**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM10-K**

 

**ý****ANNUALREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE FISCAL YEAR ENDEDDECEMBER 31, 2005**

 

**COMMISSION FILE NUMBER 333-90273**

 

**FIDELITYD & D BANCORP, INC.**

 

COMMONWEALTH OF PENNSYLVANIAI.R.S. EMPLOYER IDENTIFICATION NO: **23-3017653**

**BLAKELY AND DRINKER STREETS**

**DUNMORE, PENNSYLVANIA  18512**

TELEPHONE NUMBER**(570) 342-8281**

 

SECURITIES REGISTEREDUNDER SECTION 12(b) OF THE ACT:

**None**

 

SECURITIES REGISTEREDUNDER SECTION 12(g) OF THE ACT:

**Common Stock, without par value**

 

Indicate by check mark if the registrant is a well-known seasonedissuer, as defined in Rule 405 of the Securities Act.

Yes o             No ý

 

Indicate by check mark if the registrant is not required to filereports pursuant to Section 13 or Section 15(d) of the Act.

Yes o             No ý

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ýNo o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of the Registrant’s knowledge, in definitive proxy or informationstatements incorporated by references in Part III of this Form 10-K or anyamendment to this Form 10-K. ý

 

Indicate by check mark whether the Registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (CheckOne)

Large acceleratedfiler o             Accelerated filer o                                          Non-acceleratedfiler ý

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12B-2 of the Act).

Yes o             No ý

 

Aggregate market value of the voting common stock held bynon-affiliates of the registrant equals $52,683,018, as of June 30, 2005, basedon a market price of $32.36. The number of shares of common stock outstandingas of March 10, 2006, was 2,044,802.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Excerpts from the Registrant’s 2005 Annual Report to Shareholders areincorporated herein by reference in response to Part I. Portions of theRegistrant’s definitive Proxy Statement to be used in connection with the 2006Annual Meeting of Shareholders are incorporated herein by reference in partialresponse to Part II and Part III.

 

 

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**Fidelity D & D Bancorp, Inc.**

**2005 Annual Report on Form 10-K**

**Table of Contents**

 
| **Part I.**    |                                                                                                                |   |
|----------------|---------------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                                |   |
| Item  1.       | Business                                                                                                            | 3      |
| Item  1A.      | Risk Factors                                                                                                        | 4      |
| Item  1B.      | Unresolved Staff Comments                                                                                           | 10     |
| Item  2.       | Properties                                                                                                          | 10     |
| Item  3.       | Legal Proceedings                                                                                                   | 11     |
| Item  4.       | Submission of Matters to a Vote of Security Holders                                                                 | 11     |
|           |                                                                                                                |   |
| **Part  II.**  |                                                                                                                |   |
|           |                                                                                                                |   |
| Item 5.        | Market for the Company’s  Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | 12     |
| Item  6.       | Select Financial Data                                                                                               | 13     |
| Item  7.       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                         | 13     |
| Item 7A.       | Quantitative and Qualitative  Disclosures About Market Risk                                                         | 43     |
| Item 8.        | Financial Statements and Supplementary  Data                                                                        | 45     |
| Item 9.        | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                               | 74     |
| Item 9A.       | Controls and  Procedures                                                                                            | 74     |
| Item 9B.       | Other Information                                                                                                   | 74     |
|           |                                                                                                                |   |
| **Part III.**  |                                                                                                                |   |
|           |                                                                                                                |   |
| Item 10.       | Directors  and Executive Officers of the Company                                                                    | 74     |
| Item 11.       | Executive Compensation                                                                                              | 74     |
| Item 12.       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 74     |
| Item 13.       | Certain  Relationships and Related Transactions                                                                     | 75     |
| Item 14.       | Principal  Accountant Fees and Services                                                                             | 75     |
|           |                                                                                                                |   |
| **Part IV.**   |                                                                                                                |   |
|           |                                                                                                                |   |
| Item 15.       | Exhibits,  Financial Statement Schedules                                                                            | 75     |
|           |                                                                                                                |   |
| Signatures     | 78                                                                                                                  |
| Exhibit Index  | 80                                                                                                                  |
| Certifications | 84                                                                                                                  |

 

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**FIDELITY D & D BANCORP, INC.**

 

###### ***PART I***

 

# ***ITEM 1:***                        BUSINESS

# *** ***

Fidelity D & D Bancorp, Inc. (the Company) was incorporated in theCommonwealth of Pennsylvania, on August 10, 1999, and is a bank holdingcompany, whose wholly owned state chartered commercial bank is The FidelityDeposit and Discount Bank (the Bank) (collectively, the Company). The Company isheadquartered at Blakely and Drinker Streets in Dunmore, Pennsylvania.

 

The Bank has offered a full range of traditional banking services sinceit commenced operations in 1903. In addition, the Bank has a personal andcorporate trust department and also provides alternative financial andinsurance products with asset management services. A complete list of servicesprovided by the Bank is detailed in the section entitled “Products &Services” contained within the 2005 Annual Report to Shareholders, incorporatedby reference. The service area is comprised of the Borough of Dunmore and thesurrounding communities within Lackawanna and Luzerne counties.

 

The Bank is one of two financial institutions headquartered in Dunmore,Pennsylvania. The banking business is highly competitive, and the profitabilityof the Company depends principally upon the Company’s ability to compete in itsmarket area. The Company competes with, among other sources, the following:

 

•                  local community banks

•                  savings banks

•                  regional banks

•                  credit unions

•                  savings & loans

•                  insurance companies

•                  money market funds

•                  mutual funds

•                  small loan companies

•                  other financial servicecompanies

 

The Company has been able to compete effectively with other financialinstitutions by emphasizing technology and customer service, including localdecision making on loans. These efforts enabled the Bank to establish long-termcustomer relationships and build customer loyalty by providing products andservices designed to address the specific needs of its customers.

 

There are no concentrations of loans that, if lost, would have amaterially adverse effect on the continued business of the Bank. The Bank’sloan portfolio does not have a material concentration within a single industryor group of related industries that are vulnerable to the risk of a near-termsevere impact. However, the Company’s success is dependent, to a significantdegree, on economic conditions in Northeastern Pennsylvania, especially in Lackawannaand Luzerne counties, which the Company defines as its primary market area. Thebanking industry is affected by general economic conditions including theeffects of inflation, recession, unemployment, real estate values, trends inthe national and global economics and other factors beyond the Company’scontrol. An economic recession or a delayed economic recovery over a prolongedperiod of time in the Company’s primary market area could cause an increase inthe level of the Bank’s non-performing assets and loan losses, and thereby causeoperating losses, impairment of liquidity and erosion of capital. We cannotassure you that adverse changes in the local economy would not have a materialeffect on the Company’s future consolidated financial condition, results ofoperations and cash flows.

 

The Company had 186 full-time equivalent employees, on December 31, 2005,which includes exempt officers and part-time employees.

 

Federal and state banking laws contain numerousprovisions that affect various aspects of the business and operations of theCompany and the Bank. The Company is subject to, among others, the regulationsof the Securities and Exchange Commission (the “SEC”) and the Federal ReserveBoard (the “FRB”) and the Bank is subject to, among others, the regulations ofthe Pennsylvania Department of Banking and the Federal Deposit InsuranceCorporation (the “FDIC”). Refer to Part II, Item 7 “Supervision and Regulation”for descriptions of and references to applicable statutes and regulations whichare not intended to be complete descriptions of these provisions or theireffects on the Company or the Bank. They are summaries only and are qualifiedin their entirety by reference to such statutes and regulations.

 

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Applicable regulations relate to, among other things:

 

•                  operations

•                  securities

•                  risk management

•                  consumercompliance

•                  mergers

•                  consolidation

•                  reserves

•                  dividends

•                  branches

•                  capital adequacy

 

The Bank is examined by the Pennsylvania Department of Banking and the FDIC.The last examination was jointly conducted by the Pennsylvania Department ofBanking and the FDIC as of September 30, 2005.

 

The Company’s website address is http://www.the-fidelity.com.The Company makes available through this website the Annual Report on Form10-K, quarterly reports on Form 10-Q and current reports on Form 8-K andamendments to those reports as soon as reasonably practical after filing withthe SEC. Further, you may read and copy any materials filed with the SEC at theSEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You mayobtain information on the operation of the Public Reference Room by calling theSEC at (202) 551-8090. The SEC also maintains an internet site that containsreports, proxy and information statements and other information about theCompany at http://www.sec.gov.

 

The Company’s accounting policies and procedures are designed to complywith accounting principles, generally accepted in the United States of America(GAAP). Refer to “Critical Accounting Policies,” which are incorporated byreference in Part II, Item 7.

 

***ITEM 1A:***  ***RISK FACTORS***

 

An investment in the Company’s common stock is subject to risksinherent to the Company’s business. The material risks and uncertainties thatmanagement believes affect the Company are described below. Before making aninvestment decision, you should carefully consider the risks and uncertaintiesdescribed below together with all of the other information included orincorporated by reference in this report. The risks and uncertainties describedbelow are not the only ones facing the Company. Additional risks anduncertainties that management is not aware of or focused on or that managementcurrently deems immaterial may also impair the Company’s business operations.This report is qualified in its entirety by these risk factors.

 

If any of the following risks actually occur, the Company’s financialcondition and results of operations could be materially and adversely affected.If this were to happen, the value of the Company’s common stock could declinesignificantly, and you could lose all or part of your investment.

 

**Risks Related To The Company’s Business**

 

*The Company’s business is subject to interest raterisk and variations in interest rates may negatively affect its financialperformance.*

 

Changes in the interest rate environment may reduce profits. TheCompany’s earnings and cash flows are largely dependent upon its net interestincome. Net interest income is the difference between the interest earned onloans, securities and other interest-earning assets, and interest paid ondeposits, borrowings and other interest-bearing liabilities. As prevailinginterest rates change, net interest spreads are affected by the differencebetween the maturities and re-pricing characteristics of interest-earningassets and interest-bearing liabilities. In addition, loan volume and yieldsare affected by market interest rates on loans, and rising interest ratesgenerally are associated with a lower volume of loan originations. An increasein the general level of interest rates may also adversely affect the ability ofcertain borrowers to pay the interest on and principal of their obligations.Accordingly, changes in levels of market interest rates could materiallyadversely affect the Company’s net interest spread, asset quality, loanorigination volume and overall profitability.

 

*The Company is subject to lendingrisk.*

 

There are inherent risks associated with the Company’s lendingactivities. These risks include, among other things, the impact of changes ininterest rates and changes in the economic conditions in the markets where the Companyoperates as well as those across the Commonwealth of Pennsylvania and theUnited States. Increases in interest rates and/or weakening economic conditionscould adversely impact the ability of borrowers to repay outstanding loans orthe value of the collateral securing these loans. The Company is also subjectto various laws and regulations that affect its lending activities. Failure tocomply with applicable laws and regulations could subject the Company toregulatory enforcement action that could result in the assessment ofsignificant civil money penalties against the Company.

 

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As of December 31, 2005, approximately 56% of the Company’s loanportfolio consisted of commercial, commercial real estate and real estateconstruction loans. These types of loans are generally viewed as having morerisk of default than residential real estate loans or consumer loans. Thesetypes of loans are also typically larger than residential real estate loans andconsumer loans. Because the Company’s loan portfolio contains a significantnumber of commercial and industrial, construction and commercial real estateloans with relatively large balances, the deterioration of one or a few ofthese loans could cause a significant increase in non-performing loans. Anincrease in non-performing loans could result in a net loss of earnings fromthese loans, an increase in the provision for possible loan losses and anincrease in loan charge-offs, all of which could have a material adverse effecton the Company’s financial condition and results of operations.

 

*The company’sallowance for possible loan losses may be insufficient.*

 

The Company maintains an allowance for possible loan losses, which is areserve established through a provision for possible loan losses charged toexpense, that represents management’s best estimate of probable losses thathave been incurred within the existing portfolio of loans. The allowance, inthe judgment of management, is necessary to reserve for estimated loan lossesand risks inherent in the loan portfolio. The level of the allowance reflectsmanagement’s continuing evaluation of industry concentrations; specific creditrisks; loan loss experience; current loan portfolio quality; present economic,political and regulatory conditions and unidentified losses inherent in thecurrent loan portfolio. The determination of the appropriate level of theallowance for possible loan losses inherently involves a high degree ofsubjectivity and requires the Company to make significant estimates of currentcredit risks and future trends, all of which may undergo material changes.Changes in economic conditions affecting borrowers, new information regardingexisting loans, identification of additional problem loans and other factors,both within and outside of the Company’s control, may require an increase inthe allowance for possible loan losses. In addition, bank regulatory agenciesperiodically review the Company’s allowance for loan losses and may require anincrease in the provision for possible loan losses or the recognition offurther loan charge-offs, based on judgments different than those of management.In addition, if charge-offs in future periods exceed the allowance for possibleloan losses, the Company will need additional provisions to increase theallowance for possible loan losses. Any increases in the allowance for possibleloan losses will result in a decrease in net income and, possibly, capital, andmay have a material adverse effect on the Company’s financial condition andresults of operations.

 

*The Companyis subject to environmental liability risk associated with lending activities.*

 

A significant portion of the Company’s loan portfolio is secured byreal property. During the ordinary course of business, the Company mayforeclose on and take title to properties securing certain loans. In doing so,there is a risk that hazardous or toxic substances could be found on theseproperties. If hazardous or toxic substances are found, the Company may beliable for remediation costs, as well as for personal injury and propertydamage. Environmental laws may require the Company to incur substantial expensesand may materially reduce the affected property’s value or limit the Company’sability to use or sell the affected property. In addition, future laws or morestringent interpretations or enforcement policies with respect to existing lawsmay increase the Company’s exposure to environmental liability. Although the Companyhas policies and procedures to perform an environmental review beforeinitiating any foreclosure action on real property, these reviews may not besufficient to detect all potential environmental hazards. The remediation costsand any other financial liabilities associated with an environmental hazardcould have a material adverse effect on the Company’s financial condition andresults of operations.

 

*The Company’s profitability dependssignificantly on economic conditions in the Commonwealth of Pennsylvania andthe local region in which it conducts business.*

 

The Company’s success depends primarily on the general economicconditions of the Commonwealth of Pennsylvania and the specific local marketsin which the Company operates. Unlike larger national or other regional banksthat are more geographically diversified, the Company provides banking andfinancial services to customers primarily in Lackawanna and Luzerne Counties. Thelocal economic conditions in these areas have a significant impact on thedemand for the Company’s products and services as well as the ability of the Company’scustomers to repay loans, the value of the collateral securing loans and thestability of the Company’s deposit funding sources. A significant decline ingeneral economic conditions, caused by inflation, recession, acts of terrorism,outbreak of hostilities or other international or domestic occurrences,unemployment, changes in securities markets or other factors could impact theselocal economic conditions and, in turn, have a material adverse effect on the Company’sfinancial condition and results of operations.

 

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*There is no assurance that the Company will be ableto successfully compete with others for business.*

 

The Company competes for loans, deposits and investment dollars withnumerous regional and national banks and other community banking institutions,as well as other kinds of financial institutions and enterprises, such assecurities firms, insurance companies, savings associations, credit unions,mortgage brokers, and private lenders. Many competitors have substantiallygreater resources than the Company does, and operate under less stringent regulatoryenvironments. The differences in resources and regulations may make it moredifficult for the Company to compete profitably, reduce the rates that it canearn on loans and investments, increase the rates it must offer on deposits andother funds, and adversely affect its overall financial condition and earnings.

 

*The Company is subject to extensivegovernment regulation and supervision.*

 

The Company, primarily through the Bank**,**issubject to extensive federal and state regulation and supervision. Bankingregulations are primarily intended to protect depositors’ funds, federaldeposit insurance funds and the banking system as a whole, not shareholders.These regulations affect the Company’s lending practices, capital structure,investment practices, dividend policy and growth, among other things. Congressand federal regulatory agencies continually review banking laws, regulationsand policies for possible changes. Changes to statutes, regulations orregulatory policies, including changes in interpretation or implementation ofstatutes, regulations or policies, could affect the Company in substantial andunpredictable ways. Such changes could subject the Company to additional costs,limit the types of financial services and products the Company may offer and/orincrease the ability of non-banks to offer competing financial services andproducts, among other things. Failure to comply with laws, regulations orpolicies could result in sanctions by regulatory agencies, civil moneypenalties and/or reputation damage, which could have a material adverse effecton the Company’s business, financial condition and results of operations. Whilethe Company has policies and procedures designed to prevent any suchviolations, there can be no assurance that such violations will not occur.

 

*The Company’s controls andprocedures may fail or be circumvented.*

 

Management regularly reviews and updates the Company’s internalcontrols, disclosure controls and procedures, and corporate governance policiesand procedures. Any system of controls, however well designed and operated, isbased in part on certain assumptions and can provide only reasonable, notabsolute, assurances that the objectives of the system are met. Any failure orcircumvention of the Company’s controls and procedures or failure to complywith regulations related to controls and procedures could have a materialadverse effect on the Company’s business, results of operations and financialcondition.

 

*New lines of business or new products and servicesmay subject the Company to additional risks.*

 

From time to time, the Company may implement new lines of business oroffer new products and services within existing lines of business. There aresubstantial risks and uncertainties associated with these efforts, particularlyin instances where the markets are not fully developed. In developing andmarketing new lines of business and/or new products and services the Companymay invest significant time and resources. Initial timetables for theintroduction and development of new lines of business and/or new products orservices may not be achieved and price and profitability targets may not provefeasible. External factors, such as compliance with regulations, competitivealternatives, and shifting market preferences, may also impact the successfulimplementation of a new line of business or a new product or service.Furthermore, any new line of business and/or new product or service could havea significant impact on the effectiveness of the Company’s system of internal controls.Failure to successfully manage these risks in the development andimplementation of new lines of business or new products or services could havea material adverse effect on the Company’s business, results of operations andfinancial condition.

 

*The Company’s ability to pay dividends dependsprimarily on dividends from its banking subsidiary, which is subject toregulatory limits.*

 

The Company is a bank holding company and its operations are conductedby its subsidiaries. Its ability to pay dividends depends on its receipt ofdividends from its subsidiaries. Dividend payments from its banking subsidiaryare subject to legal and regulatory limitations, generally based on net profitsand retained earnings, imposed by the various banking regulatory agencies. Theability of its subsidiaries to pay dividends is also subject to itsprofitability, financial condition, capital expenditures and other cash flow requirements.There is no assurance that its subsidiaries will be able to pay dividends inthe future or that the Company will generate

 

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adequate cash flow to pay dividends in the future. The Company’sfailure to pay dividends on its common stock could have a material adverseeffect on the market price of its common stock.

 

*The Company’s future acquisitions could dilute yourownership and may cause it to become more susceptible to adverse economicevents.*

 

The Company may use its common stock to acquire other companies or makeinvestments in banks and other complementary businesses in the future. The Companymay issue additional shares of common stock to pay for future acquisitions,which would dilute your ownership interest in the Company. Future businessacquisitions could be material to the Company, and the degree of successachieved in acquiring and integrating these businesses into the Company couldhave a material effect on the value of the Company’s common stock. In addition,any acquisition could require it to use substantial cash or other liquid assetsor to incur debt. In those events, it could become more susceptible to economicdownturns and competitive pressures.

 

*The Company may not be able toattract and retain skilled people.*

 

The Company’s success depends, in large part, on its ability to attractand retain key people. Competition for the best people in most activitiesengaged in by the Company can be intense and the Company may not be able tohire people or to retain them. The unexpected loss of services of one or moreof the Company’s key personnel could have a material adverse impact on the Company’sbusiness because of their skills, knowledge of the Company’s market, years ofindustry experience and the difficulty of promptly finding qualifiedreplacement personnel. The Company has an employment agreement with itsPresident and Chief Executive Officer.

 

*The Company’s information systemsmay experience an interruption or breach in security.*

 

The Company relies heavily on communications and information systems toconduct its business. Any failure, interruption or breach in security of thesesystems could result in failures or disruptions in the Company’s customerrelationship management, general ledger, deposit, loan and other systems. Whilethe Company has policies and procedures designed to prevent or limit the effectof the failure, interruption or security breach of its information systems,there can be no assurance that any such failures, interruptions or securitybreaches will not occur or, if they do occur, that they will be adequately addressed.The occurrence of any failures, interruptions or security breaches of the Company’sinformation systems could damage the Company’s reputation, result in a loss ofcustomer business, subject the Company to additional regulatory scrutiny, orexpose the Company to civil litigation and possible financial liability, any ofwhich could have a material adverse effect on the Company’s financial conditionand results of operations.

 

*The Company continually encounterstechnological change.*

 

The financial services industry is continually undergoing rapidtechnological change with frequent introductions of new technology-drivenproducts and services. The effective use of technology increases efficiency andenables financial institutions to better serve customers and to reduce costs.The Company’s future success depends, in part, upon its ability to address theneeds of its customers by using technology to provide products and servicesthat will satisfy customer demands, as well as to create additional efficienciesin the Company’s operations. Many of the Company’s competitors havesubstantially greater resources to invest in technological improvements. The Companymay not be able to effectively implement new technology-driven products andservices or be successful in marketing these products and services to itscustomers. Failure to successfully keep pace with technological changeaffecting the financial services industry could have a material adverse impacton the Company’s business and, in turn, the Company’s financial condition andresults of operations.

 

*The Companyis subject to claims and litigation pertaining to fiduciary responsibility.*

 

From time to time, customers make claims and take legal actionpertaining to the Company’s performance of its fiduciary responsibilities.Whether customer claims and legal action related to the Company’s performanceof its fiduciary responsibilities are founded or unfounded, if such claims andlegal actions are not resolved in a manner favorable to the Company they mayresult in significant financial liability and/or adversely affect the marketperception of the Company and its products and services as well as impactcustomer demand for those products and services. Any financial liability orreputation damage could have a material adverse effect on the Company’sbusiness, which, in turn, could have a material adverse effect on the Company’sfinancial condition and results of operations.

 

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*Severe weather, natural disasters,acts of war or terrorism and other external events could significantly impactthe Company’s business.*

 

Severe weather, natural disasters, acts of war or terrorism and otheradverse external events could have a significant impact on the Company’sability to conduct business. Such events could affect the stability of the Company’sdeposit base, impair the ability of borrowers to repay outstanding loans,impair the value of collateral securing loans, cause significant propertydamage, result in loss of revenue and/or cause the Company to incur additionalexpenses. Severe weather or natural disasters, acts of war or terrorism orother adverse external events may occur in the future. Although management hasestablished disaster recovery policies and procedures, the occurrence of anysuch event could have a material adverse effect on the Company’s business,which, in turn, could have a material adverse effect on the Company’s financialcondition and results of operations.

 

**Risks Associated With The Company’sCommon Stock**

 

*The Company’s stock price can bevolatile*

 

Stock price volatility may make it more difficult for you to resellyour common stock when you want and at prices you find attractive. The Company’sstock price can fluctuate significantly in response to a variety of factorsincluding, among other things:

 

•            Actualor anticipated variations in quarterly results of operations.

•            Recommendationsby securities analysts.

•            Operatingand stock price performance of other companies that investors deem comparableto the Company.

•            Newsreports relating to trends, concerns and other issues in the financial servicesindustry.

•            Perceptionsin the marketplace regarding the Company and/or its competitors.

•            Newtechnology used, or services offered, by competitors.

•            Significantacquisitions or business combinations, strategic partnerships, joint venturesor capital commitments by or involving the Company or its competitors.

•            Failureto integrate acquisitions or realize anticipated benefits from acquisitions.

•            Changesin government regulations.

•            Geopoliticalconditions such as acts or threats of terrorism or military conflicts.

 

General market fluctuations, industry factors and general economic andpolitical conditions and events, such as economic slowdowns or recessions,interest rate changes or credit loss trends, could also cause the Company’sstock price to decrease regardless of operating results.

 

*The tradingvolume in the Company’s common stock is less than that of other largerfinancial services companies.*

 

The Company’s common stock is listed for trading on theover-the-counter bulletin board; the trading volume in its common stock is lessthan that of other larger financial services companies. A public trading markethaving the desired characteristics of depth, liquidity and orderliness dependson the presence in the marketplace of willing buyers and sellers of the Company’scommon stock at any given time. This presence depends on the individualdecisions of investors and general economic and market conditions over whichthe Company has no control. Given the lower trading volume of the Company’scommon stock, significant sales of the Company’s common stock, or theexpectation of these sales, could cause the Company’s stock price to fall.

 

*An investment in the Company’scommon stock is not an insured deposit.*

 

The Company’s common stock is not a bank deposit and, therefore, is notinsured against loss by the Federal Deposit Insurance Corporation (FDIC), anyother deposit insurance fund or by any other public or private entity.Investment in the Company’s common stock is inherently risky for the reasonsdescribed in this “Risk Factors” section and elsewhere in this report and issubject to the same market forces that affect the price of common stock in anycompany. As a result, if you acquire the Company’s common stock, you may losesome or all of your investment.

 

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*The Company’s articles ofincorporation and by-laws, as well as certain banking laws may have ananti-takeover effect.*

 

Provisions of the Company’s articles of incorporation and by-laws,federal banking laws, including regulatory approval requirements, could make itmore difficult for a third party to acquire the Company, even if doing so wouldbe perceived to be beneficial to the Company’s shareholders. The combination ofthese provisions effectively inhibits a non-negotiated merger or other businesscombination, which, in turn, could adversely affect the market price of the Company’scommon stock.

 

**Risks Associated With The Company’sIndustry**

 

*Future governmental regulation and legislationcould limit the Company’s future growth.*

 

The Company is a registered bank holding company, and its subsidiarybank is a depository institution whose deposits are insured by the FederalDeposit Insurance Corporation (FDIC). As a result, the Company is subject tovarious regulations and examinations by various regulatory authorities. Ingeneral, statutes establish the corporate governance and eligible businessactivities for the Company, certain acquisition and merger restrictions,limitations on inter-company transactions such as loans and dividends, andcapital adequacy requirements, requirements for anti-money laundering programsand other compliance matters, among other regulations. The Company isextensively regulated under federal and state banking laws and regulations thatare intended primarily for the protection of depositors, federal depositinsurance funds and the banking system as a whole. Compliance with these statutesand regulations is important to its ability to engage in new activities and toconsummate additional acquisitions.

 

 In addition, the Company issubject to changes in federal and state tax laws as well as changes in bankingand credit regulations, accounting principles and governmental economic andmonetary policies. The Company cannot predict whether any of these changes mayadversely and materially affect it. Federal and state banking regulators alsopossess broad powers to take supervisory actions as they deem appropriate.These supervisory actions may result in higher capital requirements, higherinsurance premiums and limitations on the Company’s activities that could havea material adverse effect on its business and profitability. While these statutesare generally designed to minimize potential loss to depositors and the FDICinsurance funds, they do not eliminate risk, and compliance with such statutesincreases the Company’s expense, requires management’s attention and can be adisadvantage from a competitive standpoint with respect to non-regulatedcompetitors.

 

*The earnings of financial servicescompanies are significantly affected by general business and economicconditions.*

 

The Company’s operations and profitability are impacted by general businessand economic conditions in the United States and abroad. These conditionsinclude short-term and long-term interest rates, inflation, money supply,political issues, legislative and regulatory changes, fluctuations in both debtand equity capital markets, broad trends in industry and finance, and thestrength of the U.S. economy and the local economies in which the Companyoperates, all of which are beyond the Company’s control. Deterioration ineconomic conditions could result in an increase in loan delinquencies andnon-performing assets, decreases in loan collateral values and a decrease indemand for the Company’s products and services, among other things, any ofwhich could have a material adverse impact on the Company’s financial conditionand results of operations.

 

*Financial services companies dependon the accuracy and completeness of information about customers andcounterparties.*

 

In deciding whether to extend credit or enter into other transactions,the Company may rely on information furnished by or on behalf of customers andcounterparties, including financial statements, credit reports and otherfinancial information. The Company may also rely on representations of thosecustomers, counterparties or other third parties, such as independent auditors,as to the accuracy and completeness of that information. Reliance on inaccurateor misleading financial statements, credit reports or other financialinformation could have a material adverse impact on the Company’s business and,in turn, the Company’s financial condition and results of operations.

 

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*Consumers may decide not to usebanks to complete their financial transactions.*

 

Technology and other changes are allowing parties to complete financialtransactions that historically have involved banks through alternative methods.For example, consumers can now maintain funds that would have historically beenheld as bank deposits in brokerage accounts or mutual funds. Consumers can alsocomplete transactions such as paying bills and/or transferring funds directlywithout the assistance of banks. The process of eliminating banks asintermediaries, known as “disintermediation,” could result in the loss of feeincome, as well as the loss of customer deposits and the related incomegenerated from those deposits. The loss of these revenue streams and the lowercost deposits as a source of funds could have a material adverse effect on the Company’sfinancial condition and results of operations.

 

***ITEM 1B:***  ***UNRESOLVED STAFF COMMENTS***

 

**None**

 

***ITEM2:***  ***PROPERTIES***

 

As of December 31, 2005, the Bank operated 12 full-service bankingoffices, of which three were owned and nine were leased. None of the lessors ofthe properties leased by the Bank are affiliated with the Company or the Bankand all of these properties are located in the state of Pennsylvania. TheCompany is headquartered at its owner occupied main branch located on thecorner of Blakely and Drinker Streets in Dunmore, PA. The main office is afull-service banking center and has a walk-up teller window, drive-thru teller windowsand two 24-hour automated teller machines (ATMs). Executive and administrative,commercial and consumer lending, trust, asset management services, operationaldepartments and customer service areas are also located at this facility. Themain office complex is owned by the Company and free of any encumbrances.

 

The Green Ridge Branch, the first Scranton facility, operates fromleased space in the Green Ridge Shopping Center in Scranton, PA. This branch isa full-service office with a 24-hour ATM.

 

A second Scranton Branch is in a leased facility located at 139 WyomingAvenue, Scranton, PA. This office has an outside walk-up teller window andprovides full-service banking to the downtown Scranton area.

 

The Abington Branch is located on the Morgan Highway in Clarks Summit,PA. The building from which the branch operates is leased. This office providesfull-service financial products, including a 24-hour ATM and drive-thru teller windows.This office provides convenience to our customers located throughout thegreater Abington area. In addition, there is a banking facility located in theClarks Summit State Hospital. The office is leased from the hospital under alease-for-service-provided agreement with service limited to employees andpatients of the hospital.

 

The Keystone Industrial Park Branch (KIP) is located in Dunmore, PA. Thisoffice provides full-service banking with drive-thru teller windows and a 24-hourATM. KIP is owned by the Company and is free of encumbrances.

 

The Pittston Branch is located in Bruno’s Supermarket, 403 KennedyBoulevard, Pittston, PA. The space in the supermarket is leased. This officeprovides full-service banking including a 24-hour ATM. This location providesconvenient service at extended hours to the Bank’s clientele in Luzerne County,Pennsylvania.

 

The Financial Center Branch is located at 338 North Washington Avenuein Scranton, PA. This office provides full-service banking, including a 24-hourATM. Executive, mortgage lending, finance and operational offices are locatedin this building. A portion of the third floor is leased to a non-relatedentity. The Company owns the property free of encumbrance. The Company alsoowns, free of encumbrance, an adjacent attached building which was leased to anon-related entity for most of 2005.

 

The Moosic Branch is located at 4010 Birney Avenue, Moosic, PA. Thebranch operates from leased space and provides full-service banking, includinga 24-hour ATM and drive-thru teller windows. The branch’s location provides thenecessary link between the Lackawanna and Luzerne County branch offices.

 

The West Pittston Branch is located in the Insalaco Shopping Center at801 Wyoming Avenue, West Pittston, PA. The branch operates from leased space. Thisoffice provides full-service banking, including a 24-hour ATM, to the LuzerneCounty area.

 

10

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The Peckville Branch is located at 1598 Main Street, Peckville, PA. Thebranch operates from leased space and provides full-service banking, includinga 24-hour ATM and drive-thru teller windows.

 

The Bank’s branch coverage in Luzerne County includes leased spaceknown as the Kingston Branch, located at 247 Wyoming Avenue, Kingston, PA. Thisoffice provides full-service financial products, including a 24-hour ATM anddrive-thru teller windows.

 

The Eynon Branch is located on Route 6 Business, Eynon, PA. The branchoperates from leased space. This office provides full-service financial products,including a 24-hour ATM and drive-thru teller windows.

 

In addition to the properties above, the Bank maintains severalfree-standing 24-hour ATMs located at the following locations in Pennsylvania:

 

•                  300 MeadowAvenue, Scranton

•                  511 Main Street,Childs

•                  1650 West MainStreet, Stroudsburg

•                  320 SouthBlakely Street, Dunmore

•                  MarywoodCollege, 2300 Adams Avenue, Nazareth Hall, Scranton

•                  Montage SkiLodge, Moosic

•                  LackawannaCounty Stadium, Moosic

•                  Convenient FoodMart, Highland Avenue, Clarks Summit

•                  Ice Box SportsComplex, Olive Street, Scranton

 

The Bank also owns a commercial facility located at 116 – 118 N.Blakely Street, Dunmore, PA which is leased to a non-related entity.

 

Other real estate owned includes all foreclosed properties listed forsale. Foreclosed properties are recorded on the Company’s balance sheet, uponpossession, at the lower of cost or fair value.

 

***ITEM3:    LEGAL PROCEEDINGS***

 

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business. However, in the opinion of the Company afterconsulting with legal counsel, no legal proceedings are pending, which, ifdetermined adversely to the Company or the Bank, would have a material effect onthe Company’s undivided profits or financial condition. No legal proceedingsare pending other than ordinary routine litigation incidental to the businessof the Company and the Bank. In addition, to Management’s knowledge, nogovernmental authorities have initiated or contemplated any material legalactions against the Company or the Bank.

 

##### **ITEM 4:  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

##### ** **

No matter was submitted during the quarter ended December 31, 2005 to avote of our security holders through solicitation of proxies or otherwise.

 

11

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###### ***PART II***

 

***ITEM5:***  ***MARKET FOR THE COMPANY’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES***

 

The common stock of the Company is traded on the over-the-counterbulletin board under the symbol “FDBC.” Shareholders requesting informationabout the Company’s common stock may contact Salvatore R. DeFrancesco, Jr., Treasurer.Requests may be mailed to:

 

Fidelity D & D Bancorp, Inc.

Blakely and Drinker St.

