<PAGE>
 
                            SELECTED FINANCIAL DATA

                             ---------------------
<TABLE>
<CAPTION>
                                           Year Ended December 31,

                               1997       1996       1995      1994      1993                                       
--------------------------------------------------------------------------------
                                            (dollars in thousands)
<S>                          <C>        <C>        <C>       <C>       <C>      
Summary of Operations:
Interest income              $  8,353   $  8,008   $ 6,602   $ 5,996   $ 5,680
Interest expense                3,491      3,610     3,607     2,862     2,730
                             -------------------------------------------------
Net interest income             4,862      4,398     2,995     3,134     2,950
Provision for loan losses          60         50       350        26        25
                             -------------------------------------------------
Net interest income after
 provision for loan losses      4,802      4,348     2,645     3,108     2,925
Other income                      145        114       127       111       125
Other expenses (1)              2,514      2,123     1,605     1,495     1,202
                             -------------------------------------------------
Income before tax expense       2,433      2,339     1,167     1,724     1,848
Income tax expense                901        858       430       617       700
Cumulative effect of a
 change in accounting
 principle                                                                 (24)
                             -------------------------------------------------
  Net income                 $  1,532   $  1,481   $   737   $ 1,107   $ 1,124
                             =================================================
 
Selected Year-End Balances:
Total assets                 $108,092   $105,807   $87,751   $81,560   $75,826
Loans receivable, net          92,967     82,992    75,097    65,973    55,890
Investments (2)                11,483     18,945     8,884    12,693    17,022   
Deposits                       66,973     66,564    73,035    69,140    64,282
FHLB Advances                   7,800          -     1,000         -         -
Stockholders' equity           31,076     37,368    12,562    11,729    10,719
 
Average Balance Sheet Data:
Total assets                 $105,617   $103,874   $83,921   $78,890   $70,256
Total earning assets          101,909    102,336    83,058    76,125    67,128
Loans receivable, net          87,489     78,797    70,397    61,301    52,288
Investments (2)                13,696     22,907    12,481    14,825    14,840
Deposits                       66,520     68,684    70,541    66,713    59,301
FHLB Advances                   2,788         83       167         -         -
Stockholders' equity           33,869     33,115    12,283    11,317    10,219
 
Selected Financial Ratios:
Return on average assets         1.45%      1.43%      .88%     1.40%     1.60%
Return on average equity         4.52%      4.48%     6.00%     9.78%    11.00%
Average equity to average
 assets                         32.07%     31.88%    14.64%    14.34%    14.54%
Interest rate spread (tax
 equivalent basis)               3.16%      2.62%     2.86%     3.59%     3.86%
Net interest margin (tax
 equivalent basis)               4.77%      4.32%     3.62%     4.12%     4.39%
Dividend payout ratio           55.22      54.32       N/A       N/A       N/A
Cash dividends declared
 per common share (3)        $   4.45   $   0.44       N/A       N/A       N/A
Earnings per
 share--basic(4)             $   0.82   $   0.82       N/A       N/A       N/A
Earnings per
 share--diluted (4)          $   0.82   $   0.82       N/A       N/A       N/A
</TABLE>

(1) In 1996, a one time special assessment of $456,000 was imposed on Savings
    Association  Insurance Fund (SAIF) insured institutions to recapitalize the
    SAIF.

(2) Includes investment securities, mortgage backed-securities, interest-bearing
    deposits, and federal funds.

(3) Includes a $4.00 special return of capital dividend paid on July 11, 1997.

(4) Earnings per share--basic and diluted for 1997 was calculated using weighted
    average shares outstanding of 1,872,451 shares. Earnings per share for 1996
    was computed as if the 1,825,050 shares issued on March 29, 1996 had been
    outstanding on  January 1, 1996.

                                       1
<PAGE>
 
                     MANAGEMENT'S DISCUSSION AND ANALYSIS

                       --------------------------------

   Management's discussion and analysis is intended to assist readers in the
understanding and evaluation of the financial condition and results of
operations of Stone Street Bancorp, Inc. and Mocksville Savings Bank, Inc., SSB
(collectively referred to as the "Company").  It should be read in conjunction
with the audited consolidated financial statements and accompanying notes
included in this report and the supplemental financial data appearing throughout
this discussion and analysis.

                       ANALYSIS OF RESULTS OF OPERATIONS

   The Company's results of operations depend primarily on net interest income,
which is the difference between interest income from interest-earning assets and
interest expense on interest-bearing liabilities.  Operations are also affected
by non-interest income, such as income from customer service charges, loan fee
income and other sources of income.  The Company's principal operating expenses,
aside from interest expense, consist of compensation and employee benefits,
federal deposit insurance premiums, data processing expenses, office occupancy
costs, equipment expense and income taxes.

In 1997 the Company completed its year once again with record earnings.  Net
income increased to $1.53 million for the year ended December 31, 1997 compared
to $1.48 million in 1996 and $.7 million in 1995.  Growth in net interest income
combined with an increase in other income outpaced an increase in other expense
to make 1997 the most profitable year for the Company.

                              Income and Expense

                               ----------------

   Net interest income is the Company's primary source of earnings.  Table 1
shows that tax-equivalent net interest income increased by $464,000 or 10.6% in
1997 to $4.9 million from $4.4 in 1996.  Tax equivalent net interest income in
1996 was $4.4 million as compared to $3.0 million in 1995, an increase of $1.4
million or 46.7%.  Net interest income is analyzed on a tax-equivalent basis to
adjust for the nontaxable status of income earned on certain investments such as
municipal bonds.

The increase in tax-equivalent interest income in 1997 as compared to 1996 was
primarily the result of the increase in the weighted average yield from 7.87% in
1996 to 8.20% in 1997 combined with an increase in the average balances.
Average loans increased by $8.7 million or 11.0% to $87.5 million.  Average
investments increased by $1.9 million or 24.9% as stock conversion proceeds
which were initially invested in liquid interest-bearing deposits in the FHLB
were used to purchase investments.  The weighted average yield on interest-
earning assets increased by 33 basis points in 1997.  In 1996, tax-equivalent
interest income rose 21.2% primarily due to increases in the average balances of
interest-earning assets of 22.7% increasing from $82.9 million in 1995 to $101.7
million in 1996.

Interest expense decreased by $119,000 in 1997 due primarily to a reduction in
the weighted average rate paid on interest- bearing liabilities of 19 basis
points. The balance of average interest-bearing liabilities increased $541,000
or .78%  primarily due to the $2.8 million increase in average balance of
borrowings from the FHLB net of $2.2 decrease in average deposits.

Interest expense increased by only $4,000 in 1996.  Average interest-bearing
liabilities decreased by $1.8 million or 2.74% in 1996 while the average rate
paid on those liabilities increased by 14 basis points.   As a result, the
increase in interest expense in 1996 was due primarily to increases in deposit
rates.

Interest rate spread (on a tax equivalent basis) increased to 3.16% in 1997 from
2.62% in 1996 due to the increase in the yield on interest earning assets
combined with the decrease in average rate on interest bearing liabilities.  Net
interest margin increased to 4.77% in 1997 from 4.32% in 1996.  Interest rate
spread declined to 2.62% in 1996 from 2.86% in 1995 as the increase in the cost
of interest-bearing liabilities outpaced the increase in the yield on interest-
earning assets.  Despite the decline in interest rate spread, net interest
margin (on a tax equivalent basis) increased to 4.32% in 1996 from 3.62% in
1995.  While Conversion proceeds were invested at yields somewhat less than the
weighted average yield on total interest-earning assets, those investments
contributed to the increase in net interest margin.

                                       4
<PAGE>
 
--------------------------------------------------------------------------------

Table 2 shows the effect of variances in volume and rate on taxable-equivalent
interest income, interest expense, and net interest income.  The table shows
that increases in net interest income were due to volume and rate changes in
1997 while increases in net interest income in 1996 were primarily due to volume
changes.

<TABLE> 
<CAPTION> 

Table 1:  NET INTEREST INCOME ANALYSIS-TAX EQUIVALENT
-------------------------------------------------------------------------------------------------------------------------------
 
                                                     1997                          1996                         1995
                                         ---------------------------   ---------------------------   --------------------------
 
                                                             Average                       Average                      Average
                                          Average             Yield/    Average             Yield/   Average             Yield/
                                          Balance  Interest     Rate    Balance  Interest     Rate   Balance  Interest     Rate
                                         ---------------------------   ---------------------------   --------------------------
                                                                          (dollars in thousands)
<S>                                      <C>       <C>       <C>       <C>       <C>       <C>       <C>      <C>       <C> 
Assets:
Interest-earning assets:
 Loans receivable (1)                    $ 87,489    $7,490     8.56%  $ 78,797    $6,662     8.45%  $70,397    $5,980     8.50%
 Investment securities (2)                  9,517       519     5.45%     7,617       607     6.75%    8,646       383     4.43%
 Interest-bearing deposits                  4,179       291     6.96%    14,645       692     4.72%    3,273       198     6.04%
 FHLB common stock                            724        53     7.32%       645        47     7.29%      562        41     7.30%
                                         ---------------------------   ---------------------------   --------------------------
Total interest-earning assets             101,909     8,353     8.20%   101,704     8,008     7.87%   82,878     6,602     7.97%
Non-interest-earning assets                 3,708                         2,170                        1,043
                                         --------                      --------                      -------
  TOTAL                                  $105,617                      $103,874                      $83,921
                                         ========                      ========                      =======
 
Liabilities and stockholders' equity:
Interest-bearing liabilities:
 Deposit accounts                        $ 66,520    $3,345     5.03%  $ 68,684     3,604     5.24%  $70,541    $3,607     5.11%
 FHLB advances                              2,788       146     5.24%        83         6     8.43%        -         -        -
                                         ---------------------------   ---------------------------   --------------------------
Total interest-bearing liabilities         69,308     3,491     5.04%    68,767     3,610     5.25%   70,541     3,607     5.11%
Non-interest-bearing liabilities            2,440                         1,992                        1,097
Stockholders' equity                       33,869                        33,115                       12,283
                                         --------                      --------                      -------
  TOTAL                                  $105,617                      $103,874                      $83,921
                                         ========                      ========                      =======
 
Net interest income and interest
 rate spread                                         $4,862     3.16%              $4,398     2.62%             $2,995     2.86%
                                                     ======   ======               ======   ======              ======   ======
Net interest- earning assets
 and net interest margin                 $ 32,601               4.77%  $ 32,937               4.32%  $12,337               3.62%
                                         ========             ======   ========             ======   =======             ======
Ratio of interest-earning assets
 to interest bearing liabilities                              147.04%                       147.90%                      117.49%
                                                              ======                        ======                       ======
</TABLE>

(1)  Includes nonaccrual loans

(2) Interest earned on tax-exempt investment securities has been adjusted to a
    tax-equivalent basis using the applicable federal rate of 34% and state
    rates in 1997 and 1996 of 7.50%, and 7.75% respectively, and reduced by the
    nondeductible portion of interest expense.

<TABLE> 
<CAPTION> 

Table 2:  RATE/VOLUME ANALYSIS
--------------------------------------------------------------------------------------------------------------
 
                                                      1997 vs 1996                      1996 vs 1995
                                              -----------------------------   --------------------------------
                                                               Rate/                           Rate/
                                              Volume   Rate   Volume    Net   Volume   Rate   Volume     Net
                                              -----------------------------   --------------------------------
                                                                   (dollars in thousands)
<S>                                           <C>      <C>    <C>      <C>    <C>      <C>    <C>      <C>
 
Interest income (tax-equivalent) on:
 Loans                                         $ 734    (86)      (8)   828   $  714    (31)   $  (4)  $  679
 Investment securities                           151   (191)     (48)   (88)     (45)   306      (37)     224
 Interest-bearing deposits                      (494)   328     (235)  (401)     687    (43)    (150)     494
 FHLB common stock                                 6      -        -      6        6      -        -        6
                                              -----------------------------   --------------------------------
  Total interest income                          397    223     (275)   345    1,362    232     (191)   1,403
                                              -----------------------------   --------------------------------
 
 Deposit accounts                               (113)  (151)       5   (259)     (95)    92        -       (3)
 FHLB advances                                   228     (3)     (85)   140        7      -        -        7
                                              -----------------------------   --------------------------------
  Total interest expense                         115   (154)     (80)  (119)     (88)    92        -        4
                                              -----------------------------   --------------------------------
 
Increase (decrease) in net interest income     $ 282    377     (195)   464   $1,450   $140    $(191)  $1,399
                                              =============================   ================================
</TABLE> 

                                       5
<PAGE>
 
--------------------------------------------------------------------------------

                         INCOME AND EXPENSES Continued

                           Provision for Loan Losses

   The provision for loan losses is charged to earnings to maintain the total
allowance for loan losses at a level considered adequate to cover loan losses
based on existing loan levels and types of loans outstanding, nonperforming
loans, prior loan loss experience, industry standards and general economic
conditions.  Provisions for loan losses were $60,000 in 1997 compared to $50,000
in 1996, and $350,000 in 1995.  During 1995, the provision and resulting
allowance for loan losses were increased based on management's efforts to
reflect industry practices regarding the allowance for loan losses.  During 1996
and 1997, the provision was lowered, largely as a result of an improved level of
the relationship between the allowance and outstanding loans.

                                 Other Income

   Other income increased from $114,000 in 1996 to $145,000 in 1997, and was
$127,000 in 1995.  The increase in other income was primarily in customer
service charges and other fees which increased $30,000 in 1997 from the 1996
level.  Other income in 1996 decreased $8,000 over the 1995 amount.  This
decrease was primarily in loan fees and charges that totaled $45,000 in 1996
compared to $53,000 in 1995.

                                Other Expenses

   Other expenses increased by 18.4% in 1997 compared to an increase of 32.3% in
1996.  As a percent of average assets, other expense for 1997 was 2.4% as
compared to 2.0% in 1996 and 1.9% in 1995.

Other expenses totaled $2,514,000 in 1997 compared to $2,123,000 and $1,605,000
in 1996 and 1995, respectively.  This significant increase was primarily
attributable to large expenses that occurred in the second quarter of fiscal
year 1997 related to the ESOP and MRP plans of the Company.  First, in 1997, the
Company recorded $351,000 of compensation expense related to the Company's
employee stock ownership plan ("ESOP"), primarily associated with the release
and allocation of approximately 23,617 shares of common stock of the Parent to
participants of the ESOP during 1997.  The special dividend paid on the Parents
stock on July 11, 1997 and management's decision to use the special dividends
paid on the unallocated shares of the Parent's common stock held by the ESOP to
pre-pay the ESOP loan from the Parent to the ESOP resulted in a significant
portion of that share release, approximately 15,869 shares.  As a result,
approximately, $171,000 of the ESOP-related compensation expense is deemed to be
of a non-recurring nature.

