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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D. C. 20549

                                   FORM 10-KSB


                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2005                File Number 000-28037

                            FIRST SOUTH BANCORP, INC.
                 (Name of Small Business Issuer in its Charter)

         South Carolina                                  57-1086258
(State or Other Jurisdiction of             (IRS Employer Identification Number)
 Incorporation or Organization)

        1450 John B. White, Sr., Blvd., Spartanburg, South Carolina 29306
                (Address of Principal Executive Office, Zip Code)

         Issuer's Telephone Number, Including Area Code: (864) 595-0455

        Securities Registered Pursuant to Section 12(b) of the Act: None

           Securities Registered Pursuant to Section 12(g) of the Act:
                           Common Stock, No Par Value
                                (Title of Class)

         Check  whether the issuer is not required to file  reports  pursuant to
Section 13 or 15(d) of the Exchange Act { }

         Check whether the issuer (1) has filed all reports required to be filed
by  Section  13 or 15(d) of the  Exchange  Act during the past 12 months (or for
such shorter period that the Registrant was required to file such reports),  and
(2) has been subject to such filing requirements for the past 90 days.
 Yes {X}   No { }

         Check if there is no  disclosure  of  delinquent  filers in response to
Item 405 of  Regulation  S-B contained in this form,  and no disclosure  will be
contained,  to the  best of  registrant's  knowledge,  in  definitive  proxy  or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. { }

         Indicate by check mark whether the registrant is a shell company (as
Defined in Rule 126-2 of the Exchange Act).  Yes { }   No {X}

         The issuer's revenues for its most recent fiscal year were $21,725,929.

         The aggregate  market value of the Common Stock held by  non-affiliates
on February  28, 2006 was  approximately  $35,776,030.  As of February 28, 2006,
there were  1,750,444  shares of the  Registrant's  Common Stock,  no par value,
outstanding.  For purposes of the foregoing  calculation only, all directors and
executive officers of the Registrant have been deemed affiliates.

                       DOCUMENTS INCORPORATED BY REFERENCE

(1)  Portions of the Registrant's Proxy Statement for the 2006 Annual Meeting of
     Shareholders - Part III

Transitional Small Business Disclosure Format (check one): Yes {  }  No {X}

<PAGE>

                                     Part 1

Item 1.  Description of Business.

General

         First South Bancorp,  Inc.,  (the  "Company") is a bank holding company
with no operations other than those carried on by its  wholly-owned  subsidiary,
First South Bank (the "Bank").  The Company was organized in 1999 under the laws
of South  Carolina  for the purpose of becoming a holding  company for the Bank.
The Bank conducts a general banking  business under a state charter  approved by
the South Carolina State Board of Financial Institutions (the "State Board") and
granted by the Secretary of State of South  Carolina.  The Bank was organized in
1996. The Bank conducts its activities from its main office and a branch office,
opened in 1997, in Spartanburg,  South Carolina,  a branch opened in March, 2000
in  Columbia,  South  Carolina,  a branch  opened in July,  2003 in Hilton  Head
Island,  South  Carolina,  and a  loan  production  office  opened  in  2003  in
Asheville, North Carolina.

         The Bank's business primarily consists of accepting deposits and making
loans.  The Bank seeks deposit  accounts from  households  and businesses in its
primary  market areas by offering a full range of savings  accounts,  retirement
accounts (including Individual Retirement  Accounts),  checking accounts,  money
market accounts,  and time  certificates of deposit.  It also makes  commercial,
real estate and installment loans, primarily on a secured basis, to borrowers in
and around  Spartanburg,  Richland,  and Beaufort Counties in South Carolina and
Buncombe  County in North  Carolina.  In  addition,  the Bank also  makes  other
authorized investments. As of December 31, 2005, the Bank employed 58 persons on
a full time equivalent basis.

Competition

         The Bank competes  primarily in the South Carolina city of Spartanburg,
for which the most recent market share data available is as of June 30, 2005. At
that time, in Spartanburg,  13 banks,  savings and loans, and savings banks with
43 branch  locations  competed for aggregate  deposits of  approximately  $2.086
billion.  The Bank has a city-wide  deposit  market  share of 7.20% and a market
share  rank of 7 out of the 13  competitors.  The Bank  also has a  full-service
branch  located in the city of  Columbia,  South  Carolina and  Bluffton,  South
Carolina.  The  Columbia  branch has a market  share of .80%,  and the  Bluffton
branch has a market share of 1.86%.

         Banks generally compete with other financial  institutions  through the
savings  products and services  offered,  the pricing of services,  the level of
service provided,  the convenience and availability of services,  and the degree
of expertise  and  personal  concern  with which  services  are offered.  In the
conduct of certain  areas of its business,  the Bank  competes  with  commercial
banks, credit unions,  consumer finance companies,  insurance  companies,  money
market  mutual  funds and other  financial  institutions,  some of which are not
subject to the same degree of regulation and restriction  imposed upon the Bank.
Many of these  competitors  have  substantially  greater  resources  and lending
limits than the Bank and offer certain services,  such as international  banking
services and trust services, which the Bank does not provide.  Moreover, most of
these  competitors  have more numerous branch offices located  throughout  their
market areas,  a competitive  advantage  that the Bank does not have to the same
degree.

         The banking industry is significantly  affected by prevailing  economic
conditions as well as by government policies and regulations  concerning,  among
other things,  monetary and fiscal affairs,  the housing  industry and financial
institutions.  Deposits at banks are influenced by a number of economic factors,
including interest rates, competing  instruments,  levels of personal income and
savings and the extent to which interest on retirement  savings  accounts is tax
deferred.  Lending  activities  are  also  influenced  by a number  of  economic
factors,  including  demand  for  and  supply  of  housing,  conditions  in  the
construction  industry and  availability of funds.  Primary sources of funds for
lending  activities  include savings  deposits,  income from  investments,  loan
principal  repayments,   and  proceeds  from  sales  of  loans  to  conventional
participating lenders.



                                       2
<PAGE>

Effect of Government Regulation

         Bank  holding  companies  and banks  are  extensively  regulated  under
federal and state law. To the extent that the  following  information  describes
statutory  and  regulatory  provisions,  it is  qualified  in  its  entirety  by
reference to such  statutes and  regulations.  Any change in  applicable  law or
regulation  may have a material  effect on the  business  of the Company and the
Bank.

General

         As a bank holding  company under the Bank Holding Company Act ("BHCA"),
the  Company  obtained  the  approval of the Board of  Governors  of the Federal
Reserve System (the "Federal Reserve") to acquire the Bank and is subject to the
regulations of the Federal Reserve. Under the BHCA, the Company's activities and
those of its subsidiaries are limited to banking, managing or controlling banks,
furnishing  services to or performing  services for its subsidiaries or engaging
in any other  activity  which the Federal  Reserve  determines  to be so closely
related to banking or managing or controlling  banks as to be a proper  incident
thereto. The Company may engage in a broader range of activities if it becomes a
"financial  holding company"  pursuant to the  Gramm-Leach-Bliley  Act, which is
described below under the caption  "Gramm-Leach-Bliley  Act." The BHCA prohibits
the Company  from  acquiring  direct or indirect  control of more than 5% of the
outstanding  voting stock or substantially all of the assets of any bank or from
merging or  consolidating  with  another  bank  holding  company  without  prior
approval of the Federal  Reserve.  Additionally,  the BHCA prohibits the Company
from engaging in or from  acquiring  ownership or control of more than 5% of the
outstanding voting stock of any company engaged in a non-banking business unless
such business is determined by the Federal  Reserve to be so closely  related to
banking as to be properly  incident  thereto.  The BHCA generally does not place
territorial   restrictions  on  the  activities  of  such  non-banking   related
activities.

         The Company is also subject to regulation and  supervision by the South
Carolina  State Board of Financial  Institutions  (the "State  Board").  A South
Carolina bank holding company must provide the State Board with information with
respect to the financial  condition,  operations,  management and  inter-company
relationships of the holding company and its subsidiaries.  The State Board also
may require such other information as is necessary to keep itself informed about
whether the  provisions  of South  Carolina law and the  regulations  and orders
issued  there under by the State Board have been  complied  with,  and the State
Board may examine any bank holding company and its subsidiaries.

Obligations of the Company to its Subsidiary Bank

         A number of obligations  and  restrictions  are imposed on bank holding
companies  and their  depository  institution  subsidiaries  by Federal  law and
regulatory  policy that are designed to reduce  potential  loss  exposure to the
depositors of such  depository  institutions  and to the FDIC insurance funds in
the event the depository  institution  is in danger of becoming  insolvent or is
insolvent.  For example, under the policy of the Federal Reserve, a bank holding
company is required to serve as a source of financial strength to its subsidiary
depository  institutions and to commit resources to support such institutions in
circumstances  where it might not do so absent such  policy.  In  addition,  the
"cross-guarantee"  provisions of the Federal  Deposit  Insurance Act, as amended
("FDIA"),  require  insured  depository  institutions  under  common  control to
reimburse the FDIC for any loss suffered or reasonably anticipated by either the
Savings  Association  Insurance Fund ("SAIF") or the Bank Insurance Fund ("BIF")
of the  FDIC  as a  result  of the  default  of a  commonly  controlled  insured
depository  institution or for any assistance provided by the FDIC to a commonly
controlled  insured  depository  institution in danger of default.  The FDIC may
decline to enforce the cross-guarantee provisions if it determines that a waiver
is in the best  interest  of the SAIF or the BIF or both.  The FDIC's  claim for
damages  is  superior  to  claims  of  shareholders  of the  insured  depository
institution  or its holding  company but is subordinate to claims of depositors,
secured  creditors and holders of subordinated  debt (other than  affiliates) of
the commonly controlled insured depository institutions.

         The FDIA also provides that amounts  received from the  liquidation  or
other resolution of any insured  depository  institution by any receiver must be
distributed (after payment of secured claims) to pay the deposit  liabilities of
the  institution  prior to payment  of any other  general  or  unsecured  senior
liability,   subordinated  liability,  general  creditor  or  shareholder.  This
provision gives depositors a preference over general and subordinated  creditors
and  shareholders  in the event a receiver is appointed to distribute the assets
of the Bank.



                                       3
<PAGE>

         Any capital  loans by a bank holding  company to any of its  subsidiary
banks are  subordinate  in right of payment  to  deposits  and to certain  other
indebtedness of such subsidiary  bank. In the event of a bank holding  Company's
bankruptcy,  any  commitment  by the bank  holding  company  to a  federal  bank
regulatory  agency to maintain the capital of a subsidiary  bank will be assumed
by the bankruptcy trustee and entitled to a priority of payment.

Capital Adequacy Guidelines for Bank Holding Companies and State Banks

         The various federal bank regulators,  including the Federal Reserve and
the FDIC have adopted  risk-based and leverage capital  adequacy  guidelines for
assessing bank holding company and bank capital adequacy. These standards define
what qualifies as capital and establish minimum capital standards in relation to
assets and off-balance sheet exposures, as adjusted for credit risks.

         Failure to meet capital  guidelines could subject the Bank to a variety
of enforcement  remedies,  including the termination of deposit insurance by the
FDIC and a prohibition on the taking of brokered deposits. See "Other Safety and
Soundness Regulations - Prompt Corrective Action" below.

         The risk-based  capital standards of both the Federal Reserve Board and
the FDIC explicitly identify  concentrations of credit risk and the risk arising
from non-traditional  activities,  as well as an institution's ability to manage
these risks,  as  important  factors to be taken into account by the agencies in
assessing an institution's overall capital adequacy. The capital guidelines also
provide that an institution's exposure to a decline in the economic value of its
capital  due to changes in interest  rates be  considered  by the  agencies as a
factor in evaluating a bank's capital  adequacy.  The Federal Reserve Board also
has issued additional  capital guidelines for bank holding companies that engage
in certain trading activities.

         The Company and the Bank met all requirements to be well capitalized at
December 31, 2005.

Payment of Dividends

         The  Company is a legal  entity  separate  and  distinct  from its bank
subsidiary.  Most of the  revenues of the  Company  are  expected to result from
dividends  paid to the Company by the Bank.  There are statutory and  regulatory
requirements  applicable to the payment of dividends by the  subsidiary  bank as
well as by the  Company  to its  shareholders.  It is not  anticipated  that the
Company will pay cash dividends in the near future.


Certain Transactions by the Company with its Affiliates

         Federal  law   regulates   transactions   among  the  Company  and  its
affiliates,  including  the  amount of the  Bank's  loans to or  investments  in
non-bank  affiliates and the amount of advances to third parties  collateralized
by  securities  of an  affiliate.  Further,  a  bank  holding  company  and  its
affiliates  are  prohibited  from  engaging in certain  tie-in  arrangements  in
connection with any extension of credit, lease or sale of property or furnishing
of services.

FDIC Insurance Assessments

         Because the Bank's deposits are insured by the BIF, the Bank is subject
to insurance assessments imposed by the FDIC. Currently, the assessments imposed
on all FDIC deposits for deposit insurance have an effective rate ranging from 0
to 27 basis points per $100 of insured deposits,  depending on the institution's
capital position and other supervisory factors. However,  legislation enacted in
1996 requires that both  SAIF-insured  and  BIF-insured  deposits pay a pro rata
portion  of the  interest  due  on  the  obligations  issued  by  the  Financing
Corporation  ("FICO").  The FICO  assessment  is adjusted  quarterly  to reflect
changes in the assessment  bases of the respective funds based on quarterly Call
Report and Thrift Financial Report  submissions.  The Federal Deposit  Insurance
Reform Act of 2005 will  change the manner and amount of  insurance  assessments
beginning in 2006. The changes are not expected to have a material affect on The
Bank in 2006


                                       4
<PAGE>

Regulation of the Bank

         The Bank is subject to regulation  and  examination by the FDIC and the
State Board. In addition, the Bank is subject to various other state and federal
laws and regulations,  including state usury laws, laws relating to fiduciaries,
consumer  credit  laws and laws  relating  to branch  banking.  The Bank's  loan
operations  are  also  subject  to  certain  federal  consumer  credit  laws and
regulations promulgated there under, including,  but not limited to: the federal
Truth-In-Lending   Act,  governing  disclosures  of  credit  terms  to  consumer
borrowers; the Home Mortgage Disclosure Act, requiring financial institutions to
provide certain information  concerning their mortgage lending; the Equal Credit
Opportunity  Act and the Fair Housing  Act,  prohibiting  discrimination  on the
basis of  certain  prohibited  factors  in  extending  credit;  the Fair  Credit
Reporting  Act,  governing  the use  and  provision  of  information  to  credit
reporting agencies;  the Bank Secrecy Act, dealing with, among other things, the
reporting of certain  currency  transactions;  and the Fair Debt Collection Act,
governing  the manner in which  consumer  debts may be collected  by  collection
agencies.  The deposit  operations  of the Bank are also subject to the Truth in
Savings Act, requiring certain disclosures about rates paid on savings accounts;
the  Expedited  Funds  Availability  Act,  which  deals with  disclosure  of the
availability  of funds  deposited in accounts and the  collection  and return of
checks by banks;  the Right to Financial  Privacy Act,  which  imposes a duty to
maintain  certain   confidentiality   of  consumer  financial  records  and  the
Electronic  Funds Transfer Act and regulations  promulgated  there under,  which
govern  automatic   deposits  to  and  withdrawals  from  deposit  accounts  and
customers'  rights and  liabilities  arising  from the use of  automated  teller
machines and other electronic banking services.

         The  Bank  is  also  subject  to  the  requirements  of  the  Community
Reinvestment  Act (the  "CRA").  The CRA imposes on  financial  institutions  an
affirmative  and  ongoing  obligation  to meet the credit  needs of their  local
communities,  including low- and moderate-income neighborhoods,  consistent with
the safe and sound operation of those institutions. Each financial institution's
actual performance in meeting community credit needs is evaluated as part of the
examination process, and also is considered in evaluating mergers,  acquisitions
and applications to open a branch or facility.

Other Safety and Soundness Regulations

         Prompt  Corrective  Action.  The federal  banking  agencies  have broad
powers under  current  federal law to take prompt  corrective  action to resolve
problems of insured depository institutions.  The extent of these powers depends
upon whether the  institutions in question are "well  capitalized,"  "adequately
capitalized,"    "undercapitalized,"    "significantly    undercapitalized"   or
"critically undercapitalized."

         A bank that is "undercapitalized"  becomes subject to provisions of the
FDIA:   restricting  payment  of  capital  distributions  and  management  fees;
requiring the FDIC to monitor the condition of the bank; requiring submission by
the bank of a capital  restoration plan;  prohibiting the acceptance of employee
benefit plan deposits; restricting the growth of the bank's assets and requiring
prior approval of certain  expansion  proposals.  A bank that is  "significantly
undercapitalized" is also subject to restrictions on compensation paid to senior
management  of the bank,  and a bank that is  "critically  undercapitalized"  is
further subject to  restrictions on the activities of the bank and  restrictions
on payments of subordinated debt of the bank. The purpose of these provisions is
to require banks with less than adequate capital to act quickly to restore their
capital and to have the FDIC move promptly to take over banks that are unwilling
or unable to take such steps.

         Brokered Deposits.  Under current FDIC regulations,  "well capitalized"
banks may accept brokered deposits without restriction, "adequately capitalized"
banks may accept  brokered  deposits  with a waiver  from the FDIC  (subject  to
certain  restrictions on payment of rates), while  "undercapitalized"  banks may
not accept brokered  deposits.  The regulations  provide that the definitions of
"well capitalized", "adequately capitalized" and "undercapitalized" are the same
as the  definitions  adopted by the agencies to implement the prompt  corrective
action  provisions  described in the  previous  paragraph.  Management  does not
believe  that  these  regulations  will have a  material  adverse  effect on the
operations of the Bank.

                                       5
<PAGE>

Interstate Banking

         Under the Riegle-Neal  Interstate Banking and Branching  Efficiency Act
of 1994 the Company and any other  adequately  capitalized  bank holding company
located in South  Carolina can acquire a bank located in any other state,  and a
bank  holding  company  located  outside  South  Carolina  can acquire any South
Carolina-based  bank, in either case subject to certain  deposit  percentage and
other restrictions.  Unless prohibited by state law, adequately  capitalized and
managed bank holding  companies are permitted to  consolidate  their  multistate
bank operations into a single bank subsidiary and to branch  interstate  through
acquisitions. De novo branching by an out-of-state bank is permitted only if the
laws of the host state expressly permit it. The authority of a bank to establish
and operate  branches within a state continue to be subject to applicable  state
branching  laws.  South  Carolina law was amended,  effective  July 1, 1996,  to
permit such  interstate  branching but not de novo branching by an  out-of-state
bank.

Gramm-Leach-Bliley Act

          The  Gramm-Leach-Bliley  Act,  which makes it easier for  affiliations
between banks,  securities firms and insurance  companies to take place,  became
effective  in March,  2000.  The Act removes  Depression-era  barriers  that had
separated  banks and  securities  firms,  and seeks to  protect  the  privacy of
consumers' financial information.

         Under  provisions of the  legislation  and  regulations  adopted by the
appropriate regulators, banks, securities firms and insurance companies are able
to structure new affiliations  through a holding company  structure or through a
financial subsidiary. The legislation creates a new type of bank holding company
called a "financial  holding  company" which has powers much more extensive than
those of standard holding companies.  These expanded powers include authority to
engage in "financial activities," which are activities that are (1) financial in
nature;  (2)  incidental  to  activities  that are  financial in nature;  or (3)
complementary  to a  financial  activity  and that do not  impose  a safety  and
soundness risk. Significantly,  the permitted financial activities for financial
holding  companies include authority to engage in merchant banking and insurance
activities,  including insurance portfolio investing. A bank holding company can
qualify as a financial holding company and expand the services it offers only if
all of its subsidiary depository institutions are well-managed, well-capitalized
and  have  received  a  rating  of   "satisfactory"   on  their  last  Community
Reinvestment Act examination.

         The  legislation  also  creates  another  new type of  entity  called a
"financial subsidiary." A financial subsidiary may be used by a national bank or
a group of national banks to engage in many of the same activities permitted for
a financial holding company, though several of these activities,  including real
estate development or investment,  insurance or annuity underwriting,  insurance
portfolio  investing and merchant  banking,  are reserved for financial  holding
companies.  A bank's  investment  in a financial  subsidiary  affects the way in
which the bank calculates its regulatory capital, and the assets and liabilities
of financial  subsidiaries  may not be consolidated  with those of the bank. The
bank must also be certain that its risk  management  procedures  are adequate to
protect it from  financial and  operational  risks created both by itself and by
any financial subsidiary.  Further, the bank must establish policies to maintain
the separate corporate  identities of the bank and its financial  subsidiary and
to prevent each from becoming liable for the obligations of the other.

