**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-K**







**Annual
      Report Pursuant to Section 13 or 15(d) of the**


**Securities
      Exchange Act of 1934**




**For the fiscal year ended:
                December 31, 2006**
              ***Commission
                  File Number:
                  000-13086***




**FNB
      Financial Services Corporation**


**(Exact
      name of Registrant as specified in its Charter)**




**North
                Carolina**
            
            **56-1382275**(State
                of Incorporation)
            
            (I.R.S.
                Employer Identification No.)**1501
                Highwoods Blvd., Suite 400****Greensboro,
                North Carolina**
            
            **27410**(Address
                of principal executive offices)
            
            (Zip
                Code)




**(336)
      369-0900**


(Registrant's
      telephone number, including area code)





**Securities
      Registered Pursuant to Section 12(g) of the Securities Exchange Act of 1934:**




Title
                of each class
              
              Common
                Stock, $1.00 stated value
            
            Name
                of each exchange
              on
                which registered
              
              Nasdaq
                Global Market




Indicate
      by check mark if the registrant is a well-known seasoned issuer as defined
      in
      Rule 405 of the Securities Act. Yes o
      No x





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





Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period that the
      Registrant was required to file such reports), and (2) has been subject to
      such filing requirements for the past 90 days. Yes x No o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the
      best of the Registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference to Part III of this Form 10-K or any
      amendment to this Form 10-K. o





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





Large
                accelerated filer o
            
            Accelerated
                filerx
            
            Non-accelerated
                filer o





Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act) Yes o No x




The
      aggregate market value of the Registrant’s voting and nonvoting common equity
      held by non-affiliates of the Registrant, based on the average bid and asked
      price of such common equity on the last business day of the Registrant’s most
      recently completed second fiscal quarter, was approximately $104.7 million.
      As
      of March 5, 2007 (the most recent practicable date), the Registrant had
      outstanding 7,063,952 shares of Common Stock.




The
      Exhibit Index begins on page 93.











**FNB
      Financial Services Corporation**


**Form
      10-K**


**Table
      of Contents**





**Index**
              
              
              PagePART
                  IItem
                  1.
              
              BUSINESS
              4Item1A.
              
              RISK
                  FACTORS
              16Item
                  2.
              
              PROPERTIES
              19Item
                  3.
              
              LEGAL
                  PROCEEDINGS
              19Item
                  4.
              
              SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY HOLDERS
              19PART
                  IIItem
                  5.
              
              MARKET
                  FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
                  PURCHASES OF EQUITY SECURITIES
              20Item 6.
              
              SELECTED
                  FINANCIAL DATA
              22Item
                  7.
              
              MANAGEMENT’S
                  DISCUSSION AND ANALYSISOF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS
              23Item
                  7A.
              
              QUANTITATIVE
                  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
              43Item
                  8.
              
              FINANCIAL
                  STATEMENTS AND SUPPLEMENTARY DATA
              47Item
                  9.
              
              CHANGES
                  IN AND DISAGREEMENTS WITH ACCOUNTANTSON
                  ACCOUNTING AND FINANCIAL DISCLOSURE
              76Item 9A.
              
              CONTROLS
                  AND PROCEDURES
              76Item
                  9B.
              
              OTHER
                  INFORMATION
              76PART
                  IIIItem
                  10.
              
              DIRECTORS,
                  EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
              77Item
                  11.
              
              EXECUTIVE
                  COMPENSATION
              78Item
                  12.
              
              SECURITY
                  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                  STOCKHOLDER MATTERS
              89Item
                  13.
              
              CERTAIN
                  RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
                  INDEPENDENCE
              90Item
                  14.
              
              PRINCIPAL
                  ACCOUNTANT FEES AND SERVICES
              91PART
                  IVItem
                  15.
              
              EXHIBITS
                  AND FINANCIAL STATEMENT SCHEDULES
              93SIGNATURES
              96








*Table
            of Contents*





**Statement
      Regarding Forward-Looking Statements**




This
      Annual Report on Form 10-K contains and incorporates by reference statements
      relating to future results of FNB Financial Services Corporation (the “Company”)
      that are considered “forward-looking” within the meaning of Section 27A of the
      Securities Act of 1933, as amended (the “Securities Act”), and Section 21B of
      the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  The
      forward-looking statements are principally, but not exclusively, contained
      in
      Item 1: “Business” and Item 7: “Management’s Discussion and Analysis of
      Financial Condition and Results of Operations.”  These statements relate
      to, among other things, expectations concerning the proposed merger of the
      Company, loan demand, growth and performance, simulated changes in interest
      rates and the adequacy of our allowance for loan losses.  These statements
      involve known and unknown risks, uncertainties and other factors that may cause
      our actual results, performance or achievements to be materially different
      from
      any future results, performance or achievements expressed or implied by the
      forward-looking statements. Actual results may differ materially from those
      expressed or implied as a result of certain risks and uncertainties, including,
      but not limited to: the risk that the Company’s proposed merger with LSB
      Bancshares, Inc. (“LSB”) will not receive necessary regulatory and shareholder
      approvals, or will not be completed within the expected timeframe; the risk
      that
      the business of LSB and the Company will not be integrated successfully or
      such
      integration may be more difficult, time consuming or costly than expected;
      expected revenue synergies and cost savings from the merger may not be fully
      realized or realized within the expected timeframe; revenues following the
      merger may be lower than expected, customer and employee relationships and
      business operations may be disrupted by the merger, changes in political and
      economic conditions, interest rate fluctuations, competitive product and pricing
      pressures within our markets, equity and fixed income market fluctuations,
      personal and corporate customers’ bankruptcies, inflation, acquisitions and
      integrations of acquired businesses, technological changes, changes in law
      and
      regulations, changes in fiscal, monetary, regulatory and tax policies, monetary
      fluctuations, success in gaining  regulatory approvals when required, as
      well as, other risks and uncertainties reported from time to time in our filings
      with the Securities and Exchange Commission (the “SEC”).  Forward-looking
      statements and factors that may cause actual results to differ materially are
      also discussed at the beginning of Item 7:  “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations.” Broadly speaking,
      forward-looking statements include:




• descriptions
      of plans, objectives, agreements, or expectations concerning the proposed merger
      with LSB;


• projections
      of the Company’s revenues, income, earnings per share, capital expenditures,
      dividends, capital structure or other financial items;


• descriptions
      of plans or objectives of the Company’s management for future operations,
      products or services;


• forecasts
      of the Company’s future economic performance; and


• descriptions
      of assumptions underlying or relating to any of the foregoing.




The
      Company may make forward-looking statements discussing management’s expectations
      about:




• future
      business combinations, including the proposed merger with LSB;


• future
      credit losses and nonperforming assets;


• the
      impact of new accounting standards;


• future
      short-term and long-term interest rate levels and their impact on the Company’s
      net interest margin, net income, liquidity and capital; and


• future
      capital expenditures.




Forward-looking
      statements discuss matters that are not historical facts.  Because they
      discuss future events or conditions, forward-looking statements often include
      words such as “anticipate,” “might,” “believe,” “estimate,” “expect,” “plan,”
“could,” “may,” “should,” “will,” “would,” or similar expressions.  Do not
      unduly rely on forward-looking statements.  They detail management’s
      expectations about the future and are not guarantees.  Forward-looking
      statements speak only as of the date they are made, and management may not
      update them to reflect changes that occur after the date the statements are
      made.





*Table
          of Contents*





**PART
      I**


**Item
                  1.**
              **BUSINESS**





**General**




FNB
        Financial Services Corporation (the “Company”) is a North Carolina (“NC”) bank
        holding company with consolidated assets of $1.01 billion, deposits of $818.6
        million and shareholders’ equity of $72.7 million as of December 31, 2006.
 
 In
        1984
        the Company was organized to serve as a holding company for FNB Southeast
        (the
“Bank”). The Company is registered with the Board of Governors of the Federal
        Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of
        1956, as amended (the “BHCA”) and the bank holding company laws of North
        Carolina. The Company’s office is located at 1501 Highwoods Boulevard, Suite
        400, Greensboro, NC 27410. The Company’s principal source of income is earnings
        on investments, including any dividends that are declared and paid by the
        Bank
        on its capital stock.
 
 The
        Bank
        is the sole banking subsidiary of the Company. A trust ( FNB
        Financial Services Capital
        Trust I) was formed as a subsidiary to the Company to facilitate the issuance
        of
        Trust-Preferred Securities, as a means of capital raising for the Company.
        The
        trust is not consolidated in the financial statements. The Bank itself has
        two
        subsidiaries, FNB Southeast Investment Services, Inc. and FNB Southeast Mortgage
        Corporation. The majority of the Company’s operations are located at the Bank
        level.
 
 In
        1910,
        the Bank commenced operations as “Rockingham Savings Bank and Trust.” In 1918,
        it was chartered as a national bank, under the name “First National Bank of
        Reidsville.” In 1997, the Bank changed its name to “First National Bank
        Southeast” to reflect its expansion into new markets, and in 1999, was
        chartered as a NC state bank and changed its name to “FNB Southeast.”
 
 From
        its
        early base in Rockingham County, NC, by the end of 2006 the Bank’s operations
        have grown to cover four market areas: the Triad and Coastal Regions of NC,
        and
        the Southwest and Shenandoah Valley Regions of Virginia (“VA”) with a total of
        17 branches, 13 in NC and four in VA.
 
 The
        Bank
        is community oriented and focuses primarily on offering commercial, real
        estate
        and consumer loans, deposit and other financial services to individuals,
        small
        to medium-sized businesses and other organizations in its market areas. It
        emphasizes individualized services and community involvement, while at the
        same
        time providing its customers with the financial sophistication and selection
        of
        products typically offered by larger banks. It competes successfully with
        larger
        banks located within and outside NC and VA by retaining its personalized
        approach and community focus.
 
 The
        Bank
        has a vision of becoming the premier and preferred community bank within
        its
        markets through the following three-part strategy: (1) generate internal
        growth
        at its existing banking offices by offering new and complementary services
        and
        products; (2) position the Bank to manage its planned growth by adding
        experienced personnel and upgrading its internal systems and procedures;
        and (3)
        increase market share and geographic reach through opportunistic acquisitions
        in
        markets where the mix of economic, operational, cultural and other factors
        are
        favorable. As part of this strategy, the Bank has: (a) increased the number
        of
        its NC banking offices to thirteen; (b) expanded the number of its full-time
        personnel by adding new employees, including several senior executives; (c)
        completed the merger with Black Diamond Savings Bank, FSB (“Black Diamond”) to
        extend the Bank’s reach into selected VA markets; (d) enhanced its mix of
        products and services by forming investment services and mortgage banking
        subsidiaries; (e) relocated its corporate headquarters to Greensboro, NC.;
        (f)
        completed a systematic review and revision of its loan administration, loan
        policy and credit procedures; and (g) completed its leadership transition
        strategy by promoting Pressley A. Ridgill to President and Chief Executive
        Officer (“CEO”) of the Company and the Bank. Ridgill joined the Bank in 2000 as
        its Executive Vice President and Chief Operating Officer and during this
        time
        has directed the operations of numerous areas within the Bank and the Company,
        including Finance, Deposit Operations, Information Technology, Risk Management,
        and Investor Relations.







4
 *Table
            of Contents*





Since
        2004, the Bank has also added several key members to its management team
        to
        support its continued growth. During 2006, the Bank completed the renovation
        of
        its Operations Center in Reidsville, NC and opened its new Coastal Region
        Headquarters in Wilmington, NC. The Bank also plans, where appropriate, to
        continue to upgrade its systems and procedures and refine its ability to
        offer
        customers sophisticated services without sacrificing its personalized approach.
 
 **Memorandum
        of Understanding - Lifted as of 12/31/2006**
 
 In
        June
        2005, the Bank discovered that its lending activities in its Shenandoah Valley
        Region were not being operated in compliance with the Bank’s policies and
        procedures and certain regulatory guidelines. The Bank began internal
        investigations and engaged independent consultants to review the Harrisonburg
        loan portfolio and aspects of the Bank’s credit and credit administration
        operations.
 
 Upon
        the
        commencement in October 2005 of the Federal Reserve Bank of Richmond’s (the
“Reserve Bank”) periodic safety and soundness examination of the Bank, the Bank
        advised the Reserve Bank of the findings of its internal investigations and
        of
        its independent consultants. In its examination, the Reserve Bank identified
        additional items of concern.
 
 On
        February 23, 2006, the Company and the Bank entered into a Memorandum of
        Understanding (the “MOU”) with the Reserve Bank and the Office of the North
        Carolina Commissioner of Banks (the “Commission”). The MOU generally
        required:
 
 §
              The
                  creation of a Compliance Committee by the Boards of Directors of
                  the
                  Company and the Bank to oversee compliance by the Company and the
                  Bank
                  with the MOU.
 §
              The
                  engagement of an independent consultant to advise the Boards on
                  the
                  characteristics, composition, and structure of the Boards and the
                  structure and composition of management.
 §
              The
                  adoption of a written plan to strengthen the Bank’s loan administration
                  capacity through supplementing and improving its lending and credit
                  administration staffing, management information systems, reporting
                  procedures, lending policies, and internal loan review function.
 §
              The
                  adoption of a written plan to address its risk position with respect
                  to
                  certain loans identified by its internal reviews and by its independent
                  consultants and also by the Reserve Bank.
 §
              An
                  increased focus upon compliance with federal regulations concerning
                  real
                  estate appraisal procedures and federal guidelines concerning loans
                  in
                  excess of certain loan-to-value standards.
 §
              Increased
                  resources and staffing for the Bank’s internal audit function.
 
 The
        Company and the Bank took prompt and aggressive actions to address the issues
        discovered in the Bank’s internal reviews and through independent consultants,
        as well as those additional concerns raised by the Reserve Bank.
 
 Following
        the most recent joint safety and soundness examination conducted by the Reserve
        Bank and the Commission which was completed in late 2006, the Company and
        the
        Bank were found to be substantially in compliance with the MOU. Effective
        December 31, 2006, the MOU was lifted.


5
 *Table
            of Contents*








**Merger
      of Equals with LSB Bancshares, Inc. (“LSB”)**





During
      the period that an MOU, having the general provisions discussed above, is in
      effect, the financial institution is discouraged from seeking to expand through
      acquisitions or requesting approval to open additional branches. Accordingly,
      during the period of the MOU, the Bank deferred pursuit of its strategy of
      expanding its current markets or entering into new markets through acquisition
      or branching. Notwithstanding the MOU, the Bank opened its new Coastal Region
      headquarters in Wilmington, NC in October, 2006, having received regulatory
      permission to do so prior to the MOU.





Upon
      the
      lifting of the MOU, the Company returned to its previous strategy of
      strengthening its presence in existing markets and opportunistically reaching
      into new markets in NC and VA. In pursuit of this strategy, on February 26,
      2007
      (outwith the period of this Annual Report on Form 10-K) the Company entered
      into
      a definitive agreement with LSB to combine in a merger of equals. Details of
      the
      merger, including the Company’s joint press release and copies of the Agreement
      and Plan of Merger and Agreement and Plan of Bank Merger have been filed with
      the Securities and Exchange Commission (the “SEC”) and are available by
      accessing FNB’s website ( http://www.fnbsoutheast.com) ,
      the
      SEC’s website ( http://www.sec.gov )
      or
      LSB’s website ( http://www.lsbnc.com ).





In
      connection with the merger, LSB will file a registration statement, which will
      include a joint proxy statement/prospectus to be sent to the Company’s
      stockholders, and each of LSB and the Company may file other relevant documents
      concerning the merger with SEC. **STOCKHOLDERS
      ARE URGED TO READ THE REGISTRATION STATEMENT AND THE JOINT PROXY
      STATEMENT/PROSPECTUS REGARDING THE MERGER WHEN THEY BECOME AVAILABLE AND ANY
      OTHER RELEVANT DOCUMENTS FILED WITH THE SEC, AS WELL AS ANY AMENDMENTS OR
      SUPPLEMENTS TO THOSE DOCUMENTS, BECAUSE THEY WILL CONTAIN IMPORTANT INFORMATION.** **A
      FREE COPY OF THE JOINT PROXY STATEMENT/PROSPECTUS, AS WELL AS OTHER FILINGS
      CONTAINING INFORMATION ABOUT LSB AND THE COMPANY ARE AVAILABLE BY ACCESSING
      THE
      COMPANY, LSB AND/OR THE SEC’S WEBSITES.**





The
      Company, and its directors and executive officers may be deemed to be
      participants in the solicitation of proxies from the shareholders of the Company
      in connection with the merger. Information about the directors and executive
      officers of the Company is set forth in Part III of this Annual Report
      on Form 10-K.








**Strategy**





*Expand
      Banking Operations* .
      Throughout most of its 96-year history, the Bank’s banking activities have been
      centered around Reidsville, located in Rockingham County in the north central
      part of NC. Beginning in 1995, the Bank initiated a growth strategy to further
      penetrate existing and new markets, such as Wilmington and Greensboro in NC
      and
      into VA. Management selects its target markets based on a number of factors,
      including market size and growth potential, banking relationships developed
      by
      members of management during their careers and the ability to integrate the
      targeted market into the Bank’s community oriented culture.





Our
      expansion strategy, both within and outside of our existing markets, involves
      three key elements: (i) ascertaining which markets may be underserved by
      financial institutions whose primary focus is to cater to the individualized
      needs of the customer; (ii) installing high-quality, well-trained management
      to
      serve the market; and (iii) locating reasonably priced facilities. Management
      believes that it has been generally successful in implementing these strategic
      elements in its expansion program to date. The Guilford County deposit market
      is
      the largest in the Bank’s market area and totaled $7.39 billion at June 30,
      2006. In 2004, the Company and the Bank completed the relocation of their
      headquarters to 1501 Highwoods Boulevard, Greensboro **.** The
      Bank
      is the largest bank holding company headquartered in Greensboro, NC. This move
      provided the Company and the Bank more access to the financial markets and
      assists the Bank in reaching the larger customer base in Guilford County. The
      Bank opened a full-service banking center and Coastal Region Headquarters in
      the
      Mayfaire area of Wilmington, NC in October 2006. Regulatory approval for this
      branch was received prior to the Bank entering into the MOU with the Reserve
      Bank and the Commission. We continue to evaluate potential sites for additional
      branches in the Triad and Coastal Regions of NC and the Shenandoah Valley Region
      of VA, and will request regulatory approval to establish new branches in these
      market areas as and when appropriate.





*Seize
      Market Expansion Opportunities.* We
      intend to continue to capitalize on opportunities to enter new and contiguous
      markets which we believe are underserved as a result of banking consolidation
      and in which our community oriented philosophy and culture might flourish.
      We
      believe that there is value to be added by providing the opportunity for greater
      personalized banking relationships than exist with larger commercial banks
      in
      our markets, although we also recognize the need to carefully analyze markets
      that are already well served by numerous institutions. Our goal is for the
      Bank
      to continue to distinguish itself by emphasizing high quality, sophisticated
      services with a hometown flavor.





*Establish
      a Platform for Future Growth.* The Bank
      seeks to position itself to manage its expected growth in three fundamental
      ways: (1) attract, retain and reward experienced personnel who are committed
      both to conducting business in a friendly and personable manner and to serving
      the communities in which they work and live; (2) continue to upgrade, modify
      and
      expand its internal systems, procedures, equipment and software to improve
      operating efficiencies; and (3) create an organizational structure that supports
      localized decisions on customer contact issues. The Bank will continue to
      analyze technological developments in the banking industry for opportunities
      to
      improve or augment its services and products; however, management will continue
      to make every effort to maintain the Bank’s personalized approach.









6
 *Table
            of Contents*





*Maintain
        a Friendly Environment for Employees and Customers* .
        We have
        instituted various programs to instill high morale among our employees, which
        we
        believe translate into exceptional customer service. We hold weekly sales
        meetings to elicit ideas about featured products and services and to develop
        and
        communicate ideas for expanding banking relationships with existing and
        potential customers. Management believes that the overall effect of these
        type
        of programs is to improve morale, customer service and financial performance.
        Also, as part of the Bank’s team concept level, weekly teleconferences are held
        to encourage open and direct communication between members of senior management
        and provide regular updates on significant activities within their respective
        areas. Periodic off-site strategic planning sessions of the senior management
        team provide an open forum to address concerns and develop initiatives for
        the
        continued improvement of the Bank.
 
 **Market
        Areas**
 
 For
        operational purposes, the Bank groups its markets into four regions: the
        Triad
        and Coastal regions of NC, and the Southwest and Shenandoah Valley regions
        of
        VA. The Bank’s deposit market share in the Rockingham County portion of the
        Triad Region as of June 30, 2006, the most recent date for which data is
        available, was 27.8%, which ranked first among banks and thrift institutions.
        The following table summarizes the banking offices and deposit totals for
        the
        Bank’s offices, categorized by city.


**Region
                and City**
            
            **Deposits
                at December 31,****2006**
            
            **2005**
            
            **2004***(In
                thousands)***Triad
                Region:**Reidsville*(1*)
            
            $
            195,180
            
            $
            179,357
            
            $
            174,132Eden*(2*)
            
            
            64,951
            
            
            69,420
            
            
            52,935Madison
            
            
            27,416
            
            
            25,869
            
            
            20,984Ruffin
            
            
            17,354
            
            
            15,051
            
            
            12,256Greensboro*(1*)
            
            
            173,909
            
            
            171,231
            
            
            135,964Subtotal
            
            
            478,810
            
            
            460,928
            
            
            396,271**Coastal
                Region:**Wilmington*(2*)
                *(3)*
            
            
            130,918
            
            
            128,223
            
            
            122,330Burgaw
            
            
            48,300
            
            
            41,683
            
            
            32,094Subtotal
            
            
            179,218
            
            
            169,906
            
            
            154,424**Southwest
                VA Region:**Norton
            
            
            42,216
            
            
            68,718
            
            
            60,801Pennington
                Gap
            
            
            17,816
            
            
            20,182
            
            
            19,735Subtotal
            
            
            60,032
            
            
            88,900
            
            
            80,536**Shenandoah
                Valley Region:**Harrisonburg*(2)*
            
            
            100,508
            
            
            104,897
            
            
            93,054Total
                deposits
            
            $
            818,568
            
            $
            824,631
            
            $
            724,285





*(1)
      Includes three banking offices for all years.*


*(2)
      Includes two banking offices for all years.*


*(3)
      The Bank opened a full service banking center and Coastal Region Headquarters
      in
      the Mayfaire area of Wilmington in October 2006. The Wrightsville Avenue office
      was closed in December 2006.*





7
 *Table
            of Contents*





The
      following is a summary description of the Company’s market areas.





*Triad
      Region - Rockingham County.* Rockingham County is located in the north central area of NC. It has a land
      area
      of 565 square miles and a population of approximately 90,000. The Commonwealth
      of VA borders the County on the north, while Guilford County is the neighboring
      county to the south. Piedmont Triad International Airport is located twenty
      miles away, and Norfolk Southern has two rail connection lines in the County.
      U.S. Highways 29, 158, and 220 serve the area. The NC Employment Security
      Commission reported a December 2006 unemployment rate of 6.0% for Rockingham
      County. Business and government leaders in the County have made progress in
      diversifying the area’s economy to make up for job losses primarily in the
      textile and tobacco industries.




*Triad
      Region - Guilford County.* Guilford
      County has a diverse economy attributable to a blend of trade, manufacturing
      and
      service businesses. Local industry is characterized by the production of a
      wide
      range of products, including pharmaceuticals, microchips, textiles, apparel,
      furniture, tobacco, machinery, and electronics equipment. Guilford County,
      with
      a population of 440,000, has access to major domestic and international markets
      from Interstate Highways 40 and 85; U.S. Highways 29, 70, 220 and 421; major
      rail connections; and the Piedmont Triad International Airport. According to
      the
      NC Employment Security Commission, Guilford County reported an unemployment
      rate
      of 4.6% for December 2006, compared to a statewide unemployment rate of 4.7%.
      The planned FedEx hub is on schedule for completion in 2009 and is expected
      to
      have a significant positive impact on the Triad Region of NC. During 2005,
      Dell
      opened a major assembly plant in the Triad. Additionally, Dell suppliers and
      other complementary businesses are expected to contribute positively to the
      economy of the Triad Region. Most recently, HondaJet announced plans to
      establish their production facilities in Greensboro, NC.





*Coastal
      Region.* Wilmington is the county seat and industrial center of New Hanover County,
      located on the southeast coast of NC. The total population of the County is
      approximately 180,000. Interstate Highway 40 and U.S. Highways 17 and 74, as
      well as major rail connections serve the County. This area is serviced by
      national and regional airlines through facilities at the New Hanover
      International Airport located near Wilmington. The New Hanover County area
      has
      experienced extensive industrial development and service/trade sector growth
      over the past twenty years. Industries in the Wilmington region produce fiber
      optic cables for the communications industry; aircraft engine parts,
      pharmaceuticals, nuclear fuel components and various textile products. The
      New
      Hanover County area economy has become broadly diversified and has developed
      into a major resort area, a busy sea port (one of NC’s two deep water ports), a
      light manufacturing center, chemical manufacturing center and the distribution
      hub of southeastern NC. The NC Employment Security Commission reported a
      December 2006 unemployment rate of 3.6% for New Hanover County.





*Southwest
      VA Region.* Norton
      is located in southwestern VA in the midst of the Appalachian Mountains. The
      mining, retail and service industries of this region operate from an abundant
      natural resource base that includes natural gas, coal, timber and mineral
      deposits. The area is served by several U.S. Highways and by major rail
      connections. The Bank operates branches in Norton (Wise County) and, Pennington
      Gap (Lee County). The Company sold its Richlands, VA branch in 2004. **** For
      December 2006, the VA Employment Commission reported the unemployment rate
      in
      Wise County was 3.6%.





*Shenandoah
      Valley Region.* Rockingham County is centrally located in the Shenandoah Valley in west central
      VA. Harrisonburg, the county seat with a population of 40,000, is an important
      educational, industrial, retail, tourism, commercial, agricultural and
      governmental center. Interstate Highway 81, several primary U. S. highways,
      the
      Shenandoah Valley Regional Airport and a major rail connection serve the area.
      The Bank operates two branches in Harrisonburg, serving the counties of
      Rockingham and Augusta. According to the VA Employment Commission, the December
      2006 unemployment rate for Rockingham County was 2.1% compared to a statewide
      unemployment rate of 2.7%.








8
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            of Contents*





**Deposits**





The
      Company offers a variety of deposit products to individuals and to small and
      medium-sized businesses and other organizations through the Bank at interest
      rates generally competitive with local market conditions. The accompanying
      table
      sets forth the mix of depository accounts at the Company as a percentage of
      total deposits of the Company at the dates indicated.





**As
                of December 31,****2006**
            
            **2005**
            
            **2004**Noninterest-bearing
                demand
            
            
            10.6
            %
            
            11.4
            %
            
            10.9
            %Savings,
                NOW, MMI
            
            
            22.8
            
            
            26.0
            
            
            26.5Certificates
                of deposit
            
            
            66.6
            
            
            62.6
            
            
            62.6100.0
            %
            
            100.0
            %
            
            100.0
            %





The
      Bank
      accepts deposits at its 17 banking offices, 15 of which have automated teller
      machines (“ATMs”). Its memberships in the “STAR”, “CIRRUS” and “PLUS” networks
      allow customers access to their depository accounts from regional ATM
      facilities. Competitive fees are charged for the use of its ATM
      facilities by customers not having an account with the Bank. Deposit flows
      are
      controlled primarily through the pricing of such deposits and, to a certain
      extent, through promotional activities. Such promotional activities include
      the
      Company’s “Legacy Banking” and “Presidential Banking” accounts for deposit
      relationships of $25,000 and $75,000, respectively, and the “Freedom 50 Club”,
      which extends special privileges and sponsors group excursions to sites and
      performances of interest to account holders in certain markets over the age
      of
      50. At December 31, 2006, the Bank had $111.8 million in certificates of deposit
      of $100,000 or more. The Bank is a member of an electronic network that allows
      it to post interest rates and attract certificates of deposit nationally. It
      also utilizes brokered deposits to supplement in-market deposit growth. The
      accompanying table presents the scheduled maturities of time deposits of
      $100,000 or more at December 31, 2006.





**Scheduled
                maturity of time deposits of $100,000 or more***(In
                thousands)*Less
                than three months
            
            $
            27,990Three
                through six months
            
            
            26,414Seven
                through twelve months
            
            
            34,689Over
                twelve months
            
            
            22,733Total
                time deposits - $100,000 or more
            
            $
            111,826





**See
      also Note 8 in the Notes to Consolidated Financial Statements of this Annual
      Report on Form 10-K.**





**Subsidiaries**





In
      2000,
      FNB Southeast Investment Services, Inc. (the “Investment Company”) was formed as
      a wholly owned subsidiary of the Bank. The Investment Company employs three
      investment advisors who are based in the Company’s largest markets of Greensboro
      and Wilmington, NC. They allocate their time among the Company’s branches and
      are available to current and potential customers. The advisors offer a complete
      line of investment products and services. Through a registered broker-dealer,
      the Bank receives revenues based on the advisors’ sales and benefits (i) by
      earning additional fee income and (ii) by attracting potential customers to
      its
      branches. In January 2006, the Bank and the Investment Company entered into
      an
      agreement with an investment advisory group in Harrisonburg, VA to provide
      investment and insurance services to our customers in that area. We share in
      the
      revenue that is generated from our referrals. The Investment Company generated
      revenues of $402,000 in 2006 and $486,000 in 2005.





In
      2001,
      FNB Southeast Mortgage Corporation (the “Mortgage Company”) was formed as a
      wholly owned subsidiary of the Bank. At inception, the Mortgage Company
      purchased selected assets of a mortgage brokerage company operating in the
      coastal area near Wilmington, NC. Fee income generated





9
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by
      the
      Mortgage Company decreased to $828,000 in 2006, compared to $2,569,000 in 2005,
      as a result of a 48% decline in mortgage loan originations through the retail
      and wholesale lending functions. The Mortgage Company had net operating losses
      of $455,000 and $410,000 in 2006 and 2005, respectively.





**Marketing**





The
      Company currently markets its services through various advertising campaigns
      and
      promotions which include newspapers, magazines, billboards, and direct mailings,
      as well as through promotional items, such as caps, pens, pencils and shirts.
      The Company’s officers are also heavily involved in local civic affairs and
      philanthropic organizations. The Company occasionally sponsors community events
      and holds grand opening ceremonies for its new branches, inviting local
      dignitaries to speak and participate in the festivities. The Company engages
      two
      marketing firms to assist with creative design, market research, media
      placement, etc., as well as assisting with promoting the overall brand of the
      Company to the general public and investment community. The Company has also
      retained the services of a consultant to assist with public relation activities.
      Since 2004, the Company has employed a Director of Marketing to manage and
      coordinate the Company’s marketing and public relations efforts on a full-time
      basis.





·
            *Value*.
                Among other things, the Company offers attractive rates for its financial
                products, including its certificates of deposit, money market accounts
                and
                checking accounts. This pricing structure has been successful in
                attracting depositors who are motivated by the Company’s rates and its
                variety of individualized services.





·
            *Convenience
                and Service*.
                The Company’s personnel focus upon serving the individual needs of the
                Company’s customers. For example, members of senior management are
                accessible on very short notice, before, during, and after normal
                banking
                hours, by way of mobile phones and other means.





Management
      intends to continue to market the Company’s services through a combination of
      advertising campaigns, public relations activities and local affiliations.
      While
      the key messages of value, convenience, service and reliability will continue
      to
      play a major role in the Company’s marketing and public relations efforts,
      management may also focus on targeted groups, such as professionals, in addition
      to small to medium-sized local businesses.





A
      vital
      part of the Company’s marketing plan is the execution of a public relations
      strategy. Many traditional public relations methods are used in promoting its
      services. Management pursues media coverage, including general press, industry
      periodicals and other media covering banking and finance, consumer issues and
      special interests. Press releases, quarterly shareholder reports, media alerts
      and presentations are used to announce new banking services as they are added.





**Competition**





Commercial
      banking in most of the southeastern United States is extremely competitive,
      due
      in large part to intrastate and interstate branching laws. Currently, many
      of
      the Company’s competitors are significantly larger and have greater resources.
      The Company continues to encounter significant competition from a number of
      sources, including bank holding companies, financial holding companies,
      commercial banks, thrift institutions, credit unions, and other financial
      institutions and financial intermediaries. The Company competes in its market
      areas with some of the largest banking organizations in the Southeast, several
      of which have numerous branches in NC and VA. The Company’s competition is not
      limited to financial institutions based in NC and VA. The enactment of federal
      legislation authorizing nationwide interstate banking has greatly increased
      the
      size and financial resources of some of the Company’s competitors. Consequently,
      many of its competitors have substantially higher lending limits due to their
      greater total capitalization, and many perform functions for their customers,
      such as trust services, that the Company generally does not offer. The Company
      primarily relies on





10
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            of Contents*





providing
      quality products and services at a competitive price within its market area.
      As
      a result of interstate banking legislation, the Company’s market is open to
      future penetration by banks located in other states provided that the other
      states allow their domestic banking institutions to acquire NC banking
      institutions, thereby increasing competition.





In
      its
      Triad Region, as of June 2006, the Company competed with 21 commercial banks
      and
      savings institutions, as well as numerous credit unions. As of that date, the
      Company competed with 15 commercial banks and savings institution, and several
      credit unions, in its Coastal Region. In its Southwest VA Region, as of June
      2006, the Company competed with 7 commercial banks. As of that date, the Company
      competed with 11 commercial banks in its Shenandoah Valley Region.





**Employees**





All
      employees during 2006 were compensated by the Bank or its subsidiaries. At
      December 31, 2006, the Company had approximately 278 full-time and 14 part-time
      employees. None of the Company’s employees are represented by a collective
      bargaining unit, and we have not experienced any type of strike or labor
      dispute. We consider our relationship with our employees to be very good, as
      they are extremely important to our long-term success. The Board and management
      continually seek ways to enhance their benefits and well being.





**Available
      Information**





The
      Company makes its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q,
      Current Reports on Form 8-K and amendments to those reports available free
      of
      charge on its internet website www.fnbsoutheast.com ,
      as soon
      as reasonably practicable after the reports are electronically filed with the
      SEC. Any materials that the Company files with the SEC may be read and/or copied
      at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549.
      Information on the operation of the Public Reference Room may be obtained by
      calling the SEC at 1-800-SEC-0330. These filings are also accessible on the
      SEC’s website at www.sec.gov .





Additionally,
      the Company’s corporate governance policies, including the charters of the
      Audit, Compensation, and Corporate Governance and Nominating committees; and
      the
      Code of Business Conduct and Ethics may also be found under the *“Investor
      Relations”* section
      of the Company’s website. The Company elects to disclose any amendments to or
      waivers of any provisions of its Code of Business Conduct and Ethics applicable
      to its principal executive officers and senior financial officers on its
      website. A written copy of the foregoing corporate governance policies is
      available upon written request to the Company.





**Supervision
      and Regulation**





*Bank
      holding companies and commercial banks are extensively regulated under both
      federal and state law. The following is a brief summary of certain statutes
      and
      rules and regulations that affect or will affect the Company, the Bank, and
      the
      Bank’s subsidiaries. This summary is qualified in its entirety by reference to
      the particular statute, and regulatory provisions referred to below, and is
      not
      intended to be an exhaustive description of the statutes or regulations
      applicable to the business of the Company and the Bank. Supervision, regulation
      and examination of the Company and the Bank by the regulatory agencies are
      intended primarily for the protection of depositors rather than shareholders
      of
      the Company.*  *Statutes
      and regulations which contain wide-ranging proposals for altering the
      structures, regulations, and competitive relationship of financial institutions
      are introduced regularly. The Company cannot predict whether, or in what form,
      any proposed statute or regulation will be adopted or the extent to which the
      business of the Company and the Bank may be affected by such statute or
      regulation.*





**General.** There
      are a number of obligations and restrictions imposed on bank holding companies
      and their depository institution subsidiaries by law and regulatory policy
      that
      are designed to minimize potential loss to the depositors of such depository
      institutions and the Federal Deposit Insurance





11
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            of Contents*





Corporation
      (the “FDIC”) insurance funds in the event the depository institution becomes in
      danger of default or in default. For example, to avoid receivership of an
      insured depository institution subsidiary, a holding company is required to
      guarantee the compliance of any insured depository institution subsidiary that
      may become “undercapitalized” with the terms of any capital restoration plan
      filed by such subsidiary with its appropriate federal banking agency up to
      the
      lesser of (i) an amount equal to 5% of the bank's total assets at the time
      the
      bank became undercapitalized or (ii) the amount which is necessary (or would
      have been necessary) to bring the bank into compliance with all acceptable
      capital standards as of the time the bank fails to comply with such capital
      restoration plan. The Company, as a registered bank holding company, is subject
      to the regulation of the Federal Reserve. Under a policy of the Federal Reserve
      with respect to holding company operations, a holding company is required to
      serve as a source of financial strength to its subsidiary depository
      institutions and to commit resources to support such institutions in
      circumstances where it might not do so absent such policy. The Federal Reserve,
      under the BHCA, also has the authority to require a holding company to
      terminate any activity or to relinquish control of a nonbank subsidiary (other
      than a nonbank subsidiary of a bank) upon the Federal Reserve's determination
      that such activity or control constitutes a serious risk to the financial
      soundness and stability of any bank subsidiary of the holding
      company.





In
      addition, insured depository institutions under common control are required
      to
      reimburse the FDIC for any loss suffered by its deposit insurance funds as
      a
      result of the default of a commonly controlled insured depository institution
      or
      for any assistance provided by the FDIC to a commonly controlled insured
      depository institution in danger of default. The FDIC may decline to enforce
      the
      cross-guarantee provisions if it determines that a waiver is in the best
      interest of the deposit insurance funds. The FDIC's claim for damages is
      superior to claims of stockholders of the insured depository institution or
      its
      holding company but is subordinate to claims of depositors, secured creditors
      and holders of subordinated debt (other than affiliates) of the commonly
      controlled insured depository institutions.





As
      a
      result of the Company's ownership of the Bank, the Company is also registered
      under the bank holding company laws of North Carolina. Accordingly, the Company
      is also subject to regulation and supervision by the Commissioner.





**Capital
      Adequacy Guidelines for Holding Companies.** The
      Federal Reserve has adopted capital adequacy guidelines for bank holding
      companies and banks that are members of the Federal Reserve System and have
      consolidated assets of $150 million or more. Bank holding companies subject
      to
      the Federal Reserve’s capital adequacy guidelines are required to comply with
      the Federal Reserve's risk-based capital guidelines. Under these regulations,
      the minimum ratio of total capital to risk-weighted assets is 8%. At least
      half
      of the total capital is required to be “Tier I capital,” principally consisting
      of common stockholders' equity, noncumulative perpetual preferred stock, and
      a
      limited amount of cumulative perpetual preferred stock, less certain goodwill
      items. The remainder (“Tier II capital”) may consist of a limited amount of
      subordinated debt, certain hybrid capital instruments and other debt securities,
      perpetual preferred stock, and a limited amount of the general loan loss
      allowance. In addition to the risk-based capital guidelines, the Federal Reserve
      has adopted a minimum Tier I capital (leverage) ratio, under which a holding
      company must maintain a minimum level of Tier I capital to average total
      consolidated assets of at least 3% in the case of a holding company which has
      the highest regulatory examination rating and is not contemplating significant
      growth or expansion. All other holding companies are expected to maintain a
      Tier
      I capital (leverage) ratio of at least 1% to 2% above the stated
      minimum.





**Capital
      Requirements for the Bank.** The
      Bank, as a NC commercial bank, is required to maintain a surplus account equal
      to 50% or more of its paid-in capital stock. As a NC chartered, FDIC-insured
      commercial bank that is a member of the Federal Reserve System, it is also
      subject to capital requirements imposed by the Federal Reserve. Under Federal
      Reserve regulations, member banks must maintain a minimum ratio of qualifying
      capital to weighted risk assets equal to 8%. At least half of the total capital
      is required to be Tier I Capital, with the remainder consisting of Tier II
      Capital. In addition to the foregoing risk based capital guidelines, member
      banks which receive the highest rating in the examination process and are not
      anticipating or experiencing any significant growth, must maintain
      a





12
 *Table
            of Contents*





minimum
      level of Tier I Capital to total assets of 3%. Member banks, which do not fall
      within the foregoing standards, are required to maintain higher capital ratios.
      The Bank exceeded all applicable minimum capital requirements as of December
      31,
      2006.




**Dividend
      and Repurchase Limitations.** The
      Company must obtain Federal Reserve approval prior to repurchasing common stock
      for consideration in excess of 10% of its net worth during any twelve-month
      period unless the Company (i) both before and after the redemption satisfies
      capital requirements for "well capitalized" state member banks; (ii) received
      a
      one or two rating in its last examination; and (iii) is not the subject of
      any
      unresolved supervisory issues.





Although
      the payment of dividends and repurchase of stock by the Company are subject
      to
      certain requirements and limitations of NC corporate law, except as set forth
      in
      this paragraph, neither the Commission nor the FDIC have promulgated any
      regulations specifically limiting the right of the Company to pay dividends
      and
      repurchase shares. However, the ability of the Company to pay dividends or
      repurchase shares is dependent upon the Company's receipt of dividends from
      the
      Bank.