Without the effect of the non-recurring portion of ESOP-related compensation
expense, other expenses would have totaled $2,343,000, a $220,000 increase from
1996.  Compensation and fringe benefits, excluding non-recurring items,
increased by $569,000 to $1,582,000 compared to $1,013,000 in 1996, primarily
related to the ESOP and the Company's management recognition plan ("MRP").  The
ESOP, which was established in conjunction with the Conversion in 1996 provides
a potentially higher level of retirement benefits to employees than the previous
retirement plan. The recurring portion of ESOP-related compensation expense for
1997 totaled $180,000 compared to $175,000 recorded for 1996.  Also contributing
to the increase in compensation expense was $353,000 of amortization of deferred
compensation associated with the MRP implemented May 9, 1997.

"Other" other expenses increased $113,000 to $390,000 in 1997 from $277,000 in
1996 due to increases in marketing expenses, shareholder reporting expenses, and
franchise tax expenses.  These increased expenses are mitigated to a degree by a
$535,000 decrease in FDIC-insurance premiums to $46,000 for 1997 from $581,000
for 1996 which included a special one time assessment of $456,000.  Deposit
insurance premiums decreased starting with the quarter ended December 31, 1996.
The reduced level of FDIC-insurance premiums is anticipated to continue into the
future.

Occupancy and equipment expense increased by $45,000 or 20.8% in 1997 over 1996
as the Bank improved its customer information technology.  Professional fees
increased $28,000 from 1996 which included costs associated with the conversion
and regulatory filings.

                                       6
<PAGE>
 
--------------------------------------------------------------------------------

                        ANALYSIS OF FINANCIAL CONDITION

                          ---------------------------

Other expenses increased by 32.3% in 1996 compared to an increase of 7.4% in
1995. As a percent of average assets, other expense for 1996 was 2.0% as
compared to 1.9% in 1995.

Compensation and fringe benefits in 1996 representing over 47.72% of total other
expenses increased by $56,000 or 5.9% over 1995.  Retirement expense increased
by $24,000 in 1996 over 1995.  Retirement expense in 1996 reflects the
implementation of the Bank's Employee Stock Ownership Plan ("ESOP") which
provides a higher level of retirement benefits to employees than the retirement
plan which was in place in previous years.  Director's compensation increased by
$21,500 in 1996 due to extra meetings associated with the Conversion and
employee benefit programs.

Occupancy and equipment expense decreased by $26,000 in 1996 from 1995.  Reasons
for the increase in 1995 included investments in technology primarily the
installation of an ATM machine, and related costs.  Deposit insurance premiums
increased $423,000 over the 1995 level due to the special one time assessment by
the FDIC in September, 1996. Professional fees increased by $5,000 in 1996
compared to 1995 as the Company obtained assistance in making the transition
from mutual to stock ownership.

Management continues to look for ways to improve cost efficiency while offering
new services to its customers.

                              Income Tax Expense

          Income tax expense increased $43,000 or 5.0% to $901,000 in 1997 from
$858,000 in 1996.  The effective tax rate was 37.0% in 1997 to 36.7% in 1996.
Income tax expense totaled $430,000 in 1995, and the effective tax rate was
36.8%.  Changes in income tax expenses were caused primarily by changes in net
income.

                        ANALYSIS OF FINANCIAL CONDITION

                          ---------------------------

   On March 29, 1996 Mocksville Savings Bank, Inc., SSB (the "Bank") completed
its conversion from a mutual to a stock savings bank through the sale of
1,825,050 shares of no par common stock of Stone Street Bancorp, Inc. (the
"Parent"). Total proceeds of $27,375,750 were reduced by Conversion expenses of
$1,116,905.  The Parent retained 50% of the net conversion proceeds after
deducting the proceeds of a loan to the Bank's Employee Stock Ownership Plan
("ESOP") and paid the balance to the Bank in exchange for the common stock of
the Bank issued in the Conversion.  The increase in assets from $87.8 million at
December 31, 1995 to $105.8 million at December 31, 1996 is directly
attributable to proceeds of the Conversion which were invested in loans and
investment securities.

                                     Loans

   The Company's primary source of revenue is interest and fee income from
lending activities, consisting primarily of one-to-four family residential
mortgage loans located in its primary market area.  The Company also makes loans
secured by improved nonresidential real estate, construction loans, loans
secured by undeveloped real estate, home equity loans, and consumer loans, both
secured and unsecured.

At December 31, 1997, the net loan portfolio totaled $93.0 million and
represented 86% of total assets.  During 1997, loans increased by $10.0 million
or 12%.  Loan originations increased from $23.3 million in 1996 to $27.6 million
in 1997, largely in response to the Company's efforts to expand its loan
programs into adjacent counties.  The relative composition of the Company's loan
portfolio has remained consistent during recent years, with residential one-to-
four family loans comprising approximately 82% of the portfolio as of December
31, 1997.  Table 3 sets forth the composition of the loan portfolio at the dates
indicated.

                                       7
<PAGE>
 
<TABLE>
<CAPTION>
  
Table 3:  TYPES OF LOANS
-----------------------------------------------------------------------------------------------------------------------------------
 
                                                                         December 31,
                              -----------------------------------------------------------------------------------------------------
                                     1997                 1996                1995                 1994                 1993
                              ------------------   -------------------  ------------------   ------------------  ------------------
                              Amount  Percentage    Amount  Percentage  Amount  Percentage   Amount  Percentage  Amount  Percentage
                              ------  ----------    ------  ----------  ------  ----------   ------  ----------  ------  ----------
                                                                      (dollars in thousands)
<S>                          <C>         <C>      <C>         <C>      <C>         <C>      <C>         <C>      <C>         <C>
Real estate loans:                                                    
 Residential 1-4 family       $76,894   82.71%     $67,844   81.75%     $63,329   84.33%     $54,321   82.34%     $45,724   81.81%
 Nonresidential real estate     9,541   10.26        5,716    6.88        4,260    5.67        4,987    7.56        5,312    9.50
 Home equity and other       
  second mortgage               2,675    2.88        2,473    2.98        2,185    2.91        1,423    2.16        1,447    2.59
 Construction                   8,571    9.22       12,492   15.05       11,735   15.63       11,589   17.56        8,033   14.37
                              ---------------      ---------------      ---------------      ---------------      ---------------
  Total real estate loans      97,681  105.07       88,525  106.66       81,509  108.54       72,320  109.62       60,516  108.27
Other installment loans           632     .68          372     .45          222     .30          197    0.30          133    0.24
   Less:                     
 Unearned fees                  1,058    1.14        1,009    1.22          962    1.29        1,095    1.66          711    1.27
 Loans in process               3,718    4.00        4,385    5.28        5,211    6.94        5,334    8.09        3,959    7.08
 Allowance for loan losses        570     .61          511     .61          462     .61          115    0.17           89    0.16
                              ---------------      ---------------      ---------------      ---------------      ---------------
 Total reductions               5,346    5.75        5,905    7.11        6,635    8.84        6,544    9.92        4,759    8.51
                              ---------------      ---------------      ---------------      ---------------      ---------------
                             
   Total loans, net           $92,967  100.00%     $82,992  100.00%     $75,096  100.00%     $65,973  100.00%     $55,890  100.00%
                              ===============      ===============      ===============      ===============      ===============
----------------------------------------------------------------------------------------------------------------------------------- 

</TABLE>

In order to protect the Company's net interest margin, management has, as part
of its interest rate risk management program, placed an emphasis on increasing
adjustable rate mortgage loans and home equity lines of credit in its portfolio.
This strategy will result in more consistent net interest income and lower
interest sensitivity than experienced by traditional fixed-rate residential
mortgage lending.

The following table sets forth the time to repricing or contractual maturity of
the Company's loan portfolio at December 31, 1997.  Loans which have adjustable
rates are shown as being due in the period during which rates are next subject
to change, while fixed rate and other loans are shown as due in the period of
contractual maturity.  Demand loans, loans having no stated maturity and
overdrafts are reported as due in one year or less.  The table does not include
prepayments or scheduled principle repayments.  Amounts in the table are net of
loans in process.

<TABLE> 
<CAPTION> 
Table 4:  LOAN MATURITIES
----------------------------------------------------------------------------------------------- 
                                                     December 31, 1997
                             ------------------------------------------------------------------
                                         Over 1    Over 3     Over 5    
                             One Year    Year to   Years to   Years to    Over 10    
                             Or Less     3 Years   5 Years    10 Years     Years       Total 
                             ------      -----     ------     -------     -------     ------- 
<S>                          <C>         <C>       <C>        <C>         <C>         <C>
                                                (dollars in thousands)               
Fixed rate 1-4 family        $   89       $475     $2,934     $31,027     $45,154     $79,679
Adjustable rate 1-4 family    1,247                                                     1,247
Adjustable home equity        2,438                                                     2,438
Fixed rate-nonresidential         1         41        709       3,858       4,932       9,541
Other loans                     632                                                       632
Less:                                                                             
 Allowance for loan losses     (570)                                                     (570)
                             ------       ----     ------     -------     -------     -------
  Total Loans                $3,837       $516     $3,643     $34,885     $50,086     $92,967
                             ======       ====     ======     =======     =======     =======
-----------------------------------------------------------------------------------------------  
</TABLE>

                                       8
<PAGE>
 
--------------------------------------------------------------------------------

                  Asset Quality and Allowance for Loan Losses


The following table sets forth information with respect to nonperforming assets
including nonaccrual loans and real estate owned at the dates indicated.

Table 5:  SUMMARY OF NONPERFORMING AND PROBLEM ASSETS
--------------------------------------------------------------------------------
 
                                                December 31,
                             --------------------------------------------------
                               1997       1996       1995      1994      1993
                             ---------  ---------  --------  --------  --------
                                           (dollars in thousands)
 
Total nonaccrual loans       $      -   $      -   $     -   $     -   $     -
Total restructured loans            -          -         -         -         -
                             --------   --------   -------   -------   -------
 Total nonperforming loans          -          -         -         -         -
                             --------   --------   -------   -------   -------
Real estate owned                              -         -         -         -
In-substance foreclosures           -          -         -         -         -
                             --------   --------   -------   -------   -------
 Total foreclosed property          -          -         -         -         -
                             --------   --------   -------   -------   -------
Total nonperforming assets   $      -   $      -   $     -   $     -   $     -
                             ========   ========   =======   =======   =======
 
Accruing loans, delinquent
 90 days or more             $    295   $    423   $   201   $   280   $   292
                             ========   ========   =======   =======   =======
 
Nonperforming loans to
 total loans                     0.00%      0.00%     0.00%     0.00%     0.00%
Nonperforming assets to
 total assets                    0.00%      0.00%     0.00%     0.00%     0.00%
Total assets                 $108,092   $105,807   $87,751   $81,560   $75,826
Total loans, net             $ 92,967   $ 82,992   $75,097   $65,973   $55,890
--------------------------------------------------------------------------------

The allowance for loan losses represents management's estimate of an amount
adequate to provide for potential losses inherent in the loan portfolio.  The
adequacy of the allowance for loan losses and the related provision are based
upon management's evaluation of the risk characteristics of the loan portfolio
under current economic conditions with consideration to such factors as
financial condition of the borrowers, collateral values, growth and composition
of the loan portfolio, the relationship of the allowance for loan losses to
outstanding loans, and delinquency trends.  Management believes that the
allowance for loan losses is adequate.  While management uses all available
information to recognize losses on loans, future additions to the allowance may
be necessary based on changes in economic conditions.  Various regulatory
agencies, as an integral part of their examination process, periodically review
the Company's allowance for loan losses.  Such agencies may require the Company
to recognize additions to the allowance based on their judgments about
information available to them at the time of their examination.

The provision for loan losses is calculated and charged to earnings to maintain
the total allowance for loan losses at a level considered adequate to cover loan
losses based on existing loan levels, types of loans outstanding, nonperforming
loans, prior loan loss experience, industry standards and general economic
conditions.  Provisions for loan losses were $60,000 in 1997 compared to $50,000
in 1996, and $350,000 in 1995.  During 1995, the provision and resulting
allowance for loan losses were increased based on management's efforts to
reflect industry practices regarding the allowance for loan losses.  During 1996
and 1997, the provision was lowered, largely as a result of an improved level of
the relationship between the allowance and outstanding loans.

                                       9
<PAGE>
 
--------------------------------------------------------------------------------

The following tables describe the activity related to the allowance for loan
losses and the allocation of the allowance for loan losses to various categories
of loans for the periods indicated.

Table 6:  ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
--------------------------------------------------------------------------------
 
                                              Year Ended December 31
                                       1997    1996    1995    1994    1993
                                      ------  ------  ------  ------  ------
                                                  (in thousands)
 
Balance, beginning of period          $ 511   $ 462   $ 115   $  89   $  65
Provision for loan losses                60      50     350      26      25
Charge-offs                               1       1       3       -       1
Recoveries                                -       -       -       -       -
                                      -----   -----   -----   -----   -----
Balance, end of period                $ 570   $ 511   $ 462   $ 115   $  89
                                      =====   =====   =====   =====   =====
 
Allowance as a percentage of loans      .61%    .62%    .62%    .17%    .16%
 
Table 7:  ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
--------------------------------------------------------------------------------
 
                                                   December 31,
                                         ---------------------------------
                                         1997   1996   1995   1994   1993
                                         ---------------------------------
                                                  (in thousands)
 
Residential 1-4 family                   $ 154  $ 138  $ 127  $  45  $  35
Nonresidential real estate                 171    153    138     23     19
Home equity and other second mortgage       58     52     46     12     10
Construction                               143    128    115     24     16
                                         ---------------------------------
Total real estate loans                    526    471    426    104     80
Other loans                                 44     40     36     11      9
                                         ---------------------------------
Total allowance for loan losses          $ 570  $ 511  $ 462  $ 115  $  89
                                         =================================

The allocation of the allowance for loan losses to the respective loan
classifications is not necessarily indicative of future losses or future
allocations.  Refer to Table 3 for percentages of loans in each category to
total loans.