         The Act also  establishes  the  concept  of  "functional  supervision,"
meaning that  similar  activities  should be  regulated  by the same  regulator.
Accordingly,  the Act spells out the regulatory authority of the bank regulatory
agencies,  the Securities and Exchange Commission and state insurance regulators
so that each type of activity is  supervised by a regulator  with  corresponding
expertise.  The Federal  Reserve Board is intended to be an umbrella  supervisor
with the  authority  to  require a bank  holding  company or  financial  holding
company  or any  subsidiary  of  either  to  file  reports  as to its  financial
condition,  risk management  systems,  transactions with depository  institution
subsidiaries  and  affiliates,  and compliance  with any federal law that it has
authority to enforce.



                                       6
<PAGE>

         Although the Act reaffirms that states are the regulators for insurance
activities  of  all  persons,  including   federally-chartered  banks,  the  Act
prohibits  states from preventing  depository  institutions and their affiliates
from conducting insurance activities.

         The Act also  establishes  a minimum  federal  standard  of  privacy to
protect the confidentiality of a consumer's  personal financial  information and
gives the consumer the power to choose how personal financial information may be
used by  financial  institutions.  The privacy  provisions  of the Act have been
implemented by adoption of regulations by various federal agencies.

         The Act and the  regulations  adopted  pursuant  to the Act  create new
opportunities  for the Company to offer  expanded  services to  customers in the
future,  though  the  Company  has not yet  determined  what the  nature  of the
expanded  services  might be or when the Company might find it feasible to offer
them. The Act has increased competition from larger financial  institutions that
are  currently  more  capable  than  the  Company  of  taking  advantage  of the
opportunity  to  provide a  broader  range of  services.  However,  the  Company
continues to believe that its commitment to providing high quality, personalized
service to customers will permit it to remain competitive in its market area.

Sarbanes-Oxley Act

         The  Sarbanes-Oxley  Act was  signed  into  law on July 30,  2002,  and
mandated  extensive reforms and requirements for public  companies.  The SEC has
adopted   extensive  new  regulations   pursuant  to  the  requirements  of  the
Sarbanes-Oxley  Act. The  Sarbanes-Oxley  Act and the SEC's new regulations have
increased  the  Company's  cost of  doing  business,  particularly  its fees for
internal  and  external  audit  services  and  legal  services,  and the law and
regulations  are  expected to continue to do so.  However,  the Company does not
believe that it will be affected by  Sarbanes-Oxley  and the new SEC regulations
in ways that are materially different or more onerous than those of other public
companies of similar size and in similar businesses.

Legislative Proposals

         Proposed  legislation which could significantly  affect the business of
banking is  introduced  in Congress  from time to time.  Management  of the Bank
cannot predict the future course of such  legislative  proposals or their impact
on the Company and the Bank should they be adopted.

Fiscal and Monetary Policy

         Banking is a business  which depends to a large extent on interest rate
differentials. In general, the difference between the interest paid by a bank on
its deposits and its other  borrowings,  and the interest  received by a bank on
its loans and  securities  holdings,  constitutes  the major portion of a bank's
earnings.  Thus, the earnings and growth of the Company and the Bank are subject
to the influence of economic  conditions  generally,  both domestic and foreign,
and also to the  monetary  and  fiscal  policies  of the  United  States and its
agencies,  particularly the Federal Reserve.  The Federal Reserve  regulates the
supply of money through various means,  including open market dealings in United
States government  securities,  the discount rate at which banks may borrow from
the Federal Reserve,  and the reserve  requirements on deposits.  The nature and
timing of any changes in such  policies  and their impact on the Company and the
Bank cannot be predicted.

Further Information

         Further  information  about the business of the Company and the Bank is
set forth in Item 6 - Management's Discussion and Analysis or Plan of Operation.

Item 2.  Description of Property.

     The  Bank  owns  the real  property  at 1450  John B.  White,  Sr.,  Blvd.,
Spartanburg,  South Carolina,  where its main offices are located. The Bank also
owns the real  property  adjacent to its main office at 1460 John B. White,  Sr.
Blvd,  Spartanburg,  South  Carolina.  A portion of this facility houses deposit
operations and the financial  services division of the Bank. The remaining space
is used for  several  tenants  and would  allow  further  expansion  of the main
office.  The  Bank  leases  the  properties  at  1035  Fernwood  Glendale  Road,
Spartanburg, South Carolina, 1333 Main Street, Columbia, South Carolina, 7 Arley
Way, Hilton Head, South Carolina.  All properties are believed to be well suited
for the Bank's needs.

                                       7
<PAGE>

Item 3.  Legal Proceedings.

         On May 6, 2002, Lisa Lesavoy,  as successor trustee,  filed a complaint
in the United States  District Court for the District of South Carolina  against
the  Corporation  and an employee of the  Corporation's  subsidiary,  as well as
against eight other entities and individuals.  The complaint alleged that one of
the individual  defendants  (not the employee) was the  plaintiff's  predecessor
trustee and  breached  various  duties to the two trusts in question  all to the
financial  detriment  of the trusts.  The  complaint  further  alleges  that the
Corporation and the employee by lending to and arranging credit transactions for
the  trusts,  together  with the other  defendants,  aided and abetted the prior
trustee's   breaches  and  violated  the   Racketeer   Influenced   and  Corrupt
Organizations  (RICO) Act. The complaint  sought  monetary  damages and attorney
fees. The claims filed under the RICO Act were summarily  dismissed by the court
in 2003. The Corporation  settled the remaining  complaint  allegations  through
mediation  in June  of 2005  and  recorded  a  pretax  settlement  expense  of $
1,677,155.

Item 4.  Submission of Matters to Vote of Security Holders.

         No matters  were  submitted  to a vote of security  holders  during the
fourth quarter of 2005.

                                     PART II

Item 5.  Market for Common  Equity and  Related  Stockholder  Matters  and Small
         Business Issuer Purchases of Equity Securities.

Market for Common Stock, Stockholders and Dividends

         Although the common stock of the Company is traded from time to time on
an individual  basis,  no  established  trading market has developed and none is
expected to develop in the foreseeable future. The common stock is not traded on
any exchange or on the NASDAQ  National Market System.  During 2005,  management
was aware of a few  transactions in which the Company's common stock traded in a
range from $27.00 to $35.50 per share.  However,  management has not ascertained
that these transactions are the result of arm's length negotiations  between the
parties, and because of the limited number of shares involved,  these prices may
not be indicative of the market value of the common stock.

         As of February 28, 2006, there were approximately 508 holders of record
of the Company's  common stock,  excluding  individual  participants in security
position listings.

         The  Company  has never paid any cash  dividends,  and to  support  its
continued  capital  growth,  does not expect to pay cash  dividends  in the near
future.  The dividend  policy of the Company is subject to the discretion of the
Board of  Directors  and depends upon a number of factors,  including  earnings,
financial  condition,  cash needs and general  business  conditions,  as well as
applicable regulatory  considerations.  At present, the Company's only source of
funds with which it could pay  dividends  is  dividend  payments  from the Bank.
South Carolina  banking  regulations  restrict the amount of cash dividends that
can  be  paid  to  shareholders,  and  all  of  the  Bank's  cash  dividends  to
shareholders   are  subject  to  the  prior   approval  of  the  South  Carolina
Commissioner of Banking.

Securities Authorized for Issuance under Equity Compensation Plans

         The information  required by Item 201(d) of Regulation S-B is set forth
in Item 11 of this Form 10-KSB.

Recent Sales of Unregistered Securities

         During  2005,  the  Company  did not issue any  unregistered  shares of
Common Stock  pursuant to the  Company's  stock  option  plan,  except for those
previously reported.

                                       8
<PAGE>

 Purchases of Equity Securities by the Company and Affiliated Purchasers

         Neither  the Company nor any  "affiliated  purchaser"  as defined in 17
C.F.R.  240.10b-18(a)(3)  purchased  any  shares  or units  of any  class of the
Company's  equity  securities  that is registered  pursuant to Section 12 of the
Exchange Act during the fourth  quarter of 2005.  Accordingly,  no disclosure is
required pursuant to 17 C.F.R. 228.703.

Item 6.  Management's Discussion and Analysis or Plan of Operation.

         Statements  included in this report which are not  historical in nature
are intended to be, and are hereby  identified as  "forward-looking  statements"
for purposes of the safe harbor  provided by section 21E of the  Securities  and
Exchange Act of 1934, as amended. Words such as "estimate", "project", "intend",
"expect",  "believe",  "anticipate",  "plan", and similar  expressions  identify
forward looking  statements.  The Company  cautions readers that forward looking
statements,  including without  limitation,  those relating to the Company's new
offices,  future  business  prospects,  revenues,  working  capital,  liquidity,
capital  needs,  adequacy of allowance  for loan  losses,  interest  costs,  and
income,  are subject to certain risks and uncertainties  that could cause actual
results to differ from those  indicated in forward  looking  statements,  due to
several important factors herein  identified,  among others, and other risks and
factors  identified  from time to time in the  Company's  reports filed with the
Securities and Exchange Commission.  These forward-looking  statements are based
on  current   expectations,   estimates  and  projections  about  our  industry,
management's  beliefs,  and  assumptions  made by management.  Such  information
includes,  without  limitation,   discussions  as  to  estimates,  expectations,
beliefs,  plans,  strategies,  and objectives  concerning  the Company's  future
financial and operating  performance.  These  statements  are not  guarantees of
future performance and are subject to risks,  uncertainties and assumptions that
are difficult to predict,  particularly in light of the fact that the Company is
a relatively  new company  with limited  operating  history.  Therefore,  actual
results may differ from those  expressed or forecasted  in such  forward-looking
statements. The risks and uncertainties include, but are not limited to:

     o The Company's growth and ability to maintain growth:

     o    government  monetary and fiscal  policies,  as well as legislative and
          regulatory changes:

     o    the effect of interest  rate changes on our level and  composition  of
          deposits,  loan  demand  and the  value  of our  loan  collateral  and
          securities:

     o    the effects of competition from other financial institutions operating
          in the Company's  market areas and elsewhere,  including  institutions
          operating locally, regionally, nationally and internationally:

     o    failure of assumptions  underlying the  establishment of the allowance
          for loan losses, including the value of collateral securing loans; and

     o    loss of consumer  confidence and economic  disruptions  resulting from
          terrorist activities.

     The Company  undertakes  no  obligation  to  publicly  update or revise any
forward-looking  statements,  whether  as a result  of new  information,  future
events or otherwise.  In light of these risks,  uncertainties,  and assumptions,
the forward-looking events discussed in this report might not occur.


    This  discussion  is  intended  to assist  in  understanding  the  financial
condition  and  results  of  operations  of the  Company,  and should be read in
conjunction with the financial  statements and related notes contained elsewhere
herein. Because the Bank is responsible for all of the Company's operations, the
discussion will refer to the results of operations of the Bank.

                                      9
<PAGE>

Critical Accounting Policies

         The Company has adopted  various  accounting  policies which govern the
application of accounting  principles generally accepted in the United States of
America  in  the  preparation  of  the  Company's  financial   statements.   The
significant accounting policies of the Company are described in the footnotes to
the consolidated financial statements.

         Certain   accounting   policies  involve   significant   judgments  and
assumptions by management, which have a material impact on the carrying value of
certain assets and liabilities. Management considers such accounting policies to
be  critical  accounting  policies.   The  judgments  and  assumptions  used  by
management  are based on  historical  experience  and other  factors,  which are
believed to be reasonable under the circumstances.  Because of the nature of the
judgments and assumptions  made by management,  actual results could differ from
those  judgments  and  estimates,  which  could  have a  material  impact on the
carrying  values of assets and  liabilities and the results of operations of the
Company.

         The  Company  believes  the  allowance  for loan  losses is a  critical
accounting  policy that  requires the most  significant  judgments and estimates
used in  preparation  of its  consolidated  financial  statements.  Refer to the
section  "Allowance  for  Loan  Losses"  for  a  description  of  the  Company's
estimation and methodology related to the allowance for loan losses.

Earnings Performance

         The Company had net income from  operations for the year ended December
31, 2005, of $3,400,004, or $1.97 per share, compared to net income for the year
ended  December 31, 2005, of  $3,000,055 or $1.87 per common share.  The Company
had net interest  income (the  difference  between  interest  earned on interest
earning assets and interest paid on interest bearing liabilities) of $12,669,011
for 2005,  as  compared to  $10,102,590  for 2004.  The  Company  also had other
operating Income (principally service charges, fees and commissions) of $915,831
in 2005 and  $1,189,247 in 2004. The Company  provided  $561,086 and $705,522 to
its  allowance  for loan  losses in 2005 and 2004,  respectively,  and had other
ordinary operating  expenses(principally salaries and benefits and occupancy and
equipment  expenses) of $6,004,254 in 2005,  and $5,930,260 in 2004. The Company
also recorded in 2005 an extraordinary  expense of $1,677,155 resulting from the
mediated  settlement of the legal  complaint  filed in May 2002, as discussed in
Part 1, Item 3 - Legal Proceedings.

Net Interest Income

         Net  interest  income is the  amount  of  interest  earned on  interest
earning assets (loans, investment securities, interest-bearing deposits in other
banks and federal funds sold),  less the interest  expenses incurred on interest
bearing  liabilities  (interest bearing deposits and borrowed money), and is the
principal source of the Company's  earnings.  Net interest income is affected by
the level of  interest  rates,  volume and mix of  interest  earning  assets and
interest bearing liabilities, and the relative funding of these assets.

         For  the  year  ended  December  31,  2005,  net  interest  income  was
$12,669,011.  During the year ended December 31, 2004,  net interest  income was
$10,102,590.  The 25.4% increase in net interest income in 2005 can be primarily
attributed to the two hundred basis point  increase in the prime rate during the
year. The extent of the Company's asset sensitivity (a balance sheet position in
which earning assets reprice more frequently than interest-bearing  liabilities)
in the rising interest rate environment of 2005 contributed significantly to the
increase in net interest income.  The increase in average earning assets in 2005
of  $33.1   million,   especially   as  compared  to  the  increase  in  average
interest-bearing  liabilities during the same period of 30.7 million, was also a
significant  contributor  to the  increase  in net  interest  income.  These two
factors served as the primary basis for the  improvement of the interest  spread
between the earning assets yield and  interest-bearing  liabilities funding cost
of 35 basis points, from 3.52% in 2004 to 3.87% in 2005, and the increase in the
net interest margin of 44 basis points, from 3.81% in 2004 to 4.25% in 2005.

                                       10
<PAGE>

           The table "Average  Balances,  Yields and Rates," provides a detailed
analysis of the effective yields and rates on the categories of interest earning
assets and interest  bearing  liabilities for the years ended December 31, 2005,
2004, and 2003.

<TABLE>
<CAPTION>
                                                                  Average Balances, Yields, and Rates
                                                                         (Dollars in Thousands)
                                                                        Year Ended December 31,
                                                                        -----------------------

                                                       2005                          2004                           2003
                                                       ----                          ----                           ----
                                                       Interest                      Interest                       Interest
                                           Average     Income/  Yields/  Average     Income/  Yields/   Average     Income/  Yields/
                                           Balances(1) Expense  Rates    Balances(1) Expense  Rates     Balances(1) Expense  Rates
                                           ----------- -------  -----    ----------- ------  -----     ------------ ------  -----
Assets

Due From banks -
<S>                                        <C>         <C>      <C>      <C>         <C>      <C>      <C>         <C>      <C>
Interest-bearing                           $ 15,705    $   506  3.22%    $  9,266    $   137  1.48%    $  6,761    $    70  1.04%
Investment securities (2)                    24,398        932  3.82%      16,759        598  3.57%      13,666        533  3.90%
Loans (3) (4)                               257,949     19,372  7.51%     238,958     14,576  6.10%     194,944     12,282  6.30%
                                           --------    -------                       -------                       -------
Total interest earning assets               298,052    $20,810  6.98%     264,983    $15,311  5.78%     215,374    $12,884  5.98%
Cash and due from banks                       5,555                         4,715                         4,663
Valuation reserve for investment
securities                                    (150)                            27                           100
Allowance for loan losses                   (3,035)                       (2,694)                        (2,144)
Premises and equipment                        5,268                         5,369                         4,217
Investment in Trust                             155                           142                             -
Other assets                                  4,692                         3,780                         3,630
                                           --------                      --------                      --------
Total assets                               $310,537                      $276,322                      $225,840
                                           ========                      ========                      ========
Liabilities and shareholders' equity
Interest bearing transaction accounts      $ 38,481    $   976  2.54%    $ 33,917    $   586  1.73%    $ 33,729    $   579  1.72%
Savings                                      49,612      1,276  2.57%      47,889        845  1.76%      34,094        613  1.80%
Time deposits $100,000 and over              44,868      1,505  3.35%      35,525        850  2.39%      28,312        699  2.47%
Other time deposits                         108,713      3,487  3.21%      93,294      2,218  2.38%      80,867      2,035  2.52%
                                           --------    -------           --------    -------           --------    -------
Total interest bearing deposits            $241,674    $ 7,244  2.99%    $210,625    $ 4,499  2.14%    $177,002    $ 3,926  2.22%
Retail repurchase agreements                  4,706        127  2.70%       5,156         47  0.91%       4,903         25  0.51%
Subordi nated debt                            5,000        311  6.22%       4,583        201  4.39%           -          -  0.00%
Other Borrowed Funds - Long Term             10,000        452  4.52%      10,543        461  4.37%      10,672        460  4.31%
Other Borrowed Funds - Short Term               238          7  2.94%         543          9  1.66%         672          8  1.19%
                                           --------    -------                             -           --------    -------
Total interest bearing liabilities         $261,618    $ 8,141  3.11%    $231,450    $ 5,217  2.25%    $192,577    $ 4,411  2.29%
Non-interest bearing demand deposits         17,450                        20,837                        16,046
Other liabilities                             2,508                         2,088                         1,854
Shareholders' equity                         28,961                        22,490                        15,363
                                           --------                      --------                      --------
Total liabilities and  shareholders'
equity                                     $310,537                      $276,865                      $225,840
                                           ========                      ========                      ========
Interest rate spread (5)                                        3.87%                         3.52%                         3.69%
Net interest income and net yield on
earning  assets (6)                                    $12,669  4.25%                $10,094  3.81%                $ 8,473  3.93%
Interest free funds supporting
earning assets (7)                         $ 36,434                      $ 34,076                      $ 22,797

</TABLE>
(1)  Average balances are computed on a daily basis.
(2)  Average investment securities include $183,796 Tax Exempt securities.
(3)  Nonaccruing  loans are included in the average loan  balances and income on
     such loans is  recognized  on a cash basis and excludes  impact of deferred
     loan origination fees.
(4)  Interest income on loans for 2005, 2004, and 2003, included total loan fees
     of $1,039, $993, and $893, respectively.
(5)  Total  interest  earning  assets  yield  less the  total  interest  bearing
     liabilities rate.
(6)  Net interest income divided by total interest  earning assets (net interest
     margin).
(7)  Total interest earning assets less total interest bearing liabilities.

                                       11
<PAGE>

Rate/Volume Analysis of Net Interest Income

         The  effect  of  changes  in  average  balances  (volume)  and rates on
interest  income,  interest  expense and net  interest  income,  for the periods
indicated,  is shown below.  The effect of a change in average  balance has been
determined  by applying the average rate in the earlier  period to the change in
average balance in the later period,  as compared with the earlier  period.  The
effect of a change in the  average  rate has been  determined  by  applying  the
average  balance in the later  period to the change in the  average  rate in the
later  period,  as compared  with the earlier  period.  Changes  resulting  from
average balance/rate variances are included in changes resulting from volume.

                                                   Year Ended December 31,
                                                    2005 compared to 2004
                                                 Increase (Decrease) Due to
                                                   (Dollars in thousands)

                                                Volume       Rate        Total
                                                ------       ----        -----
Interest earned on:
  Due from banks-interest-bearing ........     $    95      $   274     $   369
  Invesments .............................         272           62         334
  Net Loans ..............................       1,159        3,637       4,796
                                               -------      -------     -------

Total Interest Income ....................     $ 1,526      $ 3,973     $ 5,499
                                               -------      -------     -------

Interest paid on:
  Interest Checking ......................     $    79      $   311     $   390
  Savings Deposits .......................          30          401         431
  Time Deposits 100,000 and over .........         224          431         655
  Other time deposits ....................         366          903       1,269
  Retail Repurchase Agreements ...........          (4)          84          80
  Subordinated Debt ......................          18           92         110
  Other Borrowed Funds ...................         (13)          11          (2)
                                               -------      -------     -------

Total Interest Expense ...................     $   700      $ 2,233     $ 2,933
                                               -------      -------     -------

Change in Net Interest Income ............     $   826      $ 1,740     $ 2,566
                                               =======      =======     =======

During the year 2006  management  expects that  interest  rates will continue to
rise slightly.  Slight improvements in net interest income for 2006 are expected
to be the result of  increases  in the volume and rates.  Management  expects to
continue following the market strategies which it has employed to date.

