigned a loss ratio, which is determined based on the experience of management, discussions with banking regulators, and the independent loan review process. The amount allocated for impaired loans is based on estimated cash flows discounted at the loan's original effective interest rate or the underlying collateral value. Historical data, including actual loss experience on specific types of homogenous loans, is used to allocate amounts for loans or groups of loans meeting the specified criteria. More detailed historical data is being accumulated by category of retail and commercial credit and performance characteristics to broaden the analysis and improve monitoring of potential credit risk.

Criteria considered in evaluating the adequacy of the ALLL are:

* Portfolio quality trends;

* Changes in the nature and volume of the portfolio;

* Present and prospective economic and business conditions, locally and nationally;

* Management review systems and board oversight, including external loan review processes;

* Changes in credit policy, credit administration, portfolio management and procedures; and

* Changes in personnel, management, and staff;

* Existence and effect of any concentrations of credit.

In assessing the adequacy of the ALLL, the risk characteristics of the entire loan portfolio are evaluated. This process includes the judgment of management, input from independent loan reviews, and reviews that may have been conducted by bank regulators as part of their usual examination process.

Deferred Income Tax Assets

Deferred income tax assets consist mainly of the tax effect of excess provisions for loan losses over actual losses incurred and deferred compensation. The Corporation and the Bank have paid taxes for many years. Management believes that it is more likely than not that these assets will be realized in future years

Selected Financial Information
(Dollars in Thousands, Except Per Share Data)

		2004		2003		2002		2001		2000
Interest Income
Interest and fees on loans	$	24,426	$	28,388	$	37,116	$	39,031	$	31,358
Income on investment securities
Taxable interest		10,263		11,045		11,390		10,218		10,097
Exempt from federal income tax		2,568		2,738		3,214		3,420		3,108
Dividends		213		130		166		307		278

		13,044		13,913		14,770		13,945		13,483

Other interest income		94		250		299		359		598

Total Interest Income		37,564		42,551		52,185		53,335		45,439

Interest Expense
Interest on deposits		8,429		11,388		17,767		23,738		21,486
Interest on other short term borrowings		58		21		39		147		117

Total Interest Expense		8,487		11,409		17,806		23,885		21,603

Net Interest Income		29,077		31,142		34,379		29,450		23,836

Provision For Possible Loan Losses		(677)		433		7,450		1,200		900
Net Interest Income After
Provision for Loan Losses		29,754		30,709		26,929		28,250		22,936

Noninterest Income
Trust department income		2,088		1,806		1,781		1,862		1,813
Service fees on deposit accounts		7,189		7,217		7,175		6,822		5,136
Other service fees, commissions, and fees		408		433		435		537		422
Other operating income		873		(15)		611		758		566
Securities gains		917		737		124		54		-

Total Noninterest Income		11,475		10,178		10,126		10,033		7,937

Noninterest Expense
Salaries and employee benefits		15,791		15,254		13,045		11,567		9,711
Net occupancy expense		2,289		2,184		2,187		1,765		1,485
Furniture and equipment expense		1,317		1,422		1,461		928		1,192
Other operating expenses		9,724		10,437		9,515		8,980		6,780

Total Noninterest Expense		29,121		29,297		26,208		23,240		19,168

Income Before Provision
For income Taxes		12,108		11,590		10,847		15,043		11,705
Provision For Income Taxes		3,252		3,040		2,329		4,430		3,379

Net Income	$	8,856	$	8,550	$	8,518	$	10,613	$	8,326


Earnings Per Common Share
(5,840,000 outstanding shares)	$	1.52	$	1.47	$	1.46	$	1.82	$	1.43
										``````
Share and per share data have been restated to give retroactive effect to the two-for-one stock split effected as a stock
dividend declared on April 20, 2004. (See Note 1 of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS)

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors

First Farmers and Merchants Corporation

Columbia, Tennessee

We have audited the consolidated balance sheets of First Farmers and Merchants Corporation (the "Corporation") and its wholly-owned subsidiary, First Farmers and Merchants National Bank (the "Bank"), as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Farmers and Merchants Corporation and Subsidiary as of December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.

/s/ Kraft CPAs PLLC

Nashville, Tennessee

February 17, 2005

KraftCPAs PLLC - Certified Public Accountants and Consultants

555 Great Circle Road - Suite 200 - Nashville, TN 37228 - Phone 615-242-7351 - Fax 615-782-4271

610 North Garden St. - Suite 200 - Columbia, TN 38401 - Phone 931-388-3711 - Fax 931-388-9998

105 Bay Court - Lebnaon, TN 37087 - Phone 615-449-2334 - Fax 615-444-6259

An independently owned member of the RSM McGladrey Network. www.kraftcpas.com

FIRST FARMERS AND MERCHANTS CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
			December 31,		December 31,
	(Dollars In Thousands, Except Per Share Data)		2004		2003

ASSETS	Cash and due from banks	$	22,203	$	26,137
	Interest-bearing deposits in banks		48		297
	Federal funds sold		0		12,000
	Total cash and cash equivalents		22,251		38,434
	Securities
	Available for sale (amortized cost $225,880
	and $243,038 respectively)		226,792		249,653
	Held to maturity (fair value $79,722
	and $84,199 respectively)		76,267		79,138
	Total securities		303,059		328,791
	Loans, net of deferred fees		449,053		424,504
	Allowance for possible loan losses		(8,509)		(10,123)
	Net loans		440,544		414,381
	Bank premises and equipment, at cost
	less allowance for depreciation		12,417		12,997
	Core deposit and other intangibles		11,986		13,042
	Other assets		24,228		21,168
	TOTAL ASSETS	$	814,485	$	828,813

LIABILITIES	Deposits
	Noninterest-bearing	$	115,583	$	112,334
	Interest-bearing (including certificates of deposit
	over $100: 2004 - $71,588; 2003 - $71,968)		578,272		604,099
	Total deposits		693,855		716,433
	Federal funds purchased and securities sold
	under agreements to repurchase		9,128		1,820
	Dividends payable		1,752		1,635
	Other short term liabilities		614		648
	Accounts payable and accrued liabilities		4,948		5,992
	TOTAL LIABILITIES		710,297		726,528

SHAREHOLDERS'	Common stock - $10 par value, 8,000,000 shares
EQUITY	authorized; issued and outstanding -
	5,840,000 shares		58,400		29,200
	Additional paid-in capital		4,320		4,320
	Retained earnings		40,908		64,698
	Accumulated other comprehensive income		560		4,067
	TOTAL SHAREHOLDERS' EQUITY		104,188		102,285

	TOTAL LIABILITIES AND
	SHAREHOLDERS' EQUITY	$	814,485	$	828,813


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

FIRST FARMERS AND MERCHANTS CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME


	(Dollars In Thousands Except Per Share Data)

	Years Ended December 31,		2004		2003		2002

INTEREST & DIVIDEND INCOME	Interest and fees on loans	$	24,426	$	28,388	$	37,116
	Income on investment securities
	Taxable interest		10,263		11,045		11,390
	Exempt from federal income tax		2,568		2,738		3,214
	Dividends		213		130		166
			13,044		13,913		14,770
	Other interest income		94		250		299
	TOTAL INTEREST & DIVIDEND INCOME		37,564		42,551		52,185