                             Investment Securities

   Interest and dividend income from interest bearing deposits and investment
securities generally provides the second largest source of income to the Company
after interest on loans.  The Company's interest bearing deposits primarily
include deposits with the FHLB of Atlanta and federal funds, while its portfolio
of investment securities includes U.S. government and agency securities,
mortgage-backed securities, obligations of states and local governments and
mutual funds.  The mortgage-backed securities consist of collateralized mortgage
obligations issued by the GNMA and FHLMC which are secured by mortgage-backed
securities guaranteed by the GNMA or FHLMC.

Interest bearing deposits totaled $2.5 million at December 31, 1997, a decrease
of $5.4 million from 1996.  These funds were used to pay the special dividend of
$4.00 per share in July 1997 to the stockholders.  The Company also had
$1,034,000 of federal funds sold at December 31, 1997, an increase of $464,000
over 1996.

                                       10
<PAGE>
 
Investment securities totaled $7.7 million at December 31, 1997, a decrease of
$2.7 million from $10.4 million at December 31, 1996. Proceeds from matured
investments were also used to fund the special dividend paid to stockholders in
1997. At December 31, 1997, net unrealized gains of $4,678 were included in the
carrying value of securities classified available-for-sale compared to net
unrealized losses of $7,600 on such securities at December 31, 1996. Net
unrealized gains or losses were caused by fluctuations in market interest rates
rather than by concerns about the issuer's ability to meet their obligations.

Table 8 shows maturities of investment securities held by the Company at
December 31, 1996 and the weighted average tax-equivalent yields for each type
of security and maturity. Further information about the Company's investment
securities as of December 31, 1996 and 1995 is presented in Note 2 of the notes
to the consolidated financial statements.

Table 8:  INVESTMENT SECURITIES - MATURITY/YIELD SCHEDULE
---------------------------------------------------------
<TABLE>
<CAPTION>
 
                                                                           More than
                                One Year or Less    1 Year to 5 Years  5 Years to 10 Years       Over 10 Years              Total
                               ------------------- ------------------- --------------------  -----------------   ------------------
                                         Weighted           Weighted   Weighted              Weighted            Weighted
                               Carrying   Average  Carrying  Average   Carrying    Average   Carrying  Average   Carrying  Average
                                Value      Yield    Value     Yield      Value      Yield     Value     Yield     Value     Yield
                               --------  --------- -------- ---------  ---------  ---------  --------  --------  --------  --------
                                                                     (dollars in thousands)
<S>                              <C>       <C>      <C>       <C>       <C>        <C>       <C>       <C>        <C>        <C>
Held-to-Maturity:
U.S. government and agency       $ 2,749   5.59%    $ 740     5.22%     $    -         -%    $     -        -     $ 3,489    5.53%
Mortgage-backed securities (1)        -      -         -        -            -         -       2,400     7.38 %     2,400    7.38
                                 --------------     --------------      ----------------     ----------------     ---------------
   Total held-to-maturity        $ 2,749   5.59%    $ 740     5.22%     $    -         -%    $ 2,400     7.38 %   $ 5,889    6.28%
                                 --------------     --------------      ----------------     ----------------     ---------------
 
Available-for-sale:
State and local government (2)   $ 1,090   5.69%    $   -        -      $  764      6.28%    $     -        -     $ 1,854    5.93%
                                 --------------     --------------      ----------------     ----------------     ---------------
   Total available-for-sale      $ 1,090   5.69%        -        -         764      6.28%          -        -       1,854    5.93%
                                 --------------     --------------      ----------------     ----------------     ---------------
Total investments
   at carrying value             $ 3,839   5.63%    $ 740     5.22%     $  764      6.28%    $ 2,400     7.38%    $ 7,743    6.20%
                                 ==============     ==============      ================     ================     ===============
</TABLE>

(1)  Mortgage-backed securities are shown at their weighted average expected
life obtained from an outside evaluation of the average remaining life of each
security based on historic prepayment speeds of the underlying mortgages at
December 31, 1997.

(2)  Yields are stated on taxable equivalent basis assuming statutory tax rates
of 34% for federal and 7.50% for state purposes. Book yields without regard to
tax-equivalent adjustments are: one year or less, 5.18%; two to five years,
5.22%; six to ten years, 4.60%; more than ten year, 7.38%; total, 5.81%.

In addition to the investment securities discussed above, the Company also earns
interest on its correspondent bank account at the Federal Home Loan Bank
("FHLB") of Atlanta and dividends on its FHLB stock. The Bank is required to
maintain, as a condition of membership, an investment in stock of the FHLB of
Atlanta equal to the greater of 1% of outstanding home loans or 5% of its
outstanding advances.  No ready market exists for such stock, which is carried
at cost. As of December 31, 1997, the Company's investment in stock of the FHLB
of Atlanta was $741,000.

                                Funding Sources

   Deposits are the primary source of the Company's funds for lending and other
investment purposes. The Company attracts both short-term and long-term
deposits from the general public by offering a variety of accounts with varying
maturities. Deposit inflows and outflows are significantly influenced by
general interest rates and other market conditions, primarily competition. As
competition for deposits has increased both from larger financial institutions
in its local market place and from mutual funds and other investments,
borrowings have provided an additional source of funding. The use of borrowed
funds to provide liquidity assists the Company in matching the interest rates on
its assets and liabilities because the interest rates on most borrowed funds are
fixed and therefore more predictable than the costs of deposits which are
subject to change based upon market conditions and other factors.

                                       11
<PAGE>
 
                                   Deposits

--------------------------------------------------------------------------------

   Deposits totaled $67.0 million at December 31, 1997, compared to $66.6
million at December 31, 1996, an increase of approximately $409,000. The 
following table sets forth certain information regarding the Company's average 
savings deposits for the last three years.

Table 9:  AVERAGE DEPOSITS
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
 
                                              1997                 1996                  1995
                                        -----------------    ------------------   ------------------
                                        Average   Average    Average   Average     Average   Average
                                         Amount     Rate     Amount     Rate       Amount     Rate
                                        -----------------    ------------------   -----------------
                                                           (dollars in thousands)
 
<S>                                     <C>         <C>      <C>        <C>        <C>         <C>
NOW and money market deposit account    $ 4,260     1.71%    $ 3,996    1.80%      $ 4,521     1.81%
Savings account                          11,928     3.00       9,270    3.51         9,525     3.02
Certificates of deposit                  50,332     5.79      55,418    5.84        56,495     5.73
                                        ----------------     ---------------       ----------------
 Total deposits                         $66,520     5.03%    $68,684    5.24%      $70,541     5.11%
                                        ================     ===============       ================
</TABLE>

As of December 31, 1997, the Company had outstanding $5,514,098 in time
certificates of deposit of $100,000 or more. Maturities of certificates of
deposits of $100,000 or more at December 31, 1997 were as follows: three months
or less, $2,480,837; over three months through six months, $794,089, over six
months through twelve months $1,607,599; and over one year through twenty-four
months, $528,495; and over twenty-four months, $103,078.

                                    Borrowings

   The Company's principal source of long-term borrowings are advances from the
FHLB of Atlanta. As a requirement for membership, the Bank is required to own
capital stock in the FHLB of Atlanta and is authorized to apply for advances on
the security of that stock and a floating lien on its family residential
mortgage loans. Each credit program has its own interest rate and range of
maturities. At December 31, 1997, the Company had outstanding FHLB advances
totaling $7,800,000, compared to no advances outstanding at December 31, 1996.
Additional information on borrowings is provided in Note 6 of the notes to the
consolidated financial statements.

                  Liquidity and Interest Rate Risk Management

                    --------------------------------------

   Liquidity is the ability to raise funds or convert assets to cash in order to
meet customer and operating needs. The Company's primary sources of liquidity
are its portfolio of investment securities available-for-sale, principal and
interest payments on loans and mortgage-backed securities, interest income from
investment securities, maturities of investment securities held-to-maturity,
increases in deposits, and advances from the FHLB of Atlanta. At December 31,
1997, the Bank had an additional $4 million of credit available from the FHLB
which would be collateralized by a blanket lien on qualifying loans secured by
first mortgages on family residences. Additional amounts may be made available
under this blanket floating lien or by using investment securities as
collateral. Management believes that it will have sufficient funds available to
meet its anticipated future loan commitments as well as other liquidity needs.

Interest rate risk is the sensitivity of interest income and interest expense to
changes in interest rates. Management continues to structure its assets and
liabilities in an attempt to protect net interest income from large fluctuations
associated with changes in interest rates. Table 10 shows the amount of
interest-earning assets and interest-bearing liabilities outstanding at December
31, 1997 which are projected to reprice or mature in each of the future time
periods shown. At December 31, 1997, the Company had a negative cumulative one
year asset-sensitive gap position of $47.6 million or 45.14% of interest-earning
assets. This generally indicates that net interest income would decrease in a
rising rate environment and would experience upward trend in a declining rate
environment.

                                       12
<PAGE>

--------------------------------------------------------------------------------
 
A static interest rate "gap" analysis may not be an accurate indicator of how
net interest income will react to changes in interest rates. A static gap
computation uses contractual maturities and does not make assumptions for
prepayments, scheduled loan principal payments or deposit decays. Income
associated with interest-earning assets and costs associated with interest-
bearing liabilities may not react uniformly to changes in interest rates. In
addition, the magnitude and duration of changes in interest rates may have a 
significant impact on net interest income. For example, although certain 
assets and liabilities may have similar maturities or periods to repricing, 
they may react in different degrees to changes in market interest rates. 
Interest rates on certain types of assets and liabilities typically fluctuate 
in advance of changes in general market interest rates, while interest rates 
on other types may lag behind changes in general market rates.

It should be noted that this table reflects the interest-sensitivity of the
balance sheet as of a specific date and is not necessarily indicative of future
results. The computations were made without using assumptions for loan
repayments or deposit delays. Except as stated below, the amounts of assets and
liabilities shown which reprice or mature within a given period were determined
in accordance with contractual terms of the assets or liabilities. In making
the computations, all adjustable rate loans were considered to be due at the end
of the next upcoming adjustment period. Fixed rate loans were considered to
reprice at their contractual maturities with no consideration given to
prepayments or scheduled payments. Liquid interest-earning investments with no
contractual maturities are assumed to be subject to immediate repricing.
Statement savings and money market accounts are subject to immediate
availability and repricing and have been placed in the earliest gap category.
In addition, fixed maturity deposits were assumed to reprice at their
contractual maturities without consideration for early withdrawals. The
interest rate sensitivity of the Company's assets and liabilities illustrated in
the following table would vary substantially if different assumptions were used
or if actual experience differs from that indicated by such assumptions.
Because of these and other limitations, management also monitors interest rate
sensitivity through the use of a model which estimates the change in net
portfolio value and net interest income in response to a range of assumed
changes in market interest rates. Based on interest sensitivity measures as of
December 31, 1997, management realizes its need to improve the Company's
interest rate exposure and has developed strategies to address this issue.

 
Table 10:  INTEREST SENSITIVITY
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>

                                                                                December 31, 1997
                                              -------------------------------------------------------------------------------------
                                                                       More than    More than        Over
                                               3 Months    4 to 12     1 Year to    3 Years to    5 Years to     Over
                                               Or Less      Months      3 Years      5 Years       10 Years    10 Years     Total
                                              ----------  ----------  -----------  ------------  ------------  ---------  ---------
<S>                                           <C>         <C>         <C>          <C>           <C>           <C>        <C>
Interest earning assets                                                         (dollars in thousands)
Mortgage loans:
 Fixed rate residential 1-4 family            $      -    $     89     $    475      $  2,934      $ 31,027     $45,154   $ 79,679
 Adjustable rate residential 1-4 family              -       1,247            -             -             -           -      1,247
 Adjustable home equity                          2,438           -            -             -             -           -      2,438
 Fixed rate-nonresidential                           -           1           41           709         3,858       4,932      9,541
                                              --------     --------    --------      --------      --------     -------   --------
  Total mortgage loans                           2,438       1,337          516         3,643        34,885      50,086     92,905
 Other loans                                       632           -            -             -             -           -        632
                                              --------    --------     --------      --------      --------     -------   --------
  Total loans                                    3,070       1,337          516         3,643        34,885      50,086     93,537
Interest-bearing deposits(2)                     3,531           -            -             -             -           -      3,531
Investment securities (1)                        3,838           -            -           740           770       2,400      7,748
FHLB common stock                                  741           -            -             -             -           -        741
                                              --------    --------     --------      --------      --------     -------   --------
  Total interest-earning assets               $ 11,180    $  1,337     $    516      $  4,383      $ 35,655     $52,486   $105,557
                                              --------    --------     --------      --------      --------     -------   --------
 
Interest-bearing liabilities
Deposits:
 Fixed maturity deposits                      $ 12,522    $ 25,954     $ 14,603      $      -      $      -     $     -   $ 53,079
 NOW accounts money market accounts              4,704           -            -             -             -           -      4,704
 Savings accounts                                9,190           -            -             -             -           -      9,190
                                              --------    --------     --------      --------      --------     -------   --------
  Total deposits                                26,416      25,954       14,603             -             -           -     66,973
 FHLB advances                                               7,800                                                           7,800
                                              --------    --------     --------      --------      --------     -------   --------
  Total interest-bearing liabilities          $ 26,416    $ 33,754     $ 14,603      $      -      $      -     $     -   $ 74,773
                                              --------    --------     --------      --------      --------     -------   --------
 
Interest sensitivity gap per period           $(15,236)   $(32,417)    $(14,087)     $  4,383      $ 35,655     $52,486   $ 30,784
Cumulative interest-sensitivity gap           $(15,236)   $(47,653)    $(61,740)     $(57,357)     $(21,702)    $30,784   $ 30,784
Cumulative gap as a percentage of
 total interest-earning assets                (14.43 %)    (45.14%)     (58.49%)      (54.34%)      (20.56%)     29.16%     29.16%
Cumulative interest-earning assets as a
 percentage of interest-bearing liabilities     42.32%      20.80%       17.43%        23.29%        70.98%     141.17%    141.17%
</TABLE>

(1) Includes investments and mortgage-backed securities
(2) Includes interest-bearing deposits and federal funds

                                       13
<PAGE>
 
--------------------------------------------------------------------------------

                               Capital Resources

                                ---------------

   Stockholders' equity decreased from $37.4 million at December 31, 1996 to
$31.0 million at December 31, 1997, largely as a result of the $4.00 special
dividend paid to stockholders in July, 1997 which totaled $7,592,000.

