*** ***

***Exhibit 13***

*** ***

***C O N T E N T S***

*** ***
| **REPORT OF INDEPENDENT REGISTERED PUBLIC  ACCOUNTING FIRM** |                                                                                                         |   |
|--------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------|--------|
|                                                         |                                                                                                         |   |   |
| **CONSOLIDATED FINANCIAL STATEMENTS**                        |                                                                                                         |   |
|                                                         |                                                                                                         |   |   |
|                                                         | Balance sheets                                                                                               |   |   |
|                                                         | Statements of income                                                                                         |   |   |
|                                                         | Statements of changes in stockholders’  equity                                                          |   |   |
|                                                         | Statements of cash flows                                                                                     |   |   |
|                                                         | Notes to consolidated financial statements                                                                   |   |   |
|                                                         |                                                                                                         |   |   |
| **ACCOMPANYING FINANCIAL INFORMATION**                       |                                                                                                         |   |
|                                                         |                                                                                                         |   |   |
|                                                         | Selected five year financial data                                                                            |   |   |
|                                                         | Summary of quarterly financial data                                                                          |   |   |
|                                                         | Distribution of assets, liabilities and  stockholders’ equity, interest rates and interest differential |   |   |
|                                                         | Changes in net interest income                                                                               |   |   |
|                                                         | Management’s discussion and analysis of  consolidated financial condition and results of operations     |   |   |
|                                                         | Stock market analysis and dividends                                                                          |   |   |

 

----

 

***REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM***

 

Board of Directors

Fulton Bancshares Corporation

McConnellsburg, Pennsylvania

 

We have audited the accompanying consolidatedbalance sheets of the Fulton Bancshares Corporation and its wholly-ownedsubsidiaries as of December 31, 2004 and 2003 and the related consolidatedstatements of income, changes in stockholders’ equity, and cash flows for eachof the three years in the period ended December 31, 2004.  These consolidated financial statements arethe responsibility of the Corporation’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether theconsolidated financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the consolidated financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonablebasis for our opinion.

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, thefinancial position of the Fulton Bancshares Corporation and its wholly-ownedsubsidiaries as of December 31, 2004 and 2003, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2004 in conformity with accounting principles generallyaccepted in the United States of America.

 

As discussed in Note 20 to the financialstatements, the Corporation corrected errors in the accounting for theamortization and accretion of premiums and discounts on certain investments,which resulted in restatement of the prior years financial statements.

 

 
|   |                                              |
|--------|---------------------------------------------------|
|   | /S/ Smith Elliott Kearns &  Company, LLC |

 

 

Chambersburg, Pennsylvania

March 2,2005, except for Notes 14 and 15, as

to which the date is March 29, 2005

 

----

 