INTEREST EXPENSE	Interest on deposits		8,429		11,388		17,767
	Interest on other short term borrowings		58		21		39
	TOTAL INTEREST EXPENSE		8,487		11,409		17,806

	NET INTEREST INCOME		29,077		31,142		34,379
	PROVISION (REDUCTION) FOR POSSIBLE
	LOAN LOSSES		(677)		433		7,450
	NET INTEREST INCOME AFTER
	PROVISION (REDUCTION)
	FOR LOAN LOSSES		29,754		30,709		26,929

NONINTEREST INCOME	Trust department income		2,088		1,806		1,781
	Service fees on deposit accounts		7,189		7,217		7,175
	Other fees and commissions		408		433		435
	Other operating income (expense)		873		(15)		611
	Securities gains		917		737		124
	TOTAL NONINTEREST INCOME		11,475		10,178		10,126

NONINTEREST EXPENSES	Salaries and employee benefits		15,791		15,254		13,045
	Net occupancy expense		2,289		2,184		2,187
	Furniture and equipment expense		1,317		1,422		1,461
	Other operating expenses		9,724		10,437		9,515
	TOTAL NONINTEREST EXPENSES		29,121		29,297		26,208
	INCOME BEFORE PROVISION FOR
	INCOME TAXES		12,108		11,590		10,847
	PROVISION FOR INCOME TAXES		3,252		3,040		2,329

	NET INCOME	$	8,856	$	8,550	$	8,518


EARNINGS PER SHARE	Common Stock
	(Shares outstanding: 5,840,000)	$	1.52	$	1.47	$	1.46


Share and per share data have been restated to give retroactive effect to the two-for-one stock split effected as a stock dividend declared
on April 20, 2004.
The accompanying notes are an integral part of the consolidated financial statements.

FIRST FARMERS AND MERCHANTS CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY

Accumulated

(Dollars In Thousands Except Per Share Data)

Additional

Other

Common

Paid-in

Retained

Comprehensive

Years Ended December 31, 2004, 2003, and 2002

Stock

Capital

Earnings

Income (Loss)

Total

BALANCE AT JANUARY 1, 2002

29,200

4,320

53,995

2,273

89,788

Comprehensive income

Net income

8,518

Change in net unrealized gain (loss) on securities

available-for-sale, net of reclassification

adjustment and tax effects

4,500

Total comprehensive income

13,018

Cash dividends declared, $0.535 per share *

(3,124)

BALANCE AT DECEMBER 31, 2002

29,200

4,320

59,389

6,773

99,682

Comprehensive income

Net income

8,550

Change in net unrealized gain (loss) on securities

available-for-sale, net of reclassification

adjustment and tax effects

(2,706)

Total comprehensive income

5,844

Cash dividends declared, $0.555per share *

(3,241)

BALANCE AT DECEMBER 31, 2003

29,200

4,320

64,698

4,067

102,285

Comprehensive income

Net income

8,856

Change in net unrealized gain (loss) on securities

available-for-sale, net of reclassification

adjustment and tax effects

(3,507)

Total comprehensive income

5,349

Two-for-one stock split - Note 1

29,200

(29,200)

Cash dividends declared, $0.59 per share

(3,446)

