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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2004

Commission File Number 000-30707

First Northern Community Bancorp

(Exact name of registrant as specified in its charter)

195 N. First St., Dixon, CA

(Address of principal executive offices)

95620

(Zip Code)

707-678-3041

(Registrant’s telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

As of November 5, 2004, there were 3,595,986 shares of Common Stock, no par value, outstanding.

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FIRST NORTHERN COMMUNITY BANCORP

INDEX

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PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

See notes to unaudited condensed consolidated financial statements.

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UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

See notes to unaudited condensed consolidated financial statements.

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Unaudited Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income

(in thousands, except share amounts)

See notes to unaudited condensed consolidated financial statements.

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UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See notes to unaudited condensed consolidated financial statements.

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004 and 2003 and December 31, 2003

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Articles 9 and 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for any interim period are not necessarily indicative of results expected for the full year. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in First Northern Community Bancorp’s (the “Company”) Annual Report to shareholders and Form 10-K for the year ended December 31, 2003. All material intercompany balances and transactions have been eliminated in consolidation.

In December 2003, FASB issued Statement No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Benefits. This Statement prescribes employers’ disclosures about pension plans and other postretirement benefit plans; it does not change the measurement or recognition of those plans. The Statement retains and revises the disclosure requirements contained in the original Statement 132. It also requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit plans and other postretirement benefit plans. The Statement generally is effective for fiscal years ending after December 15, 2003. The Company currently has postretirement benefit plans that are within the scope of this Statement. Management has done an analysis of the impact of this accounting pronouncement and this has been disclosed in the sections of this report entitled “FIRST NORTHERN BANK - EXECUTIVE SALARY CONTINUATION PLAN” and “FIRST NORTHERN BANK - DIRECTORS’ RETIREMENT PLAN”.

In March, 2004, the Emerging Issues Task Force (“EITF”) Issue No. 03-1 “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” consensus was published. Issue No. 03-1 contained new guidance effectively codifying the provisions of SEC Staff Accounting Bulletin No. 59 and creates a new model that calls for new judgments and additional evidence gathering. The Company does not expect the adoption of this EITF to have a material impact on the Company’s Consolidated Financial Statements.

The allowance for loan losses is maintained at levels considered adequate by management to provide for loan losses that can be reasonably anticipated. The allowance is based on management’s assessment of various factors affecting the loan portfolio, including problem loans, economic conditions and loan loss experience, and an overall evaluation of the quality of the underlying collateral. Changes in the allowance for loan losses during the nine-month periods ended September 30, 2004 and 2003 and for the year ended December 31, 2003 were as follows (in thousands):

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Transfers and servicing of financial assets and extinguishments of liabilities are accounted for and reported based on consistent application of a financial-components approach that focuses on control. Transfers of financial assets that are sales are distinguished from transfers that are secured borrowings. Retained interests (mortgage servicing rights) in loans sold are measured by allocating the previous carrying amount of the transferred assets between the loans sold and retained interest, if any, based on their relative fair value at the date of transfer. Fair values are estimated using discounted cash flows based on a current market interest rate.

The Company recognizes a gain and a related asset for the fair value of the rights to service loans for others when loans are sold. The Company sold substantially all of its conforming long-term residential mortgage loans originated during the nine months ended September 30, 2004 for cash proceeds equal to the fair value of the loans.

The recorded value of mortgage servicing rights is included in other assets, and is amortized in proportion to, and over the period of, estimated net servicing revenues. The Company assesses capitalized mortgage servicing rights for impairment based upon the fair value of those rights at each reporting date. For purposes of measuring impairment, the rights are stratified based upon the product type, term and interest rates. Fair value is determined by discounting estimated net future cash flows from mortgage servicing activities using discount rates that approximate current market rates and estimated prepayment rates, among other assumptions. The amount of impairment recognized, if any, is the amount by which the capitalized mortgage servicing rights for a stratum exceeds their fair value. Impairment, if any, is recognized through a valuation allowance for each individual stratum.

