Principles of Consolidation: The consolidated financial statements include the accounts of Northern States Financial Corporation (Company) and its wholly owned subsidiary, Bank of Waukegan (“Bank” or “Subsidiary”).
      All significant intercompany transactions and balances have been eliminated in consolidation.
      Nature of Operations: The Company’s and the Bank’s revenues, operating income, and assets are primarily from the banking industry. Loan customers are mainly located in Lake County, Illinois and surrounding areas, and include a wide range of individuals, businesses, and other organizations. A major portion of loans are secured by various forms of collateral, including real estate, business assets, consumer property, and other items.
      Use of Estimates: To prepare financial statements in conformity with generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The collectibility of loans, fair values of financial instruments, and status of contingencies are particularly subject to change.
      Cash Flow Reporting: Cash and cash equivalents are defined as cash and due from banks, federal funds sold, and interest-bearing deposits in financial institutions with original maturities under 90 days. Net cash flows are reported for customer loan and deposit transactions, securities sold under agreements to repurchase and other short-term borrowings, and interest-bearing deposits in financial institutions with maturities over 90 days.
      Securities: Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported separately as other compre-hensive income, net of tax. Other securities, such as Federal Home Loan Bank stock and Federal Reserve Bank stock, are carried at cost. Securities are written down to fair value when a decline in fair value is not temporary.
      Gains and losses on sales are determined using the amortized cost of the specific security sold. Interest income includes amortization of purchase premiums and discounts.
      Loans Held for Sale: Loans held for sale are reported at the lower of cost or market value in the aggregate.
      Loans: Loans are reported at the principal balance outstanding, net of deferred loan fees and costs and the

allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term.
      Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days. Payments received on such loans are reported as principal reductions.
      Allowance for Loan Losses: Because some loans may not be repaid in full, an allowance for loan losses is recorded. Increases to the allowance are recorded by a provision for loan losses charged to expense. Estimating the risk of loss and the amount of loss on any loan is necessarily subjective. Accordingly, the allowance is maintained by management at a level considered adequate to cover losses that are currently anticipated based on past loss experience, general economic conditions, information about specific borrower situations including their financial position and collateral values, and other factors and estimates which are subject to change over time. While management may periodically allocate portions of the allowance for specific problem loan situations, the whole allowance is available for any loan charge-offs that occur. A loan is charged-off by management as a loss when deemed uncollectible, although collection efforts continue and future recoveries may occur.
      While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to provide additions to the allowance based on their judgements at the time of their examinations.
      Loans are considered impaired if full principal or interest payments are not anticipated. Impaired loans are carried at the present value of expected cash flows dis-counted at the loan’s effective interest rate or at fair value of the collateral if the loan is collateral dependent. A portion of the allowance for loan losses is allocated to impaired loans.
      Smaller-balance homogeneous loans are evaluated for impairment in total. Such loans include residential first mortgage loans secured by one-to-four family residences, residential construction loans, and automobile, home equity and second mortgage loans. Commercial loans and mortgage loans secured by other properties are evaluated individually for impairment. All loans in nonaccrual status and other selected watch list loans are considered impaired. Impaired loans or portions thereof are charged off when deemed uncollectible.