BALANCE AT DECEMBER 31, 2004

58,400

4,320

40,908

560

104,188

````

* Cash dividends per share amounts for 2002 and 2003 are restated to give retroactive effect to the two-for-one stock split

as of April 20, 2004.

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

	FIRST FARMERS AND MERCHANTS CORPORATION AND SUBSIDIARY
	CONSOLIDATED STATEMENTS OF CASH FLOWS


	(Dollars In Thousands)

	Years Ended December 31,		2004						2003		2002

OPERATING	Net income	$	8,856				$		8,550	$	8,518
ACTIVITIES	Adjustments to reconcile net income to net cash provided by operating activities
	Excess (deficiency) of provision for possible loan losses
	over net charge offs			(1,615)					(1,252)		4,132
	Provision for depreciation and amortization of premises and equipment		1,249						1,390		1,313
	Amortization of intangibles			1,056					1,056		1,021
	Amortization of investment security premiums,
	net of accretion of discounts				2,731				2,642		1,112
	Securities gains				(917)				(737)		(124)
	Increase in cash surrender value of life insurance contracts				(442)				(438)		(460)
	(Increase) decrease, net of effects from acquisitions, in
	Deferred income taxes				(103)				759		(1,312)
	Interest receivable				503				902		39
	Other assets				(568)				(537)		916
	Increase (decrease), net of effects from acquisitions, in
	Interest payable				(123)				(687)		(1,563)
	Other liabilities				(920)				895		999
	Total Adjustments				851				3,993		6,073
	Net cash provided by operating activities				9,707				12,543		14,591

INVESTING	Proceeds from maturities, calls, and sales of
ACTIVITIES	available-for-sale securities				43,016				55,688		35,232
	Proceeds from maturities and calls of held-to-maturity securities				20,026				23,412		20,674
	Purchases of investment securities
	Available-for-sale				(27,588)				(103,262)		(120,028)
	Held-to-maturity				(17,242)				-		-
	Net (increase) decrease in loans, net of effects from acquisitions				(24,548)				76,012		38,454
	Purchases of premises and equipment, net of effects from acquisitions		(832)						(1,336)		(1,531)
	Disposition of fully depreciated assets					164			-		-
	Purchase of single premium life insurance contracts				(253)				(190)		(3,970)
	Net increase in cash from acquisitions				-				-		8,017
	Net cash provided by (used by) investing activities				(7,257)				50,324		(23,152)

FINANCING	Net increase (decrease) in noninterest-bearing and interest-bearing deposits,
ACTIVITIES	net of effects from acquisition					(22,578)			(72,754)		32,509
	Net increase (decrease) in short term borrowings					7,274			(197)		155
	Cash dividends					(3,329)			(3,183)		(3,066)
	Net cash provided by (used by) financing activities					(18,633)			(76,134)		29,598

	Increase (decrease) in cash and cash equivalents					(16,183)			(13,267)		21,037
	Cash and cash equivalents at beginning of period					38,434			51,701		30,664
	Cash and cash equivalents at end of period				$	22,251		$	38,434	$	51,701

	Supplemental disclosures of cash flow information
	Cash paid during the period for expenses
	Interest on deposits and borrowed funds				$	8,611		$	12,096	$	19,183
	Income taxes					5,988			1,391		4,433

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

NOTE-1 GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Accounting Policies

The accounting principles followed and the methods of applying those principles conform with accounting principles generally accepted in the United States of America and to general practices in the banking industry. The significant accounting policies applicable to the Corporation are summarized as follows.

Principles of Consolidation

The accompanying consolidated financial statements present the accounts of the Corporation and its wholly-owned subsidiary, the Bank. Material intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates in the Preparation of Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities. Those estimates and assumptions also affect disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of foreclosed real estate and deferred tax assets.

Stock Split

On April 20, 2004, the Corporation's shareholders approved a two-for-one split effected in the form of a 100% stock dividend to shareholders of record on April 20, 2004. In accordance with State corporate legal requirements, the transaction was recorded by a transfer from retained earnings to common stock in the amount of $29,200,000 ($10 for each additional share issued). All per share and share data in the accompanying consolidated financial statements and footnotes have been restated to give retroactive effect to the transaction.

Significant Group Concentrations of Credit Risk

Most of the Bank's activities are with customers located within its service area which is comprised of Maury, Lawrence, Marshall, Hickman, Dickson, Giles, and adjacent counties in southern middle Tennessee. Note 2 discusses the types of securities in which the Bank invests. Note 3 discusses the types of lending in which the Bank engages. Management recognizes that 37.7% of the total loan portfolio is made up of first mortgage loans secured by one to four family residential properties. This is a concentration risk that is acceptable given the quality of underwriting and the low historical loss experience. Within the commercial loan portfolio, the Bank does not have any industry concentrations as measured by regulatory guidelines. However, the Bank does have heavy exposure among four broad industry categories, construction, manufacturing, real estate rental and leasing, other services, and public administration. Given the level of exposure in each of these categories, the particular industries are monitored closely to ensure that underwriting practices and policies, as well as, allowance levels match the level of risk posed.

NOTE 1-GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Cash and Due From Bank

Included in cash and due from banks are legally reserved amounts which are required to be maintained on an average basis in the form of cash and balances due from the Federal Reserve Bank and other banks. At December 31, 2004, approximately $6.8 million was required to be maintained at the Federal Reserve Bank. Interest-bearing deposits in banks mature within one year and are carried at cost. From time to time throughout the year, the Bank's balances due from other financial institutions exceeded FDIC insurance limits. Management considers this to be a normal business risk.

Cash Equivalents

Cash equivalents include cash on hand, cash due from banks, and federal funds sold. Federal funds are sold for one-day periods. Interest-bearing deposits in banks included in cash equivalents mature within ninety days.

Securities

Trading account securities that are bought and held principally for the purpose of selling them in the near term are carried at market value. Gains and losses, both realized and unrealized, are included in other operating income. There were no securities so classified in 2004 or 2003.

Debt securities that the Bank has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Securities not classified as held-to-maturity or trading, including equity securities with readily determinable fair values, are classified as available-for-sale and reported at fair value, with unrealized gains and losses, net of deferred tax, excluded from earnings and reported in other comprehensive income.

Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of individual available-for-sale and held-to-maturity securities below their cost that are other than temporary are included in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Bank to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sales of securities are recorded on the trade date and are determined using the specific identification method.

Loans

The Bank grants mortgage, commercial, and consumer loans to customers. 37.7% of the total loan portfolio is made up of first mortgage loans secured by one to four family residential properties. Most of the Bank's activities are with customers located within southern middle Tennessee. The ability of the Bank's debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff generally are stated at their outstanding unpaid principal balances net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans.

Interest on loans is accrued daily. Loan origination fees and related direct costs are deferred and recognized ratably over the life of the loan as an adjustment of yield. Interest accruals are discontinued when loans are ninety days past-due or when interest is not expected to be collected. Interest income