Interest Rate Sensitivity

         Interest rate  sensitivity  management is concerned with the timing and
magnitude of repricing  assets  compared to liabilities and is an important part
of asset/liability  management. It is the objective of interest rate sensitivity
management to generate stable growth in net interest income,  and to control the
risks  associated  with interest rate movement.  Management  constantly  reviews
interest rate risk exposure and the expected  interest rate  environment so that
timely adjustments in interest rate sensitivity can be made.

         The  table,  "Interest  Sensitivity  Analysis",  indicates  that,  on a
cumulative  basis through twelve months,  rate  sensitive  assets  exceeded rate
sensitive liabilities,  resulting in an asset sensitive position at December 31,
2005 of $29.1  million  for a  cumulative  gap ratio of 111.65%.  When  interest
sensitive  liabilities exceed interest sensitive assets for a specific repricing
"horizon", a negative interest sensitivity gap results. The gap is positive when
interest sensitive assets exceed interest sensitive liabilities, as was the case
at December 31,  20045,  with respect to the one year time  horizon.  For a bank
with a positive gap, such as the Bank,  rising  interest rates would be expected
to have a positive  effect on net  interest  income and  falling  rates would be
expected to have the opposite effect.

                                       12
<PAGE>

         The table below  reflects the balances of interest  earning  assets and
interest  bearing  liabilities  at the  earlier of their  repricing  or maturity
dates.  Amounts  of fixed  rate  loans are  reflected  at the  earlier  of their
contractual  maturity  date or the  date at  which  the  loans  may be  repriced
contractually.  Time  deposits in other  banks are  reflected  in the  deposits'
maturity dates.  Repurchase agreements and other borrowed funds are reflected in
the earliest  contractual  repricing  interval due to the immediately  available
nature  of  these  funds.  Interest  bearing  liabilities  with  no  contractual
maturity,  such as interest bearing  transaction  accounts and savings deposits,
are reflected in the earliest repricing interval due to contractual arrangements
which give  management the  opportunity to vary the rates paid on these deposits
within a thirty day or shorter period.  However, the Bank is under no obligation
to vary the rates paid on those  deposits  within any given  period.  Fixed rate
time  deposits are reflected at their  contractual  maturity  dates.  Fixed rate
advances are reflected at their  contractual  maturity dates,  and variable rate
advances  are  reflected  in the  earliest  repricing  interval  since they were
borrowed under the daily rate credit option, and reprice daily.

<TABLE>
<CAPTION>
                                                                              Interest Sensitivity Analysis
                                                                        Repricing Schedule as of December 31, 2005
                                                                                  (Amounts in thousands)

                                                            Within          4-12       After One Year      After
                                                           3 Months        Months       to Five Years    Five Years         Total
                                                           --------        ------       -------------    ----------         -----
Interest Earning Assets

<S>                                                      <C>             <C>              <C>             <C>              <C>
Interest-bearing deposits in other banks ..........      $  13,510       $       -        $       -       $       -        $  13,510
Other investments (Book Value)* ...................          4,052           7,766           14,490           4,605           30,913
Loans**
  Fixed rate ......................................          4,992           9,733           11,787           1,238           27,750
  Variable rate ...................................        238,889               -                -               -          238,889
                                                         ---------       ---------        ---------       ---------        ---------
Total interest earning assets .....................      $ 261,443       $  17,499        $  26,277       $   5,843        $ 311,062
                                                         =========       =========        =========       =========        =========
Interest Bearing
Liabilities
  Interest bearing deposits
    Interest bearing transaction accounts .........      $  34,497              $-               $-              $-        $  34,497
    Savings .......................................         45,784               -                -          45,784
    Time deposits $100,000 and over ...............         11,201          35,361            7,234               -           53,796
    Other time deposits ...........................         31,496          75,459           10,783               -          117,828
                                                         ---------       ---------        ---------       ---------        ---------
      Total interest bearing deposits .............      $ 122,978       $ 110,820        $  18,107              $-        $ 251,905
    Retail  repurchase
agreements ........................................          5,740                                -               -            5,740
    Subordinated debt .............................          5,000               -                -               -            5,000
    Other borrowed funds ..........................          5,298               -                -          10,000           15,298
                                                         ---------       ---------        ---------       ---------        ---------

Total interest bearing liabilities ................      $ 139,016       $ 110,820        $  18,107       $  10,000        $ 277,943
                                                         =========       =========        =========       =========        =========

Interest Sensitivity Gap ..........................      $ 122,427       $ (93,321)       $   8,170       $  (4,157)       $  33,119
Cumulative interest sensitivity gap ...............      $ 122,427       $  29,106        $  37,276       $  33,119
Gap ratio .........................................         188.07%          15.79%          145.12%          58.43%
Cumulative gap ratio ..............................         188.07%         111.65%          113.91%         111.92%
</TABLE>

*includes restricted FHLB stock $1,269
** excludes loans in non-accrual status totaling $1,893




                                       13
<PAGE>

Provision for Loan Losses

         The allowance for loan losses,  established  through charges to expense
in the form of a provision for loan losses,  allows for loan losses  inherent in
the Bank's loan  portfolio.  Loan losses or  recoveries  are charged or credited
directly to the  allowance.  The level of the  allowance  for loan losses at any
given reportable  period is the result of applying the methodology  discussed in
the section  under the heading  "Allowance  for Loan  Losses." The Bank provided
$561,086,  $705,522,  and  $949,302  to the  allowance  during  the years  ended
December 31, 2005,  2004,  and 2003  respectively.  The decreases of $144,436 in
2005 and $243,780 in 2004 were  primarily due to slower  growth in loans.  Total
loans grew by $13.8 million in 2005 and $27.5 million in 2004.

Other Income

         Other income,  which consists  primarily of mortgage banking loan fees,
loan brokerage fees, service charges on deposit accounts,  and other commissions
and fees  income,  decreased  by  $273,802,  or 23.0% to  $915,445  in 2005 from
$1,189,247  in 2004.  The overall  decline  resulted from a decline in all Other
Income  categories.  Service  charges,  commissions  and fees income declined by
$42,241,  or 6.1%; loan brokerage fees declined by $77,722,  or 32.2%,  mortgage
loan fees declined by $76,697,  or 60.0%.  The  remainder of the total  $273,802
decline,  $77,142,  was due almost  exclusively  to the  difference  between the
amounts received in 2004 and 2005 from the sale of bank owned assets.


Other Expenses

         Other expenses,  those non-interest  expenses most commonly referred to
as other  operating  expenses,  increased  by  $1,770,807,  or  29.9%,  in 2005.
However, most of the net increase on other expenses resulted from the $1,677,155
litigation  settlement  expense  discussed in Part 1, Item 3 Legal  Proceedings.
Excluding this extraordinary expense item, the total of other expenses increased
by only $93,652,  or 1.6%, with some  categories of other expenses  declining in
2005 from 2004. Most notable of the categories  with a declining  annual expense
were  occupancy  and equipment  expense,  down  $63,223,  or 7.7%,  and expenses
related to use of third party providers of services exclusive of data processing
services.  The total of the other outside services expense category decreased by
$44,348,  or 34.5%.  The categories of other expenses  having the largest dollar
increase  were salaries and benefits  expense,  up $182,619,  or 5.1%,  and data
processing expense, up $21,553, or 1.1%.

Income Taxes

         During the year ended December 31, 2004, the Company accrued $1,700,000
for current  income taxes.  The Company  accrued  $1,946,300  for current income
taxes  during  2005.  The Company  accounts for income taxes under SFAS No. 109,
"Accounting for Income Taxes." Certain items of income and expense  (principally
provision for loan losses and depreciation) are included in one reporting period
for financial  accounting  purposes and another for income tax  purposes.  These
accounting  timing  differences  resulted  in a deferred  income tax  benefit of
$24,000 being recognized in 2005, and $44,000 being recognized in 2004.

Investment Portfolio

         As of December 31,  2005,  the book value of the  Company's  investment
portfolio comprised approximately 9.5 % of its total assets. The following table
summarizes the carrying value amounts of securities held by the Bank at December
31, 2005, 2004, and 2003.



                                       14
<PAGE>

Securities Portfolio Composition
(dollars in thousands)

<TABLE>
<CAPTION>
                                             December 31, 2005                 December 31, 2004          December 31, 2003
                                             -----------------                -----------------          -----------------
                                                   Net                               Net                          Net
                                                 Unrealized                       Unrealized                    Unrealized
                                         Book     Holding     Fair       Book      Holding      Fair     Book    Holding      Fair
                                        Value    Gain/(Loss) Value       Value    Gain/(Loss)  Value    Value   Gain/(Loss)  Value
                                        -----    -----------------       -----    -----------  -----    -----   -----------  -----
Available for sale:
<S>                                   <C>        <C>        <C>        <C>        <C>        <C>       <C>       <C>        <C>
U. S. Government agency obligations   $ 21,490   $   (264)  $ 21,226   $ 16,499   $    (18)  $ 16,481  $  9,498  $     47   $  9,545
State and local obligations .......        123          6        129        123          4        127       123         5        128
Mortgage-backed securities ........        766        (24)       742        961        (16)       944         -         -          -
Restricted FHLB Stock .............      1,269          -      1,269        954          -        954       700         -        700
                                      --------   --------   --------   --------   --------   --------  --------  --------   --------
                                      $ 23,648   $   (282)  $ 23,366   $ 18,536   $    (30)  $ 18,506  $ 10,321  $     52   $ 10,373
                                      ========   ========   ========   ========   ========   ========  ========  ========   ========
Held for investment:
U.S. Government Agency obligations    $  6,000   $     (2)  $  5,998   $  1,004   $     (1)  $  1,003  $  1,011  $     13   $  1,024
Trust Preferred securities ........        481        153        634        479        133        613       478       127        605
State and local obligations .......          -          -          -        375         10        385       375        12        387
Mortgage-backed securities ........        783         12        795      1,500         39      1,539     2,010         7      2,017
                                      --------   --------   --------   --------   --------   --------  --------  --------   --------
                                      $  7,264   $    163   $  7,427   $  3,358   $    181   $  3,539  $  3,874  $    159   $  4,033
                                      ========   ========   ========   ========   ========   ========  ========  ========   ========
</TABLE>

         On an ongoing basis,  management  assigns securities upon purchase into
one of two categories  (available-for-sale or held-to-maturity) based on whether
it has the intent to hold the securities to maturity,  taking into consideration
factors such as expectations  for changes in market  interest  rates,  liquidity
needs,  asset/liability  management  strategies,  and capital requirements.  The
Company does not maintain a securities trading account.

         The following table presents scheduled maturities of debt securities at
December 31, 2005.  Available-for-sale  securities  are stated at estimated fair
value and held-for-investment securities are stated at amortized cost.




                                       15
<PAGE>

Securities Portfolio Maturities

<TABLE>
<CAPTION>
                                                                                       Analysis of Investment Securities
                                                                                               December 31, 2005
                                                                                            (dollars in thousands)

                                                                                  Available-for-Sale            Held-for-Investment
                                                                                  ------------------            -------------------
                                                                              Amortized       Estimated       Amortized    Estimated
                                                                                Cost          Fair Value        Cost      Fair Value
                                                                                ----          ----------        ----      ----------
<S>                                                                           <C>             <C>              <C>            <C>
U.S. Government Agency Obligations Due in one year or less ............       $  9,000        $  8,938         $    -         $    -
    Due after one through five years ..................................         10,491          10,327          4,000          3,990
    Due after five through ten years ..................................          1,000             985          2,000          2,008
    Due after ten years ...............................................          1,000             976              -              -
State and local obligations (1)
    Due after ten years ...............................................            123             129              -              -

Trust Preferred securities
    Due after ten years ...............................................              -               -            481            634
Mortgage Backed securities ............................................            766             742            783            795

Equity Securities .....................................................          1,269           1,269              -              -

Total (2)(3)

    Due in one year or less ...........................................       $  9,000        $  8,938         $    -         $    -
    Due after one through five years ..................................         10,491          10,327          4,000          3,990
    Due after five through ten years ..................................          1,000             985          2,000          2,008
    Due after ten years ...............................................          1,123           1,105            783            795
</TABLE>
(1)  Not adjusted for tax equivalency
(2)  Excludes equity securities
(3)  Weighted average yields on debt securities scheduled to mature in less than
     one year,  one to five  years,  five to ten years,  and after ten years are
     2.57%,  3.46%,  3.96% and 4.54%,  respectively.  Due to call  features (the
     ability of the  issuing  entity to redeem a security  on a  specified  date
     prior to  maturity),  the  yields  shown for the four  maturity  ranges are
     disclosed for  information  purposes only as of December 31, 2005,  and are
     likely to change.

  Loan Portfolio

         Management believes the loan portfolio is adequately diversified. There
are no  significant  concentrations  of loans in any  particular  individuals or
industry or group of related individuals or industries, or any foreign loans.

         The amount of loans outstanding at December 31, 2005, 2004, 2003, 2002,
and 2001 are shown in the following table according to type of loan.

                                       16
<PAGE>

Loan Portfolio Composition

<TABLE>
<CAPTION>
                                                                                      December 31,
                                                                                      ------------
                                                       2005             2004             2003              2002             2001
                                                       ----             ----             ----              ----             ----
<S>                                               <C>              <C>              <C>              <C>              <C>
Commercial, financial and agricultural ........   $  45,229,728    $  46,728,921    $  51,523,910    $  47,099,954    $  36,270,381
Real estate - construction ....................      14,041,295       17,223,132       14,345,975       14,211,986       13,097,957
Real estate  - mortgage .......................     208,851,125      190,325,765      160,813,718       96,495,309       76,168,473
Consumer ......................................         409,653          470,787          554,999        1,053,596          629,235
                                                  -------------    -------------    -------------    -------------    -------------
    Total loans ...............................     268,531,801      254,748,605      227,238,602      158,860,845      126,166,046

Less allowance for loan losses ................      (3,000,000)      (2,900,000)      (2,600,000)      (1,750,000)      (1,450,000)
                                                  -------------    -------------    -------------    -------------    -------------

Total Loans, net of allowance for loan losses .   $ 265,531,801    $ 251,848,605    $ 224,638,602    $ 157,110,845    $ 124,716,046
                                                  =============    =============    =============    =============    =============
</TABLE>

         A certain degree of risk taking is inherent in the extension of credit.
Management has established loan and credit policies designed to control both the
types and  amounts of risks  assumed and to  ultimately  minimize  losses.  Such
policies include limitations on  loan-to-collateral  values for various types of
collateral,  requirements for appraisals of real estate collateral, problem loan
management  practices and collection  procedures,  and nonaccrual and charge-off
guidelines.

         Commercial loans primarily represent loans made to businesses,  and may
be made on either a secured or an  unsecured  basis.  Collateral  is  ordinarily
taken unless the borrower has strong cash flows,  low debt to worth ratios,  and
the loan is of short duration.  When taken, collateral usually consists of liens
on  receivables,  equipment,  inventories,  furniture  and  fixtures.  Unsecured
business loans are generally short-term with emphasis on repayment strengths and
low debt to worth ratios.  Commercial lending involves  significant risk because
repayment usually depends on the cash flows generated by a borrower's  business,
and the debt service capacity of a business can deteriorate because of downturns
in  national  and local  economic  conditions.  To  control  risk,  initial  and
continuing financial analysis of a borrower's financial information is required.

         Real estate  construction  loans  generally  consist of  financing  the
construction  of 1-4 family  dwellings  and some  nonfarm,  nonresidential  real
estate.  Usually, loan to cost ratios are limited to 75% and permanent financing
commitments are required prior to the advancement of loan proceeds.

         Loans  secured by real  estate  mortgages  comprised  nearly 78% of the
Bank's loan  portfolio  at December  31,  2005.  Residential  real estate  loans
consist mainly of first and second  mortgages on single family homes,  with some
multifamily  loans.  Loan-to-value  ratios for these  instruments  are generally
limited  to 90%.  Nonfarm,  nonresidential  loans are  secured by  business  and
commercial  properties with  loan-to-value  ratios generally limited to 80%. The
repayment  of both  residential  and  business  real estate  loans is  dependent
primarily  on the income and cash flows of the  borrowers,  with the real estate
serving as a secondary or liquidation source of repayment.

         Consumer loans generally involve more risks than other loans because of
the type and nature of the underlying  collateral,  or because of the absence of
collateral.  Consumer loan repayments are dependent on the borrower's continuing
financial stability and are likely to be adversely affected by job loss, divorce
and illness.  Furthermore,  the  application of various  federal and state laws,
including federal and state bankruptcy and insolvency laws, may limit the amount
which can be  recovered  on such loans in the case of a default.  In most cases,
any  repossessed  collateral will not provide an adequate source of repayment of
the outstanding loan balance.



                                       17
<PAGE>

Nonperforming Loans; Other Problem Assets

         When a loan is 90 days past due as to interest or principal or there is
serious doubt as to collectibility,  the accrual of interest income is generally
discontinued  unless  the  estimated  net  realizable  value  of  collateral  is
sufficient to assure  collection of the principal  balance and accrued interest.
When the  collectibility  of a  significant  amount of  principal  is in serious
doubt,  the  principal  balance  is  reduced  to the  estimated  fair  value  of
collateral by  charge-off  to the  allowance for loan losses and any  subsequent
collections  are credited first to the remaining  principal  balance and then to
the  allowance  for loan  losses as a  recovery  of the  amount  charged  off. A
nonaccrual loan is not returned to accrual status unless  principal and interest
are current and the borrower  has  demonstrated  the ability to continue  making
payments as agreed.  At December 31, 2005, the Company had twelve loans totaling
$1,892,763  on  non-accrual  status.  Net income for 2005  includes  no interest
income on these  loans.  Had these loans been current in  accordance  with their
original terms,  $117,463 of additional interest income would have been recorded
in 2005. At December 31, 2004, the Company had three loans totaling  $350,167 on
non-accrual status.

The following table presents information on non-performing loans and real estate
acquired in settlement of loans:

<TABLE>
<CAPTION>
                                                                                               December 31,
                                                                                               ------------
                                                                                          (dollars in thousands)
Non-performing Assets                                                2005           2004           2003           2002         2001
                                                                     ----           ----           ----           ----         ----

Non-performing loans:
<S>                                                                 <C>            <C>            <C>            <C>           <C>
  Non-accrual loans ........................................        $1,893         $  350         $  295         $  112        $  -
  Past due 90 days or more .................................            57              -              -              -           -
  Other restructured loans .................................             -              -              -              -           -
                                                                    ------         ------         ------         ------        ----
Total non-performing loans .................................        $1,950         $  350         $  295         $  112        $  -
Real estate acquired in settlement of loans ................           520            520              -            625           -
                                                                    ------         ------         ------         ------        ----
Total non-performing assets ................................        $2,470         $  870         $  295         $  737        $  -
                                                                    ======         ======         ======         ======        ====
Non-performing assets as a
  Percentage of loans and
  other real estate ........................................          0.90%          0.34%          0.13%          0.46%       0.00%

Allowance for loan losses as
  a percentage of non-performing loans .....................        153.80%        828.57%        881.36%        1,562.50%      NA
</TABLE>

Potential Problem Loans

         Management  has  identified  and maintains a list of potential  problem
loans.  These are loans that are neither  included in  non-accrual  status,  nor
loans that are past due 90 days or more and still  accruing.  A loan is added to
the potential  problem list when management  becomes aware of information  about
possible  credit  problems of  borrowers  that causes  serious  doubts as to the
ability of such  borrowers to comply with the current loan repayment  terms.  On
December  31, 2005 the total  amount of loans  determined  by  management  to be
potential  problem  loans was $735,000.  This amount  consisted of loans made to
eight borrowers.

Real Estate Owned

         The Company  foreclosed on real estate collateral during the year ended
December 31, 2004 and transferred the loans and accrued interest balances at the
time of foreclosure to other real estate owned in the amount of $520,234.

Allowance for Loan Losses

         The  allowance  for loan  losses  is  increased  by direct  charges  to
operating  expense.  Losses on loans are charged  against the  allowance  in the
period in which  management has determined  that it is more likely than not such
amounts have become  uncollectible.  Recoveries of previously  charged off loans
are credited to the  allowance.  The table,  "Summary of Loan Loss  Experience,"
summarizes loan balances at the end of each period indicated,  averages for each
period, changes in the allowance arising from charge-offs and recoveries by loan
category, and additions to the allowance which have been charged to expense.