At September 30, 2004, the Company had $8,893,000 of mortgage loans held for sale. At September 30, 2004 and December 31, 2003, the Company serviced real estate mortgage loans for others of $104,530,000 and $98,172,000, respectively.

The following table summarizes the Company’s mortgage servicing rights assets as of September 30, 2004 and December 31, 2003.

There was no valuation allowance recorded for mortgage servicing rights as of September 30, 2004 and December 31, 2003.

During the nine months ended September 30, 2004, the Company obtained an additional amortizing advance on March 15, 2004, in the amount of $5,625,084, from the Federal Home Loan Bank (FHLB). The advance matures on March 16, 2009, and has a fixed interest rate of 3.14 percent. The purpose of the advance was to offset the interest rate risk associated with a loan with similar payment characteristics.

On January 22, 2004, the Board of Directors of the Company declared a 6% stock dividend payable as of March 31, 2004 to shareholders of record as of February 28, 2004. Earnings per share amounts have been adjusted to reflect the effect of the stock dividend.

Earnings Per Share (EPS)

Basic EPS includes no dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS includes all common stock equivalents (“in-the-money” stock options, warrants and rights, convertible bonds and preferred stock), which reflects the potential dilution of securities that could share in the earnings of an entity.

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The following table presents basic and diluted EPS for the three-month and nine-month periods ended September 30, 2004 and 2003 (amounts in thousands, except share and earnings per share amounts):

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Stock-based employee compensation recognized for all stock options granted after January 1, 2003 is based on the fair value recognition provisions of Statements of Financial Accounting Standards Nos. 123 and 148. For stock options issued prior to January 1, 2003, the Company is using the intrinsic value method, under which compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. The following table illustrates the effect on net income and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period:

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Pension Benefit Plans

First Northern Bank has an unfunded noncontributory defined benefit pension plan (“Salary Continuation Plan”) for a select group of highly compensated employees. The plan provides defined benefit levels between $50,000 and $125,000 depending on responsibilities at the bank. The retirement benefits are paid for 10 years following retirement at age 65. Reduced retirement benefits are available after age 55 and 10 years of service.

Company estimates at December 31, 2004 that the net periodic benefit cost will be $215,873. This compares to net periodic benefit costs of $208,970 and $178,361 at December 31, 2003 and 2002, respectively.

Estimated Contributions for Fiscal 2004

For unfunded plans, contributions to the plan are the benefit payments made to participants. First Northern Bank is not expected to make any benefit payments during fiscal 2004.

Pension Benefit Plans

First Northern Bank has an unfunded noncontributory defined benefit pension plan (“Directors’ Retirement Plan”) for directors of First Northern Bank. The plan provides a retirement benefit equal to $1,000 per year of service as a director, up to a maximum of $15,000. The retirement benefit is payable for 10 years following retirement at age of 65. Reduced retirement benefits are available after age 55 and 10 years of service.

Company estimates at December 31, 2004 that the net periodic benefit cost will be $92,919. This compares to net periodic benefit costs of $79,659 and $139,064 at December 31, 2003 and 2002, respectively.

Estimated Contributions for Fiscal 2004

For unfunded plans, contributions to the plan are the benefit payments made to participants. First Northern Bank is not expected to make any benefit payments during fiscal 2004.

