**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

**FORM 10-K**

| **x** | **ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|-------|-------------------------------------------------------------------------------------|

** **

**FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006**

**COMMISSION FILE NUMBER 333-90273**

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

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

**BLAKELYAND DRINKER STREETS**

**DUNMORE,PENNSYLVANIA  18512**

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

SECURITIES REGISTERED UNDER SECTION 12(b) OF THE ACT:**None**

SECURITIES REGISTERED UNDER SECTION 12(g) OF THE ACT:**Common Stock, without par value**

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act.  Yes o  No x

Indicate by checkmark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act.  Yes o  No x

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x  No o

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of the Registrant’s knowledge, in definitive proxy or informationstatements incorporated by references in Part III of this Form 10-Kor any amendment to this Form 10-K. x

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.  (Check One)

| Large accelerated  filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |
|---------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12B-2of the Act).  Yes o  No x

Aggregate marketvalue of the voting common stock held by non-affiliates of the registrantequals $58,290,031, as of June 30, 2006, based on a market price of $35.00.  The number of shares of common stockoutstanding as of March 10, 2007, was 2,063,357.

**DOCUMENTSINCORPORATED BY REFERENCE**

Excerpts from the Registrant’s 2006 Annual Report toShareholders are incorporated herein by reference in response to Part I.Portions of the Registrant’s definitive Proxy Statement to be used inconnection with the 2007 Annual Meeting of Shareholders are incorporated hereinby reference in partial response to Part II and Part III.

 

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**Fidelity D & D Bancorp, Inc.2006 Annual Report on Form 10-KTable of Contents**

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

 

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

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

# ***ITEM 1:*        *BUSINESS***

Fidelity D & DBancorp, Inc. (the Company) was incorporated in the Commonwealth ofPennsylvania, on August 10, 1999, and is a bank holding company, whose whollyowned state chartered commercial bank is The Fidelity Deposit and Discount Bank(the Bank) (collectively, the Company). The Company is headquartered at Blakely and Drinker Streets in Dunmore,Pennsylvania.

The Bank hasoffered a full range of traditional banking services since it commenced operationsin 1903.  The Bank has a personal andcorporate trust department and also provides alternative financial andinsurance products with asset management services.  A complete list of services provided by theBank is detailed in the section entitled “Products & Services” containedwithin the 2006 Annual Report to Shareholders, incorporated by reference.  The service area is comprised of the Boroughof Dunmore and the surrounding communities within Lackawanna and Luzernecounties.

The bankingbusiness is highly competitive, and the profitability of the Company dependsprincipally upon the Company’s ability to compete in its market area.  The Company competes with, among othersources, the following:

·                  localcommunity banks

·                  savingsbanks

·                  regionalbanks

·                  creditunions

·                  savings& loans

·                  insurancecompanies

·                  moneymarket funds

·                  mutualfunds

·                  smallloan companies

·                  otherfinancial service companies

The Company hasbeen able to compete effectively with other financial institutions byemphasizing technology and customer service, including local decision making onloans.  These efforts enabled the Bank toestablish long-term customer relationships and build customer loyalty byproviding products and services designed to address the specific needs of itscustomers.

There are noconcentrations of loans that, if lost, would have a materially adverse effecton the continued business of the Bank. The Bank’s loan portfolio does not have a material concentration withina single industry or group of related industries that are vulnerable to therisk of a near-term severe impact. However, the Company’s success is dependent, to a significant degree, oneconomic conditions in Northeastern Pennsylvania, especially in Lackawanna andLuzerne counties, which the Company defines as its primary market area.  The banking industry is affected by generaleconomic conditions including the effects of inflation, recession,unemployment, real estate values, trends in national and global economies andother factors beyond the Company’s control. 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 therebycause operating losses, impairment of liquidity and erosion of capital.  We cannot assure you that adverse changes inthe local economy would not have a material effect on the Company’s futureconsolidated financial condition, results of operations and cash flows.

The Company had 188 full-time equivalent employees onDecember 31, 2006, 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 issubject to, among others, the regulations of the Securities and ExchangeCommission (the SEC) and the Federal Reserve Board (the FRB) and the Bank issubject to, among others, the regulations of the Pennsylvania Department of Bankingand the Federal Deposit Insurance Corporation (the FDIC).  Refer to Part II, Item 7 “Supervision andRegulation” for descriptions of and references to applicable statutes andregulations which are not intended to be complete descriptions of these provisionsor their effects on the Company or the Bank. They are summaries only and are qualified in their entirety by referenceto such statutes and regulations.

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Applicableregulations relate to, among other things:
| · |   | operations          |
|--------|--------|---------------------|
|   |   |                |
| · |   | securities          |
|   |   |                |
| · |   | risk management     |
|   |   |                |
| · |   | consumer compliance |
|   |   |                |
| · |   | mergers             |
|   |   |                |
| · |   | consolidation       |
|   |   |                |
| · |   | reserves            |
|   |   |                |
| · |   | dividends           |
|   |   |                |
| · |   | branches            |
|   |   |                |
| · |   | capital adequacy    |

 

The Bank isexamined by the Pennsylvania Department of Banking and the FDIC.  The last examination was conducted by theFDIC as of December 31, 2006.

The Company’swebsite address is http://www.the-fidelity.com. The Company makes available through this website the annual reports onForm 10-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 copyany materials filed with the SEC at the SEC’s Public Reference Room at 100 FStreet, NE, Washington, DC 20549.  Youmay obtain information on the operation of the Public Reference Room by callingthe SEC at (202) 551-8090.  The SEC alsomaintains an internet site that contains reports, proxy and informationstatements and other information about the Company at http://www.sec.gov.

The Company’saccounting policies and procedures are designed to comply with accountingprinciples generally accepted in the United States of America (GAAP).  Refer to “Critical Accounting Policies,”which are incorporated by reference in Part II, Item 7.

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

An investment inthe Company’s common stock is subject to risks inherent to the Company’sbusiness.  The material risks anduncertainties that Management believes affect the Company are describedbelow.  Before making an investmentdecision, you should carefully consider the risks and uncertainties describedbelow together with all of the other information included or incorporated byreference in this report.  The risks anduncertainties described below are not the only ones facing the Company.  Additional risks and uncertainties thatManagement is not aware of or focused on or that Management currently deemsimmaterial may also impair the Company’s business operations.  This report is qualified in its entirety bythese risk factors.

If any of thefollowing risks actually occur, the Company’s financial condition and resultsof operations could be materially and adversely affected.  If this were to happen, the value of theCompany’s common stock could decline significantly, and you could lose all orpart of your investment.

**RisksRelated to the Company’s Business**

*TheCompany’s business is subject to interest rate risk and variations in interestrates may negatively affect its financial performance.*

Changes in theinterest rate environment may reduce profits. The Company’s earnings and cash flows are largely dependent upon its netinterest income. Net interest income is the difference between the interestearned on loans, securities and other interest-earning assets, and interestpaid on deposits, borrowings and other interest-bearing liabilities.  As prevailing interest rates change, netinterest spreads are affected by the difference between the maturities andre-pricing characteristics of interest-earning assets and interest-bearingliabilities.  In addition, loan volumeand yields are affected by market interest rates on loans, and rising interestrates generally are associated with a lower volume of loan originations. Anincrease in the general level of interest rates may also adversely affect theability of certain borrowers to pay the interest on and principal of theirobligations.  Accordingly, changes inlevels of market interest rates could materially adversely affect the Company’snet interest spread, asset quality, loan origination volume and overallprofitability.

*TheCompany is subject to lending risk.*

There are inherentrisks associated with the Company’s lending activities.  These risks include, among other things, theimpact of changes in interest rates and changes in the economic conditions inthe markets where the Company operates as well as those across the Commonwealthof Pennsylvania and the United States. Increases in interest rates and/or weakening

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economicconditions could adversely impact the ability of borrowers to repay outstandingloans or the value of the collateral securing these loans.  The Company is also subject to various lawsand regulations that affect its lending activities.  Failure to comply with applicable laws andregulations could subject the Company to regulatory enforcement action thatcould result in the assessment of significant civil money penalties against theCompany.

As ofDecember 31, 2006, approximately 55% of the Company’s loan portfolioconsisted of commercial, commercial real estate and real estate constructionloans.  These types of loans aregenerally viewed as having more risk of default than residential real estateloans or consumer loans.  These types ofloans are also typically larger than residential real estate loans and consumerloans.  Because the Company’s loanportfolio contains a significant number of commercial, commercial real estateand construction loans with relatively large balances, the deterioration of oneor a few of these loans could cause a significant increase in non-performingloans.  An increase in non-performingloans could result in a net loss of earnings from these loans, an increase inthe provision for possible loan losses and an increase in loan charge-offs, allof which could have a material adverse effect on the Company’s financialcondition and results of operations.

*The Company’s allowance for possible loan losses maybe insufficient.*

The Companymaintains an allowance for possible loan losses, which is a reserve establishedthrough a provision for possible loan losses charged to expense, thatrepresents Management’s best estimate of probable losses that have beenincurred within the existing portfolio of loans.  The allowance, in the judgment of Management,is necessary to reserve for estimated loan losses and risks inherent in theloan portfolio.  The level of theallowance reflects Management’s continuing evaluation of industryconcentrations; specific credit risks; loan loss experience; current loanportfolio quality; present economic, political and regulatory conditions andunidentified losses inherent in the current loan portfolio.  The determination of the appropriate level ofthe allowance 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 affectingborrowers, new information regarding existing loans, identification ofadditional problem loans and other factors, both within and outside of theCompany’s control, may require an increase in the allowance for possible loanlosses.  In addition, bank regulatoryagencies periodically review the Company’s allowance for loan losses and may requirean increase in the provision for possible loan losses or the recognition offurther loan charge-offs, based on judgments different than those ofManagement.  In addition, if charge-offsin future periods exceed the allowance for possible loan losses, the Companywill need additional provisions to increase the allowance for possible loanlosses.  Any increases in the allowancefor loan losses will result in a decrease in net income and, capital, and mayhave a material adverse effect on the Company’s financial condition and resultsof operations.

*The Company is subject to environmental liabilityrisk associated with lending activities.*

A significantportion of the Company’s loan portfolio is secured by real property.  During the ordinary course of business, theCompany may foreclose on and take title to properties securing certainloans.  In doing so, there is a risk thathazardous or toxic substances could be found on these properties.  If hazardous or toxic substances are found,the Company may be liable for remediation costs, as well as for personal injuryand property damage.  Environmental lawsmay require the Company to incur substantial expenses and may materially reducethe affected property’s value or limit the Company’s ability to use or sell theaffected property.  In addition, futurelaws or more stringent interpretations or enforcement policies with respect toexisting laws may increase the Company’s exposure to environmentalliability.  Although the Company haspolicies and procedures to perform an environmental review before initiatingany foreclosure action on real property, these reviews may not be sufficient todetect all potential environmental hazards. The remediation costs and any other financial liabilities associatedwith an environmental hazard could have a material adverse effect on theCompany’s financial condition and results of operations.

*TheCompany’s profitability depends significantly on economic conditions in theCommonwealth of Pennsylvania and the local region in which it conductsbusiness.*

The Company’ssuccess depends primarily on the general economic conditions of theCommonwealth of Pennsylvania and the specific local markets in which theCompany operates.  Unlike larger nationalor other regional banks that are more geographically diversified, the Companyprovides banking and financial services to customers primarily in Lackawannaand Luzerne Counties.  The local economicconditions in these areas have a significant impact on the demand for theCompany’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 in general economicconditions, caused by inflation, recession, acts of terrorism, an outbreak ofhostilities or other international or domestic occurrences, unemployment,changes in securities markets or other factors could impact these localeconomic conditions and, in turn, have a material adverse effect on the Company’sfinancial condition and results of operations.

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*There isno assurance that the Company will be able to successfully compete with othersfor business.*

The Companycompetes for loans, deposits and investment dollars with numerous regional andnational banks and other community banking institutions, as well as other kindsof financial institutions and enterprises, such as securities firms, insurancecompanies, savings associations, credit unions, mortgage brokers, and privatelenders.  Many competitors havesubstantially greater resources than the Company does, and operate under lessstringent regulatory environments.  Thedifferences in resources and regulations may make it more difficult for theCompany to compete profitably, reduce the rates that it can earn on loans andinvestments, increase the rates it must offer on deposits and other funds, andadversely affect its overall financial condition and earnings.

*TheCompany is subject to extensive government regulation and supervision.*

The Company,primarily through the Bank**,**is subject toextensive federal and state regulation and supervision.  Banking regulations are primarily intended toprotect depositors’ funds, federal deposit insurance funds and the bankingsystem as a whole, not shareholders. These regulations affect the Company’s lending practices, capitalstructure, investment practices, dividend policy and growth, among otherthings.  Federal or commonwealthregulatory agencies continually review banking laws, regulations and policiesfor possible changes.  Changes tostatutes, regulations or regulatory policies, including changes ininterpretation or implementation of statutes, regulations or policies, couldaffect the Company in substantial and unpredictable ways.  Such changes could subject the Company toadditional costs, limit the types of financial services and products theCompany may offer and/or increase the ability of non-banks to offer competingfinancial services and products, 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.  While the Company has policies and proceduresdesigned to prevent any such violations, there can be no assurance that suchviolations will not occur.

*TheCompany’s controls and procedures may fail or be circumvented.*

Managementregularly reviews and updates the Company’s internal controls, disclosurecontrols and procedures, and corporate governance policies and procedures.  Any system of controls, however well designedand operated, is based in part on certain assumptions and can provide onlyreasonable, not absolute, assurances that the objectives of the system aremet.  Any failure or circumvention of theCompany’s controls and procedures or failure to comply with regulations relatedto controls and procedures could have a material adverse effect on the Company’sbusiness, results of operations and financial condition.

*New linesof business or new products and services may subject the Company to additionalrisks.*

From time-to-time,the Company may implement new lines of business or offer new products andservices within existing lines of business. There are substantial risks and uncertainties associated with theseefforts, particularly in instances where the markets are not fullydeveloped.  In developing and marketingnew lines of business and/or new products and services the Company may investsignificant time and resources.  Initialtimetables for the introduction and development of new lines of business and/ornew products or services may not be achieved and price and profitabilitytargets may not prove feasible.  Externalfactors, such as compliance with regulations, competitive alternatives, andshifting market preferences, may also impact the successful implementation of anew line of business or a new product or service.  Furthermore, any new line of business and/or newproduct or service could have a significant impact on the effectiveness of theCompany’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.

*TheCompany’s ability to pay dividends depends primarily on dividends from itsbanking subsidiary, which is subject to regulatory limits.*

The Company is abank holding company and its operations are conducted by its subsidiary.  Its ability to pay dividends depends on itsreceipt of dividends from its subsidiary. Dividend payments from its banking subsidiary are subject to legal andregulatory limitations, generally based on net profits and retained earnings,imposed by the various banking regulatory agencies.  The ability of its subsidiary to paydividends is also subject to its profitability, financial condition, capitalexpenditures and other cash flow requirements. There is no assurance that its subsidiary will be able to pay dividendsin the future or that the Company will generate adequate cash flow to paydividends 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.

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*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 othercompanies or make investments in banks and other complementary businesses inthe future.  The Company may issueadditional shares of common stock to pay for future acquisitions, which woulddilute your ownership interest in the Company. Future business acquisitions could be material to the Company, and thedegree of success achieved in acquiring and integrating these businesses intothe Company could have a material effect on the value of the Company’s commonstock.  In addition, any acquisitioncould require it to use substantial cash or other liquid assets or to incurdebt.  In those events, it could becomemore susceptible to economic downturns and competitive pressures.

*TheCompany may not be able to attract and retain skilled people.*

The Company’ssuccess depends, in large part, on its ability to attract and retain keypeople.  Competition for the best peoplein most activities engaged in by the Company can be intense and the Company maynot be able to hire people or to retain them. The unexpected loss of services of one or more of the Company’s keypersonnel could have a material adverse impact on the Company’s businessbecause of their skills, knowledge of the Company’s market, years of industryexperience and the difficulty of promptly finding qualified replacementpersonnel.  The Company has an employmentagreement with its President and Chief Executive Officer.

*TheCompany’s information systems may experience an interruption or breach insecurity.*

The Company reliesheavily on communications and information systems to conduct its business.  Any failure, interruption or breach insecurity of these systems could result in failures or disruptions in theCompany’s customer relationship management, general ledger, deposit, loan andother systems.  While the Company haspolicies and procedures designed to prevent or limit the effect of the failure,interruption or security breach of its information systems, there can be noassurance that any such failures, interruptions or security breaches will notoccur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptionsor security breaches of the Company’s information systems could damage theCompany’s reputation, result in a loss of customer business, subject theCompany to additional regulatory scrutiny, or expose the Company to civillitigation and possible financial liability, any of which could have a materialadverse effect on the Company’s financial condition and results of operations.

*TheCompany continually encounters technological change.*

The financialservices industry is continually undergoing rapid technological change withfrequent introductions of new technology-driven products and services.  The effective use of technology increasesefficiency and enables financial institutions to better serve customers and toreduce costs.  The Company’s futuresuccess depends, in part, upon its ability to address the needs of itscustomers by using technology to provide products and services that will satisfycustomer demands, as well as to create additional efficiencies in the Company’soperations.  Many of the Company’scompetitors have substantially greater resources to invest in technologicalimprovements.  The Company may not beable to effectively implement new technology-driven products and services or besuccessful in marketing these products and services to its customers.  Failure to successfully keep pace withtechnological change affecting the financial services industry could have amaterial adverse impact on the Company’s business and, in turn, the Company’sfinancial condition and results of operations.

*The Company is subject to claims and litigationpertaining to fiduciary responsibility.*

From time-to-time,customers make claims and take legal action pertaining to the Company’sperformance of its fiduciary responsibilities. Whether customer claims and legal action related to the Company’sperformance of its fiduciary responsibilities are founded or unfounded, if suchclaims and legal actions are not resolved in a manner favorable to the Companythey may result in significant financial liability and/or adversely affect themarket perception of the Company and its products and services as well asimpact customer demand for those products and services.  Any financial liability or reputation damagecould have a material adverse effect on the Company’s business, which, in turn,could have a material adverse effect on the Company’s financial condition andresults of operations.

*Severeweather, natural disasters, acts of war or terrorism and other external eventscould significantly impact the Company’s business.*

Severe weather,natural disasters, acts of war or terrorism and other adverse external eventscould have a significant impact on the Company’s ability to conductbusiness.  Such events could affect thestability of the Company’s deposit base, impair the ability of borrowers torepay outstanding loans, impair the value of collateral securing loans, causesignificant property damage, result in loss of revenue and/or cause the Companyto incur additional expenses.  Severeweather or natural disasters, acts of war or terrorism or other adverseexternal events may occur in the future. Although Management has established disaster recovery policies and procedures,the occurrence of any such event could have a material adverse effect on theCompany’s business, which, in turn, could have a material adverse effect on theCompany’s financial condition and results of operations.

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**RisksAssociated with the Company’s Common Stock**

*TheCompany’s stock price can be volatile.*

Stock pricevolatility may make it more difficult for you to resell your common stock whenyou want and at prices you find attractive. The Company’s stock price can fluctuate significantly in response to avariety of factors including, 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 marketfluctuations, industry factors and general economic and political conditionsand events, such as economic slowdowns or recessions, interest rate changes orcredit loss trends, could also cause the Company’s stock price to decreaseregardless of operating results.

*The trading volume in the Company’s common stock isless than that of other larger financial services companies.*

The Company’scommon stock is listed for trading on the over-the-counter bulletin board; thetrading volume in its common stock is less than that of other larger financialservices companies.  A public tradingmarket having the desired characteristics of depth, liquidity and orderlinessdepends on the presence in the marketplace of willing buyers and sellers of theCompany’s common stock at any given time. This presence depends on the individual decisions of investors andgeneral economic and market conditions over which the Company has nocontrol.  Given the lower trading volumeof the Company’s common stock, significant sales of the Company’s common stock,or the expectation of these sales, could cause the Company’s stock price tofall.

*Aninvestment in the Company’s common stock is not an insured deposit.*

The Company’scommon stock is not a bank deposit and, therefore, is not insured against lossby the FDIC, any other deposit insurance fund or by any other public or privateentity.  Investment in the Company’scommon stock is inherently risky for the reasons described in this “RiskFactors” section and elsewhere in this report and is subject to the same marketforces that affect the price of common stock in any company.  As a result, if you acquire the Company’scommon stock, you may lose some or all of your investment.

*TheCompany’s articles of incorporation and by-laws, as well as certainbanking laws may have an anti-takeover effect.*

Provisions of theCompany’s articles of incorporation and by-laws, federal banking laws,including regulatory approval requirements, could make it more difficult for athird party to acquire the Company, even if doing so would be perceived to bebeneficial to the Company’s shareholders. The combination of these provisions effectively inhibits anon-negotiated merger or other business combination, which, in turn, couldadversely affect the market price of the Company’s common stock.

**RisksAssociated with the Company’s Industry**

*Futuregovernmental regulation and legislation could limit the Company’s futuregrowth.*

The Company is aregistered bank holding company, and its subsidiary bank is a depositoryinstitution whose deposits are insured by the FDIC.  As a result, the Company is subject tovarious regulations and examinations by various regulatory authorities.  In general, statutes establish the corporategovernance and eligible business activities for the Company, certainacquisition and merger restrictions, limitations on inter-company transactionssuch as loans and dividends, capital adequacy requirements, requirements foranti-money laundering programs and other compliance matters, among otherregulations.  The Company is extensivelyregulated under federal and state banking laws and regulations that areintended primarily for the protection of depositors, federal deposit insurancefunds and the banking system as a whole. Compliance with these statutes

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and regulations isimportant to its ability to engage in new activities and to consummateadditional acquisitions.

In addition, theCompany is subject to changes in federal and state tax laws as well as changesin banking and credit regulations, accounting principles and governmentaleconomic and monetary policies.  TheCompany cannot predict whether any of these changes may adversely andmaterially affect it.  Federal and statebanking regulators also possess broad powers to take supervisory actions asthey deem appropriate.  These supervisoryactions may result in higher capital requirements, higher insurance premiums andlimitations on the Company’s activities that could have a material adverseeffect on its business and profitability. While these statutes are generally designed to minimize potential lossto depositors and the FDIC insurance funds, they do not eliminate risk, andcompliance with such statutes increases the Company’s expense, requiresManagement’s attention and can be a disadvantage from a competitive standpointwith respect to non-regulated competitors.

*Theearnings of financial services companies are significantly affected by generalbusiness and economic conditions.*

The Company’soperations and profitability are impacted by general business and economicconditions in the United States and abroad. These conditions include short-term and long-term interest rates,inflation, money supply, political issues, legislative and regulatory changes,fluctuations in both debt and equity capital markets, broad trends in industryand finance, and the strength of the U.S. economy and the local economiesin which the Company operates, all of which are beyond the Company’scontrol.  Deterioration in economicconditions could result in an increase in loan delinquencies and non-performingassets, decreases in loan collateral values and a decrease in demand for theCompany’s products and services, among other things, any of which could have amaterial adverse impact on the Company’s financial condition and results ofoperations.

*Financialservices companies depend on the accuracy and completeness of information aboutcustomers and counterparties.*

In decidingwhether to extend credit or enter into other transactions, the Company may relyon information furnished by or on behalf of customers and counterparties,including financial statements, credit reports and other financialinformation.  The Company may also relyon representations of those customers, counterparties or other third parties,such as independent auditors, as to the accuracy and completeness of thatinformation.  Reliance on inaccurate ormisleading financial statements, credit reports or other financial informationcould have a material adverse impact on the Company’s business and, in turn,the Company’s financial condition and results of operations.

*Consumersmay decide not to use banks to complete their financial transactions.*

Technology andother changes are allowing parties to complete financial transactions thathistorically have involved banks through alternative methods.  For example, consumers can now maintain fundsthat would have historically been held as bank deposits in brokerage accountsor mutual funds.  Consumers can alsocomplete transactions such as paying bills and/or transferring funds directlywithout the assistance of banks.  Theprocess of eliminating banks as intermediaries, known as “disintermediation,”could result in the loss of fee income, as well as the loss of customerdeposits and the related income generated from those deposits.  The loss of these revenue streams and thelower cost deposits as a source of funds could have a material adverse effecton the Company’s financial condition and results of operations.

***ITEM 1B:***  ***UNRESOLVEDSTAFF COMMENTS***

None

***ITEM 2:***  ***PROPERTIES***

As of December 31, 2006,the Bank operated 12 full-service banking offices, of which three were ownedand nine were leased.  None of thelessors of the properties leased by the Bank are affiliated with the Company orthe Bank and all of the properties are located in the commonwealth ofPennsylvania.  The Company isheadquartered at its owner occupied main branch located on the corner ofBlakely and Drinker Streets in Dunmore, PA.

9

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The following tableprovides information with respect to the principal properties from which theBank conducts business:

 
| **Location**                                | ** ** | **Owned/leased*** | ** ** | **Type of use**                  | ** ** | **Full service** | ** ** | **Drive-thru** | ** ** | **ATM** |
|---------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------|------------|----------------|------------|---------|
| Drinker &  Blakely Streets, Dunmore, PA |       | Owned             |       | Main Branch (1)                  |       | þ           |       | þ         |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| Green Ridge  Plaza, Scranton, PA            |       | Leased            |       | Green Ridge  Branch (2)          |       | þ           |       |           |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 139 Wyoming  Avenue, Scranton, PA           |       | Leased            |       | Scranton Branch                  |       | þ           |       |           |       |    |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 1311 Morgan  Highway, Clarks Summit, PA     |       | Leased            |       | Abington Branch (3)              |       | þ           |       | þ         |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| Industrial Park  Road, Dunmore, PA          |       | Owned             |       | Keystone  Industrial Park Branch |       | þ           |       | þ         |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 403 Kennedy  Boulevard, Pittston, PA        |       | Leased            |       | Pittston Branch                  |       | þ           |       |           |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 338 North  Washington Avenue, Scranton, PA  |       | Owned             |       | Financial Center  Branch (4)     |       | þ           |       |           |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 4010 Birney  Ave., Moosic, PA               |       | Leased            |       | Moosic Branch                    |       | þ           |       | þ         |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 801 Wyoming  Avenue, West Pittston, PA      |       | Leased            |       | West Pittston  Branch            |       | þ           |       |           |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 1598 Main  Street, Peckville, PA            |       | Leased            |       | Peckville Branch                 |       | þ           |       | þ         |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 247 Wyoming  Avenue, Kingston, PA           |       | Leased            |       | Kingston Branch                  |       | þ           |       | þ         |       | þ  |
|                                        |       |              |       |                             |       |             |       |           |       |    |
| 511  Scranton-Carbondale Highway, Eynon, PA |       | Leased            |       | Eynon Branch                     |       | þ           |       | þ         |       | þ  |

----

*Allof the owned properties are free of encumbrances

(1)Executive and administrative, commercial lending, trust, asset managementservices, operational departments and customer service areas are located atthis facility.  This office also providestwo automated teller machines (ATMs).

(2)The Green Ridge branch is in the process of relocating within the Green RidgePlaza and will be operated under a long-term lease agreement that expires in2031, including renewal options.

(3) In addition, there is a banking facility located in the ClarksSummit State Hospital.  The office isleased from the hospital under a lease-for-service-provided agreement withservice limited to employees and patients of the hospital.

(4) Executive, mortgage and consumer lending, finance and operationaloffices are located in this building.  Aportion of the building is leased to a non- related entity.  The Company also owns an adjacent attachedbuilding which was leased to a non-related entity during a portion of 2006.

The Bank maintainsseveral free-standing 24-hour ATMs located at the following locations inPennsylvania:

·                  511 Main Street, Childs

·                  1650 West Main Street, Stroudsburg

·                  Riccardo’s Market, 320 South BlakelyStreet, Dunmore

·                  Marywood College, 2300 Adams Avenue,Nazareth Hall, Scranton

·                  Snö Mountain Ski Resort, 1000 MontageMountain Road, Moosic

·                  Convenient Food Mart, 100 HighlandAvenue, Clarks Summit

·                  IceBox Sports Complex, Olive Street, Scranton

The Bank also ownsa commercial facility located at 116—118 N. Blakely Street, Dunmore, PA whichis leased to a non-related entity.  InDecember 2006, the Company entered into a contract to sell this propertysubject to certain due diligence provisions of the buyer, and should settlewithin the first quarter of 2007.

Other real estateowned includes all foreclosed properties listed for sale.  Foreclosed properties are recorded on theCompany’s balance sheet, upon possession, at the lower of cost or fair value.

10

----

 

***ITEM 3:    LEGAL PROCEEDINGS***

The nature of theCompany’s business generates some litigation involving matters arising in theordinary course 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 effecton the 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.  Inaddition, to Management’s knowledge, no governmental authorities have initiatedor contemplated any material legal actions against the Company or the Bank.

***ITEM 4:  SUBMISSION OF MATTERS TOA VOTE OF SECURITY HOLDERS***

No matter wassubmitted during the quarter ended December 31, 2006 to a vote of our securityholders through solicitation of proxies or otherwise.

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

***ITEM5:***  ***MARKET FOR REGISTRANT’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES***

The common stockof the Company is traded on the over-the-counter bulletin board under thesymbol “FDBC.”  Shareholders requestinginformation about the Company’s common stock may contact Salvatore R.DeFrancesco, Jr., Treasurer.  Requestsmay be mailed to:

Fidelity D & DBancorp, Inc.

Blakely and Drinker St.

Dunmore, PA 18512

(570)342-8281

The followingtable lists the quarterly cash dividends paid per share and the range of salesprices for the Company’s common stock. Such over-the-counter prices do notinclude retail mark-ups, markdowns or commissions:
| ** **       | ** ** | **2006**   | ** ** | ** **    | ** ** | **2005**   | ** ** | ** **    | ** ** |
|------------------|------------|------------|------------|---------------|------------|------------|------------|---------------|------------|
| ** **       | ** ** | **Prices** | ** ** | **Dividends** | ** ** | **Prices** | ** ** | **Dividends** | ** ** |
| ** **       | ** ** | **High**   | ** ** | **Low**       | ** ** | **paid**   | ** ** | **High**      | ** ** | **Low** | ** ** | **paid** | ** ** |
| 1st Quarter |       | $          | 42.50      |          | $          | 36.36      |       | $             | 0.22       |   | $ | 32.95 |   | $ | 30.82 |   | $ | 0.20 |   |
| 2nd Quarter |       | $          | 38.00      |          | $          | 32.50      |       | $             | 0.22       |   | $ | 33.14 |   | $ | 31.82 |   | $ | 0.20 |   |
| 3rd Quarter |       | $          | 35.00      |          | $          | 32.10      |       | $             | 0.22       |   | $ | 33.64 |   | $ | 31.82 |   | $ | 0.20 |   |
| 4th Quarter |       | $          | 35.50      |          | $          | 31.25      |       | $             | 0.22       |   | $ | 37.73 |   | $ | 31.82 |   | $ | 0.20 |   |

 

Dividends aredetermined and declared by the Board of Directors of the Company.  On January 17, 2006, the Board ofDirectors declared a 10% stock dividend. The new shares were distributed on February 15, 2006 toshareholders of record at the close of business on January 30, 2006.  The Company expects to continue to pay cashdividends in the future.  However, futuredividends are dependent upon earnings, financial condition, capital needs ofthe Company and other factors.  For afurther discussion of regulatory capital requirements see Note 14, “Regulatorymatters,” contained within the notes to the consolidated financial statements.

The Company hasestablished a dividend reinvestment plan for its shareholders.  The plan is designed to make the Company’sstock more available to our shareholders and to raise additional capital forfuture needs.

The Company hadapproximately 1,355 shareholders at March 10, 2007 and approximately 1,359 atDecember 31, 2006.  The number ofshareholders is the actual number of individual shareholders of record.  Each security depository is considered asingle shareholder for purposes of determining the approximate number ofshareholders.

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

The information required under this section is incorporated byreference herein, to the information presented in the Company’s definitiveProxy Statement for its 2007 Annual Meeting of Shareholders to be filed withthe SEC.