                                       18
<PAGE>


       In reviewing  the adequacy of the  allowance for loan losses at each year
end,  management took into  consideration the historical loan losses experienced
by the Company,  current economic conditions affecting the borrowers' ability to
repay,  the volume of loans,  and the  trends in  delinquent,  nonaccruing,  and
potential  problem loans, and the quality of collateral  securing  nonperforming
and problem loans. After charging off all known losses, management considers the
allowance for loan losses adequate to cover its estimate of loan losses inherent
in the loan portfolio as of December 31, 2005.

         In  calculating  the amount  required in the allowance for loan losses,
management  applies a  consistent  methodology  that is updated  quarterly.  The
methodology  utilizes a loan risk grading  system and  detailed  loan reviews to
assess credit risks and the overall  quality of the loan  portfolio.  Also,  the
calculation provides for management's assessment of trends in national and local
economic conditions that might affect the general quality of the loan portfolio.
For  outstanding  loans,  the risk rating system is the major factor employed to
quantify the probable  losses in the loan  portfolio.  Predetermined  percentage
factors for dollars outstanding in each loan grade are applied and then totaled.
For loans specifically identified by management during loan reviews,  management
separates these loans from the general pool of loans and assigns a separate risk
rating for these  loans based on the  likelihood  of  collectibility,  financial
condition of the borrower, value of collateral,  and other relevant factors. Two
additional  calculations are based on FDIC  classifications  and daily statement
loan type total using  factors as noted below.  The four  methods for  measuring
probable losses are performed  monthly and their results  averaged to provide an
amount to be established as a reserve  against loan losses.  The monthly reserve
provisions,  and  the  details  supporting  the  calculations  utilized  in  the
computation,  are  reviewed  by the  Board's  Loan  Committee  and the  Board of
Directors.  The factors used in these  calculations  were initially derived from
prior  experience with similar systems at other banks.  These factors have been,
and will continue to be,  modified as First South Bank's actual  historical loss
experience in different  economic  environments can be fully incorporated into a
predictive model.  Regulators also review the adequacy of the allowance for loan
losses as part of their  examination of the Bank and may require  adjustments to
the  allowance  based  upon  information  available  to them at the  time of the
examination.

         Management also performs periodic reviews of the Company's  off-balance
sheet credit risks,  such as unfunded loan  commitments  and standby  letters of
credit.  When these reviews identify a probable loss, a separate loss reserve is
established.  The  review  performed  at  December  31,  2005,  as well as those
performed  throughout the 2005 year, did not identify an off-balance  sheet risk
upon which a reserve should be established.

<TABLE>
<CAPTION>
                                                                                    Summary of Loan Loss Experience
                                                                                         (Dollars in thousands)
                                                                                         Year Ended December 31,
                                                                                         -----------------------
                                                                      2005          2004          2003          2002          2001
                                                                      ----          ----          ----          ----          ----

<S>                                                                 <C>           <C>           <C>           <C>           <C>
Total loans outstanding at end of period .....................      $268,532      $254,749      $227,239      $158,861      $102,333
Average amount of loans outstanding ..........................       257,949       238,958       194,944       141,269       126,166

Balance of allowance for loan losses - beginning .............         2,900         2,600         1,750         1,450         1,055
                                                                    --------      --------      --------      --------      --------
Loans charged off

Commercial & industrial ......................................           112            10           114           375            49
Real estate-mortgage .........................................           365           409            20            18             -
Other ........................................................             -             2
Consumer installment * .......................................             3             -         1,674             -             2
                                                                    --------      --------      --------      --------      --------
Total charge-offs ............................................           480           421         1,808           393            51

Recoveries of loans previously charged-off

Commercial & industrial ......................................             3             6            35             -             -
Real estate-mortgage .........................................            16            10             -            17             -
Consumer installment * .......................................             -             -         1,674             1             1
                                                                    --------      --------      --------      --------      --------
Total recoveries .............................................            19            16         1,709            18             1

Net charge-offs ..............................................           461           405            99           375            50

Additions to allowance charged to expense ....................           561           705           949           675           445
                                                                    --------      --------      --------      --------      --------

Balance of allowance for loan losses - ending ................      $  3,000      $  2,900      $  2,600      $  1,750      $  1,450
                                                                    --------      --------      --------      --------      --------
</TABLE>

                                       19
<PAGE>

<TABLE>
<CAPTION>
Ratios
                                                                        2005        2004       2003        2002        2001
                                                                        ----        ----       ----        ----        ----
<S>                                                                    <C>         <C>        <C>         <C>         <C>
Net charge-offs during period to average loans outstanding
   during period ..................................................    0.17%       0.16%      0.05%       0.27%       0.05%
Net charge-offs to loans at end of period .........................    0.17%       0.15%      0.04%       0.24%       0.04%
Allowance for loan losses to average loans ........................    1.16%       1.21%      1.33%       1.10%       1.21%
Allowance for loan losses to loans at end of period ...............    1.11%       1.14%      1.14%       1.10%       1.15%
Nonperforming loans to allowance for loan losses at end of
   period .........................................................   65.00%      12.06%     11.35%       6.40%      27.31%
Net charge-offs to allowance for loan losses ......................   15.36%      13.98%      3.81%      21.43%       3.45%
Net charge-offs to provision for loan losses ......................   82.17%      57.48%     10.43%      55.56%      11.23%
</TABLE>


*The amount of consumer loan losses in 2003, which was matched dollar-for-dollar
by the  amount  of  consumer  loan  recoveries,  consisted  solely  of  deferred
presentment  loans.  The bank  ceased to make  this  type of loan in the  fourth
quarter of 2003.

     The  following  table  presents the  allocation  of the  allowance for loan
losses at the end of the years ended December 31, 2005,  2004,  2003,  2002, and
2001  compared with the percent of loans in the  applicable  categories to total
loans.

<TABLE>
<CAPTION>
                                              Allocation of Allowance for Loan Losses
                                                     Period Ended December 31,
                                                      (Dollars in thousands)
                                         2005              2004                2003                  2002                2001
                                  ----------------   -----------------   -----------------   ------------------   ------------------
                                              % of                % of               % of                  % of               % of
                                  Amount     Loans   Amount      Loans   Amount      Loans   Amount       Loans   Amount      Loans
                                  ------     -----   ------      -----   ------      -----   ------       -----   ------      -----
<S>                              <C>         <C>     <C>         <C>     <C>         <C>     <C>          <C>     <C>         <C>
Commercial and industrial .....  $  990      33.00%  $  965      33.27%  $1,017      39.10%  $  858       49.00%  $  703      48.50%
Real estate - construction ....     330      11.00%     321      11.07%     290      11.20%     210       12.00%     174      12.00%
Real estate - mortgage ........   1,660      55.33%   1,594      54.97%   1,272      48.90%     656       37.50%     551      38.00%
Consumer installment ..........      20       0.67%      20       0.69%      21        .80%      26        1.50%      22       1.50%
                                 ------     ------   ------     ------   ------     ------   ------      ------   ------     ------
Total .........................  $3,000     100.00%  $2,900     100.00%  $2,600     100.00%  $1,750      100.00%  $1,450     100.00%
                                 ======     ======   ======     ======   ======     ======   ======      ======   ======     ======
</TABLE>

Deposits

         The average  amounts and average rate paid on deposits held by the Bank
for the years ended December 31, 2004, 2003, and 2002 are summarized below:

<TABLE>
<CAPTION>
                                                                                                Average Deposits

                                                                                                  December 31,
                                                                                                  ------------
                                                                                   2005               2004                2003
                                                                                   ----               ----                ----
                                                                            Amount     Rate     Amount    Rate       Amount    Rate
                                                                            ------     ----     ------    ----       ------    ----
                                                                                              (Dollars in thousands)

<S>                                                                       <C>                  <C>                 <C>
Noninterest bearing demand ............................................   $ 17,450             $20,837             $ 16,046
Interest bearing transaction accounts .................................     38,481    2.54%     33,917    1.73%      33,729    1.72%
Savings ...............................................................     49,612    2.57%     47,889    1.77%      34,094    1.80%
Time deposits - $100,000 and over .....................................     44,868    3.35%     35,525    2.39%      28,312    2.47%
Other time deposits ...................................................    108,713    3.21%     93,294    2.38%      80,867    2.52%
                                                                          --------    -----    -------    -----    --------    -----

Total interest bearing deposits .......................................   $241,674    2.99%    $210,62  5 2.14%    $177,002    2.22%
                                                                          ========    =====    =======  = =====    ========    =====

</TABLE>



                                       20
<PAGE>

         As of December 31, 2005, the Bank held  $53,796,000 in time deposits of
$100,000 or more, with  approximately  $11,201,000 with maturities  within three
months,  $35,361,000  with  maturities  over three through  twelve  months,  and
$7,234,000 with maturities over twelve months. Wholesale time deposits generated
through  corporations,  banks, credit unions,  etc., on a national level totaled
approximately  $21,887,000  as of December  31,  2005.  It is a common  industry
practice not to consider these types of deposits as core deposits  because their
retention  can be  expected  to be  heavily  influenced  by rates  offered,  and
therefore  they  have  the  characteristics  of  shorter-term  purchased  funds.
Wholesale time deposits  involve the  maintenance of an appropriate  matching of
maturity distribution and a diversification of sources to achieve an appropriate
level of liquidity.  Such deposits are generally more volatile and interest rate
sensitive than other deposits.


Borrowed Funds

         Major sources of borrowed funds in 2005 and 2004,  other than deposits,
were retail repurchase agreements and Federal Home Loan Bank advances.

         Retail repurchase  agreements are short-term borrowings from commercial
customers  collateralized  by  government or government  agency  securities  and
repayable  with  interest.  At  December  31,  2005 and 2004,  the  Company  had
$5,740,153 and $4,700,237 in retail  repurchase  agreements,  respectively.  The
weighted average interest rates for retail repurchase agreements  outstanding at
December  31,  2005 and 2004  were  3.40%  and  1.73%,  respectively,  and those
repurchase agreements all had next day maturities.  The maximum amount of retail
repurchase  agreements  at the end of any  month  was  $6,413,256  in  2005  and
$7,031,903  in 2004.  The  approximate  average  amount  of  outstanding  retail
repurchase  agreements  was  $4,706,156  in 2005  and  $5,155,915  in  2004  and
approximate weighted interest rates were 2.70% in 2005 and .91% in 2004.

         At December 31, 2005, the Company had three advances of $5 million each
outstanding from the Federal Home Loan Bank of  Atlanta.("FHLB')  These advances
were  collateralized  by a lien on qualifying  first mortgage loans in an amount
necessary to satisfy  outstanding  indebtedness  plus accrued  interest.  One $5
million  advance was a daily rate credit  advance  with a 4.44% rate on December
31, 2005, and the other two $5 million  advances carried fixed interest rates of
4.3% and 4.6% with scheduled  maturities in February and March 2011. Both of the
fixed rate  advances had call  provisions  which had passed  their  initial call
dates and thus become  callable at any time prior to maturity.  The  approximate
annual  average amount of such  borrowings  outstanding in 2005 and 2004 was $10
million. The approximate weighted interest rate for 2005 and 2004 was 4.45%. The
maximum amount of such advances  outstanding at the end of any month in 2005 and
2004 was $15 million and $12.2 million, respectively.

         In  2004  the  Company  issued  subordinated  debt  in  the  amount  of
$5,155,000  to FSBS Capital Trust I. The  subordinated  debt matures in 2034 and
has a  variable  interest  rate.  The  average  amount  outstanding  in 2005 was
$5,155,000 and had an approximate  weighted  average rate of 6.22%.  In 2004 the
average amount  outstanding was 4,583,000 and the approximate  weighted  average
interest rate was 4.39% (see Note 8 to the Consolidated Financial Statements).

Return on Equity and Assets

         The following  table shows the return on assets (net income  divided by
average total assets),  return on equity (net income divided by average equity),
dividend  payout ratio  (dividends  declared per share divided by net income per
share),  and equity to assets ratio  (average  equity  divided by average  total
assets) for each period indicated.

                                                Year ended December 31,
                                                -----------------------
                                              2005        2004        2003
                                              ----        ----        ----

Return on average assets ................     1.09%       1.08%       0.93%
Return on average equity ................    11.73%      13.33%      13.70%
Dividend payout ratio ...................     0.00%       0.00%       0.00%
Equity to assets ratio ..................     9.32%       8.13%       6.80%


                                       21
<PAGE>

Liquidity

         Liquidity is the ability to meet current and future obligations through
liquidation  or maturity of existing  assets or the  acquisition  of  additional
liabilities.  Adequate  liquidity  is  necessary  to meet  the  requirements  of
customers for loans and deposit  withdrawals  in the most timely and  economical
manner. Some liquidity is ensured by maintaining assets which may be immediately
converted  into cash at minimal cost  (amounts due from banks and federal  funds
sold).  However,  the most  manageable  sources of  liquidity  are  composed  of
liabilities, with the primary focus on liquidity management being on the ability
to obtain deposits within the Bank's service area. Core deposits (total deposits
less wholesale time deposits) provide a relatively stable funding base, and were
equal to 62 % of total assets at December 31, 2005.  Asset liquidity is provided
from several sources,  including amounts due from banks, and funds from maturing
investments  and loans.  The Bank is a member of the FHLB and, as such,  has the
ability to borrow  against the security of its 1-4 family  residential  mortgage
loans. At December 31, 2005, the Company had three $5,000,000  advances from the
FHLB consisting of one $5,000,000 advance borrowed on a daily rate basis and two
ten year  $5,000,000  fixed rate loan advances.  Both of the fixed rate advances
are presently  callable.  The Company also has  additional  lines of credit with
other banks in the form of federal funds lines in the amount of $12,000,000. The
Company has never drawn on any of these federal funds lines. Management believes
that the Company's  overall liquidity sources are adequate to meet its operating
needs in the ordinary course of its business.

Capital Resources

         The equity capital of the Company increased  $4,027,348 during 2005 and
by  $10,434,729  in 2004.  The  increase  in 2005  resulted  from an increase in
retained earnings of $3,400,004,  a reduction in other  comprehensive  income of
$156,434,  and additional paid-in capital of $783,778 from the exercise of stock
options.  The increase in 2004 resulted from an increase in retained earnings of
$3,000,055,  a reduction in other  comprehensive  income of $50,693,  additional
paid-in  capital  of $3,300  from the  exercise  of stock  options,  and the net
proceeds of $7,482,067 from private issuance of 300,000 shares of common stock.

Both the  Company  and the Bank  are  subject  to  regulatory  capital  adequacy
standards.  Under  these  standards,  financial  institutions  are  required  to
maintain certain minimum ratios of capital to  risk-weighted  assets and average
total assets. Under the provisions of the Federal Deposit Insurance  Corporation
Improvements Act of 1991, federal financial institution  regulatory  authorities
are  required to  implement  prescribed  "prompt  corrective  actions"  upon the
decline in the capital  position of a bank below  certain  levels.  Increasingly
stringent regulatory corrective actions are mandated.

At  December  31,  2005,  both the  Company  and the Bank met all of the minimum
capital  adequacy  standards  and  the  Bank  met  the  requirements  to be well
capitalized  under the prompt correction action provision of the Federal Deposit
Insurance Act..  Capital ratios are presented in the table below,  compared with
the minimum  ratios and amounts  necessary to be "well  capitalized"  under FDIC
regulatory definitions and guidelines.


                                       22
<PAGE>
<TABLE>
The Bank                                                                                                          To Be Well
                                                                                                              Capitalized Under
                                                                                     For Capital              Prompt Corrective
                                                                                  Adequacy Purposes           Action Provisions
As of December 31, 2005                                   Actual                      Minimum                      Minimum
                                                          ------                      -------                      -------
                                                 Amount           Ratio        Amount         Ratio        Amount           Ratio
                                                 ------           -----        ------         -----        ------           -----
Total Capital
<S>                                            <C>                <C>       <C>                <C>      <C>                <C>
(To Risk Weighted Assets) ..............       $37,660,000        13.98%    $21,550,640        8.00%    $26,938,300        10.00%
Tier I Capital
(To Risk Weighted Assets) ..............       $29,760,000        11.05%    $10,775,320        4.00%    $16,162,980         6.00%
Tier I Capital
(To Average Assets) ....................       $29,760,000         9.21%    $12,923,840        4.00%    $16,154,800         5.00%

<CAPTION>
The Holding Company                                                                                               To Be Well
                                                                                                              Capitalized Under
                                                                                     For Capital              Prompt Corrective
                                                                                  Adequacy Purposes           Action Provisions
As of December 31, 2005                                   Actual                      Minimum                      Minimum
                                                          ------                      -------                      -------
                                                 Amount           Ratio        Amount         Ratio        Amount           Ratio
                                                 ------           -----        ------         -----        ------           -----
                                                         (Dollars in thousands)
Total Capital
<S>                                            <C>                <C>       <C>               <C>        <C>                <C>
(To Risk Weighted Assets) ..............       $38,985,000        14.46%    $21,563,040       8.00%      $26,953,800        10.00%
Tier I Capital
(To Risk Weighted Assets) ..............       $35,985,000        13.35%    $10,781,520       4.00%      $16,172,280         6.00%
Tier I Capital
(To Average Assets) ....................       $35,985,000        11.13%    $12,927,840       4.00%      $16,159,800         5.00%
</TABLE>

Inflation

        Since the assets and  liabilities  of a bank are  primarily  monetary in
nature (payable in fixed,  determinable  amounts),  the performance of a bank is
affected  more by changes in interest  rates than by inflation.  Interest  rates
generally increase as the rate of inflation increases,  but the magnitude of the
change in rates may not be the same.

         While the effect of inflation  on banks is normally not as  significant
as is its influence on those  businesses  which have large  investments in plant
and inventories, it does have an effect. During periods of high inflation, there
are  normally  corresponding  increases  in the money  supply,  and  banks  will
normally experience  above-average  growth in assets,  loans and deposits.  Also
general  increases  in the  prices  of goods  and  services  usually  result  in
increased operating expenses.


Off-Balance Sheet Arrangements

         The Company,  through the  operations  of the Bank,  makes  contractual
commitments to extend credit in the ordinary course of its business  activities.
These  commitments are legally binding  agreements to lend money to customers of
the Bank at  predetermined  interest  rates for a  specific  period of time.  At
December 31, 2005,  the Bank had issued  commitments  to extend  credit of $43.1
million through  various types of lending  arrangements.  Of these  commitments,
82.0 %, or $35.3  million,  expire within one year, and 18.0 %, or $7.8 million,
expire in more than one year or more.  Past  experience  indicates  that many of
these commitments to extend credit will expire unused.

         The  Company   evaluates   each   customer's   creditworthiness   on  a
case-by-case  basis. The amount of collateral  obtained,  if deemed necessary by
the Company upon extension of credit,  is based of the credit  evaluation of the
borrower.  Collateral  varies, but may include accounts  receivable,  inventory,
property, plant and equipment, commercial and residential real estate.

                                       23
<PAGE>

Item 7. Financial Statements.















                    FIRST SOUTH BANCORP INC. AND SUBSIDIARY

                  REPORT ON CONSOLIDATED FINANCIAL STATEMENTS

                              FOR THE YEARS ENDED
                        DECEMBER 31, 2005, 2004 AND 2003















                                       24
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED FINANCIAL STATEMENTS



TABLE OF CONTENTS

                                                                           Page

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM .............       25

FINANCIAL STATEMENTS
   Consolidated balance sheets ......................................       26
   Consolidated statements of income ................................       37
   Consolidated statements of stockholders' equity ..................       28
   Consolidated statements of cash flows ............................       29

NOTES TO FINANCIAL STATEMENTS .......................................  30 - 50














                                       25

<PAGE>










             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders
First South Bancorp, Inc. and Subsidiary
Spartanburg, South Carolina

We have  audited the  accompanying  consolidated  balance  sheets of First South
Bancorp, Inc. and Subsidiary (the Company) as of December 31, 2005 and 2004, 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, 2005.
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  standards  of the Public  Company
Accounting Oversight Board (United States). Those standards require that we plan
and  perform  the  audit  to  obtain  reasonable  assurance  about  whether  the
consolidated financial statements are free of material  misstatements.  An audit
includes  examining,  on a test  basis,  evidence  supporting  the  amounts  and
disclosures in the  consolidated  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 First South Bancorp,
Inc.  and  Subsidiary  at  December  31,  2005 and 2004 and the results of their
operations  and their cash flows for each of the years in the three year  period
ended  December 31, 2005, in conformity  with  accounting  principles  generally
accepted in the United States of America.