NOTE 1-GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

previously accrued on such loans is reversed against current period interest income. Interest income on loans in nonaccrual status is recognized only to the extent of the excess of cash payments received over principal payments due.

Allowance for Possible Loan Losses

The allowance for possible loan losses is established through provisions for loan losses charged against income. Loan losses are charged against the allowance when management determines that the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance account in the period received.

The adequacy of the allowance for possible loan losses is evaluated quarterly in conjunction with loan review reports and evaluations that are discussed in meetings with loan officers, credit administration, and the Board of Directors. The Bank's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, and other relevant factors are considered in this evaluation. This process is inherently subjective as it requires material estimates that are susceptible to significant change including the amounts and timing of future cash flows expected to be received on impaired loans. The allowance for loan losses is maintained at a level believed adequate by management to absorb estimated probable inherent loan losses.

A loan is considered impaired when it is probable that the Bank will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. The Bank evaluates smaller balance homogeneous loans collectively for impairment. Loans secured by one to four family residential properties, consumer installment loans, and line of credit loans are considered smaller-balance homogeneous loans.

Other Real Estate

Other real estate, which is included in other assets, represents real estate acquired through foreclosure and is stated at the lower of fair value, net of estimated selling costs, or cost, at the date of foreclosure. If, at the time of foreclosure, the fair value of the real estate is less than the Bank's carrying value of the related loan, a write-down is recognized through a charge to the allowance for possible loan losses, and the fair value becomes the new cost for subsequent accounting. If the Bank later determines that the cost of the property cannot be recovered through sale or use, a write-down is recognized by a charge to operations.

NOTE 1-GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

When the property is not in a condition suitable for sale or use at the time of foreclosure, completion and holding costs, including such items as real estate taxes, maintenance and insurance, are capitalized up to the estimated net realizable value of the property. However, when the property is in a condition for sale or use at the time of foreclosure, or the property is already carried at its estimated net realizable value, any subsequent holding costs are expensed.

Legal fees and any other direct costs relating to foreclosures are charged to operations when incurred. The Bank's recorded value for other real estate was approximately $834,000 at December 31, 2004, and $1,560,000 at December 31, 2003. Properties included in other real estate were sold at losses of $458,000 during 2004, which are included in other operating income (expense). Losses of $451,000 and $215,000 were realized on sales of other real estate during 2003 and 2002, respectively.

Premises and Equipment

Premises and equipment are stated at cost, less accumulated depreciation and amortization. The provision for depreciation is computed principally on an accelerated method over the estimated useful lives of the assets, which range as follows: buildings - 15 to 50 years and equipment - 3 to 33 years. Costs of major additions and improvements are capitalized. Expenditures for maintenance and repairs are charged to operations as incurred. Gains or losses from the disposition of property are reflected in operations, and the asset accounts and related allowances for depreciation are reduced.

Servicing

Loans serviced for others are not included in the accompanying consolidated balance sheets. The unpaid principal balances of mortgage and other loans serviced for others were $11.5 million and $28.0 million at December 31, 2004 and 2003, respectively. The present value of servicing income is expected to approximate an adequate compensation cost for servicing these loans. Therefore, no servicing asset has been recorded.

Income Taxes

The Corporation and the Bank file a consolidated federal income tax return. Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities.

Trust Department Income

Trust department income is recognized on the accrual basis in the applicable period earned.

NOTE 1-GENERAL AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Earnings Per Share

Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed conversion. For the years ended December 31, 2004, 2003, and 2002, there were no potentially dilutive common shares issuable.

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. A schedule of other comprehensive income is shown in Table I.

		Years Ended December 31,

		2004		2003		2002

Unrealized holding gains (losses)
on available-for-sale securities	$	(4,786)	$	(2,912)	$	6,729
Reclassification adjustment for losses
(gains) realized in income		(917)		(737)		(124)
Tax effect - (expense) benefit		2,196		943		(2,105)

Other comprehensive income (loss)	$	(3,507)	$	(2,706)	$	4,500

Table I - Components of Other Comprehensive Income (Loss)

(Dollars in Thousands)

Intangible Assets

Goodwill is accounted for in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142), which addresses the financial accounting and reporting for acquired goodwill and other intangible assets with indefinite lives. Pursuant to SFAS 142, intangible assets must be periodically tested for impairment. The Bank completed its impairment review during 2004, which indicated that there was no impairment. Deposit base intangibles are amortized using the straight-line method over their estimated useful lives of 42 to 180 months. Total amortization expense charged to operations amounted to: 2004 - $1,056,000; 2003 - $1,056,000; and 2002 - $1,021,000. Note 11 discusses the acquisition in 2002.

Segment Reporting

Segments are strategic business units that offer different products and services and are managed separately. At December 31, 2004, the Corporation and the Bank did not have any identified segments.

Recent Accounting Pronouncements

In March 2004, the Securities Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 105 ("SAB 105"), Application of Accounting Principles to Loan Commitments. Current accounting guidance requires the commitment to originate mortgage loans that will be held for sale to be recognized on the balance sheet at fair value from inception through expiration or funding. SAB 105 requires that the fair value measurement include only differences between the guaranteed interest rate in the loan commitment and a market interest rate, excluding any expected future cash flows related to the customer relationship or loan servicing. The adoption of this bulletin did not have a material impact on the consolidated financial position or results of operations of the Corporation.

Statement of Position 03-03, Accounting for Certain Loans or Debt Securities Acquired in a Transfer ("SOP 03-03") addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans acquired in purchase business combinations and applies to all nongovernmental entities, including not-for-profit organizations. The SOP does not apply to loans originated by the entity. The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. Early adoption is encouraged. Specific transition guidance applies to certain loans that currently are within the scope of Practice Bulletin 6, Amortization of Discounts on Certain Acquired loans. Its adoption is not expected to have a material impact on the consolidated financial position or results of operations of the Corporation.

NOTE 2 - SECURITIES

Securities with an amortized cost of $92,811,000 and $121,647,000 at December 31, 2004 and 2003, respectively (fair value: 2004 - $93,765,000; 2003 - $127,449,000), were pledged to secure deposits and for other purposes as required or permitted by law. The fair value is established by an independent pricing service as of the approximate dates indicated. The differences between the amortized cost and fair value reflect current interest rates and represent the potential gain (or loss) had the portfolio been liquidated on that date. Security gains (or losses) are realized only in the event of dispositions prior to maturity. The fair values of all securities at December 31, 2004, either equaled or exceeded the cost of those securities, or the decline in fair value is considered temporary. The information in Table III classifies the investments