11

----

 

***Performance graph***

The following graph and table compare the cumulative total shareholderreturn on the Company’s common stock against the cumulative total return of theNASDAQ Composite and the SNL index of greater than $500 million in-asset bankstraded on the OTC-BB and Pink Sheet (the SNL index) for the period of fivefiscal years commencing January 1, 2002, and ending December 31, 2006.  The graph illustrates the cumulative investmentreturn to shareholders, based on the assumption that a $100 investment was madeon December 31, 2001, in each of: the Company’s common stock, the NASDAQComposite and the SNL index.  Allcumulative total returns are computed assuming the reinvestment of dividendsinto the applicable securities.  Theshareholder return shown on the graph and table below is not necessarilyindicative of future performance:

** **
| ** **                            | ** ** | **Period ending** | ** ** |
|---------------------------------------|------------|------------------------|------------|
| **Index**                             | ** ** | **12/31/01**           | ** ** | **12/31/02** | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** |
| Fidelity D &  D Bancorp, Inc.     |       | 100.00                 |       | 104.30 |   | 103.33 |   | 97.08 |   | 121.80 |   | 110.87 |   |
| NASDAQ Composite                      |       | 100.00                 |       | 68.76 |   | 103.67 |   | 113.16 |   | 115.57 |   | 127.58 |   |
| SNL > $500M OTC-BB  and Pink Banks |       | 100.00                 |       | 129.24 |   | 180.12 |   | 210.68 |   | 224.21 |   | 246.01 |   |

 

12

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***ITEM6:***  ***SELECTED FINANCIAL DATA***

Set forth below are our selected consolidatedfinancial and other data.  This financialdata is derived in part from, and should be read in conjunction with, theCompany’s consolidated financial statements and related footnotes:

 
| ** **                                           | ** ** | **2006**    | ** **  | **2005**    | ** ** | **2004**    | ** ** | **2003**    | ** **  | **2002**    | ** ** |
|------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| **Balance Sheet Data:**                              | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Total  assets                                        |       | $           | 562,317,988 |        | $          | 544,060,698 |       | $           | 536,675,138 |        | $          | 575,215,466 |   | $ | 577,993,316 |   |
| Total  investment securities                         |       | 100,410,736 |        | 97,678,573  |       | 115,668,818 |       | 139,654,074 |        | 145,945,207 |       |
| Net  loans                                           |       | 417,199,048 |        | 403,144,095 |       | 381,546,375 |       | 366,981,640 |        | 354,262,050 |       |
| Loans  available-for-sale                            |       | 122,000     |        | 428,584     |       | 576,378     |       | 19,863,577  |        | 28,715,355  |       |
| Total  deposits                                      |       | 410,334,595 |        | 379,498,640 |       | 365,615,335 |       | 401,442,546 |        | 413,788,176 |       |
| Short-term  borrowings                               |       | 33,656,150  |        | 28,772,997  |       | 50,534,046  |       | 54,756,978  |        | 51,213,014  |       |
| Long-term  debt                                      |       | 62,536,210  |        | 83,704,188  |       | 71,119,188  |       | 71,876,034  |        | 63,000,000  |       |
| Total  shareholders’ equity                     |       | 51,611,863  |        | 48,846,029  |       | 46,366,760  |       | 43,931,899  |        | 45,234,433  |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Operating Data for the year  ended:**              | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Total  interest income                               |       | $           | 33,529,710  |        | $          | 29,020,261  |       | $           | 27,395,491  |        | $          | 28,462,093 |   | $ | 34,567,393 |   |
| Total  interest expense                              |       | 16,361,109  |        | 11,720,986  |       | 11,180,135  |       | 14,237,129  |        | 17,882,440  |       |
| Net  interest income                                 |       | 17,168,601  |        | 17,299,275  |       | 16,215,356  |       | 14,224,964  |        | 16,684,953  |       |
| Provision  for loan losses                           |       | 325,000     |        | 830,000     |       | 2,150,000   |       | 3,715,000   |        | 1,664,000   |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| Net  interest income after provision for loan losses |       | 16,843,601  |        | 16,469,275  |       | 14,065,356  |       | 10,509,964  |        | 15,020,953  |       |
| Other  income                                        |       | 4,522,138   |        | 4,150,502   |       | 4,153,277   |       | 4,182,739   |        | 3,302,749   |       |
| Other  operating expense                             |       | 15,878,376  |        | 14,561,968  |       | 13,818,565  |       | 12,902,963  |        | 12,751,174  |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| Income  before provision for income taxes            |       | 5,487,363   |        | 6,057,809   |       | 4,400,068   |       | 1,789,740   |        | 5,572,528   |       |
| Provision  for income taxes                          |       | 1,362,080   |        | 1,466,112   |       | 1,035,594   |       | 146,492     |        | 1,526,355   |       |
| Net  Income                                          |       | $           | 4,125,283   |        | $          | 4,591,697   |       | $           | 3,364,474   |        | $          | 1,643,248 |   | $ | 4,046,173 |   |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Per Share Data:**                                  | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Net  income per share, basic                         |       | $           | 2.01        |        | $          | 2.26        |       | $           | 1.67        |        | $          | 0.82 |   | $ | 2.03 |   |
| Net  income per share, diluted                       |       | $           | 2.01        |        | $          | 2.25        |       | $           | 1.67        |        | $          | 0.82 |   | $ | 2.02 |   |
| Dividends  declared                                  |       | $           | 1,801,361   |        | $          | 1,624,263   |       | $           | 1,610,423   |        | $          | 1,601,898 |   | $ | 1,526,371 |   |
| Dividends  per share                                 |       | $           | 0.88        |        | $          | 0.80        |       | $           | 0.80        |        | $          | 0.80 |   | $ | 0.76 |   |
| Book  value per share                                |       | $           | 25.09       |        | $          | 23.95       |       | $           | 22.92       |        | $          | 21.91 |   | $ | 22.60 |   |
| Weighted-average  number of shares outstanding *     |       | 2,047,975   |        | 2,031,211   |       | 2,013,798   |       | 2,002,443   |        | 1,999,173   |       |
| Number  of shares outstanding at year-end *          |       | 2,057,433   |        | 2,039,639   |       | 2,023,529   |       | 2,005,347   |        | 2,001,314   |       |
|                                                 |       |        |        |        |       |        |       |        |        |        |       |
| **Ratios:**                                          | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Return  on average assets                            |       | 0.73        | %           | 0.86        | %          | 0.61        | %          | 0.29        | %           | 0.70        | %          |
| Return  on average equity                            |       | 8.31        | %           | 9.64        | %          | 7.51        | %          | 3.63        | %           | 9.47        | %          |
| Net  interest margin                                 |       | 3.31        | %           | 3.51        | %          | 3.20        | %          | 2.74        | %           | 3.10        | %          |
| Efficiency  ratio                                    |       | 71.67       | %           | 65.99       | %          | 64.45       | %          | 72.32       | %           | 63.42       | %          |
| Expense  ratio                                       |       | 2.02        | %           | 1.93        | %          | 1.69        | %          | 1.68        | %           | 1.68        | %          |
| Allowance  for loan losses to total loans            |       | 1.29        | %           | 1.46        | %          | 1.54        | %          | 1.28        | %           | 1.01        | %          |
| Dividend  payout ratio                               |       | 43.67       | %           | 35.37       | %          | 47.87       | %          | 97.48       | %           | 37.72       | %          |
| Equity  to assets                                    |       | 9.18        | %           | 8.98        | %          | 8.64        | %          | 7.64        | %           | 7.83        | %          |
| Equity to deposits                                   |       | 12.58       | %           | 12.87       | %          | 12.68       | %          | 10.94       | %           | 10.93       | %          |

----

* The number of shares and theweighted-average number of shares outstanding, prior to 2006, have beenadjusted to reflect the effect of the 10% stock dividend paid on February 15,2006.

13

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

***Forward-LookingStatements***

This Annual Reporton Form 10-K contains a number of forward-looking statements within the meaningof Section 27A of the Securities Act of 1933, as amended, or the SecuritiesAct, and Section 21E of the Securities Exchange Act of 1934, as amended, or theExchange Act.  These statements may beidentified by the use of the words “anticipate,” “believe,” “could,” “estimate,”“expect,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,” “project,”“should,” “will,” “would” and similar terms and phrases, including referencesto assumptions.  Forward-lookingstatements include risks and uncertainties.

Forward-lookingstatements are based on various assumptions and analyses made by us in light ofManagement’s experience and its perception of historical trends, currentconditions and expected future developments, as well as other factors itbelieves are appropriate under the circumstances.  These statements are not guarantees of futureperformance and are subject to risks, uncertainties and other factors (many ofwhich are beyond our control) that could cause actual results to differmaterially from future results expressed or implied by such forward-lookingstatements.  These factors include,without limitation, the following:

·                  thetiming and occurrence or non-occurrence of events may be subject tocircumstances beyond our control;

·                  theremay be increases in competitive pressure among financial institutions or fromnon-financial institutions;

·                  changesin the interest rate environment may reduce interest margins;

·                  changesin deposit flows, loan demand or real estate values may adversely affect ourbusiness;

·                  changesin accounting principles, policies or guidelines may cause our financialcondition to be perceived differently;

·                  generaleconomic conditions, either nationally or locally in some or all areas in whichwe do business, or conditions in the securities markets or the banking industrymay be less favorable than we currently anticipate;

·                  legislativeor regulatory changes may adversely affect our business;

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

·                  successor consummation of new business initiatives may be more difficult or expensivethan we anticipate;

·                  actsof war or terrorism; or

·                  naturaldisaster.

Managementcautions readers not to place undue reliance on forward-looking statements,which reflect analyses only as of the date of this report.  We have no obligation to update anyforward-looking statements to reflect events or circumstances after the date ofthis document.

Readers shouldreview the risk factors described in Item 1A, above, and in other documentsthat we file, from time-to-time with the SEC, including quarterly reports onForm 10-Q and any current reports on Form 8-K.

# ***Critical accounting policies***

The presentationof financial statements in conformity with GAAP requires Management to makeestimates and assumptions that affect many of the reported amounts anddisclosures.  Actual results could differfrom these estimates.

A materialestimate that is particularly susceptible to significant change relates to thedetermination of the allowance for loan losses. Management believes that the allowance for loan losses at December 31,2006 is adequate and reasonable.  Giventhe subjective nature of identifying and valuing loan losses, it is likely thatwell-informed individuals could make different assumptions, and could,therefore calculate a materially different allowance value.  While Management uses available informationto recognize losses on loans, changes in economic conditions may necessitaterevisions in the future.  In addition,various regulatory agencies, as an integral part of their examination process,periodically review the Company’s allowance for loan losses.  Such agencies may require the Company torecognize adjustments to the allowance based on their judgment of informationavailable to them at the time of their examination.

14

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Another materialestimate is the calculation of fair values of the Company’s investmentsecurities.  The Company receivesestimated fair values of investment securities from an independent valuationservice.  In developing these fairvalues, the valuation service uses estimates of cash flows, based on historicalperformance of similar instruments in similar interest rate environments.  Based on experience, Management is aware thatestimated fair values of investment securities tend to vary among valuationservices.  Accordingly, when sellinginvestment securities, Management may obtain price quotes from more than onesource.  As described in Notes 1 and 3 ofthe consolidated financial statements, the large majority of the Company’sinvestment securities are classified as available-for-sale (AFS).  AFS securities are carried at fair value onthe consolidated balance sheet, with unrealized gains and losses, net of incometax, reported separately within shareholders’ equity through accumulated other comprehensiveincome (loss).

The fair value ofresidential mortgage loans, classified as AFS, is obtained from the FederalNational Mortgage Association (FNMA). The fair value of Small Business Administration (SBA) loans, classifiedas AFS, is obtained from 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 sells mortgage and other loans isrestricted and price quotes from other sources are not typically obtained.  For a further discussion on the accountingtreatment of AFS loans, see the section entitled “Loans available-for-sale,”contained within management’s discussion and analysis.

All significantaccounting policies are contained in Note 1, “Nature of operations and summaryof significant accounting policies,” within the notes to consolidated financialstatements, and incorporated by reference in Part II, Item 8.

The followingdiscussion and analysis presents the significant changes in the financialcondition and in the results of operations of the Company as of December 31,2006 and December 31, 2005 and for each of the years then ended.  This discussion should be read in conjunctionwith the consolidated financial statements and notes included in Part II, Item8 of this report.

***Comparisonof Financial Condition as of December 31, 2006***

***and 2005 and Results of Operations for each of the Years then Ended***

***FinancialCondition***

***Overview***

Consolidatedassets increased $18,257,000, or 3%, during the year ended December 31, 2006 to$562,318,000.  The increase resulted fromincreases in total deposits of $30,836,000 and total stockholders’ equity of$2,766,000, partially offset by a net decrease in total borrowings of$16,285,000.  During 2006, the carryingvalues of total loans and total securities increased $13,748,000 and$2,732,000, respectively, while cash and cash equivalents increased $1,206,000.

15

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The following table is a comparison of condensedbalance sheet accounts and percentage to total assets at December 31, 2006,2005 and 2004 (thousands of dollars):
| ** **                                        | ** ** | **2006**   | ** ** | **2005**    | ** ** | **2004**   | ** ** |
|---------------------------------------------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                                        | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                        | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Assets:**                                       |       |       |       |        |       |       |       |   |   |   |   |   |   |
| Cash and cash  equivalents                        |       | $          | 13,801     |        | 2.45       | %          | $          | 12,594 |   | 2.31 | % | $ | 10,216 |   | 1.90 | % |
| Investment  securities                            |       | 100,411    |       | 17.86       |       | 97,679     |       | 17.96 |   | 115,669 |   | 21.56 |   |
| Federal Home  Loan Bank Stock                     |       | 3,795      |       | 0.68        |       | 4,628      |       | 0.85 |   | 4,569 |   | 0.85 |   |
| Loans and  leases, net                            |       | 417,321    |       | 74.21       |       | 403,573    |       | 74.18 |   | 382,122 |   | 71.20 |   |
| Bank premises  and equipment                      |       | 11,324     |       | 2.01        |       | 11,683     |       | 2.15 |   | 11,163 |   | 2.08 |   |
| Life insurance  cash surrender value              |       | 8,178      |       | 1.45        |       | 7,892      |       | 1.45 |   | 7,614 |   | 1.42 |   |
| Other assets                                      |       | 7,488      |       | 1.34        |       | 6,012      |       | 1.10 |   | 5,322 |   | 0.99 |   |
| Total assets                                      |       | $          | 562,318    |        | 100.00     | %          | $          | 544,061 |   | 100.00 | % | $ | 536,675 |   | 100.00 | % |
| ** **                                        | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Liabilities:**                                  |       |       |       |        |       |       |       |   |   |   |   |   |   |
| Total deposits                                    |       | $          | 410,335    |        | 72.97      | %          | $          | 379,499 |   | 69.75 | % | $ | 365,616 |   | 68.13 | % |
| Short-term  borrowings                            |       | 33,656     |       | 5.99        |       | 28,773     |       | 5.29 |   | 50,534 |   | 9.42 |   |
| Long-term debt                                    |       | 62,536     |       | 11.12       |       | 83,704     |       | 15.39 |   | 71,119 |   | 13.25 |   |
| Other  liabilities                                |       | 4,179      |       | 0.74        |       | 3,239      |       | 0.59 |   | 3,039 |   | 0.56 |   |
| Total liabilities                                 |       | 510,706    |       | 90.82       |       | 495,215    |       | 91.02 |   | 490,308 |   | 91.36 |   |
| Shareholders’ equity                         |       | 51,612     |       | 9.18        |       | 48,846     |       | 8.98 |   | 46,367 |   | 8.64 |   |
| Total liabilities and   shareholders’ equity |       | $          | 562,318    |        | 100.00     | %          | $          | 544,061 |   | 100.00 | % | $ | 536,675 |   | 100.00 | % |

 

A comparison ofnet changes in selected balance sheet categories as of December 31, are asfollows:
| ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | **Earning**       | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** | **Short-term** | ** ** | ** ** | ** ** | **Other**      | ** ** | ** **  | ** ** |
|------------|------------|-------------|------------|------------|------------|-------------------|------------|-------------|------------|--------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|-------------|------------|
| ** ** | ** ** | **Assets**  | ** ** | **%**      | ** ** | **assets *** | ** ** | **%**       | ** ** | **Deposits** | ** ** | **%**      | ** ** | **borrowings** | ** ** | **%**      | ** ** | **borrowings** | ** ** | **%**       | ** ** |
| 2006       |       | $           | 18,257,290 |       |       | 3                 |       |        | $          | 21,202,050   |       |       | 4          |           |       | $          | 30,835,955 |           |       | 8           |       |   | $ | 4,883,153 |   |   | 17 |   |   | $ | (21,167,978 | ) |   | (25 | ) |   |
| 2005       |       | 7,385,560   |       |       | 1          |              |       | 2,784,580   |       |         | 1          |       |       | 13,883,305     |       |       | 4          |           |       | (21,761,049 | )          |   | (43 | ) |   | 12,585,000 |   |   | 18 |   |   |
| 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 | ) |   | — |   |   | — |   |   |
|            |            |             |            |            |            |                   |            |             |            |              |            |            |            |                |            |            |            |                |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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* Earning assets exclude loans placed on non-accrual status.

***Deposits***

The Bank is acommunity-based commercial financial institution that offers a variety ofdeposit accounts with a range of interest rates and terms.  Deposit products include passbook andstatement savings accounts, interest-bearing checking (NOW), money market,non-interest bearing deposits (DDAs) and certificates of deposit accounts.  The flow of deposits is significantlyinfluenced by general economic conditions, changes in prevailing interestrates, pricing and competition.  Most ofthe Bank’s deposits are obtained from the communities surrounding its 12 branchoffices.  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 depositproduct interest rates, the Bank considers local competition, market yields andthe rates charged for alternative sources of funding such as borrowings.  Although we have experienced intensecompetition for deposits, we have not increased rates significantly abovemarket rates, as we only consider cost effective strategies based upon thecurrent interest rate environment.

16

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The followingtable represents the components of total deposits as of December 31, 2006 and2005 (thousands of dollars):

|                          | ** ** | **2006**   | ** ** | **2005**    | ** ** |
|--------------------------|------------|------------|------------|-------------|------------|
| ** **               | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **               | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Money market             |       | $          | 72,359     |        | 17.6       | % | $ | 51,584 |   | 13.6 | % |
| NOW                      |       | 65,122     |       | 15.9        |       | 50,048 |   | 13.2 |   |
| Savings and  clubs       |       | 45,301     |       | 11.0        |       | 46,434 |   | 12.3 |   |
| Certificates of  deposit |       | 153,811    |       | 37.5        |       | 161,072 |   | 42.4 |   |
| Total interest-bearing   |       | 336,593    |       | 82.0        |       | 309,138 |   | 81.5 |   |
| Non-interest-bearing     |       | 73,742     |       | 18.0        |       | 70,361 |   | 18.5 |   |
| Total deposits           |       | $          | 410,335    |        | 100.0      | % | $ | 379,499 |   | 100.0 | % |

 

Total deposits increased$30,836,000, or 8%, during 2006 to $410,335,000.  The growth was principally due to increasesin money market and NOW accounts of $20,775,000 and $15,074,000, or 40% and30%, respectively.  The positiverelationships we have garnered with our customers in the public sectorcontinued to strengthen our position in NOW accounts.  The increase in money market accounts was dueto continued success in the implementation of deposit-gathering strategies inconjunction with increased short-term promotional interest rates and transfersfrom less attractive longer-term time deposits. Though the Bank has introduced some promotional strategies forshorter-term time deposits, Management did not aggressively pursue timedeposits; rather, most of the efforts were targeted to attract transactionalcore deposits such as NOW and money market accounts.  Time deposits continue to shrink with asustaining shift of depositor sentiment toward more attractive interest-bearingcore deposits.  Time deposits nowrepresent 38% of total deposits with a significant portion scheduled to maturein 2007.

The maturity distributionof time deposits at December 31, 2006 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 |       | $                     | 26,106,949 |                       | $          | 21,318,971                  |       | $                      | 8,064,774  |       | $          | 7,529,370 |   | $ | 63,020,064 |   |
| Time deposits of less than $100,000  |       | 26,844,048            |       | 21,116,811                 |       | 23,305,621                  |       | 19,524,312             |       | 90,790,792 |       |
| Total time deposits                  |       | $                     | 52,950,997 |                       | $          | 42,435,782                  |       | $                      | 31,370,395 |       | $          | 27,053,682 |   | $ | 153,810,856 |   |

 

Approximately 82% ofthese time deposits are scheduled to mature in 2007.  Renewing time deposits may re-price to higheror lower market rates depending on the direction of interest rate movements,the shape of the yield curve, competition, the rate profile of the maturingaccounts and depositor preference for alternative products.  Management intends to continue to deploystrategies that will diversify the deposit mix, including time depositofferings, to reduce the impact of the unpredictable and highly volatilelandscape of the interest rate environment. Simultaneously, due consideration will be given to customer retention.

DDAs increased 5%compared to December 31, 2005 and the Bank continues to experience growth fromboth its personal and non-personal relationship customers.  During 2007, Management will continue todevelop strategies and implement campaigns to attract and retain these all-importantcustomer bases in order to grow this source of cost-lowering funds.

***Short-termborrowings***

In addition todeposits, other funding sources available to the Bank are overnight fundspurchased from the Federal Home Loan Bank of Pittsburgh (FHLB), fed fundspurchased from various correspondent banks and repurchase agreements withvarious individuals, businesses and public entities.  The Bank uses overnight funding for assetgrowth, deposit run-off and short-term liquidity needs.  Repurchase agreements are offered in bothsweep and fixed-term products.  Theseagreements are non-insured interest-bearing liabilities that have a securityinterest in qualified pledged investments of the Bank.  A sweep account is designed to ensure that ona daily basis, an attached DDA is adequately funded and excess DDA funds aretransferred, or swept, into an interest-bearing overnight repurchase agreementaccount.  In addition, the sweep isdesigned to transfer funds to the DDA as necessary to cover checks presentedfor payment.  Due to the nature of thesweep product, these accounts tend to be more volatile than the fixed-termproduct because the daily sweep is dependent on the level of available funds indepositor accounts.  At December 31, 2006and 2005, sweep accounts represented 70% and 66%, respectively, of totalrepurchase agreements.  Overnightborrowings and repurchase agreements are included with short-term borrowings onthe consolidated balance sheet.  For afurther discussion on short-term borrowings, see Note 7, “Short-termborrowings,” contained in the notes to consolidated financial statements inPart II, Item 8.

17

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Customer liquidityand investment needs and changes in interest rates caused a net decrease inrepurchase agreements from $26,913,000, at December 31, 2005, to $22,224,000 atDecember 31, 2006.  This varianceincluded a shift from repurchase agreements to NOW and money market depositaccounts.

A combination of loandemand, investment in branch expansion projects and a desire to strategicallyreduce dependency on long-term financing has resulted in an increase inovernight borrowings of $9,626,000 at December 31, 2006 compared to December31, 2005.

***Long-term debt***

Long-term debtconsists of borrowings from the FHLB. The weighted-average rate in effect on funds borrowed at December 31,2006, was 5.15% compared to 5.16% as of December 31, 2005.  The 2006 weighted-average rate was 121 basispoints below the tax-equivalent yield of 6.36% on average earning assets forthe year ended December 31, 2006.  Rateson $53,000,000 of long-term debt advances are fixed but may adjust quarterly,should market rates increase beyond the issues’ original or strike rates.  Significant prepayment penalties attached tothe borrowings are a deterrent from paying off the high cost advances.  However, in the event underlying market ratesdrift above the rates currently paid on these borrowings, the FHLB rate willconvert to floating and the Bank has the option, at that time, to repay or torenegotiate the converted advance.  Duringthe third quarter of 2006, the Bank refinanced a portion of its long-term debtwith the FHLB in order to reduce interest expense.  The Bank repaid a $16,000,000 convertibleselect 6.22% advance scheduled to mature in 2010.  Simultaneously, the Bank entered into a newFHLB $16,000,000 convertible select 5.26% advance with a scheduled maturity in2016.  The immediate effect of the 96basis point decrease in rate was to reduce interest expense by approximately$154,000 per annum.

Long-term debt decreased$21,168,000, or 25%, during 2006, to $62,536,000.  The decrease was the result of increaseddeposit generation that was used to repay FHLB advances during the second andthird quarters of 2006 and the Bank’s desire to reduce its dependency on thislong-term funding source.  At December31, 2006, the Bank had the ability to borrow an additional $103,558,000, fromthe FHLB, by utilizing the numerous funding products available at a variety ofterms.

***Accrued expenses and other liabilities***

Net increases ininterest-bearing liabilities along with higher interest rates caused anincrease in accrued interest payable which was the primary contributor to anincrease in accrued expenses and other liabilities of $940,000, or 29%, fromDecember 31, 2005 to December 31, 2006.

***Investments***

The Bank’s investment policyis designed to complement its lending activities, generate a favorable returnwithout incurring undue interest rate and credit risk, manage interest ratesensitivity, provide monthly cash flow and manage liquidity at acceptablelevels.  In establishing investmentstrategies, the Bank considers its business, growth or restructuring plans, theeconomic 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 policy prescribes permissible investmentcategories that meet the policy standards and Management is responsible forstructuring and executing the specific investment purchases within these policyparameters.  Management buys and sellsinvestment securities from time-to-time depending on market conditions,business trends, liquidity needs, capital levels and structuring strategies.  Investment security purchases provide a wayto quickly invest excess liquidity in order to generate additionalearnings.  The Bank generally earns apositive interest spread by assuming interest rate risk and using depositsand/or borrowings to purchase securities with longer maturities.

At the time of purchase,Management classifies investment securities into one of three categories:trading, AFS or held-to-maturity (HTM). To date, Management has not purchased any securities for tradingpurposes.  Most of the securitiespurchased are classified as AFS even though there is no immediate intent tosell them.  The AFS designation affordsManagement the flexibility to sell securities and position the balance sheet inresponse to capital levels, liquidity needs or changes in market conditions.  Securities AFS are carried at net fair valuesin the consolidated balance sheet with an adjustment to shareholders’ equity,net of tax, presented under the caption “Accumulated other comprehensive income(loss).”  Securities designated as HTMare carried at amortized cost and represent debt securities that the Companyhas the ability and intent to hold until maturity.  As of December 31, 2006 and December 31,2005, the aggregate fair value of securities HTM exceeded their respectiveaggregate amortized cost by $29,000 and $49,000, respectively.

Total investmentsincreased $2,732,000, net of $221,000 appreciation in the market value of AFSinvestments.  Throughout 2006, tacticswere undertaken to re-position the portfolio to meet earnings and liquidityobjectives.  These measures contributedto the increase in the yield of the portfolio 49 basis points in 2006 comparedto 2005.  The carrying value ofinvestment securities, at December 31, 2006, was $100,411,000, or 18%, of totalassets compared to $97,679,000, or 18%, as

18

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of December 31,2005.  Mortgage-backed securities, whichamortize and provide monthly cash flow, continue to dominate the composition ofthe total investment portfolio representing 43% at December 31, 2006,essentially unchanged from 44% at December 31, 2005.

During 2006, interestrates throughout the yield curve continued to increase with the mostsignificant increase at the short-end and the least significant at thelong-end, basically resulting in a continued period of yield curve inversion.  This environment continues to precludestructured growth strategies especially for earning assets that are marketdriven, such as the investment portfolio, due to the lack of investments thatproduce adequate interest rate spreads to the Bank’s funding sources.  Because of this unusual interest rateenvironment, the Bank uses cash flows from its investment portfolio to repayborrowings and fund growth in the loan portfolio.

A comparison ofinvestments at December 31, for the three previous periods is as follows:
| ** **                         | ** ** | **2006**   | ** **  | **2005**    | ** ** | **2004**   | ** ** |
|------------------------------------|------------|------------|-------------|-------------|------------|------------|------------|
| ** **                         | ** ** | **Amount** | ** **  | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| U.S. government agencies           |       | $          | 33,891,985  |        |       | 33.8       | %          |   | $ | 31,125,909 |   |   | 31.9 | % |   | $ | 30,497,185 |   |   | 26.4 | % |   |
| Mortgage-backed securities         |       | 42,900,005 |        |        | 42.7       |       |       | 42,615,197 |   |   | 43.6 |   |   | 64,457,326 |   |   | 55.7 |   |   |
| State & municipal subdivisions |       | 12,576,684 |        |        | 12.5       |       |       | 13,401,874 |   |   | 13.7 |   |   | 11,199,084 |   |   | 9.7 |   |   |
| Preferred term securities          |       | 10,570,993 |        |        | 10.5       |       |       | 10,083,084 |   |   | 10.3 |   |   | 9,034,375 |   |   | 7.8 |   |   |
| Equity securities                  |       | 471,069    |        |        | 0.5        |       |       | 452,509 |   |   | 0.5 |   |   | 480,848 |   |   | 0.4 |   |   |
| Total                              |       | $          | 100,410,736 |        |       | 100.0      | %          |   | $ | 97,678,573 |   |   | 100.0 | % |   | $ | 115,668,818 |   |   | 100.0 | % |   |

The distribution of debt securities by stated maturity date at December31, 2006 is as follows:
| ** **                         | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|------------------------------------|------------|-------------------|------------|----------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|
| ** **                         | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies           |       | $                 | —     |                 | $          | 6,878,623             |       | $                  | 19,646,686 |       | $          | 7,366,676 |   | $ | 33,891,985 |   |
| Mortgage-backed securities         |       | —            |       | 4,898,286            |       | 6,647,971             |       | 31,353,748         |       | 42,900,005 |       |
| State & municipal subdivisions |       | —            |       | —               |       | 686,811               |       | 11,889,873         |       | 12,576,684 |       |
| Preferred term securities          |       | —            |       | —               |       | —                |       | 10,570,993         |       | 10,570,993 |       |
| Total debt securities              |       | $                 | —     |                 | $          | 11,776,909            |       | $                  | 26,981,468 |       | $          | 61,181,290 |   | $ | 99,939,667 |   |

 

AFS securities are statednet of unrealized gains and losses.  Asof December 31, 2006, AFS debt securities were recorded with a net unrealizedloss in the amount of $1,656,000.  AtDecember 31, 2006 AFS equity securities were recorded at $471,000 including anunrealized gain of $192,000.

The tax-equivalentyield on debt securities by stated maturity date at December 31, 2006, is asfollows:

 
| ** **                         | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|------------------------------------|------------|-------------------|------------|----------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|
| ** **                         | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies           |       | —            | %          | 4.35                 | %          | 4.38                  |       | 5.64               | %          | 4.65       | %          |
| Mortgage-backed securities         |       | —            |       | 3.78                 |       | 3.82                  |       | 5.01               |       | 4.69       |       |
| State & municipal subdivisions |       | —            |       | —               |       | 5.77                  |       | 5.71               |       | 5.71       |       |
| Preferred term securities          |       | —            |       | —               |       | —                |       | 7.02               |       | 7.02       |       |
| Total debt securities              |       | —            | %          | 4.11                 | %          | 4.27                  |       | 5.56               | %          | 5.04       | %          |

 

----

In the above table, thebook yields on state & municipal subdivisions were adjusted to atax-equivalent basis 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.

***Loansand leases***

Gross loans andleases increased $13,514,000, or 3%, from $409,129,000 at December 31, 2005, to$422,643,000 at December 31, 2006.  Grossloans represented 75% of total assets at December 31, 2006 and December 31,2005.

In 2006, the Bankoriginated $17,152,000 of commercial loans, $21,431,000 of mortgage loans and$29,565,000 of consumer loans.  Thiscompares to $27,030,000, $39,398,000 and $38,763,000, respectively, in2005.  Included in mortgage loans is$11,111,000 of real estate construction lines in 2006 and $18,128,000 in2005.  In addition for 2006, the Bankoriginated lines of credit in the amounts of $29,389,000 for commercialborrowers and $6,768,000 in home equity lines and consumer borrowers.

Though loanoriginations were down in 2006 compared to 2005, payoffs and pay-downs subsidedresulting in a net increase in the loan portfolio.  Despite yield curve inversion, Management isfocused on attaining profitable growth in all sectors of the loan portfolioduring 2007.  The focus for 2007 will beto develop ideas and implement programs that will build strong

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 relationships with new customers andstrengthen relationships with existing customers.  The expectation is for successfulcross-selling campaigns between our lending departments and branch network.

*Commercial and Commercial Real Estate Loans**:*

Net of scheduledprincipal curtailments, loan participation sales and pre-payments, commercialloans increased $1,924,000 to $218,213,000 from $216,289,000, or almost 1%during 2006.

*Residential Real Estate Loans*:

Residential realestate loans increased $8,822,000, or 8%, to $112,743,000.  Due to the current interest rate environment,and lower amounts of pay-downs and payoffs growth was primarily from convertedconstruction loans and to a lesser extent, sales campaigns.

*Consumer Loans**:*

Consumer loansincreased $3,659,000, or 5%, during 2006. Success in the spring and fall sales campaigns, with added advertisingand marketing, along with less pay-downs, helped boost the home equityinstallment program by more than $8,000,000. These programs more than offset declines in home equity lines of credit,during a period of a rising prime rate.

*Real Estate Construction Loans**:*

Real estateconstruction loans decreased by $829,000, or 6%, at December 31, 2006 comparedto December 31, 2005.  These loans fundresidential and commercial construction projects and then convert to aresidential mortgage or to a commercial real estate loan usually within oneyear from the origination date. Generally, the converted loans will bear the same terms as theresidential or the commercial construction loans.  The commercial construction loans did notquite offset the decline in the residential construction loan balance but bothcategories remain relatively strong.

*Direct Financing Leases**:*

The balancerepresents tax-free leasing arrangements provided to municipal customers.  For 2006, the activity represents scheduledannual run-off.  In years prior to 2005,the balance also consisted of automobile lease financing.