/s/Cherry, Bekaert & Holland, L.L.P.

Charlotte, North Carolina
March 9, 2006






                                       26
<PAGE>


                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                                           December 31,
                                                                                                           ------------
                                                                                                  2005                     2004
                                                                                                  ----                     ----
Assets
<S>                                                                                          <C>                      <C>
   Cash and due from banks .......................................................           $   5,022,070            $   4,092,178
   Interest-bearing deposits .....................................................              13,510,000                9,200,000
                                                                                             -------------            -------------
   Cash and cash equivalents .....................................................              18,532,070               13,292,178
   Securities available-for-sale .................................................              23,365,835               18,506,440
   Securities held-for-investment ................................................               7,264,070                3,358,447
   Loans, net ....................................................................             265,033,413              251,155,171
   Premises and equipment, net ...................................................               5,288,478                5,333,819
   Investment in FSBS capital trust ..............................................                 155,000                  155,000
   Other assets ..................................................................               5,093,214                4,629,282
                                                                                             -------------            -------------
         Total assets ............................................................           $ 324,732,080            $ 296,430,337
                                                                                             =============            =============
Liabilities and Stockholders' Equity
Liabilities
Deposits
   Noninterest-bearing demand ....................................................           $  13,820,544            $  18,632,817
   Interest bearing demand and savings ...........................................              80,280,670               86,078,673
   Time deposits .................................................................             171,623,759              143,163,587
                                                                                             -------------            -------------
         Total deposits ..........................................................             265,724,973              247,875,077
Retail repurchase agreements .....................................................               5,740,153                4,700,237
Other borrowed funds .............................................................              15,297,615               10,416,656
Subordinated debt ................................................................               5,155,000                5,155,000
Other accrued expenses and liabilities ...........................................               1,943,134                1,439,510
                                                                                             -------------            -------------
         Total liabilities .......................................................             293,860,875              269,586,480
Commitments and contingencies (Notes 12 and 14)
Stockholders' equity
   Common stock, no par value; 30,000,000 shares authorized;
     1,750,444 and 1,682,490 issued and outstanding at
     December 31, 2005 and 2004, respectively ....................................                       -                        -
   Paid-in capital ...............................................................              19,421,634               18,637,856
   Retained earnings .............................................................              11,624,866                8,224,862
   Accumulated other comprehensive loss ..........................................                (175,295)                 (18,861)
                                                                                             -------------            -------------
         Total stockholders' equity ..............................................              30,871,205               26,843,857
                                                                                             -------------            -------------
         Total liabilities and stockholders' equity ..............................           $ 324,732,080            $ 296,430,337
                                                                                             =============            =============
</TABLE>

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



                                       27
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
                        CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                                                          For the years ended December 31,
                                                                                          --------------------------------
                                                                                2005                   2004                 2003
                                                                                ----                   ----                 ----
Interest income
<S>                                                                        <C>                   <C>                   <C>
   Loans .........................................................         $ 19,371,996          $ 14,575,623          $ 12,282,117
   Securities
      U. S. Government and agency obligations ....................              749,803               450,766               431,568
      State and local obligations ................................                9,583                25,998                26,016
      Mortgage backed securities .................................               80,085                48,791                     -
      Other securities ...........................................               92,569                72,745                74,993
   Deposits with banks ...........................................              506,063               137,366                70,064
                                                                           ------------          ------------          ------------
         Total interest income ...................................           20,810,099            15,311,289            12,884,758
                                                                           ------------          ------------          ------------
Interest expense
   Deposits
      Time .......................................................            4,991,986             3,068,349             2,734,418
      Interest-bearing demand and savings ........................            2,252,043             1,431,436             1,191,777
   Borrowed funds ................................................              452,943               458,431               457,528
   Other .........................................................              444,115               250,483                26,583
                                                                           ------------          ------------          ------------
         Total interest expense ..................................            8,141,087             5,208,699             4,410,306
                                                                           ------------          ------------          ------------
         Net interest income .....................................           12,669,012            10,102,590             8,474,452
Provision for loan losses ........................................              561,086               705,522               949,302
                                                                           ------------          ------------          ------------
         Net interest income after provision for
           loan losses ...........................................           12,107,926             9,397,068             7,525,150
                                                                           ------------          ------------          ------------
Noninterest income
   Service charges, fees, and commissions ........................              651,514               693,755               454,579
   Loan brokerage fees ...........................................              162,526               240,248               454,344
   Mortgage banking loan fees ....................................               51,162               127,859               233,305
   Other .........................................................               50,243               127,385               112,058
                                                                           ------------          ------------          ------------
         Total noninterest income ................................              915,445             1,189,247             1,254,286
                                                                           ------------          ------------          ------------
Noninterest expenses
   Salaries and employee benefits ................................            3,747,308             3,564,689             3,190,603
   Occupancy and equipment .......................................              760,252               823,475               635,843
   Legal expenses ................................................              170,288               172,056               263,765
   Data processing ...............................................              223,396               201,843               329,269
   Other outside services ........................................               84,149               128,497               262,986
   Litigation settlement .........................................            1,677,155                     -                     -
   Other .........................................................            1,038,519             1,039,700               866,703
                                                                           ------------          ------------          ------------
         Total other operating expenses ..........................            7,701,067             5,930,260             5,549,169
                                                                           ------------          ------------          ------------
         Income before income taxes ..............................            5,322,304             4,656,055             3,230,267
Current income tax expense .......................................            1,946,300             1,700,000             1,386,000
Deferred income tax benefit ......................................              (24,000)              (44,000)             (260,000)
                                                                           ------------          ------------          ------------
         Net income ..............................................         $  3,400,004          $  3,000,055          $  2,104,267
                                                                           ============          ============          ============
Earnings per common share ........................................         $       1.97          $       1.87          $       1.52
                                                                           ============          ============          ============
Diluted earnings per common share ................................         $       1.89          $       1.76          $       1.46
                                                                           ============          ============          ============
</TABLE>

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

                                       28
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
              For the years ended December 31, 2005, 2004 and 2003

<TABLE>
<CAPTION>
                                                      Common                                         Accumulated
                                                       stock                                            other            Total
                                                     in number        Paid-in          Retained      comprehensive   stockholders'
                                                     of shares        capital          earnings      income (loss)        equity
                                                     ---------        -------          --------      -------------        ------
Balance,
<S>                                                    <C>         <C>              <C>              <C>               <C>
  December 31, 2002 .........................          920,780     $ 11,144,989     $  3,120,540     $     84,202      $ 14,349,731
  Exercised stock options ...................              600            7,500                -                -             7,500
  Comprehensive income:
     Net income .............................                -                -        2,104,267                -         2,104,267
     Net change in unrealized
       gain on securities
       available for sale, net
       of tax benefit of $32,098 ............                -                -                -          (52,370)          (52,370)
                                                                                                                       ------------
     Comprehensive income ...................                -                -                -                -         2,051,897
     Three-for-two common
       stock split ..........................          460,660                -                -                -                 -
                                                  ------------     ------------     ------------     ------------      ------------
Balance,
  December 31, 2003 .........................        1,382,040       11,152,489        5,224,807           31,832        16,409,128
  Exercised stock options ...................              450            3,300                -                -             3,300
  Issuance of common stock
     (300,000 shares at $25
     per share), net of expense
     of $17,933 .............................          300,000        7,482,067                -                -         7,482,067
  Comprehensive income:
     Net income .............................                -                -        3,000,055                -         3,000,055
     Net change in unrealized
       gain on securities
       available for sale, net
       of tax benefit of $31,070 ............                -                -                -          (50,693)          (50,693)
                                                                                                                       ------------
  Comprehensive income ......................                -                -                -                -         2,949,362
                                                  ------------     ------------     ------------     ------------      ------------
Balance,
  December 31, 2004 .........................        1,682,490       18,637,856        8,224,862          (18,861)       26,843,857
  Exercised stock options ...................           67,954          783,778                -                -           783,778
  Comprehensive income:
     Net income .............................                -                -        3,400,004                -         3,400,004
     Net change in unrealized
       gain on securities
       available for sale, net
       of tax benefit of $95,876 ............                -                -                -         (156,434)         (156,434)
                                                                                                                       ------------
  Comprehensive income ......................                -                -                -                -         3,243,570
                                                  ------------     ------------     ------------     ------------      ------------
Balance,
  December 31, 2005 .........................        1,750,444     $ 19,421,634     $ 11,624,866     $   (175,295)     $ 30,871,205
                                                  ============     ============     ============     ============      ============
</TABLE>

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


                                       29
<PAGE>


                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                          For the years ended December 31,
                                                                                          --------------------------------
                                                                                      2005              2004              2003
                                                                                      ----              ----              ----
OPERATING ACTIVITIES
<S>                                                                              <C>                <C>                <C>
   Net income .............................................................      $  3,400,004       $  3,000,055       $  2,104,267
   Adjustments to reconcile net income to net cash
      provided by operating activities
       Depreciation .......................................................           381,456            432,071            243,468
       Provision for loan losses ..........................................           561,086            705,522            949,302
       Gain on disposal of premises and equipment .........................                 -                  -             (6,453)
       (Gain) loss on sale of other real estate owned .....................                 -                  -             (3,549)
       (Gain) loss on sale of loans .......................................                 -            (78,783)                 -
       (Gain) loss on sale of bank investments ............................            (8,151)                 -                  -
       Increase in cash surrender value of life insurance .................           (30,325)           (30,344)           (37,090)
       Deferred tax provision .............................................           (24,000)           (44,000)          (260,000)
       Decrease (increase) in interest receivable .........................          (571,235)          (177,899)          (195,401)
       Decrease (increase) in other assets ................................           257,507           (829,848)           204,610
       Increase in accrued expenses and other liabilities .................           503,624             38,559            331,106
                                                                                 ------------       ------------       ------------
           Net cash provided by operating activities ......................         4,469,966          3,015,333          3,330,260
                                                                                 ------------       ------------       ------------
INVESTING ACTIVITIES
   Origination of loans, net of principal collected .......................       (14,431,177)       (28,199,269)       (67,880,945)
   Proceeds from matured/called securities available-for-sale .............         4,497,818          5,000,000         10,998,714
   Proceeds from matured/called securities held-for-investment ............         1,377,868                  -            518,503
   Proceeds from sale of securities available-for-sale ....................                 -          1,000,000                  -
   Purchase of securities available-for-sale ..............................        (9,804,288)       (14,001,975)        (6,600,000)
   Purchase of securities held-for-investment .............................        (6,000,000)                 -         (2,023,848)
   Proceeds from MBS principal paydowns ...................................           911,272            510,545                  -
   Proceeds from sale of other real estate owned ..........................                 -                  -            337,457
   Proceeds from disposal of premises and equipment .......................                 -                  -             20,487
   Purchases of premises and equipment ....................................          (336,116)          (246,905)        (2,880,721)
   Investment in trust ....................................................                 -           (155,000)                 -
                                                                                 ------------       ------------       ------------
           Net cash used for investing activities .........................       (23,784,623)       (36,092,604)       (67,510,353)
                                                                                 ------------       ------------       ------------
FINANCING ACTIVITIES
   Increase in deposits, net ..............................................        17,849,896         32,418,888         59,758,242
   Proceeds from exercise of stock options ................................           783,778              3,300              7,500
   Net (decrease) increase in retail repurchase agreements ................         1,039,916         (1,388,676)         2,859,176
   Net (decrease) increase in other borrowings ............................          (119,041)           181,103           (219,138)
   Proceeds of advances from FHLB .........................................         5,000,000         16,200,000          6,000,000
   Repayment of advances from FHLB ........................................                 -        (18,200,000)        (4,000,000)
   Proceeds from issuance of subordinated debt ............................                 -          5,155,000                  -
   Proceeds from stock issuance ...........................................                 -          7,482,067                  -
                                                                                 ------------       ------------       ------------
           Net cash provided by financing activities ......................        24,554,549         41,851,682         64,405,780
                                                                                 ------------       ------------       ------------
           Net increase in cash and cash equivalents ......................         5,239,892          8,774,411            225,687
CASH AND CASH EQUIVALENTS,
   BEGINNING OF YEAR ......................................................        13,292,178          4,517,767          4,292,080
                                                                                 ------------       ------------       ------------
CASH AND CASH EQUIVALENTS,
   END OF YEAR ............................................................      $ 18,532,070       $ 13,292,178       $  4,517,767
                                                                                 ============       ============       ============
CASH PAID FOR:
   Interest ...............................................................      $  7,874,663       $  5,208,699       $  4,347,578
                                                                                 ============       ============       ============
   Income taxes ...........................................................      $  1,517,400       $  1,524,449       $  1,132,904
                                                                                 ============       ============       ============
</TABLE>

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


                                       30
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 1 - ORGANIZATION

First South  Bancorp,  Inc.  (the  "Corporation"  or the  "Company")  is a South
Carolina  corporation  organized  in 1999 for the  purpose  of  being a  holding
company for First South Bank (the Bank).  On September  30, 1999,  pursuant to a
plan  of  exchange  approved  by  the  shareholders  of  the  Bank,  all  of the
outstanding  shares of common  stock of the Bank were  exchanged  for  shares of
common  stock  of the  Corporation.  The  Corporation  presently  engages  in no
business  other than that of owning the Bank and has no employees.  The Bank was
incorporated on April 23, 1996, and began banking operations on August 19, 1996.
The Bank is a South Carolina chartered commercial bank and is engaged in lending
and deposit gathering  activities from two branches in Spartanburg  County,  one
branch in Columbia,  South Carolina,  one branch in Hilton Head, South Carolina,
and a loan production office in Asheville, North Carolina. It operates under the
laws of South  Carolina  and the Rules and  Regulations  of the Federal  Deposit
Insurance   Corporation   and  the  South  Carolina  State  Board  of  Financial
Institutions.

On April 1, 2004,  the Company  completed a secondary  stock  offering  and sold
300,000 shares of stock at $25 per share, with net proceeds totaling $7,482,067.


NOTE 2- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES

The  following is a  description  of the  significant  accounting  and reporting
policies that First South Bancorp,  Inc. and Subsidiary follows in preparing and
presenting their financial statements.

Basis of Presentation and Consolidation - The consolidated  financial statements
include the accounts of the Corporation  and its  wholly-owned  subsidiary,  the
Bank.  All  significant   intercompany   balances  and  transactions  have  been
eliminated in consolidation.

Use of Estimates - The preparation of the consolidated  financial  statements in
conformity with accounting principles generally accepted in the United States of
America  requires  management  to make  estimates  and  assumptions  that affect
reported  amounts  of  assets  and  liabilities  and  disclosure  of  contingent
liabilities at the date of the financial  statements,  as well as the amounts of
income and expenses  during the Reporting  period.  Actual  results could differ
from those estimates.

Securities - Investments  in equity  securities  that have readily  determinable
fair values and all investments in debt securities are classified at acquisition
into one of three categories and accounted for as follows:

     o    securities  held-for-investment  are  held-to-maturity and reported at
          amortized cost,
     o    trading  securities are reported at fair value with  unrealized  gains
          and losses included in earnings, or;
     o    securities  available-for-sale  are reported at  estimated  fair value
          with unrealized  gains and losses reported as a separate  component of
          comprehensive income (net of tax effect).

The Company intends to hold the available-for-sale  securities for an indefinite
period of time but may sell them prior to maturity.  All other  securities  have
been classified as held-to-maturity securities because management has determined
that the  Company  has the  intent and the  ability to hold all such  securities
until maturity.

Gains and  losses on sales of  securities  are  recognized  when  realized  on a
specific identification,  trade date basis. Premiums and discounts are amortized
into interest income using a method that approximates the level yield method.

There were no investments  classified as trading securities at December 31, 2005
and 2004.


                                       31
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 2- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued

Securities  available-for-sale  included restricted equity securities of Federal
Home Loan Bank of Atlanta  stock in the amount of  $1,268,800  and  $954,200  at
December  31, 2005 and 2004,  respectively.  Restricted  equity  securities  are
carried at cost.  The Federal  Home Loan Bank  requires the Bank to purchase and
maintain FHLB stock in an amount equal to a certain  percentage  of  outstanding
borrowings.

Loans and  Allowance  for Loan  Losses - Loans are  carried  at their  principal
amount  outstanding.  Interest income is recorded as earned on an accrual basis.
The accrual of interest is  discontinued  when,  in  management's  opinion,  the
borrower may be unable to meet payments as they become due,  generally  when the
loan is 90 days delinquent.  All interest  accrued,  but not collected for loans
that are placed on nonaccrual, is reversed against interest income. A commercial
loan is considered  past due when a payment is not received by the next business
day after the due date. A consumer loan is considered past due when a payment is
not received within 30 days after the due date.

The  Company  uses the  allowance  method  in  providing  for loan  losses.  The
provision  for loan  losses is based upon  management's  estimate  of the amount
needed to maintain the allowance  for loan losses at an adequate  level to cover
known and expected  losses in the loan  portfolio.  In determining the provision
amount,  management  gives  consideration  to current and  anticipated  economic
conditions,  the growth and composition of the loan portfolio,  the relationship
of the  allowance  for loan  losses to  outstanding  loans  and  other  factors.
Management  believes  that the  allowance  for loan  losses is  adequate.  While
management  uses the best  information  available  to make  evaluations,  future
adjustments   may  be  necessary  if  economic  and  other   conditions   differ
substantially from the assumptions used.

Management considers loans to be impaired when, based on current information and
events,  it is probable  that the Company  will be unable to collect all amounts
due  according  to the  contractual  terms of the loan  agreement.  Factors that
influence  management's  judgments include, but are not limited to, loan payment
pattern,  source of  repayment,  and value of  collateral.  A loan  would not be
considered  impaired  if an  insignificant  delay  in loan  payment  occurs  and
management   expects  to  collect  all  amounts  due.  The  major   sources  for
identification  of loans to be  evaluated  for  impairment  include past due and
nonaccrual  reports,  internally  generated  lists of loans  with  certain  risk
grades, and regulatory reports of examination. Impaired loans are measured using
either  the  discounted  expected  cash flow  method or the value of  collateral
method.  When the ultimate  collectibility of an impaired loan's principal is in
doubt, wholly or partially, all cash receipts are applied to principal.

Other Real Estate Owned - Other real estate owned (OREO)  represents  properties
acquired through foreclosure or other proceedings.  OREO is held for sale and is
recorded  at the lower of the  recorded  amount of the loan or fair value of the
properties  less  estimated  costs of  disposal.  Fair  value is  determined  by
appraisal.  Any  write-down  to fair  value at the time of  transfer  to OREO is
charged to the  allowance  for loan losses.  Property is evaluated  regularly to
ensure the  carrying  amount is  supported  by its current  fair value.  OREO is
reported net of allowance for losses in the Company's financial statements.

Premises  and   Equipment  -  Premises  and   equipment,   including   leasehold
improvements, are stated at cost less accumulated depreciation.  Depreciation is
provided over the estimated useful lives which includes the remaining lease term
and probable  renewal  periods.  Expenditures for major renewals and betterments
are  capitalized  and those for maintenance and repairs are charged to operating
expense as incurred.

Loan  Origination Fees - Origination fees received and direct costs incurred are
amortized to interest income over the contractual lives of the loans.

Cash and Cash Equivalents - Cash and cash equivalents  include cash and due from
banks,  federal  funds  sold and  interest-bearing  deposits.  During the normal
course of business,  the Company may have cash  deposits  with banks that are in
excess of  federally  insured  limits.  First South Bank is required to maintain
certain average reserve balances as established by the Federal Reserve Board.


                                       32
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 2- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued

Cash and Cash  Equivalents  (continued) - The amounts of those reserve  balances
for the  reserve  computation  periods  for  December  31,  2005 and  2004  were
$1,603,000 and $1,585,000, respectively.

Income Taxes - Deferred tax assets and liabilities are recognized for the future
tax  consequences  attributable to differences  between the financial  statement
carrying  amount of existing  assets and  liabilities  and their  respective tax
bases.  Deferred tax assets and liabilities are measured using enacted tax rates
expected  to apply to  taxable  income  in the  years in which  those  temporary
differences  are  expected to be  recovered  in income.  Deferred tax assets are
reduced by a  valuation  allowance  if it is more  likely  than not that the tax
benefits will not be realized.

Earnings Per Common  Share - Earnings per common share is computed  based on the
weighted  average  number of common  shares  outstanding.  Diluted  earnings per
common share include the dilutive effect of outstanding stock options.