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This document contains 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, and subject to the “safe harbor” created by those sections. Forward-looking statements include the information concerning possible or assumed future results of operations of the Company set forth under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements also include statements in which words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” estimate,” “consider” or similar expressions are used, and includes assumptions concerning the Company’s operations, future results and prospects. These forward-looking statements are based upon current expectations and are subject to risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from those set forth in or implied by the forward-looking statements and related assumptions. Some factors that may cause actual results to differ from the forward-looking statements include the following: (i) the effect of changing regional and national economic conditions, including the recent budgetary crisis and continuing fiscal difficulties of the State of California; (ii) uncertainty regarding the economic outlook resulting from the continuing hostilities in Iraq and the war on terrorism, as well as actions taken or to be taken by the United States or other governments as a result of further acts or threats of terrorism; (iii) significant changes in interest rates and prepayment speeds; (iv) credit risks of commercial, agricultural, real estate, consumer and other lending activities; (v) adverse effects of current and future federal and state banking or other laws and regulations or governmental fiscal or monetary policies; (vi) competition in the banking industry; and (vii) other external developments which could materially impact the Company’s operational and financial performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made. For additional information concerning risks and uncertainties related to the Company and its operations, please refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

The following is a discussion and analysis of the significant changes in the Company’s Unaudited Condensed Consolidated Balance Sheets and of the significant changes in income and expenses reported in the Company’s Unaudited Condensed Consolidated Statements of Income and Stockholders’ Equity and Comprehensive Income as of and for the three-month and nine-month periods ended September 30, 2004 and 2003 and should be read in conjunction with the Company’s consolidated 2003 financial statements and the notes thereto contained in the Company’s Annual Report to Shareholders and Form 10-K for the year ended December 31, 2003, along with other financial information included in this report.

SUMMARY

The Company recorded net income of $4,735,000 for the nine-month period ended September 30, 2004, representing a decrease of $5,000 or 0.11% from net income of $4,740,000 for the same period in 2003.

The decrease in net income for the nine-month period ended September 30, 2004 as compared to the same period a year ago resulted primarily from a decrease in net interest income and other operating income which was partially offset by a decrease in provision for loan losses and decreases in other operating expenses.

The Company recorded net income of $1,727,000 for the three-month period ended September 30, 2004, representing an increase of $143,000 or 9.03% from net income of $1,584,000 for the same period in 2003.

The increase in net income for the three-month period ended September 30, 2004 as compared to the same period a year ago resulted primarily from a decrease in provision for loan losses and an increase in net interest income, which was partially offset by an increase in other operating expenses and a decrease in other operating income.

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CHANGES IN FINANCIAL CONDITION

The assets of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets showed a $2,209,000 decrease in cash and due from banks, a $1,400,000 increase in federal funds sold, a $1,274,000 increase in investment securities available-for-sale, a $40,209,000 increase in loans, a $1,779,000 decrease in loans held for sale, a $363,000 decrease in premises and equipment and a $1,159,000 increase in accrued interest receivable and other assets from December 31, 2003 to September 30, 2004. The decrease in cash and due from banks was due to a decrease in items in process of collection. The increase in federal funds sold was due to a decrease in cash and due from banks and an increase in deposits. The increase in investment securities available-for-sale was due purchases of U.S. government agency investment securities. The increase in loans was due to an increase in commercial, equipment, agriculture, real estate and construction loans and home equity lines of credit, which was partially offset by a decrease in commercial real estate, equipment leases and consumer loans. These fluctuations were due to changes in the demand for certain loan products by the Company’s borrowers. The decrease in loans held-for-sale was in real estate loans and was due, for the most part, to a decrease in the origination of loans compared to sales. The Company originated approximately $43,153,000 in residential mortgage loans during the first nine months of 2004, which was offset by approximately $45,314,000 in loan sales during this period. The decrease in premises and equipment was due to increased depreciation, which was partially offset by an increase in computer hardware and furniture and equipment purchases. The increase in accrued interest receivable and other assets was due to an increase in loan interest receivables, cash surrender value of bank-owned life insurance, mortgage servicing asset, and income taxes receivable, which was partially offset by decreases in computer software, securities interest receivables, prepaid expenses and unamortized costs on leases and an increase in housing tax credit amortization expense.