NC
      commercial banks, such as the Bank, are subject to legal limitations on the
      amounts of dividends they are permitted to pay. The Bank may pay dividends
      from
      undivided profits, which are determined by deducting and charging certain items
      against actual profits, including any contributions to surplus required by
      NC
      law. Also, an insured depository institution, such as the Bank, is prohibited
      from making capital distributions, including the payment of dividends, if,
      after
      making such distribution, the institution would become "undercapitalized" (as
      such term is defined in the applicable law and regulations).





**Deposit
      Insurance Assessments.** The Bank
      is subject to insurance assessments imposed by the FDIC. Under current law,
      the
      insurance assessment to be paid by members of the Bank Insurance Fund, such
      as
      the Bank, is specified in a schedule required to be issued by the FDIC. Prior
      to
      January 1, 2007, FDIC assessments for deposit insurance ranged from 0 to 27
      basis points per $100 of insured deposits, depending on the institution's
      capital position and other supervisory factors. Effective January 1, 2007,
      the
      assessments will range from 5 to 43 basis points per $100 of insured
      deposits.





**Federal
      Home Loan Bank System.**  The
      Federal Home Loan Bank ("FHLB") system provides a central credit facility for
      member institutions. In December 2004, the FHLB of Atlanta implemented a new
      capital plan. As a member of the FHLB of Atlanta, the Bank is required to own
      capital stock in the FHLB of Atlanta in an amount at least equal to 0.20% (20
      basis points) of the Bank’s total assets at the end of each calendar year, plus
      4.5% of its outstanding advances (borrowings) from the FHLB of Atlanta under
      the
      new activity-based stock ownership requirement. At December 31, 2006, the Bank
      was in compliance with this requirement.





**Community
      Reinvestment.** ** Under
      the Community Reinvestment Act (“CRA”), as implemented by regulations of the
      FDIC, an insured institution has a continuing and affirmative obligation
      consistent with its safe and sound operation to help meet the credit needs
      of
      its entire community, including low and moderate income neighborhoods. The
      CRA
      does not establish specific lending requirements or programs for financial
      institutions, nor does it limit an institution’s discretion to develop,
      consistent with the CRA, the types of products and services that it believes
      are
      best suited to its particular community. The CRA requires the federal banking
      regulators, in connection with their examinations of insured institutions,
      to
      assess the institutions’ records of meeting the credit needs of their
      communities, using the ratings of “outstanding,” “satisfactory,” “needs to
      improve,” or “substantial noncompliance,” and to take that record into account
      in its evaluation of certain applications by those institutions. All
      institutions are required to make public disclosure of their CRA performance
      ratings. The Bank received a “satisfactory” rating in its last CRA examination,
      which was completed during the fourth quarter of 2006.





**Prompt
      Corrective Action.** ** The
      FDIC
      has broad powers to take corrective action to resolve the problems of insured
      depository institutions. The extent of these powers will depend upon whether
      the
      institution in question is "well capitalized," "adequately capitalized,"
      "undercapitalized," "significantly undercapitalized," or "critically
      undercapitalized." Under the regulations, an institution is
      considered





13
 *Table
            of Contents*





"well
      capitalized" if it has (i) a total risk-based capital ratio of 10% or greater,
      (ii) a Tier I risk-based capital ratio of 6% or greater, (iii) a leverage ratio
      of 5% or greater and (iv) is not subject to any order or written directive
      to
      meet and maintain a specific capital level for any capital measure. An
      "adequately capitalized" institution is defined as one that has (i) a total
      risk-based capital ratio of 8% or greater, (ii) a Tier I risk-based capital
      ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or 3% or
      greater in the case of an institution with the highest examination rating).
      An
      institution is considered (A) "undercapitalized" if it has (i) a total
      risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital
      ratio
      of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case
      of
      an institution with the highest examination rating); (B) "significantly
      undercapitalized" if the institution has (i) a total risk-based capital ratio
      of
      less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or
      (iii)
      a leverage ratio of less than 3%; and (C) "critically undercapitalized" if
      the
      institution has a ratio of tangible equity to total assets equal to or less
      than
      2%. At December 31, 2006, the Bank had the requisite capital levels to qualify
      as “well capitalized”.





**Changes
      in Control.** The BHCA
      prohibits the Company from acquiring direct or indirect control of more than
      5%
      of the outstanding voting stock or substantially all of the assets of any bank
      or savings bank or merging or consolidating with another bank or financial
      holding company or savings bank holding company without prior approval of the
      Federal Reserve. Similarly, Federal Reserve approval (or, in certain cases,
      non-disapproval) must be obtained prior to any person acquiring control of
      the
      Company. Control is conclusively presumed to exist if, among other things,
      a
      person acquires more than 25% of any class of voting stock of the Company or
      controls in any manner the election of a majority of the directors of the
      Company. Control is presumed to exist if a person acquires more than 10% of
      any
      class of voting stock and the stock is registered under Section 12 of the
      Exchange Act or the acquiror will be the largest shareholder after the
      acquisition.





**Federal
      Securities Law** .
      The
      Company has registered its common stock with the SEC pursuant to Section 12(g)
      of the Exchange Act. As a result of such registration, the proxy and tender
      offer rules, insider trading reporting requirements, annual and periodic
      reporting and other requirements of the Exchange Act are applicable to the
      Company.





**Transactions
      with Affiliates.** ** Under
      current federal law, depository institutions are subject to the restrictions
      contained in Section 22(h) of the Federal Reserve Act with respect to loans
      to
      directors, executive officers and principal shareholders. Under Section 22(h),
      loans to directors, executive officers and shareholders who own more than 10%
      of
      a depository institution (18% in the case of institutions located in an area
      with less than 30,000 in population), and certain affiliated entities of any
      of
      the foregoing, may not exceed, together with all other outstanding loans to
      such
      person and affiliated entities, the
      institution's loans-to-one-borrower limit (as discussed below). Section 22(h)
      also prohibits loans above amounts prescribed by the appropriate federal banking
      agency to directors, executive officers and shareholders who own more than
      10%
      of an institution, and their respective affiliates, unless such loans are
      approved in advance by a majority of the board of directors of the institution.
      Any "interested" director may not participate in the voting. The FDIC has
      prescribed the loan amount (which includes all other outstanding loans to such
      person), as to which such prior board of director approval is required, as
      being
      the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further,
      pursuant to Section 22(h), the Federal Reserve requires that loans to directors,
      executive officers, and principal shareholders be made on terms substantially
      the same as offered in comparable transactions with non-executive employees
      of
      the Bank. The FDIC has imposed additional limits on the amount a bank can loan
      to an executive officer.





**Loans
      to One Borrower.** ** The
      Bank
      is subject to the loans to one borrower limits imposed by the Commissioner,
      which are substantially the same as those applicable to national banks. Under
      these limits, no loans and extensions of credit to any borrower outstanding
      at
      one time and not fully secured by readily marketable collateral shall exceed
      15%
      of the unimpaired capital and unimpaired surplus of the Bank. Loans and
      extensions of credit fully secured by readily marketable collateral may comprise
      an additional 10% of unimpaired capital and unimpaired surplus.





14
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            of Contents*





**Gramm-Leach-Bliley
      Act.** The
      federal Gramm-Leach-Bliley Act, enacted in 1999 (the “GLB Act”), dramatically
      changed various federal laws governing the banking, securities and insurance
      industries. The GLB Act has expanded opportunities for banks and bank holding
      companies to provide services and engage in other revenue-generating activities
      that previously were prohibited to them. In doing so, it increased competition
      in the financial services industry, presenting greater opportunities for our
      larger competitors which were more able to expand their service and products
      than smaller, community oriented financial institutions, such as the
      Bank.





**USA
      Patriot Act of 2001.** The
      USA
      Patriot Act of 2001 was enacted in response to the terrorist attacks that
      occurred in New York, Pennsylvania and Washington, D.C. on September 11, 2001.
      The Act is intended to strengthen the ability of U.S. law enforcement and the
      intelligence community to work cohesively to combat terrorism on a variety
      of
      fronts. The potential impact of the Act on financial institutions of all kinds
      is significant and wide ranging. The Act contains sweeping anti-money laundering
      and financial transparency laws and requires various regulations, including
      standards for verifying customer identification at account opening, and rules
      to
      promote cooperation among financial institutions, regulators, and law
      enforcement entities in identifying parties that may be involved in terrorism
      or
      money laundering.





**Sarbanes-Oxley
      Act of 2002.** The
      Sarbanes-Oxley Act (“SOX”) was signed into law in 2002 and became some of the
      most sweeping federal legislation addressing accounting, corporate governance
      and disclosure issues. The impact of SOX is wide-ranging as it applies to all
      public companies and imposes significant new requirements for public company
      governance and disclosure requirements. Some of the provisions of SOX became
      effective immediately while others have since been implemented.





In
      general, SOX established new corporate governance and financial reporting
      requirements intended to enhance the accuracy and transparency of public
      companies’ reported financial results. It established new responsibilities for
      corporate chief executive officers, chief financial officers and audit
      committees in the financial reporting process and created a new regulatory
      body
      to oversee auditors of public companies. It backed these requirements with
      new
      SEC enforcement tools, increased criminal penalties for federal mail, wire
      and
      securities fraud, and created new criminal penalties for document and record
      destruction in connection with federal investigations. It also increased the
      opportunity for more private litigation by lengthening the statute of
      limitations for securities fraud claims and providing new federal corporate
      whistleblower protection.





The
      economic and operational effects of SOX on public companies, including us,
      have
      been and will continue to be significant in terms of the time, resources and
      costs associated with compliance with its requirements.





**Other.** ** Additional regulations require annual examinations of all insured depository
      institutions by the appropriate federal banking agency, with some exceptions
      for
      small, well-capitalized institutions and state chartered institutions examined
      by state regulators, and establish operational and managerial, asset quality,
      earnings and stock valuation standards for insured depository institutions,
      as
      well as compensation standards.





The
      Bank
      is subject to examination by the Federal Reserve and the Commission. In
      addition, it is subject to various other state and federal laws and regulations,
      including state usury laws, laws relating to fiduciaries, consumer credit,
      equal
      credit, and fair credit reporting laws and laws relating to branch banking.
      The
      Bank, as an insured NC commercial bank, is prohibited from engaging as a
      principal in activities that are not permitted for national banks, unless (i)
      the FDIC or the Federal Reserve, because it is a member bank, determines that
      the activity would pose no significant risk to the Bank Insurance Fund and
      (ii)
      the Bank is, and continues to be, in compliance with all applicable capital
      standards.





**Limits
      on Rates Paid on Deposits and Brokered Deposits** .
      FDIC
      regulations limit the ability of insured depository institutions to accept,
      renew or roll-over deposits by offering rates of interest which are
      significantly higher than the prevailing rates of interest on deposits offered
      by other insured depository





15
 *Table
            of Contents*





institutions
      having the same type of charter in such depository institution's normal market
      area. Under these regulations, "well capitalized" depository institutions may
      accept, renew or roll-over such deposits without restriction, "adequately
      capitalized" depository institutions may accept, renew or roll-over such
      deposits with a waiver from the FDIC (subject to certain restrictions on
      payments of rates) and "undercapitalized" depository institutions may not
      accept, renew, or roll-over such deposits. Definitions of "well capitalized,"
      "adequately capitalized" and "undercapitalized" are the same as the definitions
      adopted by the FDIC to implement the corrective action provisions discussed
      above.





**Taxation** . *Federal
      Income Taxation* .
      Financial institutions such as the Bank are subject to the provisions of the
      Internal Revenue Code of 1986, as amended (the “Code”) in the same general
      manner as other corporations. However, banks which meet certain definitional
      tests and other conditions prescribed by the Code may benefit from certain
      favorable provisions regarding their deductions from taxable income for annual
      additions to their bad debt reserve. The Bank may compute its addition to the
      bad debt reserve under the specific charge-off method or the reserve method.
      Under the reserve method, the addition
      to bad debts from losses on loans is computed by use of the experience method.
      Use of the experience
      method requires minimum additions to the reserve based on the amount allowable
      under a six-year moving average. The Code also provides annual limits on the
      amount the Bank can add to its reserves for loan losses.





*State
      Taxation* .
      Under
      NC law, the Bank is subject to corporate income taxes at a 6.90% rate and an
      annual franchise tax at a rate of 0.15%.





**Future
      Requirements** .
      Statutes and regulations, which contain wide-ranging proposals for altering
      the
      structures, regulations and competitive relationships of financial institutions,
      are introduced regularly. Neither the Company nor the Bank can predict whether
      or what form any proposed statute or regulation will be adopted or the extent
      to
      which the business of the Company or the Bank may be affected by such statute
      or
      regulation.





**Item1A.**  **RISK
      FACTORS**





*The
      Company is subject to certain risks. In addition to the factors discussed below,
      please see the discussion under “Item 7A. Quantitative and Qualitative
      Disclosure about Market Risk.” These factors, along with the other information
      in this Annual Report on Form 10-K, should be considered in evaluating
      forward-looking statements, and undue reliance should not be placed on such
      statements.*




***We
      may have higher credit losses than our allowance for credit
      losses.***




Our
      credit losses could exceed the allowance for credit losses we have set aside.
      Reliance on historic credit loss experience may not be indicative of future
      credit losses. Approximately 65% of our loan portfolio is composed of
      construction, commercial mortgage and commercial loans. Repayment of such loans
      is generally considered more subject to market risk than residential mortgage
      loans. Industry experience shows that a portion of loans will become delinquent
      and a portion of the loans will require partial or entire charge-off. Regardless
      of the underwriting criteria we utilize, losses may be experienced as a result
      of various factors beyond our control, including, among other things, changes
      in
      market conditions affecting the value of our loan collateral and problems
      affecting the credit repayment capacity of our borrowers.




***Risks
      Relating to the Proposed Merger of Equals with LSB***


Consummation
        of the proposed merger of the Company and LSB is subject to the satisfaction
        of
        various closing conditions, including approval by the requisite votes of
        the
        shareholders of the Company and LSB, regulatory approval of the
        Federal Reserve, the FDIC and the Commission, as well as other customary
        closing
        conditions described in the Agreement
        and Plan of Merger .
        The
        Company cannot guarantee that these closing conditions will be satisfied,
        or
        that the proposed merger will be successfully completed. In the event that
        the
        proposed merger is not completed, or is not completed within the expected
        timescale: management’s attention from the Company’s day-to-day business may be
        diverted; the Company may lose key employees; the Company’s relationships with
        customers and vendors may be disrupted as a result of uncertainties as to
        the
        future of the Company; the Company may be required to pay a significant break
        up
        fee of $9 million; and the market price of the Company’s common stock may
        decline to the extent that the current market price reflects
        a market assumption that the proposed merger will be completed. In addition,
        in
        the event that the merger is completed, there is a risk that the businesses
        of
        LSB and/or the Company will not be integrated successfully or such integration
        may be more difficult, time-consuming or costly than expected; expected revenue
        synergies and cost savings from the merger may not be fully realized or realized
        within the expected time frame; revenues following the merger may be lower
        than
        expected; customer and employee relationships and business operations may
        be
        disrupted by the merger. Any such events could have a material negative impact
        on the Company’s results of operations and financial condition and could
        adversely affect the Company’s stock price.









16
 *Table
            of Contents*







***Our
        growth strategy may not be successful.***
  As
        a
        strategy, we have sought to increase the size of our franchise by aggressively
        pursuing business development opportunities, and we have grown rapidly during
        the last decade. We can provide no assurance that we will continue to be
        successful in increasing the volume of our loans and deposits at acceptable
        risk
        levels and upon acceptable terms, expanding our asset base while managing
        the
        costs and implementation risks associated with this growth strategy. There
        can
        be no assurance that any further expansion will be profitable or that we
        will
        continue to be able to sustain our historical rate of growth,




***Interest
      rate volatility could significantly harm our
      business.***




The
      Company’s results of operations are affected by the monetary and fiscal policies
      of the federal government and the regulatory policies of governmental
      authorities. A significant component of the Company’s earnings is the net
      interest income of its subsidiary, FNB Southeast. Net interest income is the
      difference between income from interest-earning assets, such as loans, and
      the
      expense of interest-bearing liabilities, such as deposits. We may not be able
      to
      effectively manage changes in what we charge as interest on our earning assets
      and the expense we must pay on interest-bearing liabilities, which may
      significantly reduce our earnings. The Reserve Bank has made significant changes
      in interest rates during the last few years. Since rates charged on loans often
      tend to react to market conditions faster than do rates paid on deposit
      accounts, these rate changes may have a negative impact on our earnings until
      we
      can make appropriate adjustments in our deposit rates. In addition, there are
      costs associated with our risk management techniques, and these costs could
      be
      material. Fluctuations in interest rates are not predictable or controllable
      and, therefore, there can be no assurances of our ability to continue to
      maintain a consistent positive spread between the interest earned on our earning
      assets and the interest paid on our interest-bearing liabilities.




***If
      we lose key employees with significant business contacts in our market area,
      our
      business may suffer.***




Our
      success is largely dependent on the personal contacts of our officers and
      employees in our market areas. If we lose key employees temporarily or
      permanently, our business could be hurt. We could be particularly hurt if our
      key employees go to work for competitors. Our future success depends on the
      continued contributions of our existing senior management personnel, many of
      whom have significant local experience and contacts in our market areas.




***Government
      regulations may prevent or impair our ability to pay dividends, engage in
      additional acquisitions, or operate in other ways.***




Current
      and future legislation and the policies established by federal and state
      regulatory authorities will affect our operations. We are subject to supervision
      and periodic examination by the Reserve Bank and the Commission. Our principal
      subsidiary, FNB Southeast, as a state chartered commercial bank, also receives
      regulatory scrutiny from the Reserve Bank, the FDIC, and the Commission. Banking
      regulations, designed primarily for the protection of depositors, may limit
      our
      growth and the return to you as an investor in our company, by restricting
      our
      activities, such as:




•
            the
                payment of dividends to shareholders;•
            possible
                transactions with or acquisitions by other institutions;•
            desired
                investments;•
            loans
                and interest rates;•
            the
                level of our allowance for credit losses;•
            imposing
                higher capital requirements;•
            interest
                rates paid on deposits;•
            the
                possible expansion of branch offices; and•
            the
                ability to provide other services.




We
      cannot
      predict what changes, if any, will be made to existing federal and state
      legislation and regulations or the effect that such changes may have on our
      business. The cost of compliance with regulatory requirements may adversely
      affect our ability to operate profitably.







17
 *Table
            of Contents*







We
        cannot
        predict what changes, if any, will be made to existing federal and state
        legislation and regulations or the effect that such changes may have on our
        business. The cost of compliance with regulatory requirements may adversely
        affect our ability to operate profitably.
  ***We
        face strong competition in our market areas, which may limit our asset growth
        and profitability.***
  The
        banking business in our market areas is very competitive, and the level of
        competition facing us may increase further, which may limit our asset growth
        and/or profitability. We experience competition in both lending and attracting
        deposits from other banks and nonbank financial institutions located
        within




***The
      common stock of FNB Financial Services Corporation is not FDIC
      insured.***




The
      common stock of the Company is not a savings or deposit account or other
      obligation of any bank and is not insured by the FDIC or any other governmental
      agency and is subject to investment risk, including the possible loss of
      principal.




**Item 1B.**
              **UNRESOLVED
                  STAFF COMMENTS**





None








18
 *Table
            of Contents*





**Item
                2.**  **PROPERTIES**





The
      Company’s executive offices are located at 1501 Highwoods Boulevard in
      Greensboro, NC. The Company’s principal support and operational functions are
      located at 202 South Main Street in Reidsville, NC. The Company has 13
      banking offices located in NC and four banking offices in VA.  The location
      of these banking offices, their form of occupancy and deposits as of December
      31, 2006, information about drive-up ATM facilities, and the year each office
      was opened is described in the accompanying table:




**Location**
              
              **Owned
                  or Leased**
              **Deposits**
                *(in
                  thousands)*
              **ATM**
              **Year**202
                  South Main Street, Reidsville, NC*(1)*
              
              Owned
              $
                  106,853
              Yes
              19101501
                  Highwoods Boulevard, Greensboro, NC*(2)*
              
              Leased
              -
              Yes
              20041646
                  Freeway Drive, Reidsville, NC
              
              Owned
              51,932
              Yes
              1972202
                  Turner Drive, Reidsville, NC
              
              Owned
              36,395
              Yes
              1969801
                  South Van Buren Road, Eden, NC
              
              Owned
              48,288
              Yes
              1996151
                  North Fieldcrest Road, Eden, NC
              
              Leased
              16,663
              No
              1996605
                  North Highway Street, Madison, NC
              
              Owned
              27,416
              Yes
              19979570
                  US 29 Business, Ruffin, NC
              
              Leased
              17,354
              No
              19972132
                  New Garden Road, Greensboro, NC
              
              Owned
              99,479
              Yes
              19974638
                  Hicone Road, Greensboro, NC
              
              Owned
              34,247
              Yes
              20003202
                  Randleman Road, Greensboro, NC
              
              Owned
              40,183
              Yes
              2000704
                  South College Road, Wilmington, NC
              
              Leased
              115,365
              Yes
              19971001
                  Military Cutoff Road, Wilmington, NC
              
              Leased
              15,553
              Yes
              20067210
                  Wrightsville Avenue, Wilmington, NC*(3)*
              
              Leased
              -
              No
              2000301
                  East Fremont Street, Burgaw, NC
              
              Leased
              48,300
              Yes
              1999600
                  Trent Street, Norton, VA
              
              Owned
              42,216
              Yes
              1973700
                  East Morgan Avenue, Pennington Gap, VA
              
              Owned
              17,816
              Yes
              1979440
                  South Main Street, Harrisonburg, VA
              
              Owned
              68,989
              Yes
              19881925
                  Reservoir Street, Harrisonburg, VA
              
              Owned
              31,519
              Yes
              2003





*(1)
      Original office opened in a different location in 1910. Current office opened
      in
      1980. Consists of 27,000 square feet in a two story building; former
      headquarters location; extensive renovations completed 2006; will continue
      to
      serve as a full service branch as well as the Operations Center for the
      Company.*


*(2)
      The current headquarters office opened in 2004.*


*(3)
      Branch closed December 2006, office space is still being used.*




**Item
                  3.**
              **LEGAL
                  PROCEEDINGS**
 
 In
        the
        ordinary course of operations, the Company and the Bank are party to various
        legal proceedings. Except as discussed in Item 1 hereof, under the headings
        “Memorandum of Understanding - Lifted as of 12/31/2006” and “Merger of Equals
        with LSB BankShares, Inc. (“LSB”)” in the opinion of management, neither the
        Company nor the Bank is involved in, nor have they terminated during the
        fourth
        quarter of 2006, any pending legal proceedings other than routine, non-material
        proceedings occurring in the ordinary course of business.
 
 **Item
                  4.**
              **SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY
                  HOLDERS**
 
 There
        were no matters submitted to a vote of the security holders of the Company
        during the fourth quarter of the Company’s fiscal year ended December 31,
        2006.


19
 *Table
            of Contents*





**PART
      II**




**Item
                  5.**
              **MARKET
                  FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
                  PURCHASES OF EQUITY
                  SECURITIES**





**Market
      Prices and Dividend Policies**





The
      Company’s common stock is traded on The NASDAQ Stock Market Global Market System
      under the symbol “FNBF.” The following table shows the high and low sale price
      of the Company’s common stock on The NASDAQ Stock Market Global Market System1,
      based on published financial sources, for each of the last two fiscal years.
      The
      table also reflects the per share amount of cash dividends paid for each share
      during the fiscal quarter for each of the last two fiscal years. Only one cash
      dividend was paid during each of the fiscal quarters listed.1





**Calendar
                Period**
            
            **High**
            
            **Low**
            
            **Dividends
                Paid**Quarter
                ended March 31, 2005
            
            $
            18.74
            
            $
            16.82
            
            $
            0.11Quarter
                ended June 30, 2005
            
            
            20.25
            
            
            16.82
            
            
            0.11Quarter
                ended September 30, 2005
            
            
            18.52
            
            
            16.56
            
            
            0.11Quarter
                ended December 31, 2005
            
            
            17.89
            
            
            14.40
            
            
            0.12Quarter
                ended March 31, 2006
            
            $
            16.46
            
            $
            14.00
            
            $
            0.12Quarter
                ended June 30, 2006
            
            
            16.21
            
            
            14.60
            
            
            0.12Quarter
                ended September 30, 2006
            
            
            15.50
            
            
            13.04
            
            
            0.12Quarter
                ended December 31, 2006
            
            
            15.82
            
            
            14.55
            
            
            0.13





*1
For
      comparative purposes, the sale prices and dividends paid amounts shown in the
      accompanying table have been restated to reflect the 5-for-4 stock split
      effected as a 25% stock dividend, effective May 31, 2005.*





As
      of
      March 5, 2007, there were approximately 2,244 beneficial owners, including
      1,155
      holders of record, of the Company’s common stock. For a discussion as to any
      restrictions on the Company or the Bank’s ability to pay dividends, please refer
      to “Item 1 - Supervision and Regulation of the Company and the
      Bank.”





At
      the
      1996 annual meeting, the shareholders approved the Omnibus Equity
      Compensation Plan (the “1996 Omnibus Plan”). The 1996 Omnibus Plan terminated
      during 2006 and, accordingly, no more options may be granted under this plan.
      At
      the 2006 annual meeting, the shareholders approved the Company’s Long Term Stock
      Incentive Plan (the “2006 Omnibus Plan”). As of December 31, 2006, no options
      have been granted under the 2006 Omnibus Plan. For more information on both
      plans, see Note 13 in the Notes to Consolidated Financial Statements of this
      Annual Report on Form 10-K.





The
      following table presents, as of December 31, 2006, the numbers of shares of
      common stock to be issued upon the exercise of outstanding options, the
      weighted-average price of the outstanding options and the number of options
      remaining that may be issued under the 1996 Omnibus Plan, and 2006 Omnibus
      Plan.




**EQUITY
                COMPENSATION PLAN INFORMATION****Plan
                category**
            
            **(a)**
              **Number
                of shares**
              **to
                be issued upon**
              **exercise
                of**
              **outstanding
                options**1
            
            **(b)**
              
              **Weighted-average**
              **exercise
                price of**
              **outstanding
                options**1
            
            **(c)**
              **Number
                of shares remaining**
              **available
                for future issuance under**
              **equity
                compensation plans (excluding**
              **shares
                reflected in column (a))**2Equity
                compensation plans
              approved
                by our security holders
            
            911,7063
            
            $14.203
            
            500,000Equity
                compensation plans not
              approved
                by our security holders
            
            -0-
            
            N/A
            
            -0-Total
            
            911,706
            
            $14.20
            
            500,000


_________________________


1
            All
                outstanding options were granted under the 1996 Omnibus
                Plan


2
            All
                options available for grant are authorized under the 2006 Omnibus
                Plan


3
            All
                options granted prior to May 31, 2005 and exercise prices have been
                adjusted to reflect the 5-for-4 stock split, effected in the form
                of a 25%
                stock dividend, effective May 31,
                2005.




20
 *Table
              of Contents*


See
      also
      Note 19 in the Notes to Consolidated Financial Statements of this Annual Report
      on Form 10-K. See also “Supervision and Regulation - Regulation of the Company,
      Dividend and Repurchase Limitations” and “Regulation of the Bank -
      Dividends.”





The
      accompanying table details, by month, information related to the activity
      related to the share repurchase program approved by the Company’s Board of
      Directors in July 2004 authorizing the repurchase of up to 343,905 shares of
      the
      Company’s outstanding common stock. The program was publicly announced in the
      month of approval.





**Stock
                Repurchase Program - Approved July 2004****Period**
            
            **(a)**
              **Total
                Number**
              **of
                Shares**
              **Purchased**
            
            **(b)**
              **Average**
              **Price
                Paid**
              **Per
                Share**
            
            **(c)**
              
              **Cumulative
                Number**
              **of
                Shares Purchased**
            
            **(d)**
              **Maximum
                Number**
              **of
                Shares that May Yet**
              **Be
                Purchased**October
                1, 2006 to October 31, 2006
            
            34,196
            
            $
                14.85
            
            258,411
            
            85,494November
                1, 2006 to November 30, 2006
            
            -
            
            -
            
            258,411
            
            85,494December
                1, 2006 to December 31, 2006
            
            8,000
            
            $
                15.00
            
            266,411
            
            77,494





**Recent
      Sales of Unregistered Securities**





The
      Company did not sell any of its equity securities in the last fiscal year,
      which
      were not registered under the Securities Act.




**FIVE-YEAR
        STOCK PERFORMANCE TABLE**
 
 The
        following table illustrates the cumulative total shareholder return on our
        Common Stock over the five-year period ended December 31, 2006 and the
        cumulative total return over the same period on The Nasdaq Stock Market Index
        (U.S.) and The Carson Medlin Company Independent Bank Index of 28 **** independent
        community banks located in eight southeastern states. The table assumes $100
        originally invested on December 31, 2001 and that all subsequent dividends
        were
        reinvested in additional shares.
 
 **FNB
        FINANCIAL SERVICES CORPORATION**
 **Comparison
        of Cumulative Total Shareholder Return**
 **Years
        Ended December 31**
  
  2001
              
              2002
              
              2003
              
              2004
              
              2005
              
              2006FNB
                  Financial Services Corporation
              
              
              100
              
              
              
              122
              
              
              
              183
              
              
              
              213
              
              
              
              197
              
              
              
              184The
                  Carson Medlin Company's Independent Bank Index1
              
              
              100
              
              
              
              124
              
              
              
              168
              
              
              
              193
              
              
              
              199
              
              
              
              230Nasdaq
                  Index
              
              
              100
              
              
              
              69
              
              
              
              103
              
              
              
              113
              
              
              
              115
              
              
              
              126
 _______________
 1  The
        Carson Medlin Company's Independent Bank Index is the compilation of the
        total
        return to shareholders over the past five years of a group of 28 independent
        community banks located in the southeastern states of Alabama, Florida, Georgia,
        North Carolina, South Carolina, Tennessee, Virginia and West Virginia. The
        total
        five year return was calculated for each of the banks in the peer group taking
        into consideration changes in stock price, cash dividends, stock dividends
        and
        stock splits since December 31, 2001. The individual results were then weighted
        by the market capitalization of each bank relative to the entire peer group.
        The
        total return approach and the weighting based upon market capitalization
        is
        consistent with the preparation of the Nasdaq total return
        index.




21
 *Table
            of Contents*





**Item
                  6.**
              **SELECTED
                  FINANCIAL DATA**





The
      annual selected historical financial data presented in the accompanying
      table is derived from the audited consolidated financial statements for FNB
      Financial Services Corporation and Subsidiary. As this information is only
      a
      summary, you should read it in conjunction with the historical financial
      statements (and related notes) of the Company and “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations” included elsewhere
      herein.




*(In
                  thousands, except per share, ratios and other data)*
              
              **As
                  of and For the Year Ended December 31,****2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002****Income
                  Statement Data:**Net
                  interest income
              
              $
              38,392
              
              $
              37,403
              
              $
              29,385
              
              $
              24,822
              
              $
              23,753Provision
                  for credit losses
              
              
              1,435
              
              
              16,132
              
              
              1,275
              
              
              1,431
              
              
              1,300Noninterest
                  income
              
              
              5,508
              
              
              7,383
              
              
              8,086
              
              
              7,425
              
              
              5,285Noninterest
                  expense
              
              
              28,907
              
              
              28,207
              
              
              23,766
              
              
              19,567
              
              
              17,429Net
                  income
              
              
              9,113
              
              
              792
              
              
              8,340
              
              
              7,460
              
              
              6,782**Balance
                  Sheet Data:**Assets
              
              $
              1,010,773
              
              $
              1,007,406
              
              $
              865,335
              
              $
              780,926
              
              $
              734,032Loans*(1)*
              
              
              707,146
              
              
              757,967
              
              
              663,426
              
              
              581,384
              
              
              563,600Allowance
                  for credit losses
              
              
              13,195
              
              
              19,142
              
              
              7,353
              
              
              7,124
              
              
              7,059Deposits
              
              
              818,568
              
              
              824,631
              
              
              724,285
              
              
              641,907
              
              
              605,005Other
                  borrowings
              
              
              80,774
              
              
              100,774
              
              
              45,000
              
              
              55,500
              
              
              52,500Shareholders’
                  equity
              
              
              72,693
              
              
              67,233
              
              
              70,430
              
              
              65,750
              
              
              64,333**Per
                  Common Share Data*****(5):***Net
                  income, basic
              
              $
              1.29
              
              $
              0.11
              
              $
              1.22
              
              $
              1.08
              
              $
              0.95Net
                  income, diluted*(2)*
              
              
              1.26
              
              
              0.11
              
              
              1.17
              
              
              1.04
              
              
              0.94Cash
                  dividends declared
              
              
              0.49
              
              
              0.45
              
              
              0.40
              
              
              0.36
              
              
              0.34Book
                  value
              
              
              10.30
              
              
              9.55
              
              
              10.15
              
              
              9.60
              
              
              9.22Tangible
                  book value
              
              
              10.18
              
              
              9.43
              
              
              10.02
              
              
              9.46
              
              
              9.18**Other
                  Data:**Branch
                  offices
              
              
              17
              
              
              17
              
              
              17
              
              
              18
              
              
              17Full-time
                  employees
              
              
              278
              
              
              248
              
              
              255
              
              
              225
              
              
              188**Performance
                  Ratios:**Return
                  on average assets
              
              
              0.89
              %
              
              0.08
              %
              
              1.02
              %
              
              0.98
              %
              
              0.97
              %Return
                  on average equity
              
              
              12.98
              
              
              1.09
              
              
              12.29
              
              
              11.55
              
              
              10.63Net
                  interest margin (tax equivalent)
              
              
              4.08
              
              
              4.18
              
              
              3.94
              
              
              3.53
              
              
              3.57Dividend
                  payout
              
              
              37.98
              
              
              409.09
              
              
              34.25
              
              
              33.68
              
              
              35.55Efficiency*(3)*
              
              
              64.46
              
              
              62.04
              
              
              62.28
              
              
              59.65
              
              
              59.71**Asset
                  Quality Ratios:**Allowance
                  for credit losses to period end loans
              
              
              1.87
              %
              
              2.53
              %
              
              1.11
              %
              
              1.23
              %
              
              1.25
              %Allowance
                  for credit losses to period endnonperforming
                  loans*(4)*
              
              
              97.59
              
              
              184.31
              
              
              209.16
              
              
              136.30
              
              
              191.87Net
                  charge-offs to average loans
              
              
              0.99
              
              
              0.59
              
              
              0.17
              
              
              0.24
              
              
              0.18Nonperforming
                  assets to period end loansand
                  foreclosed property*(4)*
              
              
              2.04
              
              
              1.56
              
              
              1.36
              
              
              1.78
              
              
              0.94**Capital
                  and Liquidity Ratios:**Average
                  equity to average assets
              
              
              6.9
              %
              
              7.5
              %
              
              8.3
              %
              
              8.5
              %
              
              9.1
              %Leverage
                  capital
              
              
              10.0
              
              
              9.1
              
              
              8.2
              
              
              8.4
              
              
              8.5Tier
                  1 risk based capital
              
              
              12.5
              
              
              11.7
              
              
              10.2
              
              
              10.7
              
              
              11.2Total
                  risk based capital
              
              
              13.7
              
              
              13.2
              
              
              11.3
              
              
              11.9
              
              
              12.5Average
                  loans to average deposits
              
              
              89.7
              
              
              93.7
              
              
              91.0
              
              
              91.7
              
              
              96.2Average
                  loans to average deposits and borrowings
              
              
              79.4
              
              
              84.3
              
              
              83.1
              
              
              83.4
              
              
              86.9





*(1)
      Loans net of unearned income, before allowance for credit
      losses.*


*(2)
      Assumes the exercise of outstanding dilutive options to acquire common stock.
      See Note 14 to the Company’s consolidated financial
      statements.*


*(3)
      Computed by dividing noninterest expense by the sum of taxable equivalent net
      interest income and noninterest income.*


*(4)
      Nonperforming loans and nonperforming assets include loans past due 90 days
      or
      more that are still accruing interest.*


*(5)
      Per share data has been reflect the 5-for-4 stock split effected as a 25% stock
      dividend, effective May 31, 2005 and the 5-for-4 stock split effected as a
      25%
      stock dividend, effective December 29, 2003.*





22
 *Table
            of Contents*





**Item
                  7.**
              **MANAGEMENT’S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                  OPERATIONS**


The
      following presents management’s discussion and analysis of our financial
      condition and results of operations and should be read in conjunction with
      the
      financial statements and related notes included elsewhere in this Annual Report
      on Form 10-K. This discussion may contain forward-looking statements that
      involve risks and uncertainties. Our actual results could differ significantly
      from those anticipated in forward-looking statements as a result of various
      factors. All share data has been adjusted to give retroactive effect to stock
      splits and stock dividends. The following discussion is intended to assist
      in
      understanding the financial condition and results of operations of the
      Company.





**Executive
      Overview**





In
      June
      2005, the Bank discovered that its lending activities in its Harrisonburg Region
      were not being carried out in compliance with the Bank’s policies and procedures
      and certain regulatory guidelines. In the internal investigations, independent
      consultant reviews, and the Reserve Bank safety and soundness examination,
      which
      were undertaken in the second half of 2005, additional issues were identified.
      In February 2006, the Company and the Bank entered into a MOU with the Reserve
      Bank and the Commissioner addressing these issues **[see - Item 1. Business - Memorandum of Understanding - Lifted as of
      12/31/2006].**T he
      Company and the Bank took prompt and aggressive actions to address them
      and, following the most recent joint safety and soundness examination conducted
      by the Reserve Bank and the Commission completed in late 2006, the Company
      and
      the Bank were found to be substantially in compliance with the MOU. Effective
      December 31, 2006, the MOU was lifted. Subsequent to yearend, the Company
      entered into a definitive agreement with LSB to combine in a merger of equals.
      **See - Item 1. Business - Merger of Equals with LSB Bancshares Inc.
      (“LSB”).**





**General**





The
      Company recorded net income of $9.11 million for the year ended December 31,
      2006, representing diluted earnings per share of $1.26. Net income for 2005
      was
      $792,000, or diluted earnings per share of $0.11. The increase in 2006 net
      income is primarily attributable to the impact on the results of 2005 of
      aggregate special provisions for credit losses of $14.5 million recorded during
      the third and fourth quarters of the year ended December 31, 2005. For the
      year
      ended December 31, 2005, the after-tax financial impact from the adverse credit
      conditions discussed above amounted to $9.5 million, or $1.32 per diluted
      share.





Total
      assets at December 31, 2006 stood at $1.01 billion, substantially unchanged
      from
      the previous yearend. Gross loans at December 31, 2006 totaled $707.1 million,
      down from $758.0 million at yearend 2005. Investment securities, which are
      the
      next largest component of assets, totaled $217.1 million at December 31, 2006,
      a
      7.5% increase from the balance of $201.9 million a year ago.





During
      2006, deposits decreased 0.7% to $818.6 million at yearend. Borrowings,
      comprised of junior subordinated notes, federal funds purchased, retail and
      wholesale repurchase agreements, and FHLB advances, totaled $107.2 million
      at
      December 31, 2006, compared to $108.1 million at the prior yearend.
      Shareholders’ equity increased 8.1%, to $72.7 million at yearend 2006. Book
      value per share was $10.30 at December 31, 2006, compared to $9.55 a year ago.





The
      Company’s subsidiary bank, FNB Southeast, is a NC chartered commercial bank
      that, as of December 31, 2006, operated thirteen banking offices in NC and
      four
      banking offices in VA. The Bank operates two wholly owned subsidiaries. FNB
      Southeast Investment Services, Inc. was formed in 2000 to provide retail
      investment products and services. FNB Southeast Mortgage Corporation was formed
      in 2001 to provide mortgage banking services.





**Financial
      Condition at December 31, 2006 and 2005**





23
 *Table
            of Contents*





The
      Company’s consolidated assets of $1.01 billion at yearend 2006 reflect an
      increase of 0.3% over the previous year, following an increase of 16.4% in
      2005.
      Total average assets increased 5.4% to $1.02 billion in 2006, compared to $965.7
      million in 2005. During 2006, the Company experienced a 5.9% increase in average
      earning assets. Average earning assets totaled $965.0 million in 2006, compared
      to $910.9 million in 2005. The increase in 2006 was primarily attributable
      to a
      32.1% growth in average investment securities.





Gross
      loans declined $50.8 million during 2006, or 6.7%, which followed increases
      of
      14.7% in 2005 and 14.1% in 2004. The loan portfolio is expected to continue
      this
      decrease through mid-year 2007 as the Company focuses on improving the quality
      of the loan portfolio and strengthening its lending staff by adding experienced
      lenders in its key markets. Loans secured by real estate totaled $514.6 million
      in 2006 and represented 72.8% of total loans, compared with 70.4% at yearend
      2005. Within this category, commercial real estate loans decreased 2.7% during
      2006 to $173.2 million, while residential real estate loans declined 18.3%
      to
      $116.3 million and construction loans increased 5.4% to $225.1 million.
      Commercial, financial and agricultural loans totaled $60.4 million at yearend
      2006, a decline of 21.5% from the end of 2005. Consumer loans decreased 10.2%
      during 2006, ending the year at $132.1 million. Management believes the Company
      is not dependent on any single customer or group of customers concentrated
      in a
      particular industry, the loss of whose deposits or whose insolvency would have
      a
      material adverse effect on operations.