Dunmore, PA 18512

(570) 342-8281

 

The following table lists the quarterly cash dividends paid per share andthe range of sales prices for the Company’s common stock. Such over-the-counterprices do not include retail mark-ups, markdowns or commissions:

 
| ** **  | ** ** | **2005**   | ** ** | ** **    | ** ** | **2004**   | ** ** | ** **    | ** ** |
|-------------|------------|------------|------------|---------------|------------|------------|------------|---------------|------------|
| ** **  | ** ** | **Prices** | ** ** | **Dividends** | ** ** | **Prices** | ** ** | **Dividends** | ** ** |
| ** **  | ** ** | **High**   | ** ** | **Low**       | ** ** | **Paid**   | ** ** | **High**      | ** ** | **Low** | ** ** | **Paid** | ** ** |
| 1st Quarter |       | $          | 32.95      |          | $          | 30.82      |       | $             | 0.20       |   | $ | 33.64 |   | $ | 32.05 |   | $ | 0.20 |   |
| 2nd Quarter |       | $          | 33.14      |          | $          | 31.82      |       | $             | 0.20       |   | $ | 32.91 |   | $ | 30.55 |   | $ | 0.20 |   |
| 3rd Quarter |       | $          | 33.64      |          | $          | 31.82      |       | $             | 0.20       |   | $ | 32.27 |   | $ | 30.50 |   | $ | 0.20 |   |
| 4th Quarter |       | $          | 37.73      |          | $          | 31.82      |       | $             | 0.20       |   | $ | 32.73 |   | $ | 30.23 |   | $ | 0.20 |   |

 

Dividends are determined and declared by the Board of Directors of theCompany. On January 17, 2006, the Board of Directors declared a 10% stockdividend. The new shares were distributed on February 15, 2006 toshareholders of record at the close of business on January 30, 2006. Theinformation presented in the above table has been adjusted to reflect the stockdividend. For a further discussion of the stock dividend, see Note 20 “SubsequentEvent”, contained within the notes to the consolidated financial statements. TheCompany expects to continue to pay dividends in the future. However, futuredividends are dependent upon earnings, financial condition, capital needs ofthe Company and other factors. For a further discussion of regulatory capitalrequirements see Note 14 “Regulatory Matters”, contained within the notes to theconsolidated financial statements.

 

The Company has established a dividend reinvestment plan for itsshareholders. The plan is designed to make the Company’s stock more availableto our shareholders and to raise additional capital for future needs.

 

The Company had approximately 1,381 shareholders at March 10, 2006 andapproximately 1,390 at December 31, 2005. The number of shareholders is theactual number of individual shareholders of record. Each security depository isconsidered a single shareholder for purposes of determining the approximatenumber of shareholders.

 

***Securities authorized forissuance under equity compensation plans***

 

The information required under this section isincorporated by reference herein, to the information presented in the Company’sdefinitive Proxy Statement for its 2006 Annual Meeting of Shareholders to befiled with the SEC.

 

12

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** **

**ITEM 6:**  ***SELECTED FINANCIAL DATA***

 

Set forth below are our selected consolidated financial and other data.This financial data is derived in part from, and should be read in conjunctionwith, our consolidated financial statements and related footnotes:

 
| ** **                                           | ** ** | **2005**    | ** **  | **2004**    | ** ** | **2003**    | ** ** | **2002**    | ** **  | **2001**    | ** ** |
|------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| **Balance  Sheet Data:**                             |       |        |        |        |       |        |       |        |        |        |       |
| Total assets                                         |       | $           | 544,060,698 |        | $          | 536,675,138 |       | $           | 575,215,466 |        | $          | 577,993,316 |   | $ | 569,029,838 |   |
| Total investment  securities                         |       | 96,678,573  |        | 115,668,818 |       | 139,654,074 |       | 145,945,207 |        | 150,473,988 |       |
| Net loans                                            |       | 403,144,095 |        | 381,546,375 |       | 366,981,640 |       | 354,262,050 |        | 353,976,324 |       |
| Loans available–for-sale                        |       | 428,584     |        | 576,378     |       | 19,863,577  |       | 28,715,355  |        | 16,150,020  |       |
| Total deposits                                       |       | 379,498,640 |        | 365,615,335 |       | 401,442,546 |       | 413,788,176 |        | 407,778,728 |       |
| Total borrowings                                     |       | 112,477,185 |        | 121,653,234 |       | 126,633,012 |       | 114,213,014 |        | 117,480,988 |       |
| Total  shareholders’ equity                     |       | 48,846,029  |        | 46,366,760  |       | 43,931,899  |       | 45,234,433  |        | 40,172,230  |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Operating  Data for the year ended:**              |       |        |        |        |       |        |       |        |        |        |       |
| Total interest  income                               |       | $           | 29,020,261  |        | $          | 27,395,491  |       | $           | 28,462,093  |        | $          | 34,567,393 |   | $ | 36,379,689 |   |
| Total interest  expense                              |       | 11,720,986  |        | 11,180,135  |       | 14,237,129  |       | 17,882,440  |        | 20,853,631  |       |
| Net interest  income                                 |       | 17,299,275  |        | 16,215,356  |       | 14,224,964  |       | 16,684,953  |        | 15,526,058  |       |
| Provision for  loan losses                           |       | 830,000     |        | 2,150,000   |       | 3,715,000   |       | 1,664,000   |        | 2,474,637   |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| Net interest  income after provision for loan losses |       | 16,469,275  |        | 14,065,356  |       | 10,509,964  |       | 15,020,953  |        | 13,051,421  |       |
| Other income                                         |       | 4,165,281   |        | 4,161,402   |       | 4,183,137   |       | 3,302,749   |        | 3,701,578   |       |
| Other operating  expense                             |       | 14,576,747  |        | 13,826,690  |       | 12,903,361  |       | 12,751,174  |        | 11,998,997  |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| Income before  provision for income taxes            |       | 6,057,809   |        | 4,400,068   |       | 1,789,740   |       | 5,572,528   |        | 4,754,002   |       |
| Provision for  income taxes                          |       | 1,466,112   |        | 1,035,594   |       | 146,492     |       | 1,526,355   |        | 905,866     |       |
| Net Income                                           |       | $           | 4,591,697   |        | $          | 3,364,474   |       | $           | 1,643,248   |        | $          | 4,046,173 |   | $ | 3,848,136 |   |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Per  Share Data: ***                               |       |        |        |        |       |        |       |        |        |        |       |
| Net income per  share – basic                   |       | $           | 2.26        |        | $          | 1.67        |       | $           | 0.82        |        | $          | 2.03 |   | $ | 1.93 |   |
| Net income per  share – diluted                 |       | $           | 2.25        |        | $          | 1.67        |       | $           | 0.82        |        | $          | 2.02 |   | $ | 1.93 |   |
| Dividends  declared                                  |       | $           | 1,624,263   |        | $          | 1,610,423   |       | $           | 1,601,898   |        | $          | 1,526,371 |   | $ | 1,426,097 |   |
| Dividends per  share                                 |       | $           | 0.80        |        | $          | 0.80        |       | $           | 0.80        |        | $          | 0.76 |   | $ | 0.72 |   |
| Book value per  share                                |       | $           | 23.95       |        | $          | 22.92       |       | $           | 21.91       |        | $          | 22.60 |   | $ | 20.07 |   |
| Weighted average  number of shares outstanding       |       | 2,031,211   |        | 2,013,798   |       | 2,002,443   |       | 1,999,173   |        | 1,992,530   |       |
| Number of shares  outstanding at year-end            |       | 2,039,639   |        | 2,023,529   |       | 2,005,347   |       | 2,001,314   |        | 2,001,085   |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Ratios:**                                          |       |        |        |        |       |        |       |        |        |        |       |
| Return on  average assets                            |       | 0.86        | %           | 0.61        | %          | 0.29        | %          | 0.70        | %           | 0.72        | %          |
| Return on  average equity                            |       | 9.64        | %           | 7.51        | %          | 3.63        | %          | 9.47        | %           | 9.64        | %          |
| Net interest  margin                                 |       | 3.51        | %           | 3.20        | %          | 2.74        | %          | 3.10        | %           | 3.17        | %          |
| Efficiency ratio                                     |       | 65.99       | %           | 64.45       | %          | 72.32       | %          | 63.42       | %           | 62.42       | %          |
| Expense ratio                                        |       | 1.93        | %           | 1.69        | %          | 1.68        | %          | 1.68        | %           | 1.68        | %          |
| Allowance for  loan losses to total loans            |       | 1.46        | %           | 1.54        | %          | 1.28        | %          | 1.01        | %           | 1.00        | %          |
| Dividend payout  ratio                               |       | 35.37       | %           | 47.87       | %          | 97.48       | %          | 37.72       | %           | 37.06       | %          |
| Equity to assets                                     |       | 8.98        | %           | 8.64        | %          | 7.64        | %          | 7.83        | %           | 7.06        | %          |
| Equity to  deposits                                  |       | 12.87       | %           | 12.68       | %          | 10.94       | %          | 10.93       | %           | 9.85        | %          |

 

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*The number of shares and per-share data has been adjusted, for all periods, toreflect the retroactive effect of a 10% stock dividend paid on February 15,2006.

 

***ITEM 7: MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND******RESULTS OF OPERATIONS***

 

***Forward Looking Statements***

 

This Annual Report on Form 10-K contains a number of forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, or the Securities Act, and Section 21E of the Securities Exchange Actof 1934, as amended, or the

 

13

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Exchange Act. These statements may be identified by the use of thewords “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,”“plan,” “potential,” “predict,” “project,” “should,” “will,” “would” andsimilar terms and phrases, including references to assumptions. Forward lookingstatements include risks and uncertainties.

 

Forward-looking statements are based on various assumptions andanalyses made by us in light of Management’s experience and its perception ofhistorical trends, current conditions and expected future developments, as wellas other factors it believes are appropriate under the circumstances. Thesestatements are not guarantees of future performance and are subject to risks,uncertainties and other factors (many of which are beyond our control) thatcould cause actual results to differ materially from future results expressedor implied by such forward-looking statements. These factors include, withoutlimitation, the following:

 

•                  the timing andoccurrence or non-occurrence of events may be subject to circumstances beyondour control;

 

•                  there may beincreases in competitive pressure among financial institutions or fromnon-financial institutions;

 

•                  changes in theinterest rate environment may reduce interest margins;

 

•                  changes indeposit flows, loan demand or real estate values may adversely affect ourbusiness;

 

•                  changes inaccounting principles, policies or guidelines may cause our financial conditionto be perceived differently;

 

•                  general economicconditions, either nationally or locally in some or all areas in which we dobusiness, or conditions in the securities markets or the banking industry maybe less favorable than we currently anticipate;

 

•                  legislative orregulatory changes may adversely affect our business;

 

•                  technologicalchanges may be more rapid, difficult or expensive than we anticipate;

 

•                  success orconsummation of new business initiatives may be more difficult or expensivethan we anticipate;

 

•                  acts of war orterrorism; or

 

•                  naturaldisaster.

 

Management cautions readers not to place undue reliance onforward-looking statements, which reflect analyses only as of the date of thisreport. We have no obligation to update any forward-looking statements toreflect events or circumstances after the date of this document.

 

Readers should review the risk factors described in Item 1A, above, andin other documents that we file, from time to time with the SEC, includingQuarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

 

# ***CriticalAccounting Policies***

# *** ***

The presentation of financial statements in conformity with GAAPrequires Management to make estimates and assumptions that affect many of thereported amounts and disclosures. Actual results could differ from theseestimates.

 

A material estimate that is particularly susceptible to significantchange relates to the determination of the allowance for loan losses. Managementbelieves that the allowance for loan losses at December 31, 2005 is adequateand reasonable. Given the subjective nature of identifying and valuing loanlosses, it is likely that well-informed individuals could make differentassumptions, and could, therefore calculate a materially different allowancevalue. While Management uses available information to recognize losses onloans, changes in economic conditions may necessitate revisions in the future. Inaddition, various regulatory agencies, as an integral part of their examinationprocess, periodically review the Company’s allowance for loan losses. Suchagencies may require the Company to recognize adjustments to the allowancebased on their judgment of information available to them at the time of theirexamination.

 

Another material estimate is the calculation of fair values of theCompany’s investment securities. The Company receives estimated fair values ofinvestment securities from an independent valuation service. In developingthese fair values, the valuation service uses

 

14

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estimates of cash flows, based on historical performance of similarinstruments in similar interest rate environments. Based on experience, Managementis aware that estimated fair values of investment securities tend to vary amongvaluation services. Accordingly, when selling investment securities, Managementmay obtain price quotes from more than one source. As described in Notes 1 and3 of the consolidated financial statements, the large majority of the Company’sinvestment securities are classified as available-for-sale (AFS). AFS securitiesare carried at fair value on the consolidated balance sheet, with unrealizedgains and losses, net of income tax, reported separately within shareholders’equity through accumulated other comprehensive income (loss).

 

The fair value of residential mortgage loans, classified as AFS, isobtained from the Federal National Mortgage Association (FNMA). The fair valueof Small Business Administration (SBA) loans, classified as AFS, is obtainedfrom an outside pricing source. To determine the fair value of student loans,classified as AFS, the Bank uses the pricing obtained from the most recentstudent loans sold from its AFS portfolio. The market to which the Bank sellsmortgage and other loans is restricted and price quotes from other sources arenot typically obtained. Further discussion on the accounting treatment of AFS loansis in the section entitled “Loans-available-for sale”, contained withinManagement’s Discussion and Analysis.

 

All significant accounting policies are contained in Note 1 “Nature ofOperations and Summary of Significant Accounting Policies”, within the notes toconsolidated financial statements, and incorporated by reference in Part II,Item 8.

 

The following discussion and analysis presents the significant changesin the financial condition and in the results of operations of the Company asof December 31, 2005 and December 31, 2004 and for each of the years then ended.This discussion should be read in conjunction with the consolidated financialstatements and notes included in Part II, Item 8 of this report. The shares ofcommon stock and per-share amounts presented within this discussion andanalysis have been adjusted, for all periods presented, to reflect the effectof a 10% stock dividend paid on February 15, 2006. For a further discussion onthe stock dividend see Part II, Item 5: Market for the Company’s Common Equity,Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

***Comparisonof Financial Condition as of December 31, 2005***

***and2004 and Results of Operations for each of the Years then Ended***

 

***Financial Condition***

 

**Overview**

 

Consolidated assets increased $7,386,000 or 1.4%, during the year endedDecember 31, 2005 to $544,061,000. The increase resulted from increases intotal deposits of $13,883,000 and total stockholders’ equity of $2,479,000. Theseitems were partially offset by a net decrease in total borrowings of $9,176,000.Since December 31, 2004, the carrying value of total loans increased $21,450,000and cash and cash equivalents increased $2,378,000. The carrying value of theBank’s investment portfolio declined $17,990,000 since December 31, 2004. Theincrease in shareholders’ equity was attributable to earnings net of dividendsdeclared of $2,967,000, an increase in common stock of $523,000, partiallyoffset by a $1,011,000 net unrealized holding loss on AFS securities recordedin other comprehensive income (loss).

 

15

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The following table is a comparison of condensed balance sheet accountsand percentage to total assets at December 31, 2005, 2004 and 2003 (thousand ofdollars):

 
| ** **                                             | ** ** | **2005**    | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|--------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
|                                                   |       | **Amount**  | ** ** | **Percent** | ** ** | **Amount**  | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** |   |
| ** **                                             |       | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| **Assets:**                                            |       | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Cash and due  from banks                               |       | $           | 12,525     |        | 2.30       | %           | $          | 9,013 |   | 1.68 | % | $ | 13,148 |   | 2.29 | % |
| Interest bearing  deposits with financial institutions |       | 69          |       | 0.01        |       | 1,203       |       | 0.22 |   | 6,083 |   | 1.06 |   |
| Investment  securities                                 |       | 97,679      |       | 17.95       |       | 115,669     |       | 21.56 |   | 139,654 |   | 24.27 |   |
| Federal Home  Loan Bank Stock                          |       | 4,628  |       | 0.85        |       | 4,569  |       | 0.85 |   | 4,753  |   | 0.83 |   |
| Net loans                                              |       | 403,144     |       | 74.10       |       | 381,546     |       | 71.09 |   | 366,982 |   | 63.80 |   |
| Loans  available-for-sale                              |       | 429         |       | 0.08        |       | 576         |       | 0.11 |   | 19,864  |   | 3.45 |   |
| Accrued interest  receivable                           |       | 1,960       |       | 0.36        |       | 1,723       |       | 0.32 |   | 1,807 |   | 0.31 |   |
| Bank premises  and equipment                           |       | 11,683      |       | 2.15        |       | 11,163      |       | 2.08 |   | 12,092 |   | 2.10 |   |
| Foreclosed  assets held for sale                       |       | 19          |       | 0.00        |       | 213         |       | 0.04 |   | 467 |   | 0.08 |   |
| Life insurance  cash surrender value                   |       | 7,892       |       | 1.45        |       | 7,614       |       | 1.42 |   | 7,293 |   | 1.27 |   |
| Other assets                                           |       | 4,033       |       | 0.74        |       | 3,386       |       | 0.63 |   | 3,072 |   | 0.54 |   |
| **Total  assets**                                      |       | $           | 544,061    |        | 100.00     | %           | $          | 536,675 |   | 100.00 | % | $ | 575,215 |   | 100.00 | % |
| ** **                                             |       |        |       |        |       |        |       |   |   |   |   |   |   |
| **Liabilities:**                                       |       |        |       |        |       |        |       |   |   |   |   |   |   |
| Deposits,  non-interest bearing                        |       | $           | 70,361     |        | 12.93      | %           | $          | 65,358 |   | 12.18 | % | $ | 64,399 |   | 11.20 | % |
| Certificates of  deposit of $100,000 or more           |       | 76,258      |       | 14.02       |       | 93,986      |       | 17.51 |   | 112,857 |   | 19.62 |   |
| Other  interest-bearing deposits                       |       | 232,880     |       | 42.80       |       | 206,272     |       | 38.44 |   | 224,186 |   | 38.96 |   |
| Short-term  borrowings                                 |       | 28,773      |       | 5.29        |       | 50,534      |       | 9.42 |   | 54,757 |   | 9.52 |   |
| Other borrowed  funds                                  |       | 83,704      |       | 15.39       |       | 71,119      |       | 13.25 |   | 71,876 |   | 12.50 |   |
| Accrued interest  payable and other liabilities        |       | 3,239       |       | 0.59        |       | 3,039       |       | 0.56 |   | 3,208 |   | 0.56 |   |
| **Total  liabilities**                                 |       | 495,215     |       | 91.02       |       | 490,308     |       | 91.36 |   | 531,283 |   | 92.36 |   |
| **Shareholders’  equity**                         |       | 48,846      |       | 8.98        |       | 46,367      |       | 8.64 |   | 43,932 |   | 7.64 |   |
| **Total  liabilities and shareholders’ equity**   |       | $           | 544,061    |        | 100.00     | %           | $          | 536,675 |   | 100.00 | % | $ | 575,215 |   | 100.00 | % |

 

A comparison of net changes in selected balance sheet categories as ofDecember 31, are as follows:

 
| ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | **Earning**  | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | **Short-term** | ** ** | ** ** | ** ** | **Other**      | ** ** | ** ** | ** ** |
|------------|------------|-------------|------------|------------|------------|--------------|------------|------------|------------|--------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|------------|------------|
| ** ** | ** ** | **Assets**  | ** ** | **%**      | ** ** | **Assets *** | ** ** | **%**      | ** ** | **Deposits** | ** ** | **%**      | ** ** | **Borrowings** | ** ** | **%**      | ** ** | **Borrowings** | ** ** | **%**      | ** ** |
| 2005       |       | $           | 7,385,560  |       | 1          | %            | $          | 2,784,580  |       | 0.6          | %          | $          | 13,883,305 |           | 3.8        | %          | $          | (21,761,049    | )          | (43.1      | )%         | $ | 12,585,000 |   | 17.7 | % |
| 2004       |       | (38,540,328 | )          | (7         | )          | (35,884,098  | )          | (7         | )          | (35,827,211  | )          | (9         | )          | (4,222,932     | )          | (8         | )          | (756,846       | )          | (1         | )          |
| 2003       |       | (2,777,850  | )          | (1         | )          | (3,007,038   | )          | (1         | )          | (12,345,630  | )          | (3         | )          | 3,543,964      |       | 7          |       | 8,876,034      |       | 14         |       |
| 2002       |       | 8,963,478   |       | 2          |       | 7,325,219    |       | 1          |       | 6,009,448    |       | 1          |       | (3,267,974     | )          | (6         | )          | —         |       | -          |       |
| 2001       |       | 77,952,784  |       | 16         |       | 60,585,502   |       | 13         |       | 68,468,400   |       | 20         |       | 6,456,267      |       | 13         |       | —         |       | -          |       |
|            |            |             |            |            |            |              |            |            |            |              |            |            |            |                |            |            |            |                |            |            |            |  |  |  |  |  |

 

----

* - Earning assets exclude loans placed onnon-accrual status.

 

***Deposits***

 

The Bank is a community-based commercial financial institution thatoffers a variety of deposit accounts with a range of interest rates and terms. Depositproducts include passbook and statement savings accounts, NOW, money market,demand deposits and certificates of deposit accounts. The flow of deposits is significantlyinfluenced by general economic conditions, changes in prevailing interestrates, pricing and competition. Most of the Bank’s deposits are obtained fromthe communities surrounding its 12 branch offices. We attempt to attract andretain deposit customers via sales and marketing efforts with new products,quality service, competitive rates and maintaining long-standing customerrelationships. To determine deposit product interest rates, the Bank considers localcompetition, market yields and the rates charged for alternative sources offunding such as borrowings. Although we have experienced intense competitionfor deposits, we have not increased rates significantly above market rates, aswe only consider cost effective strategies based upon the current interest rateenvironment.

 

 

16

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The following table represents the components of total deposits as ofDecember 31, 2005 and 2004 and comparative changes:

 
| ** **                               | ** ** | ** **            | ** **  | ** **            | ** ** | **Dollar**  | ** ** | **Percent** | ** **  |
|------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|-------------|------------|-------------|-------------|
| ** **                               | ** ** | **December 31, 2005** | ** **  | **December 31, 2004** | ** ** | **change**  | ** ** | **change**  | ** **  |
| **Non-interest-bearing deposits**        |       |                  |        |                  |       |        |       |        |        |
| Personal                                 |       | $                     | 31,303,329  |                  | $          | 28,927,588  |       | $           | 2,375,741   |   | 8.21 | % |
| Non-personal                             |       | 29,552,412            |        | 29,248,882            |       | 303,530     |       | 1.04        | %           |
| Public fund                              |       | 3,355,982             |        | 2,479,373             |       | 876,609     |       | 35.36       | %           |
| Bank checks                              |       | 6,149,363             |        | 4,701,692             |       | 1,447,671   |       | 30.79       | %           |
| Total                                    |       | $                     | 70,361,086  |                  | $          | 65,357,535  |       | $           | 5,003,551   |   | 7.66 | % |
| **Time deposits of $100,000 or greater** |       |                  |        |                  |       |        |       |        |        |
| Personal                                 |       | $                     | 35,241,384  |                  | $          | 61,694,837  |       | $           | (26,453,453 | ) | -42.88 | % |
| Non-personal                             |       | 19,671,535            |        | 17,749,896            |       | 1,921,639   |       | 10.83       | %           |
| Public fund                              |       | 16,616,868            |        | 9,023,956             |       | 7,592,912   |       | 84.14       | %           |
| IRA’s                               |       | 4,727,766             |        | 5,517,344             |       | (789,578    | )          | -14.31      | %           |
| Total                                    |       | $                     | 76,257,553  |                  | $          | 93,986,033  |       | $           | (17,728,480 | ) | -18.86 | % |
| **Other interest-bearing deposits**      |       |                  |        |                  |       |        |       |        |        |
| Time deposits  less than $100,000:       |       |                  |        |                  |       |        |       |        |        |
| Personal                                 |       | $                     | 63,812,258  |                  | $          | 66,918,765  |       | $           | (3,106,507  | ) | -4.64 | % |
| Non-personal                             |       | 3,788,687             |        | 4,024,801             |       | (236,114    | )          | -5.87       | %           |
| Public fund                              |       | 233,347               |        | 662,876               |       | (429,529    | )          | -64.80      | %           |
| IRA’s                               |       | 16,979,755            |        | 19,090,551            |       | (2,110,796  | )          | -11.06      | %           |
| sub total                                |       | 84,814,047            |        | 90,696,993            |       | (5,882,946  | )          | -6.49       | %           |
| NOW accounts                             |       | 50,048,331            |        | 41,421,525            |       | 8,626,806   |       | 20.83       | %           |
| Money market  deposits                   |       | 51,583,473            |        | 27,606,102            |       | 23,977,371  |       | 86.86       | %           |
| Savings and  clubs                       |       | 46,434,150            |        | 46,547,147            |       | (112,997    | )          | -0.24       | %           |
| Total                                    |       | $                     | 232,880,001 |                  | $          | 206,271,767 |       | $           | 26,608,234  |   | 12.90 | % |
| **Total deposits**                       |       |                  |        |                  |       |        |       |        |        |
| Noninterest-bearing  deposits            |       | $                     | 70,361,086  |                  | $          | 65,357,535  |       | $           | 5,003,551   |   | 7.66 | % |
| Interest-bearing  deposits               |       | 309,137,554           |        | 300,257,800           |       | 8,879,754   |       | 2.96        | %           |
| Total                                    |       | $                     | 379,498,640 |                  | $          | 365,615,335 |       | $           | 13,883,305  |   | 3.80 | % |
| **Public funds**                         |       |                  |        |                  |       |        |       |        |        |
| Noninterest-bearing                      |       | $                     | 3,355,982   |                  | $          | 2,479,373   |       | $           | 876,609     |   | 35.36 | % |
| Certificates of  deposit                 |       | 16,850,215            |        | 9,686,832             |       | 7,163,383   |       | 73.95       | %           |
| NOW accounts                             |       | 22,723,371            |        | 8,406,827             |       | 14,316,544  |       | 170.30      | %           |
| Money market  deposits                   |       | 598,657               |        | 4,710,720             |       | (4,112,063  | )          | -87.29      | %           |
| Savings and  clubs                       |       | 845,272               |        | 1,266,834             |       | (421,562    | )          | -33.28      | %           |
| Total                                    |       | $                     | 44,373,497  |                  | $          | 26,550,586  |       | $           | 17,822,911  |   | 67.13 | % |
|                                     |       |                  |        |                  |       |        |       |        |        |
| Total assets                             |       | $                     | 544,060,698 |                  | $          | 536,675,138 |       |        |        |   |   |
| Total deposits  to total assets          |       | 69.75                 | %           | 68.13                 | %          |        |       |        |        |
| Public funds to  total deposits          |       | 11.69                 | %           | 7.26                  | %          |        |       |        |        |
| Public funds to  total assets            |       | 8.16                  | %           | 4.95                  | %          |        |       |        |        |

 

Total deposits increased $13,883,000, or 4%, during 2005 to $379,499,000.The increase was principally due to an $8,627,000, or 21%, increase in NOWaccounts and a $5,004,000, or 8%, increase in non-interest bearing deposits(DDAs). The increase in the Bank’s NOW accounts was primarily due to a$14,316,000 increase from the public sector including a municipal customer whoformerly used the Bank’s repurchase agreements for their transactional business.The large increase in money market deposits was primarily due to  transfers of funds from time depositaccounts, which decreased by a similar amount. Core deposits, which excludestime deposits of $100,000 and greater, increased $31,612,000, or 12%, during2005 to $303,242,000. Most of the increase in core deposits resulted from theaforementioned transfer of funds from time deposits of $100,000 or greater intomoney market deposit accounts. DDAs, the lowest costing component of coredeposits, are an important source of funds for the Bank because they reduce theoverall cost of funds and thereby help increase interest rate spread and margin.The Bank is largely dependent upon these accounts as well as its base of other competitivelypriced core deposits to provide a source of low-cost funding. The Bank attemptsto retain and grow its customer base through a combination of rate, productdiversification, quality of service, convenience and a stable and experienced branchstaff.

 

During 2005, the Bank’s deposit mix shifted away from being time-deposit-dominant.Time deposits now represent 42% of total

 

17

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deposits, down from 51% as at December 31, 2004. While Managementbelieves it has achieved the goal of reducing high-cost time deposits, it willremain cautious in its pricing strategy as the Bank continues to operate in ahighly competitive market and complex interest rate environment.

 

The maturity distribution of time deposits at December31, 2005 is as follows:

 
| ** **                           | ** ** | **Three months** | ** ** | **Three to six** | ** ** | **Six to twelve** | ** ** | **Over**          | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------------|------------|------------------|------------|-------------------|------------|-------------------|------------|------------|------------|
| ** **                           | ** ** | **or less**      | ** ** | **months**       | ** ** | **months**        | ** ** | **twelve months** | ** ** | **Total**  | ** ** |
| Time deposits of $100,000 or greater |       | $                | 19,127,109 |             | $          | 18,745,022        |       | $                 | 18,682,630 |       | $          | 19,702,792 |   | $ | 76,257,553 |   |
| Time deposits of less than $100,000  |       | 10,896,518       |       | 12,896,763       |       | 26,807,575        |       | 34,213,191        |       | 84,814,047 |       |
| Total time deposits                  |       | $                | 30,023,627 |             | $          | 31,641,785        |       | $                 | 45,490,205 |       | $          | 53,915,983 |   | $ | 161,071,600 |   |

 

The over-twelve month maturity distribution of timedeposits represents 14.2% of total deposits at December 31, 2005. The Bankbelieves this category, though lower than the amount as of December 31, 2004,provides a stable source of funds for future requirements. Approximately $107,156,000of time deposits are scheduled to mature in 2006. If market interest ratescontinue to rise, renewing time deposits may re-price to a higher rate, whichcould lead to higher interest expense.

 

***Short-term borrowings***

 

In addition to deposits, other funding sourcesavailable to the Bank are overnight funds purchased from the Federal Home LoanBank of Pittsburgh (FHLB) and repurchase agreements (repos) with various individuals,businesses and public entities. The Bank uses overnight funding from the FHLBto fund asset growth, deposit run-off and short-term liquidity needs. Repos,offered in both sweep and fixed-term products, are non-insured interest-bearingliabilities that have a security interest in qualified pledged investments ofthe Bank. A sweep account is designed to ensure that on a daily basis, anattached DDA is adequately funded and excess DDA funds are transferred, orswept, into an interest-bearing overnight repo account. In addition, the sweepwill transfer funds to the DDA as necessary, to cover checks presented forpayment. Due to the nature of the sweep product, these accounts tend to be morevolatile than the fixed-term product because the daily sweep is dependent onthe level of available funds in depositor accounts. At December 31, 2005 and2004, sweep accounts represented approximately 66% of total repos. Overnightborrowings and repos are included with short-term borrowings on the consolidatedbalance sheet. For a further discussion on short-term borrowings, refer to Note7 “Short-term Borrowings”, contained in the notes to consolidated financial statementsin Part II, Item 8.

 

Liquidity, investment needs and interest rates caused anet decrease in repos from $40,684,000 at December 31, 2004, to $26,913,000 atDecember 31, 2005. Included in this variance was the effect of the preference forone of the Bank’s municipal customers to transfer its funds from the repoproduct to the Bank’s NOW deposit account.

 

A combination of increased deposits at December 31,2005 and a strategy to extend short-term borrowings into long-term debt, in aneffort to insulate the Bank from the effect of continued interest rateincreases, has required less overnight funding from the FHLB. As a result,overnight funding from the FHLB was $769,000 at December 31, 2005 compared to $8,760,000at December 31, 2004.

 

***Long-term debt***

 

Long-term debt consists of borrowings from the FHLB. Theweighted-average rate in effect on funds borrowed at December 31, 2005, was 5.16%compared to 5.10% as of December 31, 2004. The quarterly re-pricing of$5,000,000 of advances was the primary cause of the six basis point increase inthe weighted-average interest rate. The 2005 weighted-average rate is 66 basispoints below the tax-equivalent yield of 5.82% on average earning-assets forthe year ended December 31, 2005. Rates on $58,000,000 of long-term debt advancesare fixed but may adjust quarterly, should market rates increase beyond theissues’ original rates. At December 31, 2005, similar advances from the FHLB were139 basis points below the average rate paid by the Bank. Significantprepayment penalties attached to the borrowings is a deterrent from paying offthe high cost advances. However, in the event underlying market rates drift abovethe rates currently paid on these borrowings, the FHLB will convert to floatingand the Bank has the option, at that time, to repay or to renegotiate the convertedadvance.

 

18

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Long-term debt increased $12,585,000 during 2005, or18%, to $83,704,000. The primary purpose of the increase was to reduce ourexposure to rising interest rates by reducing short-term overnight borrowings andlocking in longer-term fixed-rate positions. At December 31, 2005, the Bank hadthe ability to borrow an additional $54,550,000 from the FHLB. The FHLB hasshort-, medium- and long-term funding products available to the Bank.

 

***Accrued expenses and otherliabilities***

 

Increases in interest-bearing deposits and borrowings alongwith higher interest rates have caused an increase in accrued interest payableof $354,000, or 36%, to $932,000. Other liabilities included a number ofaccrued expenses and liabilities that have been recognized in the financialstatements but, as of December 31, 2005, were unpaid. Collectively, theseaccounts decreased $156,000 from December 31, 2004.

 

***Investments***

 

The Bank’s investment policy is designed to complement its lendingactivities, generate a favorable return without incurring undue interest rateand credit risk, manage interest rate sensitivity, provide monthly cash flowand manage liquidity at acceptable levels. In establishing investmentstrategies, the Bank considers its business and growth or restructuring plans,the economic environment, the interest rate sensitivity position, the types ofsecurities held, permissible purchases, credit quality, maturity and re-pricingterms, call or average-life intervals and investment concentrations. The policyprescribes permissible investment categories that meet the policy standards andManagement is responsible for structuring and executing the specific investmentpurchases within these policy parameters. Management buys and sells investmentsecurities from time-to-time depending on market conditions, business trends,liquidity needs, capital levels and structuring strategies. Investment securitypurchases provide a way to quickly invest excess liquidity in order to generateadditional earnings. The Bank generally earns a positive interest spread byassuming interest rate risk and using deposits and/or borrowings to purchasesecurities with longer maturities.

 

At the time of purchase, Management classifies investment securitiesinto one of three categories: trading, AFS or, held-to-maturity (HTM). To date,Management has not purchased any securities for trading purposes. Most of thesecurities purchased are classified as AFS even though there is no immediateintent to sell them. The AFS designation affords Management the flexibility tosell securities and position the balance sheet in response to capital levels,liquidity needs or changes in market conditions. Securities AFS are carried atnet fair values in the consolidated balance sheet with an adjustment toshareholders’ equity, net of tax, and is presented under the caption “Accumulatedother comprehensive income (loss)”. Securities designated as HTM are carried atamortized cost and represent debt securities that the Company has the abilityand intent to hold until maturity. As of December 31, 2005 and December 31,2004, the aggregate fair value of securities HTM exceeded their respectiveaggregate amortized cost by $49,000 and $137,000, respectively.

 

Total investments declined $17,990,000, net of $1,532,000 depreciation inthe market value of AFS investments. The carrying value of investmentsecurities, at December 31, 2005, was $97,679,000, or 18%, of total assetscompared to $115,669,000, or 22%, as of December 31, 2004. During the firsthalf of 2005, the Bank restructured approximately $19,500,000 of investmentsecurities to enhance current earnings while simultaneously addressing theinterest rate risk in the portfolio from the continued flattening of the U.S.Treasury yield curve (the “yield curve”). The restructuring included the saleand purchase of securities that re-allocated the portfolio diversification awayfrom being heavily weighted in mortgage-backed securities. At December 31, 2005approximately 44% of the investment portfolio was comprised of mortgage-backedsecurities that amortize and provide monthly cash flow compared to 56% atDecember 31, 2004.