As a state savings bank holding company, the Parent is regulated by the Board of
Governors of the Federal Reserve Board ("FRB") and is subject to securities
registration and public reporting regulations of the Securities and Exchange
Commission.  The Bank is regulated by the Federal Deposit Insurance Corporation
("FDIC)" and the Savings Institutions Division, North Carolina Department of
Commerce ("the Administrator").

The Bank must comply with the capital requirements of the FDIC and the
Administrator.  The FDIC requires the Bank to maintain minimum ratios of Tier I
capital to total risk-weighted assets and total capital to risk-weighted assets
of 4% and 8%, respectively.  Tier I capital consists of total stockholders'
equity calculated in accordance with generally accepted accounting principles
less intangible assets, and total capital is comprised of Tier 1 capital plus
certain adjustments, the only one of which applicable to the Bank is the
allowance for loan losses.  Risk weighted assets reflect the Bank's on-and off-
balance sheet exposures after such exposures have been adjusted for their
relative risk levels using formulas set forth in FDIC regulations.  The Bank is
also subject to a leverage capital requirement, which calls for a minimum ratio
of Tier I capital (as defined above) to quarterly average total assets of 3% to
5%, depending on the institution's composite ratings as determined by its
regulators.  The Administrator requires a net worth equal to at least 5% of
assets.

At December 31, 1997 and 1996, the Bank was in compliance with all of the
aforementioned capital requirements as summarized in Table 11.  Refer to Note 7
of the consolidated financial statements for a discussion of other matters that
may affect the Company's capital resources.
 
Table 11:  REGULATORY CAPITAL
--------------------------------------------------------------------------------
 
                                                           At December 31,
                                                      ------------------------ 
                                                         1997          1996
                                                      ------------------------ 
Risk-Based and Leverage Capital                          (dollars in thousands)
Tier I capital:
  Common stockholders' equity                         $   26,030    $   24,967
  Unrealized holding loss (gain) on securities     
   available-for-sale                                         (3)            7
                                                      ------------------------ 
     Total Tier I leverage capital                        26,027        24,974
Tier II Capital:            
  Qualifying allowances for loan losses  
     Tier II capital additions                               570           511
                                                      ------------------------
Total risk-based capital                              $   26,597    $   25,485
                            
Risk-weighted assets                                      61,531        48,072
Fourth quarter average assets                            102,598        96,363
                            
Risk-based capital ratios:  
  Tier-I capital as a percent of risk-weighted assets      42.30%        51.95%
  Minimum Required Tier I capital                           4.00%         4.00%
  Total risk-based capital as a percent of            
   risk-weighted assets                                    43.23%        53.01%
  Minimum required total risk-based capital                 8.00%         8.00%
Leverage capital ratios:    
  Tier I leverage capital as a percent of fourth      
   quarter average assets                                  25.37%        25.92%
  Minimum required Tier I leverage capital             3.00-5.00%    3.00-5.00%
North Carolina regulatory capital:                   
  Total risk-based capital as a percent of fourth   
   quarter average assets                                  25.92%        26.45%
  Minimum required North Carolina capital                   5.00%         5.00%

                                       14
<PAGE>
 
--------------------------------------------------------------------------------

                    Impact of Inflation and Changing Prices

   The consolidated financial statements and accompanying footnotes have been
prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operating results in terms of
historical dollars without consideration for changes in the relative purchasing
power of money over time due to inflation.  The assets and liabilities of the
Company are primarily monetary in nature, and changes in interest rates have a
greater impact on the Company's performance than do the effects of inflation.

                               Accounting Issues

                                ---------------

   The Company prepares its consolidated financial statements and related
disclosures in conformity with standards established by, among others, the
Financial Accounting Standards Board (the "FASB").  Because the information
needed by users of financial reports is dynamic, the FASB frequently has new
rules and proposed new rules for companies to apply in reporting their
activities.  The following discussion addresses such changes as of December 31,
1997 that will affect the Company's future reporting.

   In August 1996, the Financial Accounting Standard Board ("FASB") issued
Statement of financial Accounting Standards No. 125 ("SAFS 125"), "Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities".  This statement provides accounting and reporting standards for
transfers and servicing of financial assets and extinguishments of liabilities
based on consistent application of a financial-components approach that focuses
on control.  It distinguishes transfers of financial assets that are sales from
transfers that are secured borrowings.  Under the financial-components approach,
after a transfer of financial assets, an entity recognizes all financial and
servicing assets it controls and liabilities it has incurred and does not
recognize financial assets it no longer controls and liabilities that have been
extinguished.  The financial-components approach focuses on the assets and
liabilities that exist after the transfer.  If a transfer does not meet the
criteria for a sale, the transfer is accounted for as a secured borrowing with
pledge of collateral.  This statement is effective for transfer and servicing of
financial assets and extinguishments of liabilities occurring after December 31,
1996, and is to be applied prospectively.  The Company adopted this statement on
January 1, 1997 without any impact on its consolidated financial statements.

   In February 1997, the financial Accounting Standards Board issued Statement
of financial Accounting Standards No. 128 ("SAFS 128"), "Earnings Per Share".
SFAS 128 establishes standards of computing and presenting earnings per share
(EPS) and applies to entities with publicly held common stock or potential
common stock.  This statement simplifies the standards for computing earnings
per share previously found in APB Opinion No. 15, "Earnings Per Share", and
makes them comparable to international EPS standards.  It replaces the
presentation of primary EPS with a presentation of basic EPS.  It also requires
dual presentation of basic and diluted EPS on the face of the income statement
for all entities with complex capital structures and requires a reconciliation
of the numerator and denominator of the basic EPS computation to the numerator
and denominator of the diluted EPS computation.  SFAS 128 is effective for
financial statements issued for periods ending after December 15, 1997 and
requires restatement of all prior period EPS data presented.  The Company
adopted SFAS 128 in fiscal year 1997 without any significant impact on its
consolidated financial statements.

   In February 1997, the FASB issued Statement of financial Accounting Standards
No. 129 ("SFAS 129"), "Disclosure of information about Capital Structure".  SFAS
129 establishes standards for disclosing information about an entity's capital
structure and is applicable to all entities.  It contains no change in
disclosure requirements for entities that were previously subject to the
requirements of APB Opinion No. 10, "Omnibus Opinion - 1996", APB Opinion No.
15, "Earnings Per Share", and Statement of Financial Accounting Standards No.
47, "Disclosure of Long-Term Obligations".  SFAS 129 is effective for financial
statements for periods ending after December 15, 1997.  The Company adopted SFAS
129 in fiscal 1997 without any impact on its consolidated financial statements.

                                       15
<PAGE>
 
--------------------------------------------------------------------------------

   In June 1997, the FASB issued Statement of financial Accounting Standards No.
130 ("SFAS 130"), "Reporting Comprehensive Income".  SFAS 130 establishes
standards for reporting and displaying comprehensive income and its components
(revenues, expenses, gains, and losses) in a full set of general-purpose
financial statements.  This Statement requires that an enterprise (a) classify
items of other comprehensive income by their nature in the financial statement
and (b) display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in-capital in the equity section of a
statement of financial position.  SFAS 130 is effective for fiscal years
beginning after December 15, 1997.  Reclassification of financial statements for
earlier periods provided for comparative purposes is required.  The company
plans to adopt the SFAS 130 is fiscal year 1998 and has not determined the
impact on its consolidated financial statements.

   In June 1997, the FASB issued Statement of Financial Accounting Standards No.
131 ("SFAS 131"), "Disclosures about Segments of an Enterprise and Related
Information".  SFAS 131 established standards for the way that public businesses
report information about operating segments in annual financial statements and
requires that those enterprises report selected information about operating
segments in interim financial reports issued to shareholders.  It also
establishes standards for related disclosures about products and services,
geographic areas, and major customers.  This Statement is effective for
financial statements for periods beginning after December 31, 1997 and in the
initial year of application, comparative information for earlier years is to be
restated.  The Company plans to adopt SFAS 131 in fiscal year 1998 without any
significant impact on its consolidated financial statements.

                                Year 2000 Issue

                                 -------------

   The Company has completed its assessment of the Company's vulnerability to
Year 2000 issues.  The Company's most critical computer system is utilized by
its subsidiary, Mocksville Savings Bank, for loans, deposit and accounting
functions, and is maintained by a third party service bureau.  The costs of
compliance will be borne by the vendor under the contract.  While this system is
presently substantially Year 2000 compliant, Bank personnel will participate in
tests of the system during 1998 to ensure full compliance.  Failure to prepare
this system for the Year 2000 would materially affect the Bank's ability to
operate and serve its customers.  The Company's other information technology-
controlled systems have also been identified and are in various states of
readiness.  Progress is under way to address these issues, with an estimated
cost of $60,000; the actual amount will depend on choices made by management in
the coming months.  This amount could increase materially if problems are noted
in the testing processes that have not yet been identified.  The majority of
these costs are expected to be incurred during the calendar year 1998; all such
costs will be charged to expense as incurred.

                                       16
<PAGE>
 
                         INDEPENDENT AUDITORS' REPORT
                         ----------------------------



The Board of Directors and Stockholders
Stone Street Bancorp, Inc.


We have audited the accompanying consolidated balance sheets of Stone Street
Bancorp, Inc. and subsidiary as of December 31, 1997 and 1996, and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the years in the three year period ended December 31, 1997.  These
consolidated financial statements are the responsibility of the Company's
management.  Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  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 consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Stone Street
Bancorp, Inc. and subsidiary as of December 31, 1997 and 1996, and the results
of their operations and their cash flows for each of the years in the three year
period ended December 31, 1997, in conformity with generally accepted accounting
principles.


/s/ Weir Smith Jones Miller & Elliott

Weir Smith Jones Miller & Elliott

Statesville, North Carolina
January 30, 1998

                                       17
<PAGE>
 
                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------
                          December 31, 1997 and 1996

                                                             1997       1996
                                                           --------   --------
                                                          (dollars in thousands)
ASSETS
 
Cash                                                       $    968   $  1,319
Federal funds sold                                            1,034        570
Interest-bearing deposits in other
 financial institutions                                       2,701      7,916
Investment securities (note 2)
  Held-to-maturity (Market value:    
   $5,940 in 1997 and $7,780 in 1996)                         5,889      7,736
  Available-for-sale (Cost: $1,854 in
   1997 and $2,731 in 1996)                                   1,859      2,723
Loans receivable (net of allowance
 for loan losses of $570 in 1997 and 
 $511 in 1996) (note 3)                                      92,967     82,992
Federal Home Loan Bank stock at cost                            741        667
Premises and equipment (note 4)                                 824        900
Accrued interest receivable                                     284        310
Deferred income tax                                             412        376
Refundable income tax                                           126         77
Prepaid expenses and other assets (note 8)                      141         93
Cash surrender value of life insurance                          146        128
                                                           --------   --------
    Total assets                                           $108,092   $105,807
                                                           ========   ========
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
Deposits (note 5):
  Savings accounts                                            9,190      8,861
  NOW and MMDA                                                4,704      3,932
  Other certificates of deposit                              47,565     48,626
  Certificates of deposit, $100,000 and over                  5,514      5,145
                                                           --------   --------
    Total deposits                                           66,973     66,564
Advances from the Federal Home Loan Bank (note 6)             7,800          -
Amounts payable under remittance service agreement            1,175        636
Accrued interest payable                                        144        170
Accrued expenses and other liabilities                          924        667
Accrued cash dividends payable                                    0        402
                                                           --------   --------
    Total liabilities                                        77,016     68,439
                                                           --------   --------
 
Stockholders' Equity:
Preferred stock, no par value, 5,000,000 shares 
 authorized; none issued (note 1)                                 -          -
Common stock, no par value 20,000,000 shares authorized:
 1,898,052 and 1,825,050 shares issued and outstanding, 
 respectively (note 1)                                       20,611     26,333
Unearned ESOP shares                                         (1,948)    (2,198)
Unamortized deferred compensation                            (1,518)         -
Retained earnings, substantially
 restricted (notes 7 and 8)                                  13,928     13,241
Unrealized holding gains (losses) on
 available-for-sale securities, net                               3         (8)
                                                           --------   --------
    Total stockholders' equity                               31,076     37,368
                                                           --------   --------
 
Commitments and contingencies (notes 3 and 9)
      Total liabilities and stockholders' equity           $108,092   $105,807
                                                           ========   ========
 
See accompanying notes to consolidated financial statements.

                                       18
<PAGE>
 
                  CONSOLIDATED FINANCIAL STATEMENTS OF INCOME
                  -------------------------------------------
                 Years ended December 31, 1997, 1996 and 1995
<TABLE>
<CAPTION>
 
 
                                        1997            1996           1995
                                   --------------  --------------  -------------
                                   (dollars in thousands, except per share data)
<S>                                <C>             <C>             <C>
 
Interest income:
 Interest on loans                      $7,490          $6,662         $5,980
 Interest on deposits in other
  financial institutions                   291             692            198
 Interest and dividends on
  investment securities:
   Taxable                                 486             563            336
   Non-taxable                              86              91             88
                                        ------          ------         ------
    Total interest income                8,353           8,008          6,602
                                        ------          ------         ------
 
Interest expense:
 Interest on deposits (note 5)           3,345           3,604          3,607
 Interest on borrowings                    146               6
                                        ------          ------
    Total interest expense               3,491           3,610          3,607
                                        ------          ------         ------
 
Net interest income                      4,862           4,398          2,995
Provision for loan losses (note 3)          60              50            350
                                        ------          ------         ------
 Net interest income after
  provision for loan losses              4,802           4,348          2,645
                                        ------          ------         ------
 
Other income:
 Loan fees and charges                      49              45             53
 Customer service and other fees            86              56             57
 Other                                      10              13             17
                                        ------          ------         ------
    Total other income                     145             114            127
                                        ------          ------         ------
 
Other expenses:
 Compensation and related
  benefits (note 9)                      1,753           1,013            957
 Deposit insurance premiums                 46             581            158
 Occupancy and equipment expense           261             216            242
 Professional fees                          64              36             31
 Other                                     390             277            217
                                        ------          ------         ------
    Total other expenses                 2,514           2,123          1,605
                                        ------          ------         ------
 
    Income before income tax expense     2,433           2,339          1,167
 
Income tax expense (note 8)                901             858            430
                                        ------          ------         ------
 
Net income                              $1,532          $1,481         $  737
                                        ======          ======         ======
 
Net income per share--basic (note 1)     $0.82           $0.82            N/A
                                        ======          ======         ======
 
Net income per share--diluted (note 1)   $0.82           $0.82            N/A
                                        ======          ======         ======
 
</TABLE>
See accompanying notes to consolidated financial statements.