A comparison ofdomestic loans at December 31, for the five previous periods is as follows:
| ** **                              | ** ** | **2006**    | ** **  | **2005**    | ** ** | **2004**    | ** ** | **2003**    | ** **  | **2002**    | ** ** |
|-----------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| Commercial  and  commercial real estate |       | $           | 218,213,216 |        | $          | 216,288,597 |       | $           | 221,968,137 |        | $          | 221,275,922 |   | $ | 202,974,155 |   |
| Residential  real estate                |       | 112,742,692 |        | 103,920,613 |       | 91,294,401  |       | 77,077,315  |        | 78,132,262  |       |
| Consumer                                |       | 77,729,520  |        | 74,070,328  |       | 61,487,608  |       | 62,919,070  |        | 64,300,368  |       |
| Real  estate construction               |       | 13,369,712  |        | 14,198,858  |       | 10,620,472  |       | 7,267,616   |        | 6,797,002   |       |
| Direct  financing leases                |       | 588,211     |        | 650,348     |       | 2,211,978   |       | 3,685,802   |        | 6,578,720   |       |
| Gross loans                             |       | 422,643,351 |        | 409,128,744 |       | 387,582,596 |       | 372,225,725 |        | 358,782,507 |       |
| Less:                                   |       |        |        |        |       |        |       |        |        |        |       |
| Unearned  discount                      |       | —      |        | —      |       | 48,423      |       | 247,119     |        | 620,704     |       |
| Allowance  for loan losses              |       | 5,444,303   |        | 5,984,649   |       | 5,987,798   |       | 4,996,966   |        | 3,899,753   |       |
| Net loans                               |       | $           | 417,199,048 |        | $          | 403,144,095 |       | $           | 381,546,375 |        | $          | 366,981,640 |   | $ | 354,262,050 |   |
|                                    |       |        |        |        |       |        |       |        |        |        |       |
| Loans available-for-sale                |       | $           | 122,000     |        | $          | 428,584     |       | $           | 576,378     |        | $          | 19,863,577 |   | $ | 28,715,355 |   |

 

A comparison of grossloans by percent at year-end for the five previous periods is as follows:
| ** **                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial  and  commercial real estate |       |     | 51.6       | %        |       |     | 52.9       | %        |       |     | 57.3       | % |   |   | 59.5 | % |   |   | 56.6 | % |   |
| Residential  real estate                |       |     | 26.7       |     |       |     | 25.4       |     |       |     | 23.5       |   |   |   | 20.7 |   |   |   | 21.8 |   |   |
| Consumer                                |       |     | 18.4       |     |       |     | 18.1       |     |       |     | 15.9       |   |   |   | 16.9 |   |   |   | 17.9 |   |   |
| Real  estate construction               |       |     | 3.2        |     |       |     | 3.5        |     |       |     | 2.7        |   |   |   | 1.9 |   |   |   | 1.9 |   |   |
| Direct  financing leases                |       |     | 0.1        |     |       |     | 0.1        |     |       |     | 0.6        |   |   |   | 1.0 |   |   |   | 1.8 |   |   |
| Gross loans                             |       |     | 100.0      | %        |       |     | 100.0      | %        |       |     | 100.0      | % |   |   | 100.0 | % |   |   | 100.0 | % |   |

 

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The following table sets forth the maturity distribution of selectcomponents of the loan portfolio at December 31, 2006.  Excluded from the table are residential realestate loans, consumer loans and direct financing leases (dollars inthousands):

|                                               | ** ** | **One-year**     | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|------------------|------------|---------------------------|------------|---------------------|------------|------------|------------|
| ** **                                    | ** ** | **or less** | ** ** | **years**                 | ** ** | **five years** | ** ** | **Total**  | ** ** |
| ** **                                    | ** ** | ** **       | ** ** | ** **                | ** ** | ** **          | ** ** | ** ** | ** ** |
| Commercial  and commercial  real estate loans |       | $                | 33,006     |                      | $          | 77,248              |       | $          | 107,959    |   | $ | 218,213 |   |
| Real  estate construction                     |       | 13,370           |       | —                    |       | —              |       | 13,370     |       |
| Total                                         |       | $                | 46,376     |                      | $          | 77,248              |       | $          | 107,959    |   | $ | 231,583 |   |

 

Real estate constructionloans are included in the one-year or less category since, by their nature,these loans are converted into residential and commercial real estate loanswithin one year from the date the real estate construction loan wasconsummated.  Upon conversion, theresidential and commercial real estate loans would normally mature after fiveyears.

The following table setsforth the sensitivity changes in interest rates for commercial and commercialreal estate loans at December 31, 2006 (dollars in thousands):
|                         | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------|------------|---------------------------|------------|---------------------|------------|------------|------------|------------|------------|
| ** **              | ** ** | **years**                 | ** ** | **five years** | ** ** | **Total**  | ** ** | ** ** | ** ** |
| Fixed  interest rate    |       | $                         | 23,298     |                | $          | 35,345     |       | $          | 58,643     |   |   |   |
| Variable  interest rate |       | 44,490                    |       | 9,135               |       | 53,625     |       |       |       |
| Total                   |       | $                         | 67,788     |                | $          | 44,480     |       | $          | 112,268    |   |   |   |

 

Non-refundablefees or costs associated with all loan originations are deferred.  Using the principal reduction method, thedeferral is released as charges or credits to loan interest income over thelife of the loan.

There are noconcentrations of loans to a number of borrowers engaged in similar activitiesexceeding 10% of total loans that are not otherwise disclosed as a category inthe tables above.  There are noconcentrations of loans that, if lost, would have a material adverse effect onthe 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 negative business impact.

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

Generally, uponorigination, certain residential mortgages, the guaranteed portions of SBAloans and student loans are classified as AFS. Should market rates increase, fixed-rate loans and loans not immediatelyscheduled to re-price would no longer produce yields consistent with thecurrent market.  In a declining interestrate environment, the Bank would be exposed to prepayment risk and, as rates onadjustable rate loans decrease, interest income would be negativelyaffected.  Consideration is given to thecurrent liquidity position and projected future liquidity needs.  To better manage interest rate and prepaymentrisk, loans meeting these conditions may be classified as AFS.  The carrying value of loans AFS are at thelower of cost or estimated fair value. If the fair values of these loans fall below their original cost, thedifference is written down and charged to current earnings.  Any subsequent appreciation in the portfoliois credited to current earnings but only to the extent of previous write-downs.

Loans AFS, atDecember 31, 2006, were $122,000, with a corresponding fair value of $123,000compared to $429,000 and $434,000, respectively, at December 31, 2005.  During 2006, residential mortgages andstudent loans with principal balances of $11,792,000 and $707,000,respectively, were sold into the secondary market and gains of approximately$98,000 have been recognized.  There wereno sold SBA loans during 2006.

The Bank retains themortgage servicing rights (MSRs) on loans sold into the secondary market.  MSRs are retained so that the Bank cancontinue the personal relationship developed with its customers.  At December 31, 2006 and 2005, the servicingportfolio balance of sold residential mortgage loans was $53,112,000 and $47,835,000,respectively.  For a further discussionon MSRs, see Note 4, “Loans and leases,” contained within the notes toconsolidated financial statements in Part II, Item 8.

***Allowance for loan losses***

Managementcontinually evaluates the credit quality of the Bank’s loan portfolio andperforms a formal review of the adequacy of the allowance for loan losses (theallowance) on a quarterly basis.  Theallowance reflects Management’s best estimate of the amount of credit losses inthe 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 tosignificant change.  The provision forloan losses represents the amount necessary to maintain an appropriateallowance.  Loan losses are chargeddirectly against the allowance when loans are deemed to be uncollectible.  Recoveries from previously charged-off loansare added to the allowance when received.

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Management appliestwo primary components during the loan review process to determine properallowance levels.  The two levels arespecific loan loss allocation for loans that are deemed impaired and a generalloan loss allocation for those loans not specifically allocated.  The methodology to analyze the adequacy ofthe allowance for loan losses is as follows:

·                  identificationof specific problem loans by loan category;

·                  calculationof specific allowances required based on collateral and other objective andquantifiable factors;

·                  determinationof remaining homogenous pools by loan category and eliminating loans withspecific loss allocations;

·                  applicationof historical 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 theallowance for different categories of loans is based on the methodology used bythe Bank, as explained above.  A keyelement of the methodology to determine the allowance is the Company’s creditrisk evaluation process, which includes credit risk grading of individualcommercial loans.  Commercial loans areassigned credit risk grades based on the Company’s assessment of conditionsthat affect the borrower’s ability to meet its contractual obligations underthe loan agreement.  That processincludes reviewing borrowers’ current financial information, historical paymentexperience, credit documentation, public information and other informationspecific to each individual borrower. The changes in allocations from period to period are based upon the creditrisk grading assigned from periodic reviews of the loan and lease portfolios.

Total charge-offs,net of recoveries, for the year ended December 31, 2006, were $866,000,compared to $833,000 in 2005.  Combinedconsumer loan and lease financing net charge-offs increased slightly from$141,000 at December 31, 2005 to $161,000 through December 31, 2006.  Commercial loan net charge-offs were $597,000for the year 2006 compared to $682,000 for 2005.  Mortgage loan net charge-offs were $108,000in 2006 compared to $10,000 in 2005.  Thecontinuous efforts of the collection department helped to keep the netcharge-offs in 2006 in line with 2005 levels, which were down substantiallyfrom previous years.  For furtherdiscussion on the provision for loan losses, see the “Provision for loanlosses,” located in the Results of operations section of Management’sdiscussion and analysis contained herein.

For a furtherdiscussion of delinquencies and net charge-offs, see the section entitled “Non-performingassets.”  Additional discussion is inNote 1, “Nature of operations and summary of significant accounting policies —Allowance for loan losses,” and Note 4, “Loans and leases,” contained in thenotes to consolidated financial statements, and incorporated herein byreference.

Managementbelieves that the current balance in the allowance for loan losses of$5,444,000 is sufficient to withstand the identified potential credit qualityissues that may arise and are inherent to the portfolio.  Currently, Management is unaware of anypotential problem loans that have not been reviewed.  Potential problem loans are those where thereis known information that leads Management to believe repayment of principaland/or interest is in jeopardy and the loans are currently neither on non-accrualstatus nor past due 90 days or more. However, there could be certain instances which become identified overthe upcoming year that may require additional charge-offs and/or increases tothe allowance.  The ratio of allowancefor loan losses to total loans was 1.29% at December 31, 2006 compared to 1.46%at December 31, 2005.

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The followingtable sets forth the activity in the allowance for loan losses and certain keyratios for the periods indicated (dollars in thousands):
| ** **                                                              | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at beginning  of period                                         |       | $          | 5,985      |       | $          | 5,988      |       | $          | 4,997      |       | $          | 3,900 |   | $ | 3,742 |   |
|                                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Charge-offs:                                                            |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                               |       | 661        |       | 1,077      |       | 775        |       | 1,334      |       | 928        |       |
| Real estate                                                             |       | 109        |       | 21         |       | 266        |       | 503        |       | 40         |       |
| Consumer                                                                |       | 285        |       | 288        |       | 480        |       | 1,167      |       | 850        |       |
| Lease financing                                                         |       | —     |       | 8          |       | 85         |       | 92         |       | 131        |       |
| Total                                                                   |       | 1,055      |       | 1,394      |       | 1,606      |       | 3,096      |       | 1,949      |       |
|                                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Recoveries:                                                             |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                               |       | 64         |       | 395        |       | 226        |       | 204        |       | 359        |       |
| Real estate                                                             |       | 1          |       | 11         |       | 20         |       | 34         |       | —     |       |
| Consumer                                                                |       | 124        |       | 155        |       | 178        |       | 230        |       | 69         |       |
| Lease financing                                                         |       | —     |       | —     |       | 23         |       | 10         |       | 15         |       |
| Total                                                                   |       | 189        |       | 561        |       | 447        |       | 478        |       | 443        |       |
| Net charge-offs                                                         |       | 866        |       | 833        |       | 1,159      |       | 2,618      |       | 1,506      |       |
| Provision  charged to operations                                        |       | 325        |       | 830        |       | 2,150      |       | 3,715      |       | 1,664      |       |
| Balance at end  of period                                               |       | $          | 5,444      |       | $          | 5,985      |       | $          | 5,988      |       | $          | 4,997 |   | $ | 3,900 |   |
| Net charge-offs  to average loans outstanding                           |       | 0.21       | %          | 0.22       | %          | 0.30       | %          | 0.68       | %          | 0.40       | %          |
| Allowance for  loan loss to net charge-offs                             |       | 6.29       | x          | 7.18       | x          | 5.17       | x          | 1.91       | x          | 2.59       | x          |
| Allowance for  loan loss to total gross                                 |       | 1.29       | %          | 1.46       | %          | 1.54       | %          | 1.28       | %          | 1.01       | %          |
| Loans 30 - 89  days past due and accruing                               |       | $          | 2,571      |       | $          | 1,609      |       | $          | 4,317      |       | $          | 3,975 |   | $ | 6,047 |   |
| Loans 90 days or  more past due and accruing                            |       | $          | 81         |       | $          | 197        |       | $          | 557        |       | $          | 958 |   | $ | 2,599 |   |
| Non-accruing  loans                                                     |       | $          | 3,358      |       | $          | 9,453      |       | $          | 9,904      |       | $          | 7,323 |   | $ | 4,000 |   |
| Allowance for  loan loss to loans 90 days or more past due and accruing |       | 67.54      | x          | 30.39      | x          | 10.75      | x          | 5.22       | x          | 1.50       | x          |
| Allowance for  loan loss to non-accruing loans                          |       | 1.62       | x          | 0.63       | x          | 0.60       | x          | 0.68       | x          | 0.98       | x          |
| Allowance for  loan loss to non-performing loans                        |       | 1.58       | x          | 0.62       | x          | 0.57       | x          | 0.60       | x          | 0.59       | x          |
| Average net loans                                                       |       | $          | 412,523    |       | $          | 385,800    |       | $          | 381,366    |       | $          | 383,226 |   | $ | 380,892 |   |

 

The allowance forloan losses can generally absorb losses throughout the loan and leaseportfolios.  However, in some instancesan allocation is made for specific loans or groups of loans.  Allocation of the allowance for loan lossesfor different categories of loans is based on the methodology used by the Bank,as previously explained.  The changes inthe allocations from year-to-year are based upon year-end reviews of the loanand lease portfolios.

Allocation of theallowance among major categories of loans for the past five years is summarizedbelow.  This table should not beinterpreted as an indication that charge-offs in future periods will occur inthese amounts or proportions, or that the allocation indicates futurecharge-off trends.  The portion of theallowance designated as unallocated is within the Company’s policyguidelines.  Prior to 2003, consumerloans included credit card receivables:
| ** **                             | ** ** | **2006**  | ** ** | **%**  | ** ** | **2005**  | ** ** | **%**     | ** ** | **2004**  | ** ** | **%**  | ** ** | **2003**  | ** ** | **%**  | ** ** | **2002**  | ** ** | **%**  | ** ** |
|----------------------------------------|------------|-----------|------------|--------|------------|-----------|------------|-----------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|
| Category                               |       |      |       |   |       |      |       |      |       |      |       |   |       |      |       |   |       |      |       |   |       |
| Residential real estate                |       | $         | 578,117    |   | 10.6       |      | $          | 595,092   |       | 9.9       |       | $      | 451,349    |      | 7.5        |   | $          | 354,207   |       | 7.1    |       | $ | 383,858 |   | 9.8 |   |
| Consumer                               |       | 1,157,091 |       | 21.2   |       | 1,180,175 |       | 19.7      |       | 966,081   |       | 16.1   |       | 884,689   |       | 17.7   |       | 1,092,140 |       | 28.0   |       |
| Commercial and  commercial real estate |       | 3,549,871 |       | 65.2   |       | 4,035,950 |       | 67.4      |       | 4,330,285 |       | 72.3   |       | 3,699,488 |       | 74.0   |       | 2,198,783 |       | 56.4   |       |
| Direct financing leases                |       | 14,058    |       | 0.3    |       | 14,828    |       | 0.3       |       | 40,891    |       | 0.7    |       | 42,706    |       | 0.9    |       | 81,664    |       | 2.1    |       |
| Real estate construction               |       | 59,617    |       | 1.1    |       | 59,953    |       | 1.0       |       | 46,465    |       | 0.8    |       | 15,876    |       | 0.3    |       | —    |       | — |       |
| Unallocated                            |       | 85,550    |       | 1.6    |       | 98,651    |       | 1.7       |       | 152,727   |       | 2.6    |       | —    |       | — |       | 143,307   |       | 3.7    |       |
| Total                                  |       | $         | 5,444,304  |   | 100.0      | %         | $          | 5,984,649 |       | 100.0     | %          | $      | 5,987,798  |      | 100.0      | %      | $          | 4,996,966 |       | 100.0  | %          | $ | 3,899,752 |   | 100.0 | % |

 

The allocation ofthe allowance for the commercial loan portfolio comprised 65%, or $3,550,000,of the total allowance for loan losses at December 31, 2006, of whichapproximately 2% is reserved for non-performing commercial loan relationships.

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Collateral valueswere prudently valued to provide a conservative and realistic value of thecollateral supporting these loans.  Theallocations to the other categories of loans are adequate compared to theactual three-year historical net charge-offs.

***Non-performing assets***

The Bank definesnon-performing assets as accruing loans past due 90 days or more, non-accrualloans, restructured loans, other real estate owned (ORE) and repossessedassets.  As of December 31, 2006,non-performing assets represented 0.65% of total assets compared to 1.78% atDecember 31, 2005.

The followingtable sets forth non-performing assets at December 31 (dollars in thousands):
| ** **                                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net  loans, including loans available-for-sale                                      |       | $        | 417,321    |     | $          | 403,573  |       | $        | 382,123    |     | $          | 386,846 |   | $ | 382,977 |   |
|                                                                                |       |     |       |     |       |     |       |     |       |     |       |
| Loans  past due 90 days or more and accruing                                        |       | $        | 81         |     | $          | 197      |       | $        | 557        |     | $          | 958 |   | $ | 2,599 |   |
| Non-accrual  loans                                                                  |       | 3,358    |       | 9,453    |       | 9,904    |       | 7,323    |       | 4,000    |       |
| Total non-performing loans                                                          |       | 3,439    |       | 9,650    |       | 10,461   |       | 8,281    |       | 6,599    |       |
| Restructured  loans                                                                 |       | —   |       | —   |       | —   |       | —   |       | 1,474    |       |
| Other  real estate owned                                                            |       | 197      |       | —   |       | 163      |       | 394      |       | 262      |       |
| Repossessed  assets                                                                 |       | —   |       | 19       |       | 50       |       | 73       |       | 175      |       |
| Total non-performing assets                                                         |       | $        | 3,636      |     | $          | 9,669    |       | $        | 10,674     |     | $          | 8,748 |   | $ | 8,510 |   |
|                                                                                |       |     |       |     |       |     |       |     |       |     |       |
| Non-accrual  loans to net loans                                                     |       | 0.80     | %          | 2.34     | %          | 2.59     | %          | 1.89     | %          | 1.04     | %          |
| Non-performing  assets to net loans, foreclosed real estate  and repossessed assets |       | 0.87     | %          | 2.40     | %          | 2.79     | %          | 2.26     | %          | 2.22     | %          |
| Non-performing  assets to total assets                                              |       | 0.65     | %          | 1.78     | %          | 1.99     | %          | 1.52     | %          | 1.47     | %          |
| Non-performing loans to net loans                                                   |       | 0.82     | %          | 2.39     | %          | 2.74     | %          | 2.14     | %          | 1.72     | %          |

 

In the review ofloans for both delinquency and collateral sufficiency, Management concludedthat there were a number of loans that lacked the ability to repay inaccordance with contractual terms.  Thedecision to place loans or leases on a non-accrual status is made on anindividual basis after considering factors pertaining to each specific loan.

The majority ofnon-performing loans for the period is attributed to commercial business loansand real estate loans in the process of foreclosure.  Most of these loans are collateralizedthereby reducing the Bank’s potential for loss. In 2006, non-performing loans were reduced by $6,211,000, or 64%, to$3,439,000.  There were no repossessedassets at December 31, 2006 compared to $19,000 in 2005.  At year-end 2006 ORE totaled $197,000.  There was no ORE at year-end 2005.  Five residential properties were owned at year-end2006, four of which were under agreements to be sold.  The Special Assets Department had developedspecific action plans for each of the Company’s non-performing loans.  During 2006, several of those plans came to aconclusion resulting in a substantial reduction of non-performing loans.  The non-accrual loans were $3,358,000 atDecember 31, 2006 a reduction of $6,095,000, or 64%, from year-end 2005.  During 2006 approximately $1,583,000 of loanswere placed in non-accrual status.  Thiswas more than offset by payoffs or pay-downs of $2,485,000, charge-offs of$909,000, $240,000 in transfers to foreclosed assets and $4,045,000 of loansthat returned to performing status. Loans past due 90 days or more and accruing declined by 59%, to $81,000,at December 31, 2006.  As a result, thepercentage of non-performing assets to total assets declined to 0.65% atDecember 31, 2006, compared to 1.78% for the prior year-end and non-performingloans to net loans declined to 0.82% at December 31, 2006, from 2.39% atDecember 31, 2005.

Repossessed assetsconsist of previously financed vehicles held-for-sale.  Subsequent to the loan or lease maturity, theborrower or lessee defaulted on their contract and the Company repossessed theunit.  Repossessed assets are soldthrough either a private or public sale and any deficiency balance from the saleof the asset is charged to the allowance for loan losses.  The Bank terminated its automobile leasingbusiness in 2005.

Payments receivedon non-accrual loans are recognized on a cash basis.  Payments are first applied against theoutstanding principal balance, then to the recovery of any charged-off loanamounts.  Any excess is treated as arecovery of interest income.  During2006, the Bank collected $279,000 of interest income recognized on the cashbasis.  If the non-accrual loans thatwere outstanding as of December 31, 2006 had been performing in accordance withtheir original terms, the Bank would have recognized interest income, withrespect to such loans, of $332,000 for the year ended December 31, 2006.

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***Bankpremises and equipment, net***

The Bank’spremises and equipment decreased $359,000, net of accumulateddepreciation.  During 2006, the Bankpurchased or transferred from construction in process, a component of otherassets, approximately $852,000, net of disposals compared to $1,724,000 in 2005.

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

*OtherReal Estate Owned*

ORE was$197,000.  Five residential propertieswere owned at year end 2006, four of which were under agreements to besold.  There was no foreclosed realestate properties owned at December 31, 2005.

*RepossessedAssets*

Improvement in theturn-around time on sales of repossessed vehicles and the termination of theBank’s automobile leasing business in 2005 reduced the repossessed assetbalance from $19,000 at December 31, 2005 to $0 as of December 31, 2006.

***Terminatedlease assets held-for-sale***

At the end of2005, the Bank’s vehicle lease program terminated.  Terminated lease assets are vehicles thatwere lease-financed by the Company with contractual terms fulfilled.  Pursuant to the lease agreement, the vehiclesare returned to the Company and recorded on the books in other assets at theresidual value.  These vehicles aresubsequently sold as soon as practicable. The difference between sales price and residual value, if any, ischarged against current earnings. Simultaneously, a claim is submitted to the Company’s residual insurancecarrier for payment.  Receipt of anyresidual insurance proceeds is then credited to current earnings.  All vehicles which were returned to the Bankwere subsequently sold prior to December 31, 2005.  During 2006, the Bank received $15,000 fromresidual insurance claims for vehicles that were sold at the end of 2005.

***Cashsurrender 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.  BOLIis classified as a non-interest earning asset. Increases in the cash surrender value are recorded as non-interestincome.  The BOLI is profitable from theappreciation of the cash surrender values of the pool of insurance and itstax-free advantage to the Bank.  Thisprofitability is used to offset a portion of current and future employeebenefit costs.  The BOLI can beliquidated, if necessary, with associated tax costs.  However, the Bank intends to hold this pool ofinsurance, because it provides income that enhances the Bank’s capitalposition.  Therefore, the Bank has notprovided for deferred income taxes on the earnings from the increase in cashsurrender value.***

***Accruedinterest receivable and other assets***

The increase in accruedinterest receivable of $543,000, or 28%, from December 31, 2005 to December 31,2006 was principally due to higher average balances of interest-earning assetsas well as an increase in the number of days in the accrual compared to lastyear.  The increase in other assets of$755,000, or 19%, for the same period, was due mostly to capitalized interimconstruction costs for the Bank’s branch expansion and other projects and thepurchase of an interest rate floor derivative contract.  For a further discussion on the Bank’sderivative contract, see Note 1, “Nature of operations and summary ofsignificant accounting policies,” and Note 12, “Fair value of financialinstruments and derivatives,” contained within the notes to consolidatedfinancial statements in Part II, Item 8. These increases were partially offset by a cumulative effect adjustmentrelated to the Bank’s investment in a limited partnership.  For a further discussion on the Bank’s cumulativeeffect adjustments, see Note 20, “Cumulative effect adjustments,” containedwithin the notes to consolidated financial statements in Part II, Item 8.

***Resultsof Operations***

***EarningsSummary***

The Company’sresults of operations depend primarily on net interest income.  Net interest income is the difference betweeninterest income and interest expense. Interest income is generated from yields on interest-earning assetswhich consist principally of loans and investment securities.  Interest expense is incurred from rates paidon interest-bearing liabilities which consist of deposits and borrowings.  Net interest income is determined by theCompany’s interest rate spread (i.e., the difference between the yields earnedon its interest-earning assets and the rates paid on its interest-bearingliabilities) and the relative amounts of interest-earning assets andinterest-bearing liabilities.  Theinterest rate spread is significantly impacted by: changes in interest rates andmarket yield curves and their related impact on cash flows; the composition and

25

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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’sprofitability is also affected by the level of its non-interest income andexpenses, provision for loan losses and provision for income taxes.  Non-interest income consists mostly ofservice charges on the Bank’s loan and deposit products, trust and assetmanagement service fees, increases in the cash surrender value of the BOLI, netgains or losses from the sales of loans and securities AFS and from the salesof ORE.  Non-interest expense consists ofcompensation and related employee benefit expenses, occupancy, equipment, dataprocessing, advertising, marketing, professional fees, insurance and otheroperating overhead.

The Company’sprofitability is significantly affected by general economic and competitiveconditions, changes in market interest rates, government policies and actionsof regulatory authorities.  The Company’sloan portfolio is comprised principally of commercial and commercial realestate loans.  The properties underlyingthe Company’s mortgages are concentrated in Northeastern Pennsylvania.  Credit risk, which represents the possibilityof the Company not recovering amounts due from its borrowers, is significantlyrelated to local economic conditions in the areas where the properties arelocated as well as the Company’s underwriting standards.  Economic conditions affect the market valueof the underlying collateral as well as the levels of adequate cash flow andrevenue generation from income-producing commercial properties and levels ofoccupancy of multi-family dwellings.

***Overview***

Net income for theyear ended December 31, 2006 was $4,125,000, compared to $4,592,000 for theyear ended December 31, 2005.  During thesame periods, diluted earnings per common share was $2.01 and $2.25,respectively.  For the year endedDecember 31, 2006, the Company’s return on average assets (ROA) and return onaverage shareholders’ equity (ROE) were 0.73% and 8.31%, respectively, comparedto 0.86% and 9.64% for the year ended December 31, 2005.  The decline in net income was causedprimarily by a 9% increase in non-interest expenses.  The provision for loan losses declined by$505,000 and non-interest income increased by $372,000, or 9%, while netinterest income was down marginally; less than 1% for the year ended December31, 2006 compared to year end 2005.  Thedecrease in ROA and ROE was primarily due to the variance in net income.

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***Netinterest income***

The followingtable sets forth a comparison of average balances of assets and liabilities andtheir related net tax equivalent yields and rates for 2006, 2005 and 2004(dollars in thousands):
| ** **                            | ** ** | **2006**    | ** ** | **2005**     | ** ** | **2004**   | ** ** |
|---------------------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| ** **                            | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| ** **                            | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate**   | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** |
| Interest-earning assets               |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits            |       | $           | 240        |         | $          | 9          |       | 3.82 | % | $ | 540 |   | $ | 14 |   | 2.67 | % | $ | 637 |   | $ | 6 |   | 0.93 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                          |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S.  government agencies             |       | 43,299      |       | 1,795        |       | 4.15       |       | 31,976 |   | 1,171 |   | 3.66 |   | 36,360 |   | 1,333 |   | 3.67 |   |
| Mortgage-backed  securities           |       | 42,999      |       | 1,944        |       | 4.52       |       | 54,257 |   | 2,328 |   | 4.29 |   | 73,939 |   | 3,029 |   | 4.10 |   |
| State  and municipal                  |       | 14,485      |       | 927          |       | 6.40       |       | 13,203 |   | 837 |   | 6.34 |   | 11,618 |   | 739 |   | 6.36 |   |
| Other                                 |       | 14,536      |       | 946          |       | 6.50       |       | 14,126 |   | 643 |   | 4.55 |   | 10,213 |   | 291 |   | 2.85 |   |
| Total  investments                    |       | 115,319     |       | 5,612        |       | 4.87       |       | 113,562 |   | 4,979 |   | 4.38 |   | 132,130 |   | 5,392 |   | 4.08 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans:                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                            |       | 219,482     |       | 16,018       |       | 7.30       |       | 216,385 |   | 13,646 |   | 6.31 |   | 223,660 |   | 12,172 |   | 5.44 |   |
| Consumer                              |       | 65,011      |       | 4,200        |       | 6.46       |       | 53,675 |   | 3,548 |   | 6.61 |   | 47,030 |   | 3,321 |   | 7.06 |   |
| Real  estate                          |       | 133,279     |       | 8,101        |       | 6.08       |       | 120,407 |   | 7,237 |   | 6.01 |   | 113,589 |   | 6,737 |   | 5.93 |   |
| Direct  financing leases              |       | 618         |       | 38           |       | 6.18       |       | 1,387 |   | 83 |   | 6.01 |   | 3,013 |   | 201 |   | 6.66 |   |
| Total  loans                          |       | 418,390     |       | 28,357       |       | 6.78       |       | 391,854 |   | 24,514 |   | 6.26 |   | 387,292 |   | 22,431 |   | 5.79 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal  funds sold                   |       | 2,479       |       | 123          |       | 4.97       |       | 1,866 |   | 49 |   | 2.60 |   | 1,530 |   | 17 |   | 1.13 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  earning assets                 |       | $           | 536,428    |         | $          | 34,101     |       | 6.36 | % | $ | 507,822 |   | $ | 29,556 |   | 5.82 | % | $ | 521,589 |   | $ | 27,846 |   | 5.34 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities          |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                             |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                               |       | $           | 46,422     |         | $          | 620        |       | 1.34 | % | $ | 48,273 |   | $ | 450 |   | 0.93 | % | $ | 41,860 |   | $ | 219 |   | 0.52 | % |
| NOW                                   |       | 69,138      |       | 1,880        |       | 2.72       |       | 52,244 |   | 666 |   | 1.28 |   | 37,312 |   | 121 |   | 0.32 |   |
| MMDA                                  |       | 68,476      |       | 2,948        |       | 4.30       |       | 24,183 |   | 438 |   | 1.81 |   | 30,394 |   | 383 |   | 1.26 |   |
| Time  deposits < $100,000          |       | 87,345      |       | 3,235        |       | 3.70       |       | 85,612 |   | 2,534 |   | 2.96 |   | 99,390 |   | 3,020 |   | 3.04 |   |
| Time  deposits > $100,000          |       | 67,129      |       | 2,791        |       | 4.16       |       | 89,076 |   | 2,821 |   | 3.17 |   | 105,813 |   | 2,974 |   | 2.81 |   |
| Clubs                                 |       | 1,750       |       | 19           |       | 1.08       |       | 1,781 |   | 19 |   | 1.07 |   | 1,759 |   | 19 |   | 1.08 |   |
| Total  deposits                       |       | 340,260     |       | 11,493       |       | 3.38       |       | 301,169 |   | 6,928 |   | 2.30 |   | 316,528 |   | 6,736 |   | 2.13 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Repurchase  agreements                |       | 23,391      |       | 624          |       | 2.67       |       | 35,106 |   | 634 |   | 1.81 |   | 41,695 |   | 464 |   | 1.11 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowed  funds                       |       | 79,627      |       | 4,244        |       | 5.33       |       | 82,114 |   | 4,159 |   | 5.06 |   | 78,318 |   | 3,980 |   | 5.08 |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities   |       | $           | 443,278    |         | $          | 16,361     |       | 3.69 | % | $ | 418,389 |   | $ | 11,721 |   | 2.80 | % | $ | 436,541 |   | $ | 11,180 |   | 2.56 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest income                  |       |        |       | $            | 17,740     |       |       |   |   |   | $ | 17,835 |   |   |   |   |   | $ | 16,666 |   |   |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest spread                  |       |        |       |         |       | 2.67       | %          |   |   |   |   | 3.02 | % |   |   |   |   | 2.78 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest margin                  |       |        |       |         |       | 3.31       | %          |   |   |   |   | 3.51 | % |   |   |   |   | 3.20 | % |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  average assets                 |       | $           | 564,923    |         |       |       |       |   | $ | 536,262 |   |   |   |   |   | $ | 550,223 |   |   |   |   |   |
|                                  |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average non-interest-bearing deposits |       | $           | 68,224     |         |       |       |       |   | $ | 67,093 |   |   |   |   |   | $ | 66,006 |   |   |   |   |   |

----

In the above table, interest income was adjusted to a tax-equivalentbasis to recognize the income from tax-exempt interest-earning assets as if theinterest was taxable.  This treatmentallows a uniform comparison between yields on interest-earning assets.  The calculations were computed on a fullytax-equivalent basis using the corporate federal tax rate of 34%.  Loans include loans AFS and non-accrual loansbut exclude the allowance for loan losses. Within consumer loans, direct financing leases are presented net ofunearned interest.  Average balances arebased on amortized cost and do not reflect unrealized gains or losses.  Net interest rate spread represents thedifference between the average yield on average interest-earning assets and theaverage cost of average interest-bearing liabilities.  Net interest margin represents net interestincome divided by total average interest-earning assets.