The liabilities of the Company set forth in the Unaudited Condensed Consolidated Balance Sheets showed an increase in total deposits of $30,620,000 at September 30, 2004 compared to the total at December 31, 2003. The increase in deposits was due to higher demand, savings and money market and time deposit totals combined with lower interest-bearing transaction deposit totals. These fluctuations were due to cyclical changes in deposit requirements of the Company’s depositors. Federal Home Loan Bank advance (“FHLB advance”) and other borrowings increased $5,918,000 for the nine months ended September 30, 2004 compared to the year ended December 31, 2003, due to an additional FHLB advance and an increase in treasury tax and loan note payable. Other liabilities decreased $54,000 from December 31, 2003 to September 30, 2004. The decrease in other liabilities was due to a decrease in accrued interest expense, taxes payable, accrued profit sharing and incentive compensation expenses, which were partially offset by increases in accrued retirement expense and deferred compensation expense.

CHANGES IN RESULTS OF OPERATIONS

Interest Income

The reduction in general market interest rates decreased the Company’s yields on earning assets. The Federal Open Market Committee increased the federal funds rate by a total of 75 basis points during the twelve-month period ended September 30, 2004. These increases occurred on June 30, 2004, August 10, 2004 and September 21, 2004.

Interest income on loans for the nine-month period ended September 30, 2004 was up 1.2% from the same period in 2003, increasing from $20,072,000 to $20,312,000 and was up 4.0% for the three-month period ended September 30, 2004 over the same period in 2003, from $6,981,000 to $7,260,000. The increase from the nine-month period ended September 30, 2004 as compared to the same period a year ago was primarily due to an increase in average loans which was partially offset by a 35 basis point decrease in loan yields. The increase over the three-month period ended September 30, 2004 as compared to the same period a year ago was primarily due to an increase in average loans which was partially offset by a 41 basis point decrease in loan yields.

Interest income on federal funds sold for the nine-month period ended September 30, 2004 was up 319.4% from the same period in 2003, increasing from $129,000 to $541,000 and was up 247.1% for the three-month period ended September 30, 2004 over the same period in 2003, from $68,000 to $236,000. The increase in federal funds income for the nine-month period ended September 30, 2004 was primarily due to an increase in average federal funds sold and a 14 basis point increase in federal funds rates. The increase over the three-month period ended September 30, 2004 as compared to the same period a year ago, was primarily due to an increase in average federal funds sold and a 44 basis point increase in federal funds rates. The changes in average federal funds sold were the result of the usual seasonality of transaction deposit accounts.

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Interest income on investment securities for the nine-month period ended September 30, 2004 was down 23.2% from the same period in 2003, decreasing from $2,737,000 to $2,103,000 and was down 17.0% for the three-month period ended September 30, 2004 over the same period in 2003, from $841,000 to $698,000. The decrease from the nine-month period ended September 30, 2004 as compared to the same period a year ago was primarily due to a decrease in average investment securities and a 20 basis point decrease in securities yields. The decrease over the three-month period ended September 30, 2004 as compared to the same period a year ago was primarily due to a decrease in average investment securities and by a 33 basis point decrease in investment securities yields.

Interest Expense

The reduction in general market interest rates decreased the Company’s cost of funds in the third quarter compared to the same quarter a year ago. The Federal Open Market Committee increased the federal funds rate by a total of 75 basis points during the past twelve months. These increases occurred on June 30, 2004, August 10, 2004 and September 21, 2004.

Interest expense on deposits and other borrowings for the nine-month period ended September 30, 2004 was up 8.58% from the same period in 2003, increasing from $2,318,000 to $2,517,000 and was up 12.9% for the three-month period ended September 30, 2004 over the same period in 2003 from $782,000 to $883,000. The increase in interest expense from the nine-month period ended September 30, 2004 was primarily due to increased average interest bearing deposits and an increase in FHLB advance, which was partially offset by a 7 basis point decrease in deposit rates and a decrease in other borrowings. The increase in interest expense from the three-month period ended September 30, 2004 was primarily due to increased average interest bearing deposits and an increase in FHLB advance, which was partially offset by a 4 basis point decrease in deposit rates and a decrease in other borrowings.