                                       19
<PAGE>
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                -----------------------------------------------
             For the Years ended December 31, 1997, 1996 and 1995

<TABLE>
<CAPTION>
                                                       Unearned    Unamortized               Unrealized        Total
                                  Shares      Common     ESOP       Deferred     Retained      Holding     Stockholders'
                                Outstanding   Shares    Shares    Compensation   Earnings   Gains/Losses       Equity
                                -----------  --------  ---------  -------------  ---------  -------------  --------------
                                                        (in thousands, except shares outstanding)
<S>                             <C>          <C>       <C>        <C>            <C>        <C>            <C>
 
Balance at
  December 31, 1994                       -   $          $     -                   $11,826           $(97)        $11,729
 Net income                               -         -          -                       737              -             737
Change in unrealized
 holding gains (losses)
 net of income taxes
 of $24                                                                                                96              96
                                -----------  --------  ---------  -------------  ---------  -------------  --------------
Balance at
 December 31, 1995                        -         -          -                   $12,563             (1)         12,562
 Net income                               -         -          -                     1,481              -           1,481
 Net proceeds from issuance
  of no par common stock          1,825,050    26,333          -                         -              -          26,333
 Common stock acquired
   by ESOP                                -         -     (2,198)                        -              -          (2,198)
 Cash dividends declared
  ($.44 per share)                                  -          -              -       (803)             -            (803)
 Change in unrealized
  holding gains (losses),
  net of income taxes of $3               -         -          -              -          -             (7)             (7)
                                -----------  --------  ---------  -------------  ---------  -------------  --------------
Balance at
 December 31, 1996                1,825,050    26,333     (2,198)                   13,241             (8)         37,368
Net income                                                                           1,532                          1,532
Common stock acquired
 by ESOP                                                    (329)                                                    (329)
Release of ESOP shares                                       579                                                      579
Cash dividends
 ($4.45 per share) **                          (7,593)                                (845)                        (8,438)
Change in unrealized
 holding gains (losses)
 net of income taxes
 of $4                                                                                                  11              11
Issuance of restricted stock          73,002     1,871                    (1,871)         
Amortization of unearned
 compensation                                                                353                                       353
                                 -----------  --------  ---------  -------------  ---------  -------------  --------------     
Balance at
 December 31, 1997                 1,898,052   $20,611    $(1,948)       $(1,518)   $13,928           $  3         $31,076
                                 ===========  ========  =========  =============  =========  =============  ==============
</TABLE>
** Includes $4.00 special return of capital dividend paid on July 11, 1997.



See accompanying notes to consolidated financial statements.

                                       20
<PAGE>
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                     -------------------------------------
             For the Years ended December 31, 1997, 1996 and 1995

                                                    1997       1996      1995
                                                  -----------------------------
Operating activities:                                 (dollars in thousands)
Net income                                        $  1,532  $  1,481    $   737
Adjustments to reconcile net income to net cash
 provided by operating activities:                      
 Depreciation                                           86        96         85
 Provision for loan losses                              60        50        350
 Deferred income taxes                                 (36)      (42)       (66)
 Contributions allowing the release of ESOP shares     579             
 Compensation earned under the Management              
  Recognition Plan                                     353             
 Decrease (increase) in accrued interest 
  receivable                                            26      (206)        28
 Increase in cash surrender value of life 
  insurance                                            (18)      (64)       (64)
 Decrease (increase) in refundable income taxes        (49)      (56)        40
 Increase (decrease) in amounts payable under 
  remittance service agreement                         539        41        296
 (Increase) decrease in other assets                   (48)       44        (90)
 Increase (decrease) in accrued interest payable       (26)       23         25
 Increase (decrease)  in accrued cash dividends
  payable                                             (402)      402   
 Increase (decrease) in other liabilities              257       281        143
                                                  --------  --------    -------
   Net cash provided by                                                
    operating activities                             2,853     2,050      1,484
                                                  --------  --------    -------
                                                                       
Investing activities:                              
 Net increase in loans held for investment         (10,035)   (7,996)    (9,474)
 Principal collected on                          
  mortgage-backed securities                           597       108
 Purchase of investment securities classified as  
  available-for-sale                                     -      (860)  
 Purchase of investment securities classified as 
  held-to-maturity                                    (750)   (2,760)      (500)
 Purchase of mortgage-backed securities          
  classified as held-to-maturity                         -    (2,298)
 Proceeds from maturities of investment securities
  classified as available-for-sale                     875       439
 Proceeds from maturities of investment securities
  held-to-maturity                                   2,000       500      3,280
 Purchase of FHLB Stock                                (74)      (91)       (79)
 Purchase of premises and equipment                    (10)      (47)       (92)
                                                  --------  --------    -------
   Net cash used by investing activities            (7,397)  (13,005)    (6,865)
                                                  --------  --------    -------
 
Financing activities:
 Net increase (decrease) in deposits                   409    (6,471)     3,895
 Proceeds from borrowings                            7,800                1,000
 Repayments of borrowings                                -    (1,000)
 Proceeds from issuance of no par common stock           -    26,333
 Loan to ESOP for the purchase of common stock        (329)   (2,198)
 Cash dividends paid to shareholders                (8,438)     (803)
                                                  --------  --------    -------
   Net cash provided by financing activities          (558)   15,861      4,895
                                                  --------  --------    -------
     Increase (decrease) in cash and cash
      equivalents                                   (5,102)    4,906       (486)
Cash and cash equivalents at beginning of period     9,805     4,899      5,385
                                                  --------  --------    -------
Cash and cash equivalents at end of period        $  4,703  $  9,805    $ 4,899
                                                  ========  ========    =======
Supplemental disclosure of cash flow information:
 Cash paid during the period for:
  Interest                                        $  3,517  $  3,587    $ 3,581
                                                  ========  ========    =======
  Income taxes                                    $    949  $    914    $   390
                                                  ========  ========    =======
Supplemental disclosure of noncash transactions:
 Unrealized gains (losses) on available-for-sale 
  securities, net of deferred taxes (benefit) of  
   $2 for 1997, $3 for 1996 and $24 for 1995      $      3  $      8    $    95
                                                  ========  ========    =======
 Dividends declared but unpaid                    $      -  $    402    $     -
                                                  ========  ========    =======

See accompanying notes to consolidated financial statements.
 

                                       21
<PAGE>
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------


(1) Significant Accounting Policies
    -------------------------------

    Organization and Operations
    ---------------------------

    On March 29, 1996, pursuant to a Plan of Conversion approved by its members
    and regulators, Mocksville Savings Bank, Inc., SSB (the "Bank") amended and
    restated its charter to effect its conversion from a North Carolina
    chartered mutual savings bank to a North Carolina chartered stock savings
    bank (the "Conversion"), and became a wholly-owned subsidiary of Stone
    Street Bancorp, Inc. (the "Parent"), a holding company formed in connection
    with the Conversion. The Bank is primarily engaged in the business of
    obtaining savings deposits and providing loans to the general public. The
    principal activity of the Parent is ownership of the Bank. In 1997, the Bank
    formed a subsidiary, Stone Street Financial Services, Inc. for the purpose
    of offering investment discount brokerage services to the public.

    Basis of Presentation
    ---------------------

    The consolidated financial statements include the accounts of the Parent and
    the Bank and its wholly-owned subsidiary, together referred to as "the
    Company". All significant intercompany transactions and balances are
    eliminated in consolidation. The preparation of financial statements in
    conformity with generally accepted accounting principles requires management
    to make estimates and assumptions that affect the reported amounts of assets
    and liabilities and disclosure of contingent assets and liabilities as of
    the date of the balance sheets and the reported amounts of income and
    expenses for the periods presented. Actual results could differ
    significantly from those estimates. Material estimates that are particularly
    susceptible to significant changes in the near-term relate to the
    determination of the allowance for loan losses.

    Investment and Mortgage-Backed Securities
    -----------------------------------------

    Management determines the appropriate classification of investment and
    mortgage-backed securities at the time of purchase and reevaluates such
    designation at each reporting date. Securities are classified as held-to-
    maturity when the Company has both the positive intent and ability to hold
    the securities to maturity. Held-to-maturity securities are stated at
    amortized cost. Securities not classified as held-to-maturity are classified
    as available-for-sale. Available-for-sale securities are stated at fair
    value, with the unrealized gains and losses, net of tax, reported as a
    separate component of stockholders' equity. The Company has no trading
    securities.

    The amortized cost of securities classified as held-to-maturity or 
    available-for-sale is adjusted for amortization of premiums and accretion of
    discounts to maturity, or in the case of mortgage-backed securities, over
    the estimated life of the security. Such amortization is included in
    interest income from investments. Realized gains and losses, and declines in
    value judged to be other-than-temporary are included in net securities gains
    (losses). The cost of securities sold is based on the specific
    identification method.

    Loans Receivable
    ----------------

    Loans held for investment are carried at their principal amount outstanding,
    net of deferred loan origination fees.

    Interest on loans is recorded as borrowers' monthly payments become due.
    Accrual of interest income on loans is suspended when, in management's
    judgment, doubts exist as to the collectibility of principal and interest.
    Loans are returned to accrual status when management determines, based on an
    evaluation of the underlying collateral together with the borrower's payment
    record and financial condition, that the borrower has the capability and
    intent to meet the contractual obligations of the loan agreement.

    Loan fees are accounted for in accordance with Statement of Financial
    Accounting Standards No. 91.  Loan origination fees and certain direct loan
    origination costs are deferred and the net amount amortized as an adjustment
    of the related loans' yield over the life of the related loans using a 
    level-yield method. Unamortized net loan fees or costs on loans sold are
    recorded as gain or loss on sale in the year of disposition.

                                       22
<PAGE>
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
                  ------------------------------------------

(1) Significant Accounting Policies, Continued
    ------------------------------------------
 
    Allowance for Loan Losses
    -------------------------
  
    The Company provides for loan losses on the allowance method. Accordingly,
    all loan losses are charged to the allowance and all recoveries are credited
    to it. Additions to the allowance for loan losses are provided by charges to
    operating expense. The provision is based upon management's evaluation of
    the risk characteristics of the loan portfolio under current economic
    conditions and considers such factors as financial condition of the
    borrower, collateral values, growth and composition of the loan portfolio,
    the relationship of the allowance for loan losses to outstanding loans, and
    delinquency trends.
  
    At December 31, 1997, substantially all of the Company's loans were
    collateralized by real estate in Davie and adjacent counties. The collateral
    is predominately owner-occupied residential real estate in which the
    borrower does not rely on underlying cash flows from the property to satisfy
    debt service. The ultimate collectibility of a substantial portion of the
    loan portfolio is susceptible to changes in market conditions in the
    Company's market area. While management uses available information to
    recognize losses on loans, future additions to the allowance may be
    necessary based on changes in economic conditions. Various regulatory
    agencies, as an integral part of their examination processes, periodically
    review the Company's allowance for loan losses. Such agencies may require
    the Company to recognize additions to the allowance based on their judgments
    about information available to them at the time of their examinations.
  
    For all specifically reviewed loans for which it is probable that the Bank
    will be unable to collect all amounts due according to the terms of the loan
    agreement, the Bank determines fair value either based on discounted cash
    flows using the loans' initial interest rate or the fair value of the
    collateral if the loan is collateral dependent.  Large groups of smaller
    balance homogenous loans that are collectively evaluated for impairment
    (such as residential mortgage and consumer installment loans) are excluded
    from impairment evaluation, and their allowance for loan losses is
    calculated in accordance with the allowance for loan losses policy described
    above.
  
    Investment in Federal Home Loan Bank Stock
    ------------------------------------------
  
    As a requirement for membership, the Bank invests in stock of the Federal
    Home Loan Bank of Atlanta (FHLB) in the amount of 1% of its outstanding
    residential loans or 5% of its outstanding advances from the FHLB, whichever
    is greater.  At December 31, 1997, the Bank owned 7,410 shares of the FHLB's
    $100 par value capital stock.  No ready market exists for such stock, which
    is carried at cost.
  
    Premises and Equipment
    ----------------------
  
    Premises and equipment are stated at cost. Provisions for depreciation are
    computed principally using the straight-line method and charged to
    operations over the estimated useful lives of the assets over 20 years for
    office buildings and 3 to 10 years for furniture, fixtures, and equipment
    and other improvements.
  
    Retirement Plan
    ---------------
  
    The Bank has an employee stock ownership plan which covers substantially all
    of its employees. Contributions to the plan are determined annually by the
    Board of Directors based on employee compensation. Prior to establishment of
    the employee stock ownership plan, the Company had a self-administered,
    defined contribution retirement plan that covered all eligible employees.
    This plan was terminated as of January 1, 1996 in conjunction with the
    Conversion. The Bank also has a 401(k) plan that covers all eligible
    employees.

                                       23
<PAGE>
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
                  ------------------------------------------


(1) Significant Accounting Policies, Continued
    ------------------------------------------

    Cash and Cash Equivalents
    -------------------------

    For purposes of reporting cash flows, the Company considers cash, Federal
    funds sold and interest-bearing deposits in other institutions with original
    maturities of three months or less to be cash equivalents.

    Earnings Per Share
    ------------------

    The Company adopted the provisions of SFAS No. 128, "Earnings Per Share"
    during 1997. Presentation of both basic and diluted earnings per share have
    been presented in the financial statements. Because the Company's stock
    options would have an antidilutive effect on earnings per share due to the
    average marked price not exceeding the exercise price during the period,
    both basic and diluted earnings per share are the same. Weighted average
    shares outstanding for 1997 was 1,875,541 shares and for 1996, 1,825,050
    shares were assumed outstanding for the full year.

