The following is our discussion and analysis of certain significant factors that have affected our financial position and operating results and those of our subsidiaries, Appalachian Community Bank (the "Bank"), Appalachian Community Bank, F.S.B. (the "Thrift"), and Appalachian Real Estate Holdings, Inc. (the "Real Estate Holding Company") during the periods included in the accompanying financial statements. This commentary should be read in conjunction with the financial statements and the related notes and the other statistical information included in this report.

This report contains "forward-looking statements" relating to, without limitation, future economic performance, plans and objectives of management for future operations, and projections of revenues and other financial items that are based on the beliefs of management, as well as assumptions made by and information currently available to management. The words "may," "will," "anticipate," "should," "would," "believe," "contemplate," "expect," "estimate," "continue," "may," and "intend," as well as other similar words and expressions of the future, are intended to identify forward-looking statements. Our actual results may differ materially from the results discussed in the forward-looking statements, and our operating performance each quarter is subject to various risks and uncertainties that are discussed in detail in our filings with the Securities and Exchange Commission, including, without limitation:

• significant increases in competitive pressure in the banking and financial services industries;

• the challenges, costs and complications associated with the continued development of our branches;

• changes in the interest rate environment which could reduce anticipated or actual margins;

• changes in deposit rates, net interest margin and funding sources;

• changes in political conditions or the legislative or regulatory environment and the potential negative effects of future legislation affecting financial institutions (including without limitation, laws concerning taxes, banking, securities and insurance);

• general economic conditions, either nationally or regionally and especially in our primary service area, becoming less favorable than expected resulting in, among other things, a deterioration in credit quality;

• changes occurring in business conditions and inflation;

• changes in technology;

• the level of allowance for loan loss, the potential that loan charge-offs may exceed the allowance for loan losses or that such allowance will be increased as a result of factors beyond our control;

• the rate of delinquencies and amounts of charge-offs;

• the rates of loan growth and risks inherent in making loans including repayment risks and value of collateral;

• the timely development and acceptance of products and services, including products and services offered through alternative delivery channels;

• adverse changes in asset quality and resulting credit risk-related losses and expenses;

• loss of consumer confidence and economic disruptions resulting from terrorist activities;

• the impact of changes in accounting policies by the Securities and Exchange Commission;

• changes in the securities markets; and

• other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

Overview

We were incorporated in 1996 to serve as the bank holding company for Appalachian Community Bank (formerly Gilmer County Bank), a state-chartered bank located in the foothills of the Blue Ridge Mountains in North Georgia. We are headquartered in Ellijay, Georgia, and, in March 2006, we opened our new headquarters and operations center, also located in Ellijay. Since April 2007, we also serve as the holding company for Appalachian Community Bank, F.S.B., a federally-chartered thrift. In June 2008 we formed Appalachian Real Estate Holding Company, Inc. to hold certain real estate that may be acquired by the Bank and the Thrift through foreclosure. All of our subsidiaries are 100% owned by Appalachian Bancshares, Inc.

Our primary market areas are Gilmer, Union, Fannin, Murray, Dawson, Lumpkin and Whitfield Counties, Georgia, and nearby Polk County, Tennessee, and Cherokee County, North Carolina. We provide a full range of community banking services, through the Bank and the Thrift, to individuals and small- to medium-sized businesses located within our market areas, through thirteen full-service branches in Ellijay, East Ellijay, Blue Ridge, Blairsville, Chatsworth, Dawsonville, McCaysville, Dahlonega and Dalton, Georgia, as well as Murphy, North Carolina and Ducktown, Tennessee. The following discussion describes our results of operations for the three months and nine months ended September 30, 2008, as compared to the three months and nine months ended September 30, 2007, and analyzes our financial condition as of September 30, 2008, as compared to December 31, 2007.

Like most community banks and thrifts, we derive the majority of our income from interest and fees received on our loans. Our primary source of funds for making loans and for the purchase of investments is our deposits, on the majority of which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income earned on our interest-earning assets, such as loans and investments, and the interest paid on our interest-bearing liabilities, such as deposits and borrowings. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread.