**FULTON BANCSHARESCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCE SHEETS**

**December 31, 2004 and2003**

 
| ** **                                                                                    | ** ** | **2004**    | ** **  | **2003**          | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------------|------------|
| ** **                                                                                    | ** ** | ** **  | ** **  | **(As Restated)** | ** ** |
| **ASSETS**                                                                                    |       |        |        |              |       |
| Cash and due  from banks                                                                      |       | $           | 12,808,875  |              | $          | 3,603,521 |   |
|                                                                                          |       |        |        |              |       |
| Interest-bearing  deposits in other banks                                                     |       | 55,079      |        | 249,181           |       |
| Federal  funds sold                                                                           |       | 3,500,000   |        | 0                 |       |
| Cash and  cash equivalents                                                                    |       | 16,363,954  |        | 3,852,702         |       |
|                                                                                          |       |        |        |              |       |
| Investment  securities available for sale                                                     |       | 18,985,202  |        | 29,680,370        |       |
| Federal  Reserve, Atlantic Central Bankers Bank and Federal Home Loan Bank stocks             |       | 1,207,150   |        | 1,400,850         |       |
| Loans, net  of reserve for loan losses 2004-$ 1,821,164; 2003-$ 1,899,643           |       | 92,648,992  |        | 101,388,847       |       |
|                                                                                          |       |        |        |              |       |
| Premises and  equipment                                                                       |       | 3,596,316   |        | 3,759,508         |       |
| Cash  surrender vale of life insurance                                                        |       | 5,429,963   |        | 5,229,926         |       |
| Accrued  interest receivable                                                                  |       | 659,723     |        | 661,096           |       |
| Real estate  owned other than premises                                                        |       | 1,534,000   |        | 206,199           |       |
| Other assets                                                                                  |       | 1,331,608   |        | 1,389,806         |       |
| Total assets                                                                                  |       | $           | 141,756,908 |              | $          | 147,569,304 |   |
|                                                                                          |       |        |        |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                |       |        |        |              |       |
| Deposits                                                                                      |       |        |        |              |       |
| Noninterest  bearing                                                                          |       | $           | 16,524,406  |              | $          | 13,927,479 |   |
| Interest  bearing                                                                             |       | 93,096,879  |        | 97,200,011        |       |
|                                                                                          |       | 109,621,285 |        | 111,127,490       |       |
|                                                                                          |       |        |        |              |       |
| Other  borrowed funds                                                                         |       | 15,000,000  |        | 18,825,000        |       |
| Accrued  interest payable                                                                     |       | 243,221     |        | 254,599           |       |
| Other  liabilities                                                                            |       | 1,374,307   |        | 1,258,556         |       |
| Total  liabilities                                                                            |       | 126,238,813 |        | 131,465,645       |       |
|                                                                                          |       |        |        |              |       |
| Stockholders’  Equity                                                                    |       |        |        |              |       |
| Common  stock: par value $.625 per share; 4,000,000 shares authorized; 495,000 shares  issued |       | 309,375     |        | 309,375           |       |
| Additional  paid-in capital                                                                   |       | 2,051,337   |        | 2,051,337         |       |
| Retained  earnings                                                                            |       | 13,226,245  |        | 14,208,502        |       |
| Accumulated  other comprehensive income (loss)                                                |       | 20,349      |        | (377,643          | )          |
| Treasury  stock; shares at cost- 2004 - 2,210; 2003 - 2,185                                   |       | (89,211     | )           | (87,912           | )          |
|                                                                                          |       | 15,518,095  |        | 16,103,659        |       |
| Total  liabilities and stockholders’ equity                                              |       | $           | 141,756,908 |              | $          | 147,569,304 |   |

 

*The Notesto Consolidated Financial Statements are an integral part of these statement*

 

2

----

 