 

27

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Changes in net interest income are a function of both changes ininterest rates and changes in volume of interest-earning assets andinterest-bearing liabilities.  Thefollowing table presents the extent to which changes in interest rates andchanges in volume of interest-earning assets and interest-bearing liabilitieshave affected the Bank’s interest income and interest expense during theperiods indicated.  Information isprovided in each category with respect to (1) the changes attributable tochanges in volume (changes in volume multiplied by the prior period rate), (2)the changes attributable to changes in interest rates (changes in ratesmultiplied by prior period volume) and (3) the net change.  The combined effect of changes in both volumeand rate has been allocated proportionately to the change due to volume and thechange due to rate.  Tax-exempt incomewas not converted to a tax-equivalent basis on the rate/volume analysis(dollars in thousands):
| ** **                                                               | ** ** | **Years ended December 31,**   | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                               | ** ** | **2006 Compared to 2005**      | ** ** | **2005 Compared to 2004** | ** ** |
| ** **                                                               | ** ** | **Increase (decrease) due to** | ** ** | **Increase (decrease) due to** | ** ** |
| ** **                                                               | ** ** | **Volume**                                    | ** ** | **Rate** | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Interest income:                                                         |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Loans and leases:                                                        |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage                                                                 |       | $                                             | 781        |   | $ | 82 |   | $ | 863 |   | $ | 409 |   | $ | 91 |   | $ | 500 |   |
| Commercial                                                               |       | 194                                           |       | 2,180 |   | 2,374 |   | (375 | ) | 1,778 |   | 1,403 |   |
| Consumer                                                                 |       | 682                                           |       | (73 | ) | 609 |   | 294 |   | (182 | ) | 112 |   |
| Total loans and  leases                                                  |       | 1,657                                         |       | 2,189 |   | 3,846 |   | 328 |   | 1,687 |   | 2,015 |   |
| Investment securities,  interest-bearing deposits and federal funds sold |       | 86                                            |       | 577 |   | 663 |   | (800 | ) | 410 |   | (390 | ) |
| Total interest  income                                                   |       | 1,743                                         |       | 2,766 |   | 4,509 |   | (472 | ) | 2,097 |   | 1,625 |   |
|                                                                     |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                                                        |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Certificates of deposit  greater than $100,000                           |       | (793                                          | )          | 754 |   | (39 | ) | (823 | ) | 680 |   | (143 | ) |
| Other                                                                    |       | 1,414                                         |       | 3,190 |   | 4,604 |   | 25 |   | 310 |   | 335 |   |
| Total deposits                                                           |       | 621                                           |       | 3,944 |   | 4,565 |   | (798 | ) | 990 |   | 192 |   |
| Other interest-bearing  liabilities                                      |       | (620                                          | )          | 695 |   | 75 |   | (100 | ) | 449 |   | 349 |   |
| Total interest  expense                                                  |       | 1                                             |       | 4,639 |   | 4,640 |   | (898 | ) | 1,439 |   | 541 |   |
| Net interest income                                                      |       | $                                             | 1,742      |   | $ | (1,873 | ) | $ | (131 | ) | $ | 426 |   | $ | 658 |   | $ | 1,084 |   |

 

The slope of the yieldcurve, which flattened in 2004 and continued to flatten in 2005 becameinverted, or negatively sloped in 2006. An inverted yield curve presents challenges to all banks becauseshort-term rates are higher than long-term rates.  This situation is unusual and tends tosqueeze net interest income because deposit and borrowing terms are generallyshorter than investment and loan terms. The Federal Open Market Committee (FOMC) increased short-term interestrates four times in the first half of 2006. In response to these actions, national prime also increased during2006.  National prime, the benchmark ratebanks use to set rates on various lending and other interest sensitiveproducts, also increased four times for a total increase of 100 basis pointsfrom 7.25% at December 31, 2005 to 8.25% at December 31, 2006.

The weighted-averagenational prime rate increased to 7.96% in 2006 compared to 6.19% in 2005.  This difference has continued to increase theyield on the Bank’s interest-earning assets that had largely begun in 2004 andcontinued through 2006 as new product was originated and variable-rate loansre-priced to these higher rates. However, the rate paid on interest-bearing liabilities has alsoincreased but at a faster pace, thereby putting pressure on the Bank’s interestrate margin.

As market ratesrise along with the increase in national prime, loan originations, renewingcommercial and residential loans and lines of credit should price above theaverage 2006 portfolio yields.  Inaddition, the increase in the Treasury yields and other capital market ratescould have a favorable impact on the Bank’s total investment portfolio byincreasing yields, which had begun to rise during the latter part of 2004 andshould continue unless and until rates once again decline.  As expected, the relative and predominantlyhigher interest rate environment during 2006 continued to have a positiveinfluence on the Bank’s interest-earning assets.  Total interest income increased 15.5%, from$29,020,000 in 2005 to $33,530,000 in 2006 and further, caused thetax-equivalent yield on earning assets to increase 54 basis points.  The Bank should continue to see an increasein the tax-equivalent yield on its interest-earning assets during the currentinterest rate environment.

Interest expenseincreased $4,640,000, or 39.6%, from $11,721,000 in 2005 to $16,361,000 in2006.  The cost of interest-bearingliabilities increased 89 basis points in 2006. The increased interest rate environment, in particular at the short- tomid-term range of the yield curve in conjunction with deposit gatheringstrategies, required the Bank to increase offering rates on its depositproducts.  The bulk of the rate increasesimpacted the Bank’s interest expense on customer deposits which 

28

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increased $4,565,000during 2006 of which over $3,944,000 was caused by a 108 basis point rise inrates.  Average balances in depositsincreased by more than $39,000,000 during 2006, with growth in most allcategories, resulting in additional interest expense of $621,000 during 2006.

The weighted-averageinterest rate paid on borrowed funds increased 27 basis points in 2006 comparedto 2005 largely due to higher rates paid on overnight borrowings.  During the third quarter of 2006, the Bankrefinanced a portion of its long-term debt with the FHLB in order to reduceinterest expense.  The immediate impactof the refinance was a reduction of interest expense by approximately $154,000per annum.

As a result of themix of the Bank’s interest sensitive assets and liabilities and the varyingeffects that the slope of the interest rate yield curve has had during 2006,net interest income decreased $131,000, or 0.8%, from $17,299,000 in 2005 to$17,168,000 in 2006.  On a tax-equivalentbasis, the net interest rate spread declined 35 basis points from 3.02% to2.67% and the tax-equivalent margin declined 20 basis points, from 3.51% in2005 to 3.31% in 2006, respectively.

***Provisionfor loan losses***

The provision forloan losses represents the necessary amount to charge against current earnings,the purpose of which is to increase the allowance for loan losses to a levelthat represents Management’s best estimate of known and inherent losses in theBank’s loan portfolio.  Loans and leasesdetermined to be uncollectible are charged-off against the allowance for loanlosses.  The required amount of theprovision for loan losses, based upon the adequate level of the allowance forloan losses, is subject to ongoing analysis of the loan portfolio.  The Bank’s Special Asset Committee meetsperiodically to review problem loans and leases.  The committee is comprised of BankManagement, including the chief risk officer, loan workout officers andcollection personnel.  The committeereports quarterly to the Credit Administration Committee of the Board ofDirectors.

Managementcontinuously reviews the risks inherent in the loan and lease portfolio.  Specific factors used to evaluate theadequacy of the loan loss provision during the formal process include:

·                  specific loans that could have losspotential;

·                  levels of and trends in delinquenciesand non-accrual loans;

·                  levels of and trends in charge-offs andrecoveries;

·                  trends in volume and terms of loans;

·                  changes in risk selection andunderwriting standards;

·                  changes inlending policies, procedures and practices;

·                  experience, ability and depth oflending management;

·                  national andlocal economic trends and conditions; and

·                  changesin credit concentrations.

The provision forloan losses was $325,000 for the year ended December 31, 2006, compared to$830,000 in 2005.  As a result, theallowance for loan losses was $5,444,000 at December 31, 2006, compared to$5,985,000 at December 31, 2005.  Thesignificant reduction in the provision this year was due to the improvedquality of the portfolio coupled with a decline in loans migrating tonon-performing status.  Non-performingloans, which consist of loans past due 90 days or more and non-accrual loansdeclined $6,211,000, or 64%, to $3,439,000 at December 31, 2006, from$9,650,000, at December 31, 2005.  Thereduction was both in non-accrual loans which declined by $6,095,000 to$3,358,000 at December 31, 2006, and a decline of $116,000 in loans past due 90days or more and still accruing.  TheBank continued to give heightened attention to the collection of sub-performingloans which resulted in lower levels of delinquencies and non-accruing loansfor 2006.

***Other income***

Other (non-interest) income consists of servicecharges or fees collected on the Bank’s various deposit and loan products, netmortgage servicing revenue, fees from trust, asset management and otherfinancial services, the increase in the cash surrender value of the BOLI, therealized gains and losses from the sales of investment securities, loans, leasedassets and foreclosed assets held-for-sale and other various classifications ofnon-interest related income.

For the year endedDecember 31, 2006, other income was $4,522,000, an increase of $372,000, or9.0%, from $4,150,000 for the year ended December 31, 2005.  The primary cause of the increase is the lackof losses incurred from the sales of terminated and previously leasedautomobiles.  During 2005, the Companyrecognized $335,000 in losses from these vehicle sales compared to residualinsurance claims of $15,000 in 2006.  Theautomobile leasing program expired in 2005. In addition, the strategy to sell more loans into the secondary marketresulted in gains of $98,000 in 2006 compared to $10,000 in 2005.  During 2005, the gains recognized on foreclosedassets included proceeds from an insurance claim resulting in a 

29

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gain of $57,000,compared to a minor loss in 2006.

***Otherexpense***

For the twelve monthsended December 31, 2006, other operating expenses were $15,878,000, or$1,316,000 more than the $14,562,000 recorded in the same period of 2005.  Salary and employee benefit costs increased$1,235,000, or 17.4%, for the twelve months ended December 31, 2006 compared tothe same period in 2005.  The increasewas due to pay increases, increased number of full-time equivalent employeesdue to staffing needs, one-time voluntary separation benefit payments andstock-based compensation expense.  For afurther discussion on the Bank’s stock-based compensation expense, see Note 9, “Stockplans,” contained within the notes to consolidated financial statements in PartII, Item 8.

Premises andequipment increased $190,000, or 6.4%, in 2006 compared to 2005.  Equipment maintenance increased byapproximately $58,000 due to more repairs, rental and maintenance in 2006.  Occupancy related expense increases werecaused by increased property insurance, facility maintenance and increased rentdue to activities related to the branch expansion project.

Advertising andmarketing related expenses were down $81,000, or 13.0%, during the year ended2006 compared to the year ended 2005. The decrease was related to expense savings tactics implemented duringthe fourth quarter of 2006 caused by expense overruns in some of the otherstrategic functional areas.  As a result,some of the advertising programs, use of mass media, direct mail, communityevents and sponsorships, slated for the fourth quarter of 2006, were eithercancelled or deferred to 2007 where the primary focus will be branch openingprojects.

The ratio of non-interestexpense less non-interest income (expense ratio) to average assets at December31, 2006 and 2005 was 2.02% and 1.93%, respectively.  The increase was caused predominantly byhigher overhead expenses and is comparative to the Uniform Bank Performance Reportpeer comparison group percentage.

***Provision for income taxes***

Income beforeprovision for income taxes in 2006 decreased $570,000 from 2005.  The effective federal income tax rate was24.8% and 24.2% for the years ending December 31, 2006 and 2005, respectively.  The minor increase in the effective tax rateis attributed to an increase in temporary differences that gave rise to anincrease in pre-tax income.

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

***and 2004 and Results of Operations for each of the Years then Ended***

***FinancialCondition***

***Overview***

Consolidatedassets increased $7,386,000 or 1.4%, during the year ended December 31, 2005 to$544,061,000.  The increase resulted fromincreases in total deposits of $13,883,000 and total stockholders’ equity of$2,479,000.  These items were partiallyoffset by a net decrease in total borrowings of $9,176,000.  Since December 31, 2004, the carrying valueof total loans increased $21,450,000 and cash and cash equivalents increased$2,378,000.  The carrying value of theBank’s investment portfolio declined $17,990,000 since December 31, 2004.  The increase in shareholders’ equity wasattributable to earnings net of dividends declared of $2,967,000, an increasein common stock of $523,000, partially offset by a $1,011,000 net unrealizedholding loss on AFS securities recorded in other comprehensive income (loss).

***Deposits***

Total depositsincreased $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 NOW accounts and a $5,004,000, or 8%, increasein DDAs.  The increase in the Bank’s NOWaccounts was primarily due to a $14,316,000 increase from the public sectorincluding a municipal customer who formerly used the Bank’s repurchaseagreements for its transactional business. The $23,977,000 increase in money market deposits was primarily due totransfers of funds from time deposit accounts, which decreased by a similaramount.  Core deposits increased$31,612,000, or 12%, during 2005 to $303,242,000.  Most of the increase in core depositsresulted from the aforementioned transfer of funds from time deposits of$100,000 or greater into money market deposit accounts.

During 2005, theBank’s deposit mix shifted away from being time-deposit-dominant.  Time deposits represented 42% of totaldeposits, down from 51% as at December 31, 2004.

***Short-termborrowings***

Liquidity,investment needs and interest rates caused a net decrease in repurchaseagreements from $40,684,000 at December 

30

----

31, 2004, to $26,913,000 at December 31, 2005.  Included in this variance was the effect ofthe preference for one of the Bank’s municipal customers to transfer its fundsfrom the repurchase agreement product 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, required less overnight funding from the FHLB.  As a result, overnight funding from the FHLBwas $769,000 at December 31, 2005 compared to $8,760,000 at December 31, 2004.

***Long-term debt***

Theweighted-average rate in effect on funds borrowed at December 31, 2005 was5.16% compared to 5.10% as of December 31, 2004.  The quarterly re-pricing of $5,000,000 ofadvances was the primary cause of the six basis point increase in theweighted-average interest rate.  The 2005weighted-average rate is 66 basis points below the tax-equivalent yield of5.82% on average earning assets for the year ended December 31, 2005.  Rates on $58,000,000 of long-term debtadvances were fixed but may adjust quarterly, should market rates increasebeyond the issues’ original rates.  AtDecember 31, 2005, similar advances from the FHLB were 139 basis points belowthe average rate paid by the Bank.

Long-term debtincreased $12,585,000 during 2005, or 18%, to $83,704,000.  The primary purpose of the increase was toreduce our exposure to rising interest rates by reducing short-term overnightborrowings and locking in longer-term fixed-rate positions.

***Accrued expenses and other liabilities***

Increases ininterest-bearing deposits and borrowings along with higher interest ratescaused an increase in accrued interest payable of $354,000, or 36%, to$1,339,000.  Other liabilities included anumber of accrued expenses and liabilities that have been recognized in thefinancial statements but, as of December 31, 2005, were unpaid.  Collectively, these accounts decreased$156,000 from December 31, 2004.

***Investments***

Total investmentsdeclined $17,990,000, net of $1,532,000 depreciation in the market value of AFSinvestments.  The carrying value ofinvestment securities at December 31, 2005 was $97,679,000, or 18% of totalassets, compared to $115,669,000, or 22%, as of December 31, 2004.  During the first half of 2005, the Bankrestructured approximately $19,500,000 of investment securities to enhancecurrent earnings while simultaneously addressing the interest rate risk in theportfolio from the continued flattening of the U.S. Treasury yield curve.  The restructuring included the sale andpurchase of securities that re-allocated the portfolio diversification awayfrom being heavily weighted in mortgage-backed securities.  At December 31, 2005 approximately 44% of theinvestment portfolio was comprised of mortgage-backed securities that amortizeand provide monthly cash flow compared to 56% at December 31, 2004.

During 2005, interestrates throughout the yield curve increased with the exception of the 30-yeartreasury which decreased modestly.  TheFOMC raised short-term interest rates eight times (200 basis points) since theend of 2004.  While short-term U.S.Treasury yields had shown somewhat similar increases during 2005, the medium-and long-term rates have increased at a much slower pace resulting in aflattening to a slightly inverted yield curve at the short- to mid-termrange.  This environment precluded astructured growth strategy within the investment portfolio due to lack ofprudent investments available at adequate spreads to the Bank’s fundingsources.  Accordingly, the Bank used cashflows from its investment portfolio to fund high-cost time deposit outflow,repayment of overnight borrowings and fund growth in the loan portfolio ratherthan redeploy the funds in the securities markets.

The tax-equivalentyield on debt securities by stated maturity date at December 31, 2005, is asfollows:
| ** **                         | ** ** | **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       | %          |
| Mortgage-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       | %          |

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In the above table, the book yields on state & municipalsubdivisions were adjusted to a tax-equivalent basis using the corporatefederal tax rate of 34%.  In addition,average yields on securities AFS are based on amortized cost and do not reflectunrealized gains or losses.

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***Loansand leases***

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

In 2005, the Bankoriginated $27,030,000 of commercial loans, $39,398,000 of mortgage loans and$38,763,000 of consumer loans.  Thiscompares to $34,981,000, $31,368,000 and $19,671,000, respectively, in 2004.  Included in mortgage loans is $18,128,000 ofreal estate construction lines in 2005 and $13,066,000 in 2004.  In addition for 2005, the Bank originatedlines of credit in the amounts of $21,008,000 for commercial borrowers,$6,756,000 in home equity lines and $153,000 for consumer borrowers.  The increase in the loan portfolio was fromthe successful implementation of marketing strategies for residential andconsumer lending, partially offset by a decline in commercial loans.  Though interest rates have increasedthroughout 2005, the Bank’s lending activities were relatively unaffected byborrowers’ sentiment to a sustained period of rising short-term interest rates.

*Commercial and Commercial Real Estate Loans**:*

Net of scheduledprincipal curtailments, loan participation sales and pre-payments, commercialloans decreased $5,680,000 during 2005. This decrease was due primarily to the strategic decision not to renewan automobile dealer’s floor plan that was paid off.

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 thissector was due mainly to fund loans to local municipalities for variousinfrastructure and sustaining projects.

*Residential Real Estate Loans*:

Residential realestate loans increased $12,626,000, or 13.8%, to $103,921,000.  These loans increased due to the successfulimplementation of various sales and marketing campaigns throughout 2005.  In addition, originations of these loansremained strong due to the relative low interest rate environment.

*Consumer Loans**:*

Consumer loansincreased $12,583,000, or 20.5%, during 2005. A successful spring sales campaign, with added advertising andmarketing, along with less pay-downs, helped boost the home equity installmentprogram by approximately $14,463,000.

*Real Estate Construction Loans**:*

Real estateconstruction loans increased $3,579,000, or 33.7%, during 2005.  Real estate construction loans consisted of$12,435,000 for residential construction and $1,764,000 for commercial realestate construction.  The increase wascaused by efforts to further develop this lending arrangement as well as anincrease in the average loan size in 2005 compared to 2004.

*Direct Financing Leases**:*

Direct financingleases declined $1,562,000, or 70.6%, to $650,000.  The last of the Bank’s automobile leasesterminated and its automobile leasing business concluded as of December 31,2005.  The remaining balance representstax-free leasing arrangements provided to municipal customers.

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

Loans AFS, atDecember 31, 2005, were $429,000, with a corresponding fair value of $434,000compared to $576,000 and $582,000 respectively, at December 31, 2004.  During 2005, residential mortgages andstudent loans with principal balances of $1,417,000 and $910,000, respectively,were sold into the secondary market and gains of approximately $25,000 havebeen recognized.  There were no sold SBAloans during 2005.

***Allowance for loan losses***

Total charge-offs,net of recoveries, for the year ended December 31, 2005, were $833,000,compared to $1,159,000 in 2004.  Combinedconsumer loan and lease 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 $682,000for the full year 2005 compared to $549,000 for 2004.  Mortgage loan net charge-offs were $10,000 in2005 compared to $246,000 in 2004.  Theratio of allowance for loan losses to total loans was 1.46% at December 31,2005 compared to 1.54% at December 31, 2004.

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***Non-performing assets***

In 2005,non-performing loans were reduced by $811,000, or 7.8%, to $9,650,000.  Repossessed assets were $19,000 at December31, 2005 compared to $50,000 in 2004.  Allrepossessed vehicles, except one, were sold prior to year-end 2005.  There was no ORE at year-end 2005 as allpreviously foreclosed real estate had been listed with realtors and sold priorto the end of the year.  The non-accrualloans were $9,453,000 at December 31, 2005 a reduction of $451,000, or 4.6%,from year-end 2004.  During 2005approximately $4,604,000 of loans were placed in non-accrual status.  This was more than offset by payoffs orpay-downs of $2,810,000, charge-offs of $1,131,000, $245,000 in transfers toforeclosed assets and $869,000 of loans that returned to performingstatus.  Loans past due 90 days or moreand accruing, declined by 64.6%, to $197,000, at December 31, 2005.  As a result, the percentage of non-performingassets to total assets declined to 1.78% at December 31, 2005, compared to1.99% for the prior year end and non-performing loans to net loans declined to2.39% at December 31, 2005, from 2.74% at December 31, 2004.

During 2005, theBank collected $241,000 of interest income recognized on the cash basis.  If the non-accrual loans that wereoutstanding as of December 31, 2005 had been performing in accordance withtheir original terms, the Bank would have recognized interest income, withrespect to such loans, of $806,000 for the year ended December 31, 2005.

***Bankpremises and equipment, net***

The Bank’spremises and equipment increased $520,000, net of accumulated depreciation, dueprimarily to the land acquisition for anticipated future branch expansion.  During 2005, the Bank purchased approximately$1,740,000 in premises and equipment compared to $278,000 in 2004.

***Terminatedlease assets held-for-sale***

All vehicles whichwere returned to the Bank were subsequently sold prior to December 31,2005.  The Bank’s vehicle lease programhas expired and future periods’ results of operations should be minimallyimpacted and limited to residual insurance claims that will be received in2006.

***Resultsof Operations***

***Overview***

Net income for theyear ended December 31, 2005 increased to $4,592,000, or 36%, from $3,364,000for the year ended December 31, 2004. Diluted earnings per common share increased to $2.25 for the year endedDecember 31, 2005 compared to $1.67 for the year ended December 31, 2004.  ROA and 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 improvementin net income was the result of an increase in net interest income and adecrease in the provision for loan losses partially offset by increases inother expenses and the provision for income taxes.  The improvements in ROA and ROE from 2005 to2004 were primarily the result of improved net income.

***Netinterest income***

The yield curve, whichflattened in 2004 and continued to flatten (mid- and long-term rates risingmuch slower than short-term rates), in 2005 presented challenges in 2005.  The FOMC increased short-term interest rateseight times in 2005.  National prime alsoincreased eight times, at 25 basis point increments each, for a total increaseof 200 basis points from 5.25% at December 31, 2004 to 7.25% at December 31,2005.

As market ratesrise along with the increase in national prime, loan originations, renewingcommercial and residential loans and lines of credit priced above the average2005 portfolio yields.  Total interestincome increased 5.9%, from $27,395,000 in 2004 to $29,020,000 in 2005 andfurther, caused the tax-equivalent yield on earning assets to increase 48 basispoints.

Interest expenseincreased $541,000, or 4.8%, from $11,180,000 in 2004 to $11,721,000 in2005.  The cost of interest-bearingliabilities increased 24 basis points in 2005. The increased interest rate environment, in particular at the short- tomid-term range of the yield curve required the Bank to increase offering rateson most deposit products.  The bulk ofthe rate increases impacted the Bank’s interest expense during 2005’s fourthquarter where interest expense grew $568,000 compared to the fourth quarter of2004.  Of this increase, approximately$388,000 was from deposits.  Partiallyoffsetting the increases in rates paid on interest-bearing deposit liabilitieswas an overall decrease in the average-balances on which they were 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 costing core deposits coupled with thedecline in time deposits helped contain the interest expense increase indeposits to $192,000 for the year ended 2005 compared to the year ended2004.  The weighted-average interest rateon borrowed funds decreased two basis points in 2005 compared to 2004.  The Bank paid off $5,000,000 of matured high 

33

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costing FHLBborrowings at the end of 2004 which had the effect of reducing the overall 2005rate on this funding source.

As a result of themix of the Bank’s interest sensitive assets and liabilities and the varyingeffects that the slope of the interest rate yield curve 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-equivalentbasis, the net interest rate spread improved 24 basis points from 2.78% to3.02% and the tax-equivalent margin improved 31 basis points, from 3.20% in2004 to 3.51% in 2005, respectively.

***Provisionfor loan losses***

The provision forloan losses was $830,000 for the year ended December 31, 2005, compared to$2,150,000 in 2004.  As a result, theallowance for loan losses was $5,985,000 at December 31, 2005, compared to$5,988,000 at December 31, 2004.  Thesignificant reduction in the provision was due to the improved quality of theportfolio coupled with a decline in loans migrating to non-performingstatus.  The reduction was both innon-accrual loans which declined by $451,000 to $9,453,000 at December 31,2005, and a decline of $360,000 in loans past due 90 days or more and stillaccruing.

***Other income***

For the year endedDecember 31, 2005, other income was $4,151,000, or essentially unchanged from2004.  A $432,000 increase in charges ondeposit accounts and loan fees and net gains from the sales of ORE propertieslargely offset lower net gains from the sales of investment securities andmortgage loans, declines in fees earned from trust and asset managementservices and increased losses from the final sales of terminated leasedautomobiles.  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’sautomobile leasing program has expired and there are no intentions to re-enterthe automobile leasing business.  Resultsof operations from this portfolio has concluded with the final terminatedleased vehicle disposed of in December 2005.

***Otherexpense***

For the twelvemonths ended December 31, 2005, other operating expenses were $14,562,000 or$743,000 more than the $13,819,000 recorded in the same period of 2004.  Salary and employee benefit costs increased$327,000, or 5%, for the twelve months ended December 31, 2005 compared to thesame period in 2004.  The increase wasprimarily due to filling vacancies in key functional areas and annual merit andincentive increases.

Premises andequipment increased $123,000, or 4%, in 2005 compared to 2004.  Of this increase, equipment maintenanceincreased by approximately $95,000 due to more repairs in 2005 and increasesrelated to maintenance contract renewals.

Advertising andmarketing related expenses increased $190,000, or 44%, during the year ended2005 compared to the year ended 2004. The increase was related to a number of new and increased marketingactivities during 2005 including: a significant increase in the volume of massmailing resulted from the utilization of a new marketing software system thathelps identify and target specific demographic profiles in a defined marketingarea; more advertising spending due to a wide variety of campaigns capitalizingon market opportunities; more costs related to point-of-sale signage due to thecompletion of rolling out a merchandising system and finally, during 2005, theBank took advantage of more sponsorship opportunities, and participated in morecommunity events than in 2004. Finally, a redesigned website went on-line inSeptember, 2005 that offered our customers an interactive means to both opennew accounts and communicate with the Bank as well as performing numerouscustomer-initiated transactions.

The increase inall other components of other operating expenses was primarily caused by$146,000 more professional service fees incurred in 2005 compared to 2004related to increases for the annual independent financial audit, costs relatedto the pre-implementation of the Sarbanes-Oxley §404 compliance process andcosts for participation in the Bank-wide management skills development andsales training programs.

The ratio of non-interestexpense less non-interest income to average assets at December 31, 2005 and2004 was 1.93% and 1.69%, respectively. The increase was caused predominantly by higher expenses but continuesto perform favorably compared to the Uniform Bank Performance Report peercomparison groups.

***Provision for income taxes***

Income beforeprovision for income taxes in 2005 increased $1,658,000 from 2004.  The effective federal income tax rate was24.2% and 23.5% for the years ended December 31, 2005 and 2004,respectively.  The effective tax rateincrease is attributed to a combined increase in pre-tax earnings and adecrease in tax-free interest income.

34

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

The Company is a party to financial instruments withoff-balance sheet risk in the normal course of business in order to meet thefinancing needs of its customers and in connection with the overall interestrate management strategy.  These instrumentsinvolve, to a varying degree, elements of credit, interest rate and liquidityrisk.  In accordance with GAAP, theseinstruments are either not recorded in the consolidated financial statements orare recorded in amounts that differ from the notional amounts.  Such instruments primarily include lendingcommitments, lease obligations and derivative instruments.  For a further discussion on the Bank’sderivative instrument, see Note 1, “Nature of operations and summary ofsignificant accounting policies,” and Note 12, “Fair value of financial instrumentsand derivatives,” contained within the notes to consolidated financialstatements in Part II, Item 8.

Lendingcommitments include commitments to originate loans and commitments to fundunused lines of credit.  Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract.  Commitments generally have fixed expirationdates or other termination clauses and may require payment of a fee.  Since some of the commitments are expected toexpire without being drawn upon, the total commitment amounts do notnecessarily represent future cash requirements.

In addition tolending commitments, the Company has contractual obligations related tooperating lease commitments.  Operatinglease commitments are obligations under various non-cancelable operating leaseson buildings and land used for office space and banking purposes.  During the second quarter of 2006, the Bankentered into a long-term facility lease agreement in concert with theconstruction and relocation of one branch office.  Under the lease agreement, the Bank hascommitted to an initial 15-year term with options to renew for two consecutiveperiods of five years each.  Under thisagreement, the Bank recognized $36,000 of rent expense in 2006 and willrecognize a total of $1,384,000, including $635,000 related to the two renewaloptions, through the expiration of the second renewal option on August 31,2031.

The followingtable presents, as of December 31, 2006, the Company’s significant determinablecontractual obligations by payment date and significant 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  |       | $          | 153,811    |              | $          | 126,757               |       | $                      | 17,610     |                | $          | 9,192 |   | $ | 252 |   |
| Long-term debt            |       | 62,536     |       | 8,827             |       | 709                   |       | 32,000                 |       | 21,000              |       |
| Repurchase  agreements    |       | 22,224     |       | 20,578            |       | 1,646                 |       | —                 |       | —              |       |
| Operating leases          |       | 6,398      |       | 391               |       | 712                   |       | 683                    |       | 4,612               |       |
|                      |       |       |       |              |       |                  |       |                   |       |                |       |
| Significant  commitments: |       |       |       |              |       |                  |       |                   |       |                |       |
| Letters of  credit        |       | 5,535      |       | 2,754             |       | 63                    |       | —                 |       | 2,718               |       |
| Loan commitments  *       |       | 9,842      |       | 9,842             |       | —                |       | —                 |       | —              |       |
|                      |       |       |       |              |       |                  |       |                   |       |                |       |
| Total                     |       | $          | 260,346    |              | $          | 169,149               |       | $                      | 20,740     |                | $          | 41,875 |   | $ | 28,582 |   |

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*Available creditto borrowers in the amount of $61,400 is excluded from the above table since,by its nature, the borrowers may not have the need for additional funding, and,therefore, the credit may or may not be disbursed by the Bank.

In addition to theitems above, in 2007 the Company will complete the construction and relocationof one branch office.  As of December 31,2006 approximately $1,200,000 of additional capital expenditures, representingoutstanding construction commitments, design, and equipment will be incurred in2007.

***Related Party Transactions***

Information withrespect to related parties is contained in Note 15, “Related partytransactions,” within the notes to the consolidated financial statements, andincorporated by reference in Part II, Item 8.

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

Information withrespect to the impact of accounting standards is contained in Note 18, “Recentaccounting pronouncements,” within the notes to the consolidated financialstatements, and incorporated by reference in Part II, Item 8.