Of course, there are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We maintain this allowance by charging a provision for loan losses against our earnings. We have included in this section a detailed discussion of this process.

In addition to earning interest on our loans and investments, we earn income through fees and other charges to our customers. We have also included a discussion of the various components of this noninterest income, as well as of our noninterest expense.

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in this report.

Critical Accounting Policies

In the preparation of our consolidated financial statements, we have adopted various accounting policies that govern the application of GAAP in the United States as well as the general practices within the banking industry. Our significant accounting policies are described in the notes to our audited consolidated financial statements as of December 31, 2007, as filed in our Annual Report on Form 10-K.

Certain accounting policies involve significant judgments and assumptions by management, which may have a material impact on the carrying value of certain assets and liabilities. We consider such accounting policies to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates. These differences could have a material impact on our carrying values of assets and liabilities and our results of operations.

We believe the determination of the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates when preparing our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, cash flow assumptions, the determination of loss factors for estimating credit losses, the impact of current events and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management's estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Results of Operations

Income Statement Review

Three and nine months ended September 30, 2008 and 2007

Overview

We had a net loss for the nine months ended September 30, 2008 of $782,000, compared to a net income of $4.5 million for the same period in 2007, a decrease of 117.5%. Our net loss for the three months ended September 30, 2008 was $2.6 million, compared to net income of $1.4 million for the same period in 2007, a decrease of 286.2%. Basic and diluted losses per share were $0.15 for the nine months ended September 30, 2008 and $0.49 for the quarter ended September 30, 2008, compared to earnings per share of $0.85 for the nine months ended September 30, 2007 and $0.27 for the quarter ended September 30, 2007. Return on average assets was a negative 0.10% for the nine months ended September 30, 2008 and a negative 0.95% for the quarter ended September 30, 2008, compared to 0.71% for the nine months ended September 30, 2007 and 0.63% for the quarter ended September 30, 2007. Return on average equity was negative 1.38% for the nine months ended September 30, 2008 and negative 13.70% for the quarter ended September 30, 2008, compared to 8.62% for the nine months ended September 30, 2007 and 7.84% for the quarter ended September 30, 2007. Our net interest margin was 3.88% and 3.33% for the nine months and quarter ended September 30, 2008, compared to 4.76% and 4.58% for the nine months and quarter ended September 30, 2007. Our decrease in net income for the nine months and the quarter ended September 30, 2008 was primarily due to the large increase in our provision for loan losses, our decrease to net interest margin, losses on our sales of other real estate ("ORE"), the write-down of our 20,000 shares of Federal Home Loan Mortgage Corporation ("Freddie Mac") Preferred Stock, increase in nonaccrual loans, and the increase to other operating expenses necessary to support the Company's growth.

Net Interest Income

Our primary source of revenue is net interest income, which represents the difference between the income on interest-earning assets and expense on interest-bearing liabilities. During the first nine months of 2008, net interest income was consistent remaining at $27.7 million compared to the same period in 2007. For the three months ended September 30, 2008, net interest income decreased 10.3% to $8.4 million, from $9.4 million during the comparable period in 2007. Although our average net loans increased to $851.7 million during the first nine months ended September 30, 2008 from $697.1 million during the same period in 2007, our average interest yield on these loans over the same periods decreased to 7.76% in 2008 from 9.60% in 2007. Total revenue, net of interest expense, was $30.7 million and $8.9 million for the nine months and three months ended September 30, 2008, respectively, which represents a decrease of 3.4% and 18.5% over the same periods in 2007, respectively. The decrease in total revenue is a result of the lower yield on earning assets, as well as the write-down of our 20,000 shares of Freddie Mac Preferred Stock.