 

During 2005, interest rates throughout the yield curve increased withthe exception of the 30-year treasury which decreased modestly. The FederalOpen Market Committee (the “FOMC”) raised short-term interest rates eight times(200 basis points) since the end of 2004. While short-term U.S. Treasury yieldshave shown somewhat similar increases during 2005, the medium- and long-term rateshave increased at a much slower pace resulting in a flattening to a slightlyinverted yield curve at the short- to mid- term range. This environmentprecludes a structured growth strategy within the investment portfolio due tolack of prudent investments available at adequate spreads to the Bank’s fundingsources. Accordingly, the Bank used cash flows from its investment portfolio tofund high-cost time deposit outflow, repayment of overnight borrowings and fundgrowth in the loan portfolio rather than redeploy the funds in the securitiesmarkets. The Bank will continue to monitor the investment markets but will onlyadd investments which are accretive to earnings.

 

 

19

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A comparison of investments at December 31, for the three previousperiods is as follows:

 
| ** **                          | ** ** | **2005**   | ** ** | **2004**    | ** ** | **2003**   | ** ** |
|-------------------------------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                          | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| U.S.  government agencies           |       | $          | 31,125,909 |        | 31.87      | %          | $          | 30,497,185 |   | 26.36 | % | $ | 36,323,404 |   | 26.01 | % |
| Mortgage-backed  securities         |       | 42,615,197 |       | 43.63       |       | 64,457,326 |       | 55.73 |   | 85,598,752 |   | 61.29 |   |
| State  & municipal subdivisions |       | 13,401,874 |       | 13.72       |       | 11,199,084 |       | 9.68 |   |   |   | 9.51 |   |
| Preferred  term securities          |       | 10,083,084 |       | 10.32       |       | 9,034,375  |       | 7.81 |   | 13,275,289 |   | 2.87 |   |
| Equity  securities                  |       | 452,509    |       | 0.46        |       | 480,848    |       | 0.42 |   | 449,122 |   | 0.32 |   |
| Total                               |       | $          | 97,678,573 |        | 100.00     | %          | $          | 115,668,818 |   | 100.00 | % | $ | 139,654,074 |   | 100.00 | % |

 

The distribution of debt securities by stated maturity date at December31, 2005 is as follows:

 
| ** **                         | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|---------------|------------|------------|------------|
| ** **                         | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies           |       | $            | —     |            | $          | 6,804,195        |       | $             | 21,452,964 |       | $          | 2,868,750 |   | $ | 31,125,909 |   |
| Mortgage-backed securities         |       | —       |       | 5,836,470       |       | 8,336,361        |       | 28,442,366    |       | 42,615,197 |       |
| State & municipal subdivisions |       | —       |       | 314,864         |       | 742,160          |       | 12,344,850    |       | 13,401,874 |       |
| Preferred term securities          |       | —       |       | —          |       | —           |       | 10,083,084    |       | 10,083,084 |       |
| Total debt securities              |       | $            | —     |            | $          | 12,955,529       |       | $             | 30,531,485 |       | $          | 53,739,050 |   | $ | 97,226,064 |   |

 

AFS securities are stated net of unrealized gains and losses. As ofDecember 31, 2005, AFS debt securities were recorded with a net unrealized lossin the amount of $1,859,000. At December 31, 2005 AFS equity securities wererecorded at $453,000 including an unrealized gain of $174,000.

 

The tax-equivalent yield on debt securities by stated maturity date atDecember 31, 2005, is as follows:

 
| ** **                         | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|---------------|------------|------------|------------|
| ** **                         | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies           |       | —       | %          | 3.39            | %          | 3.51             | %          | 4.27          | %          | 3.56       | %          |
| Mortgaged-backed securities        |       | —       |       | 3.70            |       | 3.83             |       | 4.93          |       | 4.50       |       |
| State & municipal subdivisions |       | —       |       | 5.24            |       | 5.96             |       | 5.75          |       | 5.75       |       |
| Preferred term securities          |       | —       |       | —          |       | —           |       | 6.08          |       | 6.08       |       |
| Total debt securities              |       | —       | %          | 3.57            | %          | 3.66             | %          | 5.32          | %          | 4.53       | %          |

 

In the above table, the bookyields on state & municipal subdivisions were adjusted to a tax-equivalentbasis using the corporate federal tax rate of 34%.In addition, average yields on securities AFSare based on amortized cost and do not reflect unrealized gains or losses.

 

***Loans and leases***

 

Loans and leases, net of unearned income, increased $21,595,000, or 5.6%,from $387,534,000 at December 31, 2004, to $409,129,000 at December 31, 2005. Grossloans represented 75.2% of total assets at December 31, 2005 compared to 72.2%at December 31, 2004.

 

In 2005, the Bank originated $27,030,000 of commercial loans, $39,398,000of mortgage loans and $38,763,000 of consumer loans. This compares to $34,981,000,$31,368,000 and $19,671,000, respectively, in 2004. Included in mortgage loansis $18,128,000 of real estate construction lines in 2005 and $13,066,000 in2004. In addition for 2005, the Bank originated lines of credit in the amountsof $21,008,000 for commercial borrowers, $6,756,000 in home equity lines and $153,000for consumer borrowers. The increase in the loan portfolio was from thesuccessful implementation and marketing strategies for residential and consumerlending, partially offset by a decline in commercial loans. Though interestrates have increased throughout 2005, the Bank’s lending activities wererelatively unaffected by borrowers’ sentiment to a sustained period of rising short-terminterest rates. With the flattening of the yield curve, Management believes thedemand for long-term loan originations will continue throughout 2006.

 

20

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*Commercial and Commercial RealEstate Loans**:*

 

Net of scheduled principal curtailments, loan participation sales andpre-payments, commercial loans decreased $5,680,000 during 2005. This decrease wasdue primarily to the strategic decision not to renew an automobile dealer’sfloor plan that was paid off.

 

The Bank continues to originate loans using the Small BusinessAdministration (SBA) guaranteed loan program. Under this program, in return forthe Bank funding a qualified loan, the SBA guarantees a material portion of theprincipal balance to the Bank. As of December 31, 2005 and 2004, the Bank had $1,793,000and $2,002,000, respectively in SBA guaranteed loans outstanding.

 

Tax-free industrial development loans made to or backed by localmunicipalities increased from $9,898,000 at December 31, 2004 to $10,770,000 atDecember 31, 2005. The increase in this sector was due mainly to fund loans tolocal municipalities for various infrastructure and sustaining projects.

 

*Residential Real Estate Loans*:

 

Residential real estate loans increased $12,626,000, or 13.8%, to $103,921,000.These loans increased due to the successful implementation of various sales andmarketing campaigns throughout 2005. In addition, originations of these loansremained strong due to the relative low interest rate environment.

 

*Consumer Loans**:*

 

Consumer loans increased $12,583,000, or 20.5%, during 2005. A successfulspring sales campaign, with added advertising and marketing, along with lesspay downs, helped boost the home equity installment program by approximately$14,463,000.

 

*Real Estate Construction Loans**:*

 

Real estate construction loans increased $3,579,000, or 33.7%, during2005. Real estate construction loans consist of $12,435,000 for residentialconstruction and $1,764,000 for commercial real estate construction. Theincrease was caused by the success to further develop this type of lendingarrangement as well as an increase in the average loan size in 2005 compared to2004. These loans fund residential and commercial construction projects and thenconvert to a residential mortgage or to a commercial real estate loan usuallywithin one year from the origination date. Generally, the converted loans willbear the same terms as the residential or the commercial construction loans.

 

*Direct Financing Leases**:*

 

Direct financing leases declined $1,562,000, or 70.6%, to $650,000. Thelast of the Bank’s automobile leases have terminated and its automobile leasingbusiness concluded as of December 31, 2005. The remaining balance represents tax-freeleasing arrangements provided to municipal customers.

 

A comparison of loans at December 31, for the five previous periods isas follows (all loans are domestic):

 
| ** **                                 | ** ** | **2005**    | ** **  | **2004**    | ** ** | **2003**    | ** ** | **2002**    | ** **  | **2001**    | ** ** |
|--------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| Residential real estate                    |       | $           | 103,920,613 |        | $          | 91,294,401  |       | $           | 77,077,315  |        | $          | 78,132,262 |   | $ | 90,766,420 |   |
| Consumer                                   |       | 74,070,328  |        | 61,487,608  |       | 62,919,070  |       | 64,300,368  |        | 73,756,002  |       |
| Commercial and commercial real estate |       | 216,288,597 |        | 221,968,137 |       | 221,275,922 |       | 202,974,155 |        | 179,043,816 |       |
| Direct financing leases                    |       | 650,348     |        | 2,211,978   |       | 3,685,802   |       | 6,578,720   |        | 9,961,967   |       |
| Real estate construction                   |       | 14,198,858  |        | 10,620,472  |       | 7,267,616   |       | 6,797,002   |        | 5,446,870   |       |
| Gross loans                                |       | 409,128,744 |        | 387,582,596 |       | 372,225,725 |       | 358,782,507 |        | 358,975,075 |       |
| Less:                                      |       |        |        |        |       |        |       |        |        |        |       |
| Unearned discount                          |       | —      |        | 48,423      |       | 247,119     |       | 620,704     |        | 1,256,818   |       |
| Allowance for loan losses                  |       | 5,984,649   |        | 5,987,798   |       | 4,996,966   |       | 3,899,753   |        | 3,741,933   |       |
| Net loans                                  |       | $           | 403,144,095 |        | $          | 381,546,375 |       | $           | 366,981,640 |        | $          | 354,262,050 |   | $ | 353,976,324 |   |
|                                       |       |        |        |        |       |        |       |        |        |        |       |
| Loans available-for-sale                   |       | $           | 428,524     |        | $          | 576,378     |       | $           | 19,863,577  |        | $          | 28,715,355 |   | $ | 16,150,020 |   |

 

 

21

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A comparison of gross loans by percent at year-end for the fiveprevious periods is as follows:

 
| ** **                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Residential real estate                      |       | 25.40    | %          | 23.56    | %          | 20.71    | %          | 21.78    | %          | 25.28    | %          |
| Consumer                                     |       | 18.10    |       | 15.86    |       | 16.90    |       | 17.92    |       | 20.55    |       |
| Commercial and  commercial  real estate |       | 52.87    |       | 57.27    |       | 59.45    |       | 56.57    |       | 49.88    |       |
| Direct financing leases                      |       | 0.16     |       | 0.57     |       | 0.99     |       | 1.83     |       | 2.77     |       |
| Real estate construction                     |       | 3.47     |       | 2.74     |       | 1.95     |       | 1.90     |       | 1.52     |       |
| Gross loans                                  |       | 100.00   | %          | 100.00   | %          | 100.00   | %          | 100.00   | %          | 100.00   | %          |

 

The following table sets forth the maturity distribution of selectcomponents of the loan portfolio at December 31, 2005. Excluded from the tableare residential real estate loans, consumer loans and direct financing leases (dollarsin thousands):

 
| ** **                                         | ** ** | **One year** | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|--------------|------------|-----------------|------------|----------------|------------|------------|------------|
| ** **                                         | ** ** | **or less**  | ** ** | **years**       | ** ** | **five years** | ** ** | **Total**  | ** ** |
| Commercial and commercial  real  estate loans |       | $            | 6,494      |            | $          | 33,349         |       | $          | 176,446    |   | $ | 216,289 |   |
| Real estate construction                           |       | 14,198       |       | —          |       | —         |       | 14,198     |       |
| Total                                              |       | $            | 20,692     |            | $          | 33,349         |       | $          | 176,446    |   | $ | 230,487 |   |

 

Real estate construction loans are included in the one-year or lesscategory since, by their nature, these loans are converted into residential andcommercial real estate loans within one year from the date the real estateconstruction loan was consummated. Upon conversion, the residential andcommercial real estate loans would normally mature after five years.

 

The following table sets forth the sensitivity changes in interestrates for commercial and commercial real estate loans at December 31, 2005 (dollarsin thousands):

 
| ** **             | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** |
|------------------------|------------|-----------------|------------|----------------|------------|------------|------------|
| ** **             | ** ** | **years**       | ** ** | **five years** | ** ** | **Total**  | ** ** |
| Fixed interest rate    |       | $               | 12,460     |           | $          | 31,236     |       | $ | 43,696 |   |
| Variable interest rate |       | 36,561          |       | 3,334          |       | 39,895     |       |
| Total                  |       | $               | 49,021     |           | $          | 34,570     |       | $ | 83,591 |   |

 

Non-refundable fees or costs associated with all loan originations aredeferred. Using the applicable method, either the principal reduction orstraight-line method, the Bank releases the deferral as charges or credits toloan interest income over the life of the loan.

 

There are no concentrations of loans to a number of borrowers engagedin similar activities exceeding 10.00% of total loans that are not otherwisedisclosed as a category in the tables above. There are no concentrations ofloans that, if lost, would have a material adverse effect on the business ofthe Bank. The Bank’s loan portfolio does not have a material concentrationwithin a single industry or group of related industries that are vulnerable tothe risk of a near-term severe negative business impact.

 

***Loans available-for-sale***

 

Generally, upon origination, certain residential mortgages, the guaranteedportions of SBA loans and student loans are classified as AFS. Should marketrates increase, fixed-rate loans and loans not immediately scheduled to re-pricewould no longer produce yields consistent with the current market. In adeclining interest rate environment, the Bank would be exposed to prepaymentrisk and, as rates on adjustable rate loans decrease interest income would be negativelyaffected. Consideration is also given to the current liquidity position andprojected future liquidity needs. To better manage interest rate and prepaymentrisk, loans meeting these conditions may be classified as AFS. The carryingvalue of loans AFS are at the lower of cost or estimated fair value. If the fairvalues of these loans fall below their original cost, the difference is writtendown and charged to current earnings. Any subsequent appreciation in theportfolio is credited to current earnings but only to the extent of previouswrite-downs.

 

Loans AFS, at December 31, 2005, were $429,000, with a correspondingfair value of $434,000 compared to $576,000 and $582,000 respectively, atDecember 31, 2004. During 2005, residential mortgages and student loans withprincipal balances of $1,417,000 and $910,000, respectively were sold into thesecondary market and gains of approximately $25,000 have been recognized. Therewere no sold SBA loans during 2005.

 

22

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The Bank retains the mortgage servicing rights (MSRs) on loans soldinto the secondary market. MSRs are retained so that the Bank can continue thepersonal relationship developed with its customers. At December 31, 2005 and2004, the servicing portfolio balance of sold residential mortgage loans was $47,835,000and $57,939,000, respectively. For a further discussion on MSRs, see Note 4, “Loansand leases” contained within the notes to consolidated financial statements inPart II, Item 8.

 

***Allowance for loan losses***

 

Management continually evaluates the credit quality of the Bank’s loanportfolio and performs a formal review of the adequacy of the allowance forloan losses (the allowance), on a quarterly basis. The allowance reflects Management’sbest estimate of the amount of credit losses in the loan portfolio. Management’sjudgment is based on the evaluation of individual loans, past experience, theassessment of current economic conditions and other relevant factors includingthe amounts and timing of cash flows expected to be received on impaired loans.Those estimates may be susceptible to significant change. The provision forloan losses represents the amount necessary to maintain an appropriateallowance. Loan losses are charged directly against the allowance when loansare deemed to be uncollectible. Recoveries from previously charged-off loansare added to the allowance when received.

 

Management applies two primary components during the loan reviewprocess to determine proper allowance levels. The two levels are specific loanloss allocation for loans that are deemed impaired and a general loan lossallocation for those loans not specifically allocated. The methodology toanalyze the adequacy of the allowance for loan losses is as follows:

 

•                  Identificationof specific problem loans by loan category;

•                  Calculation ofspecific allowances required based on collateral and other objective andquantifiable;

•                  Identificationof loans collateralized by cash and cash equivalents;

•                  Determination ofremaining homogenous pools by loan category and eliminating loanscollateralized by cash and cash equivalents and eliminating loans with specificloss allocations;

•                  Application ofhistorical loss percentages (three-year average) to pools to determine theallowance allocation; and

•                  Application ofqualitative factor adjustment percentages to historical losses for trends orchanges in the loan portfolio.

 

Allocation of the allowance for different categories of loans is basedon the methodology used by the Bank, as explained above. A key element of themethodology to determine the allowance is the Company’s credit risk evaluationprocess, which includes credit risk grading of individual commercial loans. Commercialloans are assigned credit risk grades based on the Company’s assessment ofconditions that affect the borrower’s ability to meet its contractualobligations under the loan agreement. That process includes reviewing borrowers’current financial information, historical payment experience, creditdocumentation, public information and other information specific to eachindividual borrower. The changes in the allocations from period to period arebased upon the credit risk grading assigned from periodic reviews of the loanand lease portfolios.

 

Total charge-offs, net of recoveries, for the year ended December 31,2005, were $833,000, compared to $1,159,000 in 2004. Combined consumer loan andlease financing net charge-offs decreased from $364,000, through December 31,2004, to $141,000, through December 31, 2005. Commercial loan net charge-offs were$682,000 for the full year 2005 compared to $549,000 for 2004. Mortgage loannet-charge-offs were $10,000 in 2005 compared to $246,000 in 2004. The effortsof the collection department and improvements in portfolio quality resulted ina diminution of net charge-offs in 2005. For further discussion on theprovision for loan losses, see the “Provision for loan losses” located in theResults of Operations section of Management’s Discussion and Analysis containedherein.

 

For a further discussion of delinquencies and net charge-offs, see thesection entitled “Non-performing assets.”  Additional discussion is in Note 1 “Nature ofOperations and Summary of Significant Accounting Policies – Allowance for LoanLosses” and Note 4 “Loans and Leases” contained in the notes to consolidated financialstatements, and incorporated herein by reference.

 

Management believes that the current balance in the allowance for loanlosses of $5,985,000 is sufficient to withstand the identified potential creditquality issues that may arise and are inherent to the portfolio. Currently, Managementis unaware of any potential problem loans that have not been reviewed. Potentialproblem loans are those where there is known information that leads Managementto believe repayment of principal and/or interest is in jeopardy and the loansare currently neither on non-accrual status nor past due 90 days or more. However,there could be certain instances which become identified over the upcoming yearthat may require additional charge-offs and/or increases to the allowance. Theratio of allowance for loan losses to total loans was 1.46% at December 31, 2005compared to 1.54% at December 31, 2004.

 

23

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The following table sets forth the activity in the allowance for loanlosses and certain key ratios for the periods indicated (dollars in thousands):

 
| ** **                                                              | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2001**   | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at  beginning of period                                         |       | $          | 5,988      |       | $          | 4,997      |       | $          | 3,900      |       | $          | 3,742 |   | $ | 3,264 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |       |       |
| **Charge-offs:**                                                        |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                               |       | 1,077      |       | 775        |       | 1,334      |       | 928        |       | 1,003      |       |
| Real estate                                                             |       | 21         |       | 266        |       | 503        |       | 40         |       | 119        |       |
| Consumer                                                                |       | 288        |       | 480        |       | 1,167      |       | 850        |       | 909        |       |
| Lease financing                                                         |       | 8          |       | 85         |       | 92         |       | 131        |       | 180        |       |
| Total                                                                   |       | 1,394      |       | 1,606      |       | 3,096      |       | 1,949      |       | 2,211      |       |
|                                                                    |       |       |       |       |       |       |       |       |       |       |       |
| **Recoveries:**                                                         |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                               |       | 395        |       | 226        |       | 204        |       | 359        |       | 86         |       |
| Real estate                                                             |       | 11         |       | 20         |       | 34         |       | —     |       | 3          |       |
| Consumer                                                                |       | 155        |       | 178        |       | 230        |       | 69         |       | 108        |       |
| Lease financing                                                         |       | —     |       | 23         |       | 10         |       | 15         |       | 17         |       |
| Total                                                                   |       | 561        |       | 447        |       | 478        |       | 443        |       | 214        |       |
| Net charge-offs                                                         |       | 833        |       | 1,159      |       | 2,618      |       | 1,506      |       | 1,997      |       |
| Provision  charged to operations                                        |       | 830        |       | 2,150      |       | 3,715      |       | 1,664      |       | 2,475      |       |
| Balance at end  of period                                               |       | $          | 5,985      |       | $          | 5,988      |       | $          | 4,997      |       | $          | 3,900 |   | $ | 3,742 |   |
| Net charge-offs  to average loans outstanding                           |       | 0.22       | %          | 0.30       | %          | 0.68       | %          | 0.40       | %          | 0.56       | %          |
| Allowance for  loan loss to net charge-offs                             |       | 7.18       | x          | 5.17       | x          | 1.91       | x          | 2.59       | x          | 1.87       | x          |
| Allowance for  loan loss to total gross                                 |       | 1.46       | %          | 1.54       | %          | 1.28       | %          | 1.01       | %          | 1.00       | %          |
| Loans 30 - 89  days past due and accruing                               |       | $          | 1,609      |       | $          | 4,317      |       | $          | 3,975      |       | $          | 6,047 |   | $ | 7,156 |   |
| Loans 90 days or  more past due and accruing                            |       | $          | 197        |       | $          | 557        |       | $          | 958        |       | $          | 2,599 |   | $ | 5,398 |   |
| Non-accruing  loans                                                     |       | $          | 9,453      |       | $          | 9,904      |       | $          | 7,323      |       | $          | 4,000 |   | $ | 4,914 |   |
| Allowance for  loan loss to loans 90 days or more past due and accruing |       | 30.39      | x          | 10.75      | x          | 5.22       | x          | 1.50       | x          | 0.69       | x          |
| Allowance for  loan loss to non-accruing loans                          |       | 0.63       | x          | 0.60       | x          | 0.68       | x          | 0.98       | x          | 0.76       | x          |
| Allowance for  loan loss to non-performing loans                        |       | 0.62       | x          | 0.57       | x          | 0.60       | x          | 0.59       | x          | 0.36       | x          |
| Average net  loans                                                      |       | $          | 385,800    |       | $          | 381,366    |       | $          | 383,226    |       | $          | 380,892 |   | $ | 352,230 |   |

 

The allowance for loan losses can generally absorb losses throughoutthe loan and lease portfolios. However, in some instances an allocation is madefor specific loans or groups of loans. Allocation of the allowance for loanlosses for different categories of loans is based on the methodology used bythe Bank, as previously explained. The changes in the allocations from year toyear are based upon year-end reviews of the loan and lease portfolios.

 

Allocation of the allowance among major categories of loans for thepast five years is summarized below. This table should not be interpreted as anindication that charge-offs in future periods will occur in these amounts orproportions, or that the allocation indicates future charge-off trends. The portionof the allowance designated as unallocated is within the Company’s policyguidelines. 

24

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Prior to 2003, consumer loans included credit card receivables:

 
| ** **                             | ** ** | **2005**  | ** ** | **%**  | ** ** | **2004**  | ** ** | **%**     | ** ** | **2003**  | ** ** | **%**  | ** ** | **2002**  | ** ** | **%**  | ** ** | **2001**  | ** ** | **%**  | ** ** |
|----------------------------------------|------------|-----------|------------|--------|------------|-----------|------------|-----------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|
| Category                               |       |      |       |   |       |      |       |      |       |      |       |   |       |      |       |   |       |      |       |   |       |
| Residential real estate                |       | $         | 595,092    |   | 9.94       |      | $          | 451,349   |       | 7.54      |       | $      | 354,207    |      | 7.09       |   | $          | 383,858   |       | 9.84   |       | $ | 269,490 |   | 7.20 |   |
| Consumer                               |       | 1,180,175 |       | 19.72  |       | 966,081   |       | 16.13     |       | 884,689   |       | 17.70  |       | 1,092,140 |       | 28.01  |       | 959,408   |       | 25.64  |       |
| Commercial and  commercial real estate |       | 4,035,950 |       | 67.44  |       | 4,330,285 |       | 72.32     |       | 3,699,488 |       | 74.04  |       | 2,198,783 |       | 56.38  |       | 2,197,365 |       | 58.72  |       |
| Direct financing leases                |       | 14,828    |       | 0.25   |       | 40,891    |       | 0.69      |       | 42,706    |       | 0.85   |       | 81,664    |       | 2.09   |       | 136,091   |       | 3.64   |       |
| Real estate construction               |       | 59,953    |       | 1.00   |       | 46,465    |       | 0.77      |       | 15,876    |       | 0.32   |       | —    |       | — |       | —    |       | — |       |
| Unallocated                            |       | 98,651    |       | 1.65   |       | 152,727   |       | 2.55      |       | —    |       | — |       | 143,307   |       | 3.68   |       | 179,579   |       | 4.80   |       |
| Total                                  |       | $         | 5,984,649  |   | 100.00     | %         | $          | 5,987,798 |       | 100.00    | %          | $      | 4,996,966  |      | 100.00     | %      | $          | 3,899,752 |       | 100.00 | %          | $ | 3,741,933 |   | 100.00 | % |

 

Allowance for loan losses based upon the commercial loan portfoliocomprised 67%, or $4,036,000, of the total allowance for loan losses atDecember 31, 2005, of which approximately 25% is reserved for non-performingcommercial loan relationships. Collateral values were prudently valued toprovide a conservative and realistic value of the collateral supporting theseloans. The allocations to the other categories of loans are adequate comparedto the actual three-year historical net charge-offs

 

***Non-performing assets***

 

The Bank defines non-performing assets as accruing loans past due 90days or more, non-accrual loans, restructured loans, other real estate ownedand repossessed assets. As of December 31, 2005, non-performing assetsrepresented 1.78% of total assets compared to 1.99% at December 31, 2004.

 

The following table sets forth non-performing assets at December 31(dollars in thousands):

 
| ** **                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net loans, including loans available-for-sale                                           |       | $        | 403,573    |     | $          | 382,123  |       | $        | 386,846    |     | $          | 382,977 |   | $ | 370,126 |   |
|                                                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Loans past due 90 days or more and accruing                                             |       | $        | 197        |     | $          | 557      |       | $        | 958        |     | $          | 2,599 |   | $ | 5,398 |   |
| Non-accrual loans                                                                       |       | 9,453    |       | 9,904    |       | 7,323    |       | 4,000    |       | 4,914    |       |
| Total non-performing loans                                                              |       | 9,650    |       | 10,461   |       | 8,281    |       | 6,599    |       | 10,312   |       |
| Restructured loans                                                                      |       | —   |       | —   |       | —   |       | 1,474    |       | —   |       |
| Other real estate owned                                                                 |       | —   |       | 163      |       | 394      |       | 262      |       | 465      |       |
| Repossessed assets                                                                      |       | 19       |       | 50       |       | 73       |       | 175      |       | 158      |       |
| Total non-performing assets                                                             |       | $        | 9,669      |     | $          | 10,674   |       | $        | 8,748      |     | $          | 8,510 |   | $ | 10,935 |   |
|                                                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Non-accrual loans to net loans                                                          |       | 2.34     | %          | 2.59     | %          | 1.89     | %          | 1.04     | %          | 1.33     | %          |
| Non-performing assets to net loans, foreclosed real estate  and repossessed assets |       | 2.40     | %          | 2.79     | %          | 2.26     | %          | 2.22     | %          | 2.95     | %          |
| Non-performing assets to total assets                                                   |       | 1.78     | %          | 1.99     | %          | 1.52     | %          | 1.47     | %          | 1.92     | %          |
| Non-performing loans to net loans                                                       |       | 2.39     | %          | 2.74     | %          | 2.14     | %          | 1.72     | %          | 2.79     | %          |
|                                                                                         |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |  |  |  |  |  |

 

In the review of loans for both delinquency and collateral sufficiency,Management concluded that there were a number of loans that lacked the abilityto repay in accordance with contractual terms. The decision to place loans orleases on a non-accrual status is made on an individual basis after consideringfactors pertaining to each specific loan.

 

The majority of non-performing loans for the period is attributed tocommercial business loans and real estate loans in the process of foreclosure. Mostof these loans are collateralized thereby reducing the Bank’s potential forloss. In 2005, non-performing loans were reduced by $811,000, or 7.8%, to $9,650,000.Repossessed assets were $19,000 at December 31, 2005 compared to $50,000 in2004. All repossessed vehicles, except one, were sold prior to year-end 2005. Therewas no other real estate owned (ORE) at year-end 2005 as all previouslyforeclosed real estate had been listed with realtors and sold prior to the endof year. The non-accrual loans were $9,453,000 at December 31, 2005 a reductionof $451,000, or 4.6%, from year-end 2004. During 2005 approximately $4,604,000of loans were placed in non-accrual status. This was more than offset bypayoffs or pay downs of $2,810,000, charge offs of $1,131,000, $245,000 intransfers to foreclosed assets and $869,000 of loans that returned toperforming status. Loans past due 90 days or more and accruing, declined by64.6%, to $197,000, at December 31, 2005. As a result, the percentage ofnon-performing assets to total assets declined to 1.78% at December 31, 2005,compared to 1.99% for the prior year end and non-performing loans to net loansdeclined to 2.39% at December 31, 2005, from 2.74% at December 31, 2004.

 

25

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Repossessed assets consist of previously financed vehicles held forsale. Subsequent to the loan or lease maturity, the borrower or lesseedefaulted on their contract and the Company repossessed the unit. Repossessedassets are sold through either a private or public sale and any deficiencybalance from the sale of the asset is charged to the allowance for loan losses.

 

Payments received on non-accrual loans are recognized on a cash basis. Paymentsare first applied against the outstanding principal balance, then to therecovery of any charged-off loan amounts. Any excess is treated as a recoveryof interest income. During 2005, the Bank collected $241,000 of interest incomerecognized on the cash basis. If all non-accrual loans had been performing inaccordance with their original terms, the Bank would have recorded interestincome, with respect to such loans, of $1,575,000 for the year ended December31, 2005.

 

***Bank premises and equipment, net***

 

The Bank’s premises and equipment increased $520,000, net of accumulateddepreciation, due primarily to the land acquisition for anticipated future branchexpansion. Branch expansion plans will result in future additions to bankpremises and equipment during the periods the assets are placed in service. During2005, the Bank purchased approximately $1,740,000 in premises and equipmentcompared to $278,000 in 2004.

 

***Foreclosed******assets held for sale***

 

*Other Real Estate Owned*

 

During 2005, properties acquired in foreclosure were listed withrealtors for sale and subsequently sold. As a result, there were no foreclosedreal estate properties owned by the Bank at December 31, 2005 compared to$163,000 at December 31, 2004.

 

*Repossessed Assets*

 

Continued improvement in the turn-around time on sales of repossessedvehicles resulted in a decline in repossessed assets from $50,000 at December31, 2004 to $19,000 as of December 31, 2005.

 

***Terminated lease assets held for sale***

 

Terminated lease assets are vehicles that were lease-financed by theCompany with contractual terms fulfilled. Pursuant to the lease agreement, thevehicles are returned to the Company and recorded on the books in other assetsat the residual value. These vehicles are subsequently sold as soon aspracticable. The difference between sales price and residual value, if any, ischarged against current earnings. Simultaneously, a claim is submitted to theCompany’s residual insurance carrier for payment. Receipt of any residualinsurance proceeds is then credited to current earnings. All vehicles whichwere returned to the Bank were subsequently sold prior to December 31, 2005. TheBank’s vehicle lease program has expired and future periods’ results ofoperations should be minimally impacted and limited to residual insuranceclaims that will be received in 2006.

 

***Cash surrender value of bank owned life insurance***

 

***The Bank maintains bank owned life insurance (BOLI) for achosen group of employees, namely its officers, where the Bank is the owner andsole beneficiary of the policies. BOLI is classified as a non-interest earningasset. Increases in the cash surrender value are recorded as non-interestincome. The BOLI is profitable from the appreciation of the cash surrendervalues of the pool of insurance, and its tax-free advantage to the Bank. Thisprofitability is used to offset a portion of current and future employeebenefit costs. The BOLI can be liquidated, if necessary, with tax costsassociated. However, the Bank intends to hold this pool of insurance, becauseit provides income that enhances the Bank’s capital position. Therefore, theBank has not provided for deferred income taxes on the earnings from theincrease in cash surrender value.***

*** ***

***Results of Operations***

 

***Earnings Summary:***

 

The Company’s results of operations depend primarily on net interestincome. Net interest income is the difference between interest

 

26

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income and interest expense. Interest income is generated from yieldson interest-earning assets which consist principally of loans and investment securities.Interest expense is incurred from rates paid on interest-bearing liabilitieswhich consist of deposits and borrowings. Net interest income is determined bythe Company’s interest rate spread (i.e., the difference between the yieldsearned on its interest-earning assets and the rates paid on itsinterest-bearing liabilities) and the relative amounts of interest-earning assetsand interest-bearing liabilities. The interest rate spread is significantlyimpacted by: changes in interest rates and market yield curves and theirrelated impact on cash flows; the composition and characteristics ofinterest-earning assets and interest-bearing liabilities; differences in thematurity and re-pricing characteristics of assets compared to the maturity andre-pricing characteristics of the liabilities that fund them and by thecompetition in our marketplace.

 

The Company’s profitability is also affected by the level of itsnon-interest income and expenses, provision for loan losses and provision forincome taxes. Non-interest income consists mostly of service charges on theBank’s loan and deposit products, trust and asset management service fees, increasesin the cash surrender value of the bank owned life insurance, net gains orlosses from the sales of loans and securities AFS and from the sales of ORE. Non-interestexpense consists of compensation and related employee benefit expenses,occupancy, equipment, data processing, advertising, marketing, professionalfees, insurance and other operating overhead.

 

The Company’s profitability is significantly affected by generaleconomic and competitive conditions, changes in market interest rates,government policies and actions of regulatory authorities. The Company’s loanportfolio is comprised principally of commercial and commercial real estateloans. The properties underlying the Company’s mortgages are concentrated innortheastern Pennsylvania. Credit risk, which represents the possibility of theCompany not recovering amounts due from its borrowers, is significantly relatedto local economic conditions in the areas the properties are located as well asthe Company’s underwriting standards. Economic conditions affect the marketvalue of the underlying collateral as well as the levels of adequate cash flowand revenue generation from income-producing commercial properties and levelsof occupancy of multi-family dwellings.

 

**Overview**

 

Net income for the year ended December 31, 2005 increased to$4,592,000, or 36%, from $3,364,000 for the year ended December 31, 2004. Dilutedearnings per common share increased to $2.25 for the year ended December 31,2005 compared to $1.67 for the year ended December 31, 2004. Return on averageassets (ROA) and return on average shareholders’ equity (ROE) improved to 0.86%and 9.64%, respectively, for the year ended December 31, 2005 from 0.61% and 7.51%,respectively, in 2004. The improvement in net income was the result of anincrease in net interest income and a decrease in the provision for loan lossespartially offset by increases in other expenses and the provision for incometaxes. The improvements in ROA and ROE from 2005 to 2004 were primarily theresult of improved net income.