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

The consolidatedfinancial statements and notes thereto presented herein have been prepared inaccordance with GAAP, which require measurement of our financial condition andresults of operations in terms of historical dollars without considering thechanges in the relative purchase power of money over time due to inflation.  The impact of inflation is reflected in theincreased cost of our operations.  Unlikeindustrial businesses, most all of the Company’s assets and liabilities aremonetary in nature.  As a result,interest rates have a greater impact on our performance than do the effects ofgeneral levels of inflation as interest rates do not necessarily move in thesame direction or, to the same extent, as the price of goods and services.

***Capital Resources***

During 2006, the increasein shareholders’ equity (capital) was attributable to earnings of $4,125,000,an increase in common stock from the Company’s dividend reinvestment and stockpurchase plans of $617,000, in total and a decrease of $147,000 in the netunrealized holding loss on AFS securities recorded in other comprehensiveincome (loss).  These items werepartially offset by the declaration of cash dividends of $1,801,000 and therecording of cumulative effect adjustments related to the Bank’s investment ina limited partnership and a long term lease agreement.  For a further discussion on the Bank’scumulative effect adjustments, see Note 20, “Cumulative effect adjustments,”contained within the notes to consolidated financial statements in Part II,Item 8.

The Company is subject tovarious regulatory capital requirements administered by the federal bankingagencies.  Failure to meet minimumcapital requirements can initiate certain mandatory and possible additionaldiscretionary actions by regulators that, if undertaken, could have a direct materialeffect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Company must meet specific capital guidelinesthat involve quantitative measures of the Company’s assets, liabilities andcertain off-balance-sheet items as calculated under regulatory accountingpractices.  The Company’s capital amountsand classification are also subject to qualitative judgments by the regulatorsabout components, risk-weightings and other factors.

Under theseguidelines, assets and certain off-balance sheet items are assigned to broadrisk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of totalrisk-weighted assets and 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%, including TierI capital to total risk-weighted assets (Tier I Capital) of 4% and Tier I capitalto average total assets (Leverage Ratio) of at least 4%.  Additional information with respect tocapital requirements is contained in Note 14, “Regulatory matters,” within thenotes to the consolidated financial statements, and incorporated by referencein Part II, Item 8.

The Company’s majorsource of capital during the previous five years has been from the retention ofequity in undistributed earnings of the Bank, as reflected below:

|            | ** ** | **Net**    | ** ** | **Cash dividends** | ** ** | **Earnings** | ** ** | ** ** | ** ** |
|------------|------------|------------|------------|-------------------------|------------|--------------|------------|------------|------------|
| ** ** | ** ** | **income** | ** ** | **declared**            | ** ** | **retained** | ** ** | ** ** | ** ** |
|       |       |       |       |                    |       |         |       |       |       |
| 2006       |       | $          | 4,125,283  |                    | $          | 1,801,361    |       | $          | 2,323,922  |   |   |   |
| 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    |       |       |       |
|            |            |            |            |                         |            |              |            |            |            |  |  |  |

 

At December 31,2005, the Bank reported a net unrealized loss of $1,112,000 on AFS securitiescompared to a net unrealized loss of $965,000 as of December 31, 2006.  Fluctuations in the capital markets may causefrequent changes in the fair value of AFS securities.  Further declines in value of the Bank’s AFSsecurities should not be construed as a weakness in the capital position of theCompany.  The Company monitors marketconditions closely and is prepared to take remedial action when appropriate.

***Liquidity***

Liquiditymanagement ensures that adequate funds will be available to meet customers’needs for borrowings, deposit withdrawals and maturities and normal operatingexpenses of the Bank.  Current sources ofliquidity are cash and cash equivalents, asset maturities and pay-downs withinone year, loans and investments AFS, growth of core deposits, growth ofrepurchase agreements, increases of other borrowed funds from correspondentbanks and issuance of capital 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.

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At December 31, 2006, the Company had $13,801,000 incash and cash equivalents.  In addition,the Company had $122,000 of loans AFS and $98,841,000 in investments AFS.  This combined total of $112,764,000represented 20% of total assets at December 31, 2006.  Management believes this level of liquidityto be strong and adequate and to support current operations.  For a discussion on the Bank’s significantdeterminable contractual obligations and significant commitments, see “Off-BalanceSheet Arrangements and Contractual Obligations,” above.

The Companyconsiders its primary source of liquidity to be its core deposit baseconsisting of deposits from customers throughout the branch network.  The Company will continue to promote theacquisition of deposits through its branch offices and marketing efforts.  At December 31, 2006, approximately 73% ofthe Company’s assets were funded by deposits and an additional 9% of the assetswere funded by the Company’s equity.  TheCompany expects to grow these two components, which provide a substantial andsteady source of funds.

As detailed in thestatement of cash flows, incorporated by reference, total cash and cashequivalents had a net increase of $1,206,000 during 2006.  Cash from operations of $5,871,000 wassupported with strong earnings.  The$13,359,000 increase from financing activities was due principally to an 8%increase in deposit generation which in turn allowed the Bank to repay aportion of its borrowings.  The use offunds in investing activities was due to asset growth.

At December 31,2006, the Bank had approximately $138,000,000 in unused sources of borrowedfunds available to meet liquidity requirements, if needed.  The sources were the approximate borrowingcapacity at the Federal Reserve Bank of Philadelphia of $7,000,000, availablefunding at the FHLB of $104,000,000 and $27,000,000 from correspondent banks.

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

The Company issubject to the interest rate risks inherent in its lending, investing and financingactivities.  Fluctuations of interestrates will impact interest income and interest expense along with affectingmarket values of all interest-earning assets and interest-bearing liabilities,except for those assets or liabilities with a short term remaining tomaturity.  Interest rate risk managementis an integral part of the asset/liability management process.  The Company has instituted certain proceduresand policy guidelines to manage the interest rate risk position.  Those internal policies enable the Company toreact to changes in market rates to protect net interest income fromsignificant fluctuations.  The primaryobjective in managing interest rate risk is to minimize the adverse impact ofchanges in interest rates on net interest income along with creating anasset/liability structure that maximizes earnings.

*Asset/LiabilityManagement*.  One majorobjective of the Company when managing the rate sensitivity of its assets andliabilities is to stabilize net interest income.  The management of and authority to assumeinterest rate risk is the responsibility of the Company’s Asset/LiabilityCommittee (ALCO), which is comprised of senior management and members of theboard of directors.  ALCO meets quarterlyto monitor the relationship of interest sensitive assets to interest sensitiveliabilities.  The process to reviewinterest rate risk is a regular part of managing the Company.  Consistent policies and practices ofmeasuring and reporting interest rate risk exposure, particularly regarding thetreatment of non-contractual assets and liabilities, are in effect.  In addition, there is an annual process toreview the interest rate risk policy with the board of directors which includeslimits on the impact to earnings from shifts in interest rates.

*InterestRate Risk Measurement. *Interestrate risk is monitored through the use of three complementary measures: staticgap analysis, earnings at risk simulation and economic value at risksimulation.  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.

*StaticGap*.  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 managed to take advantage of theslope of the yield curve as well as forecasted changes in the level of interestrate changes.

To manage thisinterest rate sensitivity gap position, an asset/liability model commonly knownas cumulative gap analysis is used to monitor the difference in the volume ofthe Company’s interest sensitive assets and liabilities that mature or re-pricewithin given periods.  A positive gap(asset sensitive) indicates that more assets will re-price during a givenperiod compared to liabilities, while a negative gap (liability sensitive) hasthe opposite effect.  The Company employscomputerized net interest income simulation modeling to assist in quantifyinginterest rate risk exposure.  Thisprocess measures and quantifies the impact on net interest income through varyinginterest rate changes and balance sheet compositions.  The use of this model assists the ALCO togauge the effects of the interest rate changes on interest sensitive assets andliabilities in order to determine what impact these rate changes will have uponthe net interest spread.  At December 31,2006 the Bank maintained a negative one-year cumulative gap of $71.0 million or-12.6% of total assets.  The effect ofthis negative gap position provided a mismatch of assets and liabilities whichmay expose the Bank to interest rate risk during periods of increasing

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interest rates.  Conversely, in a declining interest rateenvironment, net interest income could be positively impacted because moreliabilities than assets will re-price downward during the one-year period.

Certainshortcomings are inherent in the method of analysis discussed above andpresented in the next table.  Althoughcertain assets and liabilities may have similar maturities or periods ofre-pricing, they may react in different degrees to changes in market interestrates.  The interest rates on certaintypes of assets and liabilities may fluctuate in advance of changes in marketinterest rates, while interest rates on other types of assets and liabilitiesmay lag behind changes in market interest rates.  Certain assets, such as adjustable-rate mortgages,have features which restrict changes in interest rates on a short-term basisand 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 ability of many borrowers to servicetheir adjustable-rate debt may decrease in the event of an interest rateincrease.

The followingtable reflects the re-pricing of the balance sheet or “gap” position atDecember 31, 2006 (dollars in thousands):
| ** **                                    | ** ** | **Interest sensitivity gap at December 31, 2006** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Three months  or less**                                             | ** ** | **Three to  twelve months** | ** ** | **One to  three years** | ** ** | **Over  three years** | ** ** | **Total** | ** ** |
| Cash and cash equivalents                     |       | $                                                                               | 142        |   | $ | — |   | $ | — |   | $ | 13,659 |   | $ | 13,801 |   |
| Investment securities (1)(2)                  |       | 14,347                                                                          |       | 5,439 |   | 25,321 |   | 59,099 |   | 104,206 |   |
| Loans (2)                                     |       | 113,435                                                                         |       | 58,833 |   | 104,811 |   | 140,242 |   | 417,321 |   |
| Fixed and other assets                        |       | —                                                                          |       | 8,178 |   | — |   | 18,812 |   | 26,990 |   |
| Total assets                                  |       | $                                                                               | 127,924    |   | $ | 72,450 |   | $ | 130,132 |   | $ | 231,812 |   | $ | 562,318 |   |
| Total cumulative assets                       |       | $                                                                               | 127,924    |   | $ | 200,374 |   | $ | 330,506 |   | $ | 562,318 |   |   |   |
|                                          |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Non-interest-bearing transaction deposits (3) |       | $                                                                               | —     |   | $ | 7,374 |   | $ | 20,279 |   | $ | 46,089 |   | $ | 73,742 |   |
| Interest-bearing transaction deposits (3)     |       | 94,861                                                                          |       | — |   | 35,284 |   | 52,637 |   | 182,782 |   |
| Time deposits                                 |       | 52,951                                                                          |       | 73,693 |   | 17,666 |   | 9,501 |   | 153,811 |   |
| Repurchase agreements                         |       | 22,224                                                                          |       | — |   | — |   | — |   | 22,224 |   |
| Short-term borrowings                         |       | 11,432                                                                          |       | — |   | — |   | — |   | 11,432 |   |
| Long-term debt                                |       | 3,210                                                                           |       | 5,628 |   | 698 |   | 53,000 |   | 62,536 |   |
| Other liabilities                             |       | —                                                                          |       | — |   | — |   | 4,179 |   | 4,179 |   |
| Total liabilities                             |       | $                                                                               | 184,678    |   | $ | 86,695 |   | $ | 73,927 |   | $ | 165,406 |   | $ | 510,706 |   |
| Total cumulative  liabilities                 |       | $                                                                               | 184,678    |   | $ | 271,373 |   | $ | 345,300 |   | $ | 510,706 |   |   |   |
|                                          |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Interest sensitivity gap                      |       | $                                                                               | (56,754    | ) | $ | (14,245 | ) | $ | 56,205 |   | $ | 66,406 |   |   |   |
|                                          |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Cumulative gap                                |       | $                                                                               | (56,754    | ) | $ | (70,999 | ) | $ | (14,794 | ) | $ | 51,612 |   |   |   |
|                                          |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Cumulative gap to total assets                |       | (10.1                                                                           | )%         | (12.6 | )% | (2.6 | )% | 9.2 | % |   |   |

----

(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 periodsin which they are scheduled to be repaid based on scheduled amortization.  For amortizing loans and mortgage-backed securities,annual prepayment rates are assumed reflecting historical experience as well asManagement’s knowledge and experience of its loan products.

(3)             The Bank’sdemand and savings accounts were generally subject to immediatewithdrawal.  However, Managementconsiders a certain amount of such accounts to be core accounts havingsignificantly longer effective maturities based on the retention experiences ofsuch deposits in changing interest rate environments.  The effective maturities presented are the recommendedmaturity distribution limits for non-maturing deposits based on historicaldeposit studies.

*Earningsat Risk and Economic Value at Risk Simulations*.  The Company recognizes that moresophisticated tools exist for measuring the interest rate risk in the balancesheet beyond static re-pricing gap analysis. Although it will continue to measure its re-pricing gap position, theCompany utilizes additional modeling for identifying and measuring the interestrate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economicvalue at risk”, and how both relate to the risk-based capital position whenanalyzing the interest rate risk.

*Earningsat Risk*.  Earnings atrisk simulation measures the change in net interest income and net incomeshould interest rates rise and fall.  Thesimulation recognizes that not all assets and liabilities re-price one-for-onewith market rates (e.g., savings rate). 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.

38

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*Economic Value at Risk.* Earnings at risk simulation measures theshort-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term riskby finding the net present value of the future cash flows from the Company’sexisting assets and liabilities.  TheALCO examines this ratio quarterly utilizing an increase and decrease of 200basis points in interest rate simulation models.  The ALCO recognizes that, in some instances,this ratio may contradict the “earnings at risk” ratio.

The followingtable illustrates the simulated impact of an immediate 200 basis points upwardor downward movement in interest rates on net interest income, net income andthe change in the economic value (portfolio equity).  This analysis assumed that interest-earningasset and interest-bearing liability levels at December 31, 2006 remained constant.  The impact of the rate movements wasdeveloped by simulating the effect of the rate change over a twelve-monthperiod from the December 31, 2006 levels:

|                                                        | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
|                                                   |       |                |       |                |       |
| Earnings at risk:                                      |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | (9.8                | )%         | 4.9                 | %          |
| Net income                                             |       | (32.2               | )          | 16.1                |       |
|                                                   |       |                |       |                |       |
| Economic value at risk:                                |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (25.8               | )          | 1.1                 |       |
| Economic value  of equity as a percent of total assets |       | (3.5                | )          | 0.2                 |       |

 

Economic value hasthe most meaning when viewed within the context of risk-based capital.  Therefore, the economic value may normallychange beyond the Company’s policy guideline for a short period of time as longas the risk-based capital ratio (after adjusting for the excess equityexposure) is greater than 10%.  AtDecember 31, 2006, the Company’s risk-based capital ratio was 14.0%.

The table belowsummarizes estimated changes in net interest income over a twelve-month periodbeginning January 1, 2007, under alternate interest rate scenarios using the incomesimulation model described above (dollars in thousands):

| Change in interest rates | ** ** | **Net interest  income** | ** ** | **$  variance** | ** ** | **%  variance** | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|-----------------|------------|-----------------|------------|
|                                    |       |                          |       |            |       |            |       |
| +200 basis points                       |       | $                             | 16,149     |            | $          | (1,747          | )          | (9.8 | )% |
| +100 basis points                       |       | 17,081                        |       | (815            | )          | (4.6            | )          |
| Flat rate                               |       | 17,896                        |       | —          |       | —          |       |
| -100 basis points                       |       | 18,637                        |       | 741             |       | 4.1             |       |
| -200 basis points                       |       | 18,775                        |       | 879             |       | 4.9             |       |
|                                         |            |                               |            |                 |            |                 |            |  |  |

 

Simulation modelsrequire assumptions about certain categories of assets and liabilities.  The models schedule existing assets andliabilities by their contractual maturity, estimated likely call date orearliest re-pricing opportunity. Mortgage-backed securities and amortizing loans are scheduled based ontheir anticipated cash flow including estimated prepayments.  For investment securities, the Bank uses athird-party service to provide cash flow estimates in the various rateenvironments.  Savings accounts,including passbook, statement savings, money market and interest checkingaccounts, do not have a stated maturity or re-pricing term and can be withdrawnor re-price at any time.  This may impactthe margin if more expensive alternative sources of deposits are required tofund loans or deposit runoff.  Managementprojects the re-pricing characteristics of these accounts based on historicalperformance and assumptions that it believes reflect their rate sensitivity.Themodel reinvests all maturities, repayments and prepayments for each type ofasset or liability into the same product for a new like term at current productinterest rates provided by Management. As a result, the mix of interest-earning assets and interestbearing-liabilities is not held constant.

*DerivativeFinancial Instruments. *Aspart of the Bank’s overall interest rate risk strategy, the Company has adopteda policy whereby the Bank may periodically use derivative instruments tominimize significant fluctuations in earnings caused by interest ratevolatility.  This interest rate riskmanagement strategy entails the use of interest rate floors, caps andswaps.  In October 2006, the Bank enteredinto an interest rate floor derivative agreement on $20,000,000 notional valueof its prime-based loan portfolio.  Thepurpose of the hedge is to help protect the Bank’s interest income in the eventinterest rates decline below a pre-determined contractual interest rate.  The strategy is reflected in the scenariosfor earnings and economic value at risk and the net interest income in the twoimmediately preceding tables.  For afurther discussion on the Bank’s derivative contract, see Note 1, “Nature ofoperations and summary of significant accounting policies,” and Note 12, “Fairvalue of financial instruments and derivatives,” contained within the notes toconsolidated financial statements in Part II, Item 8.

39

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***Supervision and Regulation***

The following is abrief summary of the regulatory environment in which the Company and the Bankoperate and is not designed to be a complete discussion of all statutes andregulations affecting such operations, including those statutes and regulationsspecifically mentioned herein.  Changesin the laws and regulations applicable to the Company and the Bank can affectthe operating environment in substantial and unpredictable ways.  We cannot accurately predict whetherlegislation will ultimately be enacted, and if enacted, the ultimate effectthat legislation or implementing regulations would have on our financialcondition or results of operations. While banking regulations are material to the operations of the Companyand the Bank, it should be noted that supervision, regulation, and examinationof the Company and the Bank are intended primarily for the protection ofdepositors, not shareholders.

***Recent Legislation***

***Financial Services Regulatory Relief Act of 2006.* **This federal act amends several federalbanking laws to reduce redundant and costly regulatory burden.  Among its many provisions, the act allows thepayment of interest on certain reserve balances of depository institutions thatare held at the Federal Reserve beginning in year 2011, requires bankingregulatory agencies to streamline reports of condition, and clarifies theauthority of home and host state regulators with respect to supervision ofinterstate branches.  The act was signedinto law in October 2006.

***Federal Deposit Insurance Reform Act of 2005 and the Federal DepositInsurance Reform Conforming Amendments Act of 2005.* **These federal acts were signed into lawin February 2006 to amend the Federal Deposit Insurance Act.  These laws enact FDIC and banking industrydeposit insurance reform proposals by amendments including: increasing thecoverage for retirement accounts to $250,000 and indexing the coverage limitfor retirement accounts to inflation as with the general deposit insurancecoverage limit; merging the Bank Insurance Fund (BIF) and the SavingsAssociation Insurance Fund (SAIF) into a new fund, the Deposit Insurance Fund(DIF); establishing a percentage range within which the FDIC Board of Directorsmay set the FDIC’s Designated Reserve Ratio (DRR); allowing the FDIC to managethe pace at which the DRR varies within this range; eliminating therestrictions on premium rates based on the DRR and granting the FDIC Board thediscretion to price deposit insurance according to risk for all insuredinstitutions at all times.

***Sarbanes-Oxley Act of 2002.****** ***InJuly, 2002, the Sarbanes-Oxley Act of 2002 was enacted.  The stated goals of the Act are to increasecorporate responsibility, to provide for enhanced penalties for accounting andauditing improprieties at publicly traded companies, and to protect investorsby improving the accuracy and reliability of corporate disclosures pursuant tothe securities laws.

The Act is themost far-reaching U.S. securities legislation enacted in decades.  The Act generally applies to all companies,both U.S. and non-U.S., that file or are required to file periodic reports withthe Securities and Exchange Commission under the Securities Exchange Act of1934.

The Act includesvery specific additional disclosure requirements and corporate governancerules, requires the SEC and securities exchanges to adopt extensive additionaldisclosure, corporate governance and other related rules and mandates furtherstudies of certain issues by the SEC. The Act adds new obligations and restrictions on directors and senior executivesof public companies, such as requiring certification of financial statements,and new audit committee procedures.  TheAct represents significant federal involvement in matters traditionally left tostate regulatory systems such as the regulation of the accounting profession,and to state corporate law such as the relationship between a board ofdirectors and management and between a board of directors and its committees.

***USA PATRIOT Act of 2001.***  The Uniting and Strengthening America by ProvidingAppropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USAPATRIOT Act) was signed into law in October 2001.  The USA PATRIOT Act broadened the applicationof anti-money laundering regulations to apply to additional types of financialinstitutions, such as broker-dealers, and strengthened the ability of the U.S.government to detect and prosecute international money laundering and thefinancing of terrorism.  The principalprovisions of Title III of the USA PATRIOT Act require that regulated financialinstitutions, including banks: (1) establish an anti-money laundering programthat includes training and audit components; (2) comply with regulationsregarding the verification of the identity of any person seeking to open anaccount; (3) take additional required precautions with regard to non-U.S. ownedaccounts; and (4) perform certain verification and certification of moneylaundering risk for their foreign correspondent banking relationships. The USAPATRIOT Act also expanded the conditions under which funds in a U.S. inter-bankaccount may be subject to forfeiture and increased the penalties for violationof 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 adoptedpolicies, procedures and controls to address compliance with the requirementsof the USA PATRIOT Act under the existing regulations and will continue torevise and update its policies, procedures and controls to reflect changesrequired by the USA PATRIOT Act and implementing regulations.

40

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As part of the USAPATRIOT Act, Congress adopted the International Money Laundering Abatement andFinancial Anti-Terrorism Act of 2001 (IML Act). The IML Act amended the Bank Secrecy Act and adopted certain additionalmeasures that increase the obligation of financial institutions, including theBank, to identify their customers, watch for and report upon suspicioustransactions, respond to requests for information by federal banking regulatoryauthorities and law enforcement agencies, and share information with otherfinancial institutions.  The Secretary ofthe Treasury has adopted several regulations to implement these provisions.  The Bank is also barred from dealing withforeign “shell” banks.  In addition, theIML Act expands the circumstances under which funds in a bank account may beforfeited.  The IML Act also amended theBank Holding Company Act and the Bank Merger Act to require the federal bankingregulatory authorities to consider the effectiveness of a financial institution’santi-money laundering activities when reviewing an application to expandoperations.  The Bank has in place a BankSecrecy Act compliance program.

***Gramm-Leach-BlileyAct of 1999***.  Thislaw authorized cross-industry affiliations between banks, securities firms,insurance companies, and other financial service providers.  This was landmark legislation that repealedthe Glass-Steagall Act which since the 1930’s had prohibited suchaffiliations.  Among other provisions,the Act provided new authority for banks and created a revised framework forregulating affiliated financial services institutions.

***Regulation W.****** ***Transactionsbetween a bank and its “affiliates” are quantitatively and qualitativelyrestricted under the Federal Reserve Act. The Federal Deposit Insurance Act applies Sections 23A and 23B toinsured nonmember banks in the same manner and to the same extent as if theywere members of the Federal Reserve System. In 2002, the Federal Reserve Board issued Regulation W, whichbecame effective in 2003.  Regulation Wcodifies prior regulations under Sections 23A and 23B of the FederalReserve Act and interpretative guidance with respect to affiliate transactions.

Regulation Wincorporates the exemption from the affiliate transaction rules but expands theexemption to cover the purchase of any type of loan or extension of credit froman affiliate.  Affiliates of a bank include,among other entities, the Bank’s holding company and companies that are undercommon control with the Bank.  TheCompany is considered to be an affiliate of the Bank.

***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 legislation will be adopted, or if adopted,how the new laws would affect our business. As a consequence, we are susceptible to legislation that may increasethe cost of doing business.  Managementbelieves that the effect of any current legislative proposals on the liquidity,capital resources and the results of operations of the Company and the Bankwill be minimal.

It is possiblethat there will be regulatory proposals which, if implemented, could have amaterial effect upon our liquidity, capital resources, and results ofoperations.  In addition, the generalcost of compliance with numerous federal and state laws does have, and in thefuture may have, a negative impact on our results of operations.  As with other banks, the status of thefinancial services industry can affect the Bank.  Consolidations of institutions are expectedto continue as the financial services industry seeks greater efficiencies andmarket share.  Bank Management believesthat such consolidations may enhance the Bank’s competitive position as acommunity bank.

***Future Outlook***

Based upon the currentuncertain economic outlook and inability to predict when interest rate changeswill occur, the Company recognizes that there are challenges ahead.  The Company is prepared to meet thechallenges and effects of a changing interest rate environment.  Management believes that a significant impacton earnings depends on its ability to react to changes in interest rates.

The Company will continueto monitor interest rate sensitivity of its interest-earning assets andinterest-bearing liabilities to minimize any adverse effects on futureearnings.  The Company’s commitment toremaining a community based organization is very strong.  Our intention is to recognize a steadydisciplined growth in the loan portfolios, while increasing our base of coredeposits.  Review and implementation ofpolicies and procedures along with adding innovative products and services willcontinue.  These steps are designed toprovide the Company with stability and the wherewithal to provide customerservice and increase shareholder value.

***Item 7A: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,” containedwithin management’s discussion and analysis of financial condition and resultsof operations and incorporated herein by reference.

41

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#  

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

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

**Board of Directors andShareholders**

**FidelityD & D Bancorp, Inc.:**

We have auditedthe accompanying consolidated balance sheets of Fidelity D & D Bancorp,Inc. and Subsidiary as of December 31, 2006 and 2005 and the relatedconsolidated statements of income, changes in shareholders' equity and cashflows for each of the years in the three-year period ended December 31, 2006.These financial statements are the responsibility of the Company's management.Our responsibilty is to express an opinion on these financial statements basedon our audits.

We conducted ouraudits in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Fidelity D & D Bancorp, Inc.and Subsidiary as of December 31, 2006 and 2005, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2006 in conformity with accounting principles generallyaccepted in the United States of America.

 

Scranton, Pennsylvania

March 13, 2007

42

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

Consolidated Balance Sheets

As of December 31, 2006 and 2005
| ** **                                                                                                                                | ** ** | **2006**    | ** **  | **2005**    | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
|                                                                                                                                      |       |        |        |        |       |
| Assets:                                                                                                                                   |       |        |        |        |       |
| Cash and due from banks                                                                                                                   |       | $           | 13,732,137  |        | $          | 12,525,723 |   |
| Interest-bearing deposits with financial  institutions                                                                                    |       | 68,711      |        | 68,817      |       |
|                                                                                                                                      |       |        |        |        |       |
| Total cash and cash equivalents                                                                                                           |       | 13,800,848  |        | 12,594,540  |       |
|                                                                                                                                      |       |        |        |        |       |
| Available-for-sale securities                                                                                                             |       | 98,841,364  |        | 95,681,654  |       |
| Held-to-maturity securities                                                                                                               |       | 1,569,372   |        | 1,996,919   |       |
| Federal Home Loan Bank Stock                                                                                                              |       | 3,795,100   |        | 4,628,200   |       |
| Loans and leases, net (allowance for loan losses of  $5,444,303 in 2006; $5,984,649 in 2005)                                              |       | 417,199,048 |        | 403,144,095 |       |
| Loans available-for-sale (fair value $123,156 in  2006; $434,272 in 2005)                                                                 |       | 122,000     |        | 428,584     |       |
| Bank premises and equipment, net                                                                                                          |       | 11,324,465  |        | 11,683,148  |       |
| Cash surrender value of bank owned life insurance                                                                                         |       | 8,177,961   |        | 7,891,898   |       |
| Other assets                                                                                                                              |       | 4,788,105   |        | 4,033,132   |       |
| Accrued interest receivable                                                                                                               |       | 2,502,576   |        | 1,959,826   |       |
| Foreclosed assets held-for-sale                                                                                                           |       | 197,149     |        | 18,702      |       |
|                                                                                                                                      |       |        |        |        |       |
| Total assets                                                                                                                              |       | $           | 562,317,988 |        | $          | 544,060,698 |   |
|                                                                                                                                      |       |        |        |        |       |
| Liabilities:                                                                                                                              |       |        |        |        |       |
| Deposits:                                                                                                                                 |       |        |        |        |       |
| Interest-bearing                                                                                                                          |       | $           | 336,592,620 |        | $          | 309,137,554 |   |
| Non-interest-bearing                                                                                                                      |       | 73,741,975  |        | 70,361,086  |       |
|                                                                                                                                      |       |        |        |        |       |
| Total deposits                                                                                                                            |       | 410,334,595 |        | 379,498,640 |       |
|                                                                                                                                      |       |        |        |        |       |
| Accrued interest payable and other liabilities                                                                                            |       | 4,179,170   |        | 3,238,844   |       |
| Short-term borrowings                                                                                                                     |       | 33,656,150  |        | 28,772,997  |       |
| Long-term debt                                                                                                                            |       | 62,536,210  |        | 83,704,188  |       |
|                                                                                                                                      |       |        |        |        |       |
| Total liabilities                                                                                                                         |       | 510,706,125 |        | 495,214,669 |       |
|                                                                                                                                      |       |        |        |        |       |
|                                                                                                                                      |       |        |        |        |       |
|                                                                                                                                      |       |        |        |        |       |
| 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 2,057,433 shares in 2006; 1,854,217 shares  in 2005 |       | 18,702,537  |        | 10,594,901  |       |
|                                                                                                                                      |       |        |        |        |       |
| Retained  earnings                                                                                                                        |       | 33,874,118  |        | 39,363,461  |       |
| Accumulated  other comprehensive loss                                                                                                     |       | (964,792    | )           | (1,112,333  | )          |
|                                                                                                                                      |       |        |        |        |       |
| Total shareholders’ equity                                                                                                           |       | 51,611,863  |        | 48,846,029  |       |
|                                                                                                                                      |       |        |        |        |       |
| Total  liabilities and shareholders’ equity                                                                                          |       | $           | 562,317,988 |        | $          | 544,060,698 |   |

 

See notes to consolidated financial statements

43

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

Consolidated Statements of IncomeFor the years ended December 31, 2006, 2005 and 2004

 
| ** **                                             | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                   |       |       |       |       |       |       |       |
| Interest income:                                       |       |       |       |       |       |       |       |
| Loans and  leases:                                     |       |       |       |       |       |       |       |
| Taxable                                                |       | $          | 27,681,779 |       | $          | 23,829,470 |       | $ | 21,946,920 |   |
| Nontaxable                                             |       | 445,527    |       | 451,590    |       | 319,188    |       |
| Interest-bearing  deposits with financial institutions |       | 9,166      |       | 14,440     |       | 5,919      |       |
| Investment securities:                                 |       |       |       |       |       |       |       |
| U.S. Government  agency and corporations               |       | 3,738,995  |       | 3,498,419  |       | 4,362,455  |       |
| States and  political subdivisions (nontaxable)        |       | 590,558    |       | 539,004    |       | 481,481    |       |
| Other securities                                       |       | 940,467    |       | 638,738    |       | 262,277    |       |
| Federal funds sold                                     |       | 123,218    |       | 48,600     |       | 17,251     |       |
|                                                   |       |       |       |       |       |       |       |
| Total interest  income                                 |       | 33,529,710 |       | 29,020,261 |       | 27,395,491 |       |
|                                                   |       |       |       |       |       |       |       |
| Interest expense:                                      |       |       |       |       |       |       |       |
| Deposits                                               |       | 11,492,827 |       | 6,928,000  |       | 6,736,796  |       |
| Securities sold  under repurchase agreements           |       | 623,902    |       | 633,942    |       | 463,663    |       |
| Other short-term  borrowings and other                 |       | 377,958    |       | 328,857    |       | 98,413     |       |
| Long-term debt                                         |       | 3,866,422  |       | 3,830,187  |       | 3,881,263  |       |
|                                                   |       |       |       |       |       |       |       |
| Total interest  expense                                |       | 16,361,109 |       | 11,720,986 |       | 11,180,135 |       |
|                                                   |       |       |       |       |       |       |       |
| Net interest income                                    |       | 17,168,601 |       | 17,299,275 |       | 16,215,356 |       |
|                                                   |       |       |       |       |       |       |       |
| Provision for loan  losses                             |       | 325,000    |       | 830,000    |       | 2,150,000  |       |
|                                                   |       |       |       |       |       |       |       |
| Net interest income  after provision for loan losses   |       | 16,843,601 |       | 16,469,275 |       | 14,065,356 |       |
|                                                   |       |       |       |       |       |       |       |
| Other income:                                          |       |       |       |       |       |       |       |
| Service charges  on deposit accounts                   |       | 2,631,859  |       | 2,660,723  |       | 2,233,682  |       |
| Gain (loss) on  sale of:                               |       |       |       |       |       |       |       |
| Loans                                                  |       | 97,848     |       | 9,937      |       | 144,834    |       |
| Investment  securities                                 |       | 1,200      |       | 4,696      |       | 9,497      |       |
| Premises and  equipment                                |       | (19,654    | )          | (14,779    | )          | (8,125     | )          |
| Leased assets                                          |       | 15,154     |       | (334,663   | )          | (290,679   | )          |
| Foreclosed  assets held-for-sale                       |       | (3,390     | )          | 56,516     |       | (15,256    | )          |
| Fees and other  service charges                        |       | 1,799,121  |       | 1,768,072  |       | 2,079,324  |       |
|                                                   |       |       |       |       |       |       |       |
| Total other  income                                    |       | 4,522,138  |       | 4,150,502  |       | 4,153,277  |       |
|                                                   |       |       |       |       |       |       |       |
| Other expenses:                                        |       |       |       |       |       |       |       |
| Salaries and  employee benefits                        |       | 8,328,407  |       | 7,093,427  |       | 6,765,551  |       |
| Premises and  equipment                                |       | 3,144,669  |       | 2,954,205  |       | 2,831,418  |       |
| Advertising                                            |       | 540,543    |       | 621,103    |       | 430,667    |       |
| Other                                                  |       | 3,864,757  |       | 3,893,233  |       | 3,790,929  |       |
|                                                   |       |       |       |       |       |       |       |
| Total other  expenses                                  |       | 15,878,376 |       | 14,561,968 |       | 13,818,565 |       |
|                                                   |       |       |       |       |       |       |       |
| Income before provision  for income taxes              |       | 5,487,363  |       | 6,057,809  |       | 4,400,068  |       |
|                                                   |       |       |       |       |       |       |       |
| Provision for income  taxes                            |       | 1,362,080  |       | 1,466,112  |       | 1,035,594  |       |
|                                                   |       |       |       |       |       |       |       |
| Net income                                             |       | $          | 4,125,283  |       | $          | 4,591,697  |       | $ | 3,364,474 |   |
|                                                   |       |       |       |       |       |       |       |
| Per share data:                                        |       |       |       |       |       |       |       |
| Net income—basic                                  |       | $          | 2.01       |       | $          | 2.26       |       | $ | 1.67 |   |
| Net income—diluted                                |       | $          | 2.01       |       | $          | 2.25       |       | $ | 1.67 |   |
| Dividends                                              |       | $          | 0.88       |       | $          | 0.80       |       | $ | 0.80 |   |