Investment
      securities (at amortized cost) totaled $217.1 million at yearend 2006, a 7.5%
      increase from $201.9 million at yearend 2005. U.S. Government agency and
      mortgage backed securities continue to represent the major share of the total
      portfolio, and totaled $142.3 million, or 65.6% of the portfolio at yearend
      2006, compared to $159.7 million, or 77.7% of the portfolio one year earlier.
      Management believes that the additional risk of owning agency securities over
      U.S. Treasury securities is negligible and has capitalized on the favorable
      spreads available on the former. State and municipal obligations amounted to
      $65.5 million at yearend, compared to $38.3 million a year earlier. The
      Company’s investment strategy is to achieve acceptable total returns, while
      investing in securities with relatively short maturity dates as necessary to
      fund loan growth. To this end, the Company has consistently categorized the
      entire portfolio as “Available for Sale,” which it believes offers the greatest
      amount of flexibility in managing a total return concept. The table,
“ *Investment
      Securities,* ”
      presents the composition of the securities portfolio for the last three years,
      as well as information about cost, fair value and weighted average yield.





Total
      deposits decreased $6.1 million to $818.6 million at December 31, 2006, a 0.7%
      decrease from $824.6 million in deposits one year earlier. This decrease was
      primarily the result of a $25.9 million, or 16.1%, decrease in MMI accounts,
      as
      well as a decline of $5.8 million, or 6.3%, in non-interest bearing demand
      deposits. These declines have been partially offset by growth in time deposits
      of $27.8 million, an increase of 5.4% from yearend 2005.





The
      market for deposits remains fiercely competitive and the Company relies on
      appropriate pricing and quality customer service to retain and increase its
      retail deposit base. During the year, the Company had several featured products
      to generate new deposits and increase the customer base. For commercial
      customers, the Company is focused on building a total relationship, aimed at
      fostering growth in both loans and deposits. In addition to traditional checking
      accounts, the Company offers a cash management sweep account, online banking,
      and bill-pay to its customer base.





In
      order
      to attract additional deposits when necessary, the Company maintains membership
      in an electronic network that allows it to post interest rates and attract
      deposits nationally. From time to time, we also utilize brokered certificates
      of
      deposit. Bulletin board deposits and brokered deposits continued to decrease
      in
      amount during 2006 and these types of deposits may be utilized during 2007;
      however, these deposits can be utilized to supplement in-market funding as
      necessary.





The
      Company also has a credit facility available with the FHLB of Atlanta. Borrowing
      capacity is established at 17.5% of the Bank’s total assets as submitted on
      regulatory financial reports. The





24
 *Table
            of Contents*





Company
      also utilized a portion of the approximately $177 million line with the FHLB
      to
      fund earning assets. FHLB borrowings totaled $55.0 million at yearend.
      Management continues to believe this is a cost effective and prudent alternative
      to deposit balances, since a particular amount, term and structure may be
      selected to meet its current needs.





**Financial
      Condition at December 31, 2005 and 2004**





The
      Company’s consolidated assets of $1.01 billion at yearend 2005 reflect an
      increase of 16.4% over the previous year, following an increase of 10.8% in
      2004. Total average assets increased 18.4% to $965.7 million in 2005, compared
      to $815.6 million in 2004. During 2005, the Company experienced a 19.2% increase
      in average earning assets. Average earning assets totaled $910.9 million in
      2005, compared to $764.1 million in 2004. The increase in 2005 was primarily
      attributable to a 20.7% growth in average outstanding loans. The increase in
      average outstanding loans was funded primarily by a 17.2% rise in average
      deposits resulting from successful deposit marketing campaigns during 2005.





Gross
      loan growth during 2005 was $94.5 million, with outstanding loans up 14.7%
      at
      yearend, which followed increases of 14.1% in 2004 and 3.2% in 2003. Loans
      secured by real estate totaled $533.8 million in 2005 and represented 70.4%
      of
      total loans, compared with 66.7% at yearend 2004. Within this category,
      commercial real estate loans increased 6.8% during fiscal 2005 to a level of
      $178.0 million, while residential real estate loans rose 25.5% to $142.3 million
      and construction loans increased 31.7% to $213.5 million. Commercial, financial
      and agricultural loans totaled $77.0 million and represented 10.2% of total
      loans at the end of 2005, and 13.0% at yearend 2004. Consumer loans increased
      9.0% during 2005, led by increased home equity loans. Management believed the
      Company was not dependent on any single customer or group of customers
      concentrated in a particular industry, the loss of whose deposits or whose
      insolvency would have a material adverse effect on operations.





Investment
      securities (at amortized cost) totaled $205.6 million at yearend 2005, a 44.4%
      increase from $142.4 million at yearend 2004. U.S. Government agency and
      mortgage backed securities continue to represent the major share of the total
      portfolio, and totaled $159.7 million, or 77.7% of the portfolio at yearend
      2005, compared to $104.9 million, or 58.2% of the portfolio one year earlier.
      Management believed that the additional risk of owning agency securities over
      U.S. Treasury securities was negligible and capitalized on the favorable spreads
      available on the former. State and municipal obligations amounted to $38.3
      million at yearend, compared to $31.9 million a year earlier. The Company’s
      investment strategy was to achieve acceptable total returns, while investing
      in
      securities with relatively short maturity dates as necessary to fund loan
      growth. To this end, the Company consistently categorized the entire portfolio
      as “Available for Sale,” which it believed offered the greatest amount of
      flexibility in managing a total return concept.





Total
      deposits increased $100.3 million to $824.6 million at December 31, 2005,
      resulting in a 13.9% increase over $724.3 million in deposits one year earlier.
      This increase was driven by a $14.1 million, or 17.9%, increase in demand
      deposits and a $21.5 million, or 15.4%, increase in MMI accounts. Time deposit
      growth increased to $517.4 million from $453.2 a year earlier, an increase
      of
      14.2% from yearend 2004.





**Net
      Interest Income**




Like
      most
      financial institutions, the primary component of our earnings is net interest
      income. Net interest income is the difference between interest income,
      principally from loans and investments, and interest expense, principally on
      customer deposits and borrowings. Changes in net interest income result from
      changes in volume and changes in interest rates earned and paid. By volume,
      we
      mean the average dollar level of interest-earning assets and interest-bearing
      liabilities. Spread refers to the difference between the average yield on
      interest-earning assets and the average cost of interest-bearing liabilities,
      and margin refers to net interest income divided by average interest-earning
      assets. Spread and margin are influenced by the levels and relative mix of
      interest-earning assets and interest-bearing liabilities, as well as by levels
      of noninterest-bearing liabilities. During the years ended December 31,
      2006, 2005, and 2004, our







25
 *Table
            of Contents*







average
      interest-earning assets were $965.0 million, $910.9 million, and
      $764.1 million, respectively. During these same years, our net interest
      margins were 4.08%, 4.18%, and 3.94%, respectively.






*Average
      Balances and Average Rates Earned and Paid.* The
      accompanying table sets forth, for the years 2004 through 2006, information
      with
      regard to average balances of assets and liabilities, as well as the total
      dollar amounts of interest income from interest-earning assets and interest
      expense on interest-bearing liabilities, resultant yields or costs, net interest
      income, net interest spread, net interest margin and ratio of average
      interest-earning assets to average interest-bearing liabilities. Average loans
      include nonaccruing loans, the effect of which is to lower the average yield.




**Average
      Balance Sheets and Net Interest Income Analysis**


**Fully
      Taxable Equivalent Basis**


*(Dollars
      in thousands)*





Year
                Ended December 31,2006
            
            2005Average
              Balance
            
            Interest
              Income/
              Expense
            
            Average
              Yield/
              Rate
            
            Average
              Balance
            
            Interest
              Income/
              Expense
            
            Average
              Yield/
              Rate**Interest
                earning assets:**Loans,
                net (1)
            
            $
            742,463
            
            $
            63,598
            
            
            8.57
            %
            $
            740,468
            
            $
            56,012
            
            
            7.56
            %Taxable
                investment securities
            
            
            156,008
            
            
            6,376
            
            
            4.09
            
            
            119,634
            
            
            4,176
            
            
            3.49Tax-exempt
                investment securities (2)
            
            
            46,634
            
            
            2,785
            
            
            5.97
            
            
            33,664
            
            
            1,997
            
            
            5.94Other
                securities
            
            
            8,612
            
            
            512
            
            
            5.95
            
            
            6,659
            
            
            286
            
            
            4.29Overnight
                deposits
            
            
            11,332
            
            
            610
            
            
            5.38
            
            
            10,432
            
            
            320
            
            
            3.07Total
                earning assets
            
            
            965,049
            
            
            73,881
            
            
            7.66
            
            
            910,857
            
            
            62,791
            
            
            6.89**Non-earning
                assets:**Cash
                and due from banks
            
            
            32,685
            
            
            
            
            
            
            
            
            35,349Premises
                and equipment
            
            
            16,689
            
            
            
            
            
            
            
            
            13,232Other
                assets
            
            
            21,312
            
            
            
            
            
            
            
            
            14,830Less:
                Allowance for credit loss
            
            
            (17,587
            )
            
            
            
            
            
            
            
            (8,564
            )Total
                assets
            
            $
            1,018,148
            
            
            
            
            
            
            
            $
            965,704**Interest
                bearing liabilities:**Savings
                and NOW
            
            $
            51,719
            
            
            187
            
            
            0.36
            %
            $
            52,009
            
            
            116
            
            
            0.22
            %MMI
            
            
            123,881
            
            
            4,786
            
            
            3.86
            
            
            146,911
            
            
            4,163
            
            
            2.83Time
                deposits
            
            
            564,527
            
            
            24,062
            
            
            4.26
            
            
            505,617
            
            
            17,204
            
            
            3.40Federal
                funds purchased, borrowed funds and securities sold under agreements
                to
                repurchase
            
            
            107,619
            
            
            5,507
            
            
            5.12
            
            
            88,491
            
            
            3,226
            
            
            3.65Total
                interest bearing liabilities
            
            
            847,746
            
            
            34,542
            
            
            4.07
            
            
            793,028
            
            
            24,709
            
            
            3.12**Other
                liabilities and shareholder’s equity**Demand
                deposits
            
            
            88,378
            
            
            
            
            
            
            
            
            89,990Other
                liabilities
            
            
            11,861
            
            
            
            
            
            
            
            
            9,994Shareholders’
                equity
            
            
            70,163
            
            
            
            
            
            
            
            
            72,692Total
                liabilities and shareholders’ equity
            
            $
            1,018,148
            
            
            
            
            
            
            
            $
            965,704Net
                interest income and net yield on
              earning
                assets (3)
            
            
            
            
            $
            39,339
            
            
            4.08
            %
            
            
            
            $
            38,082
            
            
            4.18
            %Interest
                rate spread (4)
            
            
            
            
            
            
            
            
            3.58
            %
            
            
            
            
            
            
            
            3.78
            %





*(1)
      The average loan balances include nonaccruing loans and only interest income
      actually collected and recognized.*


*(2)
      The fully taxable equivalent basis is computed using a federal tax rate of
      34%.
      The adjustment made to convert to a fully taxable equivalent basis was $947,000
      for 2006, $680,000 for 2005, and $692,000 for 2004.*


*(3)
      Net yield on earning assets is computed by dividing net interest income by
      average earning assets.*


*(4)
      Earning asset yield minus interest bearing liabilities rate*














26
 *Table
            of Contents*











**Average
      Balance Sheets and Net Interest Income Analysis (cont’d)**


**Fully
      Taxable Equivalent Basis**


*(Dollars
      in thousands)*





Year
                Ended December 31,2004Average
                Balance
            
            Interest
                Income/ Expense
            
            Average
                Yield/ Rate**Interest
                earning assets:**Loans,
                net (1)
            
            $
            613,522
            
            $
            39,609
            
            
            6.46
            %Taxable
                investment securities
            
            
            102,139
            
            
            3,146
            
            
            3.08Tax-exempt
                investment securities (2)
            
            
            33,377
            
            
            2,035
            
            
            6.10Other
                securities
            
            
            4,414
            
            
            180
            
            
            4.08Overnight
                deposits
            
            
            10,644
            
            
            194
            
            
            1.82Total
                earning assets
            
            
            764,096
            
            
            45,164
            
            
            5.91**Non-earning
                assets:**Cash
                and due from banks
            
            
            20,210Premises
                and equipment
            
            
            13,587Other
                assets
            
            
            24,918Less:
                Allowance for credit loss
            
            
            (7,230
            )Total
                assets
            
            $
            815,581**Interest
                bearing liabilities:**Savings
                and NOW
            
            $
            52,263
            
            
            66
            
            
            0.13
            %MMI
            
            
            98,516
            
            
            2,070
            
            
            2.10Time
                deposits
            
            
            447,940
            
            
            11,423
            
            
            2.55Federal
                funds purchased, borrowed funds and securities sold under agreements
                to
                repurchase
            
            
            64,140
            
            
            1,528
            
            
            2.38Total
                interest bearing liabilities
            
            
            662,859
            
            
            15,087
            
            
            2.28**Other
                liabilities and shareholder’s equity**Demand
                deposits
            
            
            75,712Other
                liabilities
            
            
            9,150Shareholders’
                equity
            
            
            67,860Total
                liabilities and shareholders’ equity
            
            $
            815,581Net
                interest income and net yield on
              earning
                assets (3)
            
            
            
            
            $
            30,077
            
            
            3.94
            %Interest
                rate spread (4)
            
            
            
            
            
            
            
            
            3.63
            %





*(1)
      The average loan balances include nonaccruing loans and only interest income
      actually collected and recognized.*


*(2)
      The fully taxable equivalent basis is computed using a federal tax rate of
      34%.*


*(3)
      Net yield on earning assets is computed by dividing net interest income by
      average earning assets.*


*(4)
      Earning asset yield minus interest bearing liabilities rate*





**Rate/Volume
      Analysis**





The
      following table analyzes the dollar amount of changes in interest income and
      interest expense for major components of interest-earning assets and
      interest-bearing liabilities. The table distinguishes between (i) changes
      attributable to volume (changes in volume multiplied by the prior period’s
      rate), (ii) changes attributable to rate (changes in rate multiplied by the
      prior period’s volume), and (iii) net change (the sum of the previous
      columns). The change attributable to both rate and volume (changes in rate
      multiplied by changes in volume) has been allocated equally to both the changes
      attributable to volume and the changes attributable to rate.





27
 *Table
            of Contents*





**Analysis
      of Interest Changes Due To Volume and Rates**


**Fully
      Taxable Equivalent Basis**


*(In
      thousands)*


Year
                Ended December 31,2006
                compared with 2005
            
            2005
                compared with 2004Volume
                (2)
              Variance
            
            Rate
                (2)
              Variance
            
            Total
              Variance
            
            Volume
                (2)
              Variance
            
            Rate
                (2)
              Variance
            
            Total
              Variance**Interest
                income:**Loans,
                net
            
            $
            151
            
            $
            7,436
            
            $
            7,587
            
            $
            8,197
            
            $
            8,206
            
            $
            16,403Taxable
                investment securities
            
            
            1,270
            
            
            930
            
            
            2,200
            
            
            539
            
            
            491
            
            
            1,030Tax-exempt
                investment securities (1)
            
            
            770
            
            
            17
            
            
            787
            
            
            16
            
            
            (54
            )
            
            (38
            )Other
                securities
            
            
            84
            
            
            142
            
            
            226
            
            
            92
            
            
            14
            
            
            106Overnight
                deposits
            
            
            28
            
            
            262
            
            
            290
            
            
            (4
            )
            
            130
            
            
            126Federal
                funds sold and securities purchased under the agreement to
                resale
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Total
                change
            
            
            2,302
            
            
            8,788
            
            
            11,090
            
            
            8,840
            
            
            8,787
            
            
            17,627**Interest
                expense:**Savings
                and NOW
            
            
            (1
            )
            
            73
            
            
            72
            
            
            -
            
            
            50
            
            
            50MMI
            
            
            (653
            )
            
            1,276
            
            
            623
            
            
            1,017
            
            
            1,076
            
            
            2,093Time
                deposits
            
            
            2,004
            
            
            4,854
            
            
            6,858
            
            
            1,471
            
            
            4,310
            
            
            5,781Federal
                funds purchased, borrowed funds and securities sold under agreements
                to
                repurchase
            
            
            698
            
            
            1,582
            
            
            2,280
            
            
            579
            
            
            1,119
            
            
            1,699Total
                change
            
            
            2,050
            
            
            7,783
            
            
            9,833
            
            
            3,067
            
            
            6,555
            
            
            9,622Increase
                (decrease) in net interest income
            
            $
            252
            
            $
            1,005
            
            $
            1,257
            
            $
            5,773
            
            $
            2,232
            
            $
            8,005





*(1)
      Yields on nontaxable securities are stated on a fully taxable equivalent basis,
      assuming a 34% Federal tax rate.*


*The
      adjustments made to convert to a fully taxable equivalent basis were $947,000
      for 2006, $680,000 for 2005, and $692,000 for 2004.*


*(2)
      Changes attributable to both volume and rate have been allocated
      proportionately.*





**Results
      of Operations -Years Ended December 31, 2006 and 2005**




*Net
      Income.* Our
      net
      income for 2006 was $9.11 million, representing diluted net income per share
      of
      $1.26, compared to $0.11 per diluted share a year earlier. The increase in
      2006
      net income is primarily attributable to the impact on 2005 results of aggregate
      special provisions for credit losses of $14.5 million recorded during the third
      and fourth quarters of the year ended December 31, 2005. For the year ended
      December 31, 2005, the after-tax financial impact from the adverse credit
      conditions discussed above amounted to $9.5 million, or $1.32 per diluted share.
      We have continued to maintain a solid portfolio of earning assets, with total
      assets averaging $1.02 billion during the current year, compared to $965.7
      million in 2005, an increase of 5.4%. Our net interest income after provision
      for credit losses increased $15.7 million over the prior year. The increase
      in
      net interest income is primarily due to a decrease in the provision for credit
      losses to $1.4 million in 2006, from $16.1 million in 2005 **[see
      - Item 1. Business - Memorandum of Understanding - Lifted as of 12/31/2006].** During
      2006, the Federal Reserve continued increasing the target for the federal funds
      rate in 25 basis point increments, which ultimately increased the target for
      the
      federal funds rate a total of 100 basis points during the year. Paralleling
      this
      rise in the federal funds rate was an increase in the prime lending rate, from
      7.25% at the beginning of the year to 8.25% at yearend 2006. Net interest income
      increased $989,000, primarily as a result of the rising interest rate
      environment, combined with the growth in earning assets, more than
      offsetting the declining noninterest income and higher expenses. Our
      noninterest expense growth continued due to additional personnel and other
      infrastructure costs associated with the expansion of our business, as well
      as
      the increased use of legal, accounting, and loan review consultants required
      to
      assist management as it addressed those matters discussed in **Item
      1. Business - Memorandum of Understanding - Lifted as of
      12/31/2006.**





*Net
      Interest Income.* Net
      interest income represents the gross profit from the lending and investment
      activities of a banking organization and is the most significant factor
      affecting the earnings of the Company. Net interest income is influenced by
      changes in interest rates, volume and the mix of these various components.
      Net
      interest income on a fully taxable equivalent basis for 2006 was $39.3 million,
      which represented a 3.3% increase from the previous year’s level
      of $38.1
      million. Actual net interest





28
 *Table
            of Contents*





income
      for 2006 was $38.4 million, a $1.0 million increase from the $37.4 million
      recorded in 2005. Average total earning assets increased $54.2 million, or
      5.9%,
      during 2006 as compared to 2005, while our average net yield declined 10 basis
      points, from 4.18% in 2005 to 4.08% in 2006. The rates earned on a significant
      portion of our loans adjust when index rates such as the prime lending rate
      changes. Conversely, most of our interest-bearing liabilities, including
      certificates of deposit and borrowings, have rates fixed until maturity. As
      a
      result, interest rate increases generally result in an immediate positive impact
      to interest income on loans, with a more delayed impact on interest expense
      because increases in interest costs will occur only upon renewals of
      certificates of deposit or borrowings. Average loans outstanding during the
      2006
      fiscal year were $742.5 million, compared to $740.5 million in 2005, an increase
      of 0.3%. Average investment securities during 2006 were $211.3 million, compared
      to $160.0 million in 2005.





Trends
      in
      interest rates turned upward for the year, as the Federal Reserve increased
      the
      target for the federal funds rate by a total of 100 basis points during 2006.
      As
      a result, the prime lending rate rose to 8.25% at December 31, 2006 from 7.25%
      at December 31, 2005. This had the effect of increasing both the earning asset
      yield and the interest bearing liability rate. During 2006, the increase in
      the
      interest bearing liability rate outpaced the rise in the earning asset yield
      because of a competitive deposit pricing market.





The
      weighted average yield on earning assets increased to 7.66% for 2006, compared
      to 6.89% for 2005. This increase in the asset yield in 2006 was primarily
      attributable to the increased yield on loans, combined with an increased yield
      on investment securities. During the current year, the yield on loans increased
      101 basis points to 8.57%, from 7.56% in 2005. This rise is due to variable
      rate
      loans that repriced higher during the year in response to increases in the
      underlying index, and new fixed rate loans originated at higher
      rates.





The
      weighted average rate paid on interest bearing liabilities in 2006 was 4.07%,
      compared to 3.12% in 2005. Average interest bearing deposits for 2006 totaled
      $740.1 million, a 5.1% increase from $704.5 million in 2005. The overall rate
      for interest bearing deposits rose 87 basis points to 3.92% in 2006, compared
      to
      3.05% in the prior year. The overall rate on borrowings was 5.12% in 2006,
      compared to 3.65% a year earlier. Average borrowings totaled $107.6 million
      in
      2006 and $88.5 million in 2005, an increase of 21.6%.





The
      table, *“Average
      Balance Sheets and Net Interest Income Analysis* ,”
      summarizes net interest income and average yields earned and rates paid for
      the
      years indicated, on a tax equivalent basis. The table, “ *Analysis
      of Interest Changes Due to Volume and Rates* ,”
      presents the changes in interest income and interest expense attributable to
      volume and rate changes between the years indicated.





*Provision
      for Credit Losses and Allowance for Credit Losses.* We
      recorded a $1.4 million provision for credit losses for the year ended December
      31, 2006, compared to a $16.1 million provision in the prior year **[see
      - Item 1. Business - Memorandum of Understanding - Lifted as of 12/31/2006].** This
      decrease in the provision for credit losses in 2006 is primarily attributable
      to
      aggregate special provisions for credit losses of $14.5 million recorded during
      the third and fourth quarters of 2005. Our allowance for credit losses decreased
      from $19.1 million at December 31, 2005 to $13.2 million at December 31, 2006.
      The allowance for credit losses expressed as a percentage of total loans
      decreased from 2.53% at December 31, 2005 to 1.87% at December 31, 2006. The
      high level of provision for credit losses in 2005 and the correspondingly high
      level of our allowance for credit losses, expressed as a percentage of total
      loans, resulted directly from the evaluation of loans discussed previously.
      During 2006, the Bank has carefully monitored the ongoing analysis of those
      loans, and, as of December 31, 2006, management has concluded that the allowance
      for credit losses for the Bank is adequate to absorb probable losses inherent
      in
      the loan portfolio.





*Noninterest
      Income.* Noninterest income of $5.5 million in 2006 was $1.9 million, or 25.4%, less
      than
      the previous year amount of $7.4 million. The primary reason for the decrease
      in
      noninterest income





29
 *Table
            of Contents*





compared
      to 2005 is due to a $1.7 million decrease in mortgage banking fees. The rising
      interest rate environment has dampened the demand for mortgage loans resulting
      in a decline in fees associated with the generation of mortgage loans. There
      was
      $32,000 of net gains on sales of securities available for sale during 2006,
      compared to no net gains or losses in 2005. Service charges on deposit accounts
      were unchanged at $3.8 million for the years ended December 31, 2006 and 2005.





*Noninterest
      Expense.* Noninterest expense for 2006 was $28.9 million, a 2.5% increase compared to
      the
      $28.2 million expense in 2005. Salaries and employee benefits increased $1.6
      million because of higher costs associated with additional headcount, the
      employment of individuals with increased educational background and experience,
      and the recognition of stock option expense during 2006, combined with higher
      healthcare insurance and retirement costs. At December 31, 2006, we had
      approximately 278 full-time and 14 part-time employees, compared with 248
      full-time and 18 part-time employees at December 31, 2005. Occupancy and
      equipment expenses totaled $4.7 million for 2006, which was unchanged from
      2005.
      Other expenses were $8.1 million in 2006, compared to $9.1 million in 2005,
      resulting from the Company’s noninterest expense reduction efforts.





*Provision
      for Income Taxes.* The
      Company recorded a tax provision of $4.4 million in 2006, compared to an income
      tax benefit totaling $344,000 for 2005. The benefit in 2005 is primarily
      attributable to the $14.5 million aggregate special provisions for credit losses
      recorded during 2005. As a result, the Company posted income before taxes for
      2005 of $448,000, compared to $13.6 million in 2006. While the Company’s income
      before income taxes for 2005 was significantly lower than 2006, as a result
      of
      the high level of provision for credit losses, the level of tax exempt income
      remained relatively stable. These factors resulted in a much higher percentage
      of our income before income taxes being comprised of tax exempt income in 2005,
      compared to 2006, which in turn resulted in the aforementioned tax benefit
      in
      2005. The Company’s effective tax rates were 32.8% in 2006 and 32.9% in 2005,
      comparable to historical levels.





**Results
      of Operations -Years Ended December 31, 2005 and 2004**




*Net
      Income.* Our
      net
      income for 2005 was $792,000, representing diluted net income per share of
      $0.11, compared to $1.17 per diluted share a year earlier. The decrease in
      2005
      net income was primarily attributable to aggregate special provisions for credit
      losses of $14.5 million recorded during the third and fourth quarters of the
      year ended December 31, 2005. For the year ended December 31, 2005, the
      after-tax financial impact from the adverse credit conditions discussed above
      amounted to $9.5 million, or $1.32 per diluted share. We continued to experience
      strong growth, with total assets averaging $965.7 million during 2005, as
      compared to $815.6 million in 2004, an increase of 18.4%. Our net interest
      income after provision for credit losses decreased $6.8 million over the prior
      year. The decrease in net income was primarily due to an aggregate provision
      for
      credit losses of $16.1 million for 2005 **[see
      - Item 1. Business - Memorandum of Understanding - Lifted as of 12/31/2006].** During
      2005, the Federal Reserve continued increasing the target for the federal funds
      rate at 25 basis point increments, which ultimately increased the target for
      the
      federal funds rate a total of 200 basis points during the year. Paralleling
      this
      rise in the federal funds rate was an increase in the prime rate from 5.25%
      at
      the beginning of 2005, to 7.25% at yearend 2005. Net interest income increased
      $8.0 million, primarily as a result of the growth in earning assets, combined
      with a rising interest rate environment, helping mitigate the declining
      noninterest income and higher expenses, including the provision for credit
      losses. Our noninterest expense growth continued due to additional personnel
      and
      other infrastructure costs associated with the expansion of our business, as
      well as the utilization of the services of legal and regulatory counsel,
      accounting, loan review and consulting specialists to respond to specific issues
      addressed by management in its loan review process, in regulatory examinations
      and SOX compliance.





*Net
      Interest Income.* Net
      interest income represents the gross profit from the lending and investment
      activities of a banking organization and is the most significant factor
      affecting the earnings of the Company. Net interest income is influenced by
      changes in interest rates, volume and the mix of these various components.
      Net
      interest income on a fully taxable equivalent basis for 2005 was $39.3 million,
      which represented a 27.3% increase from the previous year level of $30.1
      million. Actual net interest  30
 *Table
            of Contents*


income
      for 2005 was $37.4 million, an $8.0 million increase from $29.4 million recorded
      in 2004.  Average total earning assets increased $146.8 million, or 19.2%,
      during 2005 as compared to 2004, while our average yield rose 24 points, from
      3.94% in 2004 to 4.18% in 2005. The rates earned on a significant portion of
      our
      loans adjust when index rates such as prime rate changes. Conversely, most
      of
      our interest-bearing liabilities, including certificates of deposit and
      borrowings, have rates fixed until maturity. As a result interest rate increases
      generally result in an immediate positive impact to interest income on loans,
      with a more delayed impact on interest expense because increases in interest
      costs will occur only upon renewals of certificates of deposit or borrowings.
      Average loans outstanding during the 2005 fiscal year were $740.5 million,
      compared to $613.5 million in 2004, an increase of 20.7%. Average investment
      securities during 2005 were $160.0 million, compared to $139.9 million in 2004.





The
      Federal Reserve increased the target for the federal funds rate by a total
      of
      200 basis points during 2005. As a result, the prime lending rate rose to 7.25%
      at December 31, 2005 from 5.25% at December 31, 2004. This had the effect of
      increasing both the earning asset yield and the interest bearing liability
      rate.
      During 2005, the rise in the earning asset yield outpaced the increase in the
      interest bearing liability rate.





The
      weighted average yield on earning assets increased to 6.89% for 2005, compared
      to 5.91% for 2004. This increase in the asset yield in 2005 was primarily
      attributable to the increased yield on loans, combined with a decreased yield
      on
      investment securities. During 2005, the yield on loans increased 110 basis
      points, to 7.56% from 6.46% in 2004. This rise was due to variable rate loans
      that repriced higher during the year in response to increases in the underlying
      index, and new fixed rate loans originated at higher rates.





The
      weighted average rate paid on interest bearing liabilities was 3.12%, compared
      to 2.28% in 2004. Average interest bearing deposits for 2005 totaled $704.5
      million, a 17.7% increase from $598.7 million in 2004. The overall rate for
      interest bearing deposits declined 46 basis points to 2.26% in 2004, compared
      to
      2.72% in the prior year. The overall rate on borrowings was 3.65% in 2005,
      compared to 2.38% a year earlier. Average borrowings totaled $88.5 million
      in
      2005 and $64.1 million in 2004, an increase of 3.8%.





The
      table, *“Average
      Balance Sheets and Net Interest Income Analysis* ,”
      summarizes net interest income and average yields earned and rates paid for
      the
      years indicated, on a tax equivalent basis. The table, “ *Analysis
      of Interest Changes Due to Volume and Rates* ,”
      presents the changes in interest income and interest expense attributable to
      volume and rate changes between the years indicated.





*Provision
      for Credit Losses and Allowance for Credit Losses.* We
      recorded a $16.1 million provision for credit losses for the year ended December
      31, 2005, compared to a $1.3 million provision in the prior year **[see
      - Item 1. Business - Memorandum of Understanding - Lifted as of 12/31/2006].** The
      provision for credit losses increased $14.9 million, compared to 2004. The
      increase in the provision for credit losses in 2005 was primarily attributable
      to aggregate special provisions for credit losses of $14.5 million recorded
      during the third and fourth quarters of the year ended December 31, 2005. Our
      allowance for credit losses increased from $7.4 million at December 31, 2004
      to
      $19.1 million at December 31, 2005. The allowance for credit losses expressed
      as
      a percentage of total loans increased from 1.11% at December 31, 2004 to 2.53%
      at December 31, 2005. This increase in our 2005 provision for credit losses
      and
      the corresponding increase in our allowance for credit losses, expressed as
      a
      percentage of total loans, resulted directly from the evaluation of loans
      discussed previously. Management also determined that, due to the specific
      facts
      and circumstances identified during these impairment evaluations, the resulting
      increase in the allowance for credit losses was properly recorded in 2005.
      As of
      December 31, 2005, management concluded that the allowance for credit losses
      for
      the Bank is adequate to absorb probable losses inherent in the loan portfolio.





*Noninterest
      Income.* Noninterest income of $7.4 million in 2005 was $703,000, or 8.7%, less than
      the
      previous year amount of $8.1 million. The primary reason for the decrease in
      noninterest income compared to prior year was due to the $825,000 net realized
      gain for the sale of the Richlands, VA  31
 *Table
            of Contents*


banking
      operation and the associated fixed assets of the branch in 2004. There were
      no
      net gains on sale of securities for 2005 compared to $109,000 in 2004. Service
      charges on deposit accounts were relatively flat at $3.8 million for the years
      ended December 31, 2005 and 2004. Revenues from our mortgage banking operation
      increased 15.1%, rising from $2.2 million in 2004 to $2.6 million in 2005 as
      we
      began to realize increased revenues from our mortgage operations.





*Noninterest
      Expense.* Because
      of our continued strong growth we experienced increases in every major component
      of our noninterest expenses. For the year ended December 31, 2005, our
      noninterest expense increased $4.4 million, or 18.7%. Personnel expense of
      $14.4
      million in 2005 exceeded the previous year expense of $12.4 million by $2.0
      million, or 16.4% and reflected increased staffing costs associated with the
      relocation of our corporate headquarters, expansion of our commercial lending
      staff, and the additional costs arising from the normal expansion of business,
      along with normal increases in salaries and benefits. At December 31, 2005,
      we
      had approximately 248 full-time and 18 part-time employees, compared with 255
      full-time and 14 part-time employees at December 31, 2004. Occupancy and
      equipment expenses totaled $4.7 million for 2005, which was up 9.4% from $4.3
      million in 2004, reflecting the expenses associated with our corporate
      headquarter relocation and investments in technology to support our banking
      operations. The credit related issues discussed previously also impacted
      noninterest expense in 2005 as the Company augmented its staff and employed
      the
      services of legal and regulatory counsel, accounting, loan review and consulting
      specialists to respond to specific issues addressed by management in its loan
      review process, in regulatory examinations and SOX compliance . Other expenses
      were $9.1 million, compared to $7.1 million in 2004, reflecting the increased
      volume of business activity, principally increases in lending and growth in
      deposit accounts.





*Provision
      for Income Taxes.* The
      Company recorded an income tax benefit totaling $344,000 for 2005, compared
      to a
      tax provision of $4.1 million in 2004. The decrease in 2005 net income is
      primarily attributable to the aggregate special provisions for credit losses
      previously discussed. As a result, the Company posted income before taxes for
      2005 of $448,000. While the Company’s income before income taxes for 2005
      declined significantly, in comparison to 2004, as a result of the increase
      in
      our provision for credit losses, the level of tax exempt income remained
      relatively stable. These factors resulted in a much larger percentage of our
      income before income taxes which was comprised of tax exempt income, which
      in
      turn, resulted in the aforementioned tax benefit in 2005.





**Liquidity
      and Cash Flow**





Market
      and public confidence in our financial strength and in the strength of financial
      institutions in general will largely determine our access to appropriate levels
      of liquidity. This confidence is significantly dependent on our ability to
      maintain sound asset quality and appropriate levels of capital resources.
      Liquidity management refers to the ability to meet day-to-day cash flow
      requirements based primarily on activity in loan and deposit accounts of the
      Company’s customers. Management measures our liquidity position by giving
      consideration to both on- and off-balance sheet sources of, and demands for,
      funds on a daily and weekly basis. Deposit withdrawals, loan funding and general
      corporate activity create a need for liquidity for the Company. Sources of
      liquidity include cash and cash equivalents, net of federal requirements to
      maintain reserves against deposit liabilities, investment securities eligible
      for pledging to secure borrowings from correspondent banks pursuant to
      securities sold under repurchase agreements, investments available for sale,
      loan repayments, loan sales, deposits, and borrowings from the FHLB secured
      with
      pledged loans and securities, and from correspondent banks under overnight
      federal funds credit lines. In addition to interest rate-sensitive deposits,
      the
      Company’s primary demand for liquidity is anticipated fundings under credit
      commitments to customers.





The
      investment portfolio at December 31, 2006, included securities with call
      features, whereby the issuer of such a security has the option to repay the
      purchaser of said instrument and cancels the instrument before the contractual
      maturity date. Due to the interest rate on the original instrument and current
      market rates on such instruments, the Company anticipates that very few debt
      instruments in the portfolio will be called in the upcoming year.





32
 *Table
            of Contents*





During
      2006, the Company’s decrease in the loan portfolio was offset by increases in
      investments. Overall, cash and cash equivalents decreased by $1.5 million,
      to
      $25.7 million at December 31, 2006.





As
      presented in the consolidated statement of cash flows, the Company generated
      $7.6 million in operating cash flow during 2006, a decrease from $24.3 million
      in 2005. This decrease was primarily the result of a decrease in the provision
      for credit losses, as well as a net increase in other liabilities. The operating
      cash flow generated in 2005 was a significant increase over 2004, when the
      Company generated $3.0 million in operating cash flow. The increase in the
      provision for credit losses, combined with a decrease in loans held for sale,
      were primary contributors to this change in 2005, offset somewhat by a net
      increase in deferred income taxes and a net increase in other assets, and a
      net
      increase in other liabilities.





In
      2006,
      the Company experienced a net decrease of $44.9 million in loans, compared
      to a
      net increase of $102.3 million in 2005. During 2006, the Company received $30.0
      million from sales, calls, and maturities of securities, while purchasing $44.8
      million. This compares to 2005, when the Company received $23.7 million from
      sales, calls, and maturities of securities, while purchasing $86.0 million.





An
      increase of $19.1 million in federal funds purchased and retail and wholesale
      repurchase agreements represented the primary source of funding for the Company
      in 2006. Net increases in deposits totaling $100.3 million, combined with a
      $15.8 million net increase in other borrowings, federal funds purchased, retail
      repurchase agreements, and the issuance of $25.8 million of junior subordinated
      notes, comprised the Company’s major financing sources during 2005, amounting to
      a net $141.9 million versus a combined total of $78.1 million during 2004.
      Partially offsetting these cash inflows was the repurchase of $1.9 million
      of
      the Company’s outstanding common stock in 2006, compared to repurchases of
      $855,000 in 2005 and $3.5 million in 2004.




Liquidity
      is further enhanced by a line of credit with the FHLB, amounting to
      approximately $177 million, collateralized by FHLB stock, investment securities,
      qualifying 1 to 4 family residential mortgage loans, and qualifying commercial
      real estate loans. The Company provides various reports to the FHLB on a regular
      basis throughout the year to maintain the availability of the credit line.
      Each
      borrowing request to the FHLB is initiated through an advance application that
      is subject to approval by the FHLB before funds are advanced under the credit
      agreement.





The
      Company also has unsecured overnight borrowing lines totaling $50 million
      available through five financial institutions. These lines are used to manage
      the day-to-day, short-term liquidity needs of the Company. Each overnight line
      has a requirement to repay the line in full on a frequent basis, typically
      within five to ten business days. The Company also has established wholesale
      repurchase agreements with regional brokerage firms. The Company can access
      this
      additional source of liquidity by pledging investment securities with the
      brokerage firm.





The
      Company also projects future cash flow requirements based on scheduled loan
      and
      deposit maturities, borrowing maturities, capital expenditures and other
      factors. At December 31, 2006 and for the upcoming twelve-month period, the
      Company had scheduled loan maturities of $241.8 million,  securities
      maturities of $26.3 million and $497.0 million in maturing time deposits. The
      Company also has $186.4 million in time deposits with no contractual maturity,
      and $87.0 million in demand deposit accounts that are subject to withdrawal
      during 2007. The Company has $25.0 million of borrowings that are scheduled
      for
      repayment in 2007. Anticipated capital expenditures during 2007 are
      approximately $3.3 million. Internal analysis indicated the Company is
      positioned to meet expected liquidity requirements during the upcoming
      twelve-month period.





**Contractual
      Obligations and Commitments**





In
      the
      normal course of business there are various outstanding contractual obligations
      of the Company that will require future cash outflows. In addition, there are
      commitments and contingent liabilities, such as commitments to extend credit,
      which may or may not require future cash outflows. Payments for borrowings
      do
      not include interest. Payments related to leases are based on actual payments
      specified in





33
 *Table
            of Contents*





the
      underlying contracts. The accompanying table reflects contractual obligations
      of
      the Company outstanding as of December 31, 2006.