**FULTONBANCSHARES CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF INCOME**

**Years Ended December 31, 2004, 2003 and 2002**

 
| ** **                                                                  | ** ** | **2004**   | ** ** | **2003**          | ** ** | **2002**          | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                  | ** ** | ** ** | ** ** | **(As Restated)** | ** ** | **(As Restated)** | ** ** |
|                                                                        |       |       |       |              |       |              |       |
| **Interest  Income**                                                        |       |       |       |              |       |              |       |
| Interest and  fees on loans                                                 |       | $          | 6,350,516  |              | $          | 6,913,532         |       | $ | 7,621,016 |   |
| Interest and  dividends on investment securities:                           |       |       |       |              |       |              |       |
| Other U.S.  Government agencies                                             |       | 278,873    |       | 352,657           |       | 708,802           |       |
| Mortgage-backed  securities                                                 |       | 91,624     |       | 126,030           |       | 197,870           |       |
| Oligations  of state and political subdivisions- tax exempt                 |       | 207,462    |       | 75,232            |       | 102,247           |       |
| FNMA and  FHLMC preferred stock                                             |       | 585,207    |       | 820,877           |       | 686,714           |       |
| Other  interest and dividends                                               |       | 27,629     |       | 77,127            |       | 120,276           |       |
| Interest on  federal funds sold                                             |       | 13,160     |       | 0                 |       | 11,976            |       |
| Total  interest income                                                      |       | 7,554,471  |       | 8,365,455         |       | 9,448,901         |       |
|                                                                        |       |       |       |              |       |              |       |
| **Interest  Expense**                                                       |       |       |       |              |       |              |       |
| Interest on  deposits                                                       |       | 1,972,493  |       | 2,132,148         |       | 3,289,201         |       |
| Interest on  federal funds purchased                                        |       | 636        |       | 726               |       | 4,111             |       |
| Interest on  other borrowed money                                           |       | 917,822    |       | 1,042,110         |       | 977,695           |       |
| Total  interest expense                                                     |       | 2,890,951  |       | 3,174,984         |       | 4,271,007         |       |
|                                                                        |       |       |       |              |       |              |       |
| Net interest  income before provision for loan losses                       |       | 4,663,520  |       | 5,190,471         |       | 5,177,894         |       |
|                                                                        |       |       |       |              |       |              |       |
| **Provision  for Loan Losses**                                              |       | 260,841    |       | 1,265,000         |       | 255,000           |       |
|                                                                        |       |       |       |              |       |              |       |
| Net interest  income after provision for loan losses                        |       | 4,402,679  |       | 3,925,471         |       | 4,922,894         |       |
|                                                                        |       |       |       |              |       |              |       |
| **Other  Income (Loss)**                                                    |       |       |       |              |       |              |       |
|                                                                        |       |       |       |              |       |              |       |
| Service  charges on deposit accounts                                        |       | 172,526    |       | 217,159           |       | 203,426           |       |
| Other  service charges and fees                                             |       | 155,616    |       | 221,896           |       | 134,755           |       |
| Earnings-Cash  surrender value of life insurance                            |       | 243,188    |       | 258,209           |       | 258,203           |       |
| Trust  services                                                             |       | 6,366      |       | 19,453            |       | 24,843            |       |
| Gain (loss)  on sale of investment securities                               |       | (1,264,993 | )          | 86,472            |       | 705               |       |
| Gain on sale  of OREO property                                              |       | 5,481      |       | 0                 |       | 8,516             |       |
| Gain on sale  of loans                                                      |       | 12,952     |       | 24,012            |       | 0                 |       |
| Other income                                                                |       | 13,299     |       | 9,515             |       | 10,544            |       |
| Total other  income (loss)                                                  |       | (655,565   | )          | 836,716           |       | 640,992           |       |
|                                                                        |       |       |       |              |       |              |       |
| **Other  Expenses**                                                         |       |       |       |              |       |              |       |
| Salaries,  fees and employee benefits                                       |       | 1,682,754  |       | 1,707,844         |       | 1,727,652         |       |
| Net  occupancy expense of bank premises and furniture and equipment expense |       | 806,466    |       | 833,377           |       | 746,394           |       |
| Professional  and loan-related fees                                         |       | 358,548    |       | 184,447           |       | 101,279           |       |
| Data  processing                                                            |       | 289,143    |       | 259,915           |       | 259,508           |       |
| FDIC  insurance premiums                                                    |       | 32,751     |       | 17,515            |       | 20,386            |       |
| Other  expenses                                                             |       | 1,049,394  |       | 1,001,919         |       | 918,334           |       |
| Total other  expenses                                                       |       | 4,219,056  |       | 4,005,017         |       | 3,773,553         |       |
|                                                                        |       |       |       |              |       |              |       |
| Income  (loss) before income taxes                                          |       | (471,942   | )          | 757,170           |       | 1,790,333         |       |
| Applicable  income tax (benefit)                                            |       | (7,110     | )          | (9,977            | )          | 335,405           |       |
|                                                                        |       |       |       |              |       |              |       |
| Net income  (loss)                                                          |       | $          | (464,832   | )                 | $          | 767,147           |       | $ | 1,454,928 |   |
|                                                                        |       |       |       |              |       |              |       |
| Earnings  (loss) per common share                                           |       | $          | (0.94      | )                 | $          | 1.56              |       | $ | 2.95 |   |

 

*The Notesto Consolidated Financial Statements are an integral part of these statements.*

 

3

----

 