 

 

27

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***Net interest income***

 

The following table sets forth a comparison of average balances ofassets and liabilities and their related net tax equivalent yields and ratesfor 2005, 2004 and 2003 (dollars in thousands):

 
| ** **                            | ** ** | **2005**    | ** ** | **2004**     | ** ** | **2003**   | ** ** |
|---------------------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| ** **                            | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| ** **                            | ** ** | **Balance** | ** ** | **Interest** | ** ** | **rate**   | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** |
| Interest-earning assets               |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits             |       | $           | 540        |         | $          | 14         |       | 2.67 | % | $ | 637 |   | $ | 6 |   | 0.93 | % | $ | 761 |   | $ | 6 |   | 0.79 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                          |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies              |       | 31,976      |       | 1,171        |       | 3.66       |       | 36,360 |   | 1,333 |   | 3.67 |   | 26,550 |   | 1,035 |   | 3.90 |   |
| Mortgage-backed securities            |       | 54,257      |       | 2,328        |       | 4.29       |       | 73,939 |   | 3,029 |   | 4.10 |   | 99,050 |   | 3,451 |   | 3.48 |   |
| State and municipal                   |       | 13,203      |       | 837          |       | 6.34       |       | 11,618 |   | 739 |   | 6.36 |   | 10,953 |   | 716 |   | 6.53 |   |
| Other                                 |       | 14,126      |       | 643          |       | 4.55       |       | 10,213 |   | 291 |   | 2.85 |   | 8,206 |   | 241 |   | 2.94 |   |
| Total investments                     |       | 113,562     |       | 4,979        |       | 4.38       |       | 132,130 |   | 5,392 |   | 4.08 |   | 144,759 |   | 5,443 |   | 3.76 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans:                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                            |       | 216,385     |       | 13,646       |       | 6.31       |       | 223,660 |   | 12,172 |   | 5.44 |   | 212,351 |   | 11,813 |   | 5.56 |   |
| Consumer                              |       | 53,675      |       | 3,548        |       | 6.61       |       | 47,030 |   | 3,321 |   | 7.06 |   | 51,836 |   | 3,879 |   | 7.48 |   |
| Real estate                           |       | 120,407     |       | 7,237        |       | 6.01       |       | 113,589 |   | 6,737 |   | 5.93 |   | 117,939 |   | 7,386 |   | 6.26 |   |
| Direct financing leases               |       | 1,387       |       | 83           |       | 6.01       |       | 3,013 |   | 201 |   | 6.66 |   | 4,546 |   | 319 |   | 7.02 |   |
| Credit cards                          |       | —      |       | —       |       | —     |       | — |   | — |   | — |   | 427 |   | 43 |   | 10.13 |   |
| Total loans                           |       | 391,854     |       | 24,514       |       | 6.26       |       | 387,292 |   | 22,431 |   | 5.79 |   | 387,099 |   | 23,440 |   | 6.06 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                    |       | 1,866       |       | 49           |       | 2.60       |       | 1,530 |   | 17 |   | 1.13 |   | 3,919 |   | 46 |   | 1.17 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total earning assets                  |       | $           | 507,822    |         | $          | 29,556     |       | 5.82 | % | $ | 521,589 |   | $ | 27,846 |   | 5.34 | % | $ | 536,538 |   | $ | 28,935 |   | 5.39 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities          |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                             |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                               |       | $           | 48,273     |         | $          | 450        |       | 0.93 | % | $ | 41,860 |   | $ | 219 |   | 0.52 | % | $ | 40,439 |   | $ | 255 |   | 0.63 | % |
| NOW                                   |       | 52,244      |       | 666          |       | 1.28       |       | 37,312 |   | 121 |   | 0.32 |   | 39,949 |   | 173 |   | 0.43 |   |
| MMDA                                  |       | 24,183      |       | 438          |       | 1.81       |       | 30,394 |   | 383 |   | 1.26 |   | 18,584 |   | 243 |   | 1.31 |   |
| Time deposits < $100,000           |       | 85,612      |       | 2,534        |       | 2.96       |       | 99,390 |   | 3,020 |   | 3.04 |   | 117,852 |   | 4,602 |   | 3.90 |   |
| Time deposits > $100,000           |       | 89,076      |       | 2,821        |       | 3.17       |       | 105,813 |   | 2,974 |   | 2.81 |   | 132,630 |   | 4,732 |   | 3.57 |   |
| Clubs                                 |       | 1,781       |       | 19           |       | 1.07       |       | 1,759 |   | 19 |   | 1.08 |   | 1,727 |   | 26 |   | 1.50 |   |
| Total deposits                        |       | 301,169     |       | 6,928        |       | 2.30       |       | 316,528 |   | 6,736 |   | 2.13 |   | 351,181 |   | 10,031 |   | 2.86 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Repurchase agreements                 |       | 35,106      |       | 634          |       | 1.81       |       | 41,695 |   | 464 |   | 1.11 |   | 41,355 |   | 503 |   | 1.22 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowed funds                        |       | 82,114      |       | 4,159        |       | 5.06       |       | 78,318 |   | 3,980 |   | 5.08 |   | 69,471 |   | 3,703 |   | 5.33 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities    |       | $           | 418,389    |         | $          | 11,721     |       | 2.80 | % | $ | 436,541 |   | $ | 11,180 |   | 2.56 | % | $ | 462,007 |   | $ | 14,237 |   | 3.08 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                   |       |        |       | $            | 17,835     |       |       |   |   |   | $ | 16,666 |   |   |   |   |   | $ | 14,698 |   |   |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest spread                   |       |        |       |         |       | 3.02       | %          |   |   |   |   | 2.78 | % |   |   |   |   | 2.31 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin                   |       |        |       |         |       | 3.51       | %          |   |   |   |   | 3.20 | % |   |   |   |   | 2.74 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total average assets                  |       | $           | 536,262    |         |       |       |       |   | $ | 550,223 |   |   |   |   |   | $ | 571,429 |   |   |   |   |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average non-interest bearing deposits |       | $           | 67,093     |         |       |       |       |   | $ | 66,006 |   |   |   |   |   | $ | 60,985 |   |   |   |   |   |

 

In the above table, interest income wasadjusted to a tax-equivalent basis to recognize the income from tax-exempt interest-earningassets as if the interest was taxable. This treatment allows a uniformcomparison between yields on interest-earning assets. The calculations werecomputed on a fully tax-equivalent basis using the corporate federal tax rateof 34%. Loans include loans AFS and non-accrual loans but exclude the allowancefor loan losses. Within consumer loans, direct financing leases are presentednet of unearned interest.

 

Average balances are based on amortized costand do not reflect unrealized gains or losses. Net interest rate spread representsthe difference between the average yield on average interest-earning assets andthe average cost of average interest-bearing liabilities. Net interest margin representsnet interest income divided by total average interest-earning assets.

 

Changes in net interest income are a function of both changes in interestrates and changes in volume of interest-earning assets and interest-bearingliabilities. The following table presents the extent to which changes ininterest rates and changes in volume of interest-earning assets andinterest-bearing liabilities have affected the Bank’s interest income andinterest expense during the periods

 

28

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indicated. Information is provided in each category with respect to (1)the changes attributable to changes in volume (changes in volume multiplied by theprior period rate), (2) the changes attributable to changes in interest rates(changes in rates multiplied by prior period volume) and (3) the net change. Thecombined effect of changes in both volume and rate has been allocatedproportionately to the change due to volume and the change due to rate. Tax-exemptincome was not converted to a tax-equivalent basis on the rate/volume analysis(dollars in thousands):

 
| ** **                                                                | ** ** | **Years ended December 31,**   | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                | ** ** | **2005 Compared to 2004**      | ** ** | **2004 Compared to 2003** | ** ** |
| ** **                                                                | ** ** | **Increase (decrease) due to** | ** ** | **Increase (decrease) due to** | ** ** |
| ** **                                                                | ** ** | **Volume**                     | ** ** | **Rate** | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Interest income:                                                          |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Loans and  leases:                                                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage                                                                  |       | $                              | 409        |   | $ | 91 |   | $ | 500 |   | $ | (268 | ) | $ | (381 | ) | $ | (649 | ) |
| Commercial                                                                |       | (375                           | )          | 1,778 |   | 1,403 |   | 605 |   | (195 | ) | 410 |   |
| Consumer                                                                  |       | 294                            |       | (182 | ) | 112 |   | (484 | ) | (245 | ) | (729 | ) |
| Total loans and  leases                                                   |       | 328                            |       | 1,687 |   | 2,015 |   | (147 | ) | (821 | ) | (968 | ) |
| Investment  securities, interest- bearing deposits and federal funds sold |       | (800                           | )          | 410 |   | (390 | ) | (1,042 | ) | 943 |   | (99 | ) |
| Total interest  income                                                    |       | $                              | (472       | ) | $ | 2,097 |   | $ | 1,625 |   | $ | (1,189 | ) | $ | 122 |   | $ | (1,067 | ) |
|                                                                      |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest  expense:                                                        |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                 |       |                           |       |   |   |   |   |   |   |   |   |   |   |
| Certificates of  deposit greater than $100,000                            |       | $                              | (823       | ) | $ | 680 |   | $ | (143 | ) | $ | (858 | ) | $ | (900 | ) | $ | (1,758 | ) |
| Other                                                                     |       | 25                             |       | 310 |   | 335 |   | (184 | ) | (1,353 | ) | (1,537 | ) |
| Total deposits                                                            |       | (798                           | )          | 990 |   | 192 |   | (1,042 | ) | (2,253 | ) | (3,295 | ) |
| Other  interest-bearing liabilities                                       |       | (100                           | )          | 449 |   | 349 |   | 337 |   | (99 | ) | 238 |   |
| Total interest  expensee                                                  |       | $                              | (898       | ) | $ | 1,439 |   | $ | 541 |   | $ | (705 | ) | $ | (2,352 | ) | $ | (3,057 | ) |
| Net interest  income                                                      |       | $                              | 426        |   | $ | 658 |   | $ | 1,084 |   | $ | (484 | ) | $ | 2,474 |   | $ | 1 ,990 |   |

 

The yield curve, which flattened in 2004 and continued to flatten (mid-and long-term rates rising much slower than short-term rates), in 2005 presentedchallenges in 2005 that will likely continue in 2006. The Federal Reserve Bank increasedthe discount rate eight times in 2005. The discount rate is the rate at whichthe Federal Reserve Bank lends overnight funds to banks. In response to theseactions, national prime also increased during of 2005. National prime, thebenchmark rate banks use to set rates on various lending and other interestsensitive products, also increased eight times, at 25 basis point incrementseach, for a total increase of 200 basis points from 5.25% at December 31, 2004to 7.25% at December 31, 2005.

 

The weighted-average national prime rate increased to 6.19% in 2005compared to 4.34% in 2004. This difference has continued to increase the yieldon the Bank’s interest-earning assets that had largely begun in 2004 continuedinto 2005 and should continue into 2006 as new product is originated andvariable-rate loans re-price to these higher rates.

 

As market rates rise along with the increase in national prime, loanoriginations, renewing commercial and residential loans and lines of credit shouldprice above the average 2005 portfolio yields. In addition, the increase in theTreasury yields and other capital market rates could have a favorable impact onthe Bank’s total investment portfolio by increasing yields which had begunduring the latter part of 2004 and should continue within this rising rateenvironment. As expected, the relative and predominant higher interest rateenvironment during 2005 had a positive influence on the Bank’s interest-earningassets. Total interest income increased 5.9%, from $27,395,000 in 2004 to $29,020,000in 2005 and further, caused the tax-equivalent yield on earning assets to increase48 basis points. The Bank should continue to see an increase in thetax-equivalent yield on its interest-earning assets during the current increasinginterest rate environment.

 

29

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Interest expense increased $541,000, or 4.8%, from $11,180,000 in 2004to $11,721,000 in 2005. The cost of interest-bearing liabilities increased 24basis points in 2005. The increased interest rate environment, in particular atthe short- to mid-term range of the yield curve required the Bank to increaseoffering rates on most deposit products. The bulk of the rate increasesimpacted the Bank’s interest expense during 2005’s fourth quarter where interestexpense grew $568,000 compared to the fourth quarter of 2004. Of this increase,approximately $388,000 was from deposits. Partially offsetting the increases inrates paid on interest-bearing deposit liabilities was an overall decrease inthe average-balances on which they are paid. Average balances in deposits decreased$15,359,000 during 2005, consisting of a $30,515,000 decrease from high-costingtime deposits and an increase in lower costing savings, club and transactionalinterest-bearing deposits of $15,156,000. The increase in these lower costingcore deposits coupled with the decline in time deposits helped contain theinterest expense increase in deposits to $192,000 for the year ended 2005 comparedto the year ended 2004. The weighted-average interest rate paid on borrowedfunds decreased two basis points in 2005 compared to 2004. The Bank paid off$5,000,000 of matured high costing FHLB borrowings at the end of 2004 which hadthe effect or reducing the overall 2005 rate paid on this funding source. Theincrease in offering rates of the Bank’s repurchase agreements (repo) was theprincipal reason for the $170,000 increase in repo interest expense.

 

As a result of the mix of the Bank’s interest sensitive assets andliabilities and the varying affects that the slope of the interest rate yieldcurve has had during 2005, net interest income increased $1,084,000, or 6.7%, from$16,215,000 in 2004 to $17,299,000 in 2005. On a tax-equivalent basis, the netinterest rate spread improved 24 basis points from 2.78% to 3.02% and thetax-equivalent margin improved 31 basis points, from 3.20% in 2004 to 3.51% in2005, respectively.

 

***Provision for loan losses***

 

The provision for loan losses represents the necessary amount to chargeagainst current earnings, the purpose of which is to increase the allowance forloan losses to a level that represents Management’s best estimate of known andinherent losses in the Bank’s loan portfolio. Loans and leases determined to beuncollectible are charged-off against the allowance for loan losses.

 

The required amount of the provision for loan losses, based upon theadequate level of the allowance for loan losses, is subject to ongoing analysisof the loan portfolio. The Bank’s Special Asset Committee meets periodically toreview problem loans and leases. The committee is comprised of Bank Management,including the chief risk officer, loan workout officers and collectionpersonnel. The committee reports quarterly to the Credit AdministrationCommittee of the Board of Directors.

 

Management continuously reviews the risks inherent in the loan andlease portfolio. Specific factors used to evaluate the adequacy of the loanloss provision during the formal process include:

 

•      Specificloans that could have loss potential

•      Levelsof and trends in delinquencies and non-accrual loans

•      Levelsof and trends in charge-offs and recoveries

•      Trendsin volume and terms of loans

•      Changesin risk selection and underwriting standards

•      Changesin lending policies, procedures and practices

•      Experience,ability and depth of lending management

•      Nationaland local economic trends and conditions

•      Changesin credit concentrations

 

The provision for loan losses was $830,000, for the year ended December31, 2005, compared to $2,150,000 in 2004. As a result, the allowance for loanlosses was $5,985,000 at December 31, 2005, compared to $5,988,000 at December31, 2004. The significant reduction in the provision was due to the improvedquality of the portfolio coupled with a decline in loans migrating to non-performing status. Non-performing loans, which consist of loans past due 90days or more and non-accrual loans declined $811,000, or 7.7%, to $9,650,000 atDecember 31, 2005, from $10,461,000, at December 31, 2004. The reduction wasboth in non-accrual loans which declined by $451,000 to $9,453,000 at December31, 2005, and a decline of $360,000 in loans past due 90 days or more and stillaccruing. Additions to the commercial lending staff resulted in improvedmanagement of the loan portfolio which enabled us to follow up sooner ondelinquent loans thereby reducing the level of delinquencies and preventingtheir migration to non-accrual status.

 

30

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***Other income***

 

Other (non-interest) income consists of service charges or fees collectedon the Bank’s various deposit and loan products, net mortgage servicingrevenue, fees from trust, asset management and other financial services, theincrease in the cash surrender value of bank owned life insurance, the realizedgains and losses from the sales of investment securities, loans, leased assetsand foreclosed assets held-for-sale and other various classifications ofnon-interest related income.

 

For the year ended December 31, 2005, other income was $4,165,000, or essentiallyunchanged from 2004. A $432,000 increase in charges on deposit accounts andloan fees and net gains from the sales of ORE properties largely offset lowernet gains from the sales of investment securities and mortgage loans, declinesin fees earned from trust and asset management services and increased lossesfrom the final sales of terminated leased automobiles. Most of the loansoriginated for sale into the secondary market began in the second half of 2005at the time when levels and interest rates on new fixed-rate loan originationsbegan to increase to a point that loan retention did not support the Bank’sinterest rate risk profile. The Bank’s automobile leasing program has expiredand there are no intentions to re-enter the automobile leasing business. Resultsof operations from this portfolio have substantially concluded with the finalterminated leased vehicle disposed of in December 2005. In 2006, no more lossesfrom the sales of leased vehicles are expected, however there may be aninsignificant amount of residual insurance from claims that were submitted in2005.

 

***Other expense***

 

For the twelve months ended December 31, 2005, other operating expenseswere $14,577,000 or $750,000 more than the $13,827,000 recorded in the sameperiod of 2004. Salary and employee benefit costs increased $327,000, or 5%,for the twelve months ended December 31, 2005 compared to the same period in2004. The increase was primarily due to filling vacancies in key functionalareas and annual merit and incentive increases.

 

Premises and equipment increased $123,000, or 4%, in 2005 compared to2004. Of this increase, equipment maintenance increased by approximately$95,000 due to more repairs in 2005 and increases related to maintenancecontract renewals.

 

Advertising and marketing related expenses increased $190,000, or 44%,during the year ended 2005 compared to the year ended 2004. The increase wasrelated to a number of new and increased marketing activities during 2005including: a significant increase in the volume of mass mailing resulted fromthe utilization of a new marketing software system, that helps identify andtarget specific demographic profiles in a defined marketing area; more advertisingspending due to a wide variety of campaigns capitalizing on marketopportunities; more costs related to point-of-sale signage due to the completionof rolling out a merchandising system and finally, during 2005, the Bank tookadvantage of more sponsorship opportunities, and participated in more communityevents than in 2004. Finally, a redesigned website went on-line in Septemberthat offered our customers an interactive means to both open new accounts andcommunicate with the Bank as well as performing numerous customer-initiatedtransactions. The focus in 2006 will be to grow and strengthen our existingcustomer relationships, while building profitable deposit, loan and financialservices with newly acquired customers.

 

The increase in all other components of other operating expenses wasprimarily caused by $146,000 more professional service fees incurred in 2005compared to 2004 related to increases for the annual independent financialaudit, costs related to the pre-implementation of the Sarbanes-Oxley §404 complianceprocess and costs for participation in the Bank-wide management skills developmentand sales training programs. Components of other operating expense also includeoffice supplies, printing, communications and data processing which did notvary significantly for the twelve months ended December 31, 2005 compared tothe same period in 2004.

 

The ratio of non-interest expense less non-interest income to averageassets at December 31, 2005 and 2004 was 1.93% and 1.69%, respectively. Theincrease was caused predominantly by higher expenses but continues to performfavorably compared to the Uniform Bank Performance Report peer comparisongroups.

 

***Provision for income taxes***

 

Income before provision for income taxes in 2005 increased $1,658,000 from2004. The effective federal income tax rate was 24.2% and 23.5% for the yearsending December 31, 2005 and 2004, respectively. The effective tax rate increaseis attributed to a combined increase in pre-tax earnings and a decrease in tax-freeinterest income.

 

31

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***Comparisonof Financial Condition as of December 31, 2004 and 2003***

 

***Deposits***

 

Total deposits decreased $35,827,000, or 9%, during 2004 to$365,315,000. Total average deposits decreased $29,619,000, or 7%, from$412,068,000 at December 31, 2003 to $382,449,000 at December 31, 2004. The decreasein deposits was primarily due to a $36,911,000 decrease in CDs to $184,683,000at December 31, 2004 from $221,595,000 at December 31, 2003. Core depositsdecreased $16,956,000, or 6%, during 2004 to $271,629,000. Approximately$18,000,000 of this decline was caused by time deposit run-off. NOW and moneymarket accounts decreased $2,869,000 and $678,000, respectively whilenon-interest bearing and savings deposits increased $4,631,000, in total. However,on average, money market accounts increased $11,800,000. In 2003, the Bankdeveloped a tiered money market checking account which customers foundattractive through 2004 and helped capture time deposit run-off. The averagebalance of DDAs increased $5,056,000, or 8%, during 2004.

 

During 2004, the Bank’s deposit mix continued to be heavilyconcentrated in time deposits but relative to total deposits, continued itsdownward trend. As of December 31, 2004, time deposits represented 51% of totaldeposits, down from 55% at December 31, 2003.

 

***Short-term borrowings***

 

Customer liquidity, investment needs and negotiatedinterest rates caused a net increase in repos from $39,363,000 at December 31,2003, to $40,684,000 at December 31, 2004. Funding requirements of the Bank,due largely to the reduction in deposits, necessitated $8,760,000 in overnightborrowings from the FHLB, at December 31, 2004. FHLB overnight borrowings atDecember 31, 2003 amounted to $14,920,000.

 

***Long-term debt***

 

The weighted-average rate on funds borrowed atDecember 31, 2004, was 5.06%. The weighted-average rate was 28 basis pointsbelow the tax-equivalent yield of 5.34% on average earning-assets for the yearended December 31, 2004. Rates on $58,000,000 of long-term debt advances are fixedbut may adjust quarterly, should market rates increase beyond the issue’soriginal rate. At December 31, 2004, similar FHLB advances were 261 basispoints below the average rate paid by the Bank.

 

During the third quarter of 2004, the Bank enteredinto a leveraged transaction and borrowed a total of $5,000,000 to purchasepreferred term securities. The three-month interest rate reset intervals forboth the purchased securities and the borrowing that funded them, are evenlymatched and therefore will be accretive to earnings. The new borrowings maturein 2006 and 2007 and carried a weighted-average interest rate of 2.61% atDecember 31, 2004. In addition, during the fourth quarter of 2004, the Bankpaid off a matured $5,000,000 borrowing that carried an interest rate of 5.92%.The effect of these transactions helped reduce the overall weighted-averagerate of the Bank’s long term debt.

 

***Accrued expenses and otherliabilities***

 

Time deposit run-off and rate reductions on high-costfunds caused accrued interest payable to decrease from $1,270,000 at December 31,2003, to $985,000 at December 31, 2004.

 

At December 31, 2004, other liabilities included abalance due on a $453,000 retirement obligation recorded in the second half of2004. The liability represented the present value of an obligation for certainbenefits, to be paid periodically in future years.

 

***Investments***

 

Total investments declined $23,985,000, net of a $170,000 appreciationin the market value of AFS investments. The carrying value of investmentsecurities, at December 31, 2004, was $115,669,000, or 22%, of total assetscompared to $139,654,000, or 24%, as December 31, 2003. At December 31, 2004approximately 56% of the investment portfolio was comprised of mortgage-backedsecurities that amortize and provide monthly cash flow. At that same time,agency bonds and municipal bonds comprised 26% and 10% of the investmentportfolio, respectively. During 2004, the Bank increased its position inpreferred term securities. See the discussion under “Long-term debt” above fora further discussion on this transaction. Preferred Term Securities, Ltd. poolstrust preferred securities issued by banks and insurance companies. Theseissuers utilize trust preferred securities because they are afforded favorablecapital treatment and provided a tax deduction for the interest paid. PreferredTerm Securities, Ltd., in turn, issue securities

 

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that are backed by obligations of these issuers, which are asset backedsecurities that have multiple classes, each with different credit ratings. Thefact that these securities are backed by multiple issuers with geographicdispersion, have size limits per issuer which enhance credit appeal, affordedlower regulatory risk-weighting and float without a cap at three-month LIBORmake these securities attractive within a low interest rate environment.

 

With the relatively low, but increasing, market interest rateenvironment throughout 2004, higher yielding U.S. Government Agency bonds alongwith state and municipal securities of $14,195,000 were called. This comparesto $24,810,000 in 2003 and $90,600,000 in 2002. The increase in the U.S.Treasury yields during the second half of 2003 resulted in a decrease inrefinance activity and related cash flows during the fourth quarter of 2003 andcontinued during 2004. As a result, prepayments on the Bank’s portfolio ofmortgage-backed securities had subsided significantly. Prepayments during 2004amounted to $18,643,000, compared to $60,127,000 in 2003.

 

During the first half of 2004, interest rates throughout the yieldcurve increased. The Federal Open Market Committee raised short-term interestrates five times (125 basis points) since the end of June 2004. Whileshort-term U.S. Treasury yields had shown somewhat similar increases during thesecond half of 2004, medium- and long-term rates had somewhat decreasedresulting in a flattening of the yield curve. Accordingly, the Bank used asignificant amount of the cash flows from its investment portfolio to fundhigh-cost time deposit outflow and repayment of overnight borrowings ratherthan redeploy the funds in the securities markets.

 

The tax-equivalent yield on debt securities by stated maturity date atDecember 31, 2004, was as follows:

 
| ** **                         | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------|------------|-----------------|------------|------------------|------------|---------------|------------|------------|------------|
| ** **                         | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies           |       | —%      |       | 3.02%           |       | 3.12%            |       | 3.98%         |       | 3.32%      |       |
| Mortgaged-backed securities        |       | —       |       | 5.40            |       | 3.66             |       | 4.85          |       | 4.48       |       |
| State & municipal subdivisions |       | —       |       | 5.66            |       | 4.93             |       | 5.84          |       | 5.71       |       |
| Preferred term securities          |       | —       |       | —          |       | —           |       | 4.12          |       | 4.12       |       |
| Total debt securities              |       | 0.00%        |       | 3.37%           |       | 3.46%            |       | 4.79%         |       | 4.26%      |       |

 

In the above table, the bookyields on state & municipal subdivisions were adjusted to a tax-equivalentbasis using the corporate federal tax rate of 34%.In addition, average yields on securities AFSare based on amortized cost and do not reflect unrealized gains or losses.

 

***Loans and leases***

 

Loans and leases, net of unearned income, increased $15,555,000, or4.2%, from $371,979,000 at December 31, 2003, to $387,534,000 at December 31,2004. Gross loans represented 72.2% of total assets at December 31, 2004.

 

In 2004, the Bank originated $34,981,000 of commercial loans,$31,368,000 of mortgage loans, including $13,066,000 of unfunded real estateconstruction lines, and $19,671,000 of consumer loans. This compares to$37,797,000, $40,028,000 and $24,041,000, respectively, in 2003. In additionfor 2004, the Bank committed to additional funding in the amounts of$20,799,000 for commercial borrowers, $10,489,000 in home equity lines and$83,000 for consumer borrowers. The increase in the portfolio was primarily inresidential real estate due the transfer of mortgage loans fromavailable-for-sale to the loan portfolio which is described in more detail inthe, “Loans available-for-sale,” section, below.

 

Loan refinancing to lower interest rates that began in 2002 andaccelerated through 2003 had subsided in 2004 - in response to anticipatedincreases in short-term interest rates and volatility in the mid- and long-termrates of the yield curve. The Bank expects the loan pre-payment and refinanceactivity to be minimal in the near-term.

 

*Commercial and Commercial RealEstate Loans**:*

 

Net of scheduled principal curtailments (run-off), loan participationsales and pre-payments, commercial loans increased $692,000 during 2004. Thisincrease was primarily due to increased lending within the small businesscommunity.

 

Tax-free industrial development loans increased from $9,020,000 atDecember 31, 2003 to $9,898,000 at December 31, 2004. The increase in thissector was due mainly to fund loans to local municipalities for variousinfrastructure and sustaining projects.

 

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*Residential Real Estate Loans*:

 

Residential real estate loans increased $14,217,000, or 18.4%, to$91,294,000. These loans increased due to the transfer, from theavailable-for-sale to the loan portfolio which is described in more detail inthe, “Loans available-for-sale,” section, below. In addition, originations of theseloans remained strong due to the sustained relative low interest rateenvironment.

 

*Consumer Loans and DirectFinancing Leases**:*

 

Consumer loans and direct-financing leases decreased $2,905,000, or4.4%, during 2004. The home equity installment loan portfolio, included withinthe consumer loans, experienced declines due to prior year’s refinancing intolower rate mortgages. In addition, the combined effect of run-off and decisionto no longer originate direct financing leases brought about the overall declinein consumer loans.

 

*Real Estate Construction Loans**:*

 

Real estate construction loans increased $3,353,000, or 46.1%, during2004. Real estate construction loans consisted of $8,095,000 for residentialconstruction and $2,526,000 for commercial real estate construction.

 

***Loans available-for-sale***

 

Loans AFS, at December 31, 2004, were $576,000, with a correspondingfair value of $582,000 compared to $19,864,000 and $20,501,000, respectively atDecember 31, 2003. During the second quarter of 2004, the Bank transferredhigher yielding mortgage loans with relatively short lives and aggregateprincipal balances of $11,246,000 and aggregate market values of $11,446,000from AFS to its loan portfolio. Similarly, during the third quarter of 2004,the Bank transferred SBA loans, with aggregate principal and market values of$1,561,000 and $1,634,000, respectively, from AFS to its loan portfolio. Inboth cases, the loans were transferred at the lower of cost or estimated marketvalue and therefore, no gain or loss was recognized. The Bank has both theability and intent to hold these loans until maturity and they will continue toprovide the Bank with yields in excess of the rates in effect at the time oftransfer. By transferring the loans from the AFS to the loan portfolio, theBank will no longer be required to apply lower of cost or market treatment tothe principal balances. Had the transferred loans remained in the AFSportfolio, in an increasing interest rate environment, the loans could attainmarket values significantly below their principal balances and, as a result,could create a significant drag on current earnings. During 2004, residentialmortgages, student loans and SBA loans with principal balances of $14,307,000,$1,128,000 and $61,000, respectively were sold into the secondary market andgains of approximately $195,000 have been recognized.

 

***Bank premises and equipment, net***

 

The Bank’s premises and equipment decreased $929,000 due primarily todepreciation. During 2004, the Bank purchased approximately $278,000 inequipment compared to $621,000 in 2003.

 

***Foreclosed******assets held for sale***

 

Real estate acquired through foreclosure decreased by $231,000, due tothe sale of foreclosed properties during the year. An increase in theturn-around time on sales of repossessed vehicles has resulted in a netdecrease of $23,000 in other repossessed assets.

 

***Comparisonof the Results of Operations for the Years December 31, 2004 and 2003***

 

***Results of Operations***

 

***Net interest income***

 

The Federal Reserve Bank increased the discount rate five times in 2004.In response to these actions, national prime increased during the second halfof 2004. National prime increased five times at 25 basis point increments each,for a total increase of 1.25% from 4.00% at December 31, 2003 to 5.25% atDecember 31, 2004.

 

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There was a 22 basis point differential between the weighted-averagerate of national prime in 2004 compared to 2003. The weighted-average rate ofnational prime in 2004 and 2003 was 4.34% and 4.12%, respectively. Thisdifference increased the yield on the Bank’s interest-earning assets as newproduct was originated and variable-rate loans re-priced to higher rates.

 

The increase in the U.S. Treasury yields during the second half of 2003resulted in a decrease in refinance activity and related cash flows during thelatter part of 2003 which continued during 2004. As market rates rose alongwith the increase in national prime, loan originations, renewing commercial andresidential loans and lines of credit priced above the average 2003 portfolioyields. In addition, Treasury yields and slowing mortgage refinance activitypositively impact the investment portfolio, increasing yields which had begunduring the third quarter of 2004. The predominant low interest rate environmentduring 2004, resulting from economic conditions, had a negative affect onearning assets, causing total interest income to decrease 3.8%, from$28,462,000 in 2003 to $27,395,000 in 2004 and further caused thetax-equivalent yield on earning assets to decrease 5 basis points.

 

Interest expense decreased 21.5%, from $14,237,000 in 2003 to$11,180,000 in 2004. The cost of interest-paying liabilities decreased 52 basispoints in 2004. Rates paid on maturing time and retained transactional depositproducts were reduced to market deposit rates throughout 2004. However, certaincontractual based, long-term time deposit products and borrowings, which mustreach maturity before they can re-price, continued to pay at above market rates.The low-cost overnight funding needs and the addition of the low-costing$5,000,000 FHLB borrowings during the third quarter and the payoff of thehigher costing $5,000,000 FHLB borrowing in the fourth quarter helped reducethe average cost of these funding sources 25 basis points.

 

As a result, net interest income increased $1,990,000, or 14%, from$14,225,000 in 2003 to $16,215,000 in 2004. On a tax-equivalent basis, the netinterest rate spread improved 47 basis points from 2.31% to 2.78% and thetax-equivalent margin improved 36 basis points, from 2.74% in 2003 to 3.20% in2004.

 

***Provision for loan losses***

 

The provision for loan losses was $2,150,000, for the year endedDecember 31, 2004, compared to $3,715,000 in 2003. As a result, the allowancefor loan losses was $5,988,000 at December 31, 2004, compared to $4,997,000 atDecember 31, 2003. Non-performing loans increased $2,180,000, or 26%, to$10,461,000 at December 31, 2004, from $8,281,000, at December 31, 2003. Ofthis increase, non-accrual loans increased $2,581,000 in 2004. The amountprovided for loan losses, for the year ended December 31, 2004, was driven byincreasing the allowance for loan losses to match the risk profile inherent tothe loan portfolio.

 

***Other income***

 

For the year ended December 31, 2004, other income was $4,161,000 or$22,000 less than the $4,183,000 recorded in 2003. Of this decreaseapproximately $404,000 was related to a decline in net gains recognized fromthe sales of loans AFS into the secondary market. The decline in loan sales wasthe result of the slowing of the mortgage refinance activity that waspropelled, during 2003, by relatively low interest rates and the anticipatedrise in interest rates on mortgage and other loan products. In addition,recognized net gains from sales of securities AFS declined from $329,000 in2003 to $9,000 in 2004. Partially offsetting these decreases was growth inservice charges on deposit related accounts by approximately $309,000 in 2004compared to 2003. During 2004, the Bank’s trust and asset management servicescombined for an increase in fees of $59,000 compared to 2003.

 

Items further impacting other income included the reduction in recordedlosses on sales of full-term leased assets in the amount of $291,000 for thetwelve months ended December 31, 2004. This compares to losses in 2003 of$409,000. In addition, amortization of mortgage servicing rights (an offsetservice fee income) declined $206,000 for the year ended 2004 compared to 2003.The decrease was due to the lower volume of mortgage prepayments and mortgagere-financing in 2004.

 

***Other expense***

 

For the twelve months ended December 31, 2004, other operating expenseswere $13,827,000 or $924,000 more than the $12,903,000 recorded in the sameperiod of 2003. Salary and employee benefit costs increased $366,000 for thetwelve months ended December 31, 2004 compared to the same period in 2003. Theincrease was primarily due to the staffing of new key management positions aswell as annual merit increases on compensation costs and the relatedincremental payroll taxes thereon. In addition, the Bank continued toexperience escalating costs of various employee benefit programs. In 2004, thecost to provide health insurance premiums to the Bank’s employees increased 21%from 2003. Advertising expenses increased $95,000, or 28%, during the year

 

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ended 2004 compared to the year ended 2003. The increase in advertisingwas due to implementation of direct marketing programs with focus on brandawareness and the acquisition of core deposits. A more scientific approach tobuying media was instituted, using various marketing models to reach a moretargeted audience. This led to the purchase of alternative media resources,such as television spots and “screen vision” at a local unaffiliated movietheater complex that it did not use during 2003. In addition, the Bank usedmore radio advertising in 2004 compared to 2003. The increase in the otheroperating expenses was primarily the result of recording an incrementalobligation related to the retirement benefit for the Company’s former chairmanand president in the amount of $476,000. The retirement benefit represents apresent value obligation for certain benefits, to be paid periodically in thefuture, that include payments, reduced by appropriate taxes, and estimatedmedical insurance reimbursements.

 

The ratio of non-interest expense less non-interest income to averageassets at December 31, 2004 and 2003 was 1.69% and 1.68%, respectively. Thisratio performed favorably to the Uniform Bank Performance Report peercomparison groups.