Provision for Loan Losses

There was a provision for loan losses of $305,000 for the nine-month period ended September 30, 2004 compared to a $1,560,000 provision for the same period in 2003. The decrease in the provision was due to a decrease in non-accrual loans and the Company’s evaluation of the quality of the loan portfolio. The September 30, 2004 allowance for loan losses of approximately $8,305,000 was 1.98% of total loans (excluding loans held for sale) compared to $7,738,000 or 2.05% of total loans (excluding loans held for sale) at December 31, 2003. The allowance for loan losses is maintained at a level considered adequate by management to provide for possible loan losses.

Other Operating Income

Other operating income was down 29.9% for the nine-month period ended September 30, 2004 from the same period in 2003, decreasing from $5,523,000 to $3,870,000. This decrease was primarily due to a decrease in gains on sales of loans, gains on other real estate owned, mortgage brokerage income, loan servicing income, and realized gains on available for sale securities, which was partially offset by an increase in service charges on deposit accounts, investment and brokerage services income, and other miscellaneous income. Decreases in gains on sales of loans, mortgage brokerage income and loan servicing income accounted for most of the decrease in other operating income during the nine-month period ended September 30, 2004, due to a slowdown in demand for mortgage financing and refinancing activity compared to the same period in 2003. The Company sold approximately $45,314,000 in residential mortgage loans during the nine-month period ended September 30, 2004, as compared to $167,867,000 for the same period in 2003. The decrease in other real estate owned income was due to a payment received on a previously owned real estate property during the nine-month period ended September 30, 2003 that was not repeated during the same period in 2004. The decrease in realized gains on available for sale securities was due to the sale of a corporate bond that was previously written down due to a decline in value during the nine-month period ended September 30, 2003 that was not repeated during the same period in 2004. The increase in service charges on deposit accounts was due to an increase in monthly service charges and other service charges. The increase in investment and brokerage services income was due to an increase in demand for investment and brokerage services. Other miscellaneous income increased for the most part due to an increase in trust income, safe deposit income, check sales income and stand-by letter of credit fees which were offset by a decrease in interest income on bank-owned life insurance policies.

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Other operating income was down 2.07% for the three-month period ended September 30, 2004 from the same period in 2003, decreasing from $1,450,000 to $1,420,000. This decrease was primarily due to a decrease in loan servicing income, mortgage brokerage income, and realized gains on available for sale securities, which was partially offset by an increase in service charges on deposit accounts, gains on sales of loans, gains on other real estate owned, investment and brokerage services income, and other miscellaneous income. Decreases in loan servicing income accounted for most of the decrease in other operating income during the three-month period ended September 30, 2004. The decrease in loan servicing income was due to a decrease in mortgage-servicing income. The decrease in mortgage brokerage income was due to a decrease in mortgage brokerage activity. The decrease in realized gains on available for sale securities was due to the reduction in sales in the three-months ended September 30, 2004 compared to sales in the same period in 2003. The increase in service charges on deposit accounts was due to an increase in overdraft fees, monthly service charges and other service charges. The increase in gains on sales of loans income was due to more favorable pricing per loan as compared to the same period last year. The Company sold approximately $12,260,000 in residential mortgage loans during the three-month period ended September 30, 2004, as compared to $74,150,000 for the same period in 2003. The increase in other real estate owned income was due to a payment received on a previously owned real estate property during the three-month period ended September 30, 2004 that did not occur during the same period in 2003. The increase in investment and brokerage services income was due to an increase in demand for investment and brokerage services. Other miscellaneous income increased for the most part due to an increase in trust income, stand-by letter of credit fees, safe deposit income, check sales income and interest income on bank-owned life insurance policies.

Other Operating Expenses

Total other operating expenses was down 3.53% for the nine-month period ended September 30, 2004 from the same period in 2003, decreasing from $17,307,000 to $16,696,000.