NOTE 2 - SECURITIES (Continued)

with unrealized losses at December 31, 2004, according to the term of the unrealized loss. Management evaluates securities for other-than-temporary impairment periodically, or more frequently when circumstances require an evaluation. An impairment judgement is based on (a) the amount of time and loss, (b) the financial condition of the issuer, and (c) the corporation's intent and ability to hold the investment long enough for any anticipated recovery in value. At December 31, 2004, two of eighty seven U.S. Government Agency securities had recorded unrealized losses for a period longer than twelve months. Their amortized cost was approximately $5.1 million compared to a fair value of approximately $5 million. As these securities declined in value when interest rates began to rise, and not from the credit quality of the issuer, and since the corporation has both the intent and ability to hold the investments, they were not considered other-than-temporarily impaired.

		Amortized		Gross	Unrealized			Fair
		Cost		Gain		Loss		Value
December 31, 2004
Available-for-sale securities
U.S. Treasury	$	5,351	$	31	$	1	$	5,381
U.S. Government agencies		216,385		2,083		1,273		217,195
Mortgage backed securities		467		15		-		482
Other securities		3,677		57		-		3,734

	$	225,880	$	2,186	$	1,274	$	226,792

Held-to-maturity securities
U.S. Government agencies	$	11,608	$	176	$	-	$	11,784
States and political subdivisions		55,548		2,736		129		58,155
Other securities		9,111		672		-		9,783

	$	76,267	$	3,584	$	129	$	79,722

December 31, 2003
Available-for-sale securities
U.S. Treasury	$	2,062	$	96	$	-	$	2,158
U.S. Government agencies		235,479		6,571		153		241,897
Mortgage backed securities		618		30		-		648
Other securities		4,879		76		5		4,950

	$	243,038	$	6,773	$	158	$	249,653

Held-to-maturity securities
U.S. Government agencies	$	18,037	$	659	$	-	$	18,696
States and political subdivisions		50,008		3,281		-		53,289
Other securities		11,093		1,121		-		12,214

	$	79,138	$	5,061	$	-	$	84,199

Table II - Amortized Cost and Fair Value of Securities

(Dollars in Thousands)

At December 31, 2004, the Bank did not hold investment securities of any single issuer, other than obligations of the U.S. Treasury and other U.S. Government agencies, whose aggregate book value exceeded ten percent of shareholders' equity.

Proceeds from the maturity, call, or sale of available-for-sale securities were $43,016,000, $55,688,000, and $35,232,000 during 2004, 2003, and 2002, respectively. Proceeds from the maturity or call of held-to-maturity securities were $20,026,000, $23,412,000, and $20,674,000 during 2004, 2003, and 2002, respectively.

NOTE 2 - SECURITIES (Continued)

		Less than 12 months				12 months or Greater				Total
		Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
Type of Security		Value		Losses		Value		Losses		Value		Losses

U.S. Treasury	$	3,317	$	1	$	-	$	-	$	3,317	$	1
U.S. Government agencies		101,780		1,161		4,985		112		106,765		1,273
States and political subdivisions		5,886		129		-		-		5,886		129
	$	110,983	$	1,291	$	4,985	$	112	$	115,968	$	1,403

Table III - Investments with Unrealized Losses

(Dollars in Thousands)

Table IV shows the amortized cost, fair value, and weighted yields (for tax-exempt obligations on a fully taxable basis assuming a 34% tax rate) of investment securities at December 31, 2004, by contractual or legal maturity. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.

		Amortized		Fair	Yield
		Cost		Value	(Unaudited)
Available-for-sale securities
U.S. Treasury
Within one year	$	2,034	$	2,065	4.1%
After one but within five years		3,317		3,316	3.5%
U.S. Government agencies
Within one year		62,427		62,654	3.5%
After one but within five years		129,528		130,358	3.6%
After five but within ten years		24,430		24,183	4.0%
Mortgage backed securities
Within one year		5		6	4.0%
After one but within five years		462		476	6.6%
Other securities
Within one year		500		500	3.6%
After one but within five years		284		332	11.0%
After ten years		2,893		2,902	6.3%

	$	225,880	$	226,792


Held-to-maturity securities
U.S. Government agencies
Within one year	$	4,998	$	5,111	6.5%
After one but within five years		3,174		3,217	4.1%
After five but within ten years		3,436		3,456	4.0%
States and political subdivisions
Within one year		3,377		3,430	7.1%
After one but within five years		12,727		13,600	7.3%
After five but within ten years		23,582		24,682	6.9%
After ten years		15,862		16,443	6.5%
Other securities
Within one year		2,195		2,262	6.9%
After one but within five years		6,916		7,521	6.8%

	$	76,267	$	79,722

Table IV - Contractual (Legal) Maturity of Securities and Weighted Tax Equivalent Yields

(Dollars in Thousands)

NOTE 3 - LOANS

		2004		2003

Commercial, financial and agricultural	$	47,780	$	58,444
Tax exempt municipal loans		24,111		12,495
Real estate
Construction		16,517		14,790
Commercial mortgages		96,051		97,148
Residential mortgages		212,046		189,402
Other		28,429		21,967
Retail loans		20,996		25,807
Lease financing receivables		3,330		4,741

		449,260		424,794
Less:
Net unamortized loan origination fees		(207)		(290)
Allowance for possible loan losses		(8,509)		(10,123)

Total net loans	$	440,544	$	414,381

Table V - Loans Outstanding by Category at December 31, 2004 and 2003

(Dollars in Thousands)

		Within		One to		After
		One Year		Five Years		Five Years		Total

Commercial, financial and agricultural	$	32,265	$	12,668	$	2,847	$	47,780
Tax exempt municipal loans		2,436		6,627		15,048		24,111
Real estate
Construction		12,102		1,766		2,649		16,517
Commercial mortgages		29,282		48,691		18,078		96,051
Residential mortgages		76,630		78,035		57,381		212,046
Other		4,941		10,464		13,024		28,429
Retail loans		11,750		8,932		314		20,996
Lease financing receivables		1,155		1,251		924		3,330

Total	$	170,561	$	168,434	$	110,265	$	449,260

Table VI - Loan Maturities and Repricings at December 31, 2004

(Unaudited)

(Dollars in Thousands)

Loans having recorded investments of $5,542,000 at December 31, 2004, have been identified as impaired and are not accruing interest. The total allowance for possible loan losses related to these loans was $1,212,000. Interest received on these loans during 2004 was $170,000, during 2003 was $364,000, and during 2002 was $389,000. Impaired loans had recorded investments of approximately $11,890,000 at December 31, 2003, with $1,676,000 of the allowance for possible loan losses related to these loans.

Loans with documentation and structural deficiencies and historical performance characteristics not meeting credit quality standards were sold during 2003. These loans, totaling $2,400,000, were sold at a loss of $358,000 which is included in other operating income (expense).

NOTE 3 - LOANS (Continued)

Certain related parties (principally directors and senior officers of the Corporation or the Bank, including their affiliates, families, and companies in which they hold ten percent or more ownership) were customers of, and had loans and other transactions with, the Bank in the ordinary course of business. An analysis of activity with respect to such loans for the years ended December 31, 2004 and 2003 is shown in Table VII. These totals exclude loans made in the ordinary course of business to other companies with which neither the Corporation nor the Bank has a relationship other than the association of one of its directors in the capacity of officer or director. These loan transactions were made on substantially the same terms as those prevailing at the time for comparable loans to other persons. They did not involve more than the normal risk of collectiblity or present other unfavorable features. No related party loans were charged off in 2004 or 2003.

Aggregate of Certain Related Party Loans
		2004		2003
Balance at Beginning of Year	$	2,742	$	2,963
Additions		2,931		2,449
Amount Collected		1,698		2,670
Balance at End of Year	$	3,975	$	2,742

Table VII - Analysis of Activity in Certain Related Party Loans

(Dollars in Thousands)

NOTE 4 - ALLOWANCE FOR POSSIBLE LOAN LOSSES

		2004		2003		2002

Balance at beginning of year	$	10,123	$	11,375	$	6,707
Increase due to acquisition		-		-		536