**Contractual
      Obligations**


*(In
      thousands)*


**Payments
                Due by Period****Within
                One**
              **Year**
            
            **One
                Year**
              **to
                Three**
              **Years**
            
            **Three
                Years**
              **to
                Five**
              **Years**
            
            **After**
              **Five**
              **Years**
            
            **Total**Other
                borrowings
            
            $
            25,000
            
            $
            30,000
            
            $
            -
            
            $
            25,774
            
            $
            80,774Federal
                funds purchased and retail repurchase agreements
            
            
            5,384
            
            
            -
            
            
            -
            
            
            21,000
            
            
            26,384Operating
                lease obligations
            
            
            937
            
            
            1,525
            
            
            864
            
            
            182
            
            
            3,508Purchase
                obligations
            
            
            2,615
            
            
            207
            
            
            10
            
            
            -
            
            
            2,832Other
                long-term liabilities
            
            
            257
            
            
            498
            
            
            476
            
            
            1,063
            
            
            2,294Total
                contractual cash obligations excluding deposits
            
            
            34,193
            
            
            32,230
            
            
            1,350
            
            
            48,019
            
            
            115,792Deposits
            
            
            770,429
            
            
            39,703
            
            
            8,392
            
            
            44
            
            
            818,568Total
                contractual cash obligations
            
            $
            804,622
            
            $
            71,933
            
            $
            9,742
            
            $
            48,063
            
            $
            934,360





**Capital
      Resources**





Banks,
      bank holding companies, and financial holding companies, as regulated
      institutions, must meet required levels of capital. The Federal Reserve has
      adopted minimum capital regulations or guidelines that categorize components
      and
      the level of risk associated with various types of assets. Financial
      institutions are required to maintain a level of capital commensurate with
      the
      risk profile assigned to their assets in accordance with the guidelines. On
      August 26, 2005, the Company completed a Trust Preferred Securities transaction
      in the amount of $25.0 million. The Company contributed $24.0 million of the
      proceeds to the Bank as Tier I capital to support the Bank’s growth. See the
      Notes to the Consolidated Financial Statements for a discussion of the Company’s
      issuance of trust preferred securities. As shown in the table, “ *Regulatory
      Capital* ,”
the
      Company and the Bank both maintained capital levels exceeding the minimum levels
      required to be categorized as “well capitalized” for each of the three years
      presented.





**Regulatory
      Capital**


*(Dollars
      in thousands)*


As
                  of / for year ended December 31,2006
              
              2005
              
              2004Total
                  capital to risk weighted assetsConsolidated
              
              $
              110,324
              
              
              13.7
              %
              
              $
              103,514
              
              
              13.2
              %
              
              $
              77,738
              
              
              11.3
              %Subsidiary
                  Bank
              
              
              106,999
              
              
              13.3
              
              
              
              101,373
              
              
              13.0
              
              
              
              75,469
              
              
              11.0Tier
                  1 capital to risk weighted assetsConsolidated
              
              
              100,243
              
              
              12.5
              
              
              
              91,751
              
              
              11.7
              
              
              
              70,025
              
              
              10.2Subsidiary
                  Bank
              
              
              96,927
              
              
              12.1
              
              
              
              91,480
              
              
              11.7
              
              
              
              68,116
              
              
              10.0Tier
                  1 capital to average assetsConsolidated
              
              
              100,243
              
              
              10.0
              
              
              
              91,751
              
              
              9.1
              
              
              
              70,025
              
              
              8.2Subsidiary
                  Bank
              
              
              96,927
              
              
              9.6
              
              
              
              91,480
              
              
              9.0
              
              
              
              68,116
              
              
              8.0





**Lending
      Activities**





*General.* The
      Company offers a broad array of lending services, including construction, real
      estate, commercial and consumer loans, to individuals and small to medium-sized
      businesses and other organizations that are located in or conduct a substantial
      portion of their business in the Company’s market areas. The Company has
      specialized lending departments for residential construction lending
      in





34
 *Table
            of Contents*





selected
      markets. The Company’s total loans at December 31, 2006, were $707.1 million, or
      70.8% of total assets. It also makes secured construction loans to homebuilders
      and residential mortgages, which are often secured by first and second real
      estate mortgages. At December 31, 2006, the Company had no large loan
      concentrations (exceeding 10% of its portfolio) in any particular industry,
      other than real estate.





*Loan
      Composition.* The
      accompanying table summarizes, at the dates indicated, the composition of the
      Company’s loan portfolio and the related percentage composition.





*Real
      Estate Loans* .
      Loans
      secured by real estate for a variety of purposes constituted $514.6 million,
      or
      72.8%, of the Company’s total loans at December 31, 2006. At yearend, the
      Company held real estate loans of various sizes ranging up to $7.8 million
      and
      commitments up to $10.7 million, secured by office buildings, retail
      establishments, residential development and construction, warehouses, motels,
      restaurants and other types of property. Loan terms are typically limited to
      five years, with payments through the date of maturity generally based on a
      15-20 year amortization schedule. Interest rates may be fixed or adjustable,
      based on market conditions, and the Company generally charges an origination
      fee. Management has attempted to reduce credit risk in the real estate portfolio
      by emphasizing loans on owner-occupied office and retail buildings where the
      loan to value ratio, established by independent appraisals, does not exceed
      80%,
      and net projected cash flow available for debt service amounts to at least
      120%
      of the debt service requirement. The Company also often requires personal
      guarantees of the principal owners of the property and obtains personal
      financial statements of the principal owners in such cases. The Company
      experienced net chargeoffs on commercial real estate loans of $1.1 million
      in
      2006, $2.4 million in 2005, and $298,000 in 2004.





**Loan
      Portfolio Composition**


*(Dollars
      in thousands)*


As
                of December 31,2006
            
            2005Real
                Estate:Commercial
            
            $
            173,203
            
            
            24.5
            %
            
            $
            177,987
            
            
            23.5
            %Residential
            
            
            116,287
            
            
            16.5
            
            
            
            142,305
            
            
            18.8Construction
            
            
            225,080
            
            
            31.8
            
            
            
            213,506
            
            
            28.2Total
                real estate
            
            
            514,570
            
            
            72.8
            
            
            
            533,797
            
            
            70.4Commercial,
                financial and
              Agricultural
            
            
            60,435
            
            
            8.5
            
            
            
            77,008
            
            
            10.2Consumer:Direct
            
            
            27,783
            
            
            3.9
            
            
            
            37,338
            
            
            4.9Home
                equity
            
            
            88,889
            
            
            12.6
            
            
            
            91,647
            
            
            12.1Revolving
            
            
            15,469
            
            
            2.2
            
            
            
            18,178
            
            
            2.4Total
                consumer
            
            
            132,141
            
            
            18.7
            
            
            
            147,163
            
            
            19.4Total
            
            $
            707,146
            
            
            100.0
            %
            
            $
            757,967
            
            
            100.0
            %





**Loan
      Portfolio Composition (** ***cont’d*** **)**


*(Dollars
      in thousands)*





As
                of December 31,2004
            
            2003
            
            2002Real
                Estate:Commercial
            
            $
            166,685
            
            
            25.1
            %
            
            $
            159,953
            
            
            27.5
            %
            
            $
            170,657
            
            
            30.3
            %Residential
            
            
            113,407
            
            
            17.1
            
            
            
            94,864
            
            
            16.3
            
            
            
            119,316
            
            
            21.2Construction
            
            
            162,143
            
            
            24.5
            
            
            
            117,786
            
            
            20.3
            
            
            
            87,696
            
            
            15.6Total
                real estate
            
            
            442,235
            
            
            66.7
            
            
            
            372,603
            
            
            64.1
            
            
            
            377,669
            
            
            67.1Commercial,
                financial andagricultural
            
            
            86,184
            
            
            13.0
            
            
            
            90,224
            
            
            15.5
            
            
            
            87,458
            
            
            15.5Consumer:Direct
            
            
            40,741
            
            
            6.1
            
            
            
            39,276
            
            
            6.7
            
            
            
            34,074
            
            
            6.0Home
                equity
            
            
            75,435
            
            
            11.4
            
            
            
            65,563
            
            
            11.3
            
            
            
            54,073
            
            
            9.6Revolving
            
            
            18,831
            
            
            2.8
            
            
            
            13,718
            
            
            2.4
            
            
            
            10,326
            
            
            1.8Total
                consumer
            
            
            135,007
            
            
            20.3
            
            
            
            118,557
            
            
            20.4
            
            
            
            98,473
            
            
            17.4Total
            
            $
            663,426
            
            
            100.0
            %
            
            $
            581,384
            
            
            100.0
            %
            
            $
            563,600
            
            
            100.0
            %





35
 *Table
            of Contents*





The
      Company originates residential loans for its portfolio on single and
      multi-family properties, both owner-occupied and non owner-occupied, and at
      December 31, 2006, it held $116.3 million of such loans. Loan terms are
      typically limited to five years, with payments through the date of maturity
      generally based on 15 to 30 year amortization schedules. Rates may be fixed
      or
      variable, and the Company typically charges an origination fee. The Company
      attempts to minimize credit risk by requiring a loan to value ratio of 80%
      or
      less. The Company experienced net chargeoffs on residential real estate loans
      of
      $538,000 and $75,000 in 2006 and 2005, respectively, and net recoveries on
      residential real estate loans of $1,000 in 2004. The Company also originates
      loans for individuals for the purchase of lots on which they plan to later
      build
      personal residences.





The
      Company also originates residential mortgage loans for sale into the secondary
      market. Through its mortgage banking activities, the Company originates both
      fixed and variable rate residential mortgage loans for sale with servicing
      released. The Company is able to generate loan origination fees, typically
      ranging from 1.0% to 1.5% of the loan balance, which are recognized as income
      when the loan is closed with the investor. At December 31, 2006, the Company
      held $2.7 million of such loans which were in process of closing with investors,
      and during 2006 the Company sold an aggregate of $45.5 million of such loans.
      The Company sells these loans on a non-recourse basis.





The
      Company’s current lending strategy is for the majority of construction and
      development loans on commercial and residential projects to be in the range
      of
      $300,000 to $5.0 million. At December
      31, 2006, 2005, and 2004, the Company held $225.1 million, $213.5 million,
      and
      $162.1 million, respectively, of such loans. To reduce credit risk associated
      with such loans, the Company emphasizes small commercial centers that have
      strong anchor tenants and are substantially pre-leased, or residential projects
      that are substantially presold and built in strong, proven markets. The leases
      on commercial projects must generally result in a loan to appraised value of
      80%
      or less and a net cash flow to debt service at no less than 120%. The Company
      typically requires a personal guarantee from the developer or builder. Loan
      terms are typically twelve to fifteen months, although the Company occasionally
      will make a “mini-permanent” loan for purposes of construction and development
      of up to a five year term. Rates are typically variable, and the Company
      typically charges an origination fee. The Company experienced net chargeoffs
      from construction and development loans during 2006 of $215,000, and no net
      chargeoffs during 2005 or 2004.





**Loan
      Portfolio - Maturities and Interest Rate Sensitivities**


*(In
      thousands)*


Maturity
              
              Maturity
                  Greater Than One YearOne
                  Year
                or
                  Less
              
              Over
                  One
                Year
                  to
                Five
                  Years
              
              Over
                Five
                Years
              
              Total
              
              Predetermined
                Interest
                  Rate
              
              Floating
                  or
                Adjustable
                RateCommercial,
                  financial and agricultural
              
              $
              23,536
              
              $
              30,516
              
              $
              6,383
              
              $
              60,435
              
              $
              9,479
              
              $
              27,419Real
                  estate - construction
              
              
              146,296
              
              
              78,276
              
              
              508
              
              
              225,080
              
              
              21,375
              
              
              57,410Real
                  estate - residential
              
              
              24,433
              
              
              82,698
              
              
              9,156
              
              
              116,287
              
              
              55,609
              
              
              36,246Real
                  estate - commercial
              
              
              43,383
              
              
              119,341
              
              
              10,479
              
              
              173,203
              
              
              62,342
              
              
              67,477Consumer
              
              
              12,661
              
              
              32,644
              
              
              86,836
              
              
              132,141
              
              
              21,151
              
              
              98,329Total
              
              $
              250,309
              
              $
              343,475
              
              $
              113,362
              
              $
              707,146
              
              $
              169,956
              
              $
              286,881


*Commercial
      Loans.* The
      Company makes loans for commercial purposes to various types of businesses.
      At
      December 31, 2006, the Company held $60.4 million of commercial loans, or 8.5%
      of its total loan portfolio. Equipment loans are typically made on terms up
      to
      five years at fixed or variable rates, with the financed equipment pledged
      as
      collateral to the Company. The Company attempts to reduce its credit risk on
      these loans by limiting the loan to value ratio to 80%. Working capital loans
      are made on terms typically not exceeding one year. These loans may be secured
      or unsecured, but the Company attempts to limit its credit risk by requiring
      the
      borrower to demonstrate its capacity to produce net cash flow available for
      debt
      service equal to 110% to 150% of its debt service requirements. The
      Company





36
 *Table
            of Contents*





experienced
      net charge-offs from commercial loans of $4.1 million in 2006, $694,000 in
      2005,
      and $248,000 in 2004.





*Consumer
      Loans.* The
      Company makes a variety of loans to individuals for personal and household
      purposes, including (i) secured and unsecured installment and term loans
      originated directly by the Company; (ii) home equity revolving lines of credit;
      (iii) unsecured revolving lines of credit, and (iv) amortizing secured lot
      loans. The home equity loans and certain of the direct loans are secured by
      the
      borrowers’ residences. At December 31, 2006, the Company held $132.1 million of
      consumer loans, including home equity lines of credit. During 2006, 2005, and
      2004, respectively, the Company experienced net consumer chargeoffs of $1.4
      million, $1.2 million, and $501,000.





*Loan
      Approval and Review.* As a
      result of its internal investigations and the reviews by independent consultants
      in 2005, the Company has revised its loan policies and adopted various levels
      of
      officer lending authority in connection with its loan approval policies. When
      the aggregate outstanding loans to a single borrower exceed that individual
      officer’s lending authority, the loan request must be considered and approved by
      an officer with a higher lending limit. Branch loan officers typically have
      retail lending
      limits ranging from $75,000 to $250,000. Regional presidents can generally
      approve commercial relationships up to $750,000. If the lending request exceeds
      the regional president’s lending limit, the loan must be submitted to and
      approved by a senior credit officer. A senior credit officer has authority
      to
      approve commercial relationships up to $2,000,000 on a secured basis. Under
      joint approval, a senior credit officer and a regional president may approve
      loans up to $2,750,000 million. All loans in excess of $2,750,000 must be
      approved by the Chief Credit Officer (“CCO”), who may approve loans up to
      $5,000,000. Loans exceeding $5,000,000 up to $10,000,000 must be unanimously
      approved by a committee of a senior credit officer, the CCO, and the CEO. Loans
      over $10,000,000 must be approved by the Credit Management Committee of the
      Board.





In
      2006
      the Company initiated a new Loan Review Program, headed by the Loan Review
      Manager who reports directly to the Board of Directors. Incumbent in this
      program is an Annual Loan Review Coverage Plan which has been approved by the
      Board and which stipulates a certain volume of loan reviews to be completed
      by
      the Loan Review Manager and employees under his guidance, and an additional
      number of loan reviews to be completed by independent loan review consulting
      firms. In addition, all loan officers are charged with the responsibility of
      reviewing their portfolios and making adjustments to the risk ratings as needed.
      Further, executive management, including the CCO and the CEO, attend meetings
      in
      which large loans from each market are presented for review by the lenders.
      A
“Watch Loan Committee”, which includes the CCO and the senior credit officers,
      reviews all loans graded Special Mention, Substandard, Doubtful and Loss on
      a
      monthly basis, and this meeting is observed by the Loan Review Manager and
      summarized for the Board on a monthly basis.





The
      Company’s credit review system supplements its loan rating system, pursuant to
      which the Company may place a loan on its criticized asset list or may classify
      a loan in one of various other classification categories. A specified minimum
      percentage of loans in each adverse asset classification category, based on
      the
      historical loss experience of the Company in each such category, are used to
      determine the adequacy of the Company’s allowance for credit losses quarterly.
      These loans are also individually reviewed by the Watch Loan Committee of the
      Company to determine whether a greater allowance allocation is justified due
      to
      the facts and circumstances of a particular adversely classified
      loan.





The
      loan
      portfolio is analyzed on an ongoing basis to evaluate current risk levels,
      and
      risk grades are adjusted accordingly. The Company’s allowance for credit losses
      is also analyzed quarterly by management. This analysis includes a methodology
      that separates the total loan portfolio into homogeneous loan classifications
      for purposes of evaluating risk. The required allowance is calculated by
      applying a risk adjusted reserve requirement to the dollar volume of loans
      within a homogenous group. Major loan portfolio subgroups include: risk graded
      commercial loans, mortgage loans, home equity loans, retail loans and retail
      credit lines. The provisions of Statement of Financial Accounting Standard
      No.
      114 (“SFAS No. 114”), Accounting by Creditors for Impairment of a Loan, and
      related





37
 *Table
            of Contents*





pronouncements
      are applied to individually significant loans. Finally, individual reserves
      may
      be recorded based on a review of loans on the “watch list.”





See
      also
      Note 5 in the Notes to Consolidated Financial Statements of this Annual Report
      on Form 10-K.





**Asset
      Quality**





The
      Company considers asset quality to be of primary importance, and employs a
      formal internal loan review process (see *“Lending
      Activities - Loan Approval and Review”* )
      to
      ensure adherence to its lending policy as approved by the Bank’s and the
      Company’s Boards of Directors. It is the responsibility of each lending officer
      to assign an appropriate risk grade to every loan originated. Credit
      Administration, through the loan review process, validates the accuracy of
      the
      initial risk grade assessment. In addition, as a given loan’s credit quality
      improves or deteriorates, it is the lending officer’s responsibility to change
      the borrower’s risk grade accordingly. The function of determining the allowance
      for loan losses is fundamentally driven by the risk grade system. In determining
      the allowance for loan losses and any resulting provision to be charged against
      earnings, particular emphasis is placed on the results of the loan review
      process. Consideration is also given to historical loan loss experience, the
      value and adequacy of collateral, economic conditions in the Bank’s market area
      and other factors. For loans determined to be impaired, the allowance is based
      on discounted cash flows using the loan’s initial effective interest rate or the
      fair value of the collateral for certain collateral dependent loans. This
      evaluation is inherently subjective, as it requires material estimates,
      including the amounts and timing of future cash flows expected to be received
      on
      impaired loans that may be susceptible to significant change. The allowance
      for
      loan losses represents management’s estimate of the appropriate level of reserve
      to provide for probable losses inherent in the loan portfolio.




Currently,
        the grading process utilized by the Company is segmented by product type *(see
        discussion below)* .
        This
        methodology does not provide a direct correlation with groupings utilized
        in the
        other tables presenting loan information. However, management has initiated
        a
        project to identify the data in the loan grading process in comparable
        categories going forward.


The
      Company’s loan portfolio consists of loans made for a variety of commercial and
      consumer purposes. Because commercial loans are made based to a great extent
      on
      the Company’s assessment of a borrower’s income, cash flow, character and
      ability to repay, such loans are viewed as involving a higher degree of credit
      risk than is the case with residential mortgage loans or consumer loans. To
      manage this risk, the Company’s commercial loan portfolio is managed under a
      defined process which includes underwriting standards and risk assessment,
      procedures for loan approvals, loan grading, ongoing identification and
      management of credit deterioration and portfolio reviews to assess loss exposure
      and to ascertain compliance with the Company’s credit policies and procedures.





**Allocation
      of the Allowance for Credit Losses**


*(Dollars
      in thousands)*





2006
            
            2005
            
            2004
            
            2003
            
            2002Balance
                at end of period applicable to:Commercial
            
            $
            9,202
            
            $
            16,124
            
            $
            5,166
            
            $
            5,116
            
            $
            5,201Real
                estate-construction
            
            
            -
            
            
            3
            
            
            1
            
            
            5
            
            
            7Real
                estate-mortgage
            
            
            57
            
            
            81
            
            
            43
            
            
            49
            
            
            180Consumer
            
            
            3,936
            
            
            2,934
            
            
            2,143
            
            
            1,954
            
            
            1,671Total
                allocation
            
            $
            13,195
            
            $
            19,142
            
            $
            7,353
            
            $
            7,124
            
            $
            7,059





In
      general, consumer loans (including mortgage and home equity) have a lower risk
      profile than commercial loans. Commercial loans (including commercial real
      estate, commercial non real estate and construction loans) are generally larger
      in size and more complex than consumer loans. Commercial real estate loans
      are
      deemed less risky than commercial non real estate and construction loans,
      because the collateral value of real estate generally maintains its value better
      than non real estate or construction collateral. Consumer loans, which are
      smaller in size and more geographically diverse across the Company’s entire
      primary market area, provide risk diversity across the portfolio. Because
      mortgage loans are secured by first liens on the consumer’s residential real
      estate, they are the Company’s lowest risk profile loan type. Home equity loans
      are deemed less risky than unsecured consumer loans as home equity loans and
      lines are secured by first or second deeds of trust on the borrower’s
      residential real estate. A centralized decision-making process is in place
      to
      control the risk of the consumer, home equity





38
 *Table
            of Contents*





and
      mortgage loan portfolio. The consumer real estate appraisal process is also
      centralized relative to appraisal engagement, appraisal review, and appraiser
      quality assessment. These processes are detailed in the underwriting guidelines,
      which cover each retail loan product type from underwriting, servicing,
      compliance issues and closing procedures.




Management
      follows a loan review program designed to evaluate the credit risk in our loan
      portfolio. Through this loan review process, we maintain an internally
      classified watch list that helps management assess the overall quality of the
      loan portfolio and the adequacy of the allowance for loan losses. In
      establishing the appropriate classification for specific assets, management
      considers, among other factors, the estimated value of the underlying
      collateral, the borrower’s ability to repay, the borrower’s payment history and
      the current delinquent status. As a result of this process, certain loans are
      categorized as substandard, doubtful or loss and reserves are allocated based
      on
      management’s judgment and historical experience.




In
      determining the allowance for loan losses and any resulting provision to be
      charged against earnings, particular emphasis is placed on the results of the
      loan review process. Consideration is also given to a review of individual
      loans, historical loan loss experience, the value and adequacy of collateral,
      and economic conditions in the Company’s market area. For loans determined to be
      impaired, the allowance is based on discounted cash flows using the loan’s
      initial effective interest rate or the fair value of the collateral for certain
      collateral dependent loans. This evaluation is inherently subjective as it
      requires material estimates, including the amounts and timing of future cash
      flows expected to be received on impaired loans that may be susceptible to
      significant change. 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 to recognize changes
      to
      the allowance based on their judgments about information available to them
      at
      the time of their examinations. Loans are charged off when in the opinion of
      management, they are deemed to be uncollectible. Recognized losses are charged
      against the allowance, and subsequent recoveries are added to the allowance.




Management
      believes the allowance for credit losses of $13.2 million at December 31,
      2006 is adequate to cover probable losses in the loan portfolio; however,
      assessing the adequacy of the allowance is a process that requires continuous
      evaluation and considerable judgment. Management’s judgments are based on
      numerous assumptions about current events which it believes to be reasonable,
      but which may or may not be valid. Thus there can be no assurance that credit
      losses in future periods will not exceed the current allowance or that future
      increases in the allowance will not be required. No assurance can be given
      that
      management’s ongoing evaluation of the loan portfolio in light of changing
      economic conditions and other relevant circumstances will not require
      significant future additions to the allowance, thus adversely affecting the
      operating results of the Company.





39
 *Table
            of Contents*







The
      following table presents an analysis of the changes in the allowance for loan
      losses.




**Summary
      of Allowance for Credit Losses**


*(Dollars
      in thousands)*


2006
            
            2005
            
            2004
            
            2003
            
            2002Balance,
                beginning of period
            
            $
            19,142
            
            $
            7,353
            
            $
            7,124
            
            $
            7,059
            
            $
            6,731Charge-offs:Commercial
            
            
            4,221
            
            
            704
            
            
            253
            
            
            890
            
            
            1,017Real
                estate-construction
            
            
            224
            
            
            23
            
            
            -
            
            
            -
            
            
            -Real
                estate-mortgage
            
            
            1,776
            
            
            2,697
            
            
            348
            
            
            207
            
            
            32Consumer
            
            
            1,862
            
            
            1,238
            
            
            522
            
            
            450
            
            
            220Total
                charge-offs
            
            
            8,083
            
            
            4,662
            
            
            1,123
            
            
            1,547
            
            
            1,269Recoveries:Commercial
            
            
            165
            
            
            10
            
            
            5
            
            
            7
            
            
            188Real
                estate-construction
            
            
            9
            
            
            164
            
            
            -
            
            
            -
            
            
            -Real
                estate-mortgage
            
            
            105
            
            
            9
            
            
            31
            
            
            16
            
            
            7Consumer
            
            
            422
            
            
            137
            
            
            41
            
            
            158
            
            
            102Total
                recoveries
            
            
            701
            
            
            320
            
            
            77
            
            
            181
            
            
            297Net
                charge-offs
            
            
            7,382
            
            
            4,342
            
            
            1,046
            
            
            1,366
            
            
            972Provision
                charged to operations
            
            
            1,435
            
            
            16,132
            
            
            1,275
            
            
            1,431
            
            
            1,300Balance,
                end of period
            
            $
            13,195
            
            $
            19,142
            
            $
            7,353
            
            $
            7,124
            
            $
            7,059Annualized
                net credit losses to average loans
            
            
            0.99
            %
            
            0.59
            %
            
            0.17
            %
            
            0.24
            %
            
            0.18
            %Allowance
                for credit losses to period-end loans
            
            
            1.87
            %
            
            2.53
            %
            
            1.11
            %
            
            1.23
            %
            
            1.25
            %





*Commercial
      loans.* All
      commercial loans within the portfolio are risk graded among nine risk grades
      based on management’s evaluation of the overall credit quality of the loan,
      including the payment history, the financial position of the borrower, the
      underlying collateral value, an internal credit risk assessment and examination
      results. There is an increased reserve percentage for each successively higher
      risk grade. As a result, the allowance is adjusted upon any migration of a
      loan
      to a higher risk grade within the commercial loan portfolio.





The
      reserve percentages utilized have been determined by management to be
      appropriate based on historical loan loss levels and the risk for each
      corresponding risk grade. Reserve percentages for risk grades 6 through 9
      remained constant in 2006. The Company had 86.51% of its total commercial loans
      in risk grade 1 through 5 at yearend 2006, compared to 84.1% at yearend
      2005.





*Mortgage,
      home equity, and credit lines.* Reserves
      are calculated on mortgage, home equity, and credit lines based on historical
      loss experience and current economic conditions. The average rolling
      eight-quarter net loss percentage is calculated for each of these loan
      categories. The reserve requirement also includes a reserve percentage for
      current economic conditions. The sum of these two components is applied to
      the
      dollar balance of loans in each of these categories to determine the required
      reserve.





*Retail
      loans.* The
      retail loans are pooled together to determine the reserve requirement. The
      average rolling eight-quarter net loss percentage is calculated for this loan
      category. The reserve requirement also includes a reserve percentage for current
      economic conditions. The sum of these two components is applied to the dollar
      balance of retail loans to determine the required reserve for current loans
      and
      loans past due less than 90 days. A separate reserve is calculated for loans
      past due 90 days or more. A reserve amount equal to 25.0% of all retail loans
      past due 90 days or more is added to the above mentioned requirement to
      determine the total reserve requirement for retail loans.





40
 *Table
            of Contents*







*Specific
        impairment under SFAS No. 114.* Management evaluates individually
        significant loans in risk grades 7 through 9 on an individual basis for
        impairment. The specific allowance is calculated based upon a review of these
        loans and the estimated losses at the balance sheet date. At December 31,
        2006
        and 2005, the recorded investment in loans considered impaired was approximately
        $34.5 million and $58.3 million, respectively. Impaired loans at December
        31,
        2006 consisted of $2.1 million of retail loans past due 90 days or more,
        $29.4
        million of risk grade 7 commercial loans, and $2.9 million of risk grade
        8
        commercial loans. Impaired loans at December 31, 2005 consisted of $3.1 million
        of retail loans past due 90 days or more, and $47.6 million of risk grade
        7
        commercial loans, $6.9 million of risk grade 8 commercial loans, and $648,000
        of
        risk grade 9 commercial loans. Calculated reserves for impaired loans at
        December 31, 2006 totaled $4.7 million, compared to $11.6 million a year
        ago.
        The decline in the amount of impaired loans held by the Company resulted
        primarily from the ongoing emphasis being placed on the quality of the loan
        portfolio and continuing efforts to resolve the quality issues identified
        through he combined efforts of internal and external loan
        reviews.





*Watch
      list review.* Specific
      allowances may be determined based on a review of specific watch list loans.
      Specific losses are estimated at each measurement date. The Company has
      established a Watch List Committee to review all loans placed on the watch
      list.
      The watch list primarily consist of loans classified as special mention,
      substandard and doubtful. An estimated loss amount and action plan is
      established for each watch list loan. By reviewing these watch list loans,
      the
      Company is able to update original probable loss amounts in light of developing
      conditions. This serves to reduce the differences between estimated and actual
      observed losses.




The
        2006
        provision for credit losses totaled $1.4 million, compared to $16.1 million
        in
        2005. As of December 31, 2006, nonperforming assets totaled $14.4 million,
        primarily comprised of $13.5 million in nonperforming loans and $0.9 million
        in
        other real estate owned. Those figures compare to $10.4 million in nonperforming
        loans and $1.5 million in other real estate owned at the end of 2005, totaling
        $11.9 million in nonperforming assets. Net charge-offs increased in 2006
        to $7.4
        million, or 0.99% of average loans outstanding, compared with $4.3 million,
        or
        0.59% of average loans outstanding in the prior year. At December 31, 2006
        and
        2005 the allowance for credit losses as a percentage of yearend loans was
        1.87%
        and 2.53%, respectively. The Company’s continued “workout” efforts focused
        during 2006 on problem loan areas within the loan portfolio, which led to
        an
        increased level of chargeoffs. The special provision for credit losses during
        2005 resulted from the identification of these problem loans areas and these
        loans comprised the significant portion of the 2006
        chargeoffs.




During
      2006, the Company continued to focus on reviewing its loan portfolio and
      reclassifying its loans, as required. Risk grade loans classified special
      mention, substandard, doubtful and loss decreased to $63.7 million at yearend
      2006, from $78.5 million at yearend 2005. The reserve requirement for this
      category of loans totaled $5.2 million and $11.8 million for 2006 and 2005,
      respectively. A diminution of credit risk occurred within the retail portfolio
      as retail loans past due 90 days or more decreased to $2.1 million at December
      31, 2006, from $3.1 million at the end of 2005. The reserve requirements for
      the
      retail loans past due 90 days or more were $537,000 and $787,000 at December
      31,
      2006 and 2005, respectively.





Nonperforming
      assets include nonaccrual loans, accruing loans contractually past due 90 days
      or more, restructured loans, and other real estate. Loans are placed on
      nonaccrual status when: (i) management has concerns relating to the ability
      to
      collect the loan principal and interest and (ii) generally when such loans
      are
      90 days or more past due. No assurance can be given, however, that economic
      conditions will not adversely affect borrowers and result in increased credit
      losses.





**Nonperforming
      Assets**


*(In
      thousands)*


As
                of December 31,2006
            
            2005
            
            2004
            
            2003
            
            2002**Nonperforming
                assets:**Nonaccrual
                loans
            
            $
            13,042
            
            $
            10,356
            
            $
            3,450
            
            $
            5,174
            
            $
            3,614Loans
                past due 90 days or more and still accruing interest
            
            
            103
            
            
            30
            
            
            65
            
            
            53
            
            
            65Troubled
              debt restructuring
            
            
            376
            
            
            -
            
            
            -
            
            
            -
            
            
            -Other
                real estate
            
            
            889
            
            
            1,483
            
            
            5,559
            
            
            5,191
            
            
            1,662





**Investment
      Activities**




Our
      investment portfolio plays a primary role in management of liquidity and
      interest rate sensitivity and, therefore, is managed in the context of the
      overall balance sheet. The securities portfolio generates a substantial
      percentage of our interest income and serves as a necessary source of liquidity.







41
 *Table
            of Contents*







Management
      attempts to deploy investable funds into instruments that are expected to
      increase the overall return of the portfolio given the current assessment of
      economic and financial conditions, while maintaining acceptable levels of
      capital, and interest rate and liquidity risk.




The
      accompanying table presents the carrying values, fair values, and weighted
      average yields of our investment portfolio at December 31, 2006, 2005, and
      2004; and the intervals of maturities or repricings at December 31,
      2006:




**Investment
      Securities**


*(Dollars
      in thousands)*


As
                of December 31, 2006
            
            As
                of December 31, 2005Amortized
              Cost
            
            Fair
              Value
            
            Weighted
              Average
              Yield
            
            Amortized
              Cost
            
            Fair
              Value
            
            Weighted
              Average
              YieldU.S.
                government agencies and mortgage backed
            
            $
            145,002
            
            $
            142,333
            
            
            4.12
            %
            $
            159,694
            
            $
            156,461
            
            
            3.83
            %State
                and municipal obligations (1)
            
            
            65,544
            
            
            65,458
            
            
            5.92
            
            
            38,276
            
            
            37,858
            
            
            5.49Other
                debt securities
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Other
                equity
            
            
            9,377
            
            
            9,336
            
            
            5.00
            
            
            7,600
            
            
            7,571
            
            
            4.47Total
                investment securities (1)
            
            $
            219,923
            
            $
            217,127
            
            
            4.10
            %
            $
            205,570
            
            $
            201,890
            
            
            3.70
            %





As
                of December 31, 2004Amortized
              Cost
            
            Fair
              Value
            
            Weighted
              Average
              YieldU.S.
                government agencies and mortgage backed
            
            $
            104,896
            
            $
            103,777
            
            
            3.09
            %State
                and municipal obligations (1)
            
            
            31,936
            
            
            32,285
            
            
            5.69Other
                debt securities
            
            
            -
            
            
            -
            
            
            -Other
                equity
            
            
            5,547
            
            
            5,541
            
            
            3.26Total
                investment securities (1)
            
            $
            142,379
            
            $
            141,603
            
            
            3.70
            %





As
                of December 31, 2006Within
              One
                Year
            
            After
                One
              Year
                to
              Five
                YearsAmount
            
            Yield
            
            Amount
            
            YieldU.S.
                government agencies and mortgage backed
            
            $
            25,632
            
            
            2.91
            %
            $
            80,791
            
            
            4.25
            %State
                and municipal obligations (1)
            
            
            629
            
            
            7.31
            
            
            2,140
            
            
            6.59Total
                debt securities (1)
            
            $
            26,260
            
            
            3.01
            %
            $
            82,930
            
            
            4.31
            %




As
                of December 31, 2006After
                Five
              Years
                to
              Ten
                Years
            
            After
              Ten
                Years
            
            
            
            Weighted
              AverageAmount
            
            Yield
            
            Amount
            
            Yield
            
            Total
            
            Yield
                (1)U.S.
                government agencies and mortgage backed
            
            $
            14,243
            
            
            4.26
            %
            $
            21,667
            
            
            4.93
            %
            $
            142,333
            
            
            4.12
            %State
                and municipal obligations (1)
            
            
            23,204
            
            
            5.49
            
            
            39,485
            
            
            6.11
            
            
            65,458
            
            
            5.92Total
                debt securities (1)
            
            $
            37,447
            
            
            5.03
            %
            $
            61,152
            
            
            5.69
            %
            $
            207,791
            
            
            4.69
            %





*(1)
      Yields stated on a tax equivalent basis.*





See
      also
      Note 4 in the Notes to Consolidated Financial Statements of this Annual Report
      on Form 10-K.





**Off-Balance
      Sheet Arrangements**





Information
      about the Company’s off-balance sheet risk exposure is presented in Note 17 to
      the accompanying consolidated financial statements.





42
 *Table
            of Contents*





**Market
      Risk**





Market
      risk is the possible chance of loss from unfavorable changes in market prices
      and rates. These changes may result in a reduction of current and future period
      net interest income, which is the favorable spread earned from the excess of
      interest income on interest-earning assets, over interest expense on
      interest-bearing liabilities.





For
      a
      complete discussion on market risk and how the Company addresses this risk,
      see
      Item 7A of this Annual Report on Form 10-K.




**Effects
      of Inflation**





Inflation
      affects financial institutions in ways that are different from most commercial
      and industrial companies, which have significant investments in fixed assets
      and
      inventories. The effect of inflation on interest rates can materially impact
      bank operations, which rely on net interest margins as a major source of
      earnings. Noninterest expense, such as salaries and wages, occupancy and
      equipment cost, are also negatively affected by inflation.





**Application
      of Critical Accounting Policies**





The
      Company's accounting policies are in accordance with accounting principles
      generally accepted in the United States and with general practice within the
      banking industry and are fundamental to understanding management's discussion
      and analysis of results of operations and financial condition. The Company's
      significant accounting policies are discussed in detail in Note 1 of the
      consolidated financial statements of the Company's 2006 Annual Report on Form
      10-K. The following is a summary of the allowance for credit losses, one of
      the
      most complex and judgmental accounting policies of the Company.





The
      allowance for credit losses, which is utilized to absorb actual losses in the
      loan portfolio, is maintained at a level consistent with management’s best
      estimate of probable credit losses incurred as of the balance sheet date. The
      Company’s allowance for credit losses is also analyzed quarterly by management.
      This analysis includes a methodology that separates the total loan portfolio
      into homogeneous loan classifications for purposes of evaluating risk. The
      required allowance is calculated by applying a risk adjusted reserve requirement
      to the dollar volume of loans within a homogenous group. Major loan portfolio
      subgroups include: risk graded commercial loans, mortgage loans, home equity
      loans, retail loans and retail credit lines. Management also analyzes the loan
      portfolio on an ongoing basis to evaluate current risk levels, and risk grades
      are adjusted accordingly. While management uses the best information available
      to make evaluations, future adjustments may be necessary, if economic or other
      conditions differ substantially from the assumptions used. See additional
      discussion under “ *Summary
      of Allowance for Credit Losses* .”




**Item
                  7A.**
              **QUANTITATIVE
                  AND QUALITATIVE DISCLOSURES ABOUT MARKET
                  RISK**





The
      Company’s primary market risk is considered to be interest rate risk. Interest
      rate risk on our balance sheet arises from the maturity mismatch of
      interest-earning assets versus interest-bearing liabilities, as well as the
      potential for maturities to shorten or lengthen on our interest-earning assets
      and interest-bearing liabilities. Market risk is the possible chance of loss
      from unfavorable changes in market prices and rates. These changes may result
      in
      a reduction of current and future period net interest income, which is the
      favorable spread earned from the excess of interest income on interest-earning
      assets, over interest expense on interest-bearing liabilities.





Interest
      rate risk management is a part of the Company’s overall asset/liability
      management process. The primary oversight of asset/liability management rests
      with the Company’s Asset and Liability Committee, which is comprised of senior
      management and members of the Company’s Board of Directors. The committee meets
      on a regular basis to review the asset/liability management activities of the
      Company





43
 *Table
            of Contents*





and
      monitor compliance with established policies. An independent member of the
      Board
      of Directors chairs the committee and reports on its activities to the full
      Board.





A
      primary
      objective of interest rate sensitivity management is to ensure the stability
      and
      quality of the Company’s primary earnings component, net interest income. This
      process involves monitoring the Company’s balance sheet in order to determine
      the potential impact that changes in the interest rate environment may have
      on
      net interest income. Rate sensitive assets and liabilities have interest rates
      that are subject to change within a specific time period, due to either maturity
      or to contractual agreements which allow the instruments to reprice prior to
      maturity. Interest rate sensitivity management seeks to ensure that both assets
      and liabilities react to changes in interest rates within a similar time period,
      thereby minimizing the risk to net interest income.





**Interest
      Sensitivity Analysis**


At
      December 31, 2006


*(Dollars
      in thousands)*


1
                -
                90
              Day
              Sensitive
            
            91
                - 365
              Day
              Sensitive
            
            Total
              Sensitive
                Within
              One
                Year
            
            Total
              Sensitive
              Over
              One
                Year
            
            Total**Interest
                earning assets:**Loans,
                net of nonaccruals
            
            $
            482,781
            
            $
            34,218
            
            $
            516,999
            
            $
            176,626
            
            $
            693,625U.
                S. government agency
            
            
            5,987
            
            
            19,645
            
            
            25,632
            
            
            116,702
            
            
            142,334State
                and municipal obligations
            
            
            607
            
            
            1,055
            
            
            1,662
            
            
            63,796
            
            
            65,458Other
                investment securities
            
            
            7,761
            
            
            -
            
            
            7,761
            
            
            1,616
            
            
            9,377Overnight
                deposits
            
            
            3,008
            
            
            -
            
            
            3,008
            
            
            -
            
            
            3,008Total
                interest earning assets
            
            
            500,144
            
            
            54,918
            
            
            555,062
            
            
            358,740
            
            
            913,802**Interest
                bearing liabilities:**NOW
            
            
            20,641
            
            
            -
            
            
            20,641
            
            
            13,761
            
            
            34,402MMI
            
            
            67,626
            
            
            -
            
            
            67,626
            
            
            67,626
            
            
            135,252Savings
            
            
            10,054
            
            
            -
            
            
            10,054
            
            
            6,703
            
            
            16,757Time
                deposits
            
            
            187,957
            
            
            309,636
            
            
            497,593
            
            
            47,517
            
            
            545,110Overnight
                borrowings
            
            
            5,384
            
            
            -
            
            
            5,384
            
            
            21,000
            
            
            26,384Junior
                subordinated notes
            
            
            25,774
            
            
            -
            
            
            25,774
            
            
            -
            
            
            25,774Other
                borrowings
            
            
            -
            
            
            25,000
            
            
            25,000
            
            
            30,000
            
            
            55,000Total
                interest bearing liabilities
            
            
            317,436
            
            
            334,636
            
            
            652,072
            
            
            186,607
            
            
            838,679Interest
                sensitivity gap
            
            $
            182,708
            
            $
            (279,718
            )
            $
            (97,010
            )
            $
            172,133
            
            $
            75,123Ratio
                of interest sensitive assets to liabilities
            
            
            1.58
            
            
            0.16
            
            
            0.85
            
            
            1.92
            
            
            1.09





The
      measurement of the Company’s interest rate sensitivity, or “gap”, is a technique
      traditionally used in asset/liability management. The interest sensitivity
      gap
      is the difference between repricing assets and repricing liabilities for a
      particular time period. The table, “ *Interest
      Sensitivity Analysis* ,”
      indicates a ratio of rate sensitive assets to rate sensitive liabilities within
      one year at December 31, 2006, to be 0.85X. This ratio indicates that a larger
      balance of liabilities, compared to assets, could potentially reprice during
      the
      upcoming twelve-month period. Included in rate sensitive liabilities are certain
      deposit accounts (NOW, MMI, and savings) that are subject to immediate
      withdrawal and repricing, yet have no stated maturity. These balances are
      presented in the category that management believes best identifies their actual
      repricing patterns. This analysis assumes 60.0% of NOW and savings accounts,
      and
      50.0% of MMI accounts, reprice within one year, and the remaining balances
      reprice after one year. The overall risk to net interest income is also
      influenced by the Company’s level of variable rate loans. These are loans with a
      contractual interest rate tied to an index, such as the prime rate. A portion
      of
      these loans may reprice on multiple occasions during a one-year period due
      to
      changes in the underlying rate index.