    New Accounting Pronouncements
    -----------------------------
  
    The Company prepares its consolidated financial statements and related
    disclosures in conformity with standards established by, among others, the
    Financial Accounting Standards Board (the "FASB").  Because the information
    needed by users of financial reports is dynamic, the FASB frequently has new
    rules and proposed new rules for companies to apply in reporting their
    activities.  The following discussion addresses such changes as of December
    31, 1997 that will affect the Company's future reporting.

    In August 1996, the financial Accounting Standards Board ("FASB") issued
    Statement of Financial Accounting Standards No. 125 ("SFAS 125"),
    "Accounting for Transfers and Servicing of financial assets and
    Extinguishments of Liabilities". This statement provides accounting and
    reporting standards for transfers and servicing of financial assets and
    extinguishments of liabilities based on consistent application of a
    financial-components approach that focuses on control. It distinguishes
    transfers of financial assets that are sales from transfers that are secured
    borrowings. Under the financial-components approach, after a transfer of
    financial assets, an entity recognizes all financial and servicing assets it
    controls and liabilities it has incurred and does not recognize financial
    assets it no longer controls and liabilities that have been extinguished.
    The financial-components approach focuses on the assets and liabilities that
    exist after the transfer. If a transfer does not meet the criteria for a
    sale, the transfer is accounted for as a secured borrowing with pledge of
    collateral. This statement is effective for transfer and servicing of
    financial assets and extinguishments of liabilities occurring after December
    31, 1996, and is to be applied prospectively. The Company adopted this
    statement on January 1, 1997 without any impact on its consolidated
    financial statements.

    In February 1997, the Financial Accounting Standards Board issued Statement
    of Financial Accounting Standards No. 128 ("SFAS 128"), "Earnings per
    Share". SFAS 128 establishes standards of computing and presenting earnings
    per share (EPS) and applies to entities with publicly held common stock or
    potential common stock. This statement simplifies the standards for
    computing earnings per share previously found in APB Opinion No. 15,
    "Earnings Per Share", and makes them comparable to international EPS
    standards. It replaces the presentation of primary EPS with a presentation
    of basic EPS. It also requires dual presentation of basic and diluted EPS on
    the face of the income statement for all entities with complex capital
    structures and requires a reconciliation of the numerator and denominator of
    the basic EPS computation to the numerator and denominator of the diluted
    EPS computation. SFAS 128 is effective for financial statements issued for
    periods ending after December 15, 1997 and requires restatement of all prior
    period EPS data presented. The Company adopted this statement in fiscal year
    1997 and has disclosed the required information in the financial statements.

                                       24
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ------------------------------------------

     In February 1997, the FASB issued Statement of Financial Accounting
     Standards No. 129 ("SFAS 129"), "Disclosure of Information about Capital
     Structure". SFAS 129 establishes standards for disclosing information about
     an entity's capital structure and is applicable to all entities. It
     contains no change in disclosure requirements for entities that were
     previously subject to the requirements of APB Opinion No. 10, "Omnibus
     Opinion - 1996", APB Opinion No. 15, "Earnings Per Share", and Statement of
     financial Accounting Standards No. 47, "Disclosure of Long-Term
     Obligations". SFAS 129 is effective for financial statements for periods
     ending after December 15, 1997. The Company adopted this statement in
     fiscal year 1997 with no impact on its consolidated financial statements.

     Reclassifications
     -----------------

     Certain reclassifications have been made for 1996 and 1995 to conform with
     the 1997 presentation. The reclassifications had no effect on previously
     reported net income or stockholders' equity.
 

(2)  Investment Securities
     ---------------------

     The following is a summary of the investment securities portfolios by major
     classification:
 
                                                 December 31, 1997
                                    --------------------------------------------
                                                   (in thousands)
                                                                       Estimated
                                    Amortized  Unrealized  Unrealized   market
                                      cost       gains       losses      value
                                    ---------  ----------  ----------  ---------

   Securities held-to-maturity:
   US government and agency
    securities                      $   3,489  $        6  $        1  $   3,494
   Mortgage-backed securities (a)       2,400          46                  2,446
                                    ---------  ----------  ----------  ---------
    Total securities                                                   
     held-to-maturity                   5,889          52           1      5,940
                                    =========  ==========  ==========  =========
   Securities available-for-sale:                                      
   States and local governments     $   1,854  $        6  $        1  $   1,859
                                    ---------  ----------  ----------  ---------
    Total securities                                                    
     available-for-sale             $   1,854  $        6  $        1  $   1,859
                                    =========  ==========  ==========  =========
                                     
 
                                                December 31, 1996
                                    --------------------------------------------
                                                  (in thousands)
                                                                       Estimated
                                    Amortized  Unrealized  Unrealized    market
                                       cost       gains      losses      value
                                    ---------  ----------  ----------  ---------
   Securities held-to-maturity:
   US government and agency
    securities                      $   4,753  $       21  $       18  $   4,756
   Mortgage-backed securities (a)       2,983          41           -      3,024
                                    ---------  ----------  ----------  ---------
    Total securities
     held-to-maturity                   7,736          62          18      7,780
                                    =========  ==========  ==========  =========
   Securities available-for-sale:
   States and local governments     $   2,019  $        4  $       12  $   2,011
   Mutual funds                           712           -           -        712
                                    ---------  ----------  ----------  ---------
    Total securities
     available-for-sale             $   2,731  $        4  $       12  $   2,723
                                    =========  ==========  ==========  =========
 

                                       25
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ------------------------------------------


(2) Investment Securities, Continued
    --------------------------------
<TABLE>
<CAPTION>
 
                                                          December 31, 1995
                                              --------------------------------------------
                                                            (in thousands)
                                                                                 Estimated
                                              Amortized  Unrealized  Unrealized   Market
                                                Cost       Gains       Losses      Value
                                              ---------  ----------  ----------  ---------

  <S>                                         <C>         <C>          <C>        <C>
  Securities held-to-maturity:
   US government and agency securities        $ 2,995     $    24      $    3     $ 3,016
   Mortgage-backed                                274           -           -         274
                                              -------     -------      ------     -------
    Total securities held-to-maturity         $ 3,269         $24      $    3     $ 3,290
                                              =======     =======      ======     =======
  Securities available-for-sale
   State and local governments                $ 1,629     $     3      $    2     $ 1,630
   Mutual Funts                                   670           2           -         672
                                              -------     -------      ------     -------
    Total securities available-for-sale       $ 2,299     $     5      $    2     $ 2,302
                                              =======     =======      ======     =======
</TABLE>

(a)  At December 31, 1997 and 1996, the Company owned mortgage-backed securities
     issued by the General National Mortgage Association (GNMA) and the Federal
     Home Loan Mortgage Corporation (FHLMC) with an aggregate amortized cost of
     $2,400,000 and $2,983,000 respectively, and a market value of $2,446,000 
     and $3,024,000.

     The aggregate amortized cost and approximate market value of the available-
     for-sale and held-to-maturity securities portfolios at December 31, 1997, 
     by remaining contractual maturity are as follows:

<TABLE>
<CAPTION>
 
                                                   Securities available-for-sale    Securities  held-to-maturity
                                                   -----------------------------    ----------------------------
                                                                           (in thousands)
 
                                                                     Estimated                       Estimated
                                                     Amortized         market        Amortized         market
                                                       cost            value            cost           value
                                                   -----------------------------    ----------------------------
 
<S>                                                  <C>             <C>               <C>            <C>
  US government securities:
   Due in 1 year or less                             $     -         $    -            $  500          $  499
   Due in 1 year through 5 years
  US government agencies securities:
   Due in 1 year or less                                                                2,249           2,250
   Due in 1 year through 5 years                                                          740             745
  Obligations of states and local governments:
   Due in 1 year or less                               1,090          1,089
   Due 1 year through 5 years                              -              -
   Due after 5 through 10 years                          764            770                 -               -
  Mortgage-backed securities                               -              -             2,400           2,446
                                                   -----------------------------    ----------------------------
   Total securities                                  $ 1,854         $1,859            $5,889          $5,940
                                                   =============================    ============================
</TABLE>

                                       26
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ------------------------------------------          

      There was no sales activity for held-to-maturity or available-for-sale
      securities for the years ended December 31, 1997, 1996 and 1995.

(3)   Loans Receivable
      ----------------
<TABLE>
<CAPTION>

                                                                                               December 31,
                                                                                             -----------------
      Loans receivable consist of the following:                                              1997      1996
                                                                                             -------   -------
                                                                                               (in thousands)
 
      Loans secured by first mortgages on real estate:
        Mortgage loans held for investment, primarily one-to-four family                     $76,894   $67,844
        Construction loans                                                                     8,571    12,492
        Nonresidential real estate                                                             9,541     5,716
                                                                                             -------   -------
                                                                                              95,006    86,052
      Home equity lines of credit                                                              2,438     2,191
      Other second mortgage loans                                                                237       282
      Other installment loans                                                                    632       372
                                                                                             -------   -------
                                                                                              98,313    88,897
      Undisbursed proceeds on loans in process                                                (3,718)   (4,385)
      Deferred loan fees                                                                      (1,058)   (1,009)
      Allowance for loan losses                                                                 (570)     (511)
                                                                                             -------   -------
                                                                                             $92,967   $82,992
                                                                                             =======   =======

<CAPTION>
 
      An analysis of the allowance for loan losses follows:
                                                                              1997         1996        1995
                                                                             -------      -------     -------
                                                                                        (in thousands)
 
      <S>                                                                    <C>          <C>         <C>
      Balance at beginning of period                                         $   511      $   462     $   115
      Provision for loan losses                                                   60           50         350
      Loans charged off                                                           (1)          (1)         (3)
      Recoveries                                                                   -            -           -
                                                                             -------      -------     -------
      Balance at end of period                                               $   570      $   511     $   462
                                                                             =======      =======     =======
</TABLE>

  At December 31, 1997 and 1996, the Company had no loans which were in
  nonaccrual status and $294,858 and $486,875 respectively, which were
  contractually delinquent for 90 days or more and still accruing.

  At December 31, 1997, the Company had mortgage loan commitments outstanding of
  $4,102,595 and preapproved but unused lines of credit totaled $2,132,705. The
  Company's exposure to credit loss for commitments to extend credit and standby
  letters of credit is the contractual amount of those financial instruments.
  The Company uses the same credit policies for making commitments and issuing
  standby letters of credit as it does for on-balance sheet financial
  instruments. Each customer's creditworthiness is evaluated on an individual
  basis. The amount and type of collateral, if deemed necessary by management,
  is based upon this evaluation of creditworthiness. Collateral obtained varies
  but may include marketable securities, deposits, real estate, investment
  assets, and property and equipment. In management's opinion, these
  commitments, and undisbursed proceeds on loans in process reflected above,
  represent no more than normal lending risk to the Company and will be funded
  from normal sources of liquidity.

  The Bank makes loans to executive officers and directors of the Company and to
  their associates. It is management's opinion that such loans are made on
  substantially the same terms, including interest rates and collateral, as
  those prevailing at the time for comparable transactions with unrelated
  persons and do not involve more than the normal risk of collectibility.
  Following is a reconciliation of loans outstanding to executive officers,
  directors, and their associates for the year ending December 31, 1997.

<TABLE>
<CAPTION>
 
     <S>                              <C>
     Balance at December 31, 1996     $1,903,882
     New loans                           334,550
     Repayments                          209,480
                                      ----------
     Balance at December 31, 1997     $2,028,952
                                      ==========
</TABLE>

                                       27
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  Continued
             -------------------------------------------

 
(4)  Premises and Equipment
     ----------------------

     Premises and equipment consist of the following:

<TABLE>
<CAPTION>
 
                                               December 31, 1997                         December 31, 1996
                                  ----------------------------------------    --------------------------------------
                                                 Accumulated     Net book                    Accumulated   Net book
                                      Cost       depreciation     value          Cost        depreciation   value
                                  ----------------------------------------    --------------------------------------
                                                    (in thousands)

  <S>                                <C>            <C>           <C>             <C>            <C>        <C>
  Land                               $ 258          $   -         $ 258           $ 258          $   -      $ 258
  Office buildings and
   improvements                        834            423           411             834            386        448
  Furniture, fixtures and
   equipment                           507            371           136             500            330        170
  Vehicles                              26              7            19              26              2         24
                                  ----------------------------------------    --------------------------------------
                                    $ 1625          $ 801         $ 824          $1,618          $ 718      $ 900
                                  ========================================    ======================================
 
</TABLE>

(5)  Deposits
     --------

     Time deposits of $100,000 or more totaled $5,514,098 and $5,144,587 at
     December 31, 1997 and 1996, respectively.

     Interest expense on deposits includes $196,905, $343,000 and $431,000 for 
     the years ended December 31, 1997, 1996 and 1995, respectively, on time 
     deposits of $100,000 or more.

     Contractual maturities of time deposits are as follows:

 
                                                          Total
     Year Ending December 31,                           Maturities
     ------------------------                     ----------------------
                                                  (dollars in thousands)
 
     1998                                               $  38,474
     1999                                                  11,667
     2000                                                   2,938
                                                        ---------
       Total time deposits                              $  53,079
                                                        =========
(6)  Advances from the Federal Home Loan Bank
     ----------------------------------------
 
     Advances from the Federal Home Loan Bank of Atlanta, with weighted 
     average interest rates, are as follows:
  
                                                    December 31, 1997
                                                  ----------------------
                                                      (in thousands)
 
     6.50% due on or before December 31, 1998           $  7,800 
                                                        ========

     There were no FHLB advances outstanding at December 31, 1996. At December 
     31, 1997, the Bank had additional credit availability from the Federal 
     Home Loan Bank of $4,200,000.

     All advances are secured by all stock in the Federal Home Loan Bank and a
     blanket floating lien on the Bank's one-to-four family residential 
     mortgage loans

                                       28
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ------------------------------------------         

(7)  Stockholders' Equity
     --------------------

     Common Stock
     ------------

     The Company is authorized to issue 20,000,000 shares of common stock. The
     common stock has no par value. As of December 31, 1997 and 1996, there were
     1,898,052 and 1,825,050 shares of common stock issued and outstanding,
     respectively. The increase is attributable to an additional 73,002 shares
     of common stock issued for the MRP as discussed in Note 9 to the
     consolidated financial statements.