On September 7, 2008, the U.S. Treasury and the Federal Housing Finance Agency (the "FHFA") announced, among other things, that Freddie Mac was being placed under conservatorship, that control of its management was being given to its regulator, the FHFA, and that Freddie Mac was prohibited from paying dividends on its Common and Preferred Stock. The estimated fair value of the Company's investment in Freddie Mac Preferred Stock has declined significantly and it remains unclear when and if the value of this investment will improve. As a result, during the quarter ended September 30, 2008, we recognized an other than temporary impairment on our 20,000 shares of Freddie Mac Preferred Stock in the amount of $816,000.

The net interest margin, or the net yield on earning assets, is computed by dividing taxable equivalent net interest income by average earning assets. This ratio represents the difference between the average yield returned on average earning assets and the average rate paid for funds used to support those earning assets. The taxable equivalent net interest margin was 3.88% for the nine month period ended September 30, 2008 compared to 4.76% for the same period in 2007. Net interest spread, the difference between the rate we earn on interest-earning assets and the rate we pay on interest-bearing liabilities, was 3.63% for the first nine months of 2008 compared to 4.31% during the same period for 2007. During the nine months ended September 30, 2008, the Prime rate ("Prime") dropped a total of 2.25%. Prime dropped 2.75% from September 30, 2007 to September 30, 2008. These decreases lowered the yield on earning assets more rapidly than it lowered the cost of funds. The average maturity of our time deposits at September 30, 2008 was 7.9 months. These time deposits made up 67% of our total deposits at September 30, 2008. Prime dropped an additional 1.0% in October 2008, and as a result, the interest margin compression continues to be a banking industry concern. Additionally, loans placed on nonaccrual status required us to reverse interest income associated with these loans during the quarter ended September 30, 2008. This interest reversal had an effect on our net interest margin during the nine and three month periods ending September 30, 2008 of 16 and 35 basis points, respectively. We believe, however, that we continue to maintain above average net interest margin levels, based on our peers, which is driven by our balance sheet mix and operating markets. Also, as our current temporary branch locations are converted to permanent banking facilities in our expansion markets, deposit growth in these markets will allow us to replace alternative funding sources with core deposits. Our core deposits, which exclude national and brokered deposits, have grown $168.2 million since December 31, 2007, of which $49.8 million of this growth is directly related to the opening of our Chatsworth facility in February 2008, and our Dawsonville facility in November 2007. We began construction to replace three of our current temporary locations and we plan to occupy at least two of these locations before year-end.

The following table shows, for the nine months ended September 30, 2008 and 2007, information related to our average balance sheets, average yields on assets, and average costs of liabilities. We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities. We derived average balances from the daily balances throughout the periods indicated.

                                             For the Nine Months Ended           For the Nine Months Ended
                                                September 30, 2008                  September 30, 2007
                                           Average    Income/    Yields/       Average    Income/    Yields/
                                           Balance    Expense    Rates(4)      Balance    Expense    Rates(4)
                                                                (Dollars in thousands)
Earning assets:
Loans, net of unearned income (1)         $ 851,685   $ 49,503       7.76 %   $ 697,059   $ 50,031       9.60 %
Mortgage loans held for sale                  3,508        151       5.75         3,124        142       6.08
Investment securities (2) (3)                80,908      3,138       5.18        76,545      2,845       4.97
Interest-bearing deposits                       930         14       2.01         1,876         73       5.20
Federal funds sold                           25,041        382       2.04         5,838        243       5.57

Total interest-earning assets (3)         $ 962,072     53,188       7.38     $ 784,442     53,334       9.09

Interest-bearing liabilities:
Demand deposits                           $  70,301      1,111       2.11     $  67,626      1,175       2.32
Savings deposits                            190,120      3,802       2.67       175,325      5,732       4.37
Time deposits                               561,302     18,163       4.32       419,081     16,752       5.34

Total deposits                              821,723     23,076       3.75       662,032     23,659       4.78
Other short-term borrowings                  13,863        272       2.62         7,479        191       3.41
Long-term debt                               63,425      1,910       4.02        40,569      1,530       5.04