The main reasons for the decrease in other operating expenses in the nine-month period ended September 30, 2004 were the following: decreases in salaries and benefits, stationery and supplies, advertising costs and other miscellaneous operating expenses; which were partially offset by increases in occupancy and equipment, and data processing expense. The decrease in salaries and benefits was due to decreases in the following: commissions for real estate loans; payroll taxes; retirement compensation expense; and profit sharing and incentive compensation provisions due to decreased profits combined with increases in group insurance expense; worker’s compensation expense; merit salary increases; deferred compensation interest expense; and welfare and recreation expense. The decrease in stationery and supplies was due to a reduction in supply usage. The decrease in advertising costs was due to reduction in production costs for the Company’s annual report compared to the same period in 2003. The decrease in other miscellaneous operating expenses was due to decreases in the following: computer software depreciation; contributions; membership dues; checks purchased expense; credit reports expense; accounting and audit fees; employee training expense; ATM processing fees; miscellaneous loan and lease expense; other director expense; messenger and armored expense; business travel and sundry losses; which was partially offset by increases in liability insurance; amortization expense of the investment in unconsolidated subsidiary for the affordable housing tax credit investment; examination fees; consulting fees; telephone expense; visa processing fees and loan collection expense. The increase in occupancy and equipment costs was due to increased rent expense, hazard and liability insurance expense, compliance expense, computer hardware depreciation and service contract expense, which was partially offset by decreases in building and equipment expense and utilities. The increase in data processing costs was due to increased expenses associated with maintaining and monitoring the Company’s data communications network and Internet banking system.

Total other operating expenses was up 4.23% for the three-month period ended September 30, 2004 from the same period in 2003, increasing from $5,798,000 to $6,043,000.

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The main reasons for the increase in other operating expenses in the three-month period ended September 30, 2004 were the following: increases in salaries and benefits; occupancy and equipment expense; data processing; stationery and supplies; and advertising costs which were partially offset by decreases in other miscellaneous operating expenses. The increase in salaries and benefits was due to increases in the following: worker’s compensation expense; merit salary increases; deferred compensation interest expense and provision for incentive compensation and profit sharing expenses due to increased profits combined with decreases in group insurance; welfare and recreation expense; retirement compensation expense; payroll taxes; and commissions for real estate loans. The increase in advertising costs was due to increased advertising compared to the same period in 2003. The increase in stationery and supplies was due to an increase in supply usage. The decrease in other miscellaneous operating expenses was due to decreases in the following: checks purchased expense; meals and entertainment expense; membership dues; messenger and armored service expense; subscriptions expense; examination fees; accounting and audit fees; debit card expenses; and employee training costs; which were partially offset by increases in consulting fees; legal fees; contributions expense; postage expense; telephone expense; public relations expense; insurance costs; miscellaneous loan and lease expense; credit reports expense; sundry loss expense; correspondent bank fees; other director expense; loan collection expense; and amortization expense of the investment in unconsolidated subsidiary for the affordable housing tax credit investment. The increase in occupancy and equipment costs was due to increased rent expense, computer hardware depreciation expense, compliance expense and service contract expense which were partially offset by decreases in utilities expense, equipment maintenance expense and bank-owned vehicle expense. The increase in data processing costs was due to increased expenses associated with maintaining and monitoring the Company’s data communications network and Internet banking system.

Income Taxes

The Company’s tax rate, the Company’s earnings before taxes and the amount of tax relief provided by nontaxable earnings primarily affect the Company’s provision for income taxes. In the nine months ended September 30, 2004, the Company’s provision for income taxes increased from $2,536,000 to $2,573,000 for the same period in 2003. The Company’s effective tax rate for the nine months ended September 30, 2004 was 35.2%, compared to 34.9% for the same period in 2003. The increase in the effective tax rate was due to lower nontaxable municipal bond income, which was partially offset by an investment in an affordable housing tax credit in the nine months ended September 30, 2004 compared to the same period in 2003. Nontaxable municipal bond income was $464,000 and $531,000 for the nine months ended September 30, 2004 and 2003, respectively.