44
 *Table
            of Contents*





Approximately
      64.3% of the total loan portfolio has a variable rate and reprices in accordance
      with the underlying rate index subject to terms of individual note
      agreements.





In
      addition to the traditional gap analysis, the Company also utilizes a computer
      based interest rate risk simulation model. This comprehensive model includes
      rate sensitivity gap analysis, rate shock net interest income analysis, and
      present value of equity analysis, under various rate shock scenarios. The
      Company uses this model to monitor interest rate risk on a quarterly basis
      and
      to detect trends that may affect the overall net interest income for the
      Company. This simulation incorporates the dynamics of balance sheet and interest
      rate changes and calculates the related effect on net interest income. As a
      result, this analysis more accurately projects the risk to net interest income
      over the upcoming 12-month period. The Company’s asset/liability policy provides
      guidance for levels of interest rate risk and potential remediations, if
      necessary, to mitigate excessive levels of risk. The modeling results indicate
      the Company is subject to an acceptable level of interest rate
      risk.





The
      Company considers interest rate risk to be its most significant market risk,
      which could potentially have the greatest impact on operating earnings. The
      Company is asset sensitive, which means that falling interest rates could result
      in a reduced amount of net interest income. The Company is not subject to other
      types of market risk, such as foreign currency exchange rate risk, commodity
      or
      equity price risk.





The
      table, “ *Market
      Sensitive Financial Instruments Maturities* ,”
      presents the Company’s financial instruments that are considered to be sensitive
      to changes in interest rates, categorized by contractual maturities, average
      interest rates and estimated fair values as of December 31, 2006.





**Market
      Sensitive Financial Instruments Maturities**


*(Dollars
      in thousands)*


Contractual
                Maturities as of December 31, 20062007
            
            2008
            
            2009
            
            2010
            
            2011
            
            After
              Five
              Years
            
            TotalFinancial
                assets:Debt
                securities
            
            $
            26,260
            
            $
            23,596
            
            $
            25,354
            
            $
            27,288
            
            $
            6,692
            
            $
            98,601
            
            $
            207,791Loans:Fixed
                rate
            
            
            82,065
            
            
            42,695
            
            
            43,224
            
            
            36,807
            
            
            37,610
            
            
            10,385
            
            
            252,786Variable
                rate
            
            
            159,693
            
            
            55,731
            
            
            56,421
            
            
            36,252
            
            
            37,042
            
            
            109,221
            
            
            454,360Total
            
            $
            268,018
            
            $
            122,022
            
            $
            124,999
            
            $
            100,347
            
            $
            81,344
            
            $
            218,207
            
            $
            914,937Financial
                liabilities:NOW
            
            $
            34,402
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            34,402MMI
            
            
            135,252
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            135,252Savings
            
            
            16,757
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            16,757Time
                deposits
            
            
            496,971
            
            
            27,677
            
            
            12,026
            
            
            5,446
            
            
            2,946
            
            
            44
            
            
            545,110Other
                borrowings
            
            
            25,000
            
            
            30,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            55,000Junior
                subordinated notes
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            25,774
            
            
            25,774Federal
                funds purchased and retail repurchase
            
            
            5,384
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            21,000
            
            
            26,384Total
            
            $
            713,766
            
            $
            57,677
            
            $
            12,026
            
            $
            5,446
            
            $
            2,946
            
            $
            46,818
            
            $
            838,679





Average
              Interest
              Rate
            
            Estimated
              Fair
                ValueFinancial
                assets:Debt
                securities
            
            
            4.07
            %
            $
            207,654Loans:Fixed
                rate
            
            
            7.68
            
            
            254,844Variable
                rate
            
            
            8.61
            
            
            449,133Total
            
            
            
            
            $
            911,631





45
 *Table
            of Contents*





Financial
                liabilities:NOW
            
            
            0.44
            
            $
            29,204MMI
            
            
            4.47
            
            
            133,796Savings
            
            
            0.33
            
            
            14,174Time
                deposits
            
            
            4.61
            
            
            547,883Other
                borrowings
            
            
            4.90
            
            
            54,824Trust
                preferred securities
            
            
            6.70
            
            
            36,178Federal
                funds purchased and retail repurchase
            
            
            3.57
            
            
            26,334Total
            
            
            
            
            $
            842,395












46
 *Table
          of Contents*




**Item
      8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY
      DATA**





**QUARTERLY
      FINANCIAL INFORMATION**




The
      following table sets forth, for the periods indicated, certain of our
      consolidated quarterly financial information. This information is derived from
      our unaudited financial statements, which include, in the opinion of management,
      all normal recurring adjustments which management considers necessary for a
      fair
      presentation of the results for such periods. This information should be read
      in
      conjunction with our consolidated financial statements included elsewhere in
      this report. The results for any quarter are not necessarily indicative of
      results for any future period.




**Quarterly
      Financial Data**


*(Dollars
      in thousands, except per share data)*


**2006**
            
            4th
                Qtr
            
            3rd
                Qtr
            
            2nd
                Qtr
            
            1st
                QtrInterest
                income
            
            $
            18,456
            
            $
            18,572
            
            $
            18,018
            
            $
            17,888Interest
                expense
            
            
            9,092
            
            
            9,185
            
            
            8,479
            
            
            7,786Net
                interest income
            
            
            9,364
            
            
            9,387
            
            
            9,539
            
            
            10,102Provision
                for credit losses
            
            
            315
            
            
            -
            
            
            365
            
            
            755Net
                interest income after provisionfor
                credit losses
            
            
            9,049
            
            
            9,387
            
            
            9,174
            
            
            9,347





Noninterest
                income
            
            
            1,459
            
            
            1,406
            
            
            1,311
            
            
            1,332Noninterest
                expense
            
            
            7,700
            
            
            7,305
            
            
            6,845
            
            
            7,057Income
                before income taxes
            
            
            2,808
            
            
            3,488
            
            
            3,640
            
            
            3,622Provision
                for income taxes
            
            
            788
            
            
            1,163
            
            
            1,250
            
            
            1,244Net
                income
            
            $
            2,020
            
            $
            2,325
            
            $
            2,390
            
            $
            2,378Earnings
                per share:Basic
            
            $
            0.29
            
            $
            0.33
            
            $
            0.34
            
            $
            0.34Diluted
            
            $
            0.28
            
            $
            0.32
            
            $
            0.33
            
            $
            0.33





**2005**
            
            4th
                Qtr
            
            3rd
                Qtr
            
            2nd
                Qtr
            
            1st
                QtrInterest
                income
            
            $
            17,182
            
            $
            16,492
            
            $
            15,061
            
            $
            13,377Interest
                expense
            
            
            7,181
            
            
            6,690
            
            
            5,975
            
            
            4,864Net
                interest income
            
            
            10,001
            
            
            9,802
            
            
            9,086
            
            
            8,513Provision
                for credit losses
            
            
            13,627
            
            
            1,187
            
            
            638
            
            
            680Net
                interest income after provisionfor
                credit losses
            
            
            (3,626
            )
            
            8,615
            
            
            8,448
            
            
            7,833





Noninterest
                income
            
            
            1,696
            
            
            1,734
            
            
            1,815
            
            
            2,138Noninterest
                expense
            
            
            7,276
            
            
            6,993
            
            
            7,045
            
            
            6,892Income
                before income taxes
            
            
            (9,206
            )
            
            3,356
            
            
            3,218
            
            
            3,079Provision
                for income taxes
            
            
            (3,601
            )
            
            1,138
            
            
            1,083
            
            
            1,036Net
                income
            
            $
            (5,605
            )
            $
            2,218
            
            $
            2,135
            
            $
            2,043Earnings
                per share:Basic
            
            $
            (0.80
            )
            $
            0.32
            
            $
            0.30
            
            $
            0.30Diluted
            
            $
            (0.80
            )
            $
            0.31
            
            $
            0.29
            
            $
            0.29








47
 *Table
            of Contents*





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
      FIRM**


To
            the
            Board of Directors and Stockholders
 FNB
            Financial Services Corporation
 
 We
            have
            audited management's assessment, included in the accompanying Management’s
            Report on Internal Control Over Financial Reporting, that FNB Financial
            Services
            Corporation and subsidiary (the “Company”) maintained effective internal control
            over financial reporting as of December 31, 2006, based on criteria established
            in *Internal
            Control—Integrated Framework* issued
            by
            the Committee of Sponsoring Organizations of the Treadway Commission.
            The
            Company’s management is responsible for maintaining effective internal control
            over financial reporting and for its assessment of the effectiveness
            of internal
            control over financial reporting. Our responsibility is to express an
            opinion on
            management's assessment and an opinion on the effectiveness of the Company's
            internal control over financial reporting based on our audit.
 
 We
            conducted our audit in accordance with the standards of the Public Company
            Accounting Oversight Board (United States). Those standards require that
            we plan
            and perform the audit to obtain reasonable assurance about whether effective
            internal control over financial reporting was maintained in all material
            respects. Our audit included obtaining an understanding of internal control
            over
            financial reporting, evaluating Management's assessment, testing and
            evaluating
            the design and operating effectiveness of internal control, and performing
            such
            other procedures as we considered necessary in the circumstances. We
            believe
            that our audit provides a reasonable basis for our opinion.
 
 A
            company's internal control over financial reporting is a process designed
            to
            provide reasonable assurance regarding the reliability of financial reporting
            and the preparation of financial statements for external purposes in
            accordance
            with generally accepted accounting principles. A company' s internal
            control
            over financial reporting includes those policies and procedures that
            (1) pertain
            to the maintenance of records that, in reasonable detail, accurately
            and fairly
            reflect the transactions and dispositions of the assets of the company;
            (2)
            provide reasonable assurance that transactions are recorded as necessary
            to
            permit preparation of financial statements in accordance with generally
            accepted
            accounting principles, and that receipts and expenditures of the company
            are
            being made only in accordance with authorizations of management and directors
            of
            the company; and (3) provide reasonable assurance regarding prevention
            or timely
            detection of unauthorized acquisition, use, or disposition of the company's
            assets that could have a material effect on the financial
            statements.
 
 Because
            of its inherent limitations, internal control over financial reporting
            may not
            prevent or detect misstatements. Also, projections of any evaluation
            of
            effectiveness to future periods are subject to the risk that controls
            may become
            inadequate because of changes in conditions, or that the degree of compliance
            with the policies or procedures may deteriorate.
 
 In
            our
            opinion, management's assessment that FNB Financial Services Corporation
            and
            subsidiary maintained effective internal control over financial reporting
            as of
            December 31, 2006, is fairly stated, in all material respects, based
            on criteria
            established in *Internal
            Control—Integrated Framework* issued
            by
            the Committee of Sponsoring Organizations of the Treadway Commission.
            Also in
            our opinion, FNB Financial Services Corporation and subsidiary maintained,
            in
            all material respects, effective internal control over financial reporting
            as of
            December 31, 2006, based on criteria established in *Internal
            Control— Integrated Framework* issued
            by
            the Committee of Sponsoring Organizations of the Treadway
            Commission.
 
 We
            have
            also audited, in accordance with the standards of the Public Company
            Accounting
            Oversight Board (United States), the consolidated balance sheets of FNB
            Financial Services Corporation and Subsidiary (the “Company”) as of December 31,
            2006 and 2005 and the related consolidated statements of income and
            comprehensive income, changes in shareholders’ equity, and cash flows for each
            of the years in the three-year period ended December 31, 2006., and our
            report
            dated March 14, 2007, expressed an unqualified opinion on those consolidated
            financial statements. As discussed in Note 1 to the consolidated financial
            statements, effective January 1, 2006, FNB Financial Service Corporation
            adopted
            the provisions of Statement of Financial Accounting Standards No. 123(R), *Share-based
            Payment* .
            Effective December 31, 2006, the Company adopted the recognition and
            disclosure
            provisions of Statement of Financial Accounting Standards No. 158, *Employers’
            Accounting for Defined Benefit Pension and OtherPostretirement
            Plans.*
 
 Charlotte,
        North Carolina
 March
        16,
        2007







48
 *Table
            of Contents*







**REPORT
          OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 Board
          of
          Directors and Shareholders of
 FNB
          Financial Services Corporation:
 
 We
          have
          audited the accompanying consolidated balance sheets of FNB Financial Services
          Corporation and Subsidiary (the “Company”) as of December 31, 2006 and 2005 and
          the related consolidated statements of income and comprehensive income,
          changes
          in shareholders’ equity, and cash flows for each of the years in the three-year
          period ended December 31, 2006. These consolidated financial statements
          are the
          responsibility of the Company’s management. Our responsibility is to express an
          opinion on these consolidated financial statements based on our
          audits.
 
 We
          conducted our audits in accordance with the standards of the Public Company
          Accounting Oversight Board (United States). Those standards require that
          we plan
          and perform the audit to obtain reasonable assurance about whether the
          financial
          statements are free of material misstatement. An audit includes examining,
          on a
          test basis, evidence supporting the amounts and disclosures in the financial
          statements, assessing the accounting principles used and significant estimates
          made by Management, as well as evaluating the overall financial statement
          presentation. We believe that our audits provide a reasonable basis for
          our
          opinion.
 
 In
          our
          opinion, the consolidated financial statements referred to above present
          fairly,
          in all material respects, the financial position of the FNB Financial Services
          Corporation and Subsidiary as of December 31, 2006 and 2005 and the results
          of
          their operations and their cash flows for each of the years in the three-year
          period ended December 31, 2006, in conformity with accounting principles
          generally accepted in the United States of America.
 
 As
          discussed in Note 1 to the consolidated financial statements, effective
          January
          1, 2006, FNB Financial Services Corporation adopted the provisions of Statement
          of Financial Accounting Standards No. 123(R), *Share-based
          Payment.* Effective
          December 31, 2006, the Company adopted the recognition and disclosure provisions
          of Statement of Financial Accounting Standards No. 158, *Employers’
          Accounting for Defined Benefit Pension and OtherPostretirement
          Plans* .
 
 We
          have
          also audited, in accordance with the standards of the Public Company Accounting
          Oversight Board (United States), the effectiveness of FNB Financial Services
          Corporation’s internal control over financial reporting as of December 31, 2006,
          based on criteria established in *Internal
          Control - Integrated Framework* issued
          by
          the Committee of Sponsoring Organizations of the Treadway Commission, and
          our
          report dated March 14, 2007 expressed unqualified opinions on both management’s
          assessment of the Company’s internal control over financial reporting and the
          effectiveness of the Company’s internal control over financial
          reporting.
 
 
 
 *Charlotte,
          North Carolina*
 *March
          16, 2007*









49
 *Table
            of Contents*





**FNB
      Financial Services Corporation and Subsidiary**


**Consolidated
      Balance Sheets**





December
      31, 2006 and 2005


*(Dollars
      in thousands, except per share data)*





2006
            
            2005ASSETSCash
                and due from banks
            
            $
            25,665
            
            $
            27,148Investment
                securities:Available
                for sale
            
            
            211,011
            
            
            195,926Federal
                Home Loan Bank and Federal Reserve Bank Stock, at cost
            
            
            6,116
            
            
            5,964Loans,
                net of allowance for credit losses of $13,195 in 2006 and $19,142
                in
                2005
            
            
            693,951
            
            
            738,825Premises
                and equipment, net
            
            
            19,609
            
            
            14,307Investment
              in life insurance
            
            
            24,889
            
            
            2,477Accrued
                income and other assets
            
            
            29,522
            
            
            22,759Total
                assets
            
            $
            1,010,773
            
            $
            1,007,406LIABILITIES
                AND SHAREHOLDERS’ EQUITYDeposits:Noninterest-bearing
            
            $
            87,047
            
            $
            92,884Interest-bearing
            
            
            731,521
            
            
            731,747Total
                deposits
            
            
            818,568
            
            
            824,631Short-term
                borrowings
            
            
            30,384
            
            
            27,305Long-term
                debt
            
            
            76,774
            
            
            80,774Accrued
                expenses and other liabilities
            
            
            12,354
            
            
            7,462Total
                liabilities
            
            
            938,080
            
            
            940,172Commitments
                and Contingent Liabilities:*See
                Note 17.*Shareholders’
                equity:Preferred
                stock, no par value; Authorized - 10,000,000 shares; none
                issued
            
            
            -
            
            
            -Common
                stock, $1.00 stated value;Authorized
                - 75,000,000 shares; Outstanding -7,060,241
                in 2006 and 7,038,110 in 2005
            
            
            7,060
            
            
            7,038Paid-in
                capital
            
            
            23,190
            
            
            22,233Retained
                earnings
            
            
            45,866
            
            
            40,208Accumulated
                other comprehensive loss
            
            
            (3,423
            )
            
            (2,245
            )Total
                shareholders’ equity
            
            
            72,693
            
            
            67,233Total
                liabilities and shareholders’ equity
            
            $
            1,010,773
            
            $
            1,007,406





*See
      notes to consolidated financial statements*





50
 *Table
            of Contents*





**FNB
      Financial Services Corporation and Subsidiary**


**Consolidated
      Statements of Income and Comprehensive Income**





Years
      ended December 31, 2006, 2005 and 2004


*(Dollars
      in thousands, except per share data)*





2006
            
            2005
            
            2004Interest
                incomeLoans
            
            $
            63,598
            
            $
            56,012
            
            $
            39,609Federal
                funds sold and overnight deposits
            
            
            610
            
            
            320
            
            
            194Investment
                securitiesTaxable
            
            
            6,376
            
            
            4,176
            
            
            3,146Tax
                exempt
            
            
            1,838
            
            
            1,318
            
            
            1,343Other
            
            
            512
            
            
            286
            
            
            180Total
                interest income
            
            
            72,934
            
            
            62,112
            
            
            44,472Interest
                expenseDeposits
            
            
            29,035
            
            
            21,483
            
            
            13,559Short-term
                borrowings
            
            
            383
            
            
            366
            
            
            151Long-term
                debt
            
            
            5,124
            
            
            2,860
            
            
            1,377Total
                interest expense
            
            
            34,542
            
            
            24,709
            
            
            15,087Net
                interest income
            
            
            38,392
            
            
            37,403
            
            
            29,385Provision
                for credit losses
            
            
            1,435
            
            
            16,132
            
            
            1,275Net
                interest income after provision for credit losses
            
            
            36,957
            
            
            21,271
            
            
            28,110Noninterest
                incomeService
                charges on deposit accounts
            
            
            3,802
            
            
            3,837
            
            
            3,769Mortgage
                banking fees
            
            
            828
            
            
            2,569
            
            
            2,233Investment
                services fees
            
            
            402
            
            
            485
            
            
            507Net
                gain on securities available for sale
            
            
            32
            
            
            -
            
            
            109Net
                gain on disposition of branch
            
            
            -
            
            
            -
            
            
            700Other
                noninterest income
            
            
            444
            
            
            493
            
            
            768Total
                noninterest income
            
            
            5,508
            
            
            7,384
            
            
            8,086Noninterest
                expenseSalaries
                and employee benefits
            
            
            16,034
            
            
            14,435
            
            
            12,401Occupancy
                expense
            
            
            1,719
            
            
            1,621
            
            
            1,392Furniture
                and equipment expense
            
            
            3,014
            
            
            3,043
            
            
            2,873Telecommunications
                expense
            
            
            858
            
            
            654
            
            
            616Marketing
                expense
            
            
            935
            
            
            1,041
            
            
            942Printing
                and supply expense
            
            
            572
            
            
            606
            
            
            533Other
                noninterest expense
            
            
            5,775
            
            
            6,807
            
            
            5,009Total
                noninterest expenses
            
            
            28,907
            
            
            28,207
            
            
            23,766Income
                before provision for income taxes
            
            
            13,558
            
            
            448
            
            
            12,430Provision
                (benefit) for income taxes
            
            
            4,445
            
            
            (344
            )
            
            4,090Net
                income
            
            
            9,113
            
            
            792
            
            
            8,340Other
                comprehensive income (loss)
            
            
            540
            
            
            (1,772
            )
            
            (324
            )Comprehensive
                income (loss)
            
            $
            9,653
            
            $
            (980
            )
            $
            8,016Net
                income per share, basic
            
            $
            1.29
            
            $
            0.11
            
            $
            1.22Net
                income per share, diluted
            
            $
            1.26
            
            $
            0.11
            
            $
            1.17





*See
      notes to consolidated financial statements*





51
 *Table
            of Contents*





**FNB
      Financial Services Corporation and Subsidiary**


**Consolidated
      Statements of Changes in Shareholders’ Equity**





Years
      ended December 31, 2006, 2005 and 2004


*(Dollars
      in thousands)*





2006
            
            2005
            
            2004Common
                stockBalance
                at beginning of period
            
            $
            7,038
            
            $
            5,550
            
            $
            5,479Stock
                repurchase
            
            
            (124
            )
            
            (40
            )
            
            (184
            )Stock
                split effected in the form of a stock dividend
            
            
            -
            
            
            1,398
            
            
            -Exercise
                of stock options
            
            
            146
            
            
            130
            
            
            255Balance
                at end of period
            
            
            7,060
            
            
            7,038
            
            
            5,550Paid-in
                capitalBalance
                at beginning of period
            
            
            22,233
            
            
            21,367
            
            
            22,025Stock
                repurchase
            
            
            (1,727
            )
            
            (815
            )
            
            (3,266
            )Exercise
                of stock options
            
            
            1,162
            
            
            1,224
            
            
            2,332Accrued
                stock based compensation
            
            
            471
            
            
            -
            
            
            -Tax
                benefit from exercise of stock options
            
            
            1,051
            
            
            452
            
            
            276Employee
                stock awards
            
            
            -
            
            
            5
            
            
            -Balance
                at end of period
            
            
            23,190
            
            
            22,233
            
            
            21,367Retained
                earningsBalance
                at beginning of period
            
            
            40,208
            
            
            43,986
            
            
            38,395Net
                income
            
            
            9,113
            
            
            792
            
            
            8,340Cash
                dividends paid
            
            
            (3,455
            )
            
            (3,167
            )
            
            (2,749
            )Cash
                paid for fractional shares
            
            
            -
            
            
            (5
            )
            
            -Stock
                split effected in the form of a stock dividend
            
            
            -
            
            
            (1,398
            )
            
            -Balance
                at end of period
            
            
            45,866
            
            
            40,208
            
            
            43,986Accumulated
                other comprehensive income (loss)Balance
                at beginning of period
            
            
            (2,245
            )
            
            (473
            )
            
            (149
            )Other
                comprehensive income (loss)
            
            
            540
            
            
            (1,772
            )
            
            (324
            )Adption
                of SFAS No. 158
            
            
            (1,718
            )
            
            -
            
            
            -Balance
                at end of period
            
            
            (3,423
            )
            
            (2,245
            )
            
            (473
            )Total
                shareholders’ equity
            
            $
            72,693
            
            $
            67,233
            
            $
            70,430





*See
      notes to consolidated financial statements*





52
 *Table
            of Contents*








**FNB
      Financial Services Corporation and Subsidiary**


**Consolidated
      Statements of Cash Flows**





Years
      ended December 31, 2006, 2005 and 2004


*(Dollars
      in thousands)*





2006
            
            2005
            
            2004**CASH
                FLOWS FROM OPERATING ACTIVITIES:**Net
                income
            
            $
            9,113
            
            $
            792
            
            $
            8,340Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation,
                accretion, and amortization
            
            
            1,062
            
            
            2,423
            
            
            1,455Provision
                for credit losses
            
            
            1,435
            
            
            16,132
            
            
            1,275Stock
                based compensation expense
            
            
            471
            
            
            -
            
            
            -Gain
                on sale of securities available for sale
            
            
            (32
            )
            
            -
            
            
            (109
            )(Gain)
                loss on disposal of premises and equipment
            
            
            95
            
            
            30
            
            
            (106
            )Loss on
                disposal of other real estate owned
            
            
            134
            
            
            568
            
            
            -Gain
                on sale of branching operation
            
            
            -
            
            
            -
            
            
            (700
            )Deferred
                income taxes
            
            
            2,199
            
            
            (4,651
            )
            
            (397
            )Net
                change in loans held for sale
            
            
            922
            
            
            6,641
            
            
            (9,233
            )Changes
                in assets and liabilities:(Increase)
                decrease in other assets
            
            
            (11,396
            )
            
            (6,097
            )
            
            476Increase
                (decrease) in other liabilities
            
            
            3,174
            
            
            8,480
            
            
            1,956Net
                cash provided by operating activities
            
            
            7,175
            
            
            24,318
            
            
            2,957**CASH
                FLOWS FROM INVESTING ACTIVITIES**Proceeds
                from sales, calls, and maturities of securities available for
                sale
            
            
            29,902
            
            
            23,740
            
            
            31,059Purchase
                of securities available for sale
            
            
            (44,351
            )
            
            (85,957
            )
            
            (29,632
            )Purchase
                of premises and equipment
            
            
            (7,035
            )
            
            (3,252
            )
            
            (2,084
            )Purchase
                of Bank-owned life insurance
            
            
            (22,000
            )
            
            -
            
            
            -Proceeds
                from disposal of premises and equipment
            
            
            7
            
            
            127
            
            
            292Proceeds
                from disposal of other real estate owned
            
            
            1,218
            
            
            2,994
            
            
            733Proceeds
                from sale of branch, net of cash transferred
            
            
            -
            
            
            -
            
            
            700Expenditures
                on other real estate owned
            
            
            (55
            )
            
            (255
            )
            
            (185
            )Net
                (increase) decrease in loans
            
            
            43,585
            
            
            (98,035
            )
            
            (83,538
            )Net
                cash provided by (used in) investing activities
            
            
            1,271
            
            
            (160,638
            )
            
            (82,467
            )**CASH
                FLOWS FROM FINANCING ACTIVITIES**Net
                increase (decrease) in deposits
            
            
            (6,062
            )
            
            100,345
            
            
            82,379Net
                increase (decrease) in other borrowings
            
            
            (20,000
            )
            
            30,000
            
            
            (10,500
            )Net
                increase (decrease) in federal funds purchased and retail repurchase
                agreements
            
            
            19,078
            
            
            (14,229
            )
            
            6,171Proceeds
                from issuance of junior subordinated notes
            
            
            -
            
            
            25,774
            
            
            -Excess
                tax benefits from share-based arrangements
            
            
            1,051Repurchase
                of common stock
            
            
            (1,851
            )
            
            (855
            )
            
            (3,450
            )Proceeds
                from issuance of common stock
            
            
            1,308
            
            
            1,354
            
            
            2,589Cash
                dividends paid and cash paid in lieu of fractional shares
            
            
            (3,455
            )
            
            (3,167
            )
            
            (2,752
            )Net
                cash provided by (used in) financing activities
            
            
            (9,929
            )
            
            139,221
            
            
            74,437Net
                increase (decrease) in cash and cash equivalents
            
            
            (1,483
            )
            
            2,902
            
            
            (5,073
            )Cash
                and cash equivalents, beginning of year
            
            
            27,148
            
            
            24,246
            
            
            29,319Cash
                and cash equivalents, end of year
            
            $
            25,665
            
            $
            27,148
            
            $
            24,246**Supplemental
                disclosures**Transfer
                of loans to other real estate
            
            $
            705
            
            $
            1,494
            
            $
            2,312Decrease
                in fair value of securities available for sale, net of tax
            
            
            (885
            )
            
            (1,772
            )
            
            (324
            )Interest
                paid on deposits and borrowed funds
            
            
            34,155
            
            
            15,453
            
            
            15,104Income
                taxes paid
            
            
            2,238
            
            
            4,694
            
            
            4,680





*See
      notes to consolidated financial statements*





53
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            of Contents*





**FNB
      Financial Services Corporation and Subsidiary**


**Notes
      to Consolidated Financial Statements**





December
      31, 2006, 2005, and 2004





**Note
      1 - Summary of significant accounting policies**




*Principles
      of consolidation*





The
      accompanying consolidated financial statements include the accounts of FNB
      Financial Services Corporation (the “Company”) and its wholly owned subsidiary
      FNB Southeast (the “Bank”). Also included are the accounts of FNB Southeast
      Mortgage Corporation, and FNB Southeast Investment Services, Inc., both of
      which
      are wholly owned subsidiaries of the Bank. All significant intercompany balances
      and transactions have been eliminated in consolidation.





*Nature
      of operations*





The
      Bank
      provides a variety of financial services to individual and corporate customers
      in North Carolina through its thirteen full-service branches in Reidsville,
      Madison, Eden, Ruffin, Greensboro, Burgaw, and Wilmington, North Carolina.
      A
      majority of the Bank’s North Carolina customers are located in Rockingham,
      Guilford, and New Hanover Counties. The Bank also provides a variety of
      financial services to customers in Virginia through its four full-service
      branches in Norton, Harrisonburg, and Pennington Gap, Virginia. A majority
      of
      the Bank’s Virginia customers are located in Wise, Russell, Lee, Rockingham, and
      Augusta Counties. FNB Southeast’s primary deposit products are
      noninterest-bearing checking accounts, interest-bearing checking accounts,
      money
      market accounts, certificates of deposit and individual retirement accounts.
      Its
      primary lending products are commercial, real estate, and consumer
      loans.





*Use
      of estimates*





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and their reported amounts of revenues and expenses
      during the reporting period. Actual results could differ from those
      estimates.





Material
      estimates that are particularly susceptible to significant change relate to
      the
      determination of the allowance for credit losses on loans. A majority of the
      Bank’s loan portfolio consists of loans in the geographic areas cited above. The
      local economies of these areas depend heavily on the industrial, agricultural,
      and service sectors. Accordingly, the ultimate collectibility of a large portion
      of the Bank’s loan portfolio would be affected by changes in local economic
      conditions.





*Cash
      and cash equivalents*





Cash
      and
      cash equivalents include cash and due from banks and interest-bearing bank
      deposits. Cash and cash equivalents are defined as cash and short-term
      investments with maturities of three months or less.





*Investment
      securities*





The
      Company classifies its investment securities at the time of purchase into three
      categories as follows:





-  Held to
      Maturity - reported at amortized cost,





-  Trading
      - reported at fair value with unrealized gains and losses included in earnings,
      or





-  Available for Sale - reported at fair value with unrealized gains and losses
      reported in other comprehensive income.





The
      Company is required to maintain certain levels of Federal Reserve Bank (“FRB”)
      and Federal Home Loan Bank of Atlanta (“FHLB”) stock based on various criteria
      established by the individual issuer.





54
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            of Contents*





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




*Other
        Than Temporary Impairment of Investment Securities*
 
 Our
        policy regarding other than temporary impairment of investment securities
        requires continuous monitoring. Individual investment securities with a fair
        market that is less than 80% of original cost over a continuous period of
        two
        quarters are evaluated for impairment during the subsequent quarter. The
        evaluation includes an assessment of both qualitative and quantitative measures
        to determine whether, in management’s judgment, the investment is likely to
        recover its original value. If the evaluation concludes that the investment
        is
        not likely to recover its original value, the unrealized loss is reported
        as an
        other than temporary impairment, and the loss is recorded as a securities
        transaction on the Consolidated Statement of Income. If the evaluation indicates
        a loss of asset value, management may elect to record an other than temporary
        impairment immediately.




*Loans*




Interest
      on loans is accrued and credited to income based on the principal amount
      outstanding. The accrual of interest on impaired loans is discontinued when,
      in
      management’s opinion, the borrower may be unable to meet payments as they become
      due. When interest accrual is discontinued, all unpaid accrued interest is
      reversed. Loans are placed on nonaccrual status when: (i) management has
      concerns relating to the ability to collect the loan principal and interest
      and
      (ii) generally when such loans are ninety days or more past due. Interest income
      is subsequently recognized only to the extent cash payments are received.
      Mortgage loans included in the warehouse line of credit are valued at the
      lower of cost or market as determined by outstanding commitments from investors
      or current investor yield requirements, calculated on the aggregate loan
      basis.





*Loan
      origination fees and costs*





Loan
      origination fees and certain direct origination costs are capitalized and
      recognized as an adjustment of the yield on the related loan.





*Impaired
      loans*





A
      loan is
      considered impaired, based on current information and events, if it is probable
      that the Company will be unable to collect the scheduled payments of principal
      or interest when due according to the contractual terms of the loan agreement.
      Generally, a loan will be considered impaired if it exhibits the same level
      of
      underlying weakness and probability of loss as loans classified doubtful or
      loss.





The
      impairment evaluation compares the recorded book value of the loan, or loan
      relationship, to the present value of the expected future principal, interest
      and collateral value (if applicable) cash flows. The expected cash flows are
      discounted at the contractual interest rate for the individual note. A specific
      reserve is established if the present value of expected future cash flows is
      less than the recorded book value of the loan.





*Allowance
      for credit losses*





The
      Company’s allowance for credit losses is based on management’s best estimate of
      probable loan losses incurred as of the balance sheet date. Factors impacting
      estimated probable loan losses include credit quality trends, past loan loss
      experience, current economic conditions, and loan volume among loan
      categories.





While
      management uses the best available information to establish the allowance for
      credit losses, future additions to the allowance may be necessary based on
      the
      factors cited above. In addition, the allowance is reviewed by regulatory
      agencies as an integral part of their examination processes. Such agencies
      may
      require the Company to recognize changes to the allowance based on their
      judgments about information available to them at the time of their examination.





*Other
      real estate*





Other
      real estate, acquired through partial or total satisfaction of loans, is
      initially recorded at fair market value, less estimated costs to sell, which
      becomes the property’s new basis. At the date of acquisition, losses are charged
      to the allowance for credit losses. Subsequent write-downs are charged to
      expense in the period they are incurred.





*Premises
      and equipment*





Premises
      and equipment are stated at cost less accumulated depreciation and amortization.
      The provision for depreciation and amortization is computed principally by
      the
      straight-line method over the estimated useful lives of the assets. Useful
      lives
      are estimated at 20 to 40 years for buildings and 3 to 10 years for equipment.
      Leasehold improvements are amortized over the expected terms of the respective
      leases or the estimated useful lives of the improvements, whichever is shorter.
      Expenditures for maintenance and repairs are charged to operations, and the
      expenditures for major replacements and betterments are added





55
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to
      the
      premises and equipment accounts. The cost and accumulated depreciation of the
      premises and equipment retired or sold are eliminated from the appropriate
      asset
      accounts at the time of retirement or sale and the resulting gain or loss is
      reflected in current operations.





*Income
      taxes*





Provisions
      for income taxes are based on taxes payable or refundable for the current year
      (after exclusion of non-taxable income such as interest on state and municipal
      securities and non-deductible expenses) and deferred taxes on temporary
      differences between the tax bases of assets and liabilities and their reported
      amounts in the financial statements at currently enacted income tax rates
      applicable to the period in which the deferred tax assets and 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 for
      income taxes.





*Common
      stock*





A
      five-for-four stock split was effected in the form of a 25% stock dividend,
      effective May 31, 2005, with the issuance of 1,398,030 shares of stock and
      the
      transfer of $1,398,030 from retained earnings to the common stock account.
      All
      per share amounts in the financial statements have been recomputed to reflect
      this split.





*Per
      share data*





The
      Company follows Statement of Financial Accounting Standards (“SFAS”) No. 128, *Earnings
      per Share* .
      SFAS
      No. 128 requires disclosure of two earnings per share amounts: basic net income
      per share of common stock and diluted net income per share of common stock.
      Basic net income per share of common stock is computed by dividing net income
      available to common shareholders by the weighted average number of shares of
      common stock outstanding during each year. Diluted net income per share of
      common stock is computed by dividing net income plus any adjustments to net
      income related to the issuance of dilutive potential common shares, comprised
      solely of outstanding options to purchase shares of common stock, by the
      weighted average number of shares of common stock outstanding during each year
      plus the number of potential dilutive common shares.





*Sales
      of loans*





Gains
      and
      losses on the sale of loans are accounted for by imputing gain or loss on those
      sales where a yield rate guaranteed to the buyer is more or less than the
      contract interest rate being collected. Such gains or losses are recognized
      in
      the financial statements at the time of the sale.





*Off
      balance sheet arrangements*





In
      the
      ordinary course of business, the Bank enters into off balance sheet financial
      instruments consisting of commitments to extend credit, commitments under credit
      card arrangements, commercial letters of credit and standby letters of credit.
      Such financial instruments are recorded in the financial statements when they
      are funded or related fees are incurred or received.





*Segment
      information*





The
      Company follows the provisions of SFAS No. 131, *Disclosures
      about Segments of an Enterprise and Related Information* .
      SFAS
      No. 131 requires that public business enterprises report certain information
      about operating segments in their annual financial statements and in condensed
      financial statements for interim periods issued to stockholders. It also
      requires that public business enterprises report related disclosures and
      descriptive information about products and services provided by significant
      segments, geographic areas, and major customers, differences between the
      measurements used in reporting segment information and those used in the
      enterprise’s general-purpose financial statements, and changes in the
      measurement of segment amounts from period to period.





Operating
      segments are components of an enterprise with separate financial information
      available for use by the chief operating decision maker to allocate resources
      and to assess performance. The Company has determined that it has one
      significant operating segment, the providing of financial services, including
      banking, mortgage, and investment services, to customers located in Reidsville,
      Madison, Eden, Ruffin, Greensboro, Burgaw, and Wilmington, North Carolina;
      Norton, Harrisonburg, and Pennington Gap,





56
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            of Contents*





Virginia;
      and surrounding communities. The various products are those generally offered
      by
      community banks, and the allocation of resources is based on the overall
      performance of the Company, rather than the individual branches or
      products.





There
      are
      no differences between the measurements used in reporting segment information
      and those used in the Company’s general-purpose financial
      statements.





*Recent
      accounting pronouncements*





On
      January 1, 2006, the Company adopted SFAS No. 123(R), *Share-Based
      Payments* ,
      which
      is a revision of SFAS No. 123 *Accounting
      for Stock-Based Compensation* and
      supersedes Accounting Principles Board (“APB”) Opinion No. 25 *Accounting
      for Stock Issued to Employees* .
      SFAS
      No. 123(R) requires companies to recognize in the income statement the
      grant-date fair value of stock options and other equity-based compensation
      issued to employees over the period during which an employee is required to
      provide service in exchange for the award, which will often be the shorter
      of
      the vesting period of the period the employee will be retirement eligible.
      SFAS
      No. 123(R) sets accounting requirements for “share-based” compensation to
      employees, including employee-stock purchase plans (“ESPPs”). Awards to most
      nonemployee directors will be accounted for as employee awards. See Note 12
      -
      Stock based Compensation for financial disclosures related to SFAS
      No. 123(R).





On
      January 1, 2006, the Company also adopted Staff Accounting Bulletin No. 107
      (“SAB 107”), which contains guidance on applying the requirements in SFAS
      No. 123(R). SAB 107 provides guidance on valuation techniques, development
      of assumptions used in valuing employee share options and related MD&A
      disclosures.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 157, *Fair
      Value Measurements* (“SFAS
      No. 157”). SFAS No. 157 enhances existing guidance for measuring assets and
      liabilities using fair value. Prior to the issuance of SFAS No. 157, guidance
      for applying fair value was incorporated in several accounting pronouncements.
      SFAS No. 157 provides a single definition of fair value, together with a
      framework for measuring it, and requires additional disclosure about the use
      of
      fair value to measure assets and liabilities. SFAS No. 157 also emphasizes
      that
      fair value is a market-based measurement, not an entity-specific measurement,
      and sets out a fair value hierarchy with the highest priority being quoted
      prices in active markets. Under SFAS No. 157, fair value measurements are
      disclosed by level within that hierarchy. While SFAS No. 157 does not add any
      new fair value measurements, it does change current practice. Changes to
      practice include: (1) a requirement for an entity to include its own credit
      standing in the measurement of its liabilities; (2) a modification of the
      transaction price presumption; (3) a prohibition on the use of block
      discounts when valuing large blocks of securities for broker-dealers and
      investment companies; and (4) a requirement to adjust the value of
      restricted stock for the effect of the restriction even if the restriction
      lapses within one year. SFAS No. 157 is effective for financial statements
      issued for fiscal years beginning after November 15, 2007, and interim
      periods within those fiscal years. The Company has not determined the impact
      of
      adopting SFAS No. 157 on its consolidated financial statements.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 158, *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans (an
      amendment of FASB Statements No. 87, 88, 106, and 132R)* (“SFAS
      No. 158”). SFAS No. 158 requires an employer to: (a) Recognize in its
      statement of financial position an asset for a plan’s overfunded status or a
      liability for a plan’s underfunded status; (b) measure a plan’s assets and
      its obligations that determine its funded status as of the end of the employer’s
      fiscal year (with limited exceptions); and (c) recognize changes in the
      funded status of a defined benefit postretirement plan in the year in which
      the
      changes occur. Those changes will be reported in comprehensive income of a
      business entity and in changes in net assets of a not-for-profit organization.
      The requirement by SFAS No. 158 to recognize the funded status of a benefit
      plan
      and the disclosure requirements of SFAS No. 158 became effective for the Company
      as of the end of the fiscal year ending December 31, 2006. See Footnote 18
      for further information. The requirement to measure plan assets and benefit
      obligations as of the date of the employer’s fiscal year-end statement of
      financial position is effective for fiscal years ending after December 15,
      2008.