     Preferred Stock
     ----------------

     The Company is authorized to issue up to 5,000,000 shares of preferred
     stock. No shares of preferred stock have been issued or were outstanding at
     December 31, 1997 or 1996. Such preferred stock may be issued in one or
     more series with such rights, preferences, and designations as the Board of
     Directors of the Parent may from time to time determine subject to
     applicable law and regulations. If and when such shares are issued, holders
     of such shares may have certain preferences, powers, and rights (including
     voting rights) senior to the rights of the holders of the common stock of
     the Company. The Board of Directors of the Parent can (without stockholder
     approval) issue preferred stock with voting and conversion rights which
     could, among other things, adversely affect the voting power of the holders
     of the common stock of the company and assist management in an unfriendly
     takeover or attempted change in control of the Company that some
     stockholders may consider to be in their best interest but to which
     management is opposed. The Company has no current plans to issue preferred
     stock.

        As of December 31, 1997, the FDIC categorized the Bank as "well-
     capitalized". The Bank is required to meet minimum ratios for total risk-
     based, and Tier I leverage (the ratio of Tier I capital to average assets)
     as set forth in the following table. There are no events or conditions
     since the notification that management believes have changed the Bank's
     category.

     <TABLE>
     <CAPTION>
                                                                                                Minimum Ratios
                                                                                         -----------------------------
                                                                                            For         To Be Well
                                                        Capital Amount       Ratio        Capital   Capitalized Under
                                                       ----------------  --------------  Adequacy   Prompt Corrective
                                                        1997     1996     1997    1996   Purposes   Action Provisions
                                                       -------  -------  ------  ------  ---------  ------------------
     <S>                                               <C>      <C>      <C>     <C>     <C>        <C>
     As of December 31:
      Tier I Capital (ratio to risk-weighted assets):  $26,027  $24,974  42.30%  51.95%    4.00%           6.00%
                                                                                                        
      Tier Capital - Tier II capital (ratio to risk-                                                       
       weighted assets):                                26,597   25,485  43.23%  53.01%    8.00%          10.00%
                                                                                                        
      Leverage - Tier I capital (ratio to average                                                          
       Assets):                                         26,027   24,974  25.92%  25.90%    4.00%           5.00%
     </TABLE>

     Liquidation Account: At the time of Conversion, the Bank established a
     liquidation account in an amount equal to its net worth at December 31,
     1995. The liquidation account will be maintained for the benefit of
     eligible deposit account holders who continue to maintain their deposit
     accounts in the Bank after Conversion. Only in the event of a complete
     liquidation will each eligible deposit account holder be entitled to
     receive a liquidation distribution from the liquidation account in the
     amount of the then current adjusted subaccount balance for deposit accounts
     then held before any liquidation distribution may be made with respect to
     the Parent's common stock. Dividends cannot be paid from this liquidation
     account.

                                       29
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ------------------------------------------

(7) Stockholders' Equity - Continued
    --------------------------------

    Dividends
    ---------

    Subject to applicable law, the Boards of Directors of the Bank and the
    Parent may each provide for the payment of dividends. Future declarations of
    cash dividends, if any, by the Parent may depend upon dividend payments by
    the Bank to the Parent. Subject to regulations of the Administrator, the
    Bank may not declare or pay a cash dividend on or repurchase any of its
    common stock if its stockholders' equity would thereby be reduced below
    either the aggregate amount then required for the liquidation account or the
    minimum regulatory capital requirements imposed by federal and state
    regulations. In addition, for a period of five years after the Conversion,
    the Bank will be required, under existing North Carolina regulations, to
    obtain prior written approval of the Administrator before it can declare and
    pay a cash dividend on its capital stock in an amount in excess of one-half
    of the greater of (i) its net income for the most recent fiscal year, or
    (ii) the average of its net income after dividends for the most recent
    fiscal year and not more than two of the immediately preceding fiscal years,
    if applicable. As a result of this limitation, the Bank cannot pay a
    dividend in excess of $663,215 without the approval of the Administrator.

    Capital Adequacy
    ----------------

    The Parent is regulated by the Board of Governors of the Federal Reserve
    System ("FRB") and is subject to securities registration and public
    reporting regulations of the Securities and Exchange Commission. The Bank is
    regulated by the Federal Deposit Insurance Corporation ("FDIC") and the
    Administrator, Savings Institutions Division, North Carolina Department of
    Commerce (the "Administrator").

    The Bank is subject to capital requirements of the FDIC and the
    Administrator. The FDIC requires the Bank to maintain minimum ratios of Tier
    1 capital to total risk-weighted assets and total capital to risk-weighted
    assets of 4% and 8%, respectively. Tier 1 capital consists of total
    shareholders' equity calculated in accordance with generally accepted
    accounting principles less intangible assets, and total capital is comprised
    of Tier 1 capital plus certain adjustments, the only one of which applicable
    to the Bank is the allowance for possible loan losses. Risk-weighted assets
    refer to the on and off-balance sheet exposures of the Bank adjusted for
    their relative risk levels using formulas set forth in FDIC regulations. The
    Bank is also subject to a FDIC leverage capital requirement, which calls for
    a minimum ratio of Tier 1 capital (as defined above) to quarterly average
    total assets of 3% to 5%, depending on the institution's composite ratings
    as determined by its regulators. The Administrator requires a net worth
    equal to at least 5% of total assets.

    At December 31, 1997 and 1996, the Bank was in compliance with all of the
    aforementioned capital requirements.

(8) Income Taxes
    ------------

    The components of income tax expense (benefit) were as follows:

 
                                                 Year ended December 31,     
                                             ------------------------------  
                                                     (in thousands)          
                                               1997       1996       1995    
                                             ------------------------------  
                                                                             
    Currently payable:                                                       
        Federal                              $   798    $   757    $   530   
        State                                    145        139         80   
                                             ------------------------------  
                                                 943        896        610   
                                             ------------------------------  
                                                                             
    Deferred:                                                                
        Federal                                  (34)       (31)      (147)  
        State                                     (8)        (7)       (33)  
                                             ------------------------------  
                                                 (42)       (38)      (180)  
                                             ------------------------------  
                                             $   901    $   858    $   430   
                                             ==============================  

                                       30
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ------------------------------------------          

    The tax effects of temporary differences that give rise to significant
    portions of the deferred tax assets and deferred tax liabilities are shown
    below:
   
                                                                 December 31,
                                                               ----------------
                                                                  1997     1996
                                                               ----------------
                                                                (in thousands)
   
    Allowance for loan losses (net)                            $   229  $   204
    Deferred loan origination fees, net of deferred costs          424      404
                                                               -------  ------- 
       Gross deferred tax assets                                   653      608
    Valuation allowance                                              0        0
                                                               -------  ------- 
       Net deferred tax assets                                     653      608
                                                               -------  ------- 
                                                                         
    Accelerated depreciation                                        46       52
    FHLB stock dividends                                           180      180
    Other temporary differences creating deferred tax assets        15   
                                                               -------  ------- 
       Gross deferred tax liabilities                              241      232
                                                               -------  ------- 
                                                                         
       Net deferred tax asset                                  $   412  $   376
                                                               =======  =======
                                                                       
    The Company has no valuation allowance at December 31, 1997 or 1996 because
    it has sufficient taxable income in the carryback period to support the
    realizability of the net deferred tax asset.

    The reconciliation of income taxes at statutory tax rates to income tax
    expense reported in the statements of income follows:

                                                              December 31,
                                                         ----------------------
                                                           1997    1996    1995
                                                         ------  ------  ------
                                                             (in thousands)
                                                       
    Income taxes at the statutory federal tax rate       $  827  $  798  $  397
    State income taxes less federal benefit                 120     120      59
    Tax exempt interest                                     (29)    (38)    (40)
    Other                                                   (17)    (22)     14
                                                         ------  ------  ------
       Total tax expense                                 $  901  $  858  $  430
                                                         ======  ======  ======

    Retained earnings at December 31, 1997 includes approximately $2,577,990 for
    which no provision for federal income tax has been made. This amount
    represents allocations of income to bad debt deductions for tax purposes
    only. Reduction of such amount for purposes other than tax bad debt losses
    will create income for tax purposes only, which will be subject to the then
    current corporate income tax rate. Legislation passed in 1996 eliminates the
    percentage of taxable income method as an option for computing bad debt
    deductions for 1996 and in all future years. The Bank will still be
    permitted to take deductions for bad debts, but will be required to compute
    such deductions using an experience method.

(9) Employee and Director Benefit Plans
    -----------------------------------

    DEFINED CONTRIBUTION RETIREMENT PLAN: The Bank had a self-administered,
    defined contribution retirement plan that covered all eligible employees.
    The Bank's policy has been to fund retirement costs accrued for the year.
    Under the plan, the Bank contributed an actuarially determined amount based
    on a participants compensation and years of service. In conjunction with the
    Conversion, the defined contribution retirement plan was terminated as of
    January 1, 1996. Funds were distributed in 1996. There was no gain or loss
    upon the termination of the defined contribution retirement plan. Retirement
    expense of this plan totaled approximately $84,000 in 1995.

                                       31
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ------------------------------------------          

(9) Employee and Director Benefit Plans - Continued
    ------------------------------------------------
 
    401(k) PLAN
    -----------

    During 1994, the Bank implemented a 401(k) plan that covers all eligible
    employees. During years prior to 1996, the Bank has matched 50% of employee
    contributions, with the Bank's contribution limited to 3% of each employee's
    salary. 401(k) matching contributions are funded when accrued. Matching
    expense totaled approximately $866 in 1997, $1,900 in 1996, and $10,000 in
    1995.

    EMPLOYEE STOCK OWNERSHIP PLAN ("ESOP"): The Bank has an ESOP whereby an
    aggregate number of shares amounting to 146,004 were purchased for future
    allocation to employees. Contributions to the ESOP are made by the Bank on a
    discretionary basis, and are allocated among ESOP participants on the basis
    of relative compensation in the year of allocation. Benefits will vest in
    full upon five years of service with credit given for years of service prior
    to the conversion.
    
    The ESOP was funded in December, 1996 by a loan from the Parent in the
    amount of $2,198,064. The loan is secured by shares of stock purchased by
    the ESOP and is not guaranteed by the Bank. Principal and interest payments
    on this loan are funded primarily from discretionary contributions by the
    Bank. Dividends, if any, paid on shares held by the ESOP may also be used to
    reduce the loan. Dividends on unallocated shares are used by the ESOP to
    repay the debt to the Parent and are not reported as dividends in the
    consolidated financial statements. Dividends on allocated shares are
    credited to the amounts of the participants and reported as dividends in the
    consolidated financial statements.

    During 1997, the Bank made a $250,491 contribution to the ESOP, representing
    the normal principal payment due for the year and the application of
    dividends on unallocated shares to the principal balance of the loan. This
    contribution resulted in the release of 23,617 shares to individual
    participant accounts. At December 31, 1997, a total of 30,822 shares have
    been released and allocated to participants and 115,182 shares remain
    unallocated.

    Total compensation expense associated with the ESOP for the years ended
    December 31, 1997 and 1996 was $180,000 and $175,000, respectively. At
    December 31, 1997, there were 115,182 unallocated ESOP shares with a total
    fair value of approximately $2,555,601.
 
    In fiscal year 1996, the $175,000 cash contribution made for the year ended
    December 31, 1996 was used to release 7,205 shares to ESOP participants.
    During the year ended December 31, 1997, 23,617 shares were considered
    committed to be released to ESOP participants, and compensation expense of
    $180,000 associated with those shares was recorded.

    Management Recognition Plan ("MRP")
    -----------------------------------

    The Bank's MRP was approved by stockholders of the Parent and by the
    Parent's and the Bank's Boards of Directors during fiscal year 1997. The MRP
    serves as a means of providing existing directors and employees of the Bank
    with an ownership interest in the Company. Shares of the Company's common
    stock awarded under the MRP vest equally over a five year period.
    Compensation expense related to those shares is recognized on a straight-
    line basis corresponding with the vesting period. Prior to vesting, each
    participant granted shares under the MRP may direct the voting of the shares
    allocated to the participant and will be entitled to receive any dividends
    or other distributions paid on such shares. On May 9, 1997, 73,002 shares
    were awarded under the MRP. Total compensation expense associated with the
    MRP for the year ended December 31, 1997 was $352,779.

 

                                       32
<PAGE>
 
                   NOTES TO FINANCIAL STATEMENTS - Continued
                   -----------------------------------------

(9) Employee and Director Benefit Plans - Continued
    -----------------------------------------------

    Stock Option Plan
    -----------------

    The Company adopted a Stock Option Plan which has also been approved by the
    stockholders of the Parent and by the Parent's and the Bank's Boards of
    Directors. The Stock Option Plan makes available options to purchase 182,505
    shares, or 10% of the shares issued in the conversion to employees and
    directors. Options granted under the Stock Option Plan to directors vest
    immediately while options granted to employees have a vesting schedule which
    provides that 20% of the options granted vest in the first year, and 20%
    will vest on each subsequent anniversary date, so that options would be
    completely vested within five years from the date of grant. Options become
    100% vested upon death or disability, if earlier. Unexercised options expire
    within ten years from the date of grant. The exercise price for options
    granted in 1997 was the fair market value at the date of grant (May 9, 1997)
    of $25.625 per share and was adjusted to $21.75 to reflect the $4.00 special
    return of capital dividend paid to stockholders in 1997.

    The weighted-average fair value per share of options granted in 1997
    amounted to $6.26. Fair values were estimated at the date of the grant using
    the Black-Scholes option-pricing model with the following weighted average
    assumptions.

          Risk-free interest rate                          6.75%
          Dividend yield                                   3.90
          Volatility                                      30.00
          Expected life                                 7 years
 
    A summary of the Company's stock option activity and related information for
    the year ended December 31, 1997 follows:
 


                                          Outstanding         Exercisable
                                       ------------------  -----------------
                                                 Weighted           Weighted
                                                 Average            Average
                                        Option   Exercise  Option   Exercise
                                        Shares    Price    Shares    Price
                                       --------  --------  -------  --------
                          
    At December 31, 1996                      -  $      -        -  $      -
    Granted                             172,244     21.75   78,241     21.75
    Exercised                                 -         -        -         -
    Forfeited                                 -         -        -         -
                                       --------  --------  -------  --------
    At December 31, 1997               $172,244  $  21.75  $78,241  $  21.75
                                       ========  ========  =======  ========
 
    DIRECTOR'S DEFERRED COMPENSATION PLAN: The Bank has a deferred compensation
    plan for its directors under which the directors would be paid specified
    amounts during the ten year period following the date that the director
    becomes 65 years of age. The Bank has purchased life insurance policies with
    the Bank named as beneficiary to fund the benefits. Total expense related to
    these plans was approximately $123,271 for 1997, $48,000 for 1996, and
    $70,000 for 1995.