Provision (reduction) charged (credited) to operating expenses		(677)		433		7,450
Loan losses:
Loans charged off		(1,680)		(1,966)		(3,646)
Recoveries on loans previously
charged off		743		281		328

Balance at end of year	$	8,509	$	10,123	$	11,375

Table VIII - Changes in the Allowance for Possible Loan Losses

(Dollars in Thousands)

At March 31, 2002, pursuant to discussions with federal bank examiners and changes in the economic outlook, both generally and in the Bank's geographical region, the Bank changed the classification of specific commercial loans with documentation and structural deficiencies and retail loans with certain historical performance characteristics. Bank management determined that this change was necessary to reflect potential increased loss inherent to such loans. The effect of the change, which was recognized as a change in accounting estimate, was to increase the provision for loan losses and decrease income before provision for income taxes by $4.4 million ($2.6 million, net of tax, or $.45 per share), for the year ended December 31, 2002.

On September 3, 2002, the Bank voluntarily entered into a written agreement with the Office of the Comptroller of the Currency ("OCC"). The agreement related to asset quality and management and board oversight of the lending function. Loan quality and management of the lending function improved in 2003 and on April 12, 2004, the Bank received written notice from the OCC that the agreement between the

NOTE 4 - ALLOWANCE FOR POSSIBLE LOAN LOSSES (Continued)

Bank and OCC, dated September 3, 2002, was terminated effective April 7, 2004. In the opinion of management, based on conditions reasonably known, the allowance was adequate at December 31, 2004.

NOTE 5 - BANK PREMISES AND EQUIPMENT

		2004		2003

Land	$	1,952	$	2,010
Premises		14,163		14,016
Furniture and equipment		8,349		7,920
Leasehold improvements		1,475		1,487

		25,939		25,433
Less allowance for depreciation and amortization		(13,522)		(12,436)

	$	12,417	$	12,997

Table IX - Premises and Equipment at December 31, 2004 and 2003

(Dollars in Thousands)

Annual provisions for depreciation and amortization of bank premises and equipment totaled $1,249,000 for 2004, $1,390,000 for 2003, and $1,313,000 for 2002. Included in premises and equipment cost and allowance for depreciation and amortization are certain fully depreciated assets totaling approximately $5,594,000 at December 31, 2004.

NOTE 6 - LIMITATION ON SUBSIDIARY DIVIDENDS

The approval of the Comptroller of the Currency is required before the Bank's dividends in a given year may exceed the total of its retained net profit (as defined) for the year combined with retained net profits of the preceding two years. As of December 31, 2004, additional dividends of approximately $16 million could have been declared by the Bank to the Corporation without regulatory agency approval.

NOTE 7 - LEASES

Real property for four of the Bank's office locations and certain equipment are leased under noncancelable operating leases expiring at various times through 2009. In most cases, the leases provide for one or more renewal options of five to ten years under the same or similar terms. In addition, various items of office equipment are leased under cancelable operating leases. Total rental expense incurred under all operating leases, including short-term leases with terms of less than one month, amounted to $35,000, $38,000, and $42,000 for equipment leases, and $220,000, $166,000, and $129,000 for building leases in 2004, 2003, and 2002, respectively. Future minimum lease commitments as of December 31, 2004, under all noncancelable operating leases with initial terms of one year or more are shown in Table X.

	Lease
Year	Payments

2005	$	214
2006		213
2007		153
2008		58
2009		3

Total	$	641

Table X - Future Minimum Lease Commitments

(Dollars in Thousands)

NOTE 8 - FEDERAL AND STATE INCOME TAXES

		2004		2003		2002
Current:
Federal	$	2,658	$	1,720	$	3,623
State		697		561		18

Total current		3,355		2,281		3,641

Deferred:
Federal		(88)		651		(1,109)
State		(15)		108		(203)

Total deferred		(103)		759		(1,312)

Total provision for income taxes	$	3,252	$	3,040	$	2,329

Table XI - Provisions for Income Taxes

(Dollars in Thousands)

		2004		2003		2002

Allowance for possible loan losses	$	3,255	$	3,806	$	4,188
Deferred compensation		1,044		955		879
Write down of other real estate		150		27		44
Amortization of core deposit intangible		673		-		-
Recognition of nonaccrual loan income		30
Deferred loan fees		-		-		1

Deferred tax asset		5,152		4,788		5,112

Unrealized gain on AFS securities		(351)		(2,547)		(3,490)
Lease financing depreciation, net of rent		(763)		(734)		(557)
Accelerated depreciation		(150)		(156)		(78)
Amortization of goodwill		(646)		(442)		(221)
Other		(447)		(413)		(455)

Deferred tax liability		(2,357)		(4,292)		(4,801)

Net deferred tax asset	$	2,795	$	496	$	311

Table XII - Deferred Tax Effects of Principal Temporary Differences

(Dollars in Thousands)

The net deferred tax asset is included in other assets in the accompanying consolidated balance sheets.

		2004		2003		2002

Tax expense at statutory rate	$	4,117	$	3,941	$	3,688
Increase (decrease) in taxes resulting from:
Tax-exempt interest		(1,097)		(1,120)		(1,288)
Nondeductible interest expense		71		75		142
Employee benefits		(150)		(149)		(156)
Other nondeductible expenses
(nontaxable income) - net		21		16		16
State income taxes, net of federal
tax benefit		450		442		(122)
Dividend income exclusion		(24)		(5)		(11)
Other		(136)		(160)		60

Total provision for income taxes	$	3,252	$	3,040	$	2,329

Effective tax rate		26.9%		26.2%		21.5%

Table XIII - Reconciliation of Total Income Taxes Reported with the Amount of Income Taxes Computed at the Federal Statutory Rate (34% Each Year)

(Dollars in Thousands)

NOTE 9 - COMMITMENTS AND CONTINGENCIES

The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in those particular financial instruments.

The total outstanding loan commitments and standby letters of credit in the normal course of business at December 31, 2004, were approximately $71 million and $5 million, respectively. Loan commitments are agreements to lend to a customer as long as there is not a violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being used. Therefore, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in making a loan.

The loan portfolio is well diversified with loans generally secured by tangible personal property, real property, bank deposit accounts or stock. The loans are expected to be repaid from cash flow or proceeds from the sale of selected assets of the borrowers. Collateral requirements for the loan portfolio are based on credit evaluation of the customer.

Various legal claims have arisen from time to time in the normal course of business which, in the opinion of management, should not have a material effect on the Corporation's consolidated financial statements.

NOTE 10 - SHAREHOLDERS' EQUITY

The Corporation and the Bank are subject to federal regulatory risk-adjusted capital adequacy standards. Failure to meet capital adequacy requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that could have a direct material adverse effect on the consolidated financial statements of the Corporation and the Bank. The regulations require the Bank to meet specific capital adequacy guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital classification is also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios of Total Capital and Tier I Capital to risk-weighted assets and of Tier I Capital to average assets. Actual capital amounts and ratios are presented in Table XIV. Management believes, as of December 31, 2004 and 2003, that the Corporation and the Bank met all capital adequacy requirements to which they were subject.

NOTE 10 - SHAREHOLDERS' EQUITY (Continued)

					For Capital			For Regulatory
		Actual			Adequacy Purposes			Compliance Purposes

As of December 31, 2004		Amount	Ratio		Amount	Ratio > or =		Amount	Ratio > or =
Total Capital (to Risk Weighted
Assets) Consolidated	$	97,796	19.63%	$	39,847	8.00%	$	-	-
Bank		96,375	19.42%		39,693	8.00%		49,616	10.00%
Tier I Capital (to Risk Weighted
Assets) Consolidated		91,542	18.38%		19,924	4.00%		-	-
Bank		90,144	18.17%		19,846	4.00%		29,770	6.00%
Tier I Capital (to Average
Assets) Consolidated		91,542	11.29%		32,441	4.00%		-	-
Bank		90,144	11.13%		32,382	4.00%		40,478	5.00%

As of December 31, 2003
Total Capital (to Risk Weighted
Assets) Consolidated		91,327	18.71%	$	39,060	8.00%	$	-	-