57
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In
      September 2006, the SEC staff issued SAB No. 108, *Considering
      the Effects of Prior Year Misstatements When Quantifying Misstatements in the
      Current Year Financial Statements* (“SAB No. 108”). SAB No. 108 addresses the diversity in
      practice by registrants when quantifying the effect of an error on the financial
      statements. SAB No. 108 provides guidance on the consideration of the
      effects of prior year misstatements in quantifying current year misstatements
      and is effective for annual periods ending after November 15, 2006. The Company
      adopted the provisions of SAB No. 108 effective
      December 31, 2006, and the adoption did not have a material impact on
      the Company’s financial results.




In
      June
      2006, the FASB issued FASB Interpretation No. 48, *Accounting for
      Uncertainty in Income Taxes* (“FIN 48”), an interpretation of FASB Statement
      No. 109, *Accounting for Income Taxes*. FIN 48 addresses the accounting
      for income taxes by prescribing the minimum recognition threshold a tax position
      is required to meet before being recognized in the financial statements. In
      addition, FIN 48 expands the disclosure requirements concerning unrecognized
      tax
      benefits as well as any significant changes that may occur in the next twelve
      months associated with such unrecognized tax benefits. FIN 48 will be effective
      for the beginning of the Company’s 2007 fiscal year, with adoption treated as a
      cumulative-effect-type adjustment to retained earnings as of the beginning
      of
      2007. The Company does not anticipate recording any material adjustment as
      a
      result of adopting this Interpretation.




In
        September 2006, the Emerging Issues Task Force (EITF) issued EITF Issue 06-4,
        *Accounting for Deferred Compensation and Postretirement Benefit Aspects
        of
        Endorsement Split-Dollar Life Insurance Arrangements* (“EITF Issue 06-4”).
        EITF Issue 06-4 requires that for endorsement split-dollar insurance
        arrangements that provide a benefit to an employee that extends to
        postretirement periods, an employer should recognize a liability for future
        benefits in accordance with FASB Statement No. 106 or Accounting Principles
        Board (APB) Opinion No. 12 based on the substantive agreement of the employee.
        If the employee has effectively agreed to maintain a life insurance policy
        during postretirement periods, the costs of the life insurance policy during
        the
        postretirement periods should be accrued in accordance with either FASB
        Statement No. 106 or APB Opinion No. 12. EITF Issue 06-4 is effective for
        fiscal
        years beginning after December 15, 2007. The Company is currently evaluating
        the
        impact of EITF Issue 06-4 on its financial statements.


From
      time
      to time the FASB issues exposure drafts for proposed statements of financial
      accounting standards. Such exposure drafts are subject to comment from the
      public, to revisions by the FASB and to final issuance by the FASB as statements
      of financial accounting standards. Management considers the effect of the
      proposed statements on the consolidated financial statements of the Company
      and
      monitors the status of changes to and proposed effective dates of exposure
      drafts.




*Reclassification*





Certain
      items for 2005 and 2004 have been reclassified to conform to the 2006
      presentation. Such reclassifications had no effect on net income or
      shareholders’ equity as previously reported.





**Note
      2 - Proposed merger**





On
      February 26, 2007, the Company entered into a definitive agreement with LSB
      Bancshares, Inc. (“LSB”) to combine in a merger of equals. LSB, headquartered in
      Lexington, North Carolina is the holding company for Lexington State Bank.
      As
      soon as practicable following the merger of the holding companies, the Bank
      will
      be merged with and into Lexington State Bank. The merger of the holding
      companies will be accounted for using the purchase method of accounting for
      business combinations and is subject to several conditions, including approval
      by the shareholders of LSB and the Company, which vote is scheduled to occur
      in
      the second quarter of 2007, and approval by applicable regulatory authorities.
      Upon satisfaction of these conditions, the merger of the holding companies
      is
      anticipated to close in the third quarter of 2007. The Company’s shareholders
      will receive 1.07 shares of LSB common stock for each share of the Company’s
      common stock. At December 31, 2006, LSB operated 25 offices through Lexington
      State Bank and had approximately $986,000,000 in total assets, $750,000,000
      in
      loans, $818,000,000 in deposits and $88,900,000 in shareholders’ equity. In
      connection with the merger, it is expected that the Company’s shareholders will
      receive approximately 7,558,000 shares of LSB common stock.




**Note
      3 - Restriction on cash and due from banks**





The
      Bank
      maintains average required reserve balances with the Federal Reserve. The
      average amounts of these reserve balances for the years ended December 31,
      2006
      and 2005 were $2,738,000 and $2,770,000, respectively.





**Note
      4 - Investment securities**




Investment
      securities at December 31 consist of the
      following:





58
 *Table
            of Contents*









Amortized
              Cost
            
            Gross
              Unrealized
              Gains
            
            Gross
              Unrealized
              Losses
            
            Estimated
              Fair
              Value*(In
                thousands)***2006:**Available
                for sale:U.S.
                government agency securities
            
            $
            102,998
            
            $
            15
            
            $
            (1,607
            )
            $
            101,406Mortgage
                backed securities
            
            
            42,004
            
            
            19
            
            
            (1,096
            )
            
            40,927State
                and municipal obligations
            
            
            65,544
            
            
            345
            
            
            (431
            )
            
            65,458Other
                debt securities
            
            
            3,261
            
            
            -
            
            
            (41
            )
            
            3,220Total
                available for saleFederal
                Home Loan Bank and Federal
            
            
            213,807
            
            
            379
            
            
            (3,175
            )
            
            211,011Reserve
                Bank stock
            
            
            6,116
            
            
            -
            
            
            -
            
            
            6,116Total
                investment securities
            
            $
            219,923
            
            $
            379
            
            $
            (3,175
            )
            $
            217,127**2005:**Available
                for sale:U.S.
                government agency securities
            
            $
            117,993
            
            $
            36
            
            $
            (2,213
            )
            $
            115,816Mortgage
                backed securities
            
            
            41,701
            
            
            1
            
            
            (1,057
            )
            
            40,645State
                and municipal obligations
            
            
            38,276
            
            
            248
            
            
            (666
            )
            
            37,858Other
                debt securities
            
            
            1,636
            
            
            -
            
            
            (29
            )
            
            1.607Total
                available for saleFederal
                Home Loan Bank and Federal
            
            
            199,606
            
            
            285
            
            
            (3,965
            )
            
            195,926Reserve
                Bank stock
            
            
            5,964
            
            
            -
            
            
            -
            
            
            5,964Total
                investment securities
            
            $
            205,570
            
            $
            285
            
            $
            (3,965
            )
            $
            201,890





The
      aggregate cost of the Company’s cost method equity investment, Federal Home Loan
      Bank stock and Federal Reserve Bank stock, totaled $6,116,000 at December 31,
      2006. Because of the redemption provisions of these entities, the Company
      estimates that the fair value equals the cost of these investments and that
      they
      are not impaired.





The
      following table shows our investments’ gross unrealized losses and fair value,
      aggregated by investment category and length of time that the individual
      securities have been in a continuous unrealized position, at December 31, 2006
      and 2005. The unrealized losses relate to debt securities that have incurred
      fair value reductions due to higher market interest rates since the securities
      were purchased. The unrealized losses are not likely to reverse unless and
      until
      market interest rates decline to the levels that existed when the securities
      were purchased.  Since none of the unrealized losses relate to the
      marketability of the securities or the issuer’s ability to honor redemption
      obligations, and the Company has the intent and ability to hold until recovery;
      none of the securities are deemed to be other than temporarily impaired.





2006
            
            Less
                than 12 months
            
            12
                months or more
            
            TotalFair
              value
            
            Unrealized
              losses
            
            Fair
              alue
            
            Unrealized
              losses
            
            Fair
              Value
            
            Unrealized
              losses*(In
                thousands)*Investment
                securities:U.S.
                government agency securities
            
            $
            5,546
            
            $
            34
            
            $
            92,577
            
            $
            1,573
            
            $
            98,123
            
            $
            1,607Mortgage
                backed securities
            
            
            3,475
            
            
            25
            
            
            33,560
            
            
            1,070
            
            
            37,035
            
            
            1,096State
                and municipal obligations
            
            
            23,466
            
            
            171
            
            
            14,047
            
            
            260
            
            
            37,513
            
            
            431Other
                debt securities
            
            
            3,220
            
            
            42
            
            
            -
            
            
            -
            
            
            3,220
            
            
            41Total
                temporarily impaired securities
            
            $
            35,707
            
            $
            272
            
            $
            140,184
            
            $
            2,903
            
            $
            178,891
            
            $
            3,175







59
 *Table
          of Contents*


2005
            
            Less
                than 12 months
            
            12
                months or more
            
            TotalFair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              losses
            
            Fair
              value
            
            Unrealized
              losses*(In
                thousands)*Investment
                securities:U.S.
                government agency securities
            
            $
            38,474
            
            $
            381
            
            $
            59,750
            
            $
            1,832
            
            $
            98,224
            
            $
            2,213Mortgage
                backed securities
            
            
            29,044
            
            
            602
            
            
            11,601
            
            
            455
            
            
            40,645
            
            
            1,057State
                and municipal obligations
            
            
            17,445
            
            
            331
            
            
            6,528
            
            
            335
            
            
            23,973
            
            
            666Other
                debt securities
            
            
            1,607
            
            
            29
            
            
            -
            
            
            -
            
            
            1,607
            
            
            29Total
                temporarily impaired securities
            
            $
            86,570
            
            $
            1,343
            
            $
            77,879
            
            $
            2,622
            
            $
            162,842
            
            $
            3,965





The
      amortized cost and estimated market value of debt securities at December 31,
      2006, by contractual maturities, are shown in the accompanying schedule.
      Expected maturities may differ from contractual maturities because borrowers
      may
      have the right to call or prepay obligations with or without call or prepayment
      penalties.





Amortized
              Cost
            
            Estimated
              Fair
                Value*(In
                thousands)*Due
                in one year or less
            
            $
            26,542
            
            $
            26,260Due
                after one through five years
            
            
            84,374
            
            
            82,930Due
                after five through ten years
            
            
            38,025
            
            
            37,448Due
                after ten years
            
            
            61,605
            
            
            61,153Total
                debt securities
            
            $
            210,546
            
            $
            207,791





Proceeds
      from the sale of investment securities available for sale, gross realized gains,
      and gross realized losses for the years ended December 31 were as
      follows:




2006
            
            2005
            
            2004*(In
                thousands)*Proceeds
                from sales
            
            $
            1,921
            
            $
            11,459
            
            $
            15,195Gross
                realized gains
            
            
            32
            
            
            66
            
            
            150Gross
                realized losses
            
            
            -
            
            
            66
            
            
            41





At
      December 31, 2006 and 2005, investment securities with a carrying value of
      approximately $93,840,000 and $71,118,000, respectively, were pledged as
      collateral to secure public deposits and for other purposes.





**Note
      5 - Loans**





Major
      classifications of loans at December 31, are as follows:





2006
            
            2005*(In
                thousands)*Commercial,
                financial and agricultural
            
            $
            60,435
            
            $
            77,007Consumer
            
            
            132,141
            
            
            147,163Real
                estate:Residential
                mortgage
            
            
            116,287
            
            
            142,305Commercial
                mortgage
            
            
            173.203
            
            
            177,986Construction
            
            
            225,080
            
            
            213,506Gross
                loans
            
            
            707,146
            
            
            757,967Less:
                allowance for credit losses
            
            
            13,195
            
            
            19,142Loans,
                net of allowance
            
            $
            693,951
            
            $
            738,825




At
      December 31, 2006 and 2005, the recorded investment in loans considered impaired
      was approximately $34,467,000 **** and
      $58,264,000, respectively. The related allowance for credit losses on these
      impaired loans was approximately $4,722,000 and $11,611,000, respectively.
      The
      average recorded investment in impaired loans for the years ended December
      31,
      2006, 2005 and 2004 was approximately $46,366,000, $25,409,000, and $11,851,000,
      respectively.





60
 *Table
            of Contents*





Impaired
      loans at December 31, 2006 consisted of $32,320,000 of impaired commercial
      loans
      and $2,147,000 of retail loans past due 90 days or more. Impaired loans at
      December 31, 2005 consisted of $55,118,000 of impaired commercial loans and
      $3,146,000 of retail loans past due 90 days or more. The amount of interest
      income recorded on nonperforming loans during 2006, 2005 and 2004 amounted
      to
      $658,000, $365,000, and $186,000, respectively. Interest income on nonperforming
      loans is recorded when cash is actually received.





**Note
      6 - Allowance for credit losses**





Changes
      in the allowance for credit losses for the years ended December 31 were as
      follows:





2006
            
            2005
            
            2004*(In
                thousands)*Balance
                at beginning of year
            
            $
            19,142
            
            $
            7,353
            
            $
            7,124Provision
                for credit losses
            
            
            1,435
            
            
            16,132
            
            
            1,275Recoveries
            
            
            701
            
            
            320
            
            
            77Losses
                charged off
            
            
            (8,083
            )
            
            (4,662
            )
            
            (1,123
            )Balance
                at end of year
            
            $
            13,195
            
            $
            19,142
            
            $
            7,353




**Note
      7 - Premises and equipment**





Premises
      and equipment at December 31 is summarized as follows:





2006
            
            2005*(In
                thousands)*Land
            
            $
            6,741
            
            $
            3,642Building
                and leasehold improvements
            
            
            11,179
            
            
            9,953Equipment
            
            
            16,305
            
            
            13,905Subtotal
            
            
            34,225
            
            
            27,500Less
                accumulated depreciation and amortization
            
            
            14,616
            
            
            13,193Total
                premises and equipment, net
            
            $
            19,609
            
            $
            14,307





Depreciation
      and amortization expense amounting to $1,631,000, $1,932,000, and $1,785,000,
      for the years ended December 31, 2006, 2005, and 2004, respectively, is included
      in occupancy and equipment expense.





**Note
      8 - Deposits**





The
      aggregate amount of jumbo certificates of deposit, each with a minimum
      denomination of $100,000, was approximately $111,826,000 and $116,623,000 in
      2006 and 2005, respectively. The accompanying table presents the scheduled
      maturities of time deposits at December 31, 2006.





Year
                ending December 31,
            
            *(In
                thousands)*2007
            
            $
            496,9712008
            
            
            27,6772009
            
            
            12,0262010
            
            
            5,4462011
            
            
            2,946Thereafter
            
            
            44Total
                time deposits
            
            $
            545,110





**Note
      9 - Short-term borrowings and long-term debt**





The
      following is a schedule of federal funds purchased, securities sold under
      agreements to repurchase and FHLB borrowings:






61
 *Table
          of Contents*





Balance
              as
                of
              December
                31
            
            Interest
                Rate
              as
                of
              December
                31
            
            Average
              Balance
            
            Average
              Interest
              Rate
            
            Maximum
              Outstanding
              at
                Any
              Monthend**2006**
            
            *(dollars
                in thousands)*Federal
                funds purchased and securitiessold
                under agreements to repurchase
            
            $
            26,384
            
            
            3.55
            %
            
            $
            7,719
            
            
            2.85
            %
            
            $
            26,384FHLB
                borrowings
            
            
            55,000
            
            
            4.90
            %
            
            
            69,932
            
            
            4.79
            %
            
            
            75,000Total
            
            $
            81,384
            
            
            
            
            
            $
            77,651
            
            
            
            
            
            $
            101,384**2005**Federal
                funds purchased and securitiessold
                under agreements to repurchase
            
            $
            7,305
            
            
            1.49
            %
            
            $
            16,974
            
            
            2.16
            %
            
            $
            28,199FHLB
                borrowings
            
            
            75,000
            
            
            4.23
            %
            
            
            62,285
            
            
            3.79
            %
            
            
            75,000Total
            
            $
            82,305
            
            
            
            
            
            $
            79,259
            
            
            
            
            
            $
            103,199


**2004**Federal
                  funds purchased and securitiessold
                  under agreements to repurchase
              
              $
              21,534
              
              
              1.82
              %
              
              $
              16,747
              
              
              0.91
              %
              
              $
              25,992FHLB
                  borrowings
              
              
              45,000
              
              
              3.30
              %
              
              
              47,393
              
              
              2.91
              %
              
              
              57,500Total
              
              $
              66,534
              
              
              
              
              
              $
              64,140
              
              
              
              
              
              $
              83,492


At
      December 31, 2006, the Bank had an approximately $177 million line of credit
      with the FHLB under which $55.0 million was outstanding. This line of credit
      is
      secured with FHLB stock and a blanket floating lien on qualifying 1 to 4 family
      residential mortgage loans and qualifying commercial real estate. The
      outstanding amounts consist of $25.0 million maturing in 2007, and $30.0 million
      maturing in 2008.





Federal
      funds purchased represent unsecured overnight borrowings from other financial
      institutions by the Bank. Securities sold under agreements to repurchase
      represent short-term borrowings by the Bank, with overnight maturities
      collateralized by securities of the United States government or its
      agencies.




The
      Company entered into a reverse repurchase agreement on December 8, 2006. The
      $21,000,000 transaction has a repurchase date of December 8, 2016, is callable
      after one year, with quarterly calls thereafter. The transaction is subject
      to a
      floating rate of 3 month LIBOR minus 100 basis points for the first year and
      a
      fixed rate of 4.03% following the first year. The purchased mortgage-backed
      securities had a market value of $25.3 million at December 31,
      2006.





The
      Company and FNB Financial Services Capital Trust I, a Delaware statutory trust
      (the “Trust,” wholly owned by the Company), issued and sold on August 26, 2005
      $25,000,000 of the Trust’s Floating Rate Preferred Securities, with a
      liquidation amount of $1,000 per preferred security, bearing a variable rate
      of
      interest per annum, reset quarterly, equal to LIBOR plus 1.46% (the “Preferred
      Securities”) and a maturity date of September 30, 2035. The Preferred Securities
      are callable in 5 years. Interest payment dates are March 30, June 30, September
      30, and December 30 of each year. The Preferred Securities are fully and
      unconditionally guaranteed on a subordinated basis by the Company with respect
      to distributions and amounts payable upon liquidation, redemption or repayment.
      The entire proceeds from the sale by the Trust to the holders of the Preferred
      Securities was combined with the entire proceeds from the sale by the Trust
      to
      the Company of its common securities (the “Common Securities”), and was used by
      the Trust to purchase $25,774,000 in principal amount of the Floating Rate
      Junior Subordinated Notes (the “Junior Subordinated Notes”) of the Company. The
      Company adopted FASB Interpretation No. (“FIN”) 46, “ *Consolidation
      of Variable Interest Entities* ,”
upon
      the establishment of the Trust and has not included the Trust in the
      consolidated financial statements.





The
      Company contributed $24,000,000 of the proceeds from the sale of the Junior
      Subordinated Notes to the Bank as Tier I Capital to support the Bank’s growth.
      Currently, regulatory capital rules allow trust preferred securities to be
      included as a component of regulatory capital.





The
      following is a schedule of the components of short-term borrowings and long-term
      debt:





2006
            
            2005*(In
                thousands)*Short-term
                borrowings:Federal
                funds purchased and securities sold under agreements to
                repurchase
            
            $
            5,384
            
            $
            7,305FHLB
                borrowings
            
            
            25,000
            
            
            20,000Total
                short-term borrowings
            
            $
            30,384
            
            $
            27,305Long-term
                debt:FHLB
                borrowings
            
            $
            30,000
            
            $
            55,000Securities
                sold under a reverse repurchase agreement
            
            
            21,000
            
            
            -Junior
                subordinated notes
            
            
            25,774
            
            
            25,774Total
                long-term debt
            
            $
            76,774
            
            $
            80,774







62
 *Table
            of Contents*





**Note
      10 - Income taxes**




The
      components of income tax expense for the years ended December 31 are as
      follows:





2006
            
            2005
            
            2004*(In
                thousands)*Current
                tax expenseFederal
            
            $
            2,124
            
            $
            3,791
            
            $
            3,864State
            
            
            202
            
            
            516
            
            
            623Total
                current
            
            
            2,326
            
            
            4,307
            
            
            4,487Deferred
                tax (benefit) expenseFederal
            
            
            1,854
            
            
            (4,089
            )
            
            (290
            )State
            
            
            265
            
            
            (562
            )
            
            (107
            )Total
                deferred
            
            
            2,119
            
            
            (4,651
            )
            
            (397
            )Total
                income tax expense (benefit)
            
            $
            4,445
            
            $
            (344
            )
            $
            4,090





The
      significant components of deferred tax assets at December 31 are as
      follows:





2006
            
            2005*(In
                thousands)*Deferred
                tax assets:Allowance
                for credit losses
            
            $
            5,043
            
            $
            7,309Non-qualified
                deferred compensation plans
            
            
            962
            
            
            1,073Deferred
                loan fees
            
            
            16
            
            
            394Nonaccrual
                interest
            
            
            249
            
            
            66Net
                unrealized loss on securities available for sale
            
            
            1,090
            
            
            1,435Net
                unrealized loss related to adoption of SFAS No. 158
            
            
            1,162
            
            
            -Stock
                based compensation
            
            
            111
            
            
            -Other
            
            
            260
            
            
            213Total
            
            
            8,893
            
            
            10,490Deferred
                tax liabilities:Depreciable
                basis of property and equipment
            
            
            607
            
            
            875Prepaid
                expenses
            
            
            250
            
            
            270Other
            
            
            18
            
            
            24Total
            
            
            875
            
            
            1,169Net
                deferred tax assets
            
            $
            8,018
            
            $
            9,321





There
      is
      no valuation allowance for deferred tax assets, as management believes that
      realization of the deferred tax assets will more likely than not be realized.
      The provision for income taxes differs from that computed by applying the
      federal statutory rate of 35% as indicated in the following
      analysis:





2006
            
            2005
            
            2004*(In
                thousands)*Tax
                based on statutory rates
            
            $
            4,745
            
            $
            157
            
            $
            4,350Increase
                (decrease) resulting from:Effect
                of tax-exempt income
            
            
            (526
            )
            
            (399
            )
            
            (427
            )State
                income taxes, net of federal benefit
            
            
            303
            
            
            (30
            )
            
            335Other,
                net
            
            
            (77
            )
            
            (72
            )
            
            (168
            )Total
                provision for income taxes
            
            $
            4,445
            
            $
            (344
            )
            $
            4,090





**Note
      11 - Lease commitments**





The
      minimum annual lease commitments under noncancelable operating leases in effect
      at December 31, 2006, are as follows:





Year
                Ending December 31
            
            *(In
                thousands)*2007
            
            $
            9372008
            
            
            7832009
            
            
            7422010
            
            
            6522011
            
            
            212Thereafter
            
            
            182Total
                lease commitments
            
            $
            3,508








63
 *Table
            of Contents*





Rental
      expense was $1,081,000, $970,000, and $722,000 for the years ended December
      31,
      2006, 2005 and 2004, respectively.





**Note
      12 - Related party transactions**





The
      Bank
      had loans outstanding to principal officers and directors and their affiliated
      companies during each of the past three years. Such loans were made
      substantially on the same terms, including interest rates and collateral, as
      those prevailing at the time for comparable transactions with other borrowers
      and do not involve more than the normal risks of collectibility. The following
      table summarizes the transactions for the past two years.





*(In
                thousands)*
            
            2006
            
            2005Balance,
                beginning of year
            
            $
            5,854
            
            $
            3,591Advances
                during year
            
            
            4,708
            
            
            4,550Repayments
                during year
            
            
            (4,636
            )
            
            (2,287
            )Balance,
                end of year
            
            $
            5,926
            
            $
            5,854





*NOTE:
      Unused credit available at December 31, 2006 totaled
      $5,046,000.*





**Note
      13 - Stock based compensation**





Effective
      January 1, 2006, the Company adopted SFAS No. 123 (revised 2004),
      Share-Based Payment, (“SFAS No. 123(R)”) which was issued by the FASB in
      December 2004. SFAS No. 123(R) revises SFAS No. 123, Accounting
      for Stock Based Compensation, and supersedes APB No. 25, Accounting for
      Stock Issued to Employees, and its related interpretations. SFAS No. 123(R)
      requires recognition of the cost of employee services received in exchange
      for
      an award of equity instruments in the financial statements over the period
      the
      employee is required to perform the services in exchange for the award
      (presumptively the vesting period). SFAS No. 123(R) also requires
      measurement of the cost of employee services received in exchange for an award
      based on the grant-date fair value of the award. SFAS No. 123(R) also
      amends SFAS No. 95, Statement of Cash Flows, to require that excess tax
      benefits be reported as financing cash inflows, rather than as a reduction
      of
      taxes paid, which is included within operating cash flows.





The
      Company adopted SFAS No. 123(R) using the modified prospective application
      as permitted under SFAS No. 123(R). Accordingly, prior period amounts have
      not been restated. Under this application, the Company is required to record
      compensation expense for all awards granted after the date of adoption and
      for
      the unvested portion of previously granted awards that remain outstanding at
      the
      date of adoption.





Prior
      to
      the adoption of SFAS No. 123(R), the Company used the intrinsic value
      method as prescribed by APB No. 25 and thus recognized no compensation
      expense for options granted with exercise prices equal to the fair market value
      of the Company’s common stock on the date of grant.





The
      Company has two share-based compensation plans, which are described below.
      The
      compensation cost that has been charged against income for these plans was
      approximately $471,000, $0, and $0 for the years ended December 31, 2006, 2005,
      and 2004, respectively. The income tax benefit recognized for share-based
      compensation arrangements was approximately $111,000 for the year ended December
      31, 2006.





At
      the
      1996 Annual Meeting, the shareholders approved the Omnibus Equity
      Compensation Plan (the “1996 Omnibus Plan”). The 1996 Omnibus Plan authorizes
      the Board of Directors to grant stock options to directors, executives, and
      key
      employees of the Company. Options granted under the





64
 *Table
            of Contents*





1996
      Omnibus Plan have a term of up to ten years and generally vest over a four-year
      period beginning on the date of the grant. Options under the 1996 Omnibus Plan
      must be granted at a price not less than the fair market value at the date
      of
      grant. If an award grant is forfeited, or otherwise expires, terminates or
      is
      canceled without the delivery of shares, then the shares covered by the
      forfeited, expired, terminated or canceled award will again be available to
      be
      delivered pursuant to awards under the plan. The 1996 Omnibus Plan expired
      in
      2006 and as of December 31, 2006 no more options may be granted.




The
        Long
        Term Stock Incentive Plan (the “2006 Omnibus Plan”) was approved by the
        shareholders of the Company at the annual meeting of shareholders held on
        May
        18, 2006 and relates to an aggregate of up to 500,000 shares of common stock
        which may be issued pursuant to the exercise of various rights granted under
        the
        2006 Omnibus Plan. Under the 2006 Omnibus Plan, the participants may be granted
        or awarded eligible options, rights to receive restricted shares of common
        stock
        and/or performance units. Except with respect to awards then outstanding,
        all
        awards must be granted or awarded on or before May 18, 2016. As of December
        31,
        2006, no options have been granted under the 2006 Plan.




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




2006
              
              2005
              
              2004Options
              
              Weighted
                Avg.
                Exercise
                Price
              
              Options
              
              Weighted
                Avg.
                Exercise
                Price
              
              Options
              
              Weighted
                Avg.
                Exercise
                PriceOutstanding
                  -Beginning
                  of year
              
              
              1,134,471
              
              $
              13.61
              
              
              962,041
              
              $
              11.64
              
              
              1,126,761
              
              $
              9.95Granted
              
              
              -
              
              
              -
              
              
              377,500
              
              
              17.18
              
              
              175,000
              
              
              15.95Exercised
              
              
              (145,905
              )
              
              8.96
              
              
              (147,414
              )
              
              9.19
              
              
              (321,996
              )
              
              8.03Forfeited
              
              
              (76,860
              )
              
              15.46
              
              
              (57,656
              )
              
              14.92
              
              
              (17,724
              )
              
              12.64Outstanding
                  - Endof
                  year
              
              
              911,706
              
              $
              14.20
              
              
              1,134,471
              
              $
              13.61
              
              
              962,041
              
              $
              11.64Exercisable
                  - Endof
                  year
              
              
              552,439
              
              $
              12.91
              
              
              557,575
              
              $
              11.43
              
              
              594,694
              
              $
              10.94Weighted
                  average fair value of options granted during the year
              
              $
              -
              
              
              
              
              $
              3.16
              
              
              
              
              $
              3.03





The
      following is a summary of information on outstanding and exercisable options
      at
      December 31, 2006:





Options
                Outstanding
            
            Options
                ExercisableRange
                of
              Exercise
                Prices
            
            Number
            
            Weighted
                Average
              Remaining
                Contractual
              Life
                (Years)
            
            Weighted
              Average
                Exercise
              Price
            
            Number
            
            Weighted
              Average
              Exercise
                Price$7.04
                - 8.01
            
            81,442
            
            3.21
            
            $
                7.58
            
            81,442
            
            $
                7.58$
                8.28 - 14.52
            
            225,016
            
            5.19
            
            10.19
            
            186,332
            
            10.08$15.31
                - 16.16
            
            259,759
            
            3.86
            
            15.96
            
            204,440
            
            15.97$16.32
                - 18.11
            
            345,489
            
            8.39
            
            17.04
            
            80,225
            
            17.08911,706
            
            5.85
            
            $
                14.20
            
            552,439
            
            $
                12.91





The
      fair
      value of each option grant is estimated on the date of grant using the
      Black-Scholes option pricing model. No options were granted during 2006. Options
      were granted in 2005 and 2004 with the following weighted average assumptions:
      dividend yield of 2.48% for 2005 and 3.07% for 2004; expected volatility of
      17.0% for 2005 and 16.0% for 2004; risk free interest rates of 3.94% for 2005
      and 3.68% for 2004, and expected lives of seven years for both years.





These
      plans provide that shares granted come from the Company’s authorized but
      unissued or reacquired common stock. The price of the options granted pursuant
      to these plans will not be less than 100 percent





65
 *Table
            of Contents*





of
      the
      fair market value of the shares on the date of grant. Subject to certain
      provisions for acceleration, the options granted in 1996 and thereafter vest
      ratably over a four-year period. No option will be exercisable after ten years
      from the date granted.




For
      the
      years ended December 31, 2006 and 2005, respectively, the intrinsic value of
      options exercised was approximately $870,000 and $1,215,000. The fair value
      of
      options vested during the periods was approximately $471,000 and $345,000,
      respectively.





Cash
      received from options exercised under all share-based payment arrangements
      for
      the year ended December 31, 2006 was $1,308,000. The actual benefit realized
      for
      the tax deductions from option exercise of the share-based arrangements totaled
      $290,000 for the year ended December 31, 2006. A total of $1,051,000 was
      recorded in 2006, of which $762,000 was related to the year ended December
      31,
      2005.





As
      of
      December 31, 2006, there was $717,000 of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under all
      of
      the Company’s stock benefit plans. That cost is expected to be recognized over a
      weighted average period of 1.04 years.





The
      adoption of SFAS No. 123(R) and its fair value compensation cost
      recognition provisions are different from the nonrecognition provisions under
      SFAS 123 and the intrinsic value method for compensation cost allowed under
      APB
      25. The effect (increase / (decrease)) of the adoption of SFAS No. 123(R)
      for the year ended December 31, 2006 is as follows:




Income
                  before income tax expense
              
              $
              (471,000
              )Net
                  income
              
              $
              (311,000
              )Cash
                  flow from operating activities
              
              $
              (1,051,000
              )Cash
                  flow provided by financing activities
              
              $
              1,051,000Basic
                  earnings per share
              
              $
              (0.04
              )Diluted
                  earnings per share
              
              $
              (0.04
              )


The
      following table illustrates the effect on net income available to common
      shareholders if the Company had applied the fair value recognition provisions
      of
      SFAS No. 123(R) to the years ended December 31, 2005 and 2004:





*(**Dollars
                in thousands, except per share data)*
            
            **2005**
            
            **2004**Net
                income, as reported
            
            $
            792
            
            $
            8,340Less:
                Stock based compensation as calculated per fair value method, net
                of tax
                effect
            
            
            (516
            )
            
            (346
            )Proforma
                net income
            
            $
            276
            
            $
            7,994Earnings
                per share:Basic
                - as reported
            
            $
            0.11
            
            $
            1.22Basic
                - proforma
            
            $
            0.04
            
            $
            1.17Diluted
                - as reported
            
            $
            0.11
            
            $
            1.17Diluted
                - proforma
            
            $
            0.04
            
            $
            1.13




**Note
      14 - Other comprehensive income**





The
      Company follows the provisions of SFAS No. 130, *Reporting
      Comprehensive Income* .
      SFAS
      No. 130 establishes requirements for the disclosure of comprehensive income
      in
      the Company’s consolidated financial statements. Comprehensive income is defined
      as net income plus transactions and other occurrences, which are the result
      of
      non-owner changes in equity.










66
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Other
      comprehensive income is defined as comprehensive income exclusive of net income.
      Unrealized gains (losses) on available for sale investment securities, represent
      the two components of the Company’s other comprehensive income. Other
      comprehensive loss at December 31 consists of the following:




2006
                  
                  2005
                  
                  2004*(In
                      thousands)*Unrealized
                      holding gains (losses) on securities AFS
                  
                  $
                  917
                  
                  $
                  (2,874
                  )
                  $
                  (423
                  )Tax
                      effect
                  
                  
                  (357
                  )
                  
                  1,102
                  
                  
                  165Unrealized
                      holding gains (losses) on AFS, net of tax
                  
                  
                  560
                  
                  
                  (1,772
                  )
                  
                  (258
                  )Reclassification
                      adjustment for realized gains
                  
                  
                  (32
                  )
                  
                  -
                  
                  
                  (109
                  )Tax
                      effect
                  
                  
                  12
                  
                  
                  -
                  
                  
                  43Reclassification
                      adjustment for realized gains, net of tax
                  
                  
                  (20
                  )
                  
                  -
                  
                  
                  (66
                  )Other
                      comprehensive (loss), net of tax
                  
                  $
                  540
                  
                  $
                  (1,772
                  )
                  $
                  (324
                  )





**Note
      15 - Net income per share**




The
      following is a reconciliation of the numerator and denominator of basic common
      stock and diluted net income per share of common stock as required by SFAS
      No.
      128:




For
                  the year ended December 31,2006
              
              2005
              
              2004Basic:Net
                  income available to common shareholders
              
              $
              9,113,000
              
              $
              792,000
              
              $
              8,340,000Weighted
                  average shares outstanding
              
              
              7,058,582
              
              
              6,997,540
              
              
              6,872,035Net
                  income per share, basic
              
              $
              1.29
              
              $
              0.11
              
              $
              1.22





Diluted:Net
                income available to common shareholders
            
            $
            9,113,000
            
            $
            792,000
            
            $
            8,340,000Weighted
                average shares outstanding
            
            
            7,058,582
            
            
            6,997,540
            
            
            6,872,035Effect
                of dilutive securities:Stock
                options
            
            
            169,479
            
            
            211,613
            
            
            274,381Weighted
                average shares outstanding and dilutive potential shares
                outstanding
            
            
            7,228,061
            
            
            7,209,153
            
            
            7,146,416Net
                income per share, diluted
            
            $
            1.26
            
            $
            0.11
            
            $
            1.17





For
      the
      years ended December 31, 2006, 2005, and 2004, there were 615,114 options,
      373,125 options, and 173,178 options, respectively, that were antidilutive
      since
      the exercise price exceeded the average market price for the year.





**Note
      16 - FNB Financial Services Corporation (Parent Company)**





67
 *Table
          of Contents*




The
      parent company’s principal asset is its investment in its subsidiary, FNB
      Southeast. The principal source of income of the parent company is dividends
      received from its subsidiary.




2006
            
            2005
            
            2004*(In
                thousands)***Condensed
                balance sheets**AssetsCash
                and due from banks
            
            $
            871
            
            $
            1,282Investment
                in wholly-owned subsidiary
            
            
            95,151
            
            
            90,886Other
                assets
            
            
            2,445
            
            
            839Total
                assets
            
            $
            98,467
            
            $
            93,007Liabilities
            
            $
            25,774
            
            $
            25,774Shareholders’
                equity
            
            
            72,693
            
            
            67,233Shareholders’
                equity and other liabilities
            
            $
            98,467
            
            $
            93,007**Condensed
                statements of income**Dividends
                from subsidiary
            
            $
            5,190
            
            $
            2,763Management
                fees
            
            
            300
            
            
            300Noninterest
                income
            
            
            52
            
            
            26Noninterest
                expense
            
            
            (1,914
            )
            
            (901
            )Income
                before tax benefit
            
            
            3,628
            
            
            2,188Income
                tax benefit
            
            
            512
            
            
            241Income
                before equity in undistributed net income of subsidiary
            
            
            4,140
            
            
            2,429Equity
                in undistributed net income (loss) of subsidiary
            
            
            4,973
            
            
            (1,637
            )Net
                income
            
            $
            9,113
            
            $
            792





**Condensed
                statements of cash flows**Cash
                flows from operating activitiesDividends
                received from subsidiary
            
            
            5,190
            
            $
            2,763
            
            $
            4,255Management
                fees received
            
            
            300
            
            
            300
            
            
            300Cash
                paid for franchise tax, registration cost, acquisition costand
                other
            
            
            (1,350
            )
            
            (653
            )
            
            (362
            )Change
                in other assets and liabilities, net
            
            
            (1,605
            )
            
            (474
            )
            
            831Net
                cash provided by operating activities
            
            
            2,535
            
            
            1,936
            
            
            5,024Cash
                flows from investing activitiesInvestment
                in subsidiary
            
            
            -
            
            
            (25,000
            )
            
            -Other,
                net
            
            
            -
            
            
            (303
            )
            
            -Net
                cash used in investing activities
            
            
            -
            
            
            (25,303
            )
            
            -Cash
                flows from financing activitiesRepurchase
                of common stock
            
            
            (1,850
            )
            
            (855
            )
            
            (3,450
            )Dividends
                paid, net of DRIP
            
            
            (3,455
            )
            
            (3,167
            )
            
            (2,752
            )Proceeds
                from issuance of junior subordinated notes
            
            
            -
            
            
            25,774
            
            
            -Excess
                tax benefit from share-based arrangements
            
            
            1,051
            
            
            -
            
            
            -Exercise
                of stock options
            
            
            1,308
            
            
            1,354
            
            
            2,589Net
                cash provided by (used in) financing activities
            
            
            (2,946
            )
            
            23,106
            
            
            (3,613
            )Increase
                (decrease) in cash
            
            
            (411
            )
            
            (261
            )
            
            1,411Cash
                at beginning of year
            
            
            1,282
            
            
            1,543
            
            
            132Cash
                at end of year
            
            $
            871
            
            $
            1,282
            
            $
            1,543**Reconciliation
                of net income to cash provided by operating
                activities**Net
                income
            
            $
            9,113
            
            $
            792
            
            $
            8,340Adjustments
                to reconcile net income to net cash providedby
                operating activities:Change
                in other assets and liabilities, net
            
            
            (1,605
            )
            
            (474
            )
            
            831Equity
                in undistributed (net income) loss of subsidiary
            
            
            (4,973
            )
            
            1,626
            
            
            (4,147
            )Net
                cash provided by operating activities
            
            $
            2,535
            
            $
            1,944
            
            $
            5,024





68
 *Table
            of Contents*





**Note
        17 - Off-balance sheet arrangements**
 
 The
        Company’s consolidated financial statements do not reflect various commitments
        and contingent liabilities which arise in the normal course of business and
        which involve elements of credit risk, interest rate risk and liquidity risk.
        These commitments and contingent liabilities are commitments to extend credit
        and standby letters of credit. A summary of the contract amount of the Bank’s
        exposure to off-balance sheet risk at December 31 is as
        follows:





Contract
                or
              Notional
                Amount2006
            
            2005*(In
                thousands)*Commitments
                to extend credit
            
            $
            169,804
            
            $
            200,346Commercial
                letters of credit
            
            
            2,909
            
            
            943Total
                commitments and contingent liabilities
            
            $
            172,713
            
            $
            201,289




The
      Bank’s exposure to credit loss in the event of nonperformance by the other party
      to the financial instrument for commitments to extend is represented by the
      contractual notional amount of those instruments. The Bank uses the same credit
      policies in making commitments and conditional obligations as it does for
      on-balance-sheet instruments.