In the three months ended September 30, 2004, the Company’s provision for income taxes increased $105,000 from $856,000 to $961,000 for the same period in 2003. The Bank’s effective tax rate for the three months ended September 30, 2004 was 35.8%, compared to 35.1% for the same period in 2003. The increase in the effective tax rate was due to lower nontaxable municipal bond income in the three months ended September 30, 2004 compared to the same period in 2003, which was partially offset by an investment in an affordable housing tax credit. Nontaxable municipal bond income was $153,000 and $163,000 for the three months ended September 30, 2004 and 2003, respectively.

Off-Balance Sheet Commitments

The following table shows the distribution of the Company’s undisbursed loan commitments at the dates indicated.

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Asset Quality

The Company manages asset quality and credit risk by maintaining diversification in its loan portfolio and through review processes that include analysis of credit requests and ongoing examination of outstanding loans and delinquencies, with particular attention to portfolio dynamics and loan mix. The Company strives to identify loans experiencing difficulty early enough to correct the problems, to record charge-offs promptly based on realistic assessments of current collateral values and to maintain an adequate allowance for loan losses at all times.

It is generally the Company’s policy to discontinue interest accruals once a loan is past due for a period of ninety days as to interest or principal payments. When a loan is placed on non-accrual, interest accruals cease and uncollected accrued interest is reversed and charged against current income. Payments received on non-accrual loans are applied against principal. A loan may only be restored to an accruing basis when it again becomes well secured and in the process of collection or all past due amounts have been collected.

Non-accrual loans amounted to $871,000 at September 30, 2004 and were comprised of three agricultural loans totaling $844,000 and two commercial loans totaling $27,000. At December 31, 2003, non-accrual loans amounted to $3,877,000 and were comprised of six commercial loans totaling $395,000, and nine agricultural loans totaling $3,482,000. At September 30, 2003, non-accrual loans amounted to $3,677,000 and were comprised of six commercial loans totaling $247,000, eleven agricultural loans totaling $3,410,000 and four installment loans totaling $20,000. The decrease in non-accrual loans at September 30, 2004 from the balance at December 31, 2003 was due to six commercial loans for which the Company received payments and/or were charged off, and nine agricultural loans, six that received payments, one that received a payment was partially charged off, one that was charged off and one with the remaining balance transferred to other real estate owned which was subsequently sold. Nearly all of the remaining non-accrual loan balances can be attributed to a relationship with one of the Company’s business customers, consisting of two agricultural loans which are in the process of collection. These loans did not require a significant increase in loan loss allowances because they were adequately collateralized. The Company’s management believes that nearly $833,000 of the non-accrual loans at September 30, 2004 are adequately collateralized or guaranteed by a governmental entity, and the remaining $38,000 may have some potential loss which management believes is sufficiently covered by the Company’s existing loan loss allowance. See “Allowance for Loan Losses” below for additional information. No assurance can be given that the existing or any additional collateral will be sufficient to secure full recovery of the obligations owed under these loans.

At September 30, 2004, the Company had no loans 90 days past due and still accruing. Such loans amounted to $4,000 at December 31, 2003, and $1,000 at September 30, 2003.

Allowance for Loan Losses

The Company’s Allowance for Loan Losses is maintained at a level believed by management to be adequate to provide for loan losses that can be reasonably anticipated. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. The Company makes credit reviews of the loan portfolio and considers current economic conditions, loan loss experience and other factors in determining the adequacy of the reserve balance. The allowance for loan losses is based on estimates and actual losses may vary from current estimates.

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The following table summarizes the loan loss experience of the Company for the nine-month periods ended September 30, 2004 and 2003, and for the year ended December 31, 2003.

Analysis of the Allowance for Loan Losses

(Dollars in Thousands)