Bank		89,970	18.50%		38,910	8.00%		48,637	10.00%
Tier I Capital (to Risk Weighted
Assets) Consolidated		85,174	17.45%		19,530	4.00%		-	-
Bank		83,840	17.24%		19,455	4.00%		55,933	11.50%
Tier I Capital (to Average
Assets) Consolidated		85,174	10.29%		33,110	4.00%		-	-
Bank		83,840	10.15%		33,037	4.00%		41,296	5.00%
Tier I Capital (to Adjusted Total
Assets) Bank		83,840	12.97%		-	-		51,733	8.00%

Table XIV - Capital Amounts and Capital Adequacy Ratios

(Dollars in Thousands)

NOTE 11 - ACQUISITIONS

In December, 2001, the Bank entered into an agreement with Community Bank, an Alabama banking corporation, to purchase certain assets and assume certain deposit liabilities of two offices in Pulaski, Giles County, Tennessee. Regulatory approval was received and the acquisition was completed March 29, 2002. The fair values of identifiable assets acquired and liabilities assumed are presented in Table XV. In addition, a core deposit intangible of $1,573,000 was recognized and is being amortized over six years, the average life of the deposits acquired.

All assets, liabilities, and associated income and expenses of those branches of the Bank are included in the consolidated financial statements from the acquisition date. The pro forma effect of the new Pulaski branches on operations if the acquisition had occurred at January 1, 2002, was not significant.

The goal of this acquisition was to increase the Bank's market presence in its community service area that had not included this county.

Cash	$	8,017	Deposits	$	35,162
Loans, net		23,256	Other liabilities		191
Premises and equipment		1,856
Other assets		652

Table XV - Assets and Liabilities Acquired Through Acquisition

(Dollars in Thousands)

NOTE 12 - FAIR VALUES OF FINANCIAL INSTRUMENTS

			December 31, 2004				December 31, 2003

		Carrying		Fair		Carrying		Fair
		Amount		Value		Amount		Value

Financial assets
Cash and due from banks	$	22,203	$	22,203	$	26,137	$	26,137
Interest-bearing deposits in banks		48		48		297		297
Federal funds sold		-		-		12,000		12,000
Securities available-for-sale		226,792		226,792		249,653		249,653
Securities held-to-maturity		76,267		79,722		79,138		84,199
Loans, net		440,544		446,372		414,381		443,885
Accrued interest receivable		5,595		5,595		6,098		6,098

Financial liabilities
Deposits		693,855		693,715		716,433		719,466
Federal funds purchased and
securities sold under agreements
to repurchase		9,128		9,128		1,820		1,820
Other short term liabilities		614		614		648		648
Accrued interest payable		1,457		1,457		1,580		1,580

Off-balance sheet credit related instruments:
Commitments to extend credit		-		71		-		44

Table XVI - Summary of Fair Values of Financial Instruments

(Dollars in Thousands)

Estimated fair values have been determined by the Bank using the best available data. Many of the Bank's financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an unforced, unforeclosed transaction. Therefore, significant estimations and present value calculations were used by the Bank for the purposes of this disclosure. Changes in assumptions or the estimation methodologies used could have a material effect on the estimated fair values included in this Note.

Financial assets - Cash and cash equivalents are considered to be carried at their fair value and have not been valued differently from historical cost accounting. Securities available-for-sale and securities held-to-maturity are valued by an independent rating service and are disclosed in detail in Note 2. A present value discounted cash flow methodology was used to value the net loan portfolio. The discount rate used in these calculations was the current rate at which new loans in the same classification for regulatory reporting purposes would be made. This rate was adjusted for credit loss and assumed prepayment risk. For loans with floating interest rates, it is presumed that estimated fair values generally approximate the recorded book balances.

Financial liabilities - Deposits with stated maturities have been valued using a present value discounted cash flow with a discount rate approximating the current market for similar liabilities. Financial instrument liabilities with no stated maturities have an estimated fair value equal to both the amount payable on demand and the recorded book balance. For deposits with floating interest rates, it is presumed that estimated fair values generally approximate the recorded book balances. The carrying amount of other short-term borrowings is considered to approximate its fair value.

Fair values for off-balance-sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing.

NOTE 12 - FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

The Bank's remaining assets and liabilities which are not considered financial instruments have not been valued differently from historical cost accounting. Management is concerned that reasonable comparability between financial institutions may be distorted due to the wide range of permitted valuation techniques and numerous estimates which must be made given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.

At December 31, 2004, the Bank had outstanding standby letters of credit and commitments to extend credit. These off-balance-sheet financial instruments are generally exercisable at the market rate prevailing at the date the underlying transaction will be completed. Please refer to Note 9 for more information about off-balance-sheet financial instruments.

NOTE 13 - QUARTERLY RESULTS OF OPERATIONS (Unaudited)

		First		Second		Third		Fourth
		Quarter		Quarter		Quarter		Quarter		Total
2004
Interest income	$	9,442	$	9,274	$	9,389	$	9,459	$	37,564
Interest expense		2,189		2,068		2,079		2,151		8,487

Net interest income		7,253		7,206		7,310		7,308		29,077
Provision for possible loan losses
(recoveries) net		-		(677)		-		-		(677)
Noninterest expenses, net of
noninterest income		3,810		4,826		4,539		4,471		17,646

Income before income taxes		3,443		3,057		2,771		2,837		12,108
Income taxes		982		805		859		606		3,252

Net income	$	2,461	$	2,252	$	1,912	$	2,231	$	8,856

Earnings per common share
(5,840,000 shares)*	$	0.42	$	0.39	$	0.33	$	0.38	$	1.52


		First		Second		Third		Fourth
		Quarter		Quarter		Quarter		Quarter		Total
2003
Interest income	$	11,395	$	10,940	$	10,424	$	9,792	$	42,551
Interest expense		3,311		3,000		2,673		2,425		11,409

Net interest income		8,084		7,940		7,751		7,367		31,142
Provision for possible loan losses
(recoveries) net		410		350		40		(367)		433
Noninterest expenses, net of
noninterest income		4,536		4,965		5,000		4,618		19,119

Income before income taxes		�� 3,138		2,625		2,711		3,116		11,590
Income taxes		674		820		625		921		3,040

Net income	$	2,464	$	1,805	$	2,086	$	2,195	$	8,550

Earnings per common share
(5,840,000 shares)*	$	0.42	$	0.31	$	0.36	$	0.38	$	1.47
* Share and per share data have been restated to give retroactive effect to the two-for-one stock split effected as
stock dividend declared on April 20, 2004.

Table XVII - Consolidated Quarterly Results of Operations

(Dollars in Thousands, Except Per Share Data)

NOTE 14 - DEPOSITS

The Bank does not have any foreign offices and all deposits are serviced in its twenty-one domestic offices. Maturities of time deposits of $100,000 or more and of all interest-bearing deposits at December 31 are indicated in Table XVIII and Table XIX, respectively.

		2004		2003		2002

Under 3 months	$	11,631	$	17,304	$	24,309
3 to 12 months		35,936		28,189		39,398
Over 12 months		24,021		26,475		28,076

Total	$	71,588	$	71,968	$	91,783

Table XVIII - Maturities of Time Deposits of $100,000 or More at December 31

(Dollars in Thousands)

Interest bearing transaction accounts		$	342,595
	2005		165,958
	2006		26,632
	2007		34,022
	2008		4,767
	2009		4,297
	Thereafter		1

	Total	$	578,272

Table XIX - Maturities of Interest Bearing Deposits at December 31, 2004

(Dollars in Thousands)

NOTE 15 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under agreements to repurchase, which are classified as secured borrowings, generally mature within one to four days from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction.

NOTE 16 - CONDENSED FINANCIAL INFORMATION OF PARENT CORPORATION

Condensed Balance Sheets
December 31, 2004 and 2003
		2004		2003

Cash	$	129	$	44
Investment in bank subsidiary - at equity		102,791		100,954
Investment in credit life insurance company - at cost		54		50
Investment in other securities		16		20
Dividends receivable from bank subsidiary		1,752		1,635
Cash surrender value - life insurance		1,857		1,781