 

***Provision for income taxes***

 

Income before provision for income taxes in 2004 increased $2,610,000from 2003. The effective federal income tax rate was 23.5% and 8.2% for theyears ending December 31, 2004 and 2003, respectively. The effective tax rateincrease is contributed to a decreased portion of combined tax-free interestincome from municipal securities, tax-free loans and tax-free earnings from theBOLI representing a smaller percentage of pre-tax earnings.

 

***Off-Balance Sheet Arrangements and Contractual Obligations***

 

The Company is a party to financial instruments with off-balance sheetrisk in the normal course of business in order to meet the financing needs of itscustomers and in connection with the overall interest rate management strategy.These instruments involve, to a varying degree, elements of credit, interestrate and liquidity risk. In accordance with GAAP, these instruments are eithernot recorded in the consolidated financial statements or are recorded inamounts that differ from the notional amounts. Such instruments primarilyinclude lending commitments, lease obligations and derivative instruments.

 

Lending commitments include commitments to originate loans andcommitments to fund unused lines of credit. Commitments to extend credit areagreements to lend to a customer as long as there is no violation of anycondition established in the contract. Commitments generally have fixedexpiration dates or other termination clauses and may require payment of a fee.Since some of the commitments are expected to expire without being drawn upon,the total commitment amounts do not necessarily represent future cashrequirements.

 

In addition to lending commitments, the Company has contractualobligations related to operating lease commitments. Operating lease commitmentsare obligations under various non-cancelable operating leases on buildings andland used for office space and banking purposes. The Bank does not expect toincur significant increases in lease payments on any of its existing leasedfacilities that would have a material impact on the Company’s results ofoperations.

 

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The following table presents, as of December 31, 2005, the Company’ssignificant determinable contractual obligations by payment date andsignificant commitments. The payment amounts represent those amountscontractually due to the recipient, excluding interest (dollars in thousands):

 
| ** **                | ** ** | ** ** | ** ** | ** **   | ** ** | **Over one**     | ** ** | **Over three**    | ** ** | ** **     | ** ** |
|---------------------------|------------|------------|------------|--------------|------------|------------------|------------|-------------------|------------|----------------|------------|
| ** **                | ** ** | ** ** | ** ** | **One year** | ** ** | **year through** | ** ** | **years through** | ** ** | **Over**       | ** ** |
| ** **                | ** ** | **Total**  | ** ** | **or less**  | ** ** | **three years**  | ** ** | **five years**    | ** ** | **five years** | ** ** |
|                      |       |       |       |         |       |             |       |              |       |           |       |
| Contractual  obligations: |       |       |       |         |       |             |       |              |       |           |       |
| Certificate of  deposits  |       | $          | 161,072    |         | $          | 107,156          |       | $                 | 33,944     |           | $          | 19,926 |   | $ | 46 |   |
| Long-term debt            |       | 83,704     |       | 11,168       |       | 19,536           |       | 48,000            |       | 5,000          |       |
| Repurchase  agreements    |       | 26,912     |       | 19,822       |       | 7,090            |       | —            |       | —         |       |
| Operating leases          |       | 5,125      |       | 357          |       | 647              |       | 620               |       | 3,501          |       |
|                      |       |       |       |         |       |             |       |              |       |           |       |
| Significant  commitments: |       |       |       |         |       |             |       |              |       |           |       |
| Letters of  credit        |       | 4,508      |       | 701          |       | 986              |       | —            |       | 2,821          |       |
| Loan commitments  *       |       | 11,220     |       | 11,220       |       | —           |       | —            |       | —         |       |
|                      |       |       |       |         |       |             |       |              |       |           |       |
| Total                     |       | $          | 292,541    |         | $          | 150,424          |       | $                 | 62,203     |           | $          | 68,546 |   | $ | 11,368 |   |

 

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* Available credit to borrowers in the amountof $56,700 is excluded from the above table since, by its nature, the borrowersmay not have the need for additional funding and therefore, the credit may ormay not be disbursed by the Bank.

 

***Related Party Transactions***

 

Information with respect to related parties is contained in Note 15, “RelatedParty Transactions” within the notes to the consolidated financial statements,and incorporated by reference in Part II, Item 8.

 

***Impact of Accounting Standards and Interpretations***

 

Information with respect to the impact of accounting standards iscontained in Note 18, “Recent Accounting Pronouncements” within the notes tothe consolidated financial statements, and incorporated by reference in PartII, Item 8.

 

***Impact of Inflation and Changing Prices***

 

The consolidated financial statements and notes thereto presentedherein have been prepared in accordance with GAAP, which require measurement ofour financial condition and results of operations in terms of historicaldollars without considering the changes in the relative purchase power of moneyover time due to inflation. The impact of inflation is reflected in theincreased cost of our operations. Unlike industrial businesses, most all of theCompany’s assets and liabilities are monetary in nature. As a result, interestrates have a greater impact on our performance than do the effects of generallevels of inflation as interest rates do not necessarily move in the samedirection or, to the same extent, as the price of goods and services.

 

***Capital Resources***

 

The Company is subject to various regulatory capital requirementsadministered by the federal banking agencies. Failure to meet minimum capitalrequirements can initiate certain mandatory and possible additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCompany must meet specific capital guidelines that involve quantitative measuresof the Company’s assets, liabilities and certain off-balance-sheet items ascalculated under regulatory accounting practices. The Company’s capital amountsand classification are also subject to qualitative judgments by the regulatorsabout components, risk weightings and other factors.

 

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Under these guidelines, assets and certain off-balance sheet items areassigned to broad risk categories, each with appropriate weights. The resultingcapital ratios represent capital as a percentage of total risk-weighted assetsand certain off-balance sheet items. The guidelines require all banks and bankholding companies to maintain a minimum ratio of total risk-based capital tototal risk-weighted assets (“Total Risk Adjusted Capital”) of 8%, includingTier I capital to total risk-weighted assets (“Tier I Capital”) of 4% and TierI capital to average total assets (“Leverage Ratio”) of at least 4%. Additionalinformation with respect to capital requirements is contained in Note 14, “RegulatoryMatters” within the notes to the consolidated financial statements, andincorporated by reference in Part II, Item 8.

 

The Company’s major source of capital has been from the retention ofequity in undistributed earnings of the Bank, as reflected below:

 
| ** ** | ** ** | **Net**    | ** ** | **Dividends** | ** ** | **Earnings** | ** ** |
|------------|------------|------------|------------|---------------|------------|--------------|------------|
| ** ** | ** ** | **income** | ** ** | **declared**  | ** ** | **retained** | ** ** |
|       |       |       |       |          |       |         |       |
| 2005       |       | $          | 4,591,697  |          | $          | 1,624,263    |       | $ | 2,967,434 |   |
| 2004       |       | 3,364,474  |       | 1,610,423     |       | 1,754,051    |       |
| 2003       |       | 1,643,248  |       | 1,601,898     |       | 41,350       |       |
| 2002       |       | 4,046,173  |       | 1,526,371     |       | 2,519,802    |       |
| 2001       |       | 3,848,136  |       | 1,426,097     |       | 2,422,039    |       |
|            |            |            |            |               |            |              |            |  |  |  |

 

Capital was further increased in 2005 through the Company’s DividendReinvestment Plan (DRIP). Shareholders reinvested $491,000 in dividends topurchase additional shares of stock. In addition, through the Employee StockPurchase Plan, employees invested approximately $32,000 in the Company’s commonstock in 2005.

 

Capital was negatively impacted by changes in market rates. The Bank’sinvestments, reacting to market changes, resulted in a $1,011,000 decline, netof deferred income taxes, in the fair value of AFS investments. At December 31,2004, the Bank reported a net unrealized loss of $101,000 on AFS securitiescompared to a net unrealized loss of $1,112,000 as of December 31, 2005. Fluctuationsin the capital markets may cause frequent changes in the fair value of AFS securities.Further declines in value of the Bank’s AFS securities should not be construedas a weakness in the capital position of the Company. The Company monitorsmarket conditions closely and is prepared to take remedial action whenappropriate.

 

During 2003, 12,720 shares of common stock became available on the openmarket. The Company purchased the stock for $458,000 with the intention toreissue the stock under the DRIP and Employee Stock Purchase Plan. During 2004,the remaining 5,227 shares of treasury stock were reissued under the DRIP andEmployee Stock Purchase Plan.

 

***Liquidity***

 

Liquidity management ensures that adequate funds will be available tomeet customers’ needs for borrowings, deposit withdrawals and maturities andnormal operating expenses of the Bank. Current sources of liquidity are cashand cash equivalents, asset maturities and pay-downs within one year, loans andinvestments AFS, growth of core deposits, growth of repurchase agreements,increases of other borrowed funds from correspondent banks and issuance ofcapital stock. Although regularly scheduled investment and loan payments are adependable source of daily funds, the sales of both loans and investments AFS,deposit activity, and investment and loan prepayments are significantlyinfluenced by general economic conditions and the level of interest rates.

 

At December 31, 2005, the Company maintained $12,595,000 in cash andcash equivalents. In addition, the Company had $429,000 of loans AFS and $95,682,000in investments AFS. This combined total of $108,706,000 represented 20% oftotal assets at December 31, 2005. Management believes this level of liquidity tobe strong and adequate and to support current operations.

 

The Company considers its primary source of liquidity to be its coredeposit base consisting of deposits from customers throughout the branchnetwork. The Company will continue to promote the acquisition of depositsthrough its branch offices and marketing efforts. At December 31, 2005,approximately 70% of the Company’s assets were funded by deposits and anadditional 9% of the assets were funded by the Company’s equity. The companyexpects to grow these two components, which provides a substantial and steadysource of funds.

 

As detailed in the statement of cash flows incorporated by reference,total cash and cash equivalents had a net increase of $2,378,000 during 2005.Cash from operations increased $6,762,000 fueled by increased earnings. The increasefrom financing activities was due

 

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principally to a net increase in deposits, partially offset by reducedborrowings. The use of funds in investing activities was due to increasedlending activities partially offset by cash inflow from reductions in theinvestment portfolio.

 

At December 31, 2005, the Bank had approximately $65,000,000 in unusedsources of borrowed funds available to meet liquidity requirements, if needed. Thesources were the approximated borrowing capacity at the Federal Reserve Bank ofPhiladelphia of $10,000,000 along with available funding at the FHLB of $55,000,000.

 

***Management of interest rate risk and market risk analysis***

 

The Company is subject to the interest rate risks inherent in ourlending, investing and financing activities. Fluctuations of interest rateswill impact interest income and interest expense along with affecting marketvalues of all interest-earning assets and interest-bearing liabilities, exceptfor those assets or liabilities with a short-term remaining to maturity. Interestrate risk management is an integral part of the asset/liability managementprocess. The Company has instituted certain procedures and policy guidelines tomanage the interest rate risk position. Those internal policies enable theCompany to react to changes in market rates to protect net interest income fromsignificant fluctuations. The primary objective in managing interest rate riskis to minimize the adverse impact of changes in interest rates on net interestincome along with creating an asset/liability structure that maximizesearnings.

 

*Asset/Liability Management*. Onemajor objective of the Company when managing the rate sensitivity of its assetsand liabilities is to stabilize net interest income. The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management and membersof the board of directors. ALCO meets quarterly to monitor the relationship ofinterest sensitive assets to interest sensitive liabilities. The process toreview interest rate risk is a regular part of managing the Company. Consistentpolicies and practices of measuring and reporting interest rate risk exposure,particularly regarding the treatment of non-contractual assets and liabilities,are in effect. In addition, there is an annual process to review the interestrate risk policy with the Board of Directors which includes limits on theimpact to earnings from shifts in interest rates.

 

*Interest Rate Risk Measurement.*Interestrate risk is monitored through the use of three complementary measures:  static gap analysis, earnings at risksimulation and economic value at risk simulation. While each of the interestrate risk measurements has limitations, taken together they represent areasonably comprehensive view of the magnitude of interest rate risk in theCompany and the distribution of risk along the yield curve, the level of riskthrough time and the amount of exposure to changes in certain interest raterelationships.

 

*Static Gap*. The ratio betweenassets and liabilities re-pricing in specific time intervals is referred to asan interest rate sensitivity gap. Interest rate sensitivity gaps can be managedto take advantage of the slope of the yield curve as well as forecasted changesin the level of interest rate changes.

 

To manage this interest rate sensitivity gap position, anasset/liability model called cumulative gap analysis is used to monitor the differencein the volume of the Company’s interest sensitive assets and liabilities thatmature or re-price within given periods. A positive gap (asset sensitive)indicates that more assets will re-price during a given period compared toliabilities, while a negative gap (liability sensitive) has the opposite effect.The Company employs computerized net interest income simulation modeling toassist in quantifying interest rate risk exposure. This process measures andquantifies the impact on net interest income through varying interest ratechanges and balance sheet compositions. The use of this model assists the ALCOto gauge the effects of the interest rate changes on interest sensitive assetsand liabilities in order to determine what impact these rate changes will haveupon the net interest spread. At December 31, 2005 the Bank maintained a one-yearcumulative negative gap of $35.0 million or -6.44% of total assets. The effectof this negative gap position provided a mismatch of assets and liabilities whichmay expose the Bank to interest rate risk during periods of increasing interestrates. Conversely, in a declining interest rate environment, net interest incomecould be positively impacted because more liabilities than assets will re-pricedownward during the one-year period.

 

Certain shortcomings are inherent in the method of analysis discussedabove and presented in the next table. Although certain assets and liabilitiesmay have similar maturities or periods of re-pricing, they may react indifferent degrees to changes in market interest rates. The interest rates oncertain types of assets and liabilities may fluctuate in advance of changes inmarket interest rates, while interest rates on other types of assets andliabilities may lag behind changes in market interest rates. Certain assets,such as adjustable-rate mortgages, have features which restrict changes ininterest rates on a short-term basis and over the life of the asset. In theevent of a change in interest rates, prepayment and early withdrawal levels maydeviate significantly from those assumed in calculating the table. The abilityof many borrowers to service their adjustable-rate debt may decrease in theevent of an interest rate increase.

 

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The following table reflects the re-pricing of the balance sheet or “gap”position at December 31, 2005 (dollars in thousands):

 
| ** **                                     | ** ** | **Interest sensitivity gap at December 31, 2005** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                     | ** ** | **Three months**                                  | ** ** | **Three to** | ** ** | **One to** | ** ** | **Over** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **or less**                                       | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total** | ** ** |
| Cash and cash  equivalents                     |       | $                                                 | 96         |   | $ | — |   | $ | — |   | $ | 12,499 |   | $ | 12,595 |   |
| Investment  securities (1)(2)             |       | 9,248                                             |       | 12,523 |   | 18,957 |   | 61,579 |   | 102,307 |   |
| Loans (2)                                      |       | 120,433                                           |       | 64,542 |   | 88,935 |   | 129,663 |   | 403,573 |   |
| Fixed and other  assets                        |       | —                                            |       | 7,892 |   | — |   | 17,694 |   | 25,586 |   |
| Total assets                                   |       | $                                                 | 129,777    |   | $ | 84,957 |   | $ | 107,892 |   | $ | 221,435 |   | $ | 544,061 |   |
| Total cumulative  assets                       |       | $                                                 | 129,777    |   | $ | 214,734 |   | $ | 322,626 |   | $ | 544,061 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Non-interest  bearing transaction deposits (3) |       | $                                                 | —     |   | $ | 7,036 |   | $ | 19,349 |   | $ | 43,976 |   | $ | 70,361 |   |
| Interest-bearing  transaction deposits (3)     |       | 49,189                                            |       | 49,839 |   | 39,263 |   | 9,775 |   | 148,066 |   |
| Time deposits                                  |       | 30,024                                            |       | 77,133 |   | 33,970 |   | 19,945 |   | 161,072 |   |
| Repurchase  agreements                         |       | 19,565                                            |       | 931 |   | 6,417 |   | — |   | 26,913 |   |
| Short-term  borrowings                         |       | 1,860                                             |       | — |   | — |   | — |   | 1,860 |   |
| Long-term debt                                 |       | 7,716                                             |       | 6,475 |   | 16,514 |   | 52,999 |   | 83,704 |   |
| Other  liabilities                             |       | —                                            |       | — |   | — |   | 3,239 |   | 3,239 |   |
| Total  liabilities                             |       | $                                                 | 108,354    |   | $ | 141,414 |   | $ | 115,513 |   | $ | 129,934 |   | $ | 495,215 |   |
| Total cumulative  liabilities                  |       | $                                                 | 108,354    |   | $ | 249,768 |   | $ | 365,281 |   | $ | 495,215 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Interest  sensitivity gap                      |       | $                                                 | 21,423     |   | $ | (56,457 | ) | $ | (7,621 | ) | $ | 91,501 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Cumulative gap                                 |       | $                                                 | 21,423     |   | $ | (35,034 | ) | $ | (42,655 | ) | $ | 48,846 |   |   |   |
|                                           |       |                                              |       |   |   |   |   |   |   |   |   |
| Cumulative gap  to total assets                |       | 3.94                                              | %          | -6.44 | % | -7.84 | % | 8.98 | % |   |   |

 

----

(1)           IncludesFHLB stock and the net unrealized gains/losses on available-for-salesecurities.

(2)           Investmentsand loans are included in the earlier of the period in which interest rateswere next scheduled to adjust or the period in which they are due. In addition,loans were included in the periods in which they are scheduled to be repaidbased on scheduled amortization. For amortizing loans and mortgage-backedsecurities, annual prepayment rates are assumed reflecting historicalexperience as well as Management’s knowledge and experience of its loanproducts.

(3)           TheBank’s demand and savings accounts were generally subject to immediatewithdrawal. However, Management considers a certain amount of such accounts tobe core accounts having significantly longer effective maturities based on theretention experiences of such deposits in changing interest rate environments. Theeffective maturities presented are the recommended maturity distribution limitsfor non-maturing deposits based on historical deposit studies.

 

*Earnings at Risk and Economic Value at RiskSimulations*. The Company recognizes that more sophisticatedtools exist for measuring the interest rate risk in the balance sheet beyondstatic re-pricing gap analysis. Although it will continue to measure itsrepricing gap position, the Company utilizes additional modeling foridentifying and measuring the interest rate risk in the overall balance sheet. TheALCO is responsible for focusing on “earnings at risk” and “economic value atrisk”, and how both relate to the risk-based capital position when analyzingthe interest rate risk.

 

*Earnings at Risk*. Earnings atrisk simulation measures the change in net interest income and net incomeshould interest rates rise and fall. The simulation recognizes that not allassets and liabilities re-price one-for-one with market rates (e.g., savingsrate). The ALCO looks at “earnings at risk” to determine income changes from abase case scenario under an increase and decrease of 200 basis points ininterest rate simulation models.

 

40

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*Economic Value at Risk.* Earningsat risk simulation measures the short-term risk in the balance sheet. Economicvalue (or portfolio equity) at risk measures the long-term risk by finding thenet present value of the future cash flows from the Company’s existing assetsand liabilities. The ALCO examines this ratio quarterly utilizing an increaseand decrease of 200 basis points in interest rates simulation model. The ALCOrecognizes that, in some instances, this ratio may contradict the “earnings atrisk” ratio.

 

The following table illustrates the simulated impact of an immediate 200basis points upward or downward movement in interest rates on net interestincome, net income and the change in the economic value (portfolio equity). Thisanalysis assumed that interest-earning asset and interest-bearing liabilitylevels at December 31, 2005 remained constant. The impact of the rate movementswas developed by simulating the effect of the rate change over a twelve-monthperiod from the December 31, 2005 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
|                                                   |       |                |       |                |       |
| Earnings at  risk:                                     |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | 2.9                 | %          | (10.3               | )%         |
| Net income                                             |       | 8.6                 |       | (28.0               | )          |
|                                                   |       |                |       |                |       |
| Economic value  at risk:                               |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (25.0               | )          | 0.80                |       |
|                                                   |       |                |       |                |       |
| Economic value  of equity as a percent of total assets |       | (2.59               | )          | 0.08                |       |

 

Economic value has the most meaning when viewed within the context ofrisk-based capital. Therefore, the economic value may normally change beyondthe Company’s policy guideline for a short period of time as long as therisk-based capital ratio (after adjusting for the excess equity exposure) isgreater than 10%. At December 31, 2005, the Company’s risk-based capital ratiowas 13.3%.

 

The table below summarizes estimated changes in net interest incomeover a twelve-month period beginning January 1, 2006, under alternate interestrate scenarios using the income simulation model described above (dollars inthousands):

 
| ** **                   | ** ** | **Net interest** | ** ** | **$**        | ** ** | **%**        | ** ** |
|------------------------------|------------|------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**       | ** ** | **variance** | ** ** | **variance** | ** ** |
|                         |       |             |       |         |       |         |       |
| +200 basis points            |       | $                | 18,496     |         | $          | 521          |       | 2.9 | % |
| +100 basis points            |       | 18,249           |       | 274          |       | 1.5          |       |
| Flat rate                    |       | 17,975           |       | —       |       | —       |       |
| -100 basis points            |       | 17,357           |       | (618         | )          | (3.4         | )          |
| -200 basis points            |       | 16,123           |       | (1,852       | )          | (10.3        | )          |
|                              |            |                  |            |              |            |              |            |  |  |

 

Simulation models require assumptions about certain categories ofassets and liabilities. The models schedule existing assets and liabilities bytheir contractual maturity, estimated likely call date or earliest re-pricingopportunity. Mortgage-backed securities and amortizing loans are scheduledbased on their anticipated cash flow including estimated prepayments. Forinvestment securities, we use a third-party service to provide cash flowestimates in the various rate environments. Savings accounts, includingpassbook, statement savings, money market and interest checking accounts, donot have a stated maturity or re-pricing term and can be withdrawn or re-priceat any time. This may impact the margin if more expensive alternative sourcesof deposits are required to fund loans or deposit runoff. Management projectsthe re-pricing characteristics of these accounts based on historical performanceand assumptions that it believes reflect their rate sensitivity. The consultingmodel reinvests all maturities, repayments and prepayments for each type ofasset or liability into the same product for a new like term then appliesgrowth or run-off estimates provided by Management. As a result, the mix ofinterest-earning assets and interest bearing-liabilities is not held constant.

 

41

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***Supervision and Regulation***

 

The following is a brief summary of the regulatory environment in whichthe Company and the Bank operate and is not designed to be a completediscussion of all statutes and regulations affecting such operations, includingthose statutes and regulations specifically mentioned herein. Changes in thelaws and regulations applicable to the Company and the Bank can affect theoperating environment in substantial and unpredictable ways. We cannotaccurately predict whether legislation will ultimately be enacted, and ifenacted, the ultimate effect that it or implementing regulations would have onour financial condition or results of operations. While banking regulations arematerial to the operations of the Company and the Bank, it should be noted thatsupervision, regulation, and examination of the Company and the Bank areintended primarily for the protection of depositors, not shareholders.

 

***Recent Legislation***

 

***USA Patriot Act of 2001.***  On October 26, 2001, theUniting and Strengthening America by Providing Appropriate Tools Required toIntercept and Obstruct Terrorism Act of 2001 (USA Patriot Act) was signed intolaw. The USA Patriot Act broadened the application of anti-money launderingregulations to apply to additional types of financial institutions, such asbroker-dealers, and strengthened the ability of the U.S. government to detectand prosecute international money laundering and the financing of terrorism.The principal provisions of Title III of the USA Patriot Act require thatregulated financial institutions, including national banks: (1) establish ananti-money laundering program that includes training and audit components; (2)comply with regulations regarding the verification of the identity of anyperson seeking to open an account; (3) take additional required precautionswith regard to non-U.S. owned accounts; and (4) perform certain verificationand certification of money laundering risk for their foreign correspondentbanking relationships. The USA Patriot Act also expanded the conditions underwhich funds in a U.S. inter-bank account may be subject to forfeiture andincreased the penalties for violation of anti-money laundering regulations.Failure of a financial institution to comply with the USA Patriot Actsrequirements could have serious legal and reputational consequences for theinstitution. The Bank has adopted policies, procedures and controls to addresscompliance with the requirements of the USA Patriot Act under the existingregulations and will continue to revise and update its policies, procedures andcontrols to reflect changes required by the USA Patriot Act and implementingregulations.

 

***IMLAFATA.***As part of the USA Patriot Act,Congress adopted the International Money Laundering Abatement and FinancialAnti-Terrorism Act of 2001 (IMLAFATA). IMLAFATA amended the Bank Secrecy Actand adopted certain additional measures that increase the obligation offinancial institutions, including the Bank, to identify their customers, watchfor and report upon suspicious transactions, respond to requests forinformation by federal banking regulatory authorities and law enforcementagencies, and share information with other financial institutions. TheSecretary of the Treasury has adopted several regulations to implement theseprovisions. The bank is also barred from dealing with foreign “shell” banks. Inaddition, IMLAFATA expands the circumstances under which funds in a bankaccount may be forfeited. IMLAFATA also amended the Bank Holding Company Actand the Bank Merger Act to require the federal banking regulatory authoritiesto consider the effectiveness of a financial institution’s anti-moneylaundering activities when reviewing an application to expand operations. TheFidelity Deposit and Discount Bank has in place a Bank Secrecy Act complianceprogram.

 

***Sarbanes-Oxley Act of 2002.******   ***In July, 2002, theSarbanes-Oxley Act of 2002 was enacted. The stated goals of the Act are toincrease corporate responsibility, to provide for enhanced penalties foraccounting and auditing improprieties at publicly traded companies and toprotect investors by improving the accuracy and reliability of corporatedisclosures pursuant to the securities laws.

 

The Act is the most far-reaching U.S. securities legislation enacted indecades. The Act generally applies to all companies, both U.S. and non-U.S.,that file or are required to file periodic reports with the Securities andExchange Commission under the Securities Exchange Act of 1934. Due to the SEC’sextensive role in implementing rules relating to many of the Act’srequirements, the final scope of these requirements remains to be determined,however, compliance with the Act is expected to impact the ongoing cost ofdoing business of the Company.

 

The Act includes very specific additional disclosure requirements andcorporate governance rules, requires the SEC and securities exchanges to adoptextensive additional disclosure, corporate governance and other related rulesand mandates further studies of certain issues by the SEC. The Act representssignificant federal involvement in matters traditionally left to stateregulatory systems such as the regulation of the accounting profession, and tostate corporate law, such as the relationship between a board of directors andmanagement and between a board of directors and its committees.

 

42

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***Regulation W.******    ***Transactionsbetween a bank and its “affiliates” are quantitatively and qualitativelyrestricted under the Federal Reserve Act. The Federal Deposit Insurance Actapplies Sections 23A and 23B to insured nonmember banks in the same mannerand to the same extent as if they were members of the Federal Reserve System.The Federal Reserve Board has also recently issued Regulation W, whichcodifies prior regulations under Sections 23A and 23B of the Federal ReserveAct and interpretative guidance with respect to affiliate transactions.

 

Regulation W incorporates the exemption from the affiliatetransaction rules but expands the exemption to cover the purchase of any typeof loan or extension of credit from an affiliate. Affiliates of a bank include,among other entities, the bank’s holding company and companies that are undercommon control with the bank. The company is considered to be an affiliate of theBank.

 

***Federal and State Legislation***

 

From time to time, various types of federal and state legislation havebeen proposed that could result in additional regulations and restrictions onthe business of the Company and the Bank. We cannot predict whether legislationwill be adopted, or if adopted, how the new laws would affect our business. Asa consequence, we are susceptible to legislation that may increase the cost ofdoing business. Management believes that the effect of any current legislative proposalson the liquidity, capital resources and the results of operations of theCompany and the Bank will be minimal.

 

Other specific regulatory recommendations which, if implemented, couldhave a material effect upon our liquidity, capital resources or results ofoperations. In addition, the general cost of compliance with numerous federaland state laws does have, and in the future may have, a negative impact on ourresults of operations.

 

Further, our business is also affected by the state of the financialservices industry, in general. As a result of legal and industry changes, Managementpredicts that the industry will continue to experience an increase inconsolidations as the financial industry strives for greater cost efficienciesand market share. Management is optimistic that these consolidations mayenhance the Bank’s competitive position as a community bank.

 

***Future Outlook***

 

Based upon the current uncertain economic outlook and inability topredict when interest rate changes will occur, the Company recognizes thatthere are challenges ahead. The Company is prepared to meet the challenges andeffects of a changing interest rate environment. The addition of key Managementpersonnel is an important step in addressing future challenges. Managementbelieves that a significant impact on earnings depends on its ability to reactto changes in interest rates.

 

The Company will continue to monitor interest rate sensitivity of its interest-earningassets and interest-bearing liabilities to minimize any adverse effects onfuture earnings. The Company’s commitment to remaining a community basedorganization is very strong. Our intention is to recognize a steady disciplinedgrowth in the loan portfolios, while increasing our base of core deposits. Reviewand implementation of policies and procedures along with adding innovativeproducts and services will continue. These steps are designed to provide theCompany with stability and the wherewithal to provide customer service andincrease shareholder value.

 

***Item7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK***

 

# ***The information required by 7A is set forth at Item 7, under“Liquidity” and “Management of Interest Rate Risk and Market Risk Analysis,”contained within Management’s Discussion and Analysis of Financial Conditionand Results of Operations and incorporated herein by reference.***

 

43

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## ***Item 8:  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA***

 

 

REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and Shareholders

Fidelity D & D Bancorp, Inc.:

 

We have audited the accompanying consolidated balance sheets ofFidelity D & D Bancorp, Inc. and Subsidiary as of December 31, 2005 and2004 and the related consolidated statements of income, changes inshareholders’ equity and cash flows for each of the years in the three-yearperiod ended December 31, 2005. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well as evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

 

As disclosed in Note 1 to the consolidated financial statements, theCompany changed the classification of loans available-for-sale in theconsolidated statement of cash flows.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of Fidelity D& D Bancorp, Inc. and Subsidiary as of December 31, 2005 and 2004, and theresults of their operations and their cash flows for each of the years in thethree-year period ended December 31, 2005 in conformity with accountingprinciples generally accepted in the United States of America.

 

 
|                        |
|------------------------|
|                   |
|                   |
| Scranton, Pennsylvania |
| February 3, 2006       |

 

44

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**FIDELITYD & D BANCORP, INC. AND SUBSIDIARY**

 

ConsolidatedBalance Sheets

Asof December 31, 2005 and 2004

 
| ** **                                                                                                                                   | ** ** | **2005**    | ** **  | **2004**    | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
|                                                                                                                                         |       |        |        |        |       |
| Assets:                                                                                                                                      |       |        |        |        |       |
| Cash and due  from banks                                                                                                                     |       | $           | 12,525,723  |        | $          | 9,013,060 |   |
| Interest-bearing  deposits with financial institutions                                                                                       |       | 68,817      |        | 1,203,334   |       |
|                                                                                                                                         |       |        |        |        |       |
| Total cash and  cash equivalents                                                                                                             |       | 12,594,540  |        | 10,216,394  |       |
|                                                                                                                                         |       |        |        |        |       |
| Available-for-sale  securities                                                                                                               |       | 95,681,654  |        | 112,612,513 |       |
| Held-to-maturity  securities                                                                                                                 |       | 1,996,919   |        | 3,056,305   |       |
| Federal Home  Loan Bank Stock                                                                                                                |       | 4,628,200   |        | 4,568,700   |       |
| Loans and  leases, net (allowance for loan losses of $5,984,649 in 2005 and $5,987,798  in 2004)                                             |       | 403,144,095 |        | 381,546,375 |       |
| Loans  available-for-sale (fair value $434,272 in 2005; $582,141 in 2004)                                                                    |       | 428,584     |        | 576,378     |       |
| Bank premises  and equipment, net                                                                                                            |       | 11,683,148  |        | 11,163,292  |       |
| Cash surrender  value of bank owned life insurance                                                                                           |       | 7,891,898   |        | 7,613,437   |       |
| Other assets                                                                                                                                 |       | 4,033,132   |        | 3,385,790   |       |
| Accrued interest  receivable                                                                                                                 |       | 1,959,826   |        | 1,722,850   |       |
| Foreclosed  assets held for sale                                                                                                             |       | 18,702      |        | 213,104     |       |
|                                                                                                                                         |       |        |        |        |       |
| Total assets                                                                                                                                 |       | $           | 544,060,698 |        | $          | 536,675,138 |   |
|                                                                                                                                         |       |        |        |        |       |
| Liabilities:                                                                                                                                 |       |        |        |        |       |
| Deposits:                                                                                                                                    |       |        |        |        |       |
| Non-interest-bearing                                                                                                                         |       | $           | 70,361,086  |        | $          | 65,357,535 |   |
| Certificates of  deposit of $100,000 or more                                                                                                 |       | 76,257,553  |        | 93,986,033  |       |
| Other  interest-bearing deposits                                                                                                             |       | 232,880,001 |        | 206,271,767 |       |
|                                                                                                                                         |       |        |        |        |       |
| Total deposits                                                                                                                               |       | 379,498,640 |        | 365,615,335 |       |
|                                                                                                                                         |       |        |        |        |       |
| Accrued interest  payable and other liabilities                                                                                              |       | 3,238,844   |        | 3,039,809   |       |
| Short-term  borrowings                                                                                                                       |       | 28,772,997  |        | 50,534,046  |       |
| Long-term debt                                                                                                                               |       | 83,704,188  |        | 71,119,188  |       |
|                                                                                                                                         |       |        |        |        |       |
| Total  liabilities                                                                                                                           |       | 495,214,669 |        | 490,308,378 |       |
|                                                                                                                                         |       |        |        |        |       |
| Commitments and  Contingencies                                                                                                               |       |        |        |        |       |
|                                                                                                                                         |       |        |        |        |       |
| Shareholders’  equity:                                                                                                                  |       |        |        |        |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                                  |       | —      |        | —      |       |
| Capital stock  authorized 10,000,000 shares with no par value; issued and outstanding  2,039,639 shares in 2005 and 2,023,529 shares in 2004 |       | 10,594,901  |        | 10,072,134  |       |
|                                                                                                                                         |       |        |        |        |       |
| Retained  earnings                                                                                                                           |       | 39,363,461  |        | 36,396,027  |       |
| Accumulated  other comprehensive loss                                                                                                        |       | (1,112,333  | )           | (101,401    | )          |
|                                                                                                                                         |       |        |        |        |       |
| Total  shareholders’ equity                                                                                                             |       | 48,846,029  |        | 46,366,760  |       |
|                                                                                                                                         |       |        |        |        |       |
| Total  liabilities and shareholders’ equity                                                                                             |       | $           | 544,060,698 |        | $          | 536,675,138 |   |

 

Seenotes to consolidated financial statements

 

45

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**FIDELITYD & D BANCORP, INC. AND SUBSIDIARY**

 

ConsolidatedStatements of Income

Forthe years ended December 31, 2005, 2004 and 2003

 
| ** **                                             | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                   |       |       |       |       |       |       |       |
| Interest income:                                       |       |       |       |       |       |       |       |
| Loans:                                                 |       |       |       |       |       |       |       |
| Taxable                                                |       | $          | 23,788,458 |       | $          | 21,793,474 |       | $ | 22,534,871 |   |
| Nontaxable                                             |       | 451,590    |       | 319,188    |       | 400,674    |       |
| Leases                                                 |       | 41,012     |       | 153,446    |       | 298,318    |       |
| Interest-bearing  deposits with financial institutions |       | 14,440     |       | 5,919      |       | 6,051      |       |
| Investment  securities:                                |       |       |       |       |       |       |       |
| U.S. Government  agency and corporations               |       | 3,498,419  |       | 4,362,455  |       | 4,486,310  |       |
| States and  political subdivisions (nontaxable)        |       | 539,004    |       | 481,481    |       | 477,327    |       |
| Other securities                                       |       | 638,738    |       | 262,277    |       | 212,791    |       |
| Federal funds  sold                                    |       | 48,600     |       | 17,251     |       | 45,751     |       |
|                                                   |       |       |       |       |       |       |       |
| Total interest  income                                 |       | 29,020,261 |       | 27,395,491 |       | 28,462,093 |       |
|                                                   |       |       |       |       |       |       |       |
| Interest  expense:                                     |       |       |       |       |       |       |       |
| Certificates of  deposit of $100,000 or more           |       | 2,830,915  |       | 2,974,337  |       | 4,731,839  |       |
| Other deposits                                         |       | 4,097,085  |       | 3,762,459  |       | 5,299,440  |       |
| Securities sold  under repurchase agreements           |       | 633,942    |       | 463,663    |       | 503,131    |       |
| Other short-term  borrowings and long-term debt        |       | 4,140,837  |       | 3,963,945  |       | 3,686,166  |       |
| Other                                                  |       | 18,207     |       | 15,731     |       | 16,553     |       |
|                                                   |       |       |       |       |       |       |       |
| Total interest  expense                                |       | 11,720,986 |       | 11,180,135 |       | 14,237,129 |       |
|                                                   |       |       |       |       |       |       |       |
| Net interest  income                                   |       | 17,299,275 |       | 16,215,356 |       | 14,224,964 |       |
|                                                   |       |       |       |       |       |       |       |
| Provision for  loan losses                             |       | 830,000    |       | 2,150,000  |       | 3,715,000  |       |
|                                                   |       |       |       |       |       |       |       |
| Net interest  income after provision for loan losses   |       | 16,469,275 |       | 14,065,356 |       | 10,509,964 |       |
|                                                   |       |       |       |       |       |       |       |
| Other income                                           |       |       |       |       |       |       |       |
| Service charges  on deposit accounts                   |       | 2,660,723  |       | 2,233,682  |       | 1,925,061  |       |
| Gain (loss) on  sale of:                               |       |       |       |       |       |       |       |
| Investment  securities                                 |       | 4,696      |       | 9,497      |       | 329,419    |       |
| Loans                                                  |       | 9,937      |       | 144,834    |       | 548,409    |       |
| Leased assets                                          |       | (334,663   | )          | (290,679   | )          | (408,921   | )          |
| Foreclosed  assets held for sale                       |       | 56,516     |       | (15,256    | )          | (11,880    | )          |
| Fees and other  service charges                        |       | 1,768,072  |       | 2,079,324  |       | 1,801,049  |       |
|                                                   |       |       |       |       |       |       |       |
| Total other  income                                    |       | 4,165,281  |       | 4,161,402  |       | 4,183,137  |       |
|                                                   |       |       |       |       |       |       |       |
| Other expenses:                                        |       |       |       |       |       |       |       |
| Salaries and  employee benefits                        |       | 7,093,427  |       | 6,765,551  |       | 6,399,792  |       |
| Premises and  equipment                                |       | 2,954,205  |       | 2,831,418  |       | 2,889,536  |       |
| Advertising                                            |       | 621,103    |       | 430,667    |       | 336,046    |       |
| Other                                                  |       | 3,908,012  |       | 3,799,054  |       | 3,277,987  |       |
|                                                   |       |       |       |       |       |       |       |
| Total other  expenses                                  |       | 14,576,747 |       | 13,826,690 |       | 12,903,361 |       |
|                                                   |       |       |       |       |       |       |       |
| Income before  provision for income taxes              |       | 6,057,809  |       | 4,400,068  |       | 1,789,740  |       |
|                                                   |       |       |       |       |       |       |       |
| Provision for  income taxes                            |       | 1,466,112  |       | 1,035,594  |       | 146,492    |       |
|                                                   |       |       |       |       |       |       |       |
| Net income                                             |       | $          | 4,591,697  |       | $          | 3,364,474  |       | $ | 1,643,248 |   |
|                                                   |       |       |       |       |       |       |       |
| Per share data:  *                                     |       |       |       |       |       |       |       |
| Net income -  basic                                    |       | $          | 2.26       |       | $          | 1.67       |       | $ | 0.82 |   |
| Net income -  diluted                                  |       | $          | 2.25       |       | $          | 1.67       |       | $ | 0.82 |   |
| Dividends                                              |       | $          | 0.80       |       | $          | 0.80       |       | $ | 0.80 |   |

 

----

* Per-share data has been adjusted, for all periods, to reflect theretroactive effect of a 10% stock dividend paid on February 15, 2006.