Total interest-bearing liabilities        $ 899,011     25,258       3.75     $ 710,080     25,380       4.78

Net interest income/net interest spread                 27,930       3.63 %                 27,954       4.31 %

Net yield on earning assets                                          3.88 %                              4.76 %

Taxable equivalent adjustment:
Loans                                                       17                                  21
Investment securities                                      257                                 254

Total taxable equivalent adjustment                        274                                 275

Net interest income                                   $ 27,656                            $ 27,679

(1) Average loans exclude average nonaccrual loans of $5.6 million and $3.0 million for the nine months ended September 30, 2008 and 2007, respectively. All loans and deposits are domestic.

(2) Taxable equivalent.

(3) Average securities exclude average unrealized losses of $476,000 and unrealized losses of $452,000 for the nine months ended September 30, 2008 and 2007, respectively.

(4) Annualized.

Provision for Loan Losses

The provision for loan losses is based on the growth of the loan portfolio, the amount of net loan losses incurred and management's estimation of potential future losses based on an evaluation of the risk in the loan portfolio. The provision for loan losses was $7.1 million and $2.3 million for the nine months ended September 30, 2008 and 2007, respectively. For the three months ended September 30, 2008 and 2007, the provision for loan losses was $4.7 million and $677,000, respectively. The increase in the provision for loan losses for the nine and three month periods ended September 30, 2008 over the same periods in 2007, was primarily due to our $11.0 million increase in nonperforming loans, $2.1 million increase in net charge-offs, primarily in real estate - construction, real estate - residential and other consumer loans, the economic slow-down particularly in the real estate market in our primary market areas, as well as increases in total loans since December 31, 2007. We continue to carefully monitor real estate - construction, real estate - residential and other consumer loans to identify any potential new loan losses, charge-offs related to all types of loans, and liquidation of foreclosed assets in a timely manner. In September 2008, management and our external loan review firm completed an evaluation of our real estate loans. This evaluation placed a greater emphasis on the real estate market slow down and its impact on the values of real estate loans and the collateral securing these loans. Please see the discussion below under "Allowance for Loan Losses" for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

Noninterest Income

Noninterest income for the nine months ended September 30, 2008 was $3.1 million, compared to $4.1 million during the same period in 2007. Noninterest income decreased $1.0 million, or 69.8%, for the three months ended September 30, 2008, as compared to the same period in 2007. These amounts are primarily from customer service fees, mortgage origination commissions, earnings on cash surrender value of life insurance, insurance commissions, as well as other fees charged to customers such as safe deposit box rental and ATM fees. Noninterest income also includes the net recognized loss on securities available-for-sale. Net losses recognized on securities increased by $817,000 for the first nine months of 2008 as compared to the same period in 2007. For the three months ended September 30, 2008, net losses recognized on securities increased by $826,000, primarily due to the recognition of the loss on our Freddie Mac Preferred Stock in the amount of $816,000. Customer service fees, the largest component of noninterest income, increased $273,000, or 16.6%, to $1.9 million for the first nine months of 2008 from $1.6 million during the same period of 2007. For the three months ended September 30, 2008, customer service fees increased $110,000, or 18.8%, as compared to the same period in 2007. The increase in customer service fees is primarily related to the deposit account growth in new markets. Additionally, our continuing efforts to increase the amount of deposit account charges, including non-sufficient funds (NSF) charges and returned check charges, have had a positive effect on noninterest income. Mortgage origination commissions decreased by $313,000 for the first nine months of 2008, and decreased by $184,000 for the three months ended September 30, 2008, as compared to the same periods in 2007. The decrease in mortgage origination commissions relates primarily to the continuing decline in the mortgage activity for these periods in 2008, as compared to the same periods in 2007. Other operating income decreased by $214,000 for the first nine months of 2008, as compared to the same period in 2007. The majority of this decrease was due to a $240,000 gain on the extinguishment of an FHLB advance during the third quarter of 2007, which was offset by increases in other income items. For the three months ended September 30, 2008, other operating income decreased by $146,000 compared to the same period in 2007.