Total assets	$	106,599	$	104,484

Liabilities
Payable to directors	$	659	$	564
Dividends payable		1,752		1,635

Total liabilities		2,411		2,199
Shareholders' equity
Common stock - $10 par value, authorized 8,000,000
shares; 5,840,000 shares issued and outstanding		58,400		29,200
Additional paid-in capital		4,320		4,320
Retained earnings		40,908		64,697
Accumulated other comprehensive income		560		4,068

Total shareholders' equity		104,188		102,285

Total liabilities and shareholders' equity	$	106,599	$	104,484

Table XX - Condensed Balance Sheets of Parent Corporation

(Dollars in Thousands)

Condensed Statements of Income
Years Ended December 31, 2004 and 2003

		2004		2003

Operating income
Dividends from bank subsidiary	$	3,446	$	3,241
Other dividend income		100		22
Interest income		1		1
Other		88		96
Operating expenses		(125)		(115)

Income before equity in undistributed net
income of bank subsidiary		3,510		3,245

Equity in undistributed net income of bank subsidiary		5,346		5,305

Net Income	$	8,856	$	8,550

Table XXI - Condensed Statements of Income of Parent Corporation

(Dollars in Thousands)

NOTE 16 - CONDENSED FINANCIAL INFORMATION OF PARENT CORPORATION

(Continued)

Condensed Statements of Cash Flows
Years Ended December 31, 2004 and 2003

		2004		2003
Operating activities
Net income for the year	$	8,856	$	8,550
Adjustments to reconcile net income to net cash
provided by operating activities
Equity in undistributed net income of bank subsidiary		(5,346)		(5,305)
Increase in cash surrender value of life insurance contracts		(77)		(78)
Increase in other assets		(110)		(58)
Increase in payables		95		62

Total adjustments		(5,438)		(5,379)

Net cash provided by operating activities		3,418		3,171

Investing activities
Proceeds from sale of credit life insurance interest		50		-
Purchase interest in credit life insurance company		(54)		-

Net cash used by investing activities		(4)		-

Financing activities
Cash dividends paid		(3,329)		(3,183)

Increase (decrease) in cash		85		(12)
Cash at beginning of year		44		56

Cash at end of year	$	129	$	44

Table XXII - Condensed Statements of Cash Flows of Parent Corporation

(Dollars in Thousands)

NOTE 17 - EMPLOYEE BENEFIT PLANS

The Bank contributes to a defined contribution, profit-sharing plan covering employees who meet participation requirements. The amount of the contribution is discretionary as determined by the Bank's Board of Directors up to the maximum deduction allowed for federal income tax purposes. Contributions to the plan, that amounted to $1,482,000, $1,292,000, and $1,136,000, in 2004, 2003, and 2002, respectively, are included in salaries and employee benefits expense.

In 1992, the Bank formalized a nonqualified salary continuation plan for certain key officers. In connection with this plan, the value of the single premium universal life insurance policies (2004 - $827,000; 2003 - $797,000) purchased in 1993 to fund the plan and the related liability (2004 - $392,000; 2003 - $421,000) were included in other assets and other liabilities, respectively. Net noncash income recognized on these policies of $30,000 in 2004 and $27,000 in 2003 is included in the above asset values. Net noncash income was $30,000 in 2002. The principal cost of the plan is being accrued over the anticipated remaining period of active employment, based on the present value of the expected retirement benefit. Expense related to this plan was $46,000 in 2004, $40,000 in 2003, and $23,000 in 2002.

In 1993, the Corporation and the Bank implemented a deferred compensation plan which permits directors to defer their director's fees and earn interest on the deferred amount. Liability increases for current deferred fees, net of benefits paid out, of $259,000 for 2004, $235,000 for 2003, and $258,000 for 2002 have been recognized in the accompanying consolidated financial statements. In connection with this plan, a single premium universal life insurance policy was purchased on the life of each director who

NOTE 17 - EMPLOYEE BENEFIT PLANS (Continued)

elected to participate. Additional single premium universal life insurance policies, totaling $235,000 in 2002, were purchased for new participants. Net noncash income recognized on these policies of $245,000 in 2004 and $245,000 in 2003 is included in the cash surrender values of $5,952,000 and $5,707,000 reported in other assets at December 31, 2004 and 2003, respectively. Net noncash income was $274,000 in 2002.

In 1996, the Bank established an officer group term replacement/split-dollar plan to provide life insurance benefits that would continue after retirement. A single premium universal life insurance policy was purchased to fund the plan and a split-dollar agreement was made with an irrevocable trust that specified the portion of the insurance proceeds that would become part of the trust. The value of this policy (2004 - $1,103,000; 2003 - $1,061,000) is included in other assets, and net noncash income recognized on this policy of $42,000 in 2004 and $42,000 in 2003 are included in the above asset values. Net noncash income was $95,000 in 2002.

In 2002, the Bank implemented a Director Split-Dollar Life Insurance Plan and an Executive Split-Dollar Life Insurance Plan. The Bank purchased a single premium whole life insurance policy on the life of each participant and endorsed a portion of the policy death benefits to the insured's estate, a trust, or another individual. The total life insurance purchased was $3,735,000 in 2002 and $190,000 in 2003. Additional single premium universal life insurance policies, totaling $253,000 in 2004, were purchased for new participants.Net noncash income was recognized on these policies of $124,000 in 2004 and $124,000 in 2003 and is included in the asset value of $4,487,000, which is a part of other assets.

The Bank is beneficiary on the insurance policies that fund the salary continuation plan, the deferred compensation plan, the group term replacement/split-dollar plan, and the split-dollar life insurance plans. These policies have an aggregate current death benefit of $18 million.

SHAREHOLDER INFORMATION

The 5,840,000 shares of common stock of First Farmers & Merchants Corporation outstanding at December 31, 2004 had a market value of $262.8 million and were held by 2,456 identifiable individuals located mostly in the market area were holders of the outstanding shares. These identifiable individuals consist of 1,953 record holders, 503 joint holders and a small number of additional shareholders not identified individually since some bank nominees, including the bank's Trust Department, are listed as single owners when, in fact, these holdings represent more than one shareholder. No single shareholder's ownership exceeded five percent at year end.

There is no established public trading market for the stock. The table at the right shows the high and low price of the Corporation's common stock taken from reported prices by those buyers and sellers willing to disclose this information. This table also shows the semiannual dividend paid per share, in each of the last three years. On April 20, 2004, the Corporation’s shareholders approved a two-for-one split effected in the form of a 100% stock dividend to shareholders of record on that date. All share data in the table have been restated to give retroactive effect to the transaction.

			High		Low		Dividend
2004	First Quarter	$	40.00		40.00	$	0.00
	Second Quarter		42.00		40.00		0.290
	Third Quarter		45.00		42.00		0.00
	Fourth Quarter		45.00		45.00		0.300

2003	First Quarter	$	37.50		37.50	$	0.00
	Second Quarter		37.50		37.50		0.275
	Third Quarter		37.50		37.50		0.00
	Fourth Quarter		40.00		37.50		0.280

2002	First Quarter	$	35.00	$	34.00	$	0.00
	Second Quarter		35.00		35.00		0.265
	Third Quarter		36.00		35.00		0.00
	Fourth Quarter		37.50		36.00		0.270

ADDITIONAL FINANCIAL DATA


COMPARATIVE DATA
(Dollars In Thousands)

		2004		2003		2002		2001		2000

Average assets	$	825,467	$	867,100	$	890,525	$	778,855	$	640,796

Average loans(net)	$	419,627	$	444,942	$	513,553	$	462,725	$	349,727

Average deposits	$	710,956	$	755,709	$	785,702	$	680,352	$	556,385
Return on
average assets		1.08%		0.99%		0.96%		1.36%		1.30%
Return on
beginning equity		8.68%		8.58%		9.50%		13.29%		11.55%
Tier 1 capital
to average assets		11.14%		10.29%		8.79%		9.08%		12.09%

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	7th grade Bad

First Farmers and Merchants (FFMH) Inactive 10-K2004 FY Annual report

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