**Note
      18 - Employee benefit plans**





The
      Company’s non-contributory defined benefit pension plan covers substantially all
      of its employees. The plan calls for benefits to be paid to eligible employees
      at retirement based primarily upon years of service with the Company and a
      percentage of qualifying compensation during final years of employment.
      Contributions to the plan are based upon the projected unit credited actuarial
      funding method and comply with the funding requirements of the Employee
      Retirement Income Security Act. Contributions are intended to provide not only
      for benefits attributed to service to date but also for those expected to be
      earned in the future. Plan assets consist primarily of cash and cash
      equivalents, U.S. government securities, and common stocks. The following table
      outlines the changes in the Company’s pension obligations, assets and funded
      status for the years ended December 31, 2006 and 2005, and the assumptions
      and
      components of net periodic pension cost for the two or three years in the period
      ended December 31, 2006.





2006
            
            2005*(Dollars
                in thousands)***Change
                in benefit obligation**Projected
                benefit obligation at beginning of year
            
            $
            8,599
            
            $
            6,879Service
                cost
            
            
            765
            
            
            695Interest
                cost
            
            
            490
            
            
            435Actuarial
                loss
            
            
            (425
            )
            
            818Benefits
                paid
            
            
            (416
            )
            
            (228
            )Projected
                benefit obligation at end of year
            
            
            9,013
            
            
            8,599**Change
                in plan assets**Fair
                value of plan assets at beginning of year
            
            
            5,943
            
            
            5,847Actual
                return on plan assets
            
            
            568
            
            
            323Employer
                contribution
            
            
            1,212
            
            
            -Benefits
                paid
            
            
            (417
            )
            
            (228
            )Fair
                value of plan assets at end of year
            
            
            7,306
            
            
            5,943**Funded
                status**Plan
                assets less than projected benefit obligation
            
            
            (1,707
            )
            
            (2,656
            )Unrecognized
                net actuarial loss
            
            
            -
            
            
            2,834Unrecognized
                prior service charge
            
            
            -
            
            
            113Pension
                asset (liability)
            
            $
            (1,707
            )
            $
            291







69
 *Table
          of Contents*


2006
            
            2005**Amounts
                recognized in the statement of financial position consists
                of:**
            
            *(Dollars
                in thousands)*Pension
                asset
            
            $
            -
            
            $
            291Accrued
                benefit liability
            
            
            1,707
            
            
            -Deferred
                tax asset
            
            
            1,162
            
            
            -Accumulated
                comprehensive income
            
            
            (1,718
            )
            
            -Net
                amount recognized
            
            $
            1,151
            
            $
            291





The
        Company adopted SFAS 158 on its effective date of December 31, 2006. The
        following table summarizes the effect on retirement benefit-related amounts
        reported in the consolidated balance sheet.
 
 Effect
                  of Adopting SFAS 158
                December
                  31, 2006
                *(Dollars
                  in thousands)*Before
                  Adoption
              
              Adjustments
              
              After
                  AdoptionOther
                  assetsPrepaid
                  pension cost
              
              $
              638
              
              $
              (638
              )
              $
              -Deferred
                  tax asset
              
              
              -
              
              
              1,162
              
              
              1,162Other
                  liabilitiesBenefit
                  liability
              
              
              -
              
              
              1,707
              
              
              1,707Shareholders’
                  equityAccumulated
                  other comprehensive income
              
              
              -
              
              
              (1,718
              )
              
              (1,718
              )


2006
            
            2005
            
            2004**Components
                of net periodic pension cost**
            
            *(Dollars
                in thousands)*Service
            
            $
            766
            
            $
            695
            
            $
            508Interest
            
            
            490
            
            
            435
            
            
            361Expected
                return on plan assets
            
            
            (546
            )
            
            (524
            )
            
            (430
            )Amortization
                of prior service cost
            
            
            155
            
            
            131
            
            
            54Net
                periodic pension cost
            
            $
            865
            
            $
            737
            
            $
            493**Weighted-average
                assumptions**Discount
                rate
            
            
            6.00
            %
            
            5.75
            %
            
            6.00
            %Expected
                return on plan assets
            
            
            9.00
            %
            
            9.00
            %
            
            9.00
            %Rate
                of compensation increase
            
            
            5.00
            %
            
            5.00
            %
            
            5.00
            %








**Weighted-average
                asset allocations at December 31, 2006**
            
            Market
              Value
            
            PercentDebt
                securities:Federated
                US Government
            
            $
            575
            
            
            7.9
            %Black
                Rock Government Fund
            
            
            581
            
            
            7.9Pimco
                Bond Investment
            
            
            722
            
            
            9.9First
                Trust Institutional Money Market
            
            
            71
            
            
            1.01,949
            
            
            26.7Equity
                securities:Oppenheimer
                Value Fund
            
            
            909
            
            
            12.4American
                Growth Fund
            
            
            1,103
            
            
            15.1Calvert
                Bond Fund
            
            
            649
            
            
            8.9American
                Euro Pacific Growth
            
            
            376
            
            
            5.1Fundamental
                Investors Inc.
            
            
            860
            
            
            11.8Columbia
                Acorn Fund
            
            
            219
            
            
            3.0First
                American SmallCap
            
            
            148
            
            
            2.0First
                American MidCap
            
            
            357
            
            
            4.9Fidelity
                Advisor MidCap
            
            
            370
            
            
            5.1Capital
                World Growth and Income
            
            
            366
            
            
            5.05,357
            
            
            73.3Net
            
            $
            7,306
            
            
            100.0
            %





Target
      allocations are established based on periodic evaluation of risk/reward under
      various economic scenarios and with varying asset class allocations. The
      near-term and long-term impact on obligations and asset values are projected
      and
      evaluated for funding and financial accounting implications. Actual allocation
      and investment performance is reviewed quarterly. The current target allocation
      ranges, along with the actual allocation as of December 31, 2006 is included
      in
      the accompanying table.






70
 *Table
          of Contents*




**Plan
                Assets**
            
            Long-Term
              Allocation
              Target
            
            Actual
              Allocation
                as
              of
                December
              31,
                2006Equity
                securities
            
            
            49%
                - 75
            %
            
            73.3
            %Debt
                securities
            
            
            18%
                - 28
            %
            
            26.7
            %Real
                estate
            
            
            0%
                - 10
            %
            
            -Other
                (primarily cash)
            
            
            2%
                - 3
            %
            
            -Total
            
            
            100
            %
            
            100
            %





The
      assumed expected return on assets considers the current level of expected
      returns on risk-free investments (primarily government bonds), the historical
      level of risk premium associated with the other asset classes in the portfolio
      and the expectation for future returns of each asset class. The expected return
      of each asset class is weighted based on the target allocation to develop the
      expected long-term rate of return on assets. This resulted in the selection
      of
      the 9.00% rate used in 2006 and to be used for 2007. The minimum required
      contribution for 2006 is $462,183 and no contribution is expected for 2007.
      The
      expected benefit payments for the next five years are as follows: (1) 2007
      -
      $188,175, (2) 2008 - $242,178, (3) 2009 - $242,746, (4) 2010 - $251,603, and
      (5)
      2011 - $303,945.





The
      Company has a Supplemental Executive Retirement Plan (“SERP”) that allows the
      Company to supplement the level of certain executives’ retirement income over
      the amount obtainable through the tax-qualified retirement plan. The net expense
      related to the SERP for
      the
      years ended December 31, 2006, 2005, and 2004 was $290,000, $474,000, and
      $431,000, respectively. The corresponding liability related to this plan was
      $2,426,000 and $2,345,000 as of December 31, 2006 and 2005,
      respectively.





The
      Bank
      also has a separate contributory 401(k) savings plan covering substantially
      all
      employees. The plan allows eligible employees to contribute up to a fixed
      percentage of their compensation, with the Bank matching a portion of each
      employee’s contribution. The Bank’s contributions were $220,000 for 2006,
      $216,000 for 2005, and $162,000 for 2004.





A
      deferred compensation plan allows the directors and certain senior officers
      of
      the Company and the Bank to defer the compensation they earn for performance
      of
      their appointed duties for the Company and the Bank. Each plan participant
      makes
      an annual election to either receive that year’s compensation currently or to
      defer receipt until his or her death, disability or retirement. Effective
      November 1, 1999, the deferred compensation balances were transferred to a
      Rabbi
      trust. The balances in the trust at December 31, 2006 and 2005 were $2,692,000
      and $2,130,000, respectively.




**Note
      19 - Regulatory matters**





The
      primary source of funds for the dividends paid by the Company to its
      shareholders is dividends received from the Bank. The Bank is restricted as
      to
      dividend payout by state laws applicable to banks and may pay dividends only
      out
      of undivided profits. Additionally, dividends paid by the Company may be limited
      due to maintaining minimum capital requirements imposed by banking regulators.
      Management does not expect any of these restrictions to materially limit its
      ability to pay dividends comparable to those paid in the past. At December
      31,
      2006, the Bank had undivided profits of approximately $40.1
      million.





The
      Bank
      is subject to various regulatory capital requirements administered by federal
      banking agencies. Failure to meet minimum capital requirements can initiate
      certain mandatory - and possible additional discretionary - actions by
      regulators that, if undertaken, could have a direct material effect on the
      Bank’s financial statements. Under capital adequacy guidelines and the
      regulatory framework for prompt corrective action, the Bank must meet specific
      capital guidelines that involve quantitative measures of assets, liabilities,
      and certain off-balance-sheet items as calculated under regulatory accounting
      practices. The Bank’s capital amounts and classification are also subject to
      qualitative judgments by the regulators about components, risk weighting, and
      other factors.





71
 *Table
            of Contents*





Quantitative
      measures established by regulation to ensure capital adequacy require the Bank
      to maintain minimum amounts and ratios (set forth in the table below) of total
      and Tier 1 capital (as defined in the regulations) to risk-weighted assets
      (as
      defined), and of Tier 1 capital to average assets (as defined). Management
      believes, as of December 31, 2006, that the Bank meets all capital adequacy
      requirements to which they are subject.





The
      most
      recent notification from the Commissioner categorized the Bank as well
      capitalized under the regulatory framework for prompt corrective action. There
      are no conditions or events since that notification that management believes
      have changed the Bank’s category. To be categorized as well capitalized the Bank
      must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage
      ratios as set forth in the accompanying table.





Actual
            
            For
                Capital
              Adequacy
              Purposes
            
            To
                Be Well
              Capitalized
                Under
              Prompt
                Corrective
              Action
                ProvisionsAmount
            
            Ratio
            
            Amount
            
            Ratio
            
            Amount
            
            Ratio*(Dollars
                in thousands)***December
                31, 2006**Total
                Capital (To Risk Weighted Assets)Consolidated
            
            $
            110,324
            
            
            13.7
            %
            $
            64,272
            
            
            ≥8.0
            %
            $
            N/ABank
            
            
            106,999
            
            
            13.3
            
            
            64,208
            
            
            ≥8.0
            
            
            80,260
            
            
            ≥10.0
            %Tier
                1 Capital (To Risk Weighted Assets)Consolidated
            
            
            100,243
            
            
            12.5
            
            
            32,136
            
            
            ≥4.0
            
            
            N/ABank
            
            
            96,927
            
            
            12.1
            
            
            32,104
            
            
            ≥4.0
            
            
            48,156
            
            
            ≥6.0
            %Tier
                1 Capital (To Average Assets)Consolidated
            
            
            100,243
            
            
            9.8
            
            
            40,726
            
            
            ≥4.0
            
            
            N/ABank
            
            
            96,927
            
            
            9.5
            
            
            40,657
            
            
            ≥4.0
            
            
            50,821
            
            
            ≥5.0
            %**December
                31, 2005**Total
                Capital (To Risk Weighted Assets)Consolidated
            
            $
            103,514
            
            
            13.2
            %
            $
            62,704
            
            
            ≥8.0
            %
            $
            N/ABank
            
            
            101,373
            
            
            13.0
            
            
            62,573
            
            
            ≥8.0
            
            
            78,216
            
            
            ≥10.0
            %Tier
                1 Capital (To Risk Weighted Assets)Consolidated
            
            
            91,751
            
            
            11.7
            
            
            31,352
            
            
            ≥4.0
            
            
            N/ABank
            
            
            91,480
            
            
            11.7
            
            
            31,286
            
            
            ≥4.0
            
            
            46,929
            
            
            ≥6.0
            %Tier
                1 Capital (To Average Assets)Consolidated
            
            
            91,751
            
            
            9.1
            
            
            40,542
            
            
            ≥4.0
            
            
            N/ABank
            
            
            91,480
            
            
            9.0
            
            
            40,510
            
            
            ≥4.0
            
            
            50,638
            
            
            ≥5.0
            %





**Note
      20 - Fair value of financial instruments**





The
      following methods and assumptions were used to estimate the fair value for
      each
      class of the Company’s financial instruments.





*Cash
      and cash equivalents.* The
      carrying amounts for cash and due from banks approximate fair value because
      of
      the short maturities of those instruments.





*Investment
      securities.* The fair
      value of investment securities is based on quoted market prices, if available.
      If a quoted market price is not available, fair value is estimated using quoted
      market prices for similar securities. The fair value of equity investments
      in
      the restricted stock of the Federal Reserve Bank and Federal Home Loan Bank
      equals the carrying value.





*Loans.*  The
      fair
      value of fixed rate loans is estimated by discounting the future cash flows
      using the current rates at which similar loans would be made to borrowers with
      similar credit ratings and for the same remaining maturities. Substantially
      all
      residential mortgage loans held for sale are pre-sold and





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their
      carrying value approximates fair value. The fair value of variable rate loans
      with frequent repricing and negligible credit risk approximates book
      value.




*Investment
      in bank-owned life insurance.*The carrying value of bank-owned life
      insurance approximates fair value because this investment is carried at cash
      surrender value, as determined by the insurer.




*Deposits.* The fair
      value of noninterest-bearing demand deposits and NOW, savings, and money market
      deposits are the amounts payable on demand at the reporting date. The fair
      value
      of time deposits is estimated using the rates currently offered for deposits
      of
      similar remaining maturities.





*Federal
      Funds Purchased and Retail and Wholesale Repurchase Agreements.* The
      carrying value of federal funds purchased and retail and wholesale repurchase
      agreements is considered to be a reasonable estimate of fair value.





*Other
      borrowings.* The
      fair
      values of these liabilities are estimated using the discounted values of the
      contractual cash flows. The discount rate is estimated using the rates currently
      in effect for similar borrowings.





*Accrued
      interest* .
      The
      carrying amounts of accrued interest approximate fair value.





*Financial
      instruments with off-balance sheet risk* .
      The
      fair value of financial instruments with off-balance sheet risk is considered
      to
      approximate carrying value, since the large majority of these future financing
      commitments would result in loans that have variable rates and/or relatively
      short terms to maturity. For other commitments, generally of a short-term
      nature, the carrying value is considered to be a reasonable estimate of fair
      value. The various financial instruments were disclosed in Note 17.





The
      estimated fair values of financial instruments at December 31 are as
      follows:





2006
            
            2005Carrying
              Value
            
            Estimated
              Fair
                Value
            
            Carrying
              Value
            
            Estimated
              Fair
                Value*(In
                thousands)***Financial
                assets:**Cash
                and cash equivalents
            
            $
            25,665
            
            $
            25,665
            
            $
            27,148
            
            $
            27,148Investment
                securitiesAvailable
                for sale
            
            
            211,011
            
            
            211,011
            
            
            195,926
            
            
            195,926Other
                equity securities
            
            
            6,116
            
            
            6,116
            
            
            5,964
            
            
            5,964Loans
                held for sale
            
            
            2,745
            
            
            2,745
            
            
            3,667
            
            
            3,667Loans
            
            
            693,951
            
            
            690,782
            
            
            738,825
            
            
            739,169Investment
                in life insurance
            
            
            24,899
            
            
            24,899
            
            
            2,477
            
            
            2,477Accrued
                interest receivable
            
            
            7,309
            
            
            7,309
            
            
            6,521
            
            
            6,521**Financial
                liabilities:**Deposits
            
            
            818,568
            
            
            812,104
            
            
            824,631
            
            
            820,055Federal
                funds purchased and retail andwholesale
                repurchase agreements
            
            
            26,384
            
            
            26,334
            
            
            7,305
            
            
            7,305Other
                borrowings
            
            
            80,774
            
            
            91,004
            
            
            100,774
            
            
            101,486Accrued
                interest payable
            
            
            1,585
            
            
            1,585
            
            
            1,069
            
            
            1,069





The
      fair
      value estimates are made at a specific point in time based on relevant market
      and other information about the financial instruments. Because no market exists
      for a significant portion of the Company’s financial instruments, fair value
      estimates are based on current economic conditions, risk characteristics of
      various financial instruments, and such other factors. These estimates are
      subjective in nature and involve uncertainties and matters of significant
      judgment and therefore cannot be determined with precision. Changes in
      assumptions could significantly affect the estimates. In addition, the tax
      ramifications related to the realization of the unrealized gains and losses
      can
      have a significant effect on fair value estimates and have not been considered
      in the estimates.


**Note
        21 - Memorandum of Understanding - Lifted as of 12/31/2006**
 
 On
        February 23, 2006, the Company and the Bank entered into a Memorandum of
        Understanding (the “MOU”) with the Reserve Bank and the Commission. The MOU
        generally required:
 
 §
            The
                creation of a Compliance Committee by the Boards of Directors of
                the
                Company and the Bank to oversee compliance by the Company and the
                Bank
                with the MOU. §
            The
                engagement of an independent consultant to advise the Boards on the
                characteristics, composition, and structure of the Boards and the
                structure and composition of management. §
            The
                adoption of a written plan to strengthen the Bank’s loan administration
                capacity through supplementing and improving its lending and credit
                administration staffing, management information systems, reporting
                procedures, lending policies, and internal loan review function. §
            The
                adoption of a written plan to address its risk position with respect
                to
                certain loans identified by its internal reviews and by its independent
                consultants and also by the Reserve Bank. §
            An
                increased focus upon compliance with federal regulations concerning
                real
                estate appraisal procedures and federal guidelines concerning loans
                in
                excess of certain loan-to-value standards. §
            Increased
                resources and staffing for the Bank’s internal audit function. 
 The
        Company and the Bank took prompt and aggressive actions to address the issues
        discovered in the Bank’s internal reviews and through independent consultants,
        as well as those additional concerns raised by the Reserve Bank.
 
 Following
        the most recent joint safety and soundness examination conducted by the Reserve
        Bank and the Commission which was completed in late 2006, the Company and
        the
        Bank were found to be substantially in compliance with the MOU. Effective
        December 31, 2006, the MOU was lifted.




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**Item
                    9.**
                **Changes
                    in and Disagreements with Accountants on Accounting and Financial
                    Disclosure**
 None.
  **Item
                    9A.**
                **CONTROLS
                    AND PROCEDURES**





**Evaluation
      of Disclosure Controls and Procedures**





The
      Company’s management, including its CEO, Chief Financial Officer (“CFO”), and
      Chief Accounting Officer (“CAO”), evaluated the effectiveness of the Company’s
      disclosure controls and procedures (as defined in Rule 13a-15(e) under the
      Securities Exchange Act of 1934) as of December 31, 2006. Based upon that
      evaluation, the Company’s CEO, CFO, and CAO each concluded that as of December
      31, 2006, the end of the period covered by this Annual Report on Form 10-K,
      the
      Company effectively maintained disclosure controls and procedures.





**Management’s
      Report on Internal Control over Financial Reporting**




Management
      is responsible for establishing and maintaining adequate internal control over
      financial reporting for the Company. The Company’s internal control over
      financial reporting is a process designed under the supervision of the Company’s
      CEO, CFO, and CAO to provide reasonable assurance regarding the reliability
      of
      financial reporting and the preparation of the Company’s financial statements
      for external reporting purposes in accordance with U.S. generally accepted
      accounting principles. Management has made a comprehensive review, evaluation
      and assessment of the Company’s internal control over financial reporting as of
      December 31, 2006. In making its assessment of internal control over financial
      reporting, management used the criteria issued by the Committee of Sponsoring
      Organizations of the Treadway Commission (“COSO”) in *Internal
      Control* — *Integrated
      Framework.* In
      accordance with Section 404 of the Sarbanes-Oxley Act of 2002, management makes
      the following assertions:




•
            
            Management
                has implemented a process to monitor and assess both the design and
                operating effectiveness of internal control over financial reporting.




•
            
            Because
                of its inherent limitations, internal control over financial reporting
                may
                not prevent or detect misstatements. Also, projections of any evaluation
                of effectiveness to future periods are subject to the risk that controls
                may become inadequate because of changes in conditions, or that the
                degree
                of compliance with the policies or procedures may deteriorate.




Management’s
      assessment of the effectiveness of the Company’s Internal Control over Financial
      Reporting as of December 31, 2006 has been audited by Dixon Hughes PLLC, an
      independent registered public accounting firm, as stated in its report (which
      expressed an unqualified opinion on management’s assessment and on the
      effectiveness of the Company’s internal control over financial reporting as of
      December 31, 2006) which appears herein.





**Changes
      in Internal Control over Financial Reporting**





Management
      of the Company has evaluated, with the participation of the Company’s CEO,
      CFO,
      and CAO, changes in the Company’s internal controls over financial reporting (as
      defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act) during the fourth
      quarter of 2006. In connection with such evaluation, the Company has determined
      that there have been no changes in internal control over financial reporting
      during the fourth quarter that have materially affected or are reasonably likely
      to materially affect, the Company’s internal control over financial reporting.


**Item
                  9B.**
              **OTHER
                  INFORMATION**





None.





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**PART
      III**


**Item
                  10.**
              DIRECTORS,
                    EXECUTIVE OFFICERS AND CORPORATE
                    GOVERNANCE


(a) **Directors
        and Executive Officers** - The following table provides information about
        the Company’s directors and anyone nominated or chosen to become a
        director.
  **Name
                          and Age****1**
                      
                      **Principal
                          Occupation, Business**
                        **Experience
                          and Other Directorships**
                      
                      **Director**
                        **Since**
                      
                      **Term
                          Ends**Gary
                          G. Blosser, 58
                      
                      President
                          and Owner, Shenandoah Nurseries, Inc., Shenandoah Landscape
                          Services, Inc.
                          and Glen-Gary, Inc. Previously, President and owner, STM
                          Landscape
                          Services, Inc. (landscaping contractor).
                      
                      1999
                      
                      2008C.
                          Arnold Britt, 57
                      
                      President
                          and owner, Carolina Apothecary, Inc. and Belmont Pharmacy,
                          Inc.
                      
                      1985
                      
                      2009Alex
                          A. Diffey, Jr., 57
                      
                      Banking
                          Consultant. Interim Chief Credit Officer of the Bank between
                          October, 2005
                          and January 2007. Previously, he was a consultant with
                          Thurmand Clower
                          & Associates, specializing in loan portfolio reviews, and
                          prior to
                          that, he was an employee of First Union National Bank (now
                          known as
                          Wachovia Corporation) for 32 years in various commercial
                          lending, loan
                          administration and capital markets positions, including
                          Chief Credit
                          Officer and Senior Vice President of First Union National
                          Bank of South
                          Carolina, Senior Vice President and a Senior Credit Officer
                          of Wachovia
                          Securities.
                      
                      2006
                      
                      2009Barry
                          Z. Dodson, 58
                      
                      Certified
                          public accountant and owner of Barry Z. Dodson, CPA; Chairman
                          of the Board
                          of Directors of the Company.
                      
                      1997
                      
                      2009Joseph
                          H. Kinnarney, 53
                      
                      Doctor
                          of Veterinary Medicine; President and owner, Reidsville
                          Veterinary
                          Hospital, Inc., Bel-Air Veterinary Hospital, Mebane Veterinary
                          Hospital
                          and Greensboro Pet Spa & Resort, Inc.
                      
                      1988
                      
                      2008Robbie
                          Perkins, 51
                      
                      President
                          and co-owner, NAI Piedmont Triad (real estate firm); former
                          Member,
                          Greensboro City Council; Co-owner, Guilford Group and Roswell
                          Associates
                          (real estate development and management partnerships).
                      
                      2005
                      
                      2007Pressley
                          A. Ridgill, 54
                      
                      President
                          and Chief Executive Officer of the Bank and the Company.
                      
                      2005
                      
                      2007E.
                          Reid Teague, 57
                      
                      President
                          and owner, Eden Oil Co., Inc.
                      
                      2002
                      
                      2007


75
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            of Contents*





**Name
                    and Age****1**
                
                **Principal
                    Occupation, Business**
                  **Experience
                    and Other Directorships**
                
                **Director**
                  **Since**
                
                **Term**
                  **Ends**Elizabeth
                    S. Ward, 45
                
                Chief
                    Financial Officer and Treasurer, The Moses Cone Health
                    System
                
                -
                
                -Kenan
                    C. Wright, 53
                
                President,
                    The Wright Co. of N.C., Inc. (general contractor)
                
                1990
                
                2008




___________________


**1**  Ages
        are
        given as of December 31, 2006.
 
 The
        Bank
        currently has a ten member board of directors which, with the exception of
        Elizabeth S. Ward, who is nominated for election to the Board of the Company
        at
        the upcoming shareholders’ meeting, is comprised of the same persons who are
        directors of the Company. Those persons elected to the Board of the Company
        at
        the annual meeting will be also be elected by the Company as directors of
        the
        Bank.
 
 The
        following table provides information about executive officers and
        all persons chosen to become executive officers of either the Company
        and/or the Bank.
  **Name**
              
              **Age********1**
              
              **Positions
                  Held During**
                **The
                  Past Five Years**
              
              **Employed
                  by the**
                **Company
                  and/or**
                **the
                  Bank Since**Pressley
                  A. Ridgill
              
              54
              
              President,
                  Chief Executive Officer and Director of theCompanyand the Bank. Previously Executive Vice President and Chief Operating
                  Officer of the Company and President and Chief Operating Officer
                  of the
                  Bank.
              
              2000Michael
                  W. Shelton
              
              45
              
              Executive
                  Vice President, Chief Financial Officer and Secretary of the Company
                  and
                  Bank; Treasurer of the Company.
              
              1996K.
                  Dwight Willoughby
              
              52
              
              Senior
                  Vice President, Chief Accounting Officer and Controller of the
                  Company and
                  the Bank. Prior to 2003, Insurance Analyst - Republic Mortgage
                  Insurance
                  Company, responsible for managing relationships with captive reinsurance
                  customers.
              
              2003





76
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William
                  W. Budd, Jr.
              
              44
              
              Executive
                  Vice President and Chief Credit Officer of the Bank. Prior to 2007,
                  Executive Vice President and various other Senior management positions
                  -
                  Sun Trust Bank (formerly Central Carolina Bank)
              
              2007G.
                  Richard Webster
              
              51
              
              Senior
                  Vice President and Chief Lending Officer of the Bank. 2005-2006,
                  Regional
                  President and various other management position within the Bank.
                  2004,
                  Vice President and Sr. Account Executive - GE Commercial Finance.
                  Prior to
                  2004, Business consultant to banking industry clients.
              
              2005
 ____________________
 
 **1**  Ages
        are
        given as of December 31, 2006.
 
 **Audit
        Committee of the Board of Directors**
 
 The
        Company has a separately designated standing audit committee, established
        in
        accordance with section 3(a)(58)(A) of the Exchange Act (the “Audit Committee”).
        During 2006 the Audit Committee was composed of four of our independent
        directors, Mr. Blosser, Chairman, Dr. Kinnarney, and Messrs. Dodson and Wright.
 
 The
        Board
        has determined that Barry Z. Dodson qualifies as an “audit committee financial
        expert” as defined under applicable SEC rules and regulations. This
        determination was based, among other things, upon Mr. Dodson’s extensive
        experience as a certified public accountant for over 33 years and his position
        as a CPA with his own accounting firm. The Board has also determined that
        the
        other members of the Committee meet the relevant financial literacy standards
        and are “independent,” as that term is defined in rule 4200 (a)(15) of the
        NASDAQ Marketplace Rules.
  (b)  **Section
        16(a) Compliance** -
        Directors, executive officers, and greater than 10% shareholders of the Company
        are required by Section 16(a) of the Exchange Act to file reports with the
        SEC
        regarding the amount of and changes in their beneficial ownership of Common
        Stock. Copies of these filings are required to be given to the Company. During
        2006, the Company did not have any greater than 10% shareholders.
 
 Based
        solely on a review of the copies of such forms we received and written
        representations from the Company’s executive officers and directors, we believe
        that during the fiscal year ended December 31, 2006, all of its executive
        officers and directors complied with all applicable Section 16(a) filing
        requirements, with the following exceptions: Mr. Dodson purchased 1,100 shares
        of the Company’s common stock on April 24, 2006.  We received notification
        and filed a report with the SEC on May 11, 2006.  Also, on May 11, Mr.
        Dodson purchased 600 shares through The Madison Investment Club.  We
        received notification and filed a report with the SEC on May 16, 2006.
        Mr. Perkins purchased 2,545 shares through his IRA on August 21, 2006.  We
        received notification and filed a report with the SEC on August 25, 2006.
        Finally, Mr. Wright purchased of 105 shares through his IRA on July 28,
        2006.  We received notification and filed a report with the SEC on August
        2, 2006.




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                Contents*




(c)  **Code
              of Ethics** - The
              Company has adopted its “Code of Business Conduct and Ethics”, a code of ethics
              that applies to its directors, officers, and employees. The Code of
              Business
              Conduct and Ethics is accessible on the Company’s website under the *“Investor
              Information”* section.
              The Company elects to disclose any amendments to or waivers of any
              provisions of
              its Code of Business Conduct and Ethics applicable to its principal
              executive
              officers and senior financial officers on its website.
  **Item
                    11.**
                **EXECUTIVE
                    COMPENSATION**


The
          following Compensation Disclosure and Analysis (“CD&A”) provides information
          about the Company’s executive compensation program, and specifically the
          compensation paid to the Company’s President and Chief Executive Officer,
          Pressley A. Ridgill, and its Executive Vice President and Chief Financial
          Officer, Michael W. Shelton, (together, the “named executive officers”) and its
          directors. Later in this Annual Report on Form 10-K, you will find a series
          of
          tables containing specific information about the compensation awarded to,
          earned
          by or paid to the Company’s directors and named executive officers in
          2006.
 
 **Compensation
          Committee**
 The
          Company’s executive compensation program is administered by its
          Compensation Committee in accordance with its charter, a copy of which
          is
          available on the “Investor Information” section of our website at http:// www.fnbsoutheast.com . The
          charter provides that members be appointed to the Committee by the Chairman
          on
          an annual basis, upon the recommendation of the Nominating and Governance
          Committee, and subject to the ratification of the Board. The
          charter further requires that the Committee consist of three or more members,
          each of whom must satisfy various independence standards. The Board has
          determined that, except for Mr. Perkins, each member of the Compensation
          Committee is “independent”, as that term is defined in Rule 4200(a)(15) of the
          NASDAQ Marketplace Rules, qualifies as a “non-employee director” for purposes of
          Rule 16b-3 under the Exchange Act and is an “outside director” for
          the purposes of Section 162(m) of the Code. **** The
          Board
          waived the “independence” requirement for Mr. Perkins, after satisfying itself
          that the committee otherwise comprised three “independent” directors, and
          that Mr. Perkins properly removed himself from any Committee consideration
          of
          transactions in which he had a conflict of interest. See Item 13 for full
          details of the transactions between the Company and Mr. Perkin’s real
          estate firm, NAI
          Piedmont Triad during 2006.
 
 To
          assist
          in evaluating the Bank and the Company’s executive officers, the Committee has
          authority to retain compensation consulting firms. During 2006 the Company
          did
          not use any compensation consultants. During 2006, the Compensation Committee
          met four times.
 
 **Compensation
          Committee Interlocks and Insider Participation**
 No
          member
          of the Compensation Committee is or has been an employee of the Company
          or any
          of its subsidiaries. None of our executive officers serve on the compensation
          committee or as a director of another entity of which an officer or director
          of
          the Company serves on the Compensation Committee. As disclosed in Item
          13, the
          Board of Directors determined that by virtue of transactions involving
          Mr.
          Perkins’ real estate firm, NAI
          Piedmont Triad, Mr.
          Perkins, was not “independent,” as that term is defined in Rule 4200(a)(15) of
          the NASDAQ Marketplace Rules. See Item 13 for full details the transactions
          between the Company and NAI
          Piedmont Triad during 2006.
  **Objectives**
 The
          overall objective of our compensation program is to create long-term value
          for
          our shareholders. Toward this goal, we have designed and implemented our
          compensation program for our named executive officers to reward them for
          sustained financial and operating performance and leadership excellence,
          to
          align their interests with those of our shareowners and to encourage them
          to
          remain with the Company.
  The
          annual and long-term compensation programs are intended to be competitive
          with
          median levels of incentive compensation paid by our competitors, and were
          developed based upon an analysis of surveys of compensation programs of
          financial institutions of similar size and characteristics in NC and the
          southeast United States, as reported in various sources, including the
          North
          Carolina Bankers Association Survey, the Bank Administration Institute
          Survey,
          Virginia Bankers Association Survey, America’s Community Bankers Survey and SNL
          Executive Compensation Review.
 
 During
          2006, for our named executive officers, these elements consisted of base
          salary, **** performance-based
          cash awards under the 2006 Annual Management Incentive Plan, **** matching
          contributions under the Bank’s 401(k) Retirement Plan (the “401(k) Plan”);
          retirement benefits under the Company’s Employees’ Pension Plan (the “Pension
          Plan”) and the Benefit Equivalency Plan (supplemental executive retirement);
          the
          Company’s Non-Qualified Deferred Compensation for Directors and Senior
          Management; **** the
          Company’s Change of Control Severance Plans; **** universal
          life insurance benefits; group life, health and other insurance benefits.
  **Compensation
          Program Decision Process**
 The
          Committee has responsibility for matters involving the compensation of
          the
          executive officers of the Company and the Bank. It is tasked with evaluating
          the
          Company’s financial performance and relative shareholder return in determining
          executive compensation, and providing oversight of management’s decisions
          concerning performance and compensation of other senior officers. In doing
          so,
          the Committee’s principal responsibility is to align the incentives of
          executives with actions that will enhance long-term shareholder
          value.
 
 At
          least
          annually, the Committee reviews and approves corporate goals and objectives
          relevant to Mr. Ridgill’s compensation, evaluates his performance in light of
          those goals and objectives, and provides recommendations to the Board for
          its
          consideration. In addition, the Committee also provides recommendations
          concerning compensation policies, incentive compensation, long term equity
          participation and benefit plans generally. The Committee delegates to Mr.
          Ridgill the responsibility to determine appropriate levels of salaries
          and
          incentive bonuses for our other officers, including the other named executive
          officer, within ranges approved by the Committee. Primary consideration
          is given
          to individual performance and to attainment of individual goals and objectives
          that are established at the beginning of each year. Additional consideration
          is
          given by both the Committee (with regard to Mr. Ridgill) and Mr. Ridgill
          (with
          regard to other officers) to the demonstration of the leadership skills
          needed
          to enable the Company to achieve the business objectives established by
          the
          Board.
  78
 **Elements
              of Compensation**
 The
              following is a discussion of each element of the compensation program
              for 2006
              with respect to our named executive officers, and a description of
              how each
              element of compensation is determined.
 
 **Base
              Salaries**At the beginning of 2006, Mr. Ridgill’s base salary was
              $250,000. His salary was reviewed during the first half of the year
              and was
              increased to $300,000, effective July 1, 2006, so as to achieve a base
              salary of
              $275,000 for 2006. Mr. Ridgill’s base salary for 2006 was set on an objective
              basis by the Board of Directors based on the recommendation of the
              Compensation
              Committee, using specific performance criteria within a range determined
              by the
              Committee to be competitive. The performance criteria included: (i)
              establishing
              a systematic reporting process monitoring actions taken toward achieving
              compliance with the MOU; (ii) implementing a new organizational structure
              with
              increased management strength and depth and; (iii) recruitment of an
              interim
              Chief Credit Offer and establishing revised policies and procedures
              that
              addressed concerns expressed by the bank examiners. The Committee concluded
              his
              prior achievements were significant in terms of the Company’s growth and
              profitability, and that Mr. Ridgill’s 2006 base salary level was reasonable and
              in accordance with the salary administration guidelines prepared from
              peer group
              data. Mr. Ridgill’s 2006 salary was 85.4%****of the median
              base salary paid to chief executive officers of banks of comparable
              size, and
              reflected a 10% increase over his 2005 base salary.
  Mr.
              Shelton’s 2006 base salary was $142,500. It was set, within ranges approved
              by
              the Compensation Committee, by Mr. Ridgill based on Mr. Ridgill’s
              evaluation
              of Mr. Shelton’s performance
              and level of responsibility, as well as his contribution to the Company’s
              financial performance for the prior fiscal year. The salary ranges
              were set by
              the Compensation Committee based on its evaluation of the level of
              demands and
              responsibility required by his position, his prior achievements, and
              the levels
              of compensation paid by financial institutions of comparable size for
              similar
              positions. Mr. Shelton’s 2006 base salary was 93.8 % of the median base salary
              paid to chief financial officers of banks of comparable size, and reflected
              a
              17.3% increase over his 2005 base salary.
 **Cash
          Incentive Bonuses** The
          cash
          incentive bonuses paid for 2006 to each of the executive officers were
          determined under the terms of the 2006 Annual Management Incentive Plan,
          based
          in part on the Company’s achievement of specified goals, such as a minimum net
          income, over a specified period (generally one calendar year) and each
          participant’s individual performance in achieving profit center, cost
          efficiency, loan production, and other similar operational goals and objectives.
          The 2006 Annual Management Incentive Plan used a “target bonus” approach to
          determine the size of each participant’s bonus. A participant’s base salary,
          salary grade and level of accountability and responsibility as of the first
          day
          of the fiscal year are used to determine his or her target bonus. During
          2006,
          individual target bonuses, as a percentage of annual base salary, ranged
          from a
          low of 5% to a high of 35%. The overall bonus fund is the sum of the target
          bonuses for all participants. Actual bonus amounts for participants in
          the 2006
          Annual Management Incentive Plan may be higher or lower than their target
          bonus
          amounts and are based upon a comparison of the Company’s actual performance to
          the designated performance measures and upon the participant’s achievement of
          his or her individual goals and objectives. The maximum bonus for any
          participant generally may not exceed 123% of his or her target bonus. Payment
          of
          bonuses under the 2006 Annual Management Incentive Plan are made within
          approximately 60 days of the end of the fiscal year. In the event the Company
          does not meet its financial performance objectives, upon the recommendation
          of
          our President and Chief Executive Officer, discretionary awards may still
          be
          made to officers and management employees if they meet planned individual
          goals
          during the specified period. For the year ended December 31, 2006, we did
          not
          meet the Company’s financial performance measures, but did meet a majority of
          the designated individual performance measures, resulting in an overall
          bonus
          fund of 73% of target bonuses. On the recommendation of the President and
          Chief
          Executive Officer, discretionary awards were made to those officers and
          management employees who met planned individual goals during 2006. Under
          the
          2006 Management Incentive Plan, the Company awarded cash incentive under
          totaling $559,591 to 65 officers.
 
 Of
          this
          amount, Mr. Shelton was awarded a cash incentive bonus of $26,375. Mr.
          Shelton
          met all his individual goals, which included the implementation of selected
          profitability strategies and participation in investor relations presentations,
          as determined by the Chief Executive Officer. Mr. Ridgill’s target incentive in
          2006 was calculated, weighted 60% on Bank-wide profit plan objectives and
          40% on
          individual goals. He received a bonus of $19,250 based on the achievement
          of the
          following individual goals: (i) Significant progress during 2006 toward
          removing
          the MOU; (ii) Documented progress toward realigning and adding depth to
          the
          Bank’s senior
          management structure. In addition, in recognition of Mr. Ridgill’s achievement
          in successfully addressing the issues raised in the MOU, the Board awarded
          Ridgill a separate performance bonus of $50,000.
 
 **Matching
          Contributions under 401(k) Plan** The
          401(k) Plan is a tax-qualified defined contribution plan designed to provide
          eligible employees of the Bank a vehicle for increasing their retirement
          savings. All Bank employees are eligible to participate in the 401(k) Plan
          after
          attaining the age of 21 and completing one qualifying year of service.
          The named
          executive officers participated in the 401(k) Plan during 2006, on the
          same
          basis as all other eligible employees of the Bank. The matching contributions
          for Mr. Ridgill and Mr. Shelton were based on a formula contained in the
          terms
          of the 401(k) Plan and were not related to the Company’s or the individual
          officer’s performance for the year. Each eligible employee of the Bank may elect
          to contribute on a pre-tax basis to the 401(k) Plan 1 % to 50% of his or
          her
          compensation, subject to certain limitations imposed by the Code. The Bank
          is
          obligated under the terms of the 401(k) Plan to match 50% of each eligible
          employee’s pre-tax contributions (excluding the employee’s pre-tax contributions
          in excess of 6% of compensation). In 2006, the Bank’s matching contributions
          totaled approximately $220,000, including $8,250 contributed for Mr. Ridgill,
          and $3,937 contributed for Mr. Shelton.
  **Employees'
            Pension Plan** All
            full-time employees of the Bank are eligible to participate in a defined
            benefit
            pension plan, designed to attract and reward employees for service to
            the Bank,
            in a tax efficient manner.  Annual benefits under this pension plan are
            calculated as follows: (a) For service prior to January 1, 2007, one
            and
            one-quarter of one percent (1.25%) of final average compensation, multiplied
            by
            the number of years of credit service; (b) For service after January
            1, 2007,
            one percent (1.0%) of final average compensation, multiplied by the number
            of
            years of credit service; and (c) Additionally, sixty-five hundredths
            of one
            percent (.65%) of final average compensation in excess of the applicable
            social
            security covered compensation in effect at the time of employment termination,
            multiplied by the number of years of service (subject to a maximum of
            35
            years).
 