See notes to consolidated financial statements

44

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

Consolidated Statements of Changes in Shareholders’ EquityFor the years ended December 31, 2006, 2005 and 2004

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|--------------|------------|-------------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Treasury stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**              | ** ** | **Shares**   | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, December 31,  2003                                                                                                    |       | 1,828,270              |       | $                       | 9,698,879  |         | (5,227     | )                 | $          | (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                  | )          | 1,635        |       | 61,370            |       |         |       |                   |       | 53,041     |       |
| Dividends reinvested  through Dividend Reinvestment Plan                                                                       |       | 10,802                 |       | 366,084                 |       | 3,592        |       | 134,678           |       |         |       |                   |       | 500,762    |       |
| Stock options exercised                                                                                                        |       | 500                    |       | 15,500                  |       |         |       |              |       |         |       |                   |       | 15,500     |       |
| Cash dividends declared                                                                                                        |       |                   |       |                    |       |         |       |              |       | (1,610,423   | )          |                   |       | (1,610,423 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, December 31,  2004                                                                                                    |       | 1,839,572              |       | 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                                                                 |       | 1,031                  |       | 31,671                  |       |         |       |              |       |         |       |                   |       | 31,671     |       |
| Dividends reinvested  through Dividend Reinvestment Plan                                                                       |       | 13,614                 |       | 491,096                 |       |         |       |              |       |         |       |                   |       | 491,096    |       |
| Cash dividends declared                                                                                                        |       |                   |       |                    |       |         |       |              |       | (1,624,263   | )          |                   |       | (1,624,263 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, December 31,  2005                                                                                                    |       | 1,854,217              |       | 10,594,901              |       | —       |       | —            |       | 39,363,461   |       | (1,112,333             | )          | 48,846,029 |       |
| Cumulative effect  adjustments*                                                                                                |       |                   |       |                    |       |         |       |              |       | (343,717     | )          |                   |       | (343,717   | )          |
| Total comprehensive  income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net  income                                                                                                                    |       |                   |       |                    |       |         |       |              |       | 4,125,283    |       |                   |       | 4,125,283  |       |
| Change  in net unrealized holding losses on available-for-sale securities, net of  reclassification adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | 146,624                |       | 146,624    |       |
| Change  in cash flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 917                    |       | 917        |       |
| Comprehensive  income                                                                                                          |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | 4,272,824  |       |
| Issuance of common stock  through Employee Stock Purchase Plan                                                                 |       | 1,571                  |       | 48,151                  |       |         |       |              |       |         |       |                   |       | 48,151     |       |
| Dividends reinvested  through Dividend Reinvestment Plan                                                                       |       | 16,251                 |       | 568,641                 |       |         |       |              |       |         |       |                   |       | 568,641    |       |
| Stock-based compensation  expense                                                                                              |       |                   |       | 28,744                  |       |         |       |              |       |         |       |                   |       | 28,744     |       |
| Cash dividends declared                                                                                                        |       |                   |       |                    |       |         |       |              |       | (1,801,361   | )          |                   |       | (1,801,361 | )          |
| Stock dividend declared                                                                                                        |       | 185,394                |       | 7,462,100               |       |         |       |              |       | (7,469,548   | )          |                   |       | (7,448     | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, December 31,  2006                                                                                                    |       | 2,057,433              |       | $                       | 18,702,537 |         | —     |              | $          | —       |       | $                      | 33,874,118 |       | $          | (964,792 | ) | $ | 51,611,863 |   |

----

* See footnote No.20, “Cumulative Effect Adjustments.”

See notes to consolidated financial statements

45

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**FIDELITYDEPOSIT & DISCOUNT BANCORP, INC. AND SUBSIDIARY**

Consolidated Statementsof Cash Flows

For the years endedDecember 31, 2006, 2005 and 2004
| ** **                                                                         | ** ** | **2006**    | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Cash flows from  operating activities:                                             |       |        |       |        |       |        |       |
| Net income                                                                         |       | $           | 4,125,283  |        | $          | 4,591,697   |       | $ | 3,364,474 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |        |       |        |       |        |       |
| Depreciation,  amortization and accretion                                          |       | 1,349,990   |       | 1,493,621   |       | 1,855,695   |       |
| Provision for  loan losses                                                         |       | 325,000     |       | 830,000     |       | 2,150,000   |       |
| Deferred income  tax benefit                                                       |       | (75,003     | )          | (318,948    | )          | (625,994    | )          |
| Stock-based  compensation expense                                                  |       | 28,744      |       | —      |       | —      |       |
| Loss from  investment in limited partnership                                       |       | 80,000      |       | 90,000      |       | —      |       |
| Proceeds from  sale of loans available-for-sale                                    |       | 12,573,745  |       | 2,337,108   |       | 15,640,705  |       |
| Originations of  loans available-for-sale                                          |       | (12,169,313 | )          | (2,179,377  | )          | (9,015,893  | )          |
| Write-down of  foreclosed assets held-for-sale                                     |       | —      |       | 63,569      |       | 155,448     |       |
| Increase in cash  surrender value of life insurance                                |       | (286,063    | )          | (278,461    | )          | (319,899    | )          |
| Net gain on sale  of loans                                                         |       | (97,848     | )          | (9,937      | )          | (144,834    | )          |
| Net gain on sale  of investment securities                                         |       | (1,200      | )          | (4,696      | )          | (9,497      | )          |
| Net loss (gain)  on sale of foreclosed assets held-for-sale                        |       | 3,390       |       | (56,516     | )          | 15,256      |       |
| Net loss on sale  of leased assets                                                 |       | —      |       | 334,663     |       | 290,679     |       |
| Net loss on  disposal of equipment                                                 |       | 19,654      |       | 14,779      |       | 8,125       |       |
| Change in:                                                                         |       |        |       |        |       |        |       |
| Accrued interest  receivable                                                       |       | (542,750    | )          | (236,976    | )          | 84,231      |       |
| Other assets                                                                       |       | (385,141    | )          | (172,882    | )          | 214,013     |       |
| Accrued interest  payable and other liabilities                                    |       | 922,747     |       | 200,655     |       | (168,200    | )          |
|                                                                               |       |        |       |        |       |        |       |
| Net cash  provided by operating activities                                         |       | 5,871,235   |       | 6,698,299   |       | 13,494,309  |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash flows from  investing activities:                                             |       |        |       |        |       |        |       |
| Held-to-maturity  securities:                                                      |       |        |       |        |       |        |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 424,880     |       | 1,053,978   |       | 1,643,513   |       |
| Available-for-sale  securities:                                                    |       |        |       |        |       |        |       |
| Proceeds from  sales                                                               |       | 19,554,141  |       | 25,283,946  |       | 3,850,562   |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 24,445,735  |       | 14,121,713  |       | 31,194,737  |       |
| Purchases                                                                          |       | (46,996,118 | )          | (24,207,221 | )          | (13,080,552 | )          |
| Net decrease (increase)  FHLB stock                                                |       | 833,100     |       | (59,500     | )          | 184,600     |       |
| Net increase in  loans and leases                                                  |       | (14,619,300 | )          | (24,026,568 | )          | (5,753,051  | )          |
| Proceeds from  sale of leased assets                                               |       | —      |       | 1,021,403   |       | 971,841     |       |
| Acquisition of  bank premises and equipment                                        |       | (1,722,368  | )          | (1,660,620  | )          | (325,908    | )          |
| Proceeds from  sale of foreclosed assets held-for-sale                             |       | 55,890      |       | 546,956     |       | 652,851     |       |
|                                                                               |       |        |       |        |       |        |       |
| Net cash (used  in) provided by investing activities                               |       | (18,024,040 | )          | (7,925,913  | )          | 19,338,593  |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash flows from  financing activities:                                             |       |        |       |        |       |        |       |
| Net increase  (decrease) in deposits                                               |       | 30,835,955  |       | 13,883,305  |       | (35,827,211 | )          |
| Net increase  (decrease) in short-term borrowings                                  |       | 4,883,153   |       | (21,761,049 | )          | (4,222,932  | )          |
| Proceeds from  issuance of long-term debt                                          |       | 16,000,000  |       | 15,000,000  |       | 5,000,000   |       |
| Repayments of  long-term debt                                                      |       | (37,167,978 | )          | (2,415,000  | )          | (5,756,846  | )          |
| Proceeds from  employee stock purchase plan                                        |       | 48,151      |       | 31,671      |       | 53,041      |       |
| Exercise of  stock options                                                         |       | —      |       | —      |       | 15,500      |       |
| Dividends paid,  net of dividends reinvested                                       |       | (1,232,720  | )          | (1,133,167  | )          | (1,109,661  | )          |
| Cash payments in  lieu of fractional shares on stock dividend                      |       | (7,448      | )          | —      |       | —      |       |
|                                                                               |       |        |       |        |       |        |       |
| Net cash  provided by (used in) financing activities                               |       | 13,359,113  |       | 3,605,760   |       | (41,848,109 | )          |
|                                                                               |       |        |       |        |       |        |       |
| Net increase (decrease)  in cash and cash equivalents                              |       | 1,206,308   |       | 2,378,146   |       | (9,015,207  | )          |
|                                                                               |       |        |       |        |       |        |       |
| Cash and cash  equivalents, beginning                                              |       | 12,594,540  |       | 10,216,394  |       | 19,231,601  |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash and cash equivalents, ending                                                  |       | $           | 13,800,848 |        | $          | 12,594,540  |       | $ | 10,216,394 |   |

 

Seenotes to consolidated financial statements

46

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

**AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

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

# **PRINCIPLESOF CONSOLIDATION**

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-company balances andtransactions have been eliminated in consolidation.

**NATURE OF OPERATIONS**

The Company provides a variety of financial servicesto individuals and corporate customers in Lackawanna and Luzerne Counties,Pennsylvania.  This region has adiversified and fairly stable economy. The Company’s primary deposit products are checking accounts, savingsaccounts, NOW accounts, money market deposit accounts and certificates ofdeposit accounts.  Its primary lendingproducts are single-family residential loans, secured consumer loans andsecured loans to businesses.  In additionto these traditional banking services, the Company also provides assetmanagement, investment and trust services.

Although the Company has a diversified loan portfolio,a substantial portion of its debtors’ ability to honor their contracts isdependent on the economic sector in which the Company operates.  While Management uses available informationto recognize losses on loans, leases and foreclosed assets, future additions tothe allowance for loan losses and foreclosed assets may be necessary based onchanges in local economic conditions.  Inaddition, regulatory agencies, as an integral part of their examinationprocess, periodically review the Company’s allowance.  Such agencies may require the Company torecognize additions to the allowance based on their judgments about informationavailable to them at the time of their examination.  Because of these factors, it is reasonablypossible that the allowance for loan losses and foreclosed assets may changematerially in the near future.

# **USE OFESTIMATES**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires Management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

Material estimates that are particularly susceptible tosignificant change relate to the determination of the allowance for loan lossesand the valuation of real estate acquired in connection with foreclosures or insatisfaction of loans.  In connectionwith the determination of allowance for losses on loans and foreclosed realestate, Management obtains independent appraisals for properties.

**HELD-TO-MATURITY SECURITIES**

Debt securities, for which the Company has thepositive intent and ability to hold to maturity, are reported at cost.  Premiums and discounts are amortized oraccreted, as a component of interest income, over the life of the relatedsecurity as an adjustment to yield using the interest method.

**TRADING SECURITIES**

Debt and equity securities held principally for resalein the near term are recorded at their fair values.  Unrealized gains and losses are included inother income.  The Company did not haveany investment securities held for trading purposes during 2006, 2005 or 2004.

**AVAILABLE-FOR-SALE SECURITIES**

Available-for-sale (AFS) securities consist of debtand equity securities not classified as either held-to-maturity securities ortrading securities and are reported at fair value.  Premiums and discounts are amortized oraccreted, as a component of interest income, over the life of the relatedsecurity as an adjustment to yield using the interest method.  Unrealized holding gains and losses, net ofdeferred income taxes, on AFS securities are reported as a separate componentof shareholders’ equity, until realized. These net unrealized holding gains and losses are a component ofaccumulated other comprehensive (loss) income.

47

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**FEDERAL HOME LOAN BANK STOCK**

Investment in Federal Home Loan Bank stock is requiredfor membership in the organization and is carried at cost since there is nomarket value available.  The Company isrequired to maintain an investment in the stock based upon the level of itsoutstanding borrowings.

**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 unamortized loan fees and costs and theallowance for loan losses.  Interest onresidential real estate loans is recorded on an amortized schedule.  Commercial loan interest is accrued on theprincipal balance on an actual day basis. Interest on consumer loans is determined using the simple interestmethod.

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 impairedloans are applied, first to the outstanding loan amounts, then to the recoveryof any charged-off loan amounts.  Anyexcess is treated as a recovery of lost interest.

**LOANS AVAILABLE-FOR-SALE**

Loans originated and intendedfor sale in the secondary market are carried at the lower of cost or estimatedfair value in the aggregate.  Netunrealized losses are recognized through a valuation allowance by charges toincome.  Unrealized gains are recognizedto the extent of previous write-downs.

**ALLOWANCE FOR LOAN LOSSES**

The allowance for loan losses is established through aprovision 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’s judgment in determining theadequacy of the allowance is based on evaluations of the collectibility of theloans.  These evaluations take intoconsideration such factors as changes in the nature and volume of the loanportfolio, current economic conditions that may affect the borrower’s abilityto pay, collateral value, overall portfolio quality and review of specificimpaired loans.  Loans considereduncollectible are charged against the allowance.  Recoveries on loans previously charged offare 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.  Factorsconsidered in determining impairment include payment status, collateral valueand the probability of collecting payments when due.  The significance of payment delays and/orshortfalls is determined on a case by case basis.  All circumstances surrounding the loan aretaken into account.  Such factors includethe length of the delinquency, the underlying reasons and the borrower’s priorpayment record.  Impairment is measuredon these loans on a loan by loan basis.

**LEASES**

The Company exited the automobile leasing businessduring 2005.  Financing of equipment andautomobiles was provided to customers under lease arrangements accounted for asdirect financing leases.  Income earnedis based on a constant periodic return on the net investment in the lease.

**LOAN FEES**

Nonrefundable loan origination fees and certain directloan origination costs are recognized as a component of interest income overthe life of the related loans as an adjustment to yield.  The unamortized balance of these fees andcosts are included as part of the loan balance to which it relates.

**BANK PREMISES AND EQUIPMENT**

Land is carried at cost.  Bank premises and equipment are stated atcost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimateduseful lives of the assets.  Leaseholdimprovements are amortized over the shorter of the term of the lease or theestimated useful lives of the improved property.

**LOANSERVICING AND LOAN SERVICING RIGHTS**

***The Company services real estate loansfor investors in the secondary mortgage market, which are not included in theaccompanying consolidated balance sheet. ***Servicing assets are recognized as a component of otherassets when 

48

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***rights are acquired through saleof mortgage loans.  Mortgage servicingrights (MSRs) recognition is based upon a computation of the present value ofestimated future servicing income.  Thecomputation incorporates assumptions such as the discount rate, estimatedprepayment speeds to determine average lives and the earnings rate.  The cost of mortgage servicing rights isamortized into other income in proportion to, and over the period of, estimatedfuture net servicing revenues.  Servicingfee income is recorded from fees earned for servicing loans.  The fees are based on a contractualpercentage of the outstanding principal balance and are recorded as a componentof other income when received.  Theamortization of MSRs is netted against loan servicing fee income.***

**BANK OWNED LIFE INSURANCE**

TheCompany is the owner and sole beneficiary of bank owned life insurance (BOLI)policies on certain employees.  Theearnings from the BOLI are recognized as a component of other income.  The BOLI is an asset that can be liquidated,if necessary, with tax costs associated. However, the Company intends to hold these policies and, accordingly,the Company has not provided for deferred income taxes on the earnings from theincrease in cash surrender value.

**FORECLOSED ASSETS HELD-FOR-SALE**

Foreclosed assets held-for-sale are carried at thelower of cost or fair value less cost to sell. Losses from the acquisition of property in full and partial satisfactionof debt are treated as credit losses.  Routineholding costs are included in other operating expenses.  Write-downs for subsequent declines in valueare recorded in other income as a component of gain or loss on sale offoreclosed assets held-for-sale.  Gainsor losses are recorded when the properties are sold.

**STOCK OPTIONS**

The Company has two stock-based compensation plans,which are described more fully in Note 9. The Company accounts for these plans under the recognition andmeasurement principles of Statement of Financial Accounting Standards (SFAS)No. 123R, *Share-Based Payment,*which replaces SFAS123, *Accounting for Stock-Based Compensation*,and supersedes Accounting Principles Bulletin (APB) Opinion 25, *Accounting for Stock Issued to Employees*.  SFAS 123R requires that the cost ofshare-based payment transactions (including those with employees andnon-employees) be recognized in the financial statements.

Prior to 2006, the Company accounted for these plansunder the recognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees*, and relatedInterpretations.  Prior to 2006, 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 table illustrates the effect onnet income and earnings per share if the Company had applied the fair valuerecognition provisions of Statement SFAS No. 123, to stock-based employeecompensation for each of the years ended December 31, (dollars in thousandsexcept for per share data):
|                                                                                                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                        |       |     |       |     |       |
| Net income, as  reported                                                                                                    |       | $        | 4,592      |     | $          | 3,364 |   |
| 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 |   |
| Earnings per share:                                                                                                         |       |     |       |     |       |
| Basic — as reported                                                                                                    |       | $        | 2.26       |     | $          | 1.67 |   |
| Basic — pro forma                                                                                                      |       | $        | 2.26       |     | $          | 1.67 |   |
|                                                                                                                        |       |     |       |     |       |
| Diluted — as reported                                                                                                  |       | $        | 2.25       |     | $          | 1.67 |   |
| Diluted — pro  forma                                                                                                   |       | $        | 2.25       |     | $          | 1.67 |   |

 

The Company did not grant stock options in 2005 or2004.

**TRUSTAND FINANCIAL SERVICE FEES**

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

49

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**ADVERTISINGCOSTS**

Advertising costs are charged to expense asincurred.  For the years ended December 31,2006, 2005 and 2004, advertising costs amounted to approximately $541,000,$621,000 and $431,000, respectively.

**FAIR VALUE OF FINANCIAL INSTRUMENTS**

**Cash and short-term instruments:**  The carrying amounts of cash and short-terminstruments approximate their fair value.

**Securities:**  Fair values for securities are based on bidprices received from securities dealers. Federal Home Loan Bank Stock is carried at cost, which approximates fairvalue.

**Loans receivable:**  The fair value of all loans is estimated bythe net present value of the future expected cash flows.

**Loans available-for-sale:**  For loans available-for-sale, the fair valueis estimated using rates currently offered for similar borrowings and arestated at the lower of cost or market.

**Deposit liabilities:**  The fair value of demand deposits, NOWaccounts, savings accounts and money market deposits is estimated by the netpresent value of the future expected cash flows.  For certificates of deposit, the discountrates used reflect the Company’s current market pricing.  The discount rates used for non-maturitydeposits are the current book rate of the deposits.

**Short-term borrowings:**  For short-term borrowings, the fair value isestimated using the rates currently offered for similar borrowings.

**Long-term debt:**  For other borrowed funds, the fair value isestimated using the rates currently offered for similar borrowings.

**Accrued interest:**  The carrying amounts of accrued interestapproximate their fair values.

**Derivative financial instruments: **The carrying amount ofinterest rate contracts are based on proprietary models from independentthird-party sources that consider size, lack of a quoted market for theinstrument and the custom tailored nature of the transaction.

**Off-balance-sheet instruments:**  Commitments to extend credit and unused linesof credit are priced to market.  Therates on standby letters of credit are priced on prime.  Therefore, the estimated fair value of thesefinancial instruments is face value.

**INCOME TAXES**

Deferred tax assets and liabilities are reflected atcurrently enacted income tax rates applicable to the period in which thedeferred tax assets or liabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted,deferred tax assets and liabilities are adjusted through the provision forincome taxes.

**DERIVATIVE INSTRUMENTS**

As part of our asset/liability management program, theCompany will utilize, from time-to-time, interest rate floors, caps or swaps toreduce its sensitivity to interest rate fluctuations.  These are derivative instruments which arerecorded as assets or liabilities in the consolidated balance sheets at fairvalue.  Changes in the fair values ofderivatives are reported in the consolidated income statements or othercomprehensive income (OCI) depending on the use of the derivative and whetherthe instrument qualifies for hedge accounting. The key criterion for hedge accounting is that the hedged relationshipmust be highly effective in achieving offsetting changes in those cash flowsthat are attributable to the hedged risk, both at inception of the hedge and onan ongoing basis.

Derivatives that qualify for hedge accountingtreatment are designated as either: a hedge of the fair value of a recognizedasset or liability or of an unrecognized firm commitment (a fair value hedge)or a hedge of a forecasted transaction or the variability of cash flows to bereceived or paid related to a recognized asset or liability (a cash flowhedge).  To date, the Company has onlyentered into a cash flow hedge.  For cashflow hedges, changes in the fair values of the derivative instruments arereported in OCI to the extent the hedge is effective.  The gains and losses on derivativeinstruments that are reported in OCI are reflected in the consolidated incomestatements in the periods in which the results of operations are impacted bythe variability of the cash flows of the hedged item.  Generally, net interest income is increasedor decreased by amounts receivable or payable with respect to the 

50

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derivatives which qualify for hedge accounting.  At inception of the hedge, the Companyestablishes the method it uses for assessing the effectiveness of the hedgingderivative and the measurement approach for determining the ineffective aspectof the hedge.  The ineffective portion ofthe hedge, if any, is recognized currently in the consolidated statements ofincome.  The Company excludes the timevalue expiration of the hedge when measuring ineffectiveness.

**CASH FLOWS**

For purposes of reporting cash flows, cash and cashequivalents includes cash on hand, amounts due from banks and interest-bearingdeposits with financial institutions.

For the years ended December 31, 2006, 2005, and 2004,the Company paid interest of $15,318,000, $11,367,000 and $11,465,000,respectively.  For the years endedDecember 31, 2006, 2005, and 2004, the Company paid cash for income taxesof $1,480,000, $1,800,000 and $1,200,000, respectively.

Transfers from loans to foreclosed assetsheld-for-sale amounted to $258,000, $322,000 and $504,000 in 2006, 2005, and2004, respectively.  Non-cash investingactivities also included the transfer of $12,807,221 from loansavailable-for-sale to loans in 2004. There were no transfers of loans from loans available-for-sale to loansin 2006 or 2005.  In addition,expenditures for construction in process, a component of other assets in theconsolidated balance sheets,  is includedin acquisition of premises and equipment.

**RECLASSIFICATIONS**

Certain reclassificationshave been made to prior years financial statements to conform to the currentpresentation.

**OTHERCOMPREHENSIVE INCOME (LOSS)**

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

|                                                                     | ** ** | **2006** | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|------------|------------|------------|------------|
|                                                                |       |     |       |       |       |       |       |
| Unrealized holding  gains (losses) on available-for-sale securities |       | $        | 223,358    |       | $          | (1,527,019 | )          | $ | 178,447 |   |
|                                                                |       |     |       |       |       |       |       |
| Less  reclassification adjustment for gains realized in income      |       | (1,200   | )          | (4,696     | )          | (9,497     | )          |
|                                                                |       |     |       |       |       |       |       |
| Net unrealized  gains (losses)                                      |       | 222,158  |       | (1,531,715 | )          | 168,950    |       |
|                                                                |       |     |       |       |       |       |       |
| Change in cash  flow hedge intrinsic value                          |       | 917      |       | —     |       | —     |       |
|                                                                |       |     |       |       |       |       |       |
| Subtotal                                                            |       | 223,075  |       | (1,531,715 | )          | 168,950    |       |
|                                                                |       |     |       |       |       |       |       |
| Tax effect                                                          |       | (75,534  | )          | 520,783    |       | (57,443    | )          |
|                                                                |       |     |       |       |       |       |       |
| Net of tax amount                                                   |       | $        | 147,541    |       | $          | (1,010,932 | )          | $ | 111,507 |   |

 

The components ofaccumulated other comprehensive loss consisted of:

|                                                             | ** ** | **2006** | ** ** | **2005** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
|                                                        |       |     |       |     |       |       |       |
| Unrealized  holding losses on available-for-sale securities |       | $        | (965,709   | )        | $          | (1,112,333 | )          |   |   |
|                                                        |       |     |       |     |       |       |       |
| Change in cash  flow hedge intrinsic value                  |       | 917      |       | —   |       |       |       |
|                                                        |       |     |       |     |       |       |       |
| Accumulated other  comprehensive loss                       |       | $        | (964,792   | )        | $          | (1,112,333 | )          |   |   |

 

51

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

The Company is required by the Federal Reserve Bank tomaintain average reserve balances based on a percentage of deposits.  The amounts of those reserve requirements onDecember 31, 2006 and 2005 were $714,000 and $627,000, respectively.

Deposits with any one financial institution areinsured up to $100,000.  Fromtime-to-time, the Company maintains cash and cash equivalents with certainother financial institutions in excess of the insured amount.

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

Amortized cost and fair value of investment securitiesat December 31, 2006 and 2005 are as follows (in thousands):

|                                                  | ** ** | **2006**            | ** ** |
|--------------------------------------------------|------------|---------------------|------------|
| ** **                                       | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                             |       |                |       |   |   |   |   |   |   |
| Held-to-maturity  securities:                    |       |                |       |   |   |   |   |   |   |
| Mortgage-backed securities                       |       | $                   | 1,569      |   | $ | 29 |   | $ | — |   | $ | 1,598 |   |
|                                             |       |                |       |   |   |   |   |   |   |
| Available-for-sale  securities:                  |       |                |       |   |   |   |   |   |   |
| U.S. government agencies and corporations        |       | $                   | 34,604     |   | $ | — |   | $ | 712 |   | $ | 33,892 |   |
| Obligations of states and political subdivisions |       | 12,560              |       | 49 |   | 33 |   | 12,576 |   |
| Corporate bonds                                  |       | 10,530              |       | 52 |   | 11 |   | 10,571 |   |
| Mortgage-backed securities                       |       | 42,332              |       | 1 |   | 1,002 |   | 41,331 |   |
|                                             |       |                |       |   |   |   |   |   |   |
| Total debt securities                            |       | 100,026             |       | 102 |   | 1,758 |   | 98,370 |   |
|                                             |       |                |       |   |   |   |   |   |   |
| Equity  securities                               |       | 279                 |       | 192 |   | — |   | 471 |   |
|                                             |       |                |       |   |   |   |   |   |   |
| Total  available-for-sale securities             |       | $                   | 100,305    |   | $ | 294 |   | $ | 1,758 |   | $ | 98,841 |   |

 

|                                                  | ** ** | **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 securities                            |       | 97,088              |       | 136 |   | 1,995 |   | 95,229 |   |
|                                             |       |                |       |   |   |   |   |   |   |
| Equity  securities                               |       | 279                 |       | 174 |   | — |   | 453 |   |
|                                             |       |                |       |   |   |   |   |   |   |
| Total  available-for-sale securities             |       | $                   | 97,367     |   | $ | 310 |   | $ | 1,995 |   | $ | 95,682 |   |

 

Most of the Company’s debt and equity securities are pledged to securetrust funds, public deposits, repurchase agreements, other short-termborrowings, Federal Home Loan Bank of Pittsburgh (FHLB) borrowings, FederalReserve Bank of Philadelphia Discount Window borrowings and certain otherdeposits as required by law.  U.S.government securities pledged on repurchase agreements are under the Company’scontrol.

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The amortized cost andfair value of debt securities at December 31, 2006 by contractual maturity areshown below (in thousands):

|                                           | ** ** | **Amortized  cost** | ** ** | **Fair  value** | ** ** |
|-------------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                      |       |                |       |            |       |
| Held-to-maturity  securities:             |       |                |       |            |       |
| Mortgage-backed securities                |       | $                   | 1,569      |            | $          | 1,598 |   |
|                                      |       |                |       |            |       |
| Available-for-sale  securities:           |       |                |       |            |       |
| Debt securities:                          |       |                |       |            |       |
| Due in one year or less                   |       | $                   | —     |            | $          | — |   |
| Due after one year through five years     |       | 6,997               |       | 6,879           |       |
| Due after five years through ten years    |       | 20,653              |       | 20,333          |       |
| Due after ten years                       |       | 30,044              |       | 29,827          |       |
|                                      |       |                |       |            |       |
| Total debt securities                     |       | 57,694              |       | 57,039          |       |
|                                      |       |                |       |            |       |
| Mortgage-backed securities                |       | 42,332              |       | 41,331          |       |
|                                      |       |                |       |            |       |
| Total  available-for-sale debt securities |       | $                   | 100,026    |            | $          | 98,370 |   |

 

Expected maturities willdiffer from contractual maturities because issuers and borrowers may have theright to call or repay obligations with or without call or prepaymentpenalty.  Federal agency and municipalsecurities are included based on their original stated maturity.  Mortgage-backed securities, which are basedon weighted-average lives and subject to monthly principal pay-downs, arelisted in total.

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The following table presents gross unrealized lossesand fair value of investments aggregated by investment category and length oftime that individual securities have been in a continuous unrealized lossposition at December 31, 2006 and 2005 (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,  2006:                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| ** **                                       |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| U.S. government agencies and corporations        |       | $                                      | 12,421     |                                 | $          | 183             |       | $ | 21,471 |   | $ | 529 |   | $ | 33,892 |   | $ | 712 |   |
| Obligations of states and political subdivisions |       | 4,820                                  |       | 30                                   |       | 203             |       | 3 |   | 5,023 |   | 33 |   |
| Mortgage-backed securities                       |       | 6,839                                  |       | 45                                   |       | 34,435          |       | 957 |   | 41,274 |   | 1,002 |   |
| Corporate bonds                                  |       | 3,514                                  |       | 11                                   |       | —          |       | — |   | 3,514 |   | 11 |   |
|                                             |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Subtotal, debt securities                        |       | 27,594                                 |       | 269                                  |       | 56,109          |       | 1,489 |   | 83,703 |   | 1,758 |   |
|                                             |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Equity securities                                |       | —                                 |       | —                               |       | —          |       | — |   | — |   | — |   |
|                                             |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Total temporarily impaired securities            |       | $                                      | 27,594     |                                 | $          | 269             |       | $ | 56,109 |   | $ | 1,489 |   | $ | 83,703 |   | $ | 1,758 |   |
|                                             |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| 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 |   |

 

Management evaluates securities forother-than-temporary impairment on a quarterly basis or more frequently wheneconomic conditions or market conditions warrant such evaluation.  Consideration is given to (1) the length oftime and the extent to which the fair value has been less than cost, (2) thefinancial condition and near-term prospects of the issuer, and (3) the intentand ability of the Company to retain its investment in the issuer for a periodof time sufficient to allow for any anticipated recovery in fair value.