Stock Options - Financial  Accounting  Standards Board (FASB)  Statement No 148,
Accounting  for  Stock-Based  Compensation  -  Transition  and  Disclosure  - An
Amendment of FASB  Statement  No. 123, was issued in December  2002 and provides
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee  compensation.  In addition,  SFAS
No. 148 amends the disclosure  requirements of SFAS No. 123 to require prominent
disclosures in both annual and interim financial  statements about the method of
accounting for stock-based  employee  compensation  and the effect of the method
used on reported  results.  The  disclosure  requirements  of this statement are
effective  for fiscal years  ending after  December 15, 2002 and are included in
these financial statements.

The Company has elected to continue using the measurement  method  prescribed in
Accounting Principles Board Opinion No. 25 and, accordingly,  FASB Statement No.
123 has no effect on the Company's  financial position or results of operations.
As a result, no compensation cost has been recognized for the stock option plan.
Had compensation  cost for the Company's stock option plan been determined based
on the fair value at the grant date of the awards consistent with the provisions
of FASB  Statement  No. 123, the  Company's  net earnings and earnings per share
would have decreased to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                                                                        For the years ended December 31,
                                                                                        --------------------------------
                                                                                  2005                2004                2003
                                                                                  ----                ----                ----
<S>                                                                        <C>                   <C>                  <C>
Net income - as reported .........................................         $   3,400,004         $   3,000,055        $    2,104,267
Net income - pro forma ...........................................             3,001,376             2,829,657             1,953,093
Earnings per common share - as reported ..........................                  1.97                  1.87                  1.52
Earnings per common share - pro forma ............................                  1.74                  1.76                  1.41
Diluted earnings per common share - as reported ..................                  1.89                  1.76                  1.46
Diluted earnings per common share - pro forma ....................                  1.67                  1.66                  1.35
</TABLE>

The  Financial  Accounting  Standards  Board  recently  published  Statement  of
Financial  Accounting  Standards  ("SFAS") No. 123 (revised 2004),  "Share-Based
Payment" ("SFAS No. 123(R)").  SFAS No. 123(R), which is effective on January 1,
2006,  will require that the fair value of  share-based  payments to  employees,
including stock options, be recognized as compensation  expense in the statement
of income in the financial statements.  Accordingly,  the Company will implement
the revised standard on January 1, 2006. Currently, the Company accounts for its
share-based payment transactions under the provisions of APB No. 25, under which
it has not recognized any  compensation  expense for its stock option grants and
related accounting  interpretations,  including FASB  Interpretation  Number 44,
"Accounting for Certain  Transactions  Involving Stock  Compensation"  ("FIN No.
44") in accounting for stock options.


                                       33
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 2- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued

Stock  Options  (continued)  - On  December  21,  2005,  the board of  directors
approved  accelerating  the  vesting  of  30,705  unvested  stock  options.  The
accelerated  vesting was  effective as of December  30,  2005.  All of the other
terms  and  conditions  applicable  to  the  outstanding  stock  options  remain
unchanged.

The decision to accelerate  vesting of these options will avoid  recognition  of
pre-tax compensation expense by the Company upon the adoption of SFAS 123(R). In
the Company's view, the future compensation expense could outweigh the incentive
and  retention  value  associated  with the stock  options.  The future  pre-tax
compensation  expense  that will be avoided,  based upon the  effective  date of
January 1, 2006,  is  expected  to be  approximately  $ 138,000 and $ 134,000 in
fiscal  years  2006 and 2007,  respectively.  Based  upon past  experience,  the
Company believes the grantees of these stock options will remain as employees of
the Company.

Fair Value of Financial  Instruments - FASB Statement No. 107, Disclosures about
Fair  Value  of  Financial  Instruments,   requires  disclosure  of  fair  value
information about financial  instruments,  whether or not recognized on the face
of the balance sheet,  for which it is  practicable to estimate that value.  The
assumptions used in the estimation of the fair value of the Company's  financial
instruments  are detailed  below.  Where quoted prices are not  available,  fair
values are based on estimates  using  discounted  cash flows and other valuation
techniques.  The use of discounted cash flows can be  significantly  affected by
the assumptions  used,  including the discount rate and estimates of future cash
flows. The following  disclosures  should not be considered an indication of the
liquidation value of the Company,  but rather represent a good-faith estimate of
the value of the financial instruments held by the Company.

The following  methods and assumptions  were used to estimate the fair value for
each class of financial instruments:

     Cash and Cash  Equivalents  - For cash on  hand,  amounts  due from  banks,
     federal  funds sold,  and  interest-bearing  deposits,  the carrying  value
     approximates fair value.

     Securities - The fair value of  investments  securities  is based on quoted
     market  prices,  if available.  If a quoted market price is not  available,
     fair value is estimated using quoted market prices for similar  securities.
     Restricted  Federal  Home Loan Bank of  Atlanta  (FHLB)  stock is valued at
     cost.

     Loans - The fair value of fixed rate loans is estimated by discounting  the
     future cash flows using the current  rates at which  similar loans would be
     made to borrowers  with similar  credit  ratings and for the same remaining
     maturities.  The fair value of variable rate loans with frequent  repricing
     and no significant changes in credit risk approximates book value.

     Deposits  and  Borrowings  - The fair  value of fixed  rate time  deposits,
     borrowed funds and subordinated debt is estimated by discounting the future
     cash flows using the current rates at which similar deposits and borrowings
     would be accepted for the same remaining maturities.

     Other   Interest-Bearing   Liabilities  -  The  carrying  value  of  retail
     repurchase  agreements  and other borrowed  funds  approximates  fair value
     since these obligations have variable interest rates with daily repricings.
     At least an equal  amount of  securities,  at their  carrying  values,  are
     pledged as collateral for all repurchase agreements.

     Commitments  - The fair value of  commitments  to extend credit is based on
     fees currently  being charged for similar  instruments and is considered to
     approximate   carrying  value.  For  other  commitments,   generally  of  a
     short-term  nature,  the carrying  value is  considered  to be a reasonable
     estimate of fair value.



                                       34
<PAGE>
                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 2- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued

Recent  Accounting  Pronouncements  -  The  following  is a  summary  of  recent
authoritative  pronouncements that affect accounting,  reporting, and disclosure
of financial information by the Company:

In December  2004, the Financial  Accounting  Standards  Board  ("FASB")  issued
Statement of Financial  Accounting  Standards  ("SFAS") No. 123 (revised  2004),
"Share-Based  Payment"  ("SFAS  No.  123(R)").  SFAS  No.  123(R)  will  require
companies to measure all employee  stock-based  compensation awards using a fair
value method and record such expense in its financial  statements.  In addition,
the adoption of SFAS No. 123(R) requires  additional  accounting and disclosures
related to the  income  tax and cash flow  effects  resulting  from  share-based
payment  arrangements.  SFAS No.  123(R) is effective  beginning as of the first
annual  reporting  period  beginning  after  December 15, 2005.  SFAS No. 123(R)
allows  for  adoption   using  either  the  modified   prospective  or  modified
retrospective  methods.  The Company anticipates using the modified  prospective
method when this  statement is adopted in the first quarter of 2006. The Company
has evaluated the impact upon adoption of SFAS No. 123(R) and has concluded that
the adoption will not result in any additional  material  charges to earnings in
2006.

In April 2005,  the  Securities  and Exchange  Commission's  Office of the Chief
Accountant  and its Division of  Corporation  Finance  issued  Staff  Accounting
Bulletin ("SAB") No. 107 to provide  guidance  regarding the application of SFAS
No.  123(R).  SAB  No.  107  provides   interpretive  guidance  related  to  the
interaction  between SFAS No. 123(R) and certain SEC rules and  regulations,  as
well as the  staff's  views  regarding  the  valuation  of  share-based  payment
arrangements for public companies.  SAB No. 107 also reminds public companies of
the  importance  of  including  disclosures  within  filings  made  with the SEC
relating to the accounting for share-based  payment  transactions,  particularly
during the transition to SFAS No. 123(R).

In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets
- an amendment  of APB Opinion No. 29".  The standard is based on the  principle
that exchanges of nonmonetary  assets should be measured based on the fair value
of the assets  exchanged and eliminates  the exception  under ABP Opinion No. 29
for an exchange of similar  productive  assets and replaces it with an exception
for exchanges of nonmonetary  assets that do not have  commercial  substance.  A
nonmonetary  exchange has  commercial  substance if the future cash flows of the
entity are expected to change  significantly  as a result of the  exchange.  The
standard is effective  for  nonmonetary  exchanges  occurring in fiscal  periods
beginning  after June 15, 2005. The adoption of SFAS 153 is not expected to have
a material impact on the Company's financial position or results of operations.

In May  2005,  the FASB  issued  SFAS No.  154,  "Accounting  Changes  and Error
Corrections  - a  replacement  of APB Opinion No. 20 and FASB  Statement No. 3."
SFAS No. 154  establishes  retrospective  application as the required method for
reporting a change in accounting principle, unless it is impracticable, in which
case the changes  should be applied to the latest  practicable  date  presented.
SFAS No. 154 also  requires that a correction of an error be reported as a prior
period adjustment by restating prior period financial  statements.  SFAS No. 154
is effective for  accounting  changes and  corrections  of errors made in fiscal
years beginning after December 15, 2005.


                                       35
<PAGE>

NOTE 2- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued

Recent  Accounting  Pronouncements  (continued) - In March 2004, the FASB issued
Emerging   Issues  Task  Force  ("EITF")   Issue  No.  03-1,   "The  Meaning  of
Other-Than-Temporary  Impairment and its  Application  to Certain  Investments."
This issue  addresses  the meaning of  other-than-temporary  impairment  and its
application  to investments  classified as either  available for sale or held to
maturity under SFAS No. 115 and it also provides  guidance on  quantitative  and
qualitative  disclosures.  The disclosure  requirements  in paragraph 21 of this
Issue were  effective for annual  financial  statements  for fiscal years ending
after December 15, 2003 and were adopted by the Company  effective  December 31,
2003.

The recognition and measurement guidance in paragraphs 6-20 of this Issue was to
be applied to  other-than-temporary  impairment evaluations in reporting periods
beginning  after June 15,  2004,  but was delayed by FASB action in October 2004
through the issuance of a proposed FASB Staff Position  ("FSP") on the issue. In
July  2005,  the FASB  issued  FSP FAS  115-1 and FAS  124-1 - "The  Meaning  of
Other-Than-Temporary  Impairment and its  Application  to Certain  Investments."
This final guidance eliminated  paragraphs 10-18 of EITF-03-1  (paragraphs 19-20
have no material  impact on the  financial  position or results of operations of
the Company) and will be effective for other-than-temporary  impairment analysis
conducted  in periods  beginning  after  December  15,  2005.  The  Company  has
evaluated  the impact  that the  adoption of FSP FAS 115-1 and FAS 124-1 and has
concluded  that the  adoption  will  not have a  material  impact  on  financial
position and results of operations upon adoption.

In December 2005,  the FASB issued FSP SOP 94-6-1,  "Terms of Loan Products that
May Give Rise to a  Concentration  of Credit Risk".  The disclosure  guidance in
this FSP is effective for interim and annual  periods  ending after December 19,
2005.  The FSP states that the terms of certain  loan  products  may  increase a
reporting  entity's  exposure  to  credit  risk  and  thereby  may  result  in a
concentration  of credit risk as that term is used in SFAS No. 107, either as an
individual  product type or as a group of products with similar  features.  SFAS
No. 107 requires  disclosures  about each significant  concentration,  including
"information  about the (shared)  activity,  region, or economic  characteristic
that   identifies  the   concentration."   The  FSP  suggests   possible  shared
characteristics  on which  significant  concentrations  may be determined  which
include,  but are not  limited  to  borrowers  subject  to  significant  payment
increases,  loans with terms that permit  negative  amortization  and loans with
high loan-to-value ratios.

This FSP requires  entities to provide the disclosures  required by SFAS No. 107
for loan products that are  determined  to represent a  concentration  of credit
risk in accordance with the guidance of this FSP for all periods presented.  The
Company adopted this disclosure standard effective December 31, 2005.

Other  accounting  standards  that have been  issued or  proposed by the FASB or
other standards-setting  bodies that do not require adoption until a future date
are not  expected  to  have a  material  impact  on the  consolidated  financial
statements upon adoption.

Operating  Segments - The Company has  determined  that,  using the  definitions
contained in FASB Statement No. 131, Disclosures about Segments of an Enterprise
and Related  Information,  all of its activities  constitute only one reportable
operating segment.



                                       36
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 2- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ACTIVITIES - continued

Concentrations of Credit Risk - Financial instruments, which potentially subject
the Company to  concentrations  of credit  risk,  consist  principally  of loans
receivable, investment securities, and amounts due from banks.

The Company makes loans to individuals and small businesses for various personal
and  commercial  purposes  primarily in and around  Spartanburg,  Richland,  and
Beaufort  counties  in South  Carolina.  The  Company's  loan  portfolio  is not
concentrated  in loans to any single  borrower or a  relatively  small number of
borrowers. Additionally,  Management is not aware of any concentrations of loans
to classes of  borrowers  or  industries  that would be  similarly  affected  by
economic conditions.

In  addition  to  monitoring  potential  concentrations  of loans to  particular
borrowers or groups of borrowers,  industries and geographic regions, Management
monitors  exposure to credit risk from  concentrations  of lending  products and
practices such as loans that subject borrowers to substantial  payment increases
(e.g.  principal  deferral periods,  loans with initial  interest-only  periods,
etc), and loans with high loan-to-value  ratios.  Management has determined that
there is no concentration of credit risk associated with its lending policies or
practices.  However, there are industry practices that could subject the Company
to increased credit risk should economic  conditions change over the course of a
loan's life.  For example,  the Company makes variable rate loans and fixed rate
principal-amortizing  loans with maturities  prior to the loans being fully paid
(i.e.  balloon payment  loans).  These loans are  underwritten  and monitored to
manage  the  associated  risks.   Therefore,   management  believes  that  these
particular practices do not subject the Company to unusual credit risk.

The Company's  investment  portfolio consists  principally of obligations of the
United States, its agencies or its corporations and general obligation municipal
securities.  In the opinion of Management,  there is no  concentration of credit
risk in its  investment  portfolio.  The Company places its  correspondent  bank
account  deposits  with high  quality  institutions,  and  sells  its  overnight
investments to the Federal Home Loan Bank of Atlanta. Management believes credit
risk associated with correspondent accounts is not significant.

Reclassification  - Certain of the prior year amounts have been  reclassified to
conform to current year presentation;  such  reclassifications are immaterial to
the financial statements.




                                       37
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 3 - SECURITIES

A  summary  of the  amortized  cost  and  estimated  fair  value  of  securities
available-for-sale follows:

<TABLE>
<CAPTION>
                                                                                         Gross Unrealized
                                                                  Amortized              ----------------                 Estimated
                                                                    Cost             Gains              Losses            Fair Value
                                                                    ----             -----              ------            ----------
December 31, 2005
<S>                                                             <C>              <C>                  <C>                <C>
   U.S. government agency obligations ..................        $21,490,708      $           -        $   264,408        $21,226,300
   State and local obligations .........................            123,204              5,670                  -            128,874
   Mortgage-backed securities ..........................            765,855                  -             23,994            741,861
   Restricted FHLB stock ...............................          1,268,800                  -                  -          1,268,800
                                                                -----------        -----------        -----------        -----------
      Total ............................................        $23,648,567        $     5,670        $   288,402        $23,365,835
                                                                ===========        ===========        ===========        ===========
December 31, 2004
   U.S. government agency obligations ..................        $16,498,891      $           -        $    18,311        $16,480,580
   State and local obligations .........................            123,153              4,239                  -            127,392
   Mortgage backed securities ..........................            960,618                  -             16,350            944,268
   Restricted FHLB stock ...............................            954,200                  -                  -            954,200
                                                                -----------        -----------        -----------        -----------
      Total ............................................        $18,536,862        $     4,239        $    34,661        $18,506,440
                                                                ===========        ===========        ===========        ===========
</TABLE>

There  were no sales of  securities  available-for-sale  in 2005 or 2003 and one
sale with proceeds of $1,000,000 in 2004.

The following table shows gross unrealized losses and fair value,  aggregated by
investment category,  and length of time that individual securities have been in
a continuous unrealized loss position, at December 31, 2005.

Securities Available-for-Sale
<TABLE>
<CAPTION>
                                                          Less Than             Twelve Months
                                                        Twelve Months              or More                        Total
                                                        -------------              -------                        -----
                                                               Unrealized                  Unrealized                    Unrealized
                                                Fair Value       Losses      Fair Value      Losses       Fair Value       Losses
                                                ----------       ------      ----------      ------       ----------       ------
<S>                                             <C>           <C>           <C>           <C>           <C>              <C>
U.S. government agency obligations ..........   $14,347,360   $   143,348   $ 6,878,940   $   121,060   $   21,226,300   $   264,408
State and local obligations .................             -             -             -             -                -             -
Mortgage backed securities ..................             -             -       741,861        23,994          741,861        23,994
                                                -----------   -----------   -----------   -----------   --------------   -----------
     Total ..................................   $14,347,360   $   143,348   $ 7,620,801   $   145,054   $   21,968,161   $   288,402
                                                ===========   ===========   ===========   ===========   ==============   ===========
<CAPTION>
Securities Held-to-Maturity
                                                         Less Than             Twelve Months
                                                        Twelve Months              or More                        Total
                                                        -------------              -------                        -----
                                                               Unrealized                  Unrealized                    Unrealized
                                                Fair Value       Losses      Fair Value      Losses       Fair Value       Losses
                                                ----------       ------      ----------      ------       ----------       ------
<S>                                             <C>            <C>            <C>           <C>          <C>            <C>
U.S. government agency obligations ..........   $1,988,480     $   11,520     $       -     $      -     $1,988,480     $   11,520
State and local obligations .................            -              -             -            -              -              -
Mortgage backed securities ..................            -              -             -            -              -              -
                                                ----------     ----------     ---------     --------     ----------     ----------

     Total ..................................   $1,988,480     $   11,520     $       -     $      -     $1,988,480     $   11,520
                                                ==========     ==========     =========     ========     ==========     ==========
</TABLE>



                                       38
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 3 - SECURITIES - continued

The following table shows gross unrealized losses and fair value,  aggregated by
investment category,  and length of time that individual securities have been in
a continuous unrealized loss position, at December 31, 2004.

Securities Available-for-Sale

<TABLE>
<CAPTION>
                                                    Less Than                 Twelve Months
                                                   Twelve Months                  or More                       Total
                                                   -------------                  -------                       -----
                                                             Unrealized                  Unrealized                      Unrealized
                                                Fair Value       Losses    Fair Value       Losses        Fair Value       Losses
                                                ----------       ------    ----------       ------        ----------       ------
<S>                                             <C>           <C>           <C>           <C>           <C>               <C>
U.S. government agency obligations .........    $9,459,359    $   40,641    $  974,380    $   25,620    $   10,433,739    $   66,261
State and local obligations ................             -             -             -             -                 -             -
Mortgage backed securities .................             -             -             -             -                 -             -
                                                ----------    ----------    ----------    ----------    --------------    ----------
   Total ...................................    $9,459,359    $   40,641    $  974,380    $   25,620    $   10,433,739    $   66,261
                                                ==========    ==========    ==========    ==========    ==============    ==========
</TABLE>

Securities classified as  available-for-sale  are recorded at fair market value.
Approximately  50.3% of the unrealized losses on securities  available-for-sale,
or six  individual  securities,  consisted of  securities  in a continuous  loss
position  for twelve  months or more.  The Company has the ability and intent to
hold these  securities  until such time as the value  recovers or the securities
mature.  The  Company  believes,  based on industry  analyst  reports and credit
ratings,  that the  deterioration  in value is attributable to changes in market
interest  rates and is not in the credit  quality  of the issuer and  therefore,
these losses are not considered other-than-temporary.