    EMPLOYMENT AGREEMENTS: In connection with the Conversion, the Bank entered
    into an employment agreement with its chief executive officer in order to
    ensure a stable and competent management base. The agreement provides for a
    three-year term, but upon each anniversary, the agreement automatically
    extends so that the remaining term shall always be three years. The
    agreement provides that the nature of the covered employee's compensation,
    duties or benefits cannot be diminished following a change in control of the
    Company.

    SEVERANCE PLAN: In connection with the Conversion, the Bank adopted a
    Severance Plan for the benefit of its employees. The Plan provides for
    severance pay benefits in the event of a change in control which results in
    the termination of such employees or diminished compensation, duties, or
    benefits within two years of a change in control. The employees covered
    would be entitled to a severance benefit of the greater of (a) the amount
    equal to two weeks'

                                       33
<PAGE>
 
                   NOTES TO FINANCIAL STATEMENTS - Continued
                   -----------------------------------------

(9)  Employee and Director Benefit Plans - Continued
     -----------------------------------------------

     salary at the existing salary rate multiplied by the employee's number of
     completed years of service or (b) the amount of one month's salary at the
     employee's salary rate at the time of termination, subject to a maximum
     payment equal to two times the employee's annual salary.

     The Company has elected to follow APB Opinion No. 25 ("APB 25"),
     "Accounting for Stock Issued to Employees" and related interpretations in
     accounting for its stock options as permitted under SFAS NO. 123 ("SFAS
     123"), "Accounting for Stock-Based Compensation". In accordance with APB
     25, no compensation cost is recognized by the Company when stock options
     are granted because the exercise price of the Company's stock options
     equals the market price of the underlying common stock on the date of
     grant. As required by SFAS 123, disclosures are presented below for the
     effect on the net income and net income per share that would result from
     the use of the fair value based method to measure compensation cost related
     to stock option grants in 1997. The effects of applying the provisions of
     SFAS 123 in 1997 are not necessarily indicative of future effects.

                                                       Amount
                                                       ------
                                       (in thousands, except per share data)
 
     Net income

            As reported                               $  1,532
            Pro forma                                    1,498
 
     Net income per share
            As reported                               $    .82
            Pro forma                                      .80
 
(10) Quarterly Financial Data (Unaudited)
     ------------------------------------

     Summarized unaudited quarterly financial data for the year ended December
     31, 1997 is as follows:
 
<TABLE> 
<CAPTION> 
                                                     First    Second     Third    Fourth
                                                    Quarter   Quarter   Quarter   Quarter
                                                   --------- --------- --------- ---------
   Operating Summary:                             (in thousands except per share amounts)
<S>                                                <C>      <C>         <C>     <C> 
   Interest income                                 $  2,110  $  2,050  $  2,099  $  2,094
   Interest expense                                     826       840       890       935
                                                   --------  --------  --------  --------
   Net interest income                                1,284     1,210     1,209     1,159  
   Provision for loan losses                             15        15        15        15
                                                   --------  --------  --------  --------
   Net interest income after provision for loan
    losses                                            1,269     1,195     1,194     1,144
   Other income                                          34        33        36        42
   Other expenses                                       450       826       604       634
                                                   --------  --------  --------  --------
   Income before income tax expense                     853       402       626       552
   Income taxes                                         327       144       240       190
                                                   --------  --------  --------  --------
   Net income                                           526       258       386       362
   Per Share Data:
   Net Income per share--basic                          .29       .14       .20       .19
   Net Income per share--diluted                        .29       .14       .20       .19
   Cash dividends declared                            .1125     .1125    4.1125     .1125
   Dividend payout                                    39.04     82.74     55.27     59.01
   Book value per share                               20.76     16.13     16.32     16.37
   Selected Average Balances:
   Assets                                          $104,971  $105,946  $103,526  $105,630
   Investment securities                             17,149    14,494    11,471    10,529
   Loans, net                                        84,256    86,024    87,469    91,095
   Interest-bearing deposits                         65,938    71,490    65,553    66,414
   FHLB advances                                          -         -     3,390     6,555
   Stockholders' equity                              37,587    34,212    30,799    31,027
</TABLE>

                                       34
<PAGE>
 
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
              ------------------------------------------          

(10) Quarterly Financial Data (Unaudited) - Continued
     ------------------------------------------------

 
     Summarized unaudited quarterly financial data for the year ended December
     31, 1996 is as follows:

 
                                   First        Second       Third       Fourth
                                  Quarter      Quarter      Quarter      Quarter
                                  ----------------------------------------------
Operating Summary:                  (in thousands except per share amounts)
Interest income                   $ 1,774     $  2,082     $  2,086     $  2,066
Interest expense                    1,016          884          860          850
                                  -------     --------     --------     --------
Net interest income                   758        1,198        1,226        1,216
Provision for loan losses              -           15           15           20
                                  -------     --------     --------     --------
Net interest income after 
provision for loan losses             758        1,183        1,211        1,196
Other income                           26           29           31           27
Other expenses                        439          368          847          468
                                  -------     --------     --------     --------
Income before income tax expense      345          844          395          755
Income taxes                          141          305          126          286
                                  -------     --------     --------     --------
Net income                            204          539          269          469
Per Share Data:              
Net income per share--basic           N/A          .30          .15          .26
Net income per share--diluted         N/A          .30          .15          .26
Cash dividends declared               N/A          .11          .11          .22
Dividend payout                       N/A        37.29        74.72        85.00
Book value per share                  N/A        21.00        20.18        20.47
Selected Average Balances:                   
Assets                            $92,835     $108,766     $108,343     $105,691
Investment securities              14,871       28,281       25,237       21,296
Loans, net                         75,883       77,704       79,520       82,081
Interest-bearing deposits          72,692       67,951       67,613       66,480
Stockholders' equity               16,621       39,401       38,944       37,494

                                       35
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
             ------------------------------------------------------

(11)  Parent Company Financial Data
      -----------------------------

      Condensed financial information for Stone Street Bancorp, Inc. (Parent
      Company) is as follows:
 
                                                     December 31,   December 31,
                                                         1997          1996
                                                        -------       -------   
Condensed Balance Sheet                                     (in thousands) 
Assets:                                                          
 Cash on deposit with bank subsidiary                   $ 3,957       $ 4,272
 Interest bearing deposits                                  204         7,531
 Investment securities available for sale at                     
  market value:                                                  
  Obligations of states and local governments,                   
   cost $860,000                                            859           859
 Investment in bank subsidiary                           26,030        25,230
 Other assets                                               118           164
                                                        -------       ------- 
   Total assets                                         $31,168       $38,056
                                                        =======       =======
                                                                 
 Liabilities and stockholders' equity:                           
  Accrued expenses and other liabilities                $    92       $   418
  Stockholders' equity, net                              31,076        37,638
                                                        -------       -------
   Total liabilities and stockholders' equity           $31,168       $38,056
                                                        =======       =======
                                                                 
Year Ended                                           December 31,   December 31,
                                                         1997          1996
                                                        -------       -------   
Condensed Statement of Income                               (in thousands) 
 Dividends from bank subsidiary                         $   619       $   435
 Interest income from bank subsidiary                       203            30
 Interest on interest bearing deposits                      149           483
 Interest on loan from bank subsidiary ESOP                 182            93
 Interest on investment securities                           33             5
                                                        -------       -------
  Total income                                            1,186         1,046
 Operating expenses                                         241            30
                                                        -------       -------
 Income before income taxes                                 945         1,016
 Income tax expense                                         120           227
                                                        -------       -------
 Income before equity in undistributed net                       
  income of subsidiary                                      825           789
 Equity in undistributed net income of bank                      
  subsidiary                                                707           692
                                                        -------       -------
   Net income                                           $ 1,532       $ 1,481
                                                        =======       =======

                                       36
<PAGE>
 
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
              ------------------------------------------------------

(11) Parent Company Financial Data - Continued                          
     -----------------------------------------
                                                             Year Ended 
                                                     December 31,   December 31,
                                                         1997          1996
                                                        -------       -------   
     Condensed Statement of Cash Flows                      (in thousands)
     Cash flows from operating activities:
     Net income                                         $ 1,532       $  1,481
     Adjustments to reconcile net income to                           
      net cash provided by operating activities:                      
     Undistributed earnings of bank subsidiary             (707)          (692)
     Payments on ESOP loan receivable from bank                       
      subsidiary                                            579              -
     (Increase) (decrease) in other assets                   47           (164)
     Increase in other liabilities                         (326)           418
                                                        -------       --------
        Net cash provided by operating activities         1,125          1,043
                                                        -------       --------
                                                                      
     Cash flows from investing activities:                            
     Purchase of available for sale securities                -           (860)
                                                        -------       --------
        Net cash used by investing activities                 -           (860)
                                                                      
     Cash flows from financing activities:                            
     Proceeds of issuance of no par common stock              -         26,333
     Loan to ESOP for purchase of common stock             (329)        (2,198)
     Capital contribution to bank subsidiary                  -        (11,712
     Cash dividends paid to stockholders                 (8,438)          (803)
                                                        -------       --------
        Net cash provided by financing activities        (8,767)        11,620
                                                        -------       --------
                                                                      
        Net increase in cash and cash equivalents        (7,642)        11,803
     Cash and cash equivalents at beginning of year      11,803              -
                                                        -------       --------
     Cash and cash equivalents at end of year           $ 4,161       $ 11,803
                                                        =======       ========
                                                                      
     Supplemental disclosure of cash flow information:
      Cash paid during the year for income taxes        $   149       $    283
                                                        =======       ========
     Supplemental disclosure of noncash transactions:                 
      Unrealized gains (losses) on securities                         
       available for sale net of deferred tax benefit 
       of $1 in each year                               $    (1)      $     (1)
                                                        =======       ========
      Unrealized gains (losses) on subsidiary's                       
       securities available for sale, net of deferred 
       tax benefit of $2 and $3 in 1997 and 1996, 
       respectively                                     $     4       $     (7)
                                                        =======       ========
      Dividends declared but unpaid                     $     -       $    402
                                                        =======       ========

                                       37
<PAGE>
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued
             ----------------------------------------------------


(12) Fair Value of Financial Instruments
     -----------------------------------

     Fair value estimates are made by management at a specific point in time,
     based on relevant information about the financial instrument and the
     market. These estimates do not reflect any premium or discount that could
     result from offering for sale at one time the Company's entire holdings of
     a particular financial instrument nor are potential taxes and other
     expenses that would be incurred in an actual sale considered. Fair value
     estimates are based on judgments regarding future expected loss experience,
     current economic conditions, risk characteristics of various financial
     instruments, and other factors. These estimates are subjective in nature
     and involve uncertainties and matters of significant judgment and therefore
     cannot be determined with precision. Changes in assumptions and/or the
     methodology used could significantly affect the estimates disclosed.
     Similarly, the fair values disclosed could vary significantly from amounts
     realized in actual transactions.

     Fair value estimates are based on existing on and off-balance sheet
     financial instruments without attempting to estimate the value of
     anticipated future business and the value of assets and liabilities that
     are not considered financial instruments.

     The following table presents the carrying values and estimated fair values
     of the Company's financial instruments at December 31, 1997 and 1996:

<TABLE>
<CAPTION>
                                                  1997                  1996
                                           --------------------  --------------------
                                           Carrying  Estimated   Carrying  Estimated
                                            Value    Fair Value   Value    fair value
                                           --------  ----------  --------  ----------
                                                       (dollars in thousands)
<S>                                        <C>       <C>         <C>       <C>         
     Financial assets:
     Cash and interest-bearing deposits     $ 4,703     $ 4,703   $ 9,805     $ 9,805
      Investment securities:
       Available-for-sale                     1,854       1,859     2,723       2,723
       Held-to-maturity                       5,889       5,940     7,736       7,780
      Net loans                              92,967      92,549    82,992      82,617
      Federal Home Loan Bank stock              741         741       667         667
 
     Financial liabilities:
      Deposits                               66,973      67,106    66,564      66,667  
      Advance from FHLB                       7,800       7,805         -           -
</TABLE>

     The estimated fair values of net loans and deposits are based on cash flows
     discounted at market interest rates. The carrying values of other financial
     instruments, including various receivables and payables, approximate fair
     value.

     At December 31, 1997, the Company had outstanding 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 complete, and, therefore, they are deemed to have no
     current fair market value. Refer to note 3.

                                       38
<PAGE>
 
                                 CAPITAL STOCK
                            -----------------------

Stone Street Bancorp's common stock is traded on the American Stock Exchange
under the symbol "SSM". As of December 31, 1997, there were 1,898,052 shares
outstanding and 720 shareholders of record, not including the number of persons
or entities whose stock is held in nominee or street name through various
brokerage firms or banks. Payment of dividends by the Bank subsidiary to the
Parent is subject to various restrictions. Under applicable banking regulations,
the Bank may not declare a cash dividend if the effect thereof would be to
reduce its net worth to an amount less than the minimum required by federal and
state banking regulations. In addition, for a period of five years after the
consummation of the Bank's stock conversion, which occurred on March 29, 1996,
the Bank will be required to obtain prior written approval from the
Administrator of the Savings Institutions Division, North Carolina Department of
Commerce, before it can declare a cash dividend in an amount in excess of one-
half the greater of (i) its net income for the most recent fiscal year or (ii)
the average of its net income after dividends for the most recent fiscal year
and not more than two of the immediately preceding fiscal years, as applicable.

           Quarterly Common Stock Performance and Dividends Declared
                     For the Year Ended December 31, 1997

<TABLE> 
<CAPTION> 
                                            Stock Price     Dividends Declared, Per Share
                                         -----------------  -----------------------------

                                          High        Low
                                         ------      -----
<S>                                       <C>      <C>        <C>
  First Quarter ended January 31        $ 27 1/2   $  20 1/8            $ .1125
 
  Second quarter ended June 30            27 1/2      20 15/16            .1125

  Third quarter ended September 30 (1)    22 1/8      21 1/8             4.1125

  Fourth quarter ended December 31        22 7/8      18 1/2              .1125

----------------------------------
</TABLE>
 
  (1)  Includes regular cash dividend of $.1125 per share and a return of
       capital dividend of $4.00 per share.

                                      40