At December 31, 2006 the debt securities withunrealized losses have depreciated 2.1% from the Company’s amortized costbasis.  The U.S. government or itsagencies guarantee most of these securities. 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.  Management believes the decline in marketvalues is attributable to changes in interest rates and not credit quality, andsince most of the deterioration of the AFS debt portfolio is from investmentsthat are guaranteed by the U.S. government or one of its agencies and theCompany has the ability and intent to hold those securities until a recovery offair value, which may be maturity, Management does not consider those securitiesto be other-than-temporarily impaired at December 31, 2006.

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Gross realized gains and losses on sales ofavailable-for-sale securities, determined using specific identification of thesecurities were as follows:

|                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
|                 |       |     |       |     |       |     |       |
| Gross realized  gain |       | $        | 71,201     |     | $          | 127,414  |       | $ | 19,978 |   |
| Gross realized  loss |       | 70,001   |       | 122,718  |       | 10,481   |       |
| Net gain             |       | $        | 1,200      |     | $          | 4,696    |       | $ | 9,497 |   |

 

**4.     LOANS AND LEASES**

The major classifications of loans and leases atDecember 31, 2006 and 2005 are summarized as follows:

|                                        | ** ** | **2006**    | ** **  | **2005**    | ** ** |
|----------------------------------------|------------|-------------|-------------|-------------|------------|
|                                   |       |        |        |        |       |
| Commercial and  commercial real estate |       | $           | 218,213,216 |        | $          | 216,288,597 |   |
| Residential real  estate               |       | 112,742,692 |        | 103,920,613 |       |
| Consumer                               |       | 77,729,520  |        | 74,070,328  |       |
| Real estate  construction              |       | 13,369,712  |        | 14,198,858  |       |
| Direct financing  leases               |       | 588,211     |        | 650,348     |       |
|                                   |       |        |        |        |       |
| Total                                  |       | 422,643,351 |        | 409,128,744 |       |
|                                   |       |        |        |        |       |
| Less:                                  |       |        |        |        |       |
| Allowance for loan losses              |       | 5,444,303   |        | 5,984,649   |       |
|                                   |       |        |        |        |       |
| Loans and  leases, net                 |       | $           | 417,199,048 |        | $          | 403,144,095 |   |

 

Net deferred loan costs of $617,709 and $605,079 havebeen added to the carrying value of loans at December 31, 2006 and 2005,respectively.

Information related to impaired and past due loans as of December 31 isas follows:

|                                                                                             | ** ** | **2006**  | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------|------------|------------|------------|
| At December 31:                                                                             |       |      |       |       |       |
| Accruing loans that are contractually past due 90  days or more as to principal or interest |       | $         | 80,603     |       | $          | 196,928 |   |
| Non-accrual loans                                                                           |       | 3,357,718 |       | 9,452,788  |       |
| Amount of impaired loans that have a specific  allowance                                    |       | 1,393,660 |       | 10,625,662 |       |
| Amount of impaired loans with no specific allowance                                         |       | 1,964,058 |       | 2,889,259  |       |
| Allowance for impaired loans                                                                |       | 278,153   |       | 1,396,446  |       |
|                                                                                        |       |      |       |       |       |
| During the year  ended December 31:                                                         |       |      |       |       |       |
| Average investment in impaired loans                                                        |       | 7,081,203 |       | 10,309,967 |       |
| Interest income  recognized on impaired loans (cash basis)                                  |       | 278,570   |       | 241,325    |       |
|                                                                                             |            |           |            |            |            |  |  |

 

Information related tothe changes in the allowance for loan losses as of December 31 is as follows:

|                              | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                         |       |       |       |       |       |       |       |
| Balance,  beginning          |       | $          | 5,984,649  |       | $          | 5,987,798  |       | $ | 4,996,966 |   |
| Recoveries                   |       | 189,668    |       | 560,496    |       | 447,772    |       |
| Provision for  loan losses   |       | 325,000    |       | 830,000    |       | 2,150,000  |       |
| Losses charged  to allowance |       | (1,055,014 | )          | (1,393,645 | )          | (1,606,940 | )          |
|                         |       |       |       |       |       |       |       |
| Balance, ending              |       | $          | 5,444,303  |       | $          | 5,984,649  |       | $ | 5,987,798 |   |

 

The Company services realestate loans for investors in the secondary mortgage market which are notincluded in the accompanying consolidated balance sheet.  The approximate amount of mortgages servicedamounted to $53,112,000 at December 31, 2006 and $47,835,000 atDecember 31, 2005.  MSRs wereapproximately $328,000 at December 31, 2006 and $309,000 at December 31, 2005and are included in other assets.

The Company recognizedservicing gains from the sales of mortgage loans of $13,189 in 2006, $12,141 in2005 and $144,246, in 2004.  Amortizationof MSRs was $73,987 in 2006, $93,351 in 2005 and $101,389 in 2004.

55

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

Components of bank premises and equipment at December31, 2006 and 2005 are summarized as follows:

|                                                 | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Land                                            |       | $          | 2,072,048  |       | $          | 2,072,048 |   |
| Bank premises                                   |       | 7,492,231  |       | 7,492,231  |       |
| Furniture, fixtures and  equipment              |       | 8,148,040  |       | 7,684,298  |       |
| Leasehold improvements                          |       | 3,021,602  |       | 3,030,139  |       |
|                                            |       |       |       |       |       |
| Total                                           |       | 20,733,921 |       | 20,278,716 |       |
|                                            |       |       |       |       |       |
| Less accumulated  depreciation and amortization |       | 9,409,456  |       | 8,595,568  |       |
|                                            |       |       |       |       |       |
| Bank premises and  equipment, net               |       | $          | 11,324,465 |       | $          | 11,683,148 |   |

 

Depreciation expense,which includes amortization of leasehold improvements, was $1,191,421,$1,189,460 and $1,198,863 for the years ended December 31, 2006, 2005 and 2004,respectively.

The Company leases itsGreen Ridge, Scranton, Pittston, West Pittston, Moosic, Kingston, Peckville,Clarks Summit and Eynon branches under the terms of operating leases.  Rental expense was $427,571 for 2006,$379,858 for 2005 and $386,980 for 2004. The future minimum rental payments at December 31, 2006 under theseleases are as follows:

| Year ending December 31 | ** ** | ** ** | ** ** | **Amount** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
|                                   |       |       |       |
| 2007                                   |       | $          | 390,689    |       |
| 2008                                   |       | 368,834    |       |
| 2009                                   |       | 343,241    |       |
| 2010                                   |       | 340,812    |       |
| 2011                                   |       | 342,479    |       |
| 2012 and  thereafter                   |       | 4,612,236  |       |
|                                   |       |       |       |
| Total                                  |       | $          | 6,398,291  |       |

 

During 2007, the Companywill complete the construction and relocation of one branch office.  As of December 31, 2006 approximately$1,200,000 of additional capital expenditures representing outstandingconstruction commitments, design, and equipment will be incurred before theentire cost of the project will be reclassified from construction in process, acomponent of other assets on the consolidated balance sheets, to bank premisesand equipment.

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

At December 31, 2006, the scheduled maturities ofcertificates of deposit are as follows:

| 2007       |   | $         | 126,757,174 |   | 82.4   | % |
|------------|--------|-----------|-------------|--------|--------|---|
| 2008       |   | 9,761,878 |        | 6.3    |   |
| 2009       |   | 7,847,734 |        | 5.1    |   |
| 2010       |   | 7,659,301 |        | 5.0    |   |
| 2011       |   | 1,532,881 |        | 1.0    |   |
| Thereafter |   | 251,888   |        | 0.2    |   |
|       |   |      |        |   |   |
|       |   | $         | 153,810,856 |   | 100.0  | % |

 

Time deposits of $100,000or more aggregated $63,020,000 and $76,258,000 at December 31, 2006 and 2005,respectively.

Investment securitieswith a fair value of $40,000,000 and letters of credit with a notional amountof $24,000,000 as of December 31, 2006 were pledged as collateral to securepublic deposits and trust funds.

56

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

Short-term borrowings are as follows at December 31,2006, 2005 and 2004:

|                                              | ** ** | **2006**   | ** ** | **2005**  | ** ** | **2004**   | ** ** |
|----------------------------------------------|------------|------------|------------|-----------|------------|------------|------------|
|                                         |       |       |       |      |       |       |       |
| Securities sold  under repurchase agreements |       | $          | 22,224,445 |      | $          | 26,912,700 |       | $ | 40,684,343 |   |
| Demand note,  U.S. Treasury                  |       | 1,036,705  |       | 1,091,297 |       | 1,089,703  |       |
| Overnight  borrowings                        |       | 10,395,000 |       | 769,000   |       | 8,760,000  |       |
|                                         |       |       |       |      |       |       |       |
| Total                                        |       | $          | 33,656,150 |      | $          | 28,772,997 |       | $ | 50,534,046 |   |

 

The maximum and average amountsof short-term borrowings outstanding and related interest rates for the yearsended December 31, 2006, 2005 and 2004 are as follows:

|                                              | ** ** | **Maximum  outstanding  at any  month end** | ** ** | **Average  outstanding** | ** ** | **Weighted-  average  rate during  the year** | ** ** | **Rate at  year end** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | ** **                                            | ** ** | ** **               | ** ** | ** **                                              | ** ** | ** **                      | ** ** |
| 2006                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
|                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Overnight  borrowings                        |       | $                                                     | 13,308,000 |                     | $          | 6,110,115                                               |       | 5.21%                           |       | 5.36% |   |
| Securities sold  under repurchase agreements |       | 24,917,518                                            |       | 23,390,881               |       | 2.67%                                                   |       | 2.80%                           |       |
| Demand note,  U.S. Treasury                  |       | 1,081,822                                             |       | 500,907                  |       | 6.11%                                                   |       | 5.06%                           |       |
|                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Total                                        |       | $                                                     | 39,307,340 |                     | $          | 30,001,903                                              |       |                            |       |   |   |
|                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
| 2005                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
|                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Overnight  borrowings                        |       | $                                                     | 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                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
|                                         |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Overnight  borrowings                        |       | $                                                     | 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                                              |       |                            |       |   |   |

 

Overnight borrowings include both Fed funds purchasedwith correspondent banks and open repurchase agreements with the FHLB.  Securities sold under agreements torepurchase (repurchase agreements) are non-insured interest-bearing liabilitiesthat have a security interest in qualified investment securities of theCompany.  Repurchase agreements arereflected at the amount of cash received in connection with thetransaction.  The carrying value of theunderlying qualified investment securities was approximately $25,000,000,$27,000,000 and $40,000,000 at December 31, 2006, 2005 and 2004,respectively.  The Company may berequired to provide additional collateral based on the fair value of theunderlying securities.  The demand note,U. S. Treasury is generally repaid within 1 to 90 days.

At December 31, 2006, the Company had approximately$103,558,000 available to borrow from the FHLB, $27,300,000 from correspondentbanks and approximately $6,846,000 that it could borrow at the Discount Windowfrom the Federal Reserve Bank of Philadelphia. There were no borrowings from the Federal Reserve Bank Discount Windowat December 31, 2006, 2005 or 2004.

57

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

Long-term debt consistsof advances from the FHLB with interest rates ranging from 2.98% to 6.14% atDecember 31, 2006.  These advances aresecured by unencumbered U.S. government agency securities, mortgage-backedsecurities, certain residential mortgages and other real estate collateralizedloans with a combined fair value of $211,000,000 at December 31, 2006.

At December 31, 2006, the maturities andweighted-average interest rates of long-term debt are as follows:

| Year ending December 31, | ** ** | ** ** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|-----------------------------------------|------------|------------|------------|------------|------------|----------|------------|
|                                    |       |       |       |       |       |
| 2007                                    |       | $          | 8,827,534  |       | 4.76       | %        |
| 2008                                    |       | 708,676    |       | 2.98       |       |
| 2010                                    |       | 32,000,000 |       | 5.50       |       |
| 2013                                    |       | 5,000,000  |       | 3.61       |       |
| 2016                                    |       | 16,000,000 |       | 5.26       |       |
|                                    |       |       |       |       |       |
| Total                                   |       | $          | 62,536,210 |       | 5.15       | %        |

 

Rates on $53,000,000 of convertible select FHLBadvances are fixed but may adjust quarterly, should market rates increasebeyond the issues’ original or strike rates. Significant prepayment penalties attached to the borrowings is a deterrentfrom paying off the high cost advances. However, in the event underlying market rates drift above the ratescurrently paid on these borrowings, the FHLB rate will convert to floating andthe Bank has the option, at that time, to repay or to renegotiate the convertedadvance.  As of December 31, 2006 the weighted-averageinterest rate on these convertible select advances was 5.25% with maturitiesranging from 2010 to 2016.

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

In December 2004, theFinancial Accounting Standard Board issued SFAS 123R, *Share-BasedPayment*, which replaces SFAS 123, *Accountingfor Stock-Based Compensation*, and supersedes Accounting PrinciplesBulletin Opinion 25, *Accounting for StockIssued to Employees*.  SFAS123R requires that the cost of share-based payment transactions (includingthose with employees and non-employees) be recognized in the financialstatements.  SFAS 123R applies to allshare-based payment transactions in which an entity acquires goods or servicesby issuing (or offering to issue) its shares, share options, or other equityinstruments (except for those held by an ESOP) or by incurring liabilities (1)in amounts based (even in part) on the price of the entity’s shares or otherequity instruments, or (2) that require (or may require) settlement by theissuance of an entity’s shares or other equity instruments.

On January 1, 2006, the Company implemented theprovisions of SFAS 123R using the Modified Prospective Application transitionmethod (the MPA).  The MPA requires theCompany to apply the provisions of SFAS 123R to: (a) new awards granted afterits adoption; (b) any awards that were granted after the first fiscal yearbeginning after December 15, 1994 that have not vested by the date the Companyadopts SFAS 123R; and (c) any outstanding liability awards.  Under the MPA, the Company is not required toadjust prior years’ financial statements. In addition, as of December 31, 2005, all of the Company’s stock optionawards granted prior to that date were fully vested and therefore the Companyis not required to apply the provisions of SFAS 123R to these previouslygranted share-based awards.  Therefore,the following discussion will be most applicable to share-based awards issuedduring 2006.

The Company has two stock-based compensation plans (thestock option plans).  The stock optionplans were shareholder-approved and permit the grant of share-basedcompensation awards to its directors, key officers and certain other employees.  The Company believes that these stock optionplans better align the interest of its directors, key officers and employeeswith the interest of its shareholders. The Company further believes that the granting of share-based awards,under the provisions of the stock option plans, is necessary to retain theknowledge base, continuity and expertise of its directors, key officers andcertain employees.

The Company established the 2000 Independent DirectorsStock Option Plan and has reserved 55,000 shares of its un-issued capital stockfor issuance under the plan.  Under the 2000Independent Directors Stock Option Plan, each outside director is awarded stockoptions 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 ofgrant.  No stock options were awardedduring 2006 or for each of the years ended December 31, 2005 and 2004 due tothe directors’ voluntary election to forego the award.  At December 31, 2006, there were 14,850unexercised stock options outstanding under this plan.

58

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The Company has also established the 2000 StockIncentive Plan and has reserved 55,000 shares of its un-issued capital stockfor issuance under the plan.  Under the2000 Stock Incentive Plan, key officers and certain other employees areeligible to be awarded qualified stock options to purchase the Company’s commonstock at the fair market value on the date of grant.  During 2006, 2,200 stock options were issuedunder the 2000 Stock Incentive plan.  Nostock options were awarded for each of the years ended December 31, 2005 and2004.  As of December 31, 2006, therewere 5,830 unexercised stock options outstanding under this plan.

Under the stock option plans, options are granted withan exercise price equal to the market price of the Company’s stock at the dateof grant.  The awards vest based on sixmonths of continuous service from the date of grant and have 10-yearcontractual terms.  Generally, all sharesthat are granted become fully vested.

The Company does not have stock options that aretraded on organized capital exchanges. As such, the estimated fair value of options awarded under its stockoption plans is determined, on the date of grant, using the Black-ScholesOption Pricing Valuation Model (the model). For the options granted in 2006, the model incorporated the assumptionsnoted in the following table:

| Expected volatility     |   | 16.00 | %           |
|-------------------------|--------|-------|-------------|
| Expected dividend       |   | 2.41  | %           |
| Risk-free interest rate |   | 4.35  | %           |
| Expected term           |   | 5.25  |  years |

 

The expectedvolatility was determined based on the daily five-year historical volatility ofthe Company’s stock.  Management believesthe five-year historical volatility measurement closely resembles thefluctuation of its stock value under most economic conditions and cycles.  Because of the relatively short vestingperiod, the model assumes that all options granted will fully vest.  The risk-free rate is for the period withinthe expected term of the options based on the U.S. Treasury yield curve.  The Company used the simplified method todetermine the term in which options are expected to be outstanding.

A summary of thestatus of the Company’s stock option plans as of December 31, 2006, December31, 2005 and December 31, 2004 and changes during the periods is presented inthe following table:

|                                                 | ** ** | **Options** | ** ** | **Weighted-  average  exercise price *** | ** ** | **Weighted-  average  remaining   contractual  terms (yrs)** | ** ** | **Aggregate  intrinsic  value** | ** ** |
|-------------------------------------------------|------------|-------------|------------|----------------------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------|------------|
|                                            |       |        |       |                                               |       |                                                                   |       |                            |       |
| Outstanding and  exercisable, December 31, 2003 |       | 27,170      |       | $                                                  | 32.17      |                                                                   | 6.7        |                            |       |   |
| Granted                                         |       | —      |       | —                                             |       |                                                                   |       |                            |       |
| Exercised                                       |       | (550        | )          | 28.18                                              |       |                                                                   |       |                            |       |
| Forfeited                                       |       | (6,050      | )          | 32.13                                              |       |                                                                   |       |                            |       |
|                                            |       |        |       |                                               |       |                                                                   |       |                            |       |
| Outstanding and  exercisable, December 31, 2004 |       | 20,570      |       | 32.29                                              |       | 5.7                                                                    |       |                            |       |
| Granted                                         |       | —      |       | —                                             |       |                                                                   |       |                            |       |
| Exercised                                       |       | —      |       | —                                             |       |                                                                   |       |                            |       |
| Forfeited                                       |       | (440        | )          | 34.09                                              |       |                                                                   |       |                            |       |
|                                            |       |        |       |                                               |       |                                                                   |       |                            |       |
| Outstanding and  exercisable, December 31, 2005 |       | 20,130      |       | 32.25                                              |       | 4.7                                                                    |       |                            |       |
| Granted                                         |       | 2,200       |       | 36.59                                              |       |                                                                   |       |                            |       |
| Exercised                                       |       | —      |       |                                               |       |                                                                   |       |                            |       |
| Forfeited                                       |       | (1,650      | )          | 33.07                                              |       |                                                                   |       |                            |       |
|                                            |       |        |       |                                               |       |                                                                   |       |                            |       |
| Outstanding and  exercisable, December 31, 2006 |       | 20,680      |       | $                                                  | 32.64      |                                                                   | 4.3        |                            | $          | 27,931 |   |
|                                                 |            |             |            |                                                    |            |                                                                        |            |                                 |            |  |  |

----

* Includes options with exercise prices ranging from $28.18 to $36.59.

No options havebeen granted under the 2000 Independent Directors Stock Option Plan since 2002and all options previously granted and outstanding are fully vested.  As of December 31, 2006, no options have beenexercised under the provisions of the 2000 Independent Directors Stock OptionPlan.

59

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Under the 2000Stock Incentive Plan, the grant-date fair value of the options granted in 2006was determined to be $6.21 per share. Approximately $13,700 of stock-based compensation expense was recordedduring 2006 and is included as a component of salaries and employee benefits inthe consolidated income statement.  Sincethe plan is a qualified option plan under the Internal Revenue Code (IRC), atax benefit is ordinarily not recorded unless there is a disqualifyingdisposition.  A disqualifying dispositionoccurs if the employee does not hold the shares for a minimum holding periodthat is required by the IRC.  During2006, there was no disqualify disposition and no tax benefit was recorded withrespect to the stock-based compensation expense recorded under this plan.

No options wereexercised during the periods presented. Since the Company adopted SFAS 123R on January 1, 2006, under the MPA,the comparable data for the previous periods is not required to bereported.  As of December 31, 2006, alloptions issued under the plan were fully vested and therefore, there is nounrecognized compensation expense related to non-vested share-based compensationagreements under the plan as of that date.

In addition to thetwo stock option plans, the Company has established the 2002 Employee StockPurchase Plan (the ESPP) and has reserved 110,000 shares of its un-issuedcapital stock for issuance under the plan. The plan was designed to promote broad-based employee ownership of theCompany’s stock.  Under the ESPP,employees may have automatic payroll deductions to purchase the Company’scapital stock at a discounted price based at the fair market value of theCompany’s capital stock on either the commencement date or terminationdate.  At December 31, 2006, 6,051 shareshave been issued under the plan.  TheESPP is considered a compensatory plan and, as such, is required to comply withthe provisions of SFAS 123R.  The Companyrecognizes compensation expense on its ESPP Plan on the date the shares arepurchased.  For the year ended December31, 2006, compensation expense related to the ESPP approximated $15,000 and isincluded as a component of salaries and employee benefits in the consolidated incomestatement.  For the year ended December31, 2007, the Company expects to issue approximately 2,300 shares and recognizecompensation expense of $7,000 under the ESPP.

Also, as of December 31, 2006, the Company hasreserved 110,000 shares of its un-issued capital stock for issuance under adividend reinvestment plan (the DRP). Shares issued under the DRP are valued at fair value as of the dividendpayment date.  At December 31, 2006,42,421 shares are available for future issuance.

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

The following temporary differences gave rise to thedeferred tax asset (liability) at December 31, 2006 and 2005:

|                                                    | ** ** | **2006**  | ** ** | **2005**   | ** ** |
|----------------------------------------------------|------------|-----------|------------|------------|------------|
| Deferred tax  assets:                              |       |      |       |       |       |
| Allowance for loan losses                          |       | $         | 1,851,063  |       | $          | 2,034,781 |   |
| Unrealized losses on available-for-sale securities |       | 497,486   |       | 573,020    |       |
| Deferred interest from non-accrual loans           |       | 163,593   |       | —     |       |
| Deferred compensation                              |       | 43,702    |       | 60,013     |       |
| Retirement settlement reserve                      |       | 46,918    |       | 55,419     |       |
| Other                                              |       | 87,755    |       | 16,488     |       |
|                                               |       |      |       |       |       |
| Total                                              |       | 2,690,517 |       | 2,739,721  |       |
|                                               |       |      |       |       |       |
| Deferred tax  liabilities:                         |       |      |       |       |       |
| Depreciation                                       |       | (328,321  | )          | (442,985   | )          |
| Loan fees and costs                                |       | (396,355  | )          | (395,624   | )          |
| Other                                              |       | (105,853  | )          | (217,660   | )          |
|                                               |       |      |       |       |       |
| Total                                              |       | (830,529  | )          | (1,056,269 | )          |
|                                               |       |      |       |       |       |
| Deferred tax  asset, net                           |       | $         | 1,859,988  |       | $          | 1,683,452 |   |

 

The provision for income taxes for the years ended December 31 are asfollows:

|                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004**  | ** ** |
|-----------------|------------|----------|------------|----------|------------|-----------|------------|
|            |       |     |       |     |       |      |       |
| Current         |       | $        | 1,437,083  |     | $          | 1,785,060 |       | $ | 1,661,588 |   |
| Deferred        |       | (75,003  | )          | (318,948 | )          | (625,994  | )          |
|            |       |     |       |     |       |      |       |
| Total provision |       | $        | 1,362,080  |     | $          | 1,466,112 |       | $ | 1,035,594 |   |

 

60

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The reconciliation between the expected statutory income tax and theactual provision for income taxes is as follows:

|                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004**  | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
|                                         |       |     |       |     |       |      |       |
| Expected  provision at the statutory rate    |       | $        | 1,865,703  |     | $          | 2,059,655 |       | $ | 1,496,023 |   |
| Tax-exempt  income                           |       | (376,906 | )          | (353,559 | )          | (297,236  | )          |
| Nondeductible  interest expense              |       | 54,670   |       | 43,296   |       | 29,748    |       |
| Bank owned life  insurance                   |       | (97,261  | )          | (94,677  | )          | (108,766  | )          |
| Nondeductible  other expenses and other, net |       | 33,575   |       | (68,489  | )          | 33,977    |       |
| Low income  housing tax credits              |       | (117,701 | )          | (120,114 | )          | (118,152  | )          |
|                                         |       |     |       |     |       |      |       |
| Actual provision  for income taxes           |       | $        | 1,362,080  |     | $          | 1,466,112 |       | $ | 1,035,594 |   |

 

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

The Company has a defined contribution profit sharing401(k) plan covering substantially all of its employees.  The plan is subject to the provisions of theEmployee Retirement Income Security Act of 1974 (ERISA).  Contributions to the plan were $241,913 in2006, $214,184 in 2005 and $196,749 in 2004.

**12.****      ****FAIR VALUE OF FINANCIALINSTRUMENTS AND DERIVATIVES**

The following tablerepresents the carrying amount and estimated fair value of the Company’sfinancial instruments as of December 31 (in thousands):

|                                          | ** ** | **2006**             | ** ** | **2005 **                 | ** ** |
|------------------------------------------|------------|----------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** |
|                                     |       |                 |       |                           |       |   |   |   |   |
| Financial  assets:                       |       |                 |       |                           |       |   |   |   |   |
| Cash and cash equivalents                |       | $                    | 13,801     |                           | $          | 13,801 |   | $ | 12,595 |   | $ | 12,595 |   |
| Held-to-maturity securities              |       | 1,569                |       | 1,598                          |       | 1,997 |   | 2,046 |   |
| Available-for-sale securities            |       | 98,841               |       | 98,841                         |       | 95,682 |   | 95,682 |   |
| FHLB Stock                               |       | 3,795                |       | 3,795                          |       | 4,628 |   | 4,628 |   |
| Loans and leases                         |       | 417,199              |       | 410,412                        |       | 403,144 |   | 397,412 |   |
| Loans available-for-sale                 |       | 122                  |       | 123                            |       | 429 |   | 434 |   |
| Accrued interest                         |       | 2,503                |       | 2,503                          |       | 1,960 |   | 1,960 |   |
|                                     |       |                 |       |                           |       |   |   |   |   |
| Financial  liabilities:                  |       |                 |       |                           |       |   |   |   |   |
| Deposit liabilities                      |       | 410,335              |       | 408,903                        |       | 379,499 |   | 377,253 |   |
| Short-term borrowings                    |       | 33,656               |       | 33,658                         |       | 28,773 |   | 28,770 |   |
| Long-term debt                           |       | 62,536               |       | 63,663                         |       | 83,704 |   | 85,517 |   |
| Accrued interest                         |       | 2,382                |       | 2,382                          |       | 1,339 |   | 1,339 |   |
|                                     |       |                 |       |                           |       |   |   |   |   |
| On-balance sheet  derivative instrument: |       |                 |       |                           |       |   |   |   |   |
| Cash flow hedge                          |       | 225                  |       | 225                            |       | — |   | — |   |
|                                          |            |                      |            |                                |            |  |  |  |  |  |  |  |  |

 

**FinancialInstruments with Off-Balance Sheet Risk**

The Company is a party to financial instruments withoff-balance-sheet risk in the normal course of business to meet the financingneeds of its customers and to manage its exposure to interest rate risk.  Interest rate risk includes the possibilitythat the Company’s net interest income will be adversely affected as a resultof changes in interest rates.  Thesefinancial instruments include commitments to extend credit, standby letters ofcredit and interest rate floors.  Thoseinstruments involve, to varying degrees, elements of credit and interest raterisk in excess of the amount recognized in the balance sheet.  The contract or notional amounts of those instrumentsreflect the extent of the Company’s involvement in particular classes offinancial instruments.

61

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A summary of the notional amounts of the Company’sfinancial instruments with off balance-sheet risk at December 31, 2006 follows:

|                               | ** ** | **Notional  amount** | ** ** |
|-------------------------------|------------|----------------------|------------|
| Commitments to extend  credit |       | $                    | 71,277,000 |   |
| Standby letters of  credit    |       | 5,535,000            |       |
| Cash flow hedge               |       | 20,000,000           |       |
|                               |            |                      |            |  |

 

**Commitmentsto Extend Credit and Standby Letters of Credit**

The Company’s exposure tocredit loss from nonperformance by the other party to the financial instrumentsfor commitments to extend credit and standby letters of credit is representedby the contractual amount of those instruments. The Company uses the same credit policies in making commitments andconditional obligations as it does for on-balance-sheet instruments.

Commitments to extend credit are legally bindingagreements to lend to customers. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of fees. Since commitments may expire without being drawn upon, the totalcommitment amounts do not necessarily represent future liquidityrequirements.  The Company evaluates eachcustomer’s credit-worthiness on a case-by-case basis.  The amount of collateral obtained, ifconsidered necessary by the Company on extension of credit, is based onManagement’s credit assessment of the customer.

Financial standby letters of credit are conditionalcommitments issued by the Company to guarantee performance of a customer to athird party.  Those guarantees are issuedprimarily to support public and private borrowing arrangements, includingcommercial paper, bond financing, and similar transactions.  The Company’s performance under the guaranteeis required upon presentation by the beneficiary of the financial standbyletter of credit.  The credit riskinvolved in issuing letters of credit is essentially the same as that involvedin extending loan facilities to customers. The Company does not have any recourse provisions or hold any assetsthat would enable it to recover from third parties any of the amounts paidunder the guarantee.  The Company was notrequired to recognize any liability in connection with the issuance of thesefinancial standby letters of credit.

The following table summarizes outstanding financialletters of credit as of December 31, 2006 (in thousands):

|                      | ** ** | **Less than** | ** ** | **One to five** | ** ** | **Over five** | ** ** | ** ** | ** ** |
|----------------------|------------|--------------------|------------|---------------------------|------------|--------------------|------------|------------|------------|
| ** **           | ** ** | **one year**  | ** ** | **years**                 | ** ** | **years**          | ** ** | **Total**  | ** ** |
| Secured by:          |       |               |       |                      |       |               |       |       |       |
| Collateral           |       | $                  | 1,661      |                      | $          | 5                  |       | $          | 2,718      |   | $ | 4,384 |   |
| Guarantees           |       | 45                 |       | —                    |       | —             |       | 45         |       |
| Bank lines of credit |       | 1,028              |       | 19                        |       | —             |       | 1,047      |       |
|                 |       |               |       |                      |       |               |       |       |       |
|                 |       | 2,734              |       | 24                        |       | 2,718              |       | 5,476      |       |
|                 |       |               |       |                      |       |               |       |       |       |
| Unsecured            |       | 20                 |       | 39                        |       | —             |       | 59         |       |
|                 |       |               |       |                      |       |               |       |       |       |
| Total                |       | $                  | 2,754      |                      | $          | 63                 |       | $          | 2,718      |   | $ | 5,535 |   |

 

The Company has not incurred any losses on itscommitments in 2006, 2005 or 2004.

**InterestRate Floors, Caps and Swaps**

As part of the Company’s overall interest rate riskmanagement strategy, the Company has adopted a policy whereby the Company mayperiodically use derivative instruments to minimize significant fluctuations inearnings caused by interest rate volatility. This interest rate risk management strategy entails the use of interestrate floors, caps and swaps.  During thefourth quarter of 2006, the Company entered into a three-year interest ratefloor derivative agreement on $20,000,000 notional value of its prime-basedloan portfolio.  The transaction requiredthe payment of a premium by the Company to the seller for the right to receivepayments in the event national prime drops below a pre-determined level (strikerate), essentially converting floating rate loans to fixed rate loans when primedrops below the contractual strike rate. When purchased, the Company recorded an asset representing the fairvalue of the hedge at the time of purchase. The Company has designated this agreement as a cash flow hedge pursuantto SFAS No. 133.  Accordingly, the changein the fair value of the instrument related to the hedge’s intrinsic value, orapproximately $900, is recorded as a component of OCI in the consolidatedstatement of changes in shareholders’ equity and the portion of the change infair value related to 

62

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the time value expiration, or approximately $22,700,is recorded in the consolidated statement of income as a reduction of interestincome.  No gain or loss has beenrecognized in earnings due to hedge ineffectiveness as of December 31, 2006.  As of December 31, 2006, the Company does notexpect to reclassify any amount from OCI to earnings over the next twelvemonths and no hedge has been discontinued. As of December 31, 2006, the fair value of the derivative contractapproximated $225,000 and is a component of other assets in the consolidatedbalance sheet.

The use of derivative instruments exposes the Companyto credit risk in the event of non-performance by the agreement’s counterpartyto the derivative instrument.  In theevent of default by the counterparty, the Company would be subject to aneconomic loss that corresponds to the cost to replace the agreement.  The Company controls the credit riskassociated with the derivative instrument by dealing only with counterpartieswith high credit ratings, establishing counterparty exposure limits andmonitoring procedures.