Noninterest Expenses

Noninterest expenses totaled $25.3 million for the first nine months of 2008, up from $22.8 million for the same period in 2007. Salaries and employee benefits increased $1.2 million, or 8.9%, to $15.0 million for the first nine months of 2008, as compared to the same period in 2007. This increase in salaries and employee benefits was primarily due to the additional staff necessary to support our continued market growth and our expansion into new markets, as well as the addition of several

management-level employees necessary to provide the infrastructure to support our continued growth. Since September 30, 2007, we have added 22 full-time equivalent employees. The three month increases in noninterest expenses are consistent with increases discussed for the nine months ended September 30, 2008.

Occupancy, furniture and equipment expenses totaled $3.2 million for the first nine months in 2008, compared to $2.7 million for the same period in 2007. The 18.2% increase is primarily due to our expansion efforts. As of September 30, 2008, our occupancy, furniture and equipment expenses included nine months of depreciation expense on the new Dawsonville facility, which opened in November 2007, as well as eight months depreciation on the new Chatsworth facility, which opened in February 2008. Previous to these openings we operated our Chatsworth and Dawsonville locations out of less-expensive, but less-effective, leased facilities.

Other operating expenses increased $812,000 to $7.1 million for the nine months ended September 30, 2008, compared to $6.3 million for the same period in 2007. This increase is primarily the result of increased losses on sales of ORE, and increases in state regulatory examination fees, FDIC deposit-assessments, amortization costs, and data processing costs. We had net losses on sales of ORE of approximately $702,000 during the first nine months of 2008, compared to an ORE net loss of $159,000 reported in noninterest expense in the same period of 2007. Our FDIC deposit insurance and state regulatory examination costs increased $447,000, over the same period in 2007, due primarily to the increase in our FDIC deposit-insurance assessments, which occurred in the third quarter of 2007, as well as the increase in premiums relating to our growth in deposits as compared to the same period in 2007. Amortization expense increased by $92,000 primarily due to a non-compete agreement entered into in October 2007 with a former employee which ended in March 2008. Increased data processing expenses, as well as various other expense increases, were required to support our market growth and new branches. These costs were offset in part by $222,000 decrease in promotional and advertising expense, as well as various other expense decreases resulting from management's efforts to keep other costs at a minimum without sacrificing service to our customers.

Income Taxes

We had an income tax benefit for the nine months ended September 30, 2008 of $964,000, compared to an income tax expense of $2.3 million in the same period in 2007. The tax benefit is the result of the net loss recorded during the third quarter of 2008, which created a year-to-date net loss at September 30, 2008. The effective tax benefit was 55.2% and the effective tax rate was 33.7% for the nine months ended September 30, 2008 and 2007, respectively. For the three months ended September 30, 2008, the income tax benefit was $1.7 million, compared to an income tax expense of $705,000 during the same period in 2007. The effective tax benefit was 40.0% and the effective tax rate was 33.4% for the three months ended September 30, 2008 and 2007, respectively. The effective tax rates have decreased due to the future tax benefits from our net losses.

Balance Sheet Review

General

At September 30, 2008, we had total assets of $1.1 billion, an increase of $148.3 million, or 15.3%, from $971.2 million, at December 31, 2007. Cash and cash equivalents increased $63.8 million, or 240.6% from December 31, 2007, to $90.3 million at September 30, 2008. Our total loans increased $86.6 million, or 10.7%, from December 31, 2007, to $894.1 million at September 30, 2008. Securities available-for-sale decreased 2.1%, from $80.5 million at December 31, 2007, to $78.8 million at September 30, 2008. Net premises and equipment increased $4.8 million, or 14.5%, since December 31, 2007, to $37.7 million at September 30, 2008.

Our liabilities at September 30, 2008 totaled $1.0 billion, which was an increase of 16.5% over total liabilities at December 31, 2007. Total deposits . . .