A summary of the carrying  value and  estimated  fair market value of securities
held-for-investment follows:
<TABLE>
<CAPTION>
                                                                                            Gross Unrealized
                                                                    Amortized               ----------------             Estimated
                                                                       Cost              Gains           Losses          Fair Value
                                                                       ----              -----           ------          ----------
December 31, 2005
<S>                                                                 <C>               <C>               <C>               <C>
   U.S. government agency obligations ......................        $6,000,000        $    9,540        $   11,520        $5,998,020
   Trust preferred securities ..............................           480,641           153,331                 -           633,972
   Mortgage backed securities ..............................           783,429            12,057                 -           795,486
                                                                    ----------        ----------        ----------        ----------
      Total securities-available-for-sale ..................        $7,264,070        $  174,928        $   11,520        $7,427,478
                                                                    ==========        ==========        ==========        ==========
December 31, 2004
   U.S. government agency obligations ......................        $1,004,235     $           -        $    1,105        $1,003,130
   Trust preferred securities ..............................           479,274           133,404                 -           612,678
   Mortgage backed securities ..............................         1,499,938            38,623                 -         1,538,561
   State and local obligations .............................           375,000             9,701                 -           384,701
                                                                    ----------        ----------        ----------        ----------
      Total securities-available-for-sale ..................        $3,358,447        $  181,728        $    1,105        $3,539,070
                                                                    ==========        ==========        ==========        ==========
</TABLE>



                                       39
<PAGE>


                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 3 - SECURITIES - continued

The    scheduled    maturities    of    securities    held-for-investment    and
available-for-sale at December 31, 2005 were as follows:

<TABLE>
<CAPTION>
                                                             Available-For-Sale                          Held-For-Investment
                                                             ------------------                          -------------------
                                                        Amortized             Estimated            Amortized             Estimated
                                                           Cost               Fair Value              Cost               Fair Value
                                                           ----               ----------              ----               ----------
<S>                                                    <C>                   <C>                  <C>                  <C>
Due in one year or less ....................           $ 9,000,000           $ 8,937,670          $          -         $           -
Due from one to five years .................            10,490,708            10,327,500             4,000,000             3,989,900
Due from five to ten years .................             1,000,000               985,000             2,000,000             2,008,120
Due after ten years ........................             1,123,204             1,105,004                     -                     -
Mortgage backed securities .................               765,855               741,861               783,429               795,486
Equity securities ..........................             1,268,800             1,268,800               480,641               633,972
                                                       -----------           -----------           -----------           -----------
                                                       $23,648,567           $23,365,835           $ 7,264,070           $ 7,427,778
                                                       ===========           ===========           ===========           ===========
</TABLE>

At December 31, 2005, securities with a book value of approximately $11,672,488,
and  market  value of  $11,514,000  were  pledged  to secure  retail  repurchase
agreements, state funds, and Treasury, tax and loan deposits.

NOTE 4 - LOANS AND ALLOWANCE FOR LOAN LOSSES

Loans at December 31, 2005 and 2004 are summarized as follows:

                                                           December 31,
                                                           ------------
                                                      2005             2004
                                                      ----             ----
Construction and land development ............   $  14,041,295    $  17,223,132
1-4 family residential properties ............      65,187,499       70,445,101
Multifamily residential properties ...........       3,761,194        1,648,521
Non-farm nonresidential properties ...........     136,691,677      117,031,288
Other real estate loans ......................       3,210,755        1,200,855
Commercial and industrial, non-real estate ...      45,229,728       46,728,921
Consumer .....................................         409,653          470,787
                                                 -------------    -------------
   Total loans ...............................     268,531,801      254,748,605
   Less allowance for loans losses ...........      (3,000,000)      (2,900,000)
   Net deferred loan fees ....................        (498,388)        (693,434)
                                                 -------------    -------------
                                                 $ 265,033,413    $ 251,155,171
                                                 =============    =============

The  activity  in the  allowance  for loan  losses for 2005,  2004,  and 2003 is
summarized as follows:

                                                     December 31,
                                                     ------------
                                         2005            2004          2003
                                         ----            ----          ----
Balance, beginning of year ........   $ 2,900,000    $ 2,600,000    $ 1,750,000
Provision charged to operations ...       561,086        705,522        949,302
Loan charge-offs ..................      (479,789)      (421,448)    (1,808,203)
Loan recoveries ...................        18,703         15,926      1,708,901
                                      -----------    -----------    -----------
Balance, end of year ..............   $ 3,000,000    $ 2,900,000    $ 2,600,000
                                      ===========    ===========    ===========

At December  31, 2005 and 2004,  nonaccrual  loans  amounted to  $1,892,763  and
$350,167,  respectively. The Company evaluates impairment of commercial loans on
an individual  loan basis.  As of December 31, 2005 and 2004 loans  individually
evaluated and considered  impaired  under FASB Statement No. 114,  Accounting by
Creditors for Impairment of a Loan, were immaterial.

At December 31, 2005, the Company had loans outstanding to officers,  directors,
and their related interests of $3,118,024. During 2005, directors, officers, and
their related interests borrowed  $1,391,840 and repaid $2,319,133.  At December
31, 2004, the Company had loans  outstanding to officers,  directors,  and their
related interests of $4,045,317.  During 2004,  directors,  officers,  and their
related interests borrowed $2,325,398 and repaid $1,710,851.

                                       40
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 4 - LOANS AND ALLOWANCE FOR LOAN LOSSES - continued

In the normal  course of  business  there are  outstanding  commitments  for the
extension of credit,  which are not  reflected in the financial  statements.  At
December  31, 2005 and 2004,  pre-approved  but unused lines of credit for loans
totaled approximately  $40,616,000 and $36,240,245,  respectively.  In addition,
the Company had issued  standby  letters of credit  amounting  to  approximately
$2,442,000  and  $2,816,000  at December  31, 2005 and 2004,  respectively.  The
Company  also had  $4,363,969  in  outstanding  variable  rate  commercial  loan
commitments at December 31, 2005. These  commitments  represent no more than the
normal  lending  risk  that  the  Company  commits  to its  borrowers.  If these
commitments  are drawn,  the  Company  will  obtain  collateral  if it is deemed
necessary  based  on  management's   credit   evaluation  of  the  counterparty.
Management  believes  that  these  commitments  can  be  funded  through  normal
operations.  The fair value of these standby  letters of credit is based on fees
currently  charged for similar  instruments  and is  immaterial to the financial
statements taken as a whole.

The Company grants primarily  commercial,  real estate, and installment loans to
customers  throughout its market area,  which consists  primarily of Spartanburg
County,  Richland  County,  and  Hilton  Head  area in  South  Carolina  and the
Asheville area in North Carolina.  The real estate  portfolio can be affected by
the condition of the local real estate market.  The  commercial and  installment
loan portfolio can be affected by the local economic conditions.


NOTE 5 - PREMISES AND EQUIPMENT

Premises and equipment at December 31, 2005 and 2004 are summarized as follows:

                                                            December 31,
                                                            ------------
                                                      2005               2004
                                                      ----               ----
    Land .....................................    $   431,412        $   431,412
   Buildings ................................      4,326,450          4,718,620
   Leasehold improvements ...................        667,474             93,590
   Furniture and equipment ..................      1,638,855          1,682,443
                                                 -----------        -----------
                                                   7,064,191          6,926,065
   Less accumulated depreciation ............     (1,775,713)        (1,592,246)
                                                 -----------        -----------
                                                 $ 5,288,478        $ 5,333,819
                                                 ===========        ===========

Depreciation  expense  for the years ended 2005,  2004,  and 2003 was  $381,456,
$432,071 and $243,468, respectively.


NOTE 6 - DEPOSITS

A summary of deposit accounts at December 31, 2005 and 2004 follows:

                                                          December 31,
                                                          ------------
                                                   2005                  2004
                                                   ----                  ----
Demand
   Non-interest bearing ..............         $ 13,820,544         $ 18,632,817
   Interest bearing ..................           34,496,978           32,297,557
Savings ..............................           45,783,692           53,781,116
Time, $100,000 and over ..............           53,795,608           39,992,374
Other time ...........................          117,828,151          103,171,213
                                               ------------         ------------
                                               $265,724,973         $247,875,077
                                               ============         ============

At December 31, 2005, the scheduled maturities of time deposits are as follows:

     2006 ............................................     $ 153,674,978
     2007 ............................................         6,784,348
     2008 ............................................        10,158,994
     2009 ............................................         1,005,439
                                                           -------------
                                                           $ 171,623,759
                                                           =============

Directors and executive officers were customers of and had transactions with the
Bank in the  ordinary  course of  business.  Included in such  transactions  are
deposit  accounts,  all of which were made under  normal  terms.  The  aggregate
amount of these  deposit  accounts was $906,178 and  $1,180,733  at December 31,
2005 and 2004, respectively.


                                       41
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 7 - RETAIL REPURCHASE AGREEMENTS

Information   concerning  securities  sold  under  agreement  to  repurchase  is
summarized as follows for the year ended December 31, 2005 and 2004:

                                                          2005           2004
                                                          ----           ----
     Average balance during the year ................. $4,706,156    $5,155,915
     Average interest rate during the year ...........       2.66%         1.73%
     Maximum month-end balance during the year .......  6,413,256     7,031,903

U.S.  government  agency securities with a book value of $7,549,283 and a market
value  of  $7,453,470  at  December  31,  2005 are  used as  collateral  for the
agreement.

NOTE 8 - OTHER BORROWED FUNDS

Other  borrowed  funds consist of advances  from the FHLB and treasury,  tax and
loan accounts.

Advances from the Federal Home Loan Bank  consisted of the following at December
31, 2005 and 2004:

                                            Interest       2005         2004
     Description                              Rate       Balance        Balance
     -----------                              ----       -------        -------
Fixed rate advances maturing:
   February 15, 2011 .............           4.29%     $ 5,000,000   $ 5,000,000
   March 21, 2011 ................           4.62%       5,000,000     5,000,000
Daily rate advances ..............           4.44%       5,000,000             -
                                                       -----------   -----------
                                                       $15,000,000   $10,000,000
                                                       ===========   ===========

Scheduled principal reductions of FHLB fixed rate advances are all in 2011.

As collateral,  the Company has pledged its qualifying  first mortgage loans. In
addition, the Company's FHLB stock is pledged to secure the borrowings.  Certain
advances are subject to prepayment penalties.

Treasury,  tax and loan  accounts  with  balances  of $297,615  and  $416,656 at
December 31, 2005 and 2004,  respectively  are also  included in other  borrowed
funds.  These  borrowings  bear interest at the federal funds rate less 25 basis
points.

At December  31,  2005,  the Bank had  $12,000,000  of unused lines of credit to
purchase federal funds from banks.


                                       42
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 9 - SUBORDINATED DEBT

In January 2004, the Company formed a wholly-owned  Delaware  statutory business
trust, FSBS Capital Trust I (the "Trust"), which issued $5,000,000 of guaranteed
preferred beneficial  interests in the Company's junior subordinated  deferrable
interest debentures (the "Trust Preferred Securities"). These debentures qualify
as Tier I capital.  All of the common  securities  of the Trust are owned by the
Company.  The proceeds from the issuance of the common  securities and the Trust
Preferred  Securities  were  used by the  Trust to  purchase  from  the  Company
$5,155,000  of junior  subordinated  debentures  of the  Company  which  carry a
variable  interest rate of 3 Month LIBOR plus 2.8 percent per annum.  The junior
subordinated debentures represent the sole asset of the Trust.

The Company has entered into contractual arrangements which, taken collectively,
fully guarantee payment of (i) accrued and unpaid  distributions  required to be
paid on the Trust Preferred  Securities;  (ii) the redemption price with respect
to any Trust Preferred Securities called for redemption by FSBS Capital Trust I,
and (iii) payments due upon a voluntary or involuntary  dissolution,  winding up
or liquidation of the Trust.

The Trust Preferred  Securities are mandatorily  redeemable upon maturity of the
debentures  in  January  2034 or upon  earlier  redemption  as  provided  in the
indenture.  The Company has the right to redeem the debentures  purchased by the
Trust in whole or in part, at any time,  however if they are redeemed before the
fifth  anniversary,  the  cost  would  be 105  percent  of the par  value of the
securities. The debentures may be redeemed after the fifth anniversary at par.


NOTE 10 - REGULATORY CAPITAL REQUIREMENTS

The Company and the Bank are subject to various regulatory capital  requirements
administered  by the federal banking  agencies.  Failure to meet minimum capital
requirements   can  initiate   certain   mandatory   and   possible   additional
discretionary  actions by regulators  that, if  undertaken,  could have a direct
material  effect on the  Company  and the  Bank's  financial  statements.  Under
capital adequacy  guidelines and the regulatory  framework for prompt corrective
action,  the Company and the Bank must meet  specific  capital  guidelines  that
involve  quantitative  measures  of  their  assets,  liabilities,   and  certain
off-balance-sheet items as calculated under regulatory accounting practices. The
capital amounts and classifications are also subject to qualitative judgments by
the regulators  about  components,  risk  weighting,  and other factors.  Prompt
corrective action provisions are not applicable to bank holding companies.

Quantitative  measures  established  by  regulation to ensure  capital  adequacy
require the Company  and the Bank to  maintain  minimum  amounts and ratios (set
forth in the  table  below)  of total  and Tier I  capital  (as  defined  in the
regulations)  to  risk-weighted  assets (as defined),  and of Tier I capital (as
defined) to average assets (as defined). Management believes, as of December 31,
2005  and  2004,  that  the  Company  and  the  Bank  met all  capital  adequacy
requirements to which it is subject.



                                       43
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 10 - REGULATORY CAPITAL REQUIREMENTS - continued

As of December 31, 2005, the most recent  notification from the FDIC categorized
the  Bank  as  well  capitalized  under  the  regulatory  framework  for  prompt
corrective  action.  To be categorized as adequately  capitalized  the Bank must
maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios
as set  forth in the  table.  There  are no  conditions  or  events  since  that
notification  that  management  believes have changed the Bank's  category.  The
Company and the Bank's actual capital amounts and ratios as of December 31, 2005
and 2004 are also presented in the tables below.

<TABLE>
<CAPTION>
                                                                                                     To Be Well-
                                                                                                               Capitalized Under
                                                                                          For Capital          Prompt Corrective
The Company                                                        Actual              Adequacy Purposes       Action Provisions
                                                                   ------              -----------------       -----------------
                                                           Amount          Ratio      Amount         Ratio     Amount         Ratio
                                                           ------          -----      ------         -----     ------         -----
December 31, 2005
<S>                                                      <C>               <C>     <C>               <C>    <C>               <C>
  Total capital (to risk-weighted assets) ..........     $38,985,000       14.46%  $21,563,000       8.00%  $26,954,000       10.00%
  Tier 1 capital (to risk-weighted assets) .........      35,985,000       13.35%   10,782,000       4.00%   16,172,000        6.00%
  Tier 1 capital (to average assets) ...............      35,985,000       11.13%   12,928,000       4.00%   16,160,000        5.00%
December 31, 2004
  Total capital (to risk-weighted assets) ..........     $34,525,000       13.92%  $19,840,000       8.00%  $24,800,000       10.00%
  Tier 1 capital (to risk-weighted assets) .........      31,625,000       12.75%    9,920,000       4.00%   14,880,000        6.00%
  Tier 1 capital (to average assets) ...............      31,625,000       10.68%   11,839,000       4.00%   14,800,000        5.00%

The Bank
December 31, 2005
  Total capital (to risk-weighted assets) ..........     $37,660,000       13.98%  $21,551,000       8.00%  $26,938,000       10.00%
  Tier 1 capital (to risk-weighted assets) .........      29,760,000       11.05%   10,775,000       4.00%   16,163,000        6.00%
  Tier 1 capital (to average assets) ...............      29,760,000        9.21%   12,924,000       4.00%   16,155,000        5.00%
December 31, 2004
  Total capital (to risk-weighted assets) ..........     $34,140,000       13.77%  $19,840,000       8.00%  $24,800,000       10.00%
  Tier 1 capital (to risk-weighted assets) .........      26,340,000       10.62%    9,920,000       4.00%   14,880,000        6.00%
  Tier 1 capital (to average assets) ...............      26,340,000        8.90%   11,839,000       4.00%   14,800,000        5.00%
</TABLE>

NOTE 11 - INCOME TAXES

The provision for income taxes is summarized below:

                                                    December 31,
                                                    ------------
                                         2005           2004             2003
                                         ----           ----             ----
Currently payable
   Federal .....................    $ 1,784,300     $ 1,556,000     $ 1,284,325
   State .......................        162,000         144,000         101,675
                                    -----------     -----------     -----------
                                      1,946,300       1,700,000       1,386,000
Deferred
   Federal .....................        (22,798)       (122,928)       (240,927)
   State .......................         (1,202)         78,928         (19,073)
                                    -----------     -----------     -----------
                                        (24,000)        (44,000)       (260,000)
                                    -----------     -----------     -----------
      Total income taxes .......    $ 1,922,300     $ 1,656,000     $ 1,126,000
                                    ===========     ===========     ===========


                                       44
<PAGE>


                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 11 - INCOME TAXES - continued

The reasons for the  difference  between the statutory  federal income tax rates
and the effective tax rates are summarized as follows for:

                                                             December 31,
                                                             ------------
                                                        2005     2004     2003
                                                        ----     ----     ----
Statutory rates .....................................   34.0%    34.0%    34.0%
   Increase (decrease) resulting from:
      State taxes, net of federal benefit ...........    3.1      2.0      2.1
      Effect of taxes exempt interest and dividends .   (0.2)    (0.6)    (0.5)
      Life insurance ................................   (0.4)    (0.7)    (0.7)
      Other, net ....................................   (0.4)     0.9      0.0
                                                        ----     ----     ----

                                                        36.1%    35.6%    34.9%
                                                        ====     ====     ====

The tax  effects of  temporary  differences  result in  deferred  tax assets and
liabilities as presented below:

                                                          December 31,
                                                          ------------
                                                      2005               2004
                                                      ----               ----
Deferred tax assets
   Allowance for loan losses .............       $   910,861        $   902,000
   Available-for-sale securities .........           107,439             12,000
   Other .................................           118,031             51,000
                                                 -----------        -----------
      Gross deferred tax assets ..........         1,136,331            965,000

      Less valuation allowance ...........                 -                  -
                                                 -----------        -----------
      Net deferred tax assets ............         1,136,331            965,000

Deferred tax liabilities
   Depreciation ..........................          (144,172)          (158,000)
   Deferred loan cost ....................          (199,573)          (230,000)
   Prepaid expenses ......................           (20,591)           (23,000)
                                                 -----------        -----------
      Gross deferred liabilities .........          (364,336)          (411,000)
                                                 -----------        -----------
         Net .............................       $   771,995        $   554,000
                                                 ===========        ===========

The change in the valuation  allowance  was $0 for the year ending  December 31,
2005 and 2004.



                                       45
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY


NOTE 12 - COMMITMENTS AND CONTINGENCY

The  Company  leases the land and  building  for its  branches  under  operating
leases. Future minimum lease payments at December 31, 2005, are as follows:

      2006 ........................................   $     113,503
      2007 ........................................          94,830
      2008 ........................................          95,779
      2009 ........................................          91,712
      2010 ........................................          47,804
      2011 and thereafter .........................         133,161
                                                      -------------
                                                      $     576,789

Total lease expense was $152,843, $177,672 and $171,176 for 2005, 2004 and 2003,
respectively.
The  Company is  subject to legal  proceedings  and  claims  which  arise in the
ordinary  course of business.  In the opinion of management,  the disposition of
these claims will not have a material  adverse impact on the financial  position
or results of operations of the Company.

In 2005,  the  Company  recorded  an expense of  approximately  $1.7  million in
connection with the settlement of a lawsuit.


NOTE 13 - RESTRICTIONS ON DIVIDENDS, LOANS AND ADVANCES

Federal and state banking  regulations  place certain  restrictions on dividends
paid and loans or advances made by the Bank to the Corporation. The total amount
of cash  dividends,  which  may be paid at any  date  without  prior  regulatory
consent,  is generally limited to the year's net income of the Bank provided the
Bank received a composite rating of one or two at the last examination conducted
by the federal or state regulatory authority,  and loans or advances are limited
to 10 percent of the Bank's common stock and surplus on a secured basis.

In  addition,  cash  dividends  paid by the  Bank to the  Corporation  would  be
prohibited  if the effect  would  cause the Bank's  capital to be reduced  below
applicable minimum regulatory capital requirements.


NOTE 14 - EMPLOYEE BENEFIT PLANS

401(k) Plan - All employees of the Company who meet certain eligibility criteria
are permitted to participate in a 401(k) plan. For each employee's  contribution
up to 6 percent  of  compensation,  the  Company  makes a 100  percent  matching
contribution. Expense related to this plan was $124,479, $117,509 and $93,770 in
2005, 2004 and 2003, respectively.

Salary  Continuation  Plan - During  1999,  the  Company  entered  into a salary
continuation  agreement with certain officers of the Company.  The plan provides
for a series of payments over a specified  number of periods to these  employees
upon  their  retirement  or  termination  as stated in the plan.  The  amount of
accrued benefit expense included in other  liabilities was $221,506 and $141,422
at December 31, 2005 and 2004, respectively.



                                       46
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 15 - STOCK OPTIONS

The  Company  has  issued  incentive  stock  options  to  certain  officers  and
employees.  As permitted by FASB Statement No. 123,  Accounting for  Stock-Based
Compensation,  the Company has elected to continue using the measurement  method
prescribed in Accounting Principles Board Opinion No. 25 and, accordingly,  FASB
Statement No. 123 has no effect on the Company's  financial  position or results
of operations.