 **Benefit
          Equivalency Plan (supplemental executive retirement)** Effective
          January 1, 2002, the Bank implemented a non-qualified supplemental retirement
          benefits plan for certain officers. The plan is designed to provide a retirement
          benefit to the officers while at the same time minimizing the financial
          impact
          on the Bank’s earnings. The plan provides retirement benefits based on an index
          formula. The index formula consists of the earnings on a specific life
          insurance
          policy, reduced by an amount equal to the Bank’s opportunity cost. Following an
          officer’s retirement, the Bank pays the earnings in excess of the opportunity
          cost to the officer annually. These payments continue for a period between
          ten
          years and the life of the officer. The Bank has purchased life insurance
          policies on the participating officers that are actuarially designed to
          offset
          the annual expenses associated with the index formula benefit. The Bank
          is the
          sole owner of all of the policies. Mr. Ridgill and selected executive officers
          participate in the Benefit Equivalency Plan. Mr.
          Shelton did not participate in this plan during 2006. During 2006, the
          net
          present value of Mr. Ridgill’s benefit under this plan increased by
          $52,438.
  79
   **Awards
          under 2006 Omnibus Plan** The Company believes that the granting of
          incentive and non-qualified stock options, rights to receive restricted
          shares
          of common stock and/or performance units under the 2006 Omnibus Plan (“Awards”)
          is the most appropriate form of long-term compensation for executive officers,
          since it aligns the executives’ incentives with the long-term interests of its
          stockholders and encourages stock ownership among executives. The granting
          of
          Awards is discretionary and is limited by the terms and conditions of the
          Plan.
          No Awards were granted to either Mr. Ridgill or Mr. Shelton during 2006.
          Because
          of the MOU and changes in the accounting rules pertaining to the expensing
          of
          stock option grants, it was decided not to grant any Awards under this
          Plan
          during 2006.
  **Potential
          Payments Upon Termination or Change in Control**  The
          Company and the Bank has an employment agreement with Mr. Ridgill (described
          below) which provides for certain payments upon termination of employment
          or in
          the event of a change in control of the Company. While Mr. Shelton does
          not have
          an employment agreement, he is covered by one of the Bank’s severance policies,
          described below. We believe that the employment agreement with Mr. Ridgill
          serves a number of important functions, including (i) retention of our
          president
          and chief executive officer; (ii) mitigation of any uncertainty about future
          employment and continuity of leadership in the event of a change in control;
          and
          (iii) protection of the Company and customers through non-compete and
          non-solicitation covenants. Similarly, we believe that the severance policies
          serve an important function by mitigating any uncertainty about future
          employment and continuity of leadership in the event of a change in
          control.




**Severance
      Policies**  The Board has adopted two severance policies for
      our senior officers, who are not covered by a currently effective severance
      agreement (the “Severance Policies”). The first policy applies to any officer
      (other than an officer covered by a currently effective severance agreement)
      who
      has been employed for five years or more and who has attained the office of
      Senior Vice President or above. Any officer covered by this first policy would
      be entitled to payments in the event of a “change in control” of the Company or
      the Bank and if the officer is not offered a position with the Company or the
      Bank, or the successor of either, at the officer’s current salary or if the
      officer is required to maintain an office more than 25 miles from his or her
      office before the “change in control.” Any officer employed for less than ten
      years would receive payments for one year, any officer employed for more than
      ten years but less than 15 years would receive monthly payments for 18 months,
      and any officer employed for more than 15 years would receive payments for
      two
      years. The second severance policy also covers our officers (except those who
      are otherwise covered by a current severance agreement) who have attained the
      level of Senior Vice President or above, have been employed for less than five
      years and are recommended for participation by our President and Chief Executive
      Officer and Board of Directors. Senior officers subject to this second policy
      receive payments only if they are terminated as a result of a “change in
      control.” Any officer employed for less than three years would receive monthly
      payments for six months, and any officer employed for more than three years
      but
      less than five years would receive monthly payments for nine months. Under
      both
      Severance Policies, payments to any officer would immediately cease if the
      officer became an officer, director, employee, consultant, or more than one
      percent owner of any bank or savings and loan institution within 50 miles of
      our
      principal executive offices and in connection with such position is responsible
      for soliciting or servicing depositors, borrowers or other customers. No amounts
      have ever been paid under either Severance Policy. The first policy applies
      to
      Mr. Shelton, and based on his current compensation and years of service, it
      is
      estimated that in the event that he became entitled to payment under the policy
      such payment would be $247,500 paid over a period of 18 months, at the same
      intervals as he currently receives his base salary.




**Ridgill
      2004 Employment Agreement**In 2004, Mr. Ridgill, then Executive Vice
      President and Chief Operating Officer of the Company and President and Chief
      Operating Officer of the Bank, entered into an Employment and Change of Control
      Agreement with the Company and the Bank (the “2004 Employment Agreement”). The
      2004 Employment Agreement provided for an initial term of 30 months ending
      December 31, 2006. Mr. Ridgill’s initial annual base salary under the 2004
      Employment Agreement was $225,000. It subsequently increased to $250,000 in
      2005, and to $300,000 as of July 1, 2006. The 2004 Employment Agreement provided
      for a number of benefits, including participation in various compensation plans
      offered to our employees and senior management. These plans included the 1996
      Omnibus Plan, the Annual Management Incentive Plan, and the Benefit Equivalency
      Plan (supplemental executive retirement). Other fringe benefits provided to
      Mr.
      Ridgill under the 2004 Employment Agreement included an annual automobile
      allowance of $12,000. The 2004 Employment Agreement provided that upon (i)
      termination of employment by the Company or the Bank within one year after
      a
“change in control,” (ii) Mr. Ridgill’s required relocation to a location other
      than the Company’s executive offices in Greensboro, North Carolina, or (iii) a
      reduction in Mr. Ridgill’s duties, responsibilities, prerogatives and authority
      under the agreement, he would be entitled to receive the sum of all accrued
      obligations, an amount equal to 2.99 times his salary, an amount equal to his
      cash bonus for the last completed fiscal year prorated for the remaining number
      of days remaining in the fiscal year after his termination, and continued
      participation in all benefit plans and fringe benefits, except qualified plans,
      for a period of time equal to the lesser of the remainder of his employment
      period under the 2004 Employment Agreement or until he becomes reemployed.
      Upon
      termination after a “change in control,” all stock options granted to Mr.
      Ridgill (subject to certain conditions in cases of recent grants) and all
      benefits under non-qualified benefit plans would vest immediately.





In
      the
      event Mr. Ridgill’s employment was terminated by the Company or the Bank other
      than for “cause,” death or disability, the 2004 Employment Agreement provided
      for payment of (a) an amount equal to his salary through the date of
      termination, (b) payment of all accrued obligations, (c) an amount equal to
      the
      product of the number of days remaining in the employment period and Mr.
      Ridgill’s base salary divided by 365 and (d) provision of benefits to Mr.
      Ridgill and his family for the remaining employment period or longer period
      as
      may be provided by any particular benefit plan or until Mr. Ridgill becomes
      re-employed.






80







**Ridgill
        2007 Employment Agreement** On
        January 25, 2007, Mr.
        Ridgill entered into an Employment and Change of Control Agreement with the
        Company and the Bank (the “2007 Employment Agreement”). The 2007 Employment
        Agreement replaced the 2004 Employment Agreement, which expired on December
        31,
        2006. The 2007 Employment Agreement has a term of three years, ending as
        of
        December 31, 2009, and provides for a base salary at the rate of at least
        $300,000 per year. It also provides for a number of benefits also offered
        to our
        senior management, including participation in various compensation plans.
        These
        plans include the 2006 Omnibus Plan, the Annual Management Incentive Plan
        and
        Long Term Incentive Plan, and the Benefit Equivalency Plan (supplemental
        executive retirement).
 
 Other
        fringe benefits provided to Mr. Ridgill under the agreement include an annual
        automobile allowance of $15,000, and reimbursement of its operating expenses.
        The termination provisions are substantially the same as under the 2004
        Employment Agreement, as described above. If terminated upon a change of
        control, the provisions of his agreement would entitle Mr. Ridgill to payment
        of
        approximately $1,056,000.
 
 **Other
        Benefits** The
        Bank
        also provides Mr. Ridgill and Mr. Shelton the same benefits that are afforded
        to
        all of our employees, including group insurance covering health, life and
        disability, details of which are footnoted to the Summary Compensation table
        below.
 
 **Interrelationship
        of Compensation Elements** The
        above
        elements of each named executive officer’s compensation are not inter-related.
        For example, if the expected level of bonus is not achieved, the base salary
        is
        not increased to make up the difference. Similarly, the value of previously
        granted options is not considered by the Committee in recommending the other
        elements of the compensation package, such as base salary and cash incentive
        bonus.
 
 **Tax
        Deductibility of Executive Compensation** Section
        162(m) of the Code places a limit of $1,000,000 on the amount of compensation
        that the Company may deduct in any one year with respect to each of it five
        most
        highly paid executive officers. Thus far, none of our named executive officers
        have received compensation in excess of the Section 162(m) limitation and,
        therefore, all compensation has been fully deductible.


**Other
      Matters** While
      we
      believe that it is important that our executive officers and directors own
      shares of the Company’s common stock, and all of the named executive officers
      and directors own common stock and/ or options to purchase common stock pursuant
      to our stock option plans, we do not have minimum equity requirements or
      guidelines, except as required by State law.





**Summary
      Compensation Table**





The
      following table shows, for the fiscal year ended December 31, 2006, the cash
      compensation received by, as well as certain other compensation paid or accrued
      for 2006, for our named executive officers, Messrs. Ridgill and Shelton, each
      of
      whom serves the Company and the Bank in the offices noted. Cash compensation
      is
      paid by the Bank, not the Company.







**SUMMARY
      COMPENSATION TABLE**




Name
                and Principal
              Position
            Salary
              ($)
            Bonus
              ($)
            Non-Equity
              Incentive
                Plan Compensation
              ($)(1)
            Change
                in Pension
              Value
                and
              Nonqualified
              Deferred
              Compensation
              Earnings
              ($)(2)
            All
                Other
              Compensation
              ($)
            Total
              ($)Pressley
                A. Ridgill, President and Chief Executive Officer
            $
                275,000
            $50,000
            $
                19,250
            $
                93,300
            $
                27,190(3)
            $
                464,740Michael
                W. Shelton, Executive Vice President and Chief Financial
                Officer
            $
                142,500
            0
            $
                26,375
            $
                20,148
            $
                9,876(4)
            $
                198,899





(1)
      Amounts shown as non-equity plan compensation accrue in the year indicated,
      and
      are paid in the following year.


(2)
Amounts
      shown represent the change in the net present value of the executive’s accrued
      pension benefit from December 31, 2005 to December 31, 2006. For Mr. Ridgill,
      $40,862 is related to the FNB Financial Services Corporation Employees’ Pension
      Plan (“Pension Plan”), and $52,438 is related to the Benefit Equivalency Plan.
      For Mr. Shelton, the amount is related entirely to the Pension
      Plan.


(3)
      Includes $8,250 401(k) matching contributions, $12,000 car allowance and $6,940
      insurance premiums.


(4)
      Includes $3,937 401(k) matching contributions and $5,939 insurance
      premiums.








81






**Outstanding
        Equity Awards at Fiscal Year-End Table**
  The
        following table shows certain information for those outstanding equity awards
        at
        December 31, 2006.


**OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-END**


Option
                  AwardsName
              Number
                  of
                Securities
                Underlying
                Unexercised
                Options
                (#)
                Exercisable
              Number
                  of
                Securities
                Underlying
                Unexercised
                Options
                (#)
                Unexercisable
              Option
                Exercise
                  Price
                ($)
              Option
                Expiration
                DatePressley
                  A. Ridgill
              11,719
              0
              $7.04
              11/16/10Pressley
                  A. Ridgill
              7,812
              0
              $7.64
              3/15/11Pressley
                  A. Ridgill
              14,062
              0
              $8.33
              9/20/11Pressley
                  A. Ridgill
              14,648
              4,8831
              $10.75
              1/7/13Pressley
                  A. Ridgill
              7,811
              7,8142
              $15.97
              1/23/14Pressley
                  A. Ridgill
              3,437
              10,3133
              $18.11
              1/3/15Pressley
                  A. Ridgill
              7,499
              22,5014
              $16.50
              10/20/15Michael
                  W. Shelton
              5,469
              0
              $16.16
              12/11/07Michael
                  W. Shelton
              5,469
              0
              $15.84
              7/16/08Michael
                  W. Shelton
              3,906
              0
              $11.20
              2/18/09Michael
                  W. Shelton
              7,031
              0
              $7.68
              10/21/09Michael
                  W. Shelton
              390
              0
              $8.33
              9/20/11Michael
                  W. Shelton
              4,101
              1,3681
              $10.75
              1/7/13Michael
                  W. Shelton
              4,687
              4,6885
              $15.97
              1/23/14Michael
                  W. Shelton
              1,562
              4,6886
              $18.11
              1/3/15Michael
                  W. Shelton
              1,249
              3,7517
              $16.50
              10/20/15





1
      These
      options became exercisable on January 7, 2007.


2
      Of this
      amount, 3,907 options became exercisable on 1/23/07, and 3,907 options become
      exercisable on 1/23/08.


3
      Of this
      amount, 3,437 options became exercisable on 1/3/07, 3,438 options become
      exercisable on 1/3/08 and 3,438 options become exercisable on
      1/3/09.


4
      Of this
      amount, 7,500 options become exercisable on 10/20/07, 7,500 options become
      exercisable on 10/20/08 and 7,501 options become exercisable on
      10/20/09.


5
      Of this
      amount, 2,344 options became exercisable on 1/23/07, and 2,344 options become
      exercisable on 1/23/08.


6
      Of this
      amount, 1,562 options became exercisable on 1/3/07, 1,563 options become
      exercisable on 1/3/08 and 1,563 options become exercisable on
      1/3/09.


7
      Of this
      amount, 1,250 options become exercisable on 10/20/07, 1,250 options become
      exercisable on 10/20/08 and 1,251 options become exercisable on
      10/20/09.





82








**Option
      Exercises and Stock Vested Table**




The
      following table shows certain information concerning the exercise of stock
      options by the named executive officers during the year ended December 31,
      2006.





**OPTION
      EXERCISES**


Option
                  AwardsName
              Number
                  of Shares Acquired on Exercise
                (#)
              Value
                  Realized on Exercise
                ($)Pressley
                  A. Ridgill
              0
              0Michael
                  W. Shelton
              11,664(1)
              $77,558(1)





(1)
      Mr.
      Shelton’s stock option exercises consisted of the following: Exercised 3,332
      options on June 7, 2006 with an exercise price of $8.01 per option and a fair
      market value on that date of approximately $15.01; Exercised 8,332 options
      on
      December 4, 2006 with an exercise price of $8.28 per option and a fair market
      value on that date of approximately $14.80.





**Pension
      Benefits Table**





The
      following table shows, for the fiscal year ended December 31, 2006, the pension
      benefits paid or earned by our named executive officers, Messrs. Ridgill and
      Shelton. Both Mr. Ridgill and Mr. Shelton participate in the FNB Financial
      Services Corporation Employees’ Pension Plan (“Pension”), while only Mr. Ridgill
      (and certain other individuals who are not named executive officers)
      participates in the Benefit Equivalency Plan (“BEP”).





**PENSION
      BENEFITS**





Name
              Name
                  of Plan
              Number
                  of
                Years
                  Credited
                Service
                (#)
              Present
                  Value of Accumulated
                Benefit
                  ($)
              Payments
                  During
                Last
                  Fiscal Year
                ($)Pressley
                  A. Ridgill
              Pension(1)(2)
              6
              140,442
              0Pressley
                  A. Ridgill
              BEP(1)(3)
              6
              110,495
              0Michael
                  W. Shelton
              Pension(1)(2)
              10
              76,734
              0







(1)
      The
“normal retirement age” (the age at which the participants may retire with no
      reduction in benefits to be paid) is age 65 for both plans


(2)
Annual
      benefits to be paid under the Pension plan are calculated by multiplying 1.00%
      of the participant’s “final average compensation” (1.25% for service prior to
      January 1, 2007) by the number of years credited service.


(3)
      Annual benefits to be paid under the BEP plan are described under the heading
      “Benefit Equivalency Plan” above.





83








**Nonqualified
      Deferred Compensation Table**





The
      following table shows, for the fiscal year ended December 31, 2006, the
      nonqualified deferred compensation paid to our named executive officers, Messrs.
      Ridgill and Shelton. Mr. Shelton does not elect to defer any portion of his
      compensation.





**NONQUALIFIED
      DEFERRED COMPENSATION**




Name
              Executive
                Contributions
                in
                  Last FY ($)(1)
              Registrant
                Contributions
                in
                  Last FY
                ($)
              Aggregate
                Earnings
                in
                  Last
                FY
                  ($)
              Aggregate
                Withdrawals/
                Distributions
                ($)
              Aggregate
                Balance
                  at
                Last
                  FYE
                ($)Pressley
                  A. Ridgill
              35,092
              0
              17,304
              0
              151,821Michael
                  W. Shelton
              0
              0
              0
              0
              0





(1)
      Includes $27,292 of compensation for Mr. Ridgill’s service as President and
      Chief Executive Officer, which is included in the amount reported as base salary
      for Mr. Ridgill in the table above under the heading “Summary Compensation
      Table”. Also includes $7,800 of compensation for Mr. Ridgill’s service as a
      member of the Board of Directors, which is included as fees earned in the table
      below under the heading “Director Compensation”.








**Director
      Compensation**




Our
      directors who are not officers or employees of the Company or the Bank are
      entitled to receive a retainer and fees for meetings of the Board and its
      committees. Directors who are employees receive only fees for Board meetings
      attended. We also reimburse directors for their travel expenses incurred in
      attending meetings. During 2006, each of our non-employee directors received
      a
      retainer of $15,000. Additionally, directors received a fee of $650 for each
      meeting of the Board and $400 for each meeting of a committee of the Board
      attended (except that the Chairman of the Board received a fee of $1,300 for
      each Board meeting attended and committee chairmen received a fee of $800 for
      attendance at each of their committee meetings). **** As
      of
      January 1, 2007, directors will **** receive
      a
      fee of $1,000 for each meeting of the Board and $500 for each meeting of a
      committee of the Board attended (except that the Chairman of the Board will
      receive a fee of $2,000 for each Board meeting attended and the committee
      chairmen will receive a fee of $1,000 for attendance at each of their committee
      meetings).




In
      order
      to increase the stock ownership of directors and further align their interests
      with our shareholders, the directors are eligible for awards under the 2006
      Omnibus Plan, which the Company implemented in September 2006. Previously,
      directors were eligible for awards under the 1996 Omnibus Plan. No awards were
      granted under either plan to any director or executive officer during 2006.





All
      of
      the Company’s directors also are eligible to participate in the Company’s
      Deferred Compensation Plan, which is intended to provide additional financial
      incentives and retirement security for the directors and certain senior
      management employees, and to allow for deferral of up to 100% of directors’
fees. Under this plan, deferred compensation is invested in mutual funds offered
      under a trust agreement with Morgan Trust Company.





84







The
      Boards of Directors of the Company and the Bank have historically been composed
      of the same persons. Under a policy of the Bank’s Board of Directors, a director
      of the Bank who retires upon reaching the age of 70 becomes a director emeritus.
      In such role, he or she is available to the Bank’s Board to provide opinions and
      suggestions and is requested to continue to promote the Bank’s services and
      business. Each director emeritus receives a monthly fee based on years of
      service and calculated as a percentage of the fee per Board meeting attended
      then being paid to current members of the Bank’s Board (“Regular Fees”). For
      service of ten or fewer years, the percentage is 25% of the Regular Fees, for
      service of eleven to nineteen years the percentage is 50%, and for service
      of 20
      or more years, the percentage is 75%. During 2006, each director emeritus
      received a payment of $487.50 for each of the 12 meetings of the Board held
      during that fiscal year (an aggregate of $5,850). The following individuals
      currently serve as directors emeriti: W. Apple, Jr., E. Green, P. Lambeth,
      Dr.
      C. Payne, J. Stanley and E. Trent, Jr. Based on the increase in directors fees
      described above, each director emeritus will receive a payment of $750.00 for
      each meeting of the Board attended, beginning January 1, 2007.





The
      following table reports all forms of compensation paid to or accrued for the
      benefit of each director during the 2006 fiscal year.




**DIRECTOR
      COMPENSATION**




Name
              Fees
                Earned
                  or
                Paid
                  in
                Cash
                  ($)
              All
                  Other
                Compensation
                ($)
              Total
                ($)Gary
                  G. Blosser
              29,600
              0
              29,600C.
                  Arnold Britt
              30,400
              0
              30,400Alex
                  A. Diffey, Jr.
              5,200
              0
              5,200Barry
                  Z. Dodson
              50,200
              0
              50,200Joseph
                  H. Kinnarney
              39,750
              0
              39,750Robbie
                  Perkins
              35,600
              0
              35,600Pressley
                  A. Ridgill
              7,800
              0
              7,800E.
                  Reid Teague, Jr.
              33,600
              0
              33,600Kenan
                  C. Wright
              28,950
              0
              28,950







**Compensation
      Committee Report**


The
      Compensation Committee has reviewed and discussed this CD&A with management
      and, based on such review and discussions, has recommended to the Board that
      the
      CD&A be included in the Company’s proxy statement and this Annual Report on
      Form 10-K.




C.
                    Arnold Britt, ChairmanJoseph
                    H. KinnarneyBarry
                    Z. DodsonRobbie
                    Perkins





85








**Item
                  12.**
              **SECURITY
                  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                  STOCKHOLDER MATTERS**





The
      following table shows the beneficial ownership of our common stock by each
      director who held office during 2006, each of our “named executive
      officers”, each nominee
      to our Board ,
      and all
      of the directors and named executive officers as a group. Rule 13d-3 under
      the Exchange Act provides that a person beneficially owns shares if he or
      she has voting and/or investment power over those shares. The business mailing
      address for each of the following individuals is: Post Office Box 18807,
      Greensboro, North Carolina 27419.


**Name
                  of Beneficial Owner**
              **Amount
                  and Nature of**
                **Beneficial
                  Ownership****1**
              **Percent
                  of Outstanding Common**
                **Stock
                  on March 5, 2007****2**Gary
                  G. Blosser3
              28,221
              *C.
                  Arnold Britt4
              101,709
              1.37%Alex
                  A. Diffey, Jr.
              1,000
              *Barry
                  Z. Dodson5
              64,552
              *Joseph
                  H. Kinnarney6
              82,030
              1.11%Robbie
                  Perkins
              7,776
              *Pressley
                  A. Ridgill7
              103,593
              1.39%Michael
                  W. Shelton8
              43,013
              *E.
                  Reid Teague, Jr.9
              33,462
              *Elizabeth
                  A. Ward
              -
              *Kenan
                  C. Wright10
              80,403
              1.08%All
                  directors and named executive officers as a group (11 persons)11
              545,759
              7.35%
 ____________________
 1
              Except
                  as otherwise noted, all shares are owned and held of record by
                  the named
                  individual, his spouse or minor children, or other entities controlled
                  by
                  the named individual.
 2
              Based
                  upon 7,063,952 shares of outstanding common stock (and options
                  held by the
                  named individuals) as of March 5, 2007. An asterisk (*) indicates
                  an
                  amount less than 1% of outstanding
                  shares.
 3
              Includes
                  25,936****shares
                  which Mr. Blosser could purchase under presently exercisable options
                  and
                  options that will be exercisable within 60 days (“Option
                  Shares”).
 4
              Includes
                  54,061 Option Shares held by Mr.
                  Britt.
 5
              Includes
                  43,514 Option Shares held by Mr.
                  Dodson.
 6
              Includes
                  54,061 Option Shares held by Dr.
                  Kinnarney.
 7
              Includes
                  79,215 Option Shares held by Mr.
                  Ridgill.
 8
              Includes
                  39,138 Option Shares held by Mr.
                  Shelton.
 9
              Includes
                  19,688 Option Shares held by Mr.
                  Teague.
 10
              Includes
                  54,061 Option Shares held by Mr.
                  Wright.
 11
              Includes
                  an aggregate of 369,674 Option Shares held by directors and named
                  executive officers.


86
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            of Contents*





**Item
                  13.**
              **CERTAIN
                  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
                  INDEPENDENCE**
 The
          Bank
          has had, and expects to have in the future, lending transactions in the
          ordinary
          course of business with many of our officers and directors and with associates
          of such persons. All loans and commitments included in those transactions
          during
          2006 were made in the ordinary course of business on substantially the
          same
          terms, including interest rates and collateral, as those prevailing at
          the time
          for comparable transactions with other persons, and in the opinion of management
          of the Bank did not involve more than the normal risk of collectibility
          or
          present other unfavorable features.
  The
            Board
            of Directors has determined that, except for Mr. Diffey and Mr. Perkins,
            all of
            its directors (listed in Item 12, above) are “independent,” as that term is
            defined in Rule 4200(a)(15) of the NASDAQ Marketplace Rules, as applicable
            to
            Nasdaq Global Market companies.  During 2006, Mr. Perkins was a member
            of the Compensation Committee.
 During
          2006 the Company and the Bank were parties to the following series
          of transactions in excess of $120,000, in which one of their directors, Mr.
          Perkins, had a direct or indirect material interest by virtue of him being
          president and co-owner of the real estate firm, NAI
          Piedmont Triad .
          In July
          the Company purchased for
          approximately $1,085,500, a proposed Bank branch site in Oak Ridge, North
          Carolina. Pursuant to its real estate brokerage agreement, NAI Piedmont
          Triad
          received three percent (3%) commission on the purchase ($32,565). Of this
          amount, Mr. Perkins received $26,052 remuneration from NAI Piedmont Triad
          and a
          further $2,833 by virtue of his 33.3% ownership interest in the firm. In
          June,
          the Company purchased for
          approximately $850,000, a proposed Bank branch site in High Point, North
          Carolina. Pursuant to its real estate brokerage agreement, NAI Piedmont
          Triad
          received five percent (5%) commission on the purchase ($42,500). Of this
          amount,
          Mr. Perkins received $34,000 remuneration from NAI Piedmont Triad and a
          further
          $2,171 by virtue of his ownership interest in the firm.
  The
            Company’s Code of Business Conduct and Ethics provides that directors, officers
            and employees should not be involved in any activity which creates or
            reasonably
            could be expected to give rise to a conflict of interest between their
            personal
            interests and the Company’s interests. A confidential hotline provides a method
            by which suspected violations may be anonymously reported. Where a transaction
            potentially gives rise to a conflict of interest, the Company’s Audit Committee
            may review and (where appropriate) approve the transaction subject to
            such
            conditions as it considers appropriate so as maintain compliance with
            the Code.
            The provisions of the Code may also be waived by resolution of the Audit
            Committee. Waivers granted to directors and executive officers are subject
            to
            public disclosure requirements.




The
        Code
        is required to be reviewed and signed by all employees and directors annually,
        and by Bank officers twice annually. The Bank’s Human Resources department
        maintains the signed forms. The Code ** requires
        that the Chairman of the Audit Committee, or his designee, investigate any
        reported violations and oversee an appropriate response, including corrective
        action and preventative measures. The Code is accessible on the Company’s
        website under the *“Investor
        Information”* section.




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


The
      certified public accounting firm of Dixon Hughes has been appointed by the
      Audit
      Committee as the Company’s independent registered public accounting firm for the
      year ending December 31, 2007. This appointment has been approved by the Board
      and is being submitted to our shareholders for ratification.




**Audit
      Fees Paid to Independent Auditor (Independent** **Registered
      Public Accounting Firm)**




The
      following table represents fees for professional services rendered by the
      Company’s independent registered public accounting firm for the audit of the
      Company’s annual consolidated financial statements for the years ended
      December 31, 2005 and 2006 and fees billed for audit-related services, tax
      services and all other services rendered by those auditors for each of those
      fiscal years.







**2006****1**
            
            **2005**1Audit
                Fees2
            
            $
            193,359
            
            $
            208,870Audit-Related
                Fees3
            
            $
            39,118
            
            $
            45,818Tax
                Fees4
            
            $
            55,270
            
            $
            25,991All
                Other Fees5
            
            $
            14,879
            
            $
            10,171Total
                Fees
            
            $
            302,626
            
            $
            290,850


________________
 1
              These
                  are fees paid for professional services rendered by Dixon Hughes
                  for the
                  fiscal year indicated.
 2
              These
                  are fees paid for professional services rendered in the audit of
                  the
                  Company’s annual consolidated financial statements and in the reviews of
                  the consolidated financial statements included in the Company’s quarterly
                  reports on Form 10-Q, and for services normally provided in connection
                  with statutory or regulatory filings or engagements.
 3
              hese
                  are fees paid for assurance and related services that were reasonably
                  related to the performance of the audit or review of our consolidated
                  financial statements and that are not reported under “Audit Fees” above,
                  including fees related to audits of financial statements of employee
                  benefit plans, pension plans, and any subsidiaries.
 4
              These
                  are fees paid for professional services rendered for tax compliance,
                  tax
                  planning and tax advice, including assistance in the preparation
                  of the
                  Company’s various federal, state and local tax returns.
 5
              These
                  are fees paid for permissible work performed by our independent
                  registered
                  public accounting firm that does not meet the above categories,
                  consisting
                  of information technology risk assessment, due diligence services
                  and
                  other special project assistance.


87
 *Table
            of Contents*





Pre-Approval
      of Audit and Permissible Non-Audit Services





All
      audited-related services, tax services and other services rendered in 2005
      and
      2006 were pre-approved by the Audit Committee, which concluded that the
      provision of those services by Dixon Hughes for 2005 and 2006 were compatible
      with the maintenance of the firm’s independence in the conduct of its auditing
      functions for the Corporation. The Audit Committee’s charter provides for
      pre-approval of all audit and non-audit services to be provided by the Company’s
      independent registered public accounting firm. The charter authorizes the Audit
      Committee to delegate to one or more of its members pre-approval authority
      with
      respect to permitted services, provided that any approvals using this procedure
      are presented to the Audit Committee at its next scheduled meeting.





**PART
      IV**


**Item
                  15.**
              **EXHIBITS
                  AND FINANCIAL STATEMENT
                  SCHEDULES**





(a)(1)  Financial
      Statements. The following financial statements and supplementary data are
      included in Item 8 of this report.








Financial
                Statements
            Form
                10-K PageQuarterly
              Financial Information
            47Reports
                of Independent Registered Public Accounting Firm
            48Consolidated
                Balance Sheets as of December 31, 2006 and 2005
            51Consolidated
                Statements of Income and Comprehensive Income for the years ended
                December
                31, 2006, 2005 and 2004
            52Consolidated
                Statements of Changes in Shareholders’ Equity for the years ended December
                31, 2006, 2005 and 2004
            53Consolidated
                Statements of Cash Flows for the years ended December 31, 2006, 2005
                and
                2004
            54Notes
                to Consolidated Financial Statements
            55





(a)(2)  Financial
      Statement Schedules. All
      applicable financial statement schedules required under Regulation S-X have
      been
      included in the Notes to the Consolidated Financial Statements.





(a)(3)  Exhibits. The
      exhibits required by Item 601 of Regulation S-K are listed below.





Exhibit
                No.
            Description3.01
                (1)
            Amended
                and Restated Articles of Incorporation.3.02
                (1)
            Bylaws
                of Company, as amended.4.01
                (2)
            Specimen
                Common Stock Certificate.4.02
                (13)
            Amended
                and Restated Declaration of Trust, regarding Trust Preferred Securities,
                dated August 26, 2005.4.03
                (13)
            Guarantee
                Agreement, regarding Trust Preferred Securities, dated August 26,
                2005.4.04
                (13)
            Indenture,
                regarding Trust Preferred Securities, dated August 26,
                2005.10.01
                (3)
            Stock
                Compensation Plan of the Registrant approved April 11, 1989, by the
                shareholders of the Registrant, with forms of stock option and stock
                bonus
                agreements attached.10.02
                (4)
            Omnibus
                Equity Compensation Plan of the Registrant.10.03
                (5)
            Severance
                Policy for Senior Officers of the Registrant (employed for five years
                or
                more).10.04
                (6)
            Revised
                Severance Plan for Senior Officers of the Registrant (employed for
                five
                years or more).10.05
                (7)
            Severance
                Policy for Senior Officers of the Registrant (employed for less than
                five
                years).10.06
                (1)
            1998
                Split-Dollar Agreement10.07
                (8)
            Benefit
                Equivalency Plan of the Registrant effective January 1,
                1994.






88
 *Table
          of Contents*




10.08
                    (8)
                Long
                    Term Incentive Plan of the Registrant.10.09
                    (10)
                Long
                    Term Incentive Plan of the Registrant for certain senior management
                    employees.10.10
                    (8)
                Employment
                    Agreement dated May 18, 1995, between the Registrant, as employer,
                    and
                    Ernest J. Sewell, former President and Chief Executive Officer
                    of the
                    Registrant.10.11
                    (9)
                Split-Dollar
                    Agreement dated January 27, 1995, between the Registrant and
                    Ernest J.
                    Sewell.10.12
                    (9)
                Split-Dollar
                    Agreement dated January 27, 1995, between the Registrant and
                    C. Melvin
                    Gantt.10.13
                    (9)
                Split-Dollar
                    Agreement dated December 8, 1995, between the Registrant and
                    Richard L.
                    Powell.10.14
                    (11)
                Amendment
                    to Benefit Equivalency Plan of the Registrant effective January
                    1,
                    1998.10.15
                    (9)
                Split-Dollar
                    Agreement, dated Mach 20, 1998, between the Registrant and Ernest
                    J.
                    Sewell.10.16
                    (12)
                Second
                    Amendment, dated May 19, 2004, to the Employment Agreement, dated
                    May 18,
                    1995, between the Registrant, as employer, and Ernest J. Sewell,
                    former
                    President and Chief Executive Officer of the
                    Registrant.10.17
                    (12)
                Third
                    Amendment to Employment Agreement and First Amendments to Split-Dollar
                    Agreements and Collateral Agreements with Ernest J. Sewell effective
                    January 1, 2004.10.18
                    (13)
                Fourth
                    Amendment to Employment Agreement with Ernest J. Sewell, executed
                    on
                    October 20, 2005 and effective February 1, 2006.10.19
                    (13)
                Independent
                    Contractor Consulting Agreement with Ernest J. Sewell, executed
                    October
                    20, 2005 and effective February 1, 2006.10.20
                    (14)
                Long
                    Term Stock Incentive Plan of the Registrant10.21
                    (15)
                Employment
                    Agreement dated January 25, 2007, between the Registrant, as
                    employer, and
                    Pressley A. Ridgill, President and Chief Executive Officer of
                    the
                    Registrant.10.22
                    (16)
                Agreement
                    and Plan of Merger by and between Registrant and LSB Bancshares,
                    Inc.,
                    dated February 26, 200710.23
                    (16)
                Agreement
                    and Plan of Bank Merger by and among Registrant, the Bank, LSB
                    Bancshares,
                    Inc. and Lexington State Bank, dated February 26, 200721.01
                Schedule
                    of Subsidiaries.23.01
                Consent
                    of Dixon Hughes PLLC.31.01
                Certification
                    of Pressley A. Ridgill31.02
                Certification
                    of Michael W. Shelton32.01
                Certification
                    of Periodic Financial Report Pursuant to 18 USC Section
                    1350.


Note:
      The
      exhibits listed above have been filed with the Securities and Exchange
      Commission but are not included in this printed copy of the Company’s Annual
      Report on Form 10-K.





Exhibit
      references:





(1)
            Incorporated
                herein by reference to the Registrant’s Current Report on Form 8-K, dated
                May 25, 2005, filed with the SEC.


(2)
            Incorporated
                herein by reference to the Registrant’s Quarterly Report on Form 10-Q for
                the fiscal quarter ended March 31, 1998, filed with the
                SEC.


(3)
            Incorporated
                herein by reference to the Registrant’s Statement on Form S-8 (No.
                33-33186), filed with the SEC.


(4)
            Incorporated
                herein by reference to the Registrant’s Annual Report on Form 10-KSB for
                the fiscal year ended December 31, 1996, filed with the
                SEC.


(5)
            Incorporated
                herein by reference to the Registrant’s Annual Report on Form 10-K for the
                fiscal year ended December 31, 1989, filed with the
                SEC.


(6)
            Incorporated
                herein by reference to the Registrant’s Annual Report on Form 10-KSB for
                the fiscal year ended December 31, 1994, filed with the
                SEC.


(7)
            Incorporated
                herein by reference to the Registrant’s Quarterly Report, on Form 10-QSB
                for the fiscal quarter ended June 30, 1995, filed with the
                SEC.





89
 *Table
            of Contents*





(8)
            Incorporated
                herein by reference to the Registrant’s Statement on Form S-2 (File No.
                333-47203) filed with the SEC on March 3,
                1998.


(9)
            Incorporated
                herein by reference to the Registrant’s Annual Report on Form 10-KSB for
                the fiscal year ended December 31, 1997, filed with the
                SEC.


(10)
            Incorporated
                herein by reference to the Registrant’s Annual Report on Form 10-K for the
                fiscal year ended December 31, 2002, filed with the
                SEC.


(11)
            Incorporated
                herein by reference to the Registrant’s Annual Report on Form 10-K for the
                fiscal year ended December 31, 1998, filed with the
                SEC.


(12)
            Incorporated
                herein by reference to the Registrant’s Annual Report on Form 10-K for the
                fiscal year ended December 31, 2004, filed with the
                SEC.


(13)
            Incorporated
                herein by reference to the Registrant’s Quarterly Report, on Form 10-Qfor
                the fiscal quarter ended September 30, 2005, filed with the
                SEC.


(14)
              Incorporated
                  herein by reference to the Registrant’s Statement on Form S-8, filed with
                  the SEC on September 22,
                  2006.


(15)
            Incorporated
                herein by reference to the Registrant’s Current Report on Form 8-K, dated
                January 30, 2007, filed with the
                SEC.


(16)
            Incorporated
                herein by reference to the Registrant’s Current Report on Form 8-K, dated
                February 27, 2007, filed with the
                SEC.











90
 *Table
            of Contents*





**SIGNATURES**





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




**FNB
                  FINANCIAL SERVICES CORPORATION**Date:
                  February 22, 2007
              By*:*
              ***/s/**Pressley
                  A. Ridgill*Pressley
                  A. Ridgill,President
                  and Chief Executive
                  Officer


Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant and in the
      capacities and on the dates indicated.





Signature
            Capacity
            Date*/s/**Pressley
                A. Ridgill*
            President,
                Chief Executive Officer, and
              Director
            February
                22, 2007Pressley
                A. Ridgill
              
              
              */s/**Michael
                W. Shelton*
            (Principal
                Executive Officer)
              
              Executive
                Vice President, Chief Financial
              Officer,
                Secretary, and Treasurer
            February
                22, 2007Michael
                W. Shelton
              
              
              */s/**K.
                Dwight Willoughby*
            (Principal
                Financial Officer)
              
              Senior
                Vice President, Chief Accounting
              Officer,
                and Controller
            February
                22, 2007K.
                Dwight Willoughby
              
              */s/**Barry
                Z. Dodson*
            (Principal
                Accounting Officer)
              
              Chairman
                of the Board
            February
                22, 2007Barry
                Z. Dodson
              
              */s/**Gary
                G. Blosser*
            Director
            February
                22, 2007Gary
                G. Blosser
              
              */s**/
                Charles A. Britt*
            Director
            February
                26, 2007Charles
                A. Britt
              
              */s/**Alex
                A.. Diffey*
            Director
            February
                22, 2007Alex
                M. Diffey
              
              */s/**Joseph
                H. Kinnarney*
            Director
            February
                22, 2007Joseph
                H. Kinnarney
              
              */s/**Robert
                V. Perkins*
            Director
            February
                22, 2007Robert
                V. Perkins
              
              */s/**E.
                Reid Teague*
            Director
            February
                22, 2007E.
                Reid Teague
              
              */s/**Kenan
                C. Wright***
            Director
            February
                22, 2007Kenan
                C. Wright








91
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            of Contents*





**EXHIBIT
      INDEX**





**Exhibit**
            **Description**21.01
            Schedule
                of Subsidiaries23.01
            Consent
                of Dixon Hughes PLLC31.01
            Certification
                of Pressley A. Ridgill31.02
            Certification
                of Michael W. Shelton32.01
            Certification
                of Periodic Financial Report Pursuant to 18 U.S.C. Section
                1350