 

See notes to consolidatedfinancial statements

 

46

----

 

**FIDELITY D & D BANCORP, INC. ANDSUBSIDIARY**

 

Consolidated Statements ofChanges in Shareholders’ Equity

For the years ended December31, 2005, 2004 and 2003

 
| ** **                                                                                                                             | ** ** | ** **         | ** ** | ** **          | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**    | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------|------------|-------------------|------------|--------------|------------|--------------------|------------|------------|------------|
| ** **                                                                                                                             | ** ** | ** **         | ** ** | ** **          | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **other**          | ** ** | ** ** | ** ** |
| ** **                                                                                                                             | ** ** | **Capital  stock** | ** ** | **Treasury  stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                             | ** ** | **Shares ***       | ** ** | **Amount**          | ** ** | **Shares *** | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income  (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                                   |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Balance, December  31, 2002                                                                                                            |       | 2,007,899          |       | $                   | 9,590,142  |         | (6,585     | )                 | $          | (221,559     | )          | $                  | 34,600,626 |       | $          | 1,265,224 |   | $ | 45,234,433 |   |
| Total  comprehensive income:                                                                                                           |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Net income                                                                                                                             |       |               |       |                |       |         |       |              |       | 1,643,248    |       |               |       | 1,643,248  |       |
| Change in net  unrealized holding gains (losses) on available-for-sale securities, net of reclassification  adjustment and tax effects |       |               |       |                |       |         |       |              |       |         |       | (1,478,132         | )          | (1,478,132 | )          |
| Comprehensive  income                                                                                                                  |       |               |       |                |       |         |       |              |       |         |       |               |       | 165,116    |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                         |       |               |       |                |       | 1,390        |       | 42,654            |       |         |       |               |       | 42,654     |       |
| Dividends  reinvested through Dividend                                                                                                 |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Reinvestment Plan                                                                                                                      |       | 3,198              |       | 108,737             |       | 12,558       |       | 410,978           |       |         |       |               |       | 519,715    |       |
| Stock options exercised                                                                                                                |       |               |       |                |       | 880          |       | 29,800            |       |         |       |               |       | 29,800     |       |
| Purchase of  treasury stock                                                                                                            |       |               |       |                |       | (13,993      | )          | (457,921          | )          |         |       |               |       | (457,921   | )          |
| Dividends  declared                                                                                                                    |       |               |       |                |       |         |       |              |       | (1,601,898   | )          |               |       | (1,601,898 | )          |
|                                                                                                                                   |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Balance, December  31, 2003                                                                                                            |       | 2,011,097          |       | 9,698,879           |       | (5,750       | )          | (196,048          | )          | 34,641,976   |       | (212,908           | )          | 43,931,899 |       |
| Total  comprehensive income:                                                                                                           |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Net income                                                                                                                             |       |               |       |                |       |         |       |              |       | 3,364,474    |       |               |       | 3,364,474  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects         |       |               |       |                |       |         |       |              |       |         |       | 111,507            |       | 111,507    |       |
| Comprehensive  income                                                                                                                  |       |               |       |                |       |         |       |              |       |         |       |               |       | 3,475,981  |       |
| Reissued treasury  stock through Employee Stock Purchase Plan                                                                          |       |               |       | (8,329              | )          | 1,799        |       | 61,370            |       |         |       |               |       | 53,041     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                               |       | 11,882             |       | 366,084             |       | 3,951        |       | 134,678           |       |         |       |               |       | 500,762    |       |
| Stock options  exercised                                                                                                               |       | 550                |       | 15,500              |       |         |       |              |       |         |       |               |       | 15,500     |       |
| Dividends  declared                                                                                                                    |       |               |       |                |       |         |       |              |       | (1,610,423   | )          |               |       | (1,610,423 | )          |
|                                                                                                                                   |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Balance, December  31, 2004                                                                                                            |       | 2,023,529          |       | 10,072,134          |       | —       |       | —            |       | 36,396,027   |       | (101,401           | )          | 46,366,760 |       |
| Total  comprehensive income:                                                                                                           |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Net income                                                                                                                             |       |               |       |                |       |         |       |              |       | 4,591,697    |       |               |       | 4,591,697  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects         |       |               |       |                |       |         |       |              |       |         |       | (1,010,932         | )          | (1,010,932 | )          |
| Comprehensive  income                                                                                                                  |       |               |       |                |       |         |       |              |       |         |       |               |       | 3,580,765  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                         |       | 1,134              |       | 31,671              |       |         |       |              |       |         |       |               |       | 31,671     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                               |       | 14,976             |       | 491,096             |       |         |       |              |       |         |       |               |       | 491,096    |       |
| Dividends  declared                                                                                                                    |       |               |       |                |       |         |       |              |       | (1,624,263   | )          |               |       | (1,624,263 | )          |
|                                                                                                                                   |       |               |       |                |       |         |       |              |       |         |       |               |       |       |       |
| Balance, December  31, 2005                                                                                                            |       | 2,039,639          |       | $                   | 10,594,901 |         | —     |              | $          | —       |       | $                  | 39,363,461 |       | $          | (1,112,333 | ) | $ | 48,846,029 |   |

 

----

* The number of shares has been adjusted, for all periods,  to reflect the retroactive effect of a 10%stock dividend paid on February 15, 2006.

 

See notes to consolidatedfinancial statements

 

47

----

 

**FIDELITY DEPOSIT & DISCOUNTBANCORP, INC. AND SUBSIDIARY**

 

Consolidated Statementsof Cash Flows

For the years endedDecember 31, 2005, 2004 and 2003

 
| ** **                                                                         | ** ** | **2005**    | ** ** | **2004**    | ** ** | **2003**     | ** ** |
|------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|--------------|------------|
|                                                                               |       |        |       |        |       |         |       |
| Cash flows from  operating activities:                                             |       |        |       |        |       |         |       |
| Net income                                                                         |       | $           | 4,591,697  |        | $          | 3,364,474    |       | $ | 1,643,248 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |        |       |        |       |         |       |
| Depreciation                                                                       |       | 1,189,460   |       | 1,198,863   |       | 1,263,376    |       |
| Net amortization  on securities                                                    |       | 210,810     |       | 555,443     |       | 1,577,783    |       |
| Provision for loan  losses                                                         |       | 830,000     |       | 2,150,000   |       | 3,715,000    |       |
| Deferred income  tax benefit                                                       |       | (318,948    | )          | (625,994    | )          | (564,570     | )          |
| Amorization of  investment in limited partnership                                  |       | 90,000      |       | —      |       | —       |       |
| Proceeds from  sale of loans available for sale                                    |       | 2,337,108   |       | 15,640,705  |       | 28,618,110   |       |
| Originations of  loans available for sale                                          |       | (2,179,377  | )          | (9,015,893  | )          | (19,217,923  | )          |
| Write-down of  foreclosed assets held for sale                                     |       | 63,569      |       | 155,448     |       | 746,244      |       |
| Increase in cash  surrender value of life insurance                                |       | (278,461    | )          | (319,899    | )          | (293,538     | )          |
| Net gain on sale  of investment securities                                         |       | (4,696      | )          | (9,497      | )          | (329,419     | )          |
| Net gain on sale  of loans                                                         |       | (9,937      | )          | (144,834    | )          | (548,409     | )          |
| Net (gain) loss  on sale of foreclosed assets held for sale                        |       | (56,516     | )          | 15,256      |       | 11,880       |       |
| Net loss on sale  of leased assets                                                 |       | 334,663     |       | 290,679     |       | 408,921      |       |
| Net loss on  disposal of equipment                                                 |       | 14,779      |       | 8,125       |       | 398          |       |
| Amortization of  loan servicing rights                                             |       | 93,351      |       | 101,389     |       | 307,085      |       |
| Change in:                                                                         |       |        |       |        |       |         |       |
| Accrued interest  receivable                                                       |       | (236,976    | )          | 84,231      |       | 540,251      |       |
| Other assets                                                                       |       | (109,407    | )          | 166,448     |       | 706,845      |       |
| Accrued interest  payable and other liabilities                                    |       | 200,655     |       | (168,200    | )          | (788,222     | )          |
|                                                                               |       |        |       |        |       |         |       |
| Net cash  provided by operating activities                                         |       | 6,761,774   |       | 13,446,744  |       | 17,797,060   |       |
|                                                                               |       |        |       |        |       |         |       |
| Cash flows from  investing activities:                                             |       |        |       |        |       |         |       |
| Held-to-maturity  securities:                                                      |       |        |       |        |       |         |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 1,053,978   |       | 1,643,513   |       | 6,992,617    |       |
| Available-for-sale  securities:                                                    |       |        |       |        |       |         |       |
| Proceeds from  sales                                                               |       | 25,283,946  |       | 3,850,562   |       | 37,071,457   |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 14,121,713  |       | 31,194,737  |       | 77,944,142   |       |
| Purchases                                                                          |       | (24,207,221 | )          | (13,080,552 | )          | (119,205,041 | )          |
| Net (increase)  decrease FHLB stock                                                |       | (59,500     | )          | 184,600     |       | (1,148,900   | )          |
| Net increase in  loans and leases                                                  |       | (24,026,568 | )          | (5,753,051  | )          | (19,577,954  | )          |
| Proceeds from  sale of leased assets                                               |       | 1,021,403   |       | 971,841     |       | 1,297,402    |       |
| Purchase of life  insurance policies                                               |       | —      |       | —      |       | (7,000,000   | )          |
| Acquisition of  bank premises and equipment, net                                   |       | (1,724,095  | )          | (278,343    | )          | (620,510     | )          |
| Proceeds from  sale of foreclosed assets held for sale                             |       | 546,956     |       | 652,851     |       | 855,363      |       |
|                                                                               |       |        |       |        |       |         |       |
| Net cash (used  in) provided by investing activities                               |       | (7,989,388  | )          | 19,386,158  |       | (23,391,424  | )          |
|                                                                               |       |        |       |        |       |         |       |
| Cash flows from  financing activities:                                             |       |        |       |        |       |         |       |
| Net increase in  non-interest-bearing deposits                                     |       | 5,003,551   |       | 958,877     |       | 3,247,193    |       |
| Net decrease in  certificates of deposit of $100,000 or more                       |       | (17,728,480 | )          | (18,871,387 | )          | (16,629,078  | )          |
| Net increase  (decrease) in other interest-bearing deposits                        |       | 26,608,234  |       | (17,914,701 | )          | 1,036,255    |       |
| Net (decrease)  increase in short-term borrowings                                  |       | (21,761,049 | )          | (4,222,932  | )          | 3,543,964    |       |
| Proceeds from  issuance of long-term debt                                          |       | 15,000,000  |       | 5,000,000   |       | 9,000,000    |       |
| Repayments of  long-term debt                                                      |       | (2,415,000  | )          | (5,756,846  | )          | (123,966     | )          |
| Purchase of  treasury stock                                                        |       | —      |       | —      |       | (457,921     | )          |
| Proceeds from  employee stock purchase plan                                        |       | 31,671      |       | 53,041      |       | 42,654       |       |
| Exercise of  stock options                                                         |       | —      |       | 15,500      |       | 29,800       |       |
| Dividends paid,  net of dividends reinvested                                       |       | (1,133,167  | )          | (1,109,661  | )          | (1,082,183   | )          |
|                                                                               |       |        |       |        |       |         |       |
| Net cash  provided by (used in) financing activities                               |       | 3,605,760   |       | (41,848,109 | )          | (1,393,282   | )          |
|                                                                               |       |        |       |        |       |         |       |
| Net increase  (decrease) in cash and cash equivalents                              |       | 2,378,146   |       | (9,015,207  | )          | (6,987,646   | )          |
|                                                                               |       |        |       |        |       |         |       |
| Cash and cash  equivalents, beginning                                              |       | 10,216,394  |       | 19,231,601  |       | 26,219,247   |       |
|                                                                               |       |        |       |        |       |         |       |
| Cash and cash  equivalents, ending                                                 |       | $           | 12,594,540 |        | $          | 10,216,394   |       | $ | 19,231,601 |   |

 

Seenotes to consolidated financial statements

 

48

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**FIDELITY D & D BANCORP, INC.**

**AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****             ****NATURE OF OPERATIONS AND SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

# **PRINCIPLES OFCONSOLIDATION**

# ** **

The accompanyingconsolidated financial statements include the accounts of Fidelity D & DBancorp, Inc. and its wholly-owned subsidiary, The Fidelity Deposit andDiscount Bank (the “Bank”) (collectively, the “Company”). All significant inter-companybalances and transactions have been eliminated in consolidation.

 

**NATURE OFOPERATIONS**

 

The Company provides avariety of financial services to individuals and corporate customers inLackawanna and Luzerne Counties, Pennsylvania. This region has a diversifiedand fairly stable economy. The Company’s primary deposit products are checkingaccounts, savings accounts, NOW accounts, money market deposit accounts and certificatesof deposit accounts. Its primary lending products are single-family residentialloans, secured consumer loans and secured loans to businesses. In addition tothese traditional banking services, the Company also provides annuities, mutualfunds and trust services.

 

Although the Company hasa diversified loan portfolio, a substantial portion of its debtor’s ability tohonor their contracts is dependent on the economic sector in which the Companyoperates. While management uses available information to recognize losses onloans, leases and foreclosed assets, future additions to the allowances forloan losses and foreclosed assets may be necessary based on changes in localeconomic conditions. In addition, regulatory agencies, as an integral part oftheir examination process, periodically review the Company’s allowances. Suchagencies may require the Company to recognize additions to the allowances basedon their judgments about information available to them at the time of theirexamination. Because of these factors, it is reasonably possible that theallowances for loan losses and foreclosed assets may change materially in thenear future.

 

# **USE OF ESTIMATES**

# ** **

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

 

Material estimates thatare particularly susceptible to significant change relate to the determination ofthe allowance for loan losses and the valuation of real estate acquired inconnection with foreclosures or in satisfaction of loans. In connection withthe determination of allowances for losses on loans and foreclosed real estate,management obtains independent appraisals for significant properties.

 

49

----

 

**HELD-TO-MATURITYSECURITIES**

 

Debt securities, forwhich the Company has the positive intent and ability to hold to maturity, arereported at cost. Premiums and discounts are amortized or accreted, as acomponent of interest income, over the life of the related security as anadjustment to yield using the interest method.

 

**TRADINGSECURITIES**

 

Debt and equitysecurities held principally for resale in the near term are recorded at theirfair values. Unrealized gains and losses are included in other income. TheCompany did not have any investment securities held for trading purposes during2005, 2004 or 2003.

 

**AVAILABLE-FOR-SALESECURITIES**

 

Available-for-sale (AFS) securitiesconsist of debt and equity securities not classified as either held-to-maturitysecurities or trading securities and are reported at fair value. Premiums anddiscounts are amortized or accreted, as a component of interest income, overthe life of the related security as an adjustment to yield using the interestmethod. Unrealized holding gains and losses, net of deferred income taxes, on AFSsecurities are reported as a net amount as a separate component of shareholders’equity, until realized. These net unrealized holding gains and losses are thesole component of accumulated other comprehensive (loss) income.

 

**FEDERALHOME LOAN BANK STOCK**

 

Investment in FederalHome Loan Bank stock is required for membership in the organization and iscarried at cost since there is no market value available. The Company isrequired to maintain an investment in the stock equal to a percentage of its outstandingborrowings.

 

**LOANS**

# ** **

Loans that management hasthe intent and ability to hold for the foreseeable future or until maturity orpayoff are stated at face value, net of unearned income, unamortized loan feesand costs and the allowance for loan losses. Interest on residential realestate loans is recorded on an amortized schedule. Commercial loan interest isaccrued on the principal balance on an actual day basis. Interest on consumerloans is determined using the simple interest method.

 

The accrual of intereston impaired loans is discontinued when, in the opinion of management, there isan indication that the borrower may be unable to meet payments as they becomedue. Any payments received on impaired loans are applied, first to theoutstanding loan amounts, then to the recovery of any charged-off loan amounts.Any excess is treated as a recovery of lost interest.

 

**LOANSAVAILABLE FOR SALE**

 

Loans originated andintended for sale in the secondary market are carried at the lower of cost orestimated fair value in the aggregate. Net unrealized losses are recognizedthrough a valuation allowance by charges to income. Unrealized gains arerecognized to the extent of previous write-downs.

 

50

----

 

**ALLOWANCEFOR LOAN LOSSES**

 

The allowance for loanlosses is established through a provision for loan losses. The allowancerepresents an amount which, in management’s judgment, will be adequate toabsorb losses on existing loans and leases that may become uncollectible. Management’sjudgment in determining the adequacy of the allowance is based on evaluationsof the collectibility of the loans. These evaluations take into considerationsuch factors as changes in the nature and volume of the loan portfolio, currenteconomic conditions that may affect the borrower’s ability to pay, collateral value,overall portfolio quality and review of specific impaired loans. Loansconsidered uncollectible are charged to the allowance. Recoveries on loanspreviously charged off are added to the allowance.

 

A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect the scheduled payments in accordance with thecontractual terms of the loan. Factors considered in determining impairmentinclude payment status, collateral value and the probability of collectingpayments when due. The significance of payment delays and/or shortfalls isdetermined on a case by case basis. All circumstances surrounding the loan aretaken into account. Such factors include the length of the delinquency, theunderlying reasons and the borrower’s prior payment record. Impairment ismeasured on these loans on a loan by loan basis.

 

**LEASES**

 

Financing of equipmentand automobiles is provided to customers under lease arrangements accounted foras direct financing leases. Income earned is based on a constant periodicreturn on the net investment in the lease.

 

**LOAN FEES**

 

Nonrefundable loanorigination fees and certain direct loan origination costs are recognized as acomponent of interest income over the life of the related loans as anadjustment to yield. The unamortized balance of these fees and costs areincluded as part of the loan balance to which it relates.

 

**BANKPREMISES AND EQUIPMENT**

 

Land is carried at cost. Bankpremises and equipment are stated at cost less accumulated depreciation. Depreciationis computed on the straight-line method over the estimated useful lives of theassets. Leasehold improvements are amortized over the shorter of the term ofthe lease or the estimated useful lives of the improved property.

 

**LOANSERVICING AND LOAN SERVICING RIGHTS**

 

TheCompany services real estate loans for investors in the secondary mortgagemarket, which are not included in the in the accompanying consolidated balancesheet. Servicing assets are recognized as a component of other assets whenrights are acquired through sale of mortgage loans. The mortgage servicingrights (MSRs) recognized is based upon a computation of the present value ofestimated future servicing income. The computation incorporates assumptionssuch as the discount rate, estimated prepayment speeds to determine averagelives and the earnings rate. The cost of mortgage servicing rights is amortizedinto other income in proportion to, and over the period of, estimated future netservicing revenues. Servicing fee income is recorded from fees earned for servicingloans. The fees are based on a contractual percentage of the outstandingprincipal balance and are recorded as a component of other income when received.The amortization of MSRs is netted against loan servicing fee income.

 

51

----

 

**BANK OWNED LIFE INSURANCE**

 

TheCompany is the owner and sole beneficiary of bank owned life insurance (“BOLI”)policies on certain employees. The earnings from the BOLI are recognized as acomponent of other income. The BOLI is an asset that can be liquidated, ifnecessary, with tax costs associated. However, the Company intends to hold thesepolicies and, accordingly, the Bank has not provided for deferred income taxeson the earnings from the increase in cash surrender value.

 

**FORECLOSEDASSETS HELD FOR SALE**

 

Foreclosed assets heldfor sale are carried at the lower of cost or fair value less cost to sell. Lossesfrom the acquisition of property in full and partial satisfaction of debt aretreated as credit losses. Routine holding costs are included in other operatingexpenses. Write downs for subsequent declines in value are recorded in other incomeas a component of gain or loss on sale of foreclosed assets held for sale. Gainsor losses are recorded when the properties are sold.

 

**STOCKOPTIONS**

 

At December 31, 2005, theCompany has two stock-based compensation plans, which are described more fullyin Note 9. The Company accounts for these plans under the recognition andmeasurement principles of APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related Interpretations. Nostock-based employee compensation cost is reflected in net income, as alloptions granted under these plans had an exercise price equal to the fair valueof the underlying common stock on the date of grant. The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123, *Accounting forStock-Based Compensation*, to stock-based employee compensation foreach of the years ended December 31, (dollars in thousand except for per sharedata). The per-share data has been adjusted, for all periods, to reflect a 10%stock dividend paid on February 15, 2006:

 
| ** **                                                                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                                                        |       |     |       |     |       |     |       |
| Net income, as  reported                                                                                                    |       | $        | 4,592      |     | $          | 3,364    |       | $ | 1,643 |   |
| Less: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of tax |       | —   |       | —   |       | —   |       |
|                                                                                                                        |       |     |       |     |       |     |       |
| Pro forma net  income                                                                                                       |       | $        | 4,592      |     | $          | 3,364    |       | $ | 1,643 |   |
| Earnings per  share:                                                                                                        |       |     |       |     |       |     |       |
| Basic – as  reported                                                                                                   |       | $        | 2.26       |     | $          | 1.67     |       | $ | 0.82 |   |
| Basic – pro  forma                                                                                                     |       | $        | 2.26       |     | $          | 1.67     |       | $ | 0.82 |   |
|                                                                                                                        |       |     |       |     |       |     |       |   |   |   |
| Diluted – as  reported                                                                                                 |       | $        | 2.25       |     | $          | 1.67     |       | $ | 0.82 |   |
| Diluted – pro  forma                                                                                                   |       | $        | 2.25       |     | $          | 1.67     |       | $ | 0.82 |   |

 

The Company did not grantstock options in 2005, 2004 or 2003.

 

**TRUST AND FINANCIAL SERVICE FEES**

 

Trust and financialservice fees are recorded on the cash basis, which is not materially differentfrom the accrual basis.

 

52

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** **

**ADVERTISINGCOSTS**

 

Advertising costs arecharged to expense as incurred. For the years December 31, 2005, 2004 and 2003,advertising costs amounted to approximately $621,000, $431,000 and $336,000, respectively.

 

**FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

**Cash andshort-term instruments:** The carrying amounts of cash and short-term instruments approximatetheir fair value.

 

**Securities:**  Fair values for securities are based on bid pricesreceived from securities dealers. Federal Home Loan Bank Stock is carried atcost, which approximates fair value.

 

**Loansreceivable:**  The fairvalue of all loans is estimated by the net present value of the future expectedcash flows.

 

**Loansavailable for sale:** For loans available for sale, the fair value is estimated using ratescurrently offered for similar borrowings and are stated at the lower of cost ormarket.

 

**Depositliabilities:**  The fairvalue of demand deposits, NOW accounts, savings accounts and money marketdeposits is estimated by the net present value of the future expected cashflows. For certificates of deposit, the discount rates used reflect the Company’scurrent market pricing. The discount rates used for non-maturity deposits arethe current book rate of the deposits.

 

**Short-termborrowings:**  Forshort-term borrowings, the fair value is estimated using the rates currentlyoffered for similar borrowings.

 

**Long-termdebt:**  For otherborrowed funds, the fair value is estimated using the rates currently offeredfor similar borrowings.

 

**Accruedinterest:**  The carryingamounts of accrued interest approximate their fair values.

 

**Off-balance-sheetinstruments:** Commitments to extend credit and unused lines of credit are priced tomarket. The rates on standby letters of credit are priced on prime. Therefore,the estimated fair value of these financial instruments is face value.

 

**INCOME TAXES**

# ** **

Deferred tax assets andliabilities are reflected at currently enacted income tax rates applicable tothe period in which the deferred tax assets or liabilities are expected to berealized or settled. As changes in tax laws or rates are enacted, deferred taxassets and liabilities are adjusted through the provision for income taxes.

 

**CASH FLOWS**

 

For purposes of reportingcash flows, cash and cash equivalents includes cash on hand, amounts due frombanks and interest-bearing deposits with financial institutions.

 

In 2005, the Companychanged its classification, within the consolidated statements of cash flows,of the activity associated with loans available-for-sale from investingactivities to operating activities. Prior years’ amounts have been reclassifiedto conform to the current year’s presentation. The effect of the changeincreased operating cash flows by $6,625,000 and

 

53

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$9,400,000 and decreasedinvesting cash flows by $6,625,000 and $9,400,000, in 2004 and 2003,respectively. The Company believes the change in classification of loansavailable-for-sale is preferable because it better reflects the primarybusiness purpose of these transactions and complies with the requirements ofSFAS 102, *Statement of Cash Flows—Exemption of CertainEnterprises and Classification of Cash Flows from Certain Securities Acquiredfor Resale.*

 

For the years endedDecember 31, 2005, 2004, and 2003, the Company paid interest of $11,367,400, $11,465,200and $14,674,100, respectively. For the years ended December 31, 2005, 2004,and 2003, the Company paid cash for income taxes of $1,800,000, $1,200,000 and $870,000,respectively.

 

Transfers from loans toforeclosed assets held for sale amounted to $321,725, $504,415 and $1,560,832in 2005, 2004, and 2003, respectively. Non-cash investing activities alsoincluded the transfer of $12,807,221 from loans available-for-sale to loans in2004. There were no transfers of loans from loans available-for-sale to loansin 2005 or 2003.

 

**RECLASSIFICATIONS**

 

Certain reclassificationshave been made to prior year’s financial statements to conform to the current presentation.

 

**OTHERCOMPREHENSIVE INCOME (LOSS)**

 

The components of othercomprehensive income (loss) and related tax effects are as follows:

 
| ** **                                                          | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003**   | ** ** |
|---------------------------------------------------------------------|------------|------------|------------|----------|------------|------------|------------|
|                                                                |       |       |       |     |       |       |       |
| Unrealized  holding gains (losses) on available-for-sale securities |       | $          | (1,527,019 | )        | $          | 178,447    |       | $ | (1,910,175 | ) |
|                                                                |       |       |       |     |       |       |       |
| Less  reclassification adjustment for gains realized in income      |       | (4,696     | )          | (9,497   | )          | (329,419   | )          |
|                                                                |       |       |       |     |       |       |       |
| Net unrealized  gains (losses)                                      |       | (1,531,715 | )          | 168,950  |       | (2,239,594 | )          |
|                                                                |       |       |       |     |       |       |       |
| Tax effect                                                          |       | 520,783    |       | (57,443  | )          | 761,462    |       |
|                                                                |       |       |       |     |       |       |       |
| Net of tax  amount                                                  |       | $          | (1,010,932 | )        | $          | 111,507    |       | $ | (1,478,132 | ) |

 

**2.****             ****CASH**

 

The Company is requiredby the Federal Reserve Bank to maintain average reserve balances based on apercentage of deposits. The amounts of those reserve requirements on December31, 2005 and 2004 were $627,000 and $616,000, respectively.

 

Deposits with any onefinancial institution are insured up to $100,000. From time-to-time, theCompany maintains cash and cash equivalents with certain other financialinstitutions in excess of the insured amount.

 

54

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**3.****             ****INVESTMENT SECURITIES**

 

Amortized cost and fairvalue of investment securities at December 31, 2005 and 2004 are as follows (inthousands):

 
| ** **                                        | ** ** | **2005**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                              |       |                |       |   |   |   |   |   |   |
| Held to maturity  securities:                     |       |                |       |   |   |   |   |   |   |
| Mortgage-backed  securities                       |       | $                   | 1,997      |   | $ | 49 |   | $ | — |   | $ | 2,046 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Available-for-sale  securities:                   |       |                |       |   |   |   |   |   |   |
| U.S. government  agencies and Corporations        |       | $                   | 32,000     |   | $ | — |   | $ | 874 |   | $ | 31,126 |   |
| Obligations of  states and political Subdivisions |       | 13,393              |       | 71 |   | 62 |   | 13,402 |   |
| Corporate bonds                                   |       | 10,019              |       | 64 |   | — |   | 10,083 |   |
| Mortgage-backed  securities                       |       | 41,676              |       | 1 |   | 1,059 |   | 40,618 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total debt                                        |       | 97,088              |       | 136 |   | 1,995 |   | 95,229 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Equity  securities                                |       | 279                 |       | 174 |   | — |   | 453 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total                                             |       | $                   | 97,367     |   | $ | 310 |   | $ | 1,995 |   | $ | 95,682 |   |

 
| ** **                                        | ** ** | **2004**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                              |       |                |       |   |   |   |   |   |   |
| Held to maturity  securities:                     |       |                |       |   |   |   |   |   |   |
| Mortgage-backed  securities                       |       | $                   | 3,056      |   | $ | 137 |   | $ | — |   | $ | 3,194 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Available-for-sale  securities:                   |       |                |       |   |   |   |   |   |   |
| U.S. government  agencies and Corporations        |       | $                   | 31,006     |   | $ | 1 |   | $ | 511 |   | $ | 30,496 |   |
| Obligations of  states and political Subdivisions |       | 11,043              |       | 160 |   | 4 |   | 11,199 |   |
| Corporate bonds                                   |       | 9,034               |       | 26 |   | 25 |   | 9,035 |   |
| Mortgage-backed  securities                       |       | 61,404              |       | 322 |   | 324 |   | 61,402 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total debt                                        |       | 112,487             |       | 509 |   | 864 |   | 112,132 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Equity  securities                                |       | 279                 |       | 202 |   | — |   | 481 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total                                             |       | $                   | 112,766    |   | $ | 711 |   | $ | 864 |   | $ | 112,613 |   |

 

55

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Most of theCompany’s debt and equity securities are pledged to secure trust funds, publicdeposits, repurchase agreements, other short-term borrowings, Federal Home LoanBank of Pittsburgh (“FHLB”) borrowings, Federal Reserve Bank of PhiladelphiaDiscount Window borrowings and certain other deposits as required by law. U.S.government securities pledged on repurchase agreements are under the Company’scontrol.