The following is a summary of stock option activity and related  information for
the years ended December 31, 2005, 2004 and 2003:

<TABLE>
<CAPTION>
                                                                2005                      2004                       2003
                                                                ----                      ----                       ----
                                                                       Weighted                  Weighted                   Weighted
                                                                        Average                   Average                    Average
                                                                       Exercise                  Exercise                   Exercise
                                                         Options        Price      Options        Price       Options        Price
                                                         -------        -----      -------        -----       -------        -----
<S>                                                     <C>             <C>        <C>          <C>            <C>         <C>
Outstanding at beginning of year ....................   185,478         13.67      177,633      $  12.68       157,890     $ 11.61
Granted .............................................    21,804         31.60        8,295         34.55        20,654       20.65
Forfeited ...........................................   (17,221)        21.07           -             -             -           -
Exercised ...........................................   (67,954)        11.53         (450)         7.33          (911)       8.33
                                                        -------      --------      -------      --------   -----------     -------
Outstanding at end of year ..........................   122,107      $  17.01      185,478      $  13.67       177,633     $ 12.68
                                                        =======      ========      =======      ========   ===========     =======
Exercisable, end of period ..........................   122,107      $  17.01      140,859      $  11.25       118,001     $ 10.41
                                                        =======      ========      =======      ========   ===========     =======
Weighted average fair value
   of options granted ...............................                $  20.82                   $  22.71                   $ 13.41
                                                                     ========                   ========                   =======
</TABLE>

Exercise prices for options  outstanding as of December 31, 2005 and 2004 ranged
from $7.33 to $35.00.  The weighted average remaining  contractual life of those
options  is  approximately  4.7  years at  December  31,  2005 and 5.8  years at
December 31, 2004.

The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option-pricing   model  with  the  following   weighted  average
assumptions  used for  grants  in 2005,  2004 and 2003;  dividend  yield of 0.00
percent,  expected  volatility of 50 percent in 2005,  2004 and 2003,  risk-free
interest  rates of 4.33 percent in 2005,  4.24 percent in 2004, and 3.77 percent
in 2003, and expected lives of 10 years for the options.


NOTE 16 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of financial instruments are as follows:

<TABLE>
<CAPTION>
                                                                                         December 31,
                                                                                         ------------
(Dollars in thousands)                                                    2005                               2004
                                                                          ----                               ----
                                                              Carrying          Estimated          Carrying           Estimated
                                                               Amount           Fair Value           Amount           Fair Value
                                                               ------           ----------           ------           ----------
Financial assets
<S>                                                           <C>                <C>                <C>                <C>
   Cash and cash equivalents ...........................      $ 18,532           $ 18,532           $ 13,292           $ 13,292
   Securities
     Available-for-sale ................................        23,366             23,366             18,506             18,506
     Held-for-investment ...............................         7,264              7,427              3,358              3,539
   Loans ...............................................       265,033            264,792            251,155            251,116
Financial liabilities
   Deposits ............................................       265,725            266,283            247,875            248,020
   Retail repurchase agreements ........................         5,740              5,710              4,700              4,700
   Other borrowed funds ................................        15,298             14,740             10,417             10,488
   Subordinated debt ...................................         5,155              5,155              5,155              5,155
</TABLE>


                                       47
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 16 - FAIR VALUE OF FINANCIAL INSTRUMENTS - continued

The fair value  estimates are made at a specific point in time based on relevant
market and other information about the financial instruments.  Because no market
exists for a significant  portion of the Company's financial  instruments,  fair
value  estimates  are  based  on  judgments   regarding   future  expected  loss
experience,   current  economic  conditions,  risk  characteristics  of  various
financial instruments, and such 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  could
significantly affect the estimates.  In addition,  the tax ramifications related
to the  realization  of the  unrealized  gains and losses can have a significant
effect on fair value estimates and have not been considered in the estimates.

NOTE 17 - EARNINGS PER COMMON SHARE (EPS)

The reconciliation of the numerators and denominators of the earnings per common
share and diluted EPS computation follows:

<TABLE>
<CAPTION>
                                                                                   Income                Shares          Per Share
December 31, 2005                                                                (Numerator)          (Denominator)        Amount
                                                                                 -----------          -------------        ------
Earnings per common share:
<S>                                                                               <C>                    <C>               <C>
   Income available to common stockholders ...........................            $3,400,004             1,725,845         $   1.97
   Dilutive effect of stock options ..................................                     -                71,373            (0.08)
                                                                                  ----------            ----------         --------
Diluted EPS:
   Income available to common stockholders
      and assumed conversions ........................................            $3,400,004             1,797,218         $   1.89
                                                                                  ==========            ==========         ========
December 31, 2004
Earnings per common share:
   Income available to common stockholders ...........................            $3,000,055             1,607,525         $   1.87
   Dilutive effect of stock options ..................................                     -                98,047            (0.11)
                                                                                  ----------            ----------         --------
Diluted EPS:
   Income available to common stockholders
      and assumed conversions ........................................            $3,000,055             1,705,572         $   1.76
                                                                                  ==========            ==========         ========
December 31, 2003
Earnings per common share:
   Income available to common stockholders ...........................            $2,104,267             1,381,722         $   1.52
   Dilutive effect of stock options ..................................                     -                62,844            (0.06)
                                                                                  ----------            ----------         --------
Diluted EPS:
   Income available to common stockholders
      and assumed conversions ........................................            $2,104,267             1,444,566         $   1.46
                                                                                  ==========            ==========         ========
</TABLE>

Options to purchase 200 shares of common  stock at $32.50 per share,  options to
purchase  8,304 shares of common stock at $33.00 per share,  options to purchase
4,742  shares of common  stock at $35.00 per share,  options to  purchase  5,100
shares of common stock at $32.00 per share and options to purchase 100 shares of
common stock at $32.25 per share were not included in the computation of diluted
earnings per share for 2005 because the options' exercise price was greater than
the average market price of common shares.

Options to purchase 100 shares of common  stock at $30.50 per share,  options to
purchase  400 shares of common  stock at $29.75 per share,  100 shares at $29.50
and 7,595  shares at $35.00  were not  included  in the  computation  of diluted
earnings per share for 2004 because the options' exercise price was greater than
the average market price of the common shares.

                                       48
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 18 - CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY

Financial information pertaining to First South Bancorp, Inc. is as follows:

                                 Balance Sheets

<TABLE>
<CAPTION>
                                                                                                             December 31,
                                                                                                             ------------
                                                                                                   2005                      2004
                                                                                                   ----                      ----
Assets
<S>                                                                                            <C>                       <C>
  Cash .........................................................................               $ 1,324,644               $   540,866
  Investment in Trust ..........................................................                   155,000                   155,000
  Investment in common stock of
      First South Bank .........................................................                29,584,893                26,321,326
      Due from Bank ............................................................                 4,900,000                 4,900,000
  Debt issuance costs ..........................................................                    61,668                    81,665
                                                                                               -----------               -----------
  Total assets .................................................................               $36,026,205               $31,998,857
                                                                                               ===========               ===========
Liabilities and Stockholders' Equity
  Due to Trust .................................................................               $ 5,155,000               $ 5,155,000
  Shareholders' equity .........................................................                30,871,205                26,843,857
                                                                                               -----------               -----------
      Total liabilities and stockholders' equity ...............................               $36,026,205               $31,998,857
                                                                                               ===========               ===========
</TABLE>

                            Statements of Operations

<TABLE>
<CAPTION>
                                                                                               For the years ended December 31,
                                                                                               --------------------------------
                                                                                                2005                       2004
                                                                                                ----                       ----
<S>                                                                                          <C>                        <C>
Operating income .............................................................               $   311,450                $   201,211
Expense ......................................................................                   331,493                    219,544
                                                                                             -----------                -----------
Loss before equity in undistributed net income
  of First South Bank ........................................................                   (20,043)                   (18,333)
Equity in undistributed net income of
  First South Bank ...........................................................                 3,420,047                  3,018,388
                                                                                             -----------                -----------
      Net income .............................................................               $ 3,400,004                $ 3,000,055
                                                                                             ===========                ===========
</TABLE>



                                       49
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

NOTE 18 - CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY - continued

                                             Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                                          For the years ended December 31,
                                                                                          --------------------------------
                                                                                  2005                2004                  2003
                                                                                  ----                ----                  ----
Operating Activities
<S>                                                                           <C>                  <C>                  <C>
  Net income ........................................................         $ 3,400,004          $ 3,000,055          $ 2,104,267
  Equity in undistributed income of
     First South Bank ...............................................          (3,420,047)          (3,018,388)          (2,104,267)
  Net change in other assets ........................................              20,043              (81,668)                   -
                                                                              -----------          -----------          -----------
       Net cash used in operating activities ........................                   -             (100,001)                   -
                                                                              -----------          -----------          -----------
Investing Activities
  Investment in Trust ...............................................                   -             (155,000)                   -
  Advances to subsidiaries ..........................................                   -           (4,900,000)                   -
                                                                              -----------          -----------          -----------
       Net cash used in investing activities ........................                   -           (5,055,000)                   -
                                                                              -----------          -----------          -----------
Financing Activities
  Contributed Capital to bank subsidiary ............................                   -           (7,000,000)                   -
  Proceeds from stock option exercise ...............................             783,778                3,300                7,500
  Proceeds from issuance of long-term debt ..........................                   -            5,155,000                    -
  Proceeds from issuance of common stock ............................                   -            7,482,067                    -
                                                                              -----------          -----------          -----------
       Net cash provided by financing activities ....................             783,778            5,640,367                7,500
                                                                              -----------          -----------          -----------
       Net increase in cash and cash equivalents ....................             783,778              485,366                7,500
Cash and cash equivalents, beginning of year ........................             540,866               55,500               48,000
                                                                              -----------          -----------          -----------
Cash and cash equivalents, end of year ..............................         $ 1,324,644          $   540,866          $    55,500
                                                                              ===========          ===========          ===========
</TABLE>


                                       50
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

Item 8.  Changes  In  and  Disagreements  With  Accountants  on  Accounting  and
         Financial Disclosure.

         Not Applicable

Item 8A. Controls and Procedures

         Based on the evaluation required by 17 C.F.R. Section  240.13a-15(b) or
240.15d-15(b) of the Company's disclosure controls and procedures (as defined in
17 C.F.R. Sections 240.13a-15(e) or 240.15d-15(e), the Company's chief executive
officer and chief financial officer concluded that such controls and procedures,
as of the end of the period covered by this annual report, were effective.

         No disclosure is required under 17 C.F.R. Section 228.308 (a) or (b).

         There  has  been no  change  in the  Company's  internal  control  over
financial  reporting  during the most recent fiscal  quarter that has materially
affected,  or is reasonably likely to materially  affect, the Company's internal
control over financial reporting.

Item 8B. Other Information

         No information was required to be disclosed by the Registrant in a Form
8-K during the fourth quarter of 2005 that was not so disclosed.


                                    PART III

Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance
        With Section 16(a) of the Exchange Act.

         The information set forth under the captions "Management of the Company
- Directors" and  "Management of the Company - Executive  Officers" and "Section
16(a)  Beneficial  Ownership  Reporting  Compliance" in registrant's  definitive
proxy  statement  filed  with the  Commission  for the 2006  Annual  Meeting  of
Shareholders (the "2006 Proxy Statement") is incorporated herein by reference.

         Audit Committee Financial Expert

         The Company's  board of directors has determined  that the Company does
not have an "audit committee  financial expert", as that term is defined by Item
401(e) of Regulation S-B promulgated by the Securities and Exchange  Commission,
serving on its audit committee.  The Company's audit committee is a committee of
directors who are elected by the  shareholders  and who are  independent  of the
Company and its  management.  After reviewing the experience and training of all
of the  Company's  independent  directors,  the board of directors has concluded
that  no  independent  director  meets  the  SEC's  very  demanding  definition.
Therefore, it would be necessary to find a qualified individual willing to serve
as both a  director  and  member of the  audit  committee  and have that  person
elected  by the  shareholders  in order to have an  "audit  committee  financial
expert" serving on the Company's audit committee.  The Company's audit committee
is,  however,  authorized to use  consultants  to provide  financial  accounting
expertise in any instance where members of the committee believe such assistance
would be useful. Accordingly, the Company does not believe that it needs to have
an "audit committee financial expert" on its audit committee.

         Code of Ethics

         The  Company  has  adopted a code of ethics  (as  defined  by 17 C.F.R.
228.406) that applies to its principal executive officer and principal financial
officer.  The Company will provide a copy of the code of ethics, free of charge,
to any person upon written request to V. Lewis Shuler, Executive Vice President,
First South Bancorp, 1450 John B. White, Sr. Blvd., Spartanburg, S.C. 29306.

Item 10. Executive Compensation.

         The information set forth under the caption "Management  Compensation,"
in the 2006 Proxy Statement is incorporated herein by reference.


                                       51
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

Item 11.  Security  Ownership of Certain  Beneficial  Owners and  Management and
          Related Stockholder Matters.


         The  information  set forth under the caption  "Security  Ownership  of
Certain  Beneficial  Owners  and  Management"  in the 2006  Proxy  Statement  is
incorporated herein by reference.


<TABLE>
<CAPTION>

                                                         Equity Compensation Plan Information

                                                 (a)                        (b)                     (c)
                                                                                           Number of securities
                                                                                           remaining available
                                                                                           for future issuance
                                                                                           under equity
                                      Number of securities to     Weighted-average         compensation plans
                                      be issued upon exercise     exercise price of        (excluding securities
                                      of outstanding options,     outstanding options,     reflected in column
                                      warrants, and rights        warrants, and rights     (a)
                                      --------------------        --------------------     ---------------------
Plan category
<S>                                          <C>                         <C>                       <C>
Equity compensation plans
approved by security holders                 122,107                     $17.01                    362,018

Equity compensation plans
not approved by security  holders                                             -                          -
                                             -------                     ------                    -------

Total                                        122,107                     $17.01                    362,018

</TABLE>


Item 12. Certain Relationships and Related Transactions.

         The information set forth under the caption "Certain  Relationships and
Related  Transactions"  in the 2006 Proxy  Statement is  incorporated  herein by
reference.



                                       52
<PAGE>




                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

Item 13. Exhibits

(a) Description of Exhibits.

Exhibit No.                Description

3.1            Articles of Incorporation of Registrant (1)
3.2            Bylaws of Registrant (1)
4.1            Form of Common Stock Certificate(2)
10.1           First South Bank Stock Option Plan (3)
10.2           Form of  Option  Agreements  with  Barry L.  Slider,  dated as of
               December 31, 1998, December 31, 1997 and December 31, 1996. (3)
10.3           Option  Agreement  with  Barry L.  Slider,  dated as of April 17,
               1997(2)
10.4           Form of Salary  Continuation  Agreements with Barry L. Slider and
               V. Lewis Shuler dated November 19, 1999 (2)
10.5           Amended  and  Restated   Declaration   of  the  Trust  among  the
               Registrant, Wells Fargo Delaware Trust Company, Wells Fargo Bank,
               National Association,  Barry L. Slider and V. Lewis Shuler, dated
               as of January 30, 2004. (4)
10.6           Indenture  between  Registrant  and Wells  Fargo  Bank,  National
               Association, dated as of January 30, 2004. (4)
10.7           Guarantee  Agreement between the Registrant and Wells Fargo Bank,
               National Association, dated as of January 30, 2004. (4)
10.8           Registrant's Junior Subordinated Debt Security Due 2034. (4)
10.9           First South Bancorp, Inc., Incentive Stock Option Plan (5)
21             Subsidiaries of Registrant (3)
23             Consent of Independent Registered Public Accounting Firm
31.1           Rule  13a-14(a) /  15d-14(a)  Certifications  of Chief  Executive
               Officer
31.2           Rule  13a-14(a) /  15d-14(a)  Certifications  of Chief  Financial
               Officer
32             Section 1350 Certifications
--------------
(1)  Incorporated by reference to Form 8-A filed November 12, 1999
(2)  Incorporated  by reference  to Form 10-KSB for the year ended  December 31,
     2000
(3)  Incorporated  by reference  to Form 10-KSB for the year ended  December 31,
     1999
(4)  Incorporated  by reference  to Form 10-QSB for the quarter  ended March 31,
     2004.
(5)  Incorporated  by  reference  to Exhibit  4.2 to  Registrant's  registration
     statement on Form S-8, Registration No. 333-128522
Item 14.   Principal Accountant Fees and Services

           The  information  set forth  under the  caption  "Independent  Public
Accountants-Fees Paid to Independent Auditors" and "Audit Committee Pre-Approval
of Audit and Permissible Non-Audit Services of Independent Auditors" in the 2006
Proxy Statement is incorporated herein by reference.


                                       53
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

                                   SIGNATURES

         In  accordance  with  Section  13 or 15(d)  of the  Exchange  Act,  the
registrant  caused  this  report to be signed on its behalf by the  undersigned,
thereunto duly authorized.

                                   First South Bancorp, Inc.


March 16, 2006                     By: s/Barry L. Slider
                                      ------------------------------------------
                                         Barry L. Slider
                                         President and Chief Executive Officer


                                   By: s/V. Lewis Shuler
                                      ------------------------------------------
                                         V. Lewis Shuler
                                         Executive Vice President
                                         (Principal Financial and Principal
                                          Accounting Officer)

         In accordance  with the Exchange Act, this Report has been signed below
by the following  persons on behalf of the  registrant and in the capacities and
on the dates indicated:


<TABLE>
<CAPTION>

Signature                                Title                                              Date
---------                                -----                                              ----

<S>                                      <C>                                               <C>
--------------------------               Director                                           March 16, 2006
Harold E. Fleming, M.D.


--------------------------               Director                                           March 16, 2006
Joel C. Griffin

--------------------------               Chairman, Director                                 March 16, 2006
Roger A. F. Habisreutinger

 s/ Herman E. Ratchford
--------------------------               Director                                           March 16, 2006
Herman E. Ratchford

 s/ Chandrakant V. Shanbhag
--------------------------               Director                                           March 16, 2006
Chandrakant V. Shanbhag

 s/ Barry L. Slider
--------------------------               President, Chief Executive Officer, Director       March 16, 2006
Barry L. Slider

 s/ David G. White
--------------------------               Director                                           March 16, 2006
David G. White
</TABLE>


                                       54
<PAGE>

                    FIRST SOUTH BANCORP, INC. AND SUBSIDIARY

                                  Exhibit Index


Exhibit No.                Description

3.1            Articles of Incorporation of Registrant (1)
3.2            Bylaws of Registrant (1)
4.1            Form of Common Stock Certificate(2)
10.1           First South Bank Stock Option Plan (3)
10.2           Form of  Option  Agreements  with  Barry L.  Slider,  dated as of
               December 31, 1998, December 31, 1997 and December 31, 1996. (3)
10.3           Option  Agreement  with  Barry L.  Slider,  dated as of April 17,
               1997(2)
10.4           Form of Salary  Continuation  Agreements with Barry L. Slider and
               V. Lewis Shuler dated November 19, 1999 (2)
10.5           Amended  and  Restated   Declaration   of  the  Trust  among  the
               Registrant, Wells Fargo Delaware Trust Company, Wells Fargo Bank,
               National Association,  Barry L. Slider and V. Lewis Shuler, dated
               as of January 30, 2004. (4)
10.6           Indenture  between  Registrant  and Wells  Fargo  Bank,  National
               Association, dated as of January 30, 2004. (4)
10.7           Guarantee  Agreement between the Registrant and Wells Fargo Bank,
               National Association, dated as of January 30, 2004. (4)
10.8           Registrant's Junior Subordinated Debt Security Due 2034. (4)
10.9           First South Bancorp, Inc., Incentive Stock Option Plan (5)
21             Subsidiaries of Registrant (3)
23             Consent of Independent Registered Public Accounting Firm
31.1           Rule  13a-14(a) /  15d-14(a)  Certifications  of Chief  Executive
               Officer
31.2           Rule  13a-14(a) /  15d-14(a)  Certifications  of Chief  Financial
               Officer
32             Section 1350 Certifications
--------------
(1)  Incorporated  by  reference  to  Form  8-A  filed  November  12,  1999
(2)  Incorporated  by reference  to Form 10-KSB for the year ended  December 31,
     2000
(3)  Incorporated  by reference  to Form 10-KSB for the year ended  December 31,
     1999
(4)  Incorporated  by reference  to Form 10-QSB for the quarter  ended March 31,
     2004.
(5)  Incorporated  by  reference  to Exhibit  4.2 to  Registrant's  registration
     statement on Form S-8, Registration No. 333-128522



                                       55