As of December 31, 2006and 2005, the notional amount and estimated fair values of the Company’sfinancial instruments with off-balance sheet risk were as follows (in thousands):

|                                           | ** ** | **2006**     | ** ** | **2005**            | ** ** |
|-------------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                                | ** ** | **Notional** | ** ** | **Estimated**       | ** ** | **Notional** | ** ** | **Estimated** | ** ** |
| ** **                                | ** ** | **amount**   | ** ** | **fair value** | ** ** | **amount** | ** ** | **fair value** | ** ** |
| Off-balance  sheet financial instruments: |       |         |       |                |       |   |   |   |   |
| Commitments to extend credit              |       | $            | 71,277     |                | $          | 71,277 |   | $ | 67,958 |   | $ | 67,958 |   |
| Standby letters of credit                 |       | 5,535        |       | 5,535               |       | 4,508 |   | 4,508 |   |
| Cash flow hedge                           |       | 20,000       |       | 225                 |       | — |   | — |   |
|                                           |            |              |            |                     |            |  |  |  |  |  |  |  |  |

 

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

Basic earnings per share(EPS) is computed by dividing income available to common shareholders by theweighted-average number of common shares outstanding for the period.  Diluted EPS is computed in the same manner asbasic EPS but reflects the potential dilution that could occur if stock optionsto issue additional common stock were exercised, which would then result inadditional stock outstanding to share in or dilute the earnings of theCompany.  The Company maintains twoshare-based compensation plans that may generate additional potential dilutivecommon shares.  Generally, dilution wouldoccur if Company-issued stock options were exercised and converted into commonstock.

In the computation ofdiluted EPS, the Company uses the treasury stock method to determine thedilutive effect of its granted but unexercised stock options.  Under this method, the assumed proceedsreceived from shares issued, in a hypothetical stock option exercise, areassumed to be used to purchase treasury stock. Pursuant to the guidance of SFAS No. 128, *Earnings PerShare*, proceeds include: proceeds from the exercise of outstandingstock options; compensation cost for future service that the Company has notyet recognized; and any “windfall” tax benefits that would be credited directlyto shareholders’ equity when the grant generates a tax deduction (or areduction in proceeds if there is a charge to equity).  For a further discussion on the Company’sstock plans, see note 9, above.

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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, 2006, 2005 and 2004.  The number of shares and per-share data hasbeen adjusted, for all periods, to reflect a 10% stock dividend paid onFebruary 15, 2006:

|                                                                           | ** ** | **2006**  | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                      |       |      |       |      |       |      |       |
| Basic EPS:                                                                |       |      |       |      |       |      |       |
|                                                                      |       |      |       |      |       |      |       |
| Net income  available to common shareholders                              |       | $         | 4,125,283  |      | $          | 4,591,697 |       | $ | 3,364,474 |   |
|                                                                      |       |      |       |      |       |      |       |
| Weighted-average  common shares outstanding                               |       | 2,047,975 |       | 2,031,211 |       | 2,013,798 |       |
|                                                                      |       |      |       |      |       |      |       |
| Basic EPS                                                                 |       | $         | 2.01       |      | $          | 2.26      |       | $ | 1.67 |   |
|                                                                      |       |      |       |      |       |      |       |
| Diluted EPS:                                                              |       |      |       |      |       |      |       |
|                                                                      |       |      |       |      |       |      |       |
| Net income  available to common shareholders                              |       | $         | 4,125,283  |      | $          | 4,591,697 |       | $ | 3,364,474 |   |
|                                                                      |       |      |       |      |       |      |       |
| Weighted-average  common shares outstanding                               |       | 2,047,975 |       | 2,031,211 |       | 2,013,798 |       |
| Diluted  potential common shares                                          |       | 1,172     |       | 2,924     |       | 320       |       |
| Weighted-average  common shares and dilutive potential shares outstanding |       | 2,049,147 |       | 2,034,135 |       | 2,014,118 |       |
|                                                                      |       |      |       |      |       |      |       |
| Diluted EPS                                                               |       | $         | 2.01       |      | $          | 2.25      |       | $ | 1.67 |   |

 

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

The Company (on a consolidated basis) and the Bank aresubject to various regulatory capital requirements administered by the federalbanking 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 financialstatements.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCompany and the Bank must meet specific capital guidelines that involvequantitative measures of their assets, liabilities and certainoff-balance-sheet items as calculated under regulatory accountingpractices.  The capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk-weightings and other factors.  Prompt corrective action provisions are notapplicable to bank holding companies.

Quantitative measures, established by regulation toensure capital adequacy, require the Company and the Bank to maintain minimumamounts and ratios (set forth in the table below) of total and Tier I capital(as defined in the regulations) to risk-weighted assets (as defined), and ofTier I capital (as defined) to average assets (as defined).  As of December 31, 2006, the Company and theBank met all capital adequacy requirements to which they are subject.

 

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To be categorized as well capitalized, the Company and the Bank mustmaintain minimum total risk-based, Tier I risk-based and Tier I leverage ratiosas set forth in the following table.  TheCompany’s and the Bank’s actual capital amounts and ratios are also presentedin the table.  No amounts were deductedfrom capital for interest-rate risk in either 2006 or 2005.

 

|                                           | ** ** | **Actual** | ** ** | **For capital  adequacy purposes** | ** ** | **To be well capitalized  under prompt corrective  action provisions** | ** **        |
|-------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------------------------|-------------------|
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                           | ** **        | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| As of  December 31, 2006:            |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 57,777,905 |                                         | 14.0%      |                                                                                                 | 3$32,913,690 |   | 38.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 57,476,581 |                                         | 14.0%      |                                                                                                 | 3$32,908,004 |   | 38.0% |   | $ | 41,135,005 |   | 310.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to risk-weighted assets) |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 52,544,818 |                                         | 12.8%      |                                                                                                 | 3$16,456,845 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 52,322,924 |                                         | 12.7%      |                                                                                                 | 3$16,454,002 |   | 34.0% |   | $ | 24,681,003 |   | 36.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to average assets)       |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 52,544,818 |                                         | 9.3%       |                                                                                                 | 3$22,533,961 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 52,322,924 |                                         | 9.3%       |                                                                                                 | 3$22,518,803 |   | 34.0% |   | $ | 28,148,504 |   | 35.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| 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% |   |

 

The Bank can pay dividends to the Company equal to the Bank’s retainedearnings which approximated $43,557,000 at December 31, 2006.  However, such dividends are limited due tothe capital requirements discussed above.

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

During the ordinary course of business, loans are madeto executive officers, directors, greater than 5% shareholders and associatesof such persons.  These transactions areexecuted on substantially the same terms and at the rates prevailing at thetime for comparable transactions with others. These loans do not involve more than the normal risk of collectibilityor present other unfavorable features.  Asummary of loan activity with officers, directors, associates of such personsand shareholders who own more than 5% of the Company’s outstanding shares is asfollows:

|                                                                                                                  | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                                                             |       |       |       |       |       |       |       |
| Balance,  beginning                                                                                              |       | $          | 9,165,554  |       | $          | 9,243,286  |       | $ | 10,125,429 |   |
| Adjustments for  loans to individuals no longer officers, directors, associates or greater  than 5% shareholders |       | —     |       | (1,100     | )          | (473,612   | )          |
| Loans  sold/participated                                                                                         |       | —     |       | —     |       | (260,000   | )          |
| Additions                                                                                                        |       | 1,600,137  |       | 1,560,469  |       | 1,183,788  |       |
| Collections                                                                                                      |       | (1,736,818 | )          | (1,637,101 | )          | (1,332,319 | )          |
|                                                                                                             |       |       |       |       |       |       |       |
| Balance, ending                                                                                                  |       | $          | 9,028,873  |       | $          | 9,165,554  |       | $ | 9,243,286 |   |

65

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

|                                                    | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004**   | ** ** |
|----------------------------------------------------|------------|------------|------------|----------|------------|------------|------------|
|                                               |       |       |       |     |       |       |       |
| Number of  persons                                 |       | 2          |       | 2        |       | 2          |       |
|                                               |       |       |       |     |       |       |       |
| Balance,  beginning                                |       | $          | 7,446,933  |     | $          | 7,890,075  |       | $ | 9,386,280 |   |
| Additions                                          |       | 2,312,295  |       | 334,734  |       | 480,580    |       |
| Collections                                        |       | (1,203,870 | )          | (777,876 | )          | (748,322   | )          |
| Prior loan  balances no longer exceeding threshold |       | (1,206,191 | )          | —   |       | (1,228,463 | )          |
|                                               |       |       |       |     |       |       |       |
| Balance, ending                                    |       | $          | 7,349,167  |     | $          | 7,446,933  |       | $ | 7,890,075 |   |

 

As of December 31, 2006, 2005 and 2004, deposits fromexecutive officers, directors and associates of such persons approximated$7,876,000, $5,405,000 and $5,818,000, respectively.

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

The following is a summary of quarterly results ofoperations for the years ended December 31, 2006, 2005 and 2004 (in thousands,except per share data):

| 2006                                   | ** ** | ** ** | ** ** | **First  quarter** | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| Interest income                        |       | $          | 7,893      |               | $          | 8,371               |       | $                  | 8,595      |                | $          | 8,671     |       | $ | 33,530 |   |
| Interest expense                       |       | (3,663     | )          | (4,106             | )          | (4,281              | )          | (4,311             | )          | (16,361             | )          |
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| Net interest income                    |       | 4,230      |       | 4,265              |       | 4,314               |       | 4,360              |       | 17,169              |       |
| Provision for  loan losses             |       | (75        | )          | (175               | )          | (75                 | )          | —             |       | (325                | )          |
| Gain on sale of  investment securities |       | —     |       | —             |       | —              |       | 1                  |       | 1                   |       |
| Other income                           |       | 1,129      |       | 1,084              |       | 1,136               |       | 1,172              |       | 4,521               |       |
| Other expenses                         |       | (3,923     | )          | (3,948             | )          | (3,996              | )          | (4,012             | )          | (15,879             | )          |
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| Income before  income taxes            |       | 1,361      |       | 1,226              |       | 1,379               |       | 1,521              |       | 5,487               |       |
| Provision for  income taxes            |       | (329       | )          | (288               | )          | (349                | )          | (396               | )          | (1,362              | )          |
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| Net income                             |       | $          | 1,032      |               | $          | 938                 |       | $                  | 1,030      |                | $          | 1,125     |       | $ | 4,125 |   |
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| Net income per share                   |       | $          | 0.51       |               | $          | 0.45                |       | $                  | 0.51       |                | $          | 0.54      |       | $ | 2.01 |   |

 

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| 2005                                   | ** ** | ** ** | ** ** | **First  quarter** | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| 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        |       | 1,123              |       | 1,228               |       | 1,047              |       | 4,145               |       |
| Other expenses                         |       | (3,565     | )          | (3,611             | )          | (3,591              | )          | (3,794             | )          | (14,561             | )          |
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| 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 |   |

 

| 2004                                   | ** ** | ** ** | ** ** | **First  quarter** | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| 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                           |       | 934        |       | 1,070              |       | 1,149               |       | 991                |       | 4,144               |       |
| Other expenses                         |       | (3,272     | )          | (3,538             | )          | (3,658              | )          | (3,350             | )          | (13,818             | )          |
|                                   |       |       |       |               |       |                |       |               |       |                |       |
| 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 |   |

** **

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

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business.  However, in theopinion of Management of the Company after consulting with the Company’s legalcounsel, no legal proceedings are pending, which, if determined adversely tothe Company or the Bank, would have a material effect on the Company’sshareholders’ equity or results of operations. No legal proceedings are pending other than ordinary routine litigationincident to the business of the Company and the Bank.  In addition, to Management’s knowledge, nogovernment authorities have initiated or contemplated any material legalactions against the Company or the Bank.

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

In February 2006, the FASB issued SFAS No. 155, *Accounting for Certain Hybrid Financial Instruments* (SFAS155).  SFAS 155 permits fair valuere-measurement for any hybrid financial instruments that contains an embeddedderivative that otherwise would require bifurcation.  This statement is effective for all financialinstruments acquired or issued after the beginning of an entity’s first fiscalyear that begins after September 15, 2006. The Company does not expect the adoption of this pronouncement to have amaterial effect on its consolidated financial statements.

In March 2006, the FASB issued SFAS No. 156, *Accounting for Servicing of Financial Assets—an amendment of SFAS No.140* (SFAS 156).  SFAS 156requires that all separately recognized servicing assets and liabilities beinitially measured at fair value and permits (but does not require) subsequentmeasurement of servicing assets and liabilities at fair value.  This statement is effective for fiscal yearsbeginning after September 15, 2006.  TheCompany does not expect the adoption of this pronouncement to have a materialeffect on its consolidated financial statements.

In July 2006, the FASB issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109* (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement 109, *Accounting for Income Taxes.* FIN 48 is effective for the year endedDecember 31, 2007.  The Company does notexpect the adoption of this pronouncement to have a material effect on itsconsolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (SFAS 157), to establish aconsistent framework for measuring fair value and expand disclosures on fairvalue measurements.  SFAS 157 iseffective for fiscal years beginning after November 15, 2007.  The Company does not expect the adoption ofthis pronouncement to have a material effect on its consolidated financialstatements.

In February 2007, FASB issued SFAS 159, *The Fair Value Option for Financial Assets and Financial Liabilities,including an amendment of FASB Statement No. 115* (SFAS 159).  SFAS 159 permits entities to choose tomeasure many financial instruments at fair value that are not currentlyrequired to be measured at fair value. It also establishes presentation and disclosure requirements designed tofacilitate comparisons between entities that choose different measurementattributes for similar types of assets and liabilities.  SFAS 159 is effective as of the beginning ofan entity’s first fiscal year that begins after November 15, 2007.  The Company does not expect the adoption ofthis pronouncement to have a material effect on its consolidated financialstatements.

**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,** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                                        |       |                  |       |   |   |
| Assets:                                     |       |                  |       |   |   |
| Cash                                        |       | $                     | 17         |   | $ | 8 |   |
| Investment in subsidiary                    |       | 51,275                |       | 48,508 |   |
| Securities available-for-sale               |       | 447                   |       | 433 |   |
|                                        |       |                  |       |   |   |
| Total                                       |       | $                     | 51,739     |   | $ | 48,949 |   |
|                                        |       |                  |       |   |   |
| Liabilities and  shareholders’ equity: |       |                  |       |   |   |
| Liabilities                                 |       | $                     | 127        |   | $ | 103 |   |
| Shareholders’ equity                   |       | 51,612                |       | 48,846 |   |
|                                        |       |                  |       |   |   |
| Total                                       |       | $                     | 51,739     |   | $ | 48,949 |   |

 

68

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**Condensed Income Statements**

|                                                 | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                            |       |                                        |       |   |   |   |   |
| Income:                                         |       |                                        |       |   |   |   |   |
| Equity in  undistributed earnings of subsidiary |       | $                                           | 2,972      |   | $ | 3,504 |   | $ | 2,311 |   |
| Dividends from  subsidiary                      |       | 1,253                                       |       | 1,167 |   | 1,156 |   |
| Other income                                    |       | 14                                          |       | 12 |   | 13 |   |
|                                            |       |                                        |       |   |   |   |   |
| Total income                                    |       | 4,239                                       |       | 4,683 |   | 3,480 |   |
|                                            |       |                                        |       |   |   |   |   |
| Operating expenses                              |       | 163                                         |       | 136 |   | 168 |   |
|                                            |       |                                        |       |   |   |   |   |
| Income before income  taxes                     |       | 4,076                                       |       | 4,547 |   | 3,312 |   |
|                                            |       |                                        |       |   |   |   |   |
| Credit for income taxes                         |       | 49                                          |       | 45 |   | 52 |   |
|                                            |       |                                        |       |   |   |   |   |
| Net income                                      |       | $                                           | 4,125      |   | $ | 4,592 |   | $ | 3,364 |   |

 

**Condensed Statements of Cash Flows**

|                                                                      | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows from  operating activities:                               |       |                                        |       |   |   |   |   |
| Net income                                                           |       | $                                           | 4,125      |   | $ | 4,592 |   | $ | 3,364 |   |
| Adjustments to  reconcile net income to net cash used in operations: |       |                                        |       |   |   |   |   |
| Equity in  earnings of subsidiary                                    |       | (4,225                                      | )          | (4,671 | ) | (3,467 | ) |
| Stock-based  compensation expense                                    |       | 29                                          |       | — |   | — |   |
| Deferred income  taxes                                               |       | —                                      |       | — |   | 2 |   |
| Changes in other  assets and liabilities, net                        |       | 19                                          |       | 16 |   | (11 | ) |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash used in  operating activities                               |       | (52                                         | )          | (63 | ) | (112 | ) |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows provided by  investing activities:                        |       |                                        |       |   |   |   |   |
| Dividends  received from subsidiary                                  |       | 1,253                                       |       | 1,167 |   | 1,156 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows from  financing activities:                               |       |                                        |       |   |   |   |   |
| Dividends paid,  net of dividend reinvestment                        |       | (1,240                                      | )          | (1,133 | ) | (1,110 | ) |
| Exercise of  stock options                                           |       | —                                      |       | — |   | 16 |   |
| Withholdings to  purchase capital stock                              |       | 48                                          |       | 32 |   | 53 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash used in  financing activities                               |       | (1,192                                      | )          | (1,101 | ) | (1,041 | ) |
|                                                                 |       |                                        |       |   |   |   |   |
| Net increase in  cash                                                |       | 9                                           |       | 3 |   | 3 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash, beginning                                                      |       | 8                                           |       | 5 |   | 2 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash, ending                                                         |       | $                                           | 17         |   | $ | 8 |   | $ | 5 |   |

 

69

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**20.****       CUMULATIVE EFFECT ADJUSTMENTS**

In September 2006, the SEC staff issued StaffAccounting Bulletin (SAB) No. 108 *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements.* SAB 108was issued in order to eliminate the diversity of practice surrounding howpublic companies quantify financial statement misstatements.

Traditionally, there have been two widely-recognizedmethods for quantifying the effects of financial statement misstatements: the “roll-over”method and the “iron curtain” method. The roll-over method focuses primarily on the impact of a misstatementon the income statement, including the reversing effect of prior yearmisstatements, but its use can lead to the accumulation of misstatements in thebalance sheet.  The iron-curtain method,on the other hand, focuses primarily on the effect of correcting the period-endbalance sheet with less emphasis on the reversing effects of prior year errorson the income statement.  Prior to theCompany’s application of the guidance in SAB 108, the Company used theroll-over method for quantifying financial statement misstatements.

In SAB 108, the SEC staff established an approach thatrequires quantification of financial statements misstatements based on theeffects of the misstatements on each of the Company’s financial statements andthe related financial statement disclosures. This model is commonly referred to as the “dual approach” because itrequires quantification of errors under both the roll-over and the iron curtainmethods.

SAB 108 permits existing public companies to initiallyapply its provisions either by (i) restating prior financial statements as ifthe dual approach had always been applied or (ii) recording the cumulativeeffect of initially applying the dual approach as adjustments to the carryingvalues of assets and liabilities as of January 1, 2006 with an offsettingadjustment recorded to the opening balance of retained earnings.  The Company elected to record the effects ofapplying SAB 108 using the cumulative effect transition method.  The following table summarizes the effects ofapplying the guidance in SAB 108:

|                         | ** ** | **Period in which misstatement originated (1)** | ** ** |
|-------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **              | ** ** | **Cumulative  prior to  January 1,**                           | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **Adjustment  recorded as of  January 1,** | ** ** |
| ** **              | ** ** | **2004**                                                                 | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Impact on:              |       |                                                                     |       |   |   |   |   |   |   |
| Other assets(2)         |       | $                                                                        | 440,347    |   | $ | 73,240 |   | $ | (12,002 | ) | $ | 501,585 |   |
| Other liabilities(3)    |       | 7,055                                                                    |       | 4,703 |   | 7,441 |   | 19,199 |   |
| Deferred income tax(4)  |       | (152,117                                                                 | )          | (26,501 | ) | 1,551 |   | (177,067 | ) |
| Impact on net income(5) |       | $                                                                        | 295,285    |   | $ | 51,442 |   | $ | (3,010 | ) |   |   |
| Retained  earnings(6)   |       |                                                                     |       |   |   |   |   | $ | 343,717 |   |

----

(1)             TheCompany previously quantified these misstatements under the roll-over methodand concluded that they were immaterial both individually and in the aggregate.

(2)             Beginningin 1999, the Company began accounting for its investment in limitedpartnerships under the cost method.  In2006, Management decided that the Company should apply the provisions of theequity method for accounting for its investment in limited partnerships.  As a result of applying the provisions of theequity method, losses from investment in limited partnerships, a component ofother expenses on the consolidated statement of income, was understated by$440,000 (cumulatively) in years prior to 2004, by $73,000 in 2004 andoverstated by $12,000 in 2005.  TheCompany recorded a $502,000 decrease in its investment in limited partnerships,a component of other assets in the consolidated balance sheet, with acorresponding reduction in retained earnings upon changing to the equity methodof accounting for investments in limited partnerships.

(3)             Beginningin 2002, the Company was not recognizing rent expense on a long-term facilitylease using the straight-line method as required by generally acceptedaccounting principles.  As a result, rentexpense, a component of premises and equipment on the consolidated statement ofincome, was understated by $7,000 (cumulatively) in years prior to 2004, by$5,000 in 2004 and $7,000 in 2005.  TheCompany recorded a $19,000 increase in accrued rent, a component of otherliabilities in the consolidated balance sheet, with a corresponding reductionin retained earnings to correct this misstatement.

(4)             Asa result of the misstatements described above, the provision for income taxeswas overstated by $152,000 (cumulatively) in years prior to 2004, by $27,000 in2004 and understated by $2,000 in 2005. The Company recorded an increase in its deferred income tax assets, acomponent of other assets in the consolidated balance sheet, in the amount of$177,000 with a corresponding increase in retained earnings to correct thesemisstatements.

(5)             Representsthe net overstatement (understatement) of net income for the indicated periodsresulting from these misstatements.

(6)             Representsthe net reduction to retained earnings recorded as of January 1, 2006 to recordthe initial application of SAB 108.

70

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***Item 9:  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON 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***

***Item 10:***  DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE

The informationrequired under Items 401 and 407(c)(3), (d)(4) and (d)(5) of Regulation S-K isincorporated by reference herein, to the information presented in the Company’sdefinitive Proxy Statement for its 2007 Annual Meeting of Shareholders to befiled with the SEC.

***Section16(a) Beneficial Ownership Reporting Compliance***

The informationrequired under this section is incorporated by reference herein, to theinformation presented in the Company’s definitive Proxy Statement for its 2007Annual Meeting of Shareholders to be filed with the SEC.

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

The Companyadopted a written code of ethics that applies to our directors, officers andemployees, including our chief executive officer and chief financial officer,which is available on our investor relations website athttp://www.the-fidelity.com under the heading “Corporate Governance” of theInvestor Relations link.  In addition,copies of our code of ethics will be provided to shareholders upon writtenrequest 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 incorporated by referenceherein, to the information presented in the Company’s 2007 definitive ProxyStatement.

#### ***Item 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT******ANDRELATED STOCKHOLDER MATTERS***

The informationrequired by this Item is incorporated by reference herein, to the informationpresented in the Company’s 2007 definitive Proxy Statement.

##### ***Item 13: CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS, AND DIRECTOR INDEPENDENCE***

The informationrequired by this Item, relating to transactions with management and others,certain business relationships and indebtedness of management, is set forthabove in Item 8 “Financial Statements and Supplementary Data” and isincorporated by reference herein to the information presented in the Company’s2007 definitive Proxy Statement.

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

The informationrequired by this Item is incorporated by reference herein, to the informationpresented in the Company’s 2007 definitive Proxy Statement.

71

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***PART IV***

***Item 15: 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 Accounting Firm.         |
|--------|-------------------------------------------------------------------|
|   | 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)Financial Statement 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 or incorporatedby reference as a part of this Form 10-K:

***3(i) Amended and RestatedArticles of Incorporation of Registrant.*** Incorporated by reference to Exhibit 3(i) toRegistrant’s Registration Statement No. 333-90273 on Form S-4/A, filed with theSEC on November 3, 1999 and as amended on April 6, 2000.

***3(ii) Bylaws of Registrant.*** Incorporated by reference to Exhibit 3(ii) toRegistrant’s Registration Statement No. 333-90273 on Form S-4/A, filed with theSEC on November 3, 1999 and as amended on April 6, 2000.

****10.1 1998 IndependentDirectors Stock Option Plan of The Fidelity Deposit and Discount Bank, asassumed by Registrant.*** Incorporated by reference to Exhibit 10.1 toRegistrant’s Registration Statement No. 333-90273 on Form S-4/A, filed with theSEC on November 3, 1999 and as amended on April 6, 2000.

****10.2 1998 Stock Incentive Planof The Fidelity Deposit and Discount Bank, as assumed by Registrant.*** Incorporated by reference to Exhibit 10.2 ofRegistrant’s Registration Statement No. 333-90273 on Form S-4/A, filed with theSEC on November 3, 1999 and as amended on April 6, 2000.

****10.3 Form of DeferredCompensation Plan of The Fidelity Deposit and Discount Bank. ***Incorporated byreference to Exhibit 10.3 to Registrant’s Registration Statement No. 333-45668 onForm S-1/A, filed with the SEC on September 12, 2000 and as amended on October11, 2000.

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

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

****10.6 Registrant’s 2000Stock Incentive Plan. ***Incorporatedby 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 2002Employee 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.

****10.8 Employment Agreementbetween Fidelity D & D Bancorp, Inc., The Fidelity Deposit and DiscountBank******and Steven C. Ackmann,dated June 21, 2004. ***Incorporatedby reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filedwith the SEC on June 24, 2004.

****10.9 Complete SettlementAgreement and General Release between Michael F. Marranca, Registrant and TheFidelity Deposit and Discount Bank, dated July 30, 2004***.  Incorporated by reference to Exhibit 99.1 toRegistrant’s Current Report on Form 8-K filed with the SEC on August 10, 2004.

72

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****10.10 Change of Controland Severance Agreement between James T. Gorman, Registrant and The FidelityDeposit and Discount Bank, dated September 19, 2005. ***Incorporated byreference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed withthe SEC on September 22, 2005.

****10.11 Amendment andTermination of the Deferred Compensation Agreement with Joseph J. Earyes,Daniel Santaniello, Registrant and The Fidelity Deposit and Discount Bank,dated November 1, 2005. ***Incorporatedby reference to Exhibits 99.1 and 99.2 to Registrant’s Current Report on Form8-K filed with the SEC on November 3, 2005.

****10.12 Amendment to theComplete Settlement Agreement and General Release between Michael F. Marranca,Registrant and The Fidelity Deposit and Discount Bank, dated November 4, 2005*. **Incorporated by referenceto****Exhibit 99.1 to Registrant’s CurrentReport on Form 8-K filed with the SEC on November 9, 2005.

****10.13 Change of ControlAgreements with Daniel J. Santaniello, Salvatore R. DeFrancesco, James T.Gorman, Registrant and The Fidelity Deposit and Discount Bank, dated March 21,2006. ***Incorporatedby reference to Exhibit 99.1, 99.2 and 99.3, respectively, to Registrant’sCurrent Report on Form 8-K filed with the SEC on March 27, 2006.

***11 Statement regardingcomputation of earnings per share. ***Includedherein in Note 13 “Earnings per Share,” contained within the notes toconsolidated financial statements, and incorporated herein by reference.

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

***13 Annual Report toShareholders. ***Incorporatedby reference to the 2006 Annual Report to Shareholders filed with the SEC onForm ARS.

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

***21 Subsidiaries of theRegistrant.***

***23 Consent of IndependentRegistered Public Accounting Firm.***

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

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

***32.1 Certification of PrincipalExecutive 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 Certification of PrincipalFinancial 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.***

----

*  Management contract or compensatory plan or arrangement.

73

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|                      | **FIDELITY D & D BANCORP, INC.** |                                                     |
|----------------------|--------------------------------------|----------------------------------------------------------|
|                 | (Registrant)                         |                                                     |
|                 |                                 |                                                     |
|                 |                                 |                                                     |
|                 | By:                                  | /s/ STEVEN C.  ACKMANN                                   |   |
| Date: March 13, 2007 |                                 |    Steven C. Ackmann,                          |
|                 |                                 |     President and Chief Executive Officer |
|                 |                                 |                                                     |
|                 |                                 |                                                     |
|                 | By:                                  | /s/ SALVATORE  R. DEFRANCESCO, JR.                       |   |
| Date: March 13, 2007 |                                 |    Salvatore R. DeFrancesco, Jr.,              |
|                 |                                 |     Treasurer and Chief Financial Officer |
|                      |                                      |                                                          |  |  |  |

 

74

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Pursuant to therequirements of the Securities and Exchange Act of 1934, this report has beensigned below by the following person on behalf of the registrant and in thecapacities and on the dates indicated.
|        | ** **                               | **DATE** | ** **     |
|--------|------------------------------------------|----------|----------------|
|   |                                     |     |           |
| By:    | /s/ STEVEN C.  ACKMANN                   |     | March 13, 2007 |   |
|   | Steven C. Ackmann, President and         |     |           |
|   | Chief Executive Officer                  |     |           |
|   |                                     |     |
| By:    | /s/ SALVATORE  R. DEFRANCESCO, JR.       |     | March 13, 2007 |   |
|   | Salvatore R. DeFrancesco, Jr., Treasurer |     |           |
|   | and Chief Financial Officer              |     |           |
|   |                                     |     |
| By:    | /s/ SAMUEL C.  CALI                      |     | March 13, 2007 |   |
|   | Samuel C. Cali, Chairman Emeritus        |     |           |
|   | and Director                             |     |           |
|   |                                     |     |
| By:    | /s/ PATRICK J.  DEMPSEY                  |     | March 13, 2007 |   |
|   | Patrick J. Dempsey, Chairman             |     |           |
|   | of the Board of Directors and Director   |     |           |
|   |                                     |     |
| By:    | /s/ PAUL A.  BARRETT                     |     | March 13, 2007 |   |
|   | Paul A. Barrett, Secretary and Director  |     |           |
|   |                                     |     |
| By:    | /s/ JOHN T.  COGNETTI                    |     | March 13, 2007 |   |
|   | John T. Cognetti, Assistant Secretary    |     |           |
|   | and Director                             |     |           |
|   |                                     |     |
| By:    | /s/ MICHAEL J.  MCDONALD                 |     | March 13, 2007 |   |
|   | Michael J. McDonald, Vice Chairman       |     |           |
|   | of the Board of Directors and Director   |     |           |
|   |                                     |     |
| By:    | /s/ DAVID L.  TRESSLER                   |     | March 13, 2007 |   |
|   | David L. Tressler, Director              |     |           |
|   |                                     |     |
| By:    | /s/ MARY E.  MCDONALD                    |     | March 13, 2007 |   |
|   | Mary E. McDonald, Director               |     |           |
|   |                                     |     |
| By:    | /s/ BRIAN J.  CALI                       |     | March 13, 2007 |   |
|   | Brian J. Cali, Director                  |     |           |
|        |                                          |          |                |  |  |

 

75

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**EXHIBITINDEX**
|                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | **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/A, 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/A, 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/A, 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/A, 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/A, 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/A, 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, 2001 and 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.                                                                                                            | *          |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                              |       |
| ***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.                                                                          | *          |

 

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| ** **                                                                                                                                                                                                                                                                                                                                                    | ** **   | **Page** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|----------|------------|
| ***10.13 Change of Control Agreements with Daniel J.  Santaniello, Salvatore R. DeFrancesco, James T. Gorman, Registrant and The  Fidelity Deposit and Discount Bank, dated March 21, 2006.***Incorporated  by reference to Exhibit 99.1, 99.2 and 99.3, respectively, to Registrant’s  Current Report on Form 8-K filed with the SEC on March 27, 2006. | *            |
| *** ***                                                                                                                                                                                                                                                                                                                                                  | *** *** |
| ***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.                                                                                                                             | 63           |
| *** ***                                                                                                                                                                                                                                                                                                                                                  | *** *** |
| ***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 2006 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.***                                                                                                                                                                                                                                                                                                                     | 78           |
|                                                                                                                                                                                                                                                                                                                                                          |         |
| ***23  Consent of Independent Registered Public Accounting Firm.***                                                                                                                                                                                                                                                                                           | 79           |
| *** ***                                                                                                                                                                                                                                                                                                                                                  | *** *** |
| ***31.1  Rule 13a-14(a) Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                                                      | 80           |
| *** ***                                                                                                                                                                                                                                                                                                                                                  | *** *** |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                                                      | 81           |
| *** ***                                                                                                                                                                                                                                                                                                                                                  | *** *** |
| ***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.***                                                                                                                                                                                           | 82           |
| *** ***                                                                                                                                                                                                                                                                                                                                                  | *** *** |
| ***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.***                                                                                                                                                                                           | 83           |

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*  Incorporated by Reference

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