 

The amortized costand fair value of debt securities at December 31, 2005 by contractual maturityare shown below:

 
| ** **                                | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|-------------------------------------------|------------|---------------------|------------|-----------------|------------|
| ** **                                | ** ** | **(in thousands)**  | ** ** |
|                                      |       |                |       |            |       |
| Held-to-maturity securities               |       |                |       |            |       |
| Mortgage-backed  securities               |       | $                   | 1,997      |            | $          | 2,046 |   |
|                                      |       |                |       |            |       |
| Available-for-sale securities             |       |                |       |            |       |
| Debt securities:                          |       |                |       |            |       |
| Due in one year  or less                  |       | $                   | —     |            | $          | — |   |
| Due after one  year through five years    |       | 7,310               |       | 7,119           |       |
| Due after five  years through ten years   |       | 22,734              |       | 22,195          |       |
| Due after ten  years                      |       | 25,368              |       | 25,297          |       |
|                                      |       |                |       |            |       |
| Total debt  securities                    |       | 55,412              |       | 54,611          |       |
|                                      |       |                |       |            |       |
| Mortgage-backed  securities               |       | 41,676              |       | 40,618          |       |
|                                      |       |                |       |            |       |
| Total available-for-sale  debt securities |       | $                   | 97,088     |            | $          | 95,229 |   |

 

Expectedmaturities will differ from contractual maturities because issuers andborrowers may have the right to call or repay obligations with or without callor prepayment penalty. Federal agency and municipal securities are includedbased on their original stated maturity. Mortgage-backed securities, which arebased on weighted-average lives and subject to monthly principal pay-downs, arelisted in total.

 

56

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The following tablepresents gross unrealized losses and fair value of investments aggregated byinvestment category and length of time that individual securities have been ina continuous unrealized loss position at December 31, 2005 and 2004 (in thousands):

 
| ** **                                        | ** ** | **Less than 12 months** | ** ** | **12 months or more**  | ** ** | **Total**       | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|------------------------|------------|-----------------|------------|
| ** **                                        | ** ** | **Fair  Value**         | ** ** | **Unrealized  Losses** | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| **December 31, 2005**                             |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| ** **                                        |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                       | 5,835      |                   | $          | 164             |       | $ | 25,290 |   | $ | 710 |   | $ | 31,125 |   | $ | 874 |   |
| Obligations of  states and political subdivisions |       | 6,736                   |       | 62                     |       | —          |       | — |   | 6,736 |   | 62 |   |
| Mortgage-backed  Securities                       |       | 23,312                  |       | 457                    |       | 17,227          |       | 602 |   | 40,539 |   | 1,059 |   |
| Corporate bonds                                   |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Subtotal, debt  Securities                        |       | 35,883                  |       | 683                    |       | 42,517          |       | 1,312 |   | 78,400 |   | 1,995 |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Equity  securities                                |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Total  temporarily impaired securities            |       | $                       | 35,883     |                   | $          | 683             |       | $ | 42,517 |   | $ | 1,312 |   | $ | 78,400 |   | $ | 1,995 |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| December 31,  2004                                |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                       | 15,778     |                   | $          | 222             |       | $ | 9,711 |   | $ | 289 |   | $ | 25,489 |   | $ | 511 |   |
| Obligations of  states and political subdivisions |       | 1,673                   |       | 4                      |       | —          |       | — |   | 1,673 |   | 4 |   |
| Mortgage-backed  Securities                       |       | 26,859                  |       | 197                    |       | 8,716           |       | 127 |   | 35,575 |   | 324 |   |
| Corporate bonds                                   |       | 5,014                   |       | 25                     |       | —          |       | — |   | 5,014 |   | 25 |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Subtotal, debt  Securities                        |       | 49,324                  |       | 448                    |       | 18,427          |       | 416 |   | 67,751 |   | 864 |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Equity  securities                                |       | —                  |       | —                 |       | —          |       | — |   | — |   | — |   |
|                                              |       |                    |       |                   |       |            |       |   |   |   |   |   |   |
| Total  temporarily impaired securities            |       | $                       | 49,324     |                   | $          | 448             |       | $ | 18,427 |   | $ | 416 |   | $ | 67,751 |   | $ | 864 |   |
|                                                   |            |                         |            |                        |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Management evaluatessecurities for other-than-temporary impairment on a quarterly basis or morefrequently when economic conditions or market conditions warrant suchevaluation. Consideration is given to (1) the length of time and the extent towhich the fair value has been less than cost, (2) the financial condition andnear-term prospects of the issuer, and (3) the intent and ability of theCompany to retain its investment in the issuer for a period of time sufficientto allow for any anticipated recovery in fair value.

 

At December 31, 2005 thedebt securities with unrealized losses have depreciated 2.5% from the Company’samortized cost basis. The U.S. government or its agencies guarantee thesesecurities. In analyzing an issuer’s financial condition, Management considerswhether the securities are issued by the U.S. government, its agencies or othergovernments, whether downgrades by bond rating agencies have occurred and theresults of reviews of the issuer’s financial condition. Because the decline inmarket values is attributable to changes in interest rates and not creditquality, and the Company has the ability and intent to hold those securitiesuntil a recovery of fair value, which may be maturity, Management does notconsider those securities to be other-than-temporarily impaired at December 31,2005.

 

 

57

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Gross realized gains andlosses on sales of available-for-sale securities, determined using specificidentification of the securities were as follows:

 
| ** **           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
|                 |       |     |       |     |       |     |       |
| Gross realized  gain |       | $        | 127,414    |     | $          | 19,978   |       | $ | 329,419 |   |
| Gross realized  loss |       | 122,718  |       | 10,481   |       | —   |       |
| Net gain             |       | $        | 4,696      |     | $          | 9,497    |       | $ | 329,419 |   |

 

**4.****             ****LOANS AND LEASES**

 

The major classificationsof loans and leases at December 31, 2005 and 2004 are summarized as follows:

 
| ** **                             | ** ** | **2005**    | ** **  | **2004**    | ** ** |
|----------------------------------------|------------|-------------|-------------|-------------|------------|
|                                   |       |        |        |        |       |
| Commercial and  commercial real estate |       | $           | 216,288,597 |        | $          | 221,968,137 |   |
| Residential real  estate               |       | 103,920,613 |        | 91,294,401  |       |
| Consumer                               |       | 74,070,328  |        | 61,487,608  |       |
| Real estate  construction              |       | 14,198,858  |        | 10,620,472  |       |
| Direct financing  leases               |       | 650,348     |        | 2,211,978   |       |
|                                   |       |        |        |        |       |
| Total                                  |       | 409,128,744 |        | 387,582,596 |       |
|                                   |       |        |        |        |       |
| Less:                                  |       |        |        |        |       |
| Unearned income                        |       | —      |        | 48,423      |       |
| Allowance for  loan losses             |       | 5,984,649   |        | 5,987,798   |       |
|                                   |       |        |        |        |       |
| Loans and  leases, net                 |       | $           | 403,144,095 |        | $          | 381,546,375 |   |

 

Net deferred loan costsof $605,079 and $372,778 have been added to the carrying value of loans atDecember 31, 2005 and 2004, respectively.

 

Informationrelated to impaired loans as of December 31, is as follows:

 
| ** **                                                                                  | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| At December 31:                                                                             |       |       |       |       |       |
| Accruing loans  that are contractually past due 90 days or more as to principal or interest |       | $          | 196,928    |       | $          | 557,492 |   |
| Amount of  impaired loans that have a specific allowance                                    |       | 10,625,662 |       | 15,552,895 |       |
| Amount of  impaired loans with no specific allowance                                        |       | 2,889,259  |       | 3,190,794  |       |
| Allowance for  impaired loans                                                               |       | 1,396,446  |       | 2,123,315  |       |
|                                                                                             |            |            |            |            |            |  |  |

 
| ** **                                                 | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|
| During the year  ended December 31:                        |       |       |       |       |       |
| Average  investment in impaired loans                      |       | 10,309,967 |       | 10,817,639 |       |
| Interest income  recognized on impaired loans (cash basis) |       | 241,325    |       | 242,623    |       |
| Principal  collected on impaired loans                     |       | 2,809,955  |       | 2,788,053  |       |

 

58

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Informationrelated to the changes in the allowance for loan losses as of December 31, is asfollows:

 
| ** **                   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                         |       |       |       |       |       |       |       |
| Balance,  beginning          |       | $          | 5,987,798  |       | $          | 4,996,966  |       | $ | 3,899,753 |   |
| Recoveries                   |       | 560,496    |       | 447,772    |       | 478,297    |       |
| Provision for  loan losses   |       | 830,000    |       | 2,150,000  |       | 3,715,000  |       |
| Losses charged  to allowance |       | (1,393,645 | )          | (1,606,940 | )          | (3,096,084 | )          |
|                         |       |       |       |       |       |       |       |
| Balance, ending              |       | $          | 5,984,649  |       | $          | 5,987,798  |       | $ | 4,996,966 |   |

 

The Companyservices real estate loans for investors in the secondary mortgage market whichare not included in the accompanying consolidated balance sheet. Theapproximate amount of mortgages serviced amounted to $47,835,000 at December31, 2005 and $57,939,000 at December 31, 2004. MSRs were approximately$309,000 at December 31, 2005 and $390,000 at December 31, 2004 and areincluded in other assets.

 

The Companyrecognized servicing gains from the sales of mortgage loans of $12,141 in 2005,$144,246 in 2004 and $231,663 in 2003. Amortization of MSRs was $93,351 in2005, $101,389 in 2004 and $307,085 in 2003.

 

**5.****             ****BANK PREMISES AND EQUIPMENT**

 

Components of bankpremises and equipment at December 31, 2005 and 2004 are summarized as follows:

 
| ** **                                      | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Land                                            |       | $          | 2,072,048  |       | $          | 1,054,330 |   |
| Bank premises                                   |       | 7,492,231  |       | 7,469,594  |       |
| Furniture,  fixtures and equipment              |       | 7,698,013  |       | 7,331,548  |       |
| Leasehold  improvements                         |       | 3,030,139  |       | 3,021,256  |       |
|                                            |       |       |       |       |       |
| Total                                           |       | 20,292,431 |       | 18,876,728 |       |
|                                            |       |       |       |       |       |
| Less accumulated  depreciation and amortization |       | 8,609,283  |       | 7,713,436  |       |
|                                            |       |       |       |       |       |
| Bank premises  and equipment, net               |       | $          | 11,683,148 |       | $          | 11,163,292 |   |

 

Depreciationexpense, which includes amortization of leasehold improvements, was $1,189,460,$1,198,863 and $1,263,376 for the years ended December 31, 2005, 2004 and 2003,respectively.

 

59

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The Company leasesits Green Ridge, Scranton, Pittston, West Pittston, Moosic, Kingston,Peckville, Clarks Summit and Eynon branches under the terms of operating leases.Rental expense was $379,858 for 2005, $386,980 for 2004 and $382,001 for 2003. Thefuture minimum rental payments at December 31, 2005 under these leases are asfollows:

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** |
|------------------------------|------------|------------|------------|
|                         |       |       |       |
| 2006                         |       | $          | 356,672    |   |
| 2007                         |       | 323,834    |       |
| 2008                         |       | 323,834    |       |
| 2009                         |       | 323,834    |       |
| 2010                         |       | 295,812    |       |
| 2011 and  thereafter         |       | 3,500,625  |       |
|                         |       |       |       |
| Total                        |       | $          | 5,124,611  |   |

 

**6.****             ****DEPOSITS**

 

At December 31, 2005, thescheduled maturities of certificates of deposit are as follows:

 
| 2006       |   | $          | 107,155,617 |   | 66.52  | % |
|------------|--------|------------|-------------|--------|--------|---|
| 2007       |   | 26,231,928 |        | 16.29  |   |
| 2008       |   | 7,711,748  |        | 4.79   |   |
| 2009       |   | 9,438,645  |        | 5.86   |   |
| 2010       |   | 10,487,228 |        | 6.51   |   |
| Thereafter |   | 46,434     |        | 0.03   |   |
|       |   |       |        |   |   |
|       |   | $          | 161,071,600 |   | 100.00 | % |

 

**7.****             ****SHORT-TERM BORROWINGS**

 

Short-term borrowings areas follows at December 31:

 
| ** **                                   | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**   | ** ** |
|----------------------------------------------|------------|-----------|------------|-----------|------------|------------|------------|
|                                         |       |      |       |      |       |       |       |
| Securities sold  under repurchase agreements |       | $         | 26,912,700 |      | $          | 40,684,343 |       | $ | 39,363,052 |   |
| Demand note,  U.S. Treasury                  |       | 1,091,297 |       | 1,089,703 |       | 473,926    |       |
| Federal funds  purchased                     |       | 769,000   |       | 8,760,000 |       | 14,920,000 |       |
|                                         |       |      |       |      |       |       |       |
| Total                                        |       | $         | 28,772,997 |      | $          | 50,534,046 |       | $ | 54,756,978 |   |

 

60

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The maximum andaverage amounts of short-term borrowings outstanding and related interest ratesfor the years ended December 31, 2005, 2004 and 2003 are as follows:

 
| ** **                                   | ** ** | **Maximum  outstanding  at any  month end** | ** ** | **Average  outstanding** | ** ** | **Weighted  average  rate during  the year** | ** ** | **Rate at  year end** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|--------------------------|------------|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | ** **                                  | ** ** | ** **               | ** ** | ** **                                   | ** ** | ** **            | ** ** |
| 2005                                         |       |                                        |       |                     |       |                                         |       |                  |       |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| Federal funds purchased                      |       | $                                           | 15,850,000 |                     | $          | 8,002,896                                    |       | 3.59                  | %          | 4.22 | % |
| Securities sold  under repurchase agreements |       | 56,137,013                                  |       | 35,105,825               |       | 1.81                                         | %          | 1.89                  | %          |
| Demand note, U.S. Treasury                   |       | 1,091,297                                   |       | 685,572                  |       | 3.35                                         | %          | 3.96                  | %          |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| Total                                        |       | $                                           | 73,078,310 |                     | $          | 43,794,293                                   |       |                  |       |   |   |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| 2004                                         |       |                                        |       |                     |       |                                         |       |                  |       |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| Federal funds purchased                      |       | $                                           | 17,997,400 |                     | $          | 4,931,714                                    |       | 1.50                  | %          | 2.21 | % |
| Securities sold  under repurchase agreements |       | 44,194,836                                  |       | 41,695,108               |       | 1.11                                         | %          | 1.23                  | %          |
| Demand note, U.S. Treasury                   |       | 1,089,703                                   |       | 750,719                  |       | 1.14                                         | %          | 1.88                  | %          |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| Total                                        |       | $                                           | 63,281,939 |                     | $          | 47,377,541                                   |       |                  |       |   |   |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| 2003                                         |       |                                        |       |                     |       |                                         |       |                  |       |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| Federal funds purchased                      |       | $                                           | 17,900,000 |                     | $          | 3,716,192                                    |       | 1.26                  | %          | 1.03 | % |
| Securities sold  under repurchase agreements |       | 46,285,260                                  |       | 41,326,103               |       | 1.22                                         | %          | 0.80                  | %          |
| Demand note, U.S. Treasury                   |       | 1,119,775                                   |       | 716,817                  |       | 0.93                                         | %          | 0.73                  | %          |
|                                         |       |                                        |       |                     |       |                                         |       |                  |       |
| Total                                        |       | $                                           | 65,305,035 |                     | $          | 45,759,112                                   |       |                  |       |   |   |
|                                              |            |                                             |            |                          |            |                                              |            |                       |            |  |  |  |  |

 

Securities sold underagreements to repurchase (repurchase agreements) are secured short-termborrowings, and generally mature within 1 to 89 days from the transaction date.Repurchase agreements are reflected at the amount of cash received inconnection with the transaction. The carrying value of the underlyingsecurities is approximately $27,000,000, $40,700,000 and $39,500,000 atDecember 31, 2005, 2004 and 2003, respectively. The Bank may be required toprovide additional collateral based on the fair value of the underlyingsecurities. The demand note, U. S. Treasury is generally repaid within 1 to 90days.

 

At December 31, 2005, theCompany had approximately $54,550,000 available to borrow from the FHLB andapproximately $9,733,000 that it can borrow at the Discount Window from theFederal Reserve Bank of Philadelphia. There were no borrowings from the FederalReserve Bank Discount Window at December 31, 2005, 2004 or 2003.

 

61

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**8.****             ****LONG-TERM DEBT**

 

Long-term debtconsists of advances from the FHLB with interest rates ranging from 2.98% to6.22% at December 31, 2005. These advances are secured by unencumbered U.S.government agency securities, mortgage-backed securities, U.S. Treasury notesand certain residential mortgages.

 

At December 31, 2005, thematurities and weighted-average interest rates of long-term debt are asfollows:

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|------------------------------|------------|------------|------------|----------|------------|
|                         |       |       |       |     |       |
| 2006                         |       | $          | 11,167,978 |     | 4.44       | % |
| 2007                         |       | 8,827,534  |       | 4.47     |       |
| 2008                         |       | 10,708,676 |       | 4.58     |       |
| 2010                         |       | 48,000,000 |       | 5.74     |       |
| 2013                         |       | 5,000,000  |       | 3.61     |       |
|                         |       |       |       |     |       |
| Total                        |       | $          | 83,704,188 |     | 5.16       | % |

 

**9.****             ****STOCK PLANS**

 

At December 31, 2005, theCompany has reserved 110,000 shares of its unissued capital stock for issuanceunder a dividend reinvestment plan. Shares issued under this plan are valued atfair value as of the dividend payment date. At December 31, 2005, 58,546 sharesare available for future issuance.

 

The Company hasestablished the 2002 Employee Stock Purchase Plan and has reserved 110,000shares of its unissued capital stock for issuance under the plan. Under the2002 Employee Purchase Plan, employees may have automatic payroll deductions topurchase the Company’s capital stock at a discounted price based on the fairmarket value of the Company’s capital stock on either the commencement date ortermination date. At December 31, 2005, 4,323 shares were issued under theplan.

 

The Company hasestablished the 2000 Independent Directors Stock Option Plan and has reserved 55,000shares of its unissued capital stock for issuance under the plan. Under the2000 Independent Directors Stock Option Plan, each outside director is awardedstock options to purchase 500 shares of the Company’s common stock on the firstbusiness day of January, each year, at the fair market value on date of grant. Nostock options were awarded in 2005, 2004 or 2003 due to the directors’ voluntaryelection to forego the award. At December 31, 2005, there were 14,850 unexercisedstock options outstanding under this plan.

 

The Company hasestablished the 2000 Stock Incentive Plan and has reserved 55,000 shares of itsunissued capital stock for issuance under the plan. Under the 2000 StockIncentive Plan, key officers and certain other employees are eligible to beawarded qualified stock options to purchase the Company’s common stock at thefair market value on the date of grant. No stock options were awarded in 2005, 2004and 2003. As of December 31, 2005, there were 5,280 unexercised stock optionsoutstanding under this plan.

 

62

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A summary of thestatus of the Company’s stock option plans as of December 31, 2005, 2004, and2003, and changes during the year ended is presented below. The number ofoptions and per-option data has been adjusted, for all periods, to reflect the10% stock dividend paid on February 15, 2006:

 
| ** **                                      | ** ** | **Options** | ** ** | **Weighted-average  exercise price** | ** ** |
|-------------------------------------------------|------------|-------------|------------|--------------------------------------|------------|
|                                            |       |        |       |                                 |       |
| Outstanding and  exercisable, December 31, 2002 |       | 28,490      |       | $                                    | 32.21      |   |
| Granted                                         |       | —      |       | —                               |       |
| Exercised                                       |       | (880        | )          | 32.55                                |       |
| Forfeited                                       |       | (440        | )          | 34.09                                |       |
|                                            |       |        |       |                                 |       |
| Outstanding and  exercisable, December 31, 2003 |       | 27,170      |       | 32.17                                |       |
| Granted                                         |       | —      |       | —                               |       |
| Exercised                                       |       | (550        | )          | 28.18                                |       |
| Forfeited                                       |       | (6,050      | )          | 32.13                                |       |
|                                            |       |        |       |                                 |       |
| Outstanding and  exercisable, December 31, 2004 |       | 20,570      |       | 32.29                                |       |
| Granted                                         |       | —      |       | —                               |       |
| Exercised                                       |       | —      |       | —                               |       |
| Forfeited                                       |       | (440        | )          | 34.09                                |       |
|                                            |       |        |       |                                 |       |
| Outstanding,  December 31, 2005                 |       | 20,130      |       | $                                    | 32.25      |   |
|                                                 |            |             |            |                                      |            |  |  |

 

The followingtable summarizes all stock options outstanding and exercisable for the plans asof December 31, 2005, segmented by exercise prices. The number of options andper-option data has been adjusted to reflect the 10% stock dividend paid onFebruary 15, 2006:

 
| **Exercise prices** | ** ** | **Number** | ** ** | **Remaining  contractual  life** | ** ** |
|---------------------|------------|------------|------------|----------------------------------|------------|
|                |       |       |       |                             |       |
| $                   | 28.18      |       |       | 3,740                            |       | 3 years |   |
| 31.94               |       |       | 4,730      |                             | 4 years    |   |
| 33.18               |       |       | 5,280      |                             | 5 years    |   |
| 34.09               |       |       | 6,380      |                             | 6 years    |   |
|                |       |       |       |                             |       |
| Total               |       | 20,130     |       |                             |       |

 

The stock optionshave a weighted-average life of 4.7 years.

 

63

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**10.****      ****INCOME TAXES**

 

The following temporarydifferences gave rise to the deferred tax asset (liability) atDecember 31:

 
| ** **                                          | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------------------------------------------|------------|------------|------------|------------|------------|
| Deferred tax  assets:                               |       |       |       |       |       |
| Allowance for  loan losses                          |       | $          | 2,034,781  |       | $          | 2,035,851 |   |
| Unrealized  losses on available-for-sale securities |       | 573,020    |       | 52,237     |       |
| Deferred  compensation                              |       | 60,013     |       | 90,868     |       |
| Retirement  settlement reserve                      |       | 55,419     |       | 153,914    |       |
| Other                                               |       | 47,088     |       | 21,404     |       |
|                                                |       |       |       |       |       |
| Total                                               |       | 2,770,321  |       | 2,354,274  |       |
|                                                |       |       |       |       |       |
| Deferred tax  liabilities:                          |       |       |       |       |       |
| Depreciation                                        |       | (442,985   | )          | (536,393   | )          |
| Loan fees and  costs                                |       | (395,624   | )          | (291,658   | )          |
| Leasing                                             |       | —     |       | (431,900   | )          |
| Other                                               |       | (248,260   | )          | (250,602   | )          |
|                                                |       |       |       |       |       |
| Total                                               |       | (1,086,869 | )          | (1,510,553 | )          |
|                                                |       |       |       |       |       |
| Deferred tax asset,  net                            |       | $          | 1,683,452  |       | $          | 843,721 |   |

 

The provision forincome taxes for the years ended December 31, are as follows:

 
| ** **      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|-----------------|------------|----------|------------|----------|------------|-----------|------------|
|            |       |     |       |     |       |      |       |
| Current         |       | $        | 1,785,060  |     | $          | 1,661,588 |       | $ | 711,062 |   |
| Deferred        |       | (318,948 | )          | (625,994 | )          | (564,570  | )          |
|            |       |     |       |     |       |      |       |
| Total provision |       | $        | 1,466,112  |     | $          | 1,035,594 |       | $ | 146,492 |   |

 

The reconciliationbetween the expected statutory income tax and the actual provision for incometaxes is as follows:

 
| ** **                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
|                                         |       |     |       |     |       |      |       |
| Expected  provision at the statutory rate    |       | $        | 2,059,655  |     | $          | 1,496,023 |       | $ | 608,510 |   |
| Tax-exempt  income                           |       | (353,559 | )          | (297,236 | )          | (312,287  | )          |
| Nondeductible  interest expense              |       | 43,296   |       | 29,748   |       | 36,934    |       |
| Bank owned life  insurance                   |       | (94,677  | )          | (108,766 | )          | (99,803   | )          |
| Nondeductible  other expenses and other, net |       | (68,489  | )          | 33,977   |       | 31,290    |       |
| Low income  housing tax credits              |       | (120,114 | )          | (118,152 | )          | (118,152  | )          |
|                                         |       |     |       |     |       |      |       |
| Actual provision  for income taxes           |       | $        | 1,466,112  |     | $          | 1,035,594 |       | $ | 146,492 |   |
|                                              |            |          |            |          |            |           |            |  |  |  |  |  |

 

64

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**11.****      ****RETIREMENT PLAN**

 

The Company has a definedprofit sharing 401(k) plan covering substantially all of its employees. Theplan is subject to the provisions of the Employee Retirement Income SecurityAct of 1974 (ERISA). Contributions to the plan were $214,184 in 2005, $196,749in 2004 and $214,756 in 2003.

 

**12.****      ****FINANCIAL INSTRUMENTS**

 

The Company is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers. These financialinstruments include commitments to extend credit and standby letters of credit.Those instruments involve, to varying degrees, elements of credit and interestrate risk in excess of the amount recognized in the balance sheet. The contractor notional amounts of those instruments reflect the extent of the Company’sinvolvement in particular classes of financial instruments.

 

The Company’sexposure to credit loss from nonperformance by the other party to the financialinstruments for commitments to extend credit and standby letters of credit isrepresented by the contractual amount of those instruments. The Company usesthe same credit policies in making commitments and conditional obligations asit does for on-balance-sheet instruments.

 

A summary of the notionalamounts of the Bank’s financial instruments with off-balance-sheet risk atDecember 31, 2005 follows:

 
| ** **                   | ** ** | **Notional  amount** | ** ** |
|------------------------------|------------|----------------------|------------|
| Commitments to extend credit |       | $                    | 67,958,000 |   |
| Standby letters of credit    |       | 4,508,000            |       |
|                              |            |                      |            |  |

 

Commitments to extendcredit are legally binding agreements to lend to customers. Commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of fees. Since commitments may expire without being drawn upon,the total commitment amounts do not necessarily represent future liquidityrequirements. The Company evaluates each customer’s credit-worthiness on acase-by-case basis. The amount of collateral obtained, if considered necessaryby the Company on extension of credit, is based on management’s creditassessment of the customer.

 

Financial standby lettersof credit are conditional commitments issued by the Company to guaranteeperformance of a customer to a third party. Those guarantees are issuedprimarily to support public and private borrowing arrangements, includingcommercial paper, bond financing, and similar transactions. The Company’sperformance under the guarantee is required upon presentation by thebeneficiary of the financial standby letter of credit. The credit risk involvedin issuing letters of credit is essentially the same as that involved inextending loan facilities to customers. The Company does not have any recourseprovisions or hold any assets that would enable it to recover from thirdparties any of the amounts paid under the guarantee. The Company was notrequired to recognize any liability in connection with the issuance of thesefinancial standby letters of credit. 

 

65

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The following tablesummarizes outstanding financial letters of credit as of December 31, 2005(in thousands):

 
| ** **            | ** ** | **Less than** | ** ** | **One to five** | ** ** | **Over five** | ** ** | ** ** | ** ** |
|-----------------------|------------|---------------|------------|-----------------|------------|---------------|------------|------------|------------|
| ** **            | ** ** | **one year**  | ** ** | **years**       | ** ** | **Years**     | ** ** | **Total**  | ** ** |
|                  |       |          |       |            |       |          |       |       |       |
| Secured by:           |       |          |       |            |       |          |       |       |       |
| Collateral            |       | $             | 501        |            | $          | 972           |       | $          | 2,821      |   | $ | 4,294 |   |
| Guarantees            |       | 111           |       | —          |       | —        |       | 111        |       |
| Bank lines of  credit |       | 54            |       | —          |       | —        |       | 54         |       |
|                  |       |          |       |            |       |          |       |       |       |
|                  |       | 666           |       | 972             |       | 2,821         |       | 4,459      |       |
|                  |       |          |       |            |       |          |       |       |       |
| Unsecured             |       | 35            |       | 14              |       | —        |       | 49         |       |
|                  |       |          |       |            |       |          |       |       |       |
| Total                 |       | $             | 701        |            | $          | 986           |       | $          | 2 ,821     |   | $ | 4,508 |   |

 

The Company has notincurred any losses on its commitments in 2005, 2004 or 2003.

 

As of December 31,2005 and 2004, the carrying or notional amount and estimated fair values of theCompany’s financial instruments were as follows (in thousands):

 
| ** **                      | ** ** | **2005**                           | ** ** | **2004**                  | ** ** |
|---------------------------------|------------|------------------------------------|------------|---------------------------|------------|
| ** **                      | ** ** | **Carrying  or  notional  amount** | ** ** | **Estimated  fair value** | ** ** | **Carrying  or  notional  amount** | ** ** | **Estimated  fair value** | ** ** |
|                            |       |                               |       |                      |       |   |   |   |   |
| Financial  assets:              |       |                               |       |                      |       |   |   |   |   |
| Cash and cash  equivalents      |       | $                                  | 12,595     |                      | $          | 12,595 |   | $ | 10,216 |   | $ | 10,216 |   |
| Held-to-maturity  securities    |       | 1,997                              |       | 2,046                     |       | 3,056 |   | 3,194 |   |
| Available-for-sale  securities  |       | 95,682                             |       | 95,682                    |       | 112,613 |   | 112,613 |   |
| FHLB Stock                      |       | 4,628                              |       | 4,628                     |       | 4,569 |   | 4,569 |   |
| Loans and leases                |       | 403,144                            |       | 397,412                   |       | 381,546 |   | 382,824 |   |
| Loans available  for sale       |       | 429                                |       | 434                       |       | 576 |   | 582 |   |
| Accrued interest                |       | 1,960                              |       | 1,960                     |       | 1,723 |   | 1,723 |   |
|                            |       |                               |       |                      |       |   |   |   |   |
| Financial  liabilities:         |       |                               |       |                      |       |   |   |   |   |
| Deposit  liabilities            |       | $                                  | 379,499    |                      | $          | 377,253 |   | $ | 365,615 |   | $ | 365,920 |   |
| Short-term  borrowings          |       | 28,773                             |       | 28,770                    |       | 50,534 |   | 50,518 |   |
| Long-term debt                  |       | 83,704                             |       | 85,517                    |       | 71,119 |   | 75,969 |   |
| Accrued interest                |       | 1,339                              |       | 1,339                     |       | 985 |   | 985 |   |
|                            |       |                               |       |                      |       |   |   |   |   |
| Off-balance  sheet liabilities: |       |                               |       |                      |       |   |   |   |   |
| Commitments to  extend credit   |       | $                                  | 67,958     |                      | $          | 67,958 |   | $ | 69,086 |   | $ | 69,086 |   |
| Standby letters  of credit      |       | 4,508                              |       | 4,508                     |       | 5,811 |   | 5,811 |   |

 

**13.****      ****EARNINGS PER SHARE**

 

Basic earnings per share(“EPS”) is computed using the weighted-average number of shares of common stockoutstanding. Diluted EPS is computed in the same manner as basic EPS butreflects the potential dilution of common stock equivalents. Dilution wouldoccur if “in-the-money” stock options were exercised and converted into commonstock. The Company uses the treasury stock method to determine the dilutiveeffect of its unexercised stock options. Under this method, the proceedsreceived from shares issued in a hypothetical exercise of stock options is assumedto be used to purchase treasury stock.

 

66

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The following dataillustrates the data used in computing earnings per share and the effects onincome and the weighted-average number of shares of potentially dilutive commonstock for the years ended December 31, 2005, 2004 and 2003. The number of sharesand per-share data has been adjusted, for all periods, to reflect a 10% stockdividend paid on February 15, 2006:

 
| ** **                                 | ** ** | **Income  numerator** | ** ** | **Common shares  denominator** | ** ** | **EPS** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|--------------------------------|------------|---------|------------|
|                                       |       |                  |       |                           |       |    |       |
| 2005                                       |       |                  |       |                           |       |    |       |
| Basic EPS                                  |       | $                     | 4,591,697  |                           | 2,031,211  |    | $          | 2.26 |   |
|                                       |       |                  |       |                           |       |    |       |
| Dilutive effect  of potential common stock |       |                  |       |                           |       |    |       |
| Stock options:                             |       |                  |       |                           |       |    |       |
| Exercise of  options outstanding           |       |                  |       | 20,130                         |       |    |       |
| Hypothetical  share repurchase at $37.73   |       |                  |       | (17,206                        | )          |    |       |
|                                       |       |                  |       |                           |       |    |       |
| Diluted EPS                                |       | $                     | 4,591,697  |                           | 2,034,135  |    | $          | 2.25 |   |
|                                       |       |                  |       |                           |       |    |       |
| 2004                                       |       |                  |       |                           |       |    |       |
| Basic EPS                                  |       | $                     | 3,364,474  |                           | 2,013,798  |    | $          | 1.67 |   |
|                                       |       |                  |       |                           |       |    |       |
| Dilutive effect  of potential common stock |       |                  |       |                           |       |    |       |
| Stock options:                             |       |                  |       |                           |       |    |       |
| Exercise of  options outstanding           |       |                  |       | 3,740                          |       |    |       |
| Hypothetical  share repurchase at $30.82   |       |                  |       | (3,420                         | )          |    |       |
|                                       |       |                  |       |                           |       |    |       |
| Diluted EPS                                |       | $                     | 3,364,474  |                           | 2,014,118  |    | $          | 1.67 |   |
|                                       |       |                  |       |                           |       |    |       |
| 2003                                       |       |                  |       |                           |       |    |       |
| Basic EPS                                  |       | $                     | 1,643,248  |                           | 2,002,443  |    | $          | 0.82 |   |
|                                       |       |                  |       |                           |       |    |       |
| Dilutive effect  of potential common stock |       |                  |       |                           |       |    |       |
| Stock options:                             |       |                  |       |                           |       |    |       |
| Exercise of  options outstanding           |       |                  |       | 18,260                         |       |    |       |
| Hypothetical  share repurchase at $30.58   |       |                  |       | (16,955                        | )          |    |       |
|                                       |       |                  |       |                           |       |    |       |
| Diluted EPS                                |       | $                     | 1,643,248  |                           | 2,003,748  |    | $          | 0.82 |   |

 

**14.****      ****REGULATORY MATTERS**

 

The Company (on aconsolidated basis) and the Bank are subject to various regulatory capitalrequirements administered by the federal banking agencies. Failure to meetminimum capital requirements can initiate certain mandatory and possibleadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Company’s and the Bank’s financial statements. Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, the Company and the Bank must meet specific capital guidelines thatinvolve quantitative measures of their assets, liabilities and certainoff-balance-sheet items as calculated under regulatory accounting practices. Thecapital amounts and classification are also subject to qualitative judgments bythe regulators about components, risk-weightings and other factors. Promptcorrective action provisions are not applicable to bank holding companies.

 

67

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Quantitative measures,established by regulation to ensure capital adequacy, require the Company andthe 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-weightedassets (as defined), and of Tier I capital (as defined) to average assets (asdefined). As of December 31, 2005, the Company and the Bank met all capitaladequacy requirements to which they are subject.

 

To be categorizedas well capitalized the Company must maintain minimum total risk-based, Tier Irisk-based and Tier I leverage ratios as set forth in the table. The Company’sand the Bank’s actual capital amounts and ratios are also presented in thetable. No amounts were deducted from capital for interest-rate risk in either2005 or 2004.

 
| ** **                               | ** ** | **Actual** | ** ** | **For capital  adequacy purposes** | ** ** | **To be well capitalized  under prompt corrective  action provisions** | ** ** |
|------------------------------------------|------------|------------|------------|------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                             | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                     |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| As of December 31, 2005:                 |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Consolidated                             |       | $          | 55,221,942 |                               | 13.3%      |                                                                   | 3$    | 33,322,328 |   | 38.0% |   | N/A |   | N/A |   |
| Bank                                     |       | $          | 54,917,536 |                               | 13.2%      |                                                                   | 3$    | 33,323,150 |   | 38.0% |   | $ | 41,653,937 |   | 310.0% |   |
|                                     |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Tier I capital (to risk-weighted assets) |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Consolidated                             |       | $          | 49,927,475 |                               | 12.0%      |                                                                   | 3$    | 16,661,164 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                     |       | $          | 49,695,324 |                               | 11.9%      |                                                                   | 3$    | 16,661,575 |   | 34.0% |   | $ | 24,992,362 |   | 36.0% |   |
|                                     |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Tier I capital (to average assets)       |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Consolidated                             |       | $          | 49,927,475 |                               | 9.3%       |                                                                   | 3$    | 21,577,465 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                     |       | $          | 49,695,324 |                               | 9.2%       |                                                                   | 3$    | 21,564,247 |   | 34.0% |   | $ | 26,955,308 |   | 35.0% |   |
|                                     |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| As of December 31, 2004:                 |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Consolidated                             |       | $          | 51,359,380 |                               | 13.3%      |                                                                   | 3$    | 30,879,151 |   | 38.0% |   | N/A |   | N/A |   |
| Bank                                     |       | $          | 51,032,749 |                               | 13.2%      |                                                                   | 3$    | 30,879,966 |   | 38.0% |   | $ | 38,599,957 |   | 310.0% |   |
|                                     |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Tier I capital (to risk-weighted assets) |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Consolidated                             |       | $          | 46,429,154 |                               | 12.0%      |                                                                   | 3$    | 15,439,576 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                     |       | $          | 46,183,330 |                               | 12.0%      |                                                                   | 3$    | 15,439,983 |   | 34.0% |   | $ | 23,159,974 |   | 36.0% |   |
|                                     |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Tier I capital (to average assets)       |       |       |       |                               |       |                                                                   |       |   |   |   |   |   |   |
| Consolidated                             |       | $          | 46,429,154 |                               | 8.6%       |                                                                   | 3$    | 21,665,350 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                     |       | $          | 46,183,330 |                               | 8.5%       |                                                                   | 3$    | 21,651,008 |   | 34.0% |   | $ | 27,063,760 |   | 35.0% |   |
|                                          |            |            |            |                                    |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

TheBank can pay dividends to the Company equal to the Bank’s retained earningswhich approximated $40,928,000 at December 31, 2005. However, such dividendsare limited due to the capital requirements discussed above.

 

**15.****      ****RELATED PARTY TRANSACTIONS**

 

During the ordinarycourse of business, loans are made to executive officers, directors,shareholders and associates of such persons. These transactions are executed onsubstantially the same terms and at the rates prevailing at the time forcomparable transactions with others. These loans do not involve more than thenormal risk of collectibility or present other unfavorable features. A summaryof loan activity with officers, directors, associates of such persons and shareholderswho own more than 5% of the Company’s outstanding shares is as follows:

 

68

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| ** **                                                                                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                                                             |       |       |       |       |       |       |       |
| Balance,  beginning                                                                                              |       | $          | 9,243,286  |       | $          | 10,125,429 |       | $ | 11,692,596 |   |
| Adjustments for  loans to individuals no longer officers, directors, associates or greater  than 5% shareholders |       | (1,100     | )          | (473,612   | )          | (221,750   | )          |
| Loans  sold/participated                                                                                         |       | —     |       | (260,000   | )          | (758,680   | )          |
| Additions                                                                                                        |       | 1,560,469  |       | 1,183,788  |       | 1,367,263  |       |
| Collections                                                                                                      |       | (1,637,101 | )          | (1,332,319 | )          | (1,954,000 | )          |
|                                                                                                             |       |       |       |       |       |       |       |
| Balance, ending                                                                                                  |       | $          | 9,165,554  |       | $          | 9,243,286  |       | $ | 10,125,429 |   |

 

Aggregate loans todirectors and associates exceeding 2.5% of shareholders’ equity included in thetable above are as follows:

 
| ** **                                         | ** ** | **2005** | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|----------------------------------------------------|------------|----------|------------|------------|------------|-----------|------------|
|                                               |       |     |       |       |       |      |       |
| Number of  persons                                 |       | 2        |       | 2          |       | 3         |       |
|                                               |       |     |       |       |       |      |       |
| Balance,  beginning                                |       | $        | 7,890,075  |       | $          | 9,386,280 |       | $ | 10,691,179 |   |
| Loans  sold/participated                           |       | —   |       | —     |       | (753,296  | )          |
| Additions                                          |       | 334,734  |       | 480,580    |       | 444,184   |       |
| Collections                                        |       | (777,876 | )          | (748,322   | )          | (995,787  | )          |
| Prior loan  balances no longer exceeding threshold |       | —   |       | (1,228,463 | )          | —    |       |
|                                               |       |     |       |       |       |      |       |
| Balance, ending                                    |       | $        | 7,446,933  |       | $          | 7,890,075 |       | $ | 9,386,280 |   |

 

As of December 31, 2005,2004 and 2003, deposits from executive officers, directors and associates ofsuch persons approximated $5,405,000, $5,818,000 and $4,990,000, respectively.

 

**16.****      ****QUARTERLY FINANCIAL INFORMATION(UNAUDITED)**

 

The following is asummary of quarterly results of operations for the years ended December 31, 2005,2004 and 2003:  

 
| **2005**                               | ** ** | **First  quarter**                           | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|----------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
| ** **                             | ** ** | **(in thousands, except per share amounts)** | ** ** |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Interest income                        |       | $                                            | 6,974      |                | $          | 7,103              |       | $                   | 7,324      |      | $          | 7,619 |   | $ | 29,020 |   |
| Interest expense                       |       | (2,698                                       | )          | (2,785              | )          | (2,962             | )          | (3,276              | )          | (11,721   | )          |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Net interest  income                   |       | 4,276                                        |       | 4,318               |       | 4,362              |       | 4,343               |       | 17,299    |       |
| Provision for  loan losses             |       | (80                                          | )          | (300                | )          | (300               | )          | (150                | )          | (830      | )          |
| Gain on sale of  investment securities |       | —                                       |       | 3                   |       | —             |       | 2                   |       | 5         |       |
| Other income                           |       | 747                                          |       | 1,124               |       | 1,228              |       | 1,061               |       | 4,160     |       |
| Other expenses                         |       | (3,565                                       | )          | (3,612              | )          | (3,591             | )          | (3,808              | )          | (14,576   | )          |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Income before  income taxes            |       | 1,378                                        |       | 1,533               |       | 1,699              |       | 1,448               |       | 6,058     |       |
| Provision for  income taxes            |       | (358                                         | )          | (397                | )          | (405               | )          | (306                | )          | (1,466    | )          |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Net income                             |       | $                                            | 1,020      |                | $          | 1,136              |       | $                   | 1,294      |      | $          | 1,142 |   | $ | 4,592 |   |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Net income per  share                  |       | $                                            | 0.50       |                | $          | 0.56               |       | $                   | 0.64       |      | $          | 0.56 |   | $ | 2.26 |   |

 

69

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| **2004**                               | ** ** | **First  quarter**                           | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|----------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
| ** **                             | ** ** | **(in thousands, except per share amounts)** | ** ** |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Interest income                        |       | $                                            | 6,963      |                | $          | 6,813              |       | $                   | 6,738      |      | $          | 6,881 |   | $ | 27,395 |   |
| Interest expense                       |       | (3,030                                       | )          | (2,722              | )          | (2,720             | )          | (2,708              | )          | (11,180   | )          |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Net interest  income                   |       | 3,933                                        |       | 4,091               |       | 4,018              |       | 4,173               |       | 16,215    |       |
| Provision for  loan losses             |       | (850                                         | )          | (400                | )          | (450               | )          | (450                | )          | (2,150    | )          |
| Gain on sale of  investment securities |       | 9                                            |       | —              |       | —             |       | —              |       | 9         |       |
| Other income                           |       | 937                                          |       | 1,071               |       | 1,149              |       | 995                 |       | 4,152     |       |
| Other expenses                         |       | (3,275                                       | )          | (3,539              | )          | (3,658             | )          | (3,354              | )          | (13,826   | )          |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Income before  income taxes            |       | 754                                          |       | 1,223               |       | 1,059              |       | 1,364               |       | 4,400     |       |
| Provision for  income taxes            |       | (129                                         | )          | (302                | )          | (245               | )          | (360                | )          | (1,036    | )          |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Net income                             |       | $                                            | 625        |                | $          | 921                |       | $                   | 814        |      | $          | 1,004 |   | $ | 3,364 |   |
|                                   |       |                                         |       |                |       |               |       |                |       |      |       |
| Net income per  share                  |       | $                                            | 0.31       |                | $          | 0.45               |       | $                   | 0.41       |      | $          | 0.50 |   | $ | 1.67 |   |

 
| **2003**                                         | ** ** | **First  quarter**                           | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
| ** **                                       | ** ** | **(in thousands, except per share amounts)** | ** ** |
|                                             |       |                                         |       |                |       |               |       |                |       |      |       |
| Interest income                                  |       | $                                            | 7,638      |                | $          | 7,147              |       | $                   | 6,783      |      | $          | 6,894 |   | $ | 28,462 |   |
| Interest expense                                 |       | (3,806                                       | )          | (3,718              | )          | (3,443             | )          | (3,270              | )          | (14,237   | )          |
|                                             |       |                                         |       |                |       |               |       |                |       |      |       |
| Net interest  income                             |       | 3,832                                        |       | 3,429               |       | 3,340              |       | 3,624               |       | 14,225    |       |
| Provision for  loan losses                       |       | (300                                         | )          | (460                | )          | (300               | )          | (2,655              | )          | (3,715    | )          |
| Gain on sale of  investment securities           |       | 82                                           |       | 132                 |       | —             |       | 115                 |       | 329       |       |
| Other income                                     |       | 875                                          |       | 1,129               |       | 1,021              |       | 829                 |       | 3,854     |       |
| Other expenses                                   |       | (3,295                                       | )          | (3,014              | )          | (3,193             | )          | (3,401              | )          | (12,903   | )          |
|                                             |       |                                         |       |                |       |               |       |                |       |      |       |
| Income (loss)  before provision for income taxes |       | 1,194                                        |       | 1,216               |       | 868                |       | (1,488              | )          | 1,790     |       |
| (Provision)  benefit for income taxes            |       | (307                                         | )          | (293                | )          | (183               | )          | 636                 |       | (147      | )          |
|                                             |       |                                         |       |                |       |               |       |                |       |      |       |
| Net income  (loss)                               |       | $                                            | 887        |                | $          | 923                |       | $                   | 685        |      | $          | (852 | ) | $ | 1,643 |   |
|                                             |       |                                         |       |                |       |               |       |                |       |      |       |
| Net income  (loss) per share                     |       | $                                            | 0.44       |                | $          | 0.45               |       | $                   | 0.35       |      | $          | (0.42 | ) | $ | 0.82 |   |

 

Inthe above tables, the per-share data has been adjusted, for all periods, toreflect a 10% stock dividend paid on February 15, 2006.

 

**17.****      ****CONTINGENCIES**

 

The nature of theCompany’s business generates some litigation involving matters arising in theordinary course of business. However, in the opinion of management of theCompany after consulting with the Company’s legal counsel, no legal proceedingsare pending, which, if determined adversely to the Company or the Bank, wouldhave a material effect on the Company’s shareholders’ equity or results ofoperations. No legal proceedings are pending other than ordinary routinelitigation incident to the business of the Company and the Bank. In addition,to management’s knowledge, no government authorities have initiated orcontemplated any material legal actions against the Company or the Bank.

 

70

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**18.****      ****RECENT ACCOUNTING PRONOUNCEMENTS**

 

In December 2004, theFASB issued SFAS 123R which replaces SFAS 123, *Accountingfor Stock-Based Compensation*, and supersedes APB Opinion 25, *Accounting for Stock Issued to Employees*. SFAS123R requires that the cost of share-based payment transactions (includingthose with employees and non-employees) be recognized in the financial statements.SFAS 123R applies to all share-based payment transactions in which an entityacquires goods or services by issuing (or offering to issue) its shares, shareoptions, or other equity instruments (except for those held by an ESOP) or byincurring liabilities (1) in amounts based (even in part) on the price of theentity’s shares or other equity instruments, or (2) that require (or mayrequire) settlement by the issuance of an entity’s shares or other equityinstruments. The Bank will implement this new standard in the first quarter of2006. As of December 31, 2005, all of the Bank’s previously granted stockoptions outstanding were fully vested and therefore the Bank will not berequired to recognize compensation expense related to these options. Also, as ofDecember 31, 2005, the Company had a liability related to the issuance of Companyshares, on behalf of participating employees under its Employee Stock PurchasePlan. Compensation expense related to the market discount of these shares willapproximate $15,000 in 2006.

 

In May 2005, the FASBissued SFAS Nos. 154, *Accounting Changes andError Corrections*that changes the requirements for the accountingfor and reporting of a change in accounting principle. SFAS No. 154 replacesAPB Opinion No. 20, *Accounting Changes*andSFAS No. 3, *Reporting Accounting Changes in Interim Financial*

 

*Statements.*APB Opinion No. 20 previously required that most voluntarychanges in accounting principle be recognized by including in net income of theperiod of the change the cumulative effect of changing to the new accountingprinciple. SFAS No. 154 requires retrospective application to prior periods’financial statements of changes in accounting principle, unless impracticableto determine either the period-specific effects or the cumulative effect of thechange. This statement also redefines “restatement” to include the revision ofpreviously issued financial statements to reflect the correction of an error. Thisstatement is effective for accounting changes and error corrections made infiscal years beginning after December 15, 2005.

 

In November 2005, theFASB issued Staff Position (FSP) Nos. 115-1 and FAS 124-1, *The Meaningof Other-Than-Temporary Impairment and Its Application to Certain Investments.*ThisFSP addresses the determination of when an investment is considered to beimpaired, whether the impairment is other-than-temporary and the measurement ofan impairment loss. This FSP also includes accounting considerations subsequentto the recognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary. The guidelines in this FSP must be applied to allreporting periods beginning after December 15, 2005.

 

71

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**19.****      ****PARENT COMPANY ONLY**

 

The following iscondensed financial information for Fidelity D & D Bancorp, Inc. on aparent company only basis (in thousands):

 

##### **Condensed Balance Sheets**

 
| ** **                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|------------------|------------|
| ** **                                  | ** ** | **2005**         | ** ** | **2004** | ** ** |
|                                        |       |             |       |   |   |
| Assets:                                     |       |             |       |   |   |
| Cash                                        |       | $                | 8          |   | $ | 5 |   |
| Investment in  subsidiary                   |       | 48,508           |       | 46,002 |   |
| Securities  available-for-sale              |       | 433              |       | 452 |   |
| Other                                       |       | —           |       | — |   |
|                                        |       |             |       |   |   |
| Total                                       |       | $                | 48,949     |   | $ | 46,459 |   |
|                                        |       |             |       |   |   |
| Liabilities and  shareholders’ equity: |       |             |       |   |   |
| Liabilities                                 |       | $                | 103        |   | $ | 92 |   |
| Shareholders’  equity                  |       | 48,846           |       | 46,367 |   |
|                                        |       |             |       |   |   |
| Total                                       |       | $                | 48,949     |   | $ | 46,459 |   |

 

##### **Condensed Income Statements**

 
| ** **                                      | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                            |       |                         |       |   |   |   |   |
| Income:                                         |       |                         |       |   |   |   |   |
| Equity in  undistributed earnings of subsidiary |       | $                            | 3,504      |   | $ | 2,311 |   | $ | 182 |   |
| Dividends from  subsidiary                      |       | 1,167                        |       | 1,156 |   | 1,590 |   |
| Other income                                    |       | 12                           |       | 13 |   | — |   |
|                                            |       |                         |       |   |   |   |   |
| Total income                                    |       | 4,683                        |       | 3,480 |   | 1,772 |   |
|                                            |       |                         |       |   |   |   |   |
| Operating  expenses                             |       | 136                          |       | 168 |   | 195 |   |
|                                            |       |                         |       |   |   |   |   |
| Income before  income taxes                     |       | 4,547                        |       | 3,312 |   | 1,577 |   |
|                                            |       |                         |       |   |   |   |   |
| Credit for  income taxes                        |       | 45                           |       | 52 |   | 66 |   |
|                                            |       |                         |       |   |   |   |   |
| Net income                                      |       | $                            | 4,592      |   | $ | 3,364 |   | $ | 1,643 |   |

 

72

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##### **Condensed Statements of Cash Flows**

 
| ** **                                                           | ** ** | **Years ended  December 31,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                           | ** ** | **2005**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                 |       |                          |       |   |   |   |   |
| Cash flows from  operating activities:                               |       |                          |       |   |   |   |   |
| Net income                                                           |       | $                             | 4,592      |   | $ | 3,364 |   | $ | 1,643 |   |
| Adjustments to  reconcile net income to net cash used in operations: |       |                          |       |   |   |   |   |
| Equity in  earnings of subsidiary                                    |       | (4,671                        | )          | (3,467 | ) | (1,772 | ) |
| Deferred income  taxes                                               |       | —                        |       | 2 |   | (66 | ) |
| Changes in other  assets and liabilities, net                        |       | 16                            |       | (11 | ) | 54 |   |
|                                                                 |       |                          |       |   |   |   |   |
| Net cash used in  operating activities                               |       | (63                           | )          | (112 | ) | (141 | ) |
|                                                                 |       |                          |       |   |   |   |   |
| Cash flows from  investing activities:                               |       |                          |       |   |   |   |   |
| Dividends  received from subsidiary                                  |       | 1,167                         |       | 1,156 |   | 1,590 |   |
|                                                                 |       |                          |       |   |   |   |   |
| Cash flows from  financing activities:                               |       |                          |       |   |   |   |   |
| Dividends paid,  net of dividend reinvestment                        |       | (1,133                        | )          | (1,110 | ) | (1,081 | ) |
| Exercise of  stock options                                           |       | —                        |       | 16 |   | 30 |   |
| Withholdings to  purchase capital stock                              |       | 32                            |       | 53 |   | 60 |   |
| Purchase of  treasury stock                                          |       | —                        |       | — |   | (458 | ) |
|                                                                 |       |                          |       |   |   |   |   |
| Net cash used in  financing activities                               |       | (1,101                        | )          | (1,041 | ) | (1,449 | ) |
|                                                                 |       |                          |       |   |   |   |   |
| Net increase in  cash                                                |       | 3                             |       | 3 |   | — |   |
|                                                                 |       |                          |       |   |   |   |   |
| Cash, beginning                                                      |       | 5                             |       | 2 |   | 2 |   |
|                                                                 |       |                          |       |   |   |   |   |
| Cash, ending                                                         |       | $                             | 8          |   | $ | 5 |   | $ | 2 |   |

 

**20.****      ****SUBSEQUENT EVENT**

 

On January 17, 2006, theBoard of Directors of the Company declared a 10% stock dividend payable onFebruary 15, 2006 to shareholders of record as of January 30, 2006. The numberof shares and per-share data has been adjusted, for all periods presented, toreflect the retroactive effect of this stock dividend.

 

73

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***Item 9:  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE***

 

None.

 

***Item 9A:*****                  *****CONTROLS AND PROCEDURES***

 

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures performed within 90 days of the filing date of this report, the Chief Executive and Chief Financial Officers of the Company concluded that the Company’s disclosure controls and procedures were effective.

 

***Item 9B:*****                  *****OTHER INFORMATION***

 

None.

 

### ***PART III***

 

***Item10: DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY***

 

The information required under Items 401 and 406 of Regulation S-K isincorporated by reference herein, to the information presented in the Company’sdefinitive Proxy Statement for its 2006 Annual Meeting of Shareholders to befiled with the SEC.

 

***Section 16(a) Beneficial Ownership Reporting Compliance***

 

The information required under this section is incorporated byreference herein, to the information presented in the Company’s definitiveProxy Statement for its 2006 Annual Meeting of Shareholders to be filed withthe SEC.

 

#### ***Code of Ethics***

#### ** **

The Company adopted a written code of ethics that applies to ourdirectors, officers and employees, including our chief executive officer andchief financial officer, which is available on our investor relations websiteat http://www.the-fidelity.com under the heading “Corporate Governance” of theInvestor Relations link. In addition, copies of our code of ethics will beprovided to shareholders upon written request to Fidelity D & D Bancorp,Inc., Blakely and Drinker Streets, Dunmore, PA 18512 at no charge.

 

#### ***Item 11: EXECUTIVE COMPENSATION***

#### ** **

The information required by this Item is incorporatedby reference herein, to the information presented in the Company’s 2006definitive Proxy Statement.

 

***Item12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT******AND RELATED STOCKHOLDER MATTERS***

 

The information required by this Item is incorporated by referenceherein, to the information presented in the Company’s 2006 definitive ProxyStatement.

 

74

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##### ***Item 13: CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS***

 

The information required by this Item, relating to transactions withmanagement and others, certain business relationships and indebtedness ofmanagement, is set forth above in Item 8 “Financial Statements andSupplementary Data” and is incorporated by reference herein to the informationpresented in the Company’s 2006 definitive Proxy Statement.

 

***Item 14:******PRINCIPAL ACCOUNTANT FEES AND SERVICES***

 

The information required by this Item is incorporated by referenceherein, to the information presented in the Company’s 2006 definitive ProxyStatement.

 

***PARTIV***

 

***Item15: EXHIBITS AND FINANCIAL STATEMENT SCHEDULES***

 

***(a)(1) Financial Statements*** - The following financialstatements are included by reference in Part II, Item 8 hereof:

 

Report of Independent Registered Public AccountingFirm.

Consolidated Balance Sheets.

Consolidated Statements of Income.

Consolidated Statements of Changes in Shareholders’Equity.

Consolidated Statements of Cash Flows.

Notes to Consolidated Financial Statements.

 

***(2)FinancialStatement Schedules***

 

Financial Statement Schedules are omitted because therequired information is either not applicable, the data is not significant orthe required information is shown in the respective financial statements or inthe notes thereto or elsewhere herein.

 

***(3)Exhibits***

 

The following exhibits are filed herewith orincorporated by reference as a part of this Form 10-K:

 

***3(i)Amended and Restated Articles of Incorporation of Registrant.***Incorporated by reference to Exhibit 3(i) to Registrant’s RegistrationStatement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 andas amended on April 6, 2000.

 

***3(ii)Bylaws of Registrant.*** Incorporated by reference toExhibit 3(ii) to Registrant’s Registration Statement No.333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended onApril 6, 2000.

 

***10.11998 Independent Directors Stock Option Plan of The Fidelity Deposit andDiscount Bank, as assumed by Registrant.*** Incorporated byreference to Exhibit 10.1 to Registrant’s Registration Statement No. 333-90273on FormS-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.

 

***10.21998 Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as assumedby Registrant.*** Incorporated by reference to Exhibit 10.2of Registrant’s Registration Statement No. 333-90273 on Form S-4, filed withthe SEC on November 3, 1999 and as amended on April 6, 2000.

 

***10.3Form of Deferred Compensation Plan of The Fidelity Deposit and Discount Bank.***Incorporatedby reference to Exhibit 10.3 to Registrant’s Registration StatementNo.333-45668 on Form S-1, filed with the SEC on September 12, 2000 and asamended on October 11, 2000.

 

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***10.4Registrant’s 2000 Dividend Reinvestment Plan.***Incorporatedby reference to Exhibit 4 to Registrant’s   Registration Statement No. 333-45668 on Form S-1, filed with the SEC onSeptember 12, 2000 and as amended by Pre- Effective Amendment No. 1 on October 11, 2000, by Post-EffectiveAmendment No. 1 on May 30, 2001 and by Post-  Effective Amendment No 2 on July 7, 2005.

 

***10.5Registrant’s 2000 Independent Directors Stock Option Plan.***Incorporatedby reference to Exhibit 4.3 to Registrant’s Registration Statement No.333-64356 on Form S-8 filed with the SEC on July 2, 2001.

 

***10.6Registrant’s 2000 Stock Incentive Plan.***Incorporated byreference to Exhibit 4.4 to Registrant’s Registration Statement No. 333-64356on Form S-8 filed with the SEC on July 2, 2001.

 

***10.7Registrant’s 2002 Employee Stock Purchase Plan.***Incorporatedby reference to Exhibit 4.5 to Registrant’s Registration Statement No.333-113339 on Form S-8 filed with the SEC on March 5, 2004.

 

***10.8Employment Agreement between Fidelity D & D Bancorp, Inc., The FidelityDeposit and Discount Bank******and StevenC. Ackmann, dated June 21, 2004.***Incorporated by reference toExhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC onJune 24, 2004.

 

***10.9Complete Settlement Agreement and General Release between Michael F. Marranca,Registrant and The Fidelity Deposit and Discount Bank, dated July 30, 2004. Incorporatedby reference to Exhibit 99.1 to Registrant’s Current*** Reporton Form 8-K filed with the SEC on August 10, 2004.

 

***10.10Change of Control and Severance Agreement between James T. Gorman, Registrantand The Fidelity Deposit and Discount Bank, dated September 19, 2005.***Incorporatedby reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filedwith the SEC on September 22, 2005.

 

***10.11Amendment and Termination of the Deferred Compensation Agreement with Joseph J.Earyes, Daniel Santaniello, Registrant and The Fidelity Deposit and DiscountBank, dated November 1, 2005.***Incorporated by referenceto Exhibits 99.1and 99.2 to Registrant’s Current Report on Form 8-K filed withthe SEC on November 3, 2005.

 

***10.12Amendment to the Complete Settlement Agreement and General Release betweenMichael F. Marranca, Registrant and The Fidelity Deposit and Discount Bank,dated November 4, 2005*.**Incorporated by reference to****Exhibit 99.1 to Registrant’s Current Report on Form 8-Kfiled with the SEC on November 9, 2005.

 

***11Statement regarding computation of earnings per share.***Includedherein in Note 13 “Earnings per Share”, contained within the notes to consolidatedfinancial statements, and incorporated herein by reference.

 

***12Statement regarding computation of ratios.***Includedherein in Item 6, “Selected Financial Data”.

 

***13Annual Report to Shareholders.***Incorporated by referenceto the 2005 Annual Report to Shareholders filed with the SEC on Form ARS.

 

***14Code of Ethics.*** Incorporated by reference to the 2003Annual Report to Shareholders on Form 10-K filed with the SEC on March 29,2004.

 

***21Subsidiaries of the Registrant.***

 

***23 Consentof Independent Registered Public Accounting Firm.***

 

***31.1Rule 13a-14(a) Certification of Principal Executive Officer, filed herewith.***

 

***31.2Rule 13a-14(a) Certification of Principal Financial Officer, filed herewith.***

 

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***32.1 Certificationof Principal Executive Officer pursuant to 18 U.S.C. Section 1350,******as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002, filed herewith.***

 

***32.2 Certificationof Principal Financial Officer pursuant to 18 U.S.C. Section 1350,******as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002, filed herewith.***

 

***(b)******                                ******The exhibits required to be filedby this Item are listed under Item 15(a) 3, above.***

 

***(c)******                                 ******Not applicable.***

 

77

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities and Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                 | **FIDELITY D & D BANCORP, INC.** |
|----------------------|--------------------------------------|
|                 | (Registrant)                         |
|                 |                                 |   |
|                 |                                 |   |
|                 |                                 | By: | /s/ Steven C. Ackmann |   |
| Date: March 21, 2006 |                                 |  Steven C.  Ackmann, |
|                 |                                 | President and  Chief Executive Officer |
|                 |                                 |   |
|                 |                                 |   |
|                 |                                 | By: | /s/ Salvatore R. DeFrancesco, Jr. |   |
| Date: March 21, 2006 |                                 | Salvatore R.  DeFrancesco, Jr., |
|                 |                                 |  Treasurer  and Chief Financial Officer |
|                      |                                      |  |  |  |  |

 

78

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Pursuant to the requirements of the Securities and Exchange Act of1934, this report has been signed below by the following person on behalf ofthe registrant and in the capacities and on the dates indicated.

 
| ** **                                      | **DATE**                          |
|-------------------------------------------------|-----------------------------------|
|                                            |                              |
| By:                                             | /s/ Steven C. Ackmann             |   | March 21, 2006 |
|  Steven C.  Ackmann, President and         |                              |
| Chief Executive  Officer                        |                              |
|                                            |                              |
| By:                                             | /s/ Salvatore R. DeFrancesco, Jr. |   | March 21, 2006 |
|  Salvatore  R. DeFrancesco, Jr., Treasurer |                              |
| and Chief  Financial Officer                    |                              |
|                                            |                              |
| By:                                             | /s/ Samuel C. Cali                |   | March 21, 2006 |
|  Samuel C.  Cali, Chairman Emeritus        |                              |
| and Director                                    |                              |
|                                            |                              |
| By:                                             | /s/ Patrick J. Dempsey            |   | March 21, 2006 |
|  Patrick J.  Dempsey, Chairman             |                              |
| of the Board of  Directors and Director         |                              |
|                                            |                              |
| By:                                             | /s/ Paul A. Barrett               |   | March 21, 2006 |
|  Paul A.  Barrett, Secretary and Director  |                              |
|                                            |                              |
| By:                                             | /s/ John T. Cognetti              |   | March 21, 2006 |
|  John T. Cognetti,  Assistant Secretary    |                              |
| and Director                                    |                              |
|                                            |                              |
| By:                                             | /s/ Michael J. McDonald           |   | March 21, 2006 |
|  Michael J.  McDonald, Vice Chairman       |                              |
| of the Board of  Directors and Director         |                              |
|                                            |                              |
| By:                                             | /s/ David L. Tressler             |   | March 21, 2006 |
|  David L.  Tressler, Director              |                              |
|                                            |                              |
| By:                                             | /s/ Mary E. McDonald              |   | March 21, 2006 |
|  Mary E.  McDonald, Director               |                              |
|                                            |                              |
| By:                                             | /s/ Brian J. Cali                 |   | March 21, 2006 |
| Brian J. Cali,  Director                        |                              |

 

79

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**EXHIBIT INDEX**

 
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          | **Page** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| ***3(i) Amended and Restated  Articles of Incorporation of Registrant.***Incorporated  by reference to Exhibit 3(i) to Registrant’s Registration Statement No.  333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended  on April 6, 2000.                                                                                                                                  | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***3(ii) Bylaws of Registrant***.  Incorporated by reference to Exhibit 3 (ii) to Registrant’s Registration  Statement No. 333-90273 on Form S-4, filed with the SEC on November 3,  1999 and as amended on April 6, 2000.                                                                                                                                                                  | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.1 1998 Independent Directors  Stock Option Plan of The Fidelity Deposit and Discount Bank, as assumed by  Registrant.*** Incorporated by reference to Exhibit 10.1  to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with  the SEC on November 3, 1999 and as amended on April 6, 2000.                                                                             | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.2 1998 Stock Incentive Plan  of The Fidelity Deposit and Discount Bank, as assumed by Registrant.***Incorporated  by reference to Exhibit 10.2 of Registrant’s Registration Statement No.  333-90273 on Form S-4, filed with the SEC on Nov. 3, 1999 and as amended on  April 6, 2000.                                                                                                     | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.3 Form of Deferred  Compensation Plan of The Fidelity Deposit and Discount Bank.***  Incorporated by reference to Exhibit 10.3 to Registrant’s Registration  Statement No. 333-45668 on Form S-1, filed with the SEC on September 12, 2000  and as amended on October 11, 2000.                                                                                                            | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.4 Registrant’s 2000 Dividend  Reinvestment Plan.***Incorporated by reference to Exhibit  4 to Registrant’s Registration Statement No. 333-45668 on Form S-1, filed  with the SEC on September 12, 2000 and as amended by Pre-Effective Amendment  No. 1 on October 11, 2000,  by Post-Effective Amendment No. 1 on May 30, 2001and by Post-Effective  Amendment No 2 on July 7, 2005. | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.5 Registrant’s 2000  Independent Directors Stock Option Plan.***Incorporated  by reference to Exhibit 4.3 to Registrant’s Registration Statement No.  333-64356 on Form S-8 filed with the SEC on July 2, 2001.                                                                                                                                                                       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.6 Registrant’s 2000 Stock  Incentive Plan.***Incorporated by reference to Exhibit  4.4 to Registrant’s Registration Statement No. 333-64356 on Form S-8 filed  with the SEC on July 2, 2001.                                                                                                                                                                                          | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.7 Registrant’s 2002 Employee  Stock Purchase Plan.***Incorporated by reference to  Exhibit 4.5 to Registrant’s Registration Statement No. 333-113339 on Form S-8  filed with the SEC on March 5, 2004.                                                                                                                                                                                | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                          |     |
| ***10.8  Employment Agreement between Fidelity D & D Bancorp, Inc., The Fidelity  Deposit and Discount Bank and Steven C. Ackmann, dated June 21, 2004.***Incorporated by reference to  Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on  June 24, 2004.                                                                                                        | *        |

 

80

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| ***10.9 Complete Settlement  Agreement and General Release between Michael F. Marranca, Registrant and The  Fidelity Deposit and Discount Bank, dated July 30, 2004.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on August 10, 2004.                                              | *      |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                                                                                                                                   |   |
| ***10.10 Change of Control and  Severance Agreement between James T. Gorman, Registrant and the Fidelity  Deposit and Discount Bank, dated September 19, 2005.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on September 22, 2005.                                                 | *      |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***10.11 Amendment and Termination  of the Deferred Compensation Agreement with Joseph J. Earyes, Daniel  Santaniello, Registrant and The Fidelity Deposit and Discount Bank, dated  November 1, 2005.***Incorporated by reference to Exhibits  99.1 and 99.2 to Registrant’s Current Report on Form 8-K filed with the SEC  on November 3, 2005. | *      |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***10.12 Amendment to the Complete  Settlement Agreement and General Release between Michael F. Marranca,  Registrant and The Fidelity Deposit and Discount Bank, dated November 4, 2005*.**Incorporated by reference to** **Exhibit 99.1  to Registrant’s Current Report on Form 8-K filed with the SEC on November 9,  2005.               | *      |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***11 Statement regarding computation  of earnings per share.*** Included herein Note 13  “Earnings per Share”, contained within the Notes to Consolidated Financial  Statements, and incorporated herein by reference.                                                                                                                      | 66     |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***12 Statement regarding  computation of ratios.***Included herein in Item 6,  “Selected Financial Data”.                                                                                                                                                                                                                                   | 13     |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***13 Annual Report to  Shareholders.***Incorporated by reference to the 2005  Annual Report to Shareholders filed with the SEC on Form ARS.                                                                                                                                                                                                           | *      |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***14 Code of Ethics.***Incorporated  by reference to the 2003 Annual Report to Shareholders on Form 10-K filed  with the SEC on March 29, 2004.                                                                                                                                                                                                       | *      |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***21 Subsidiaries of the  Registrant.***                                                                                                                                                                                                                                                                                                              | 82     |
|                                                                                                                                                                                                                                                                                                                                                   |   |
| ***23 Consent of Independent  Registered Public Accounting Firm.***                                                                                                                                                                                                                                                                                    | 83     |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***31.1 Rule 13a-14(a)  Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                                               | 84     |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***31.2 Rule 13a-14(a)  Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                                               | 85     |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***32.1 Certification of Principal  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                                                                    | 86     |
| *** ***                                                                                                                                                                                                                                                                                                                                           |   |
| ***32.2 Certification of Principal  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                                                                    | 87     |

 

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* Incorporated by Reference

 

81

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