**FULTON BANCSHARES CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**Years Ended December 31, 2004, 2003 and 2002**

 
| ** **                                                                                              | ** ** | ** ** | ** ** | ** **     | ** ** | ** **        | ** ** | **Accumulated**   | ** ** | ** **   | ** ** | ** **             | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------|------------|----------------|------------|-------------------|------------|-------------------|------------|--------------|------------|------------------------|------------|
| ** **                                                                                              | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **        | ** ** | **Other**         | ** ** | ** **   | ** ** | **Total**              | ** ** |
| ** **                                                                                              | ** ** | **Common** | ** ** | **Paid-In**    | ** ** | **Retained**      | ** ** | **Comprehensive** | ** ** | **Treasury** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                              | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Earnings**      | ** ** | **Income (Loss)** | ** ** | **Stock**    | ** ** | **Equity**             | ** ** |
| ** **                                                                                              | ** ** | ** ** | ** ** | ** **     | ** ** | **(As Restated)** | ** ** | **(As Restated)** | ** ** | ** **   | ** ** | **(As Restated)**      | ** ** |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Balance, December 31,  2001                                                                        |       | $          | 309,375    |           | $          | 2,051,106         |       | $                 | 13,006,503 |         | $          | (60,571                | )          | $ | (89,726 | ) | $ | 15,216,687 |   |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Comprehensive  income:                                                                                  |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Net income                                                                                              |       |       |       |           |       | 1,454,928         |       |              |       |         |       | 1,454,928              |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Change in  unrealized gain on investment securities available for sale, net of tax of $ 250,811    |       |       |       |           |       |              |       | 486,870           |       |         |       | 486,870                |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Total  comprehensive income                                                                             |       |       |       |           |       |              |       |              |       |         |       | 1,941,798              |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Issuance of  treasury stock (40 shares)                                                                 |       |       |       | 188            |       |              |       |              |       | 1,612        |       | 1,800                  |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Cash  dividends ($ 1.02 per share)                                                                 |       |       |       |           |       | (502,626          | )          |              |       |         |       | (502,626               | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Balance, December 31,  2002                                                                        |       | 309,375    |       | 2,051,294      |       | 13,958,805        |       | 426,299           |       | (88,114      | )          | 16,657,659             |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Comprehensive  income:                                                                                  |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Net income                                                                                              |       |       |       |           |       | 767,147           |       |              |       |         |       | 767,147                |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Change in  unrealized (loss) on investment securities available for sale, net of tax of  $ 185,338 |       |       |       |           |       |              |       | (803,942          | )          |         |       | (803,942               | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Total  comprehensive income (loss)                                                                      |       |       |       |           |       |              |       |              |       |         |       | (36,795                | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Issuance of  treasury stock (5 shares)                                                                  |       |       |       | 43             |       |              |       |              |       | 202          |       | 245                    |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Cash  dividends ($ 1.05 per share)                                                                 |       |       |       |           |       | (517,450          | )          |              |       |         |       | (517,450               | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Balance, December 31,  2003                                                                        |       | 309,375    |       | 2,051,337      |       | 14,208,502        |       | (377,643          | )          | (87,912      | )          | 16,103,659             |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Comprehensive  income:                                                                                  |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Net loss                                                                                                |       |       |       |           |       | (464,832          | )          |              |       |         |       | (464,832               | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Change in  unrealized gain on investment securities available for sale, net of tax of $ 23,786     |       |       |       |           |       |              |       | 397,992           |       |         |       | 397,992                |       |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Total  comprehensive income (loss)                                                                      |       |       |       |           |       |              |       |              |       |         |       | (66,840                | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Purchase of  treasury stock (25 shares)                                                                 |       |       |       | 0              |       |              |       |              |       | (1,299       | )          | (1,299                 | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Cash  dividends ($1.05 per share)                                                                       |       |       |       |           |       | (517,425          | )          |              |       |         |       | (517,425               | )          |
|                                                                                                    |       |       |       |           |       |              |       |              |       |         |       |                   |       |
| Balance, December 31,  2004                                                                        |       | $          | 309,375    |           | $          | 2,051,337         |       | $                 | 13,226,245 |         | $          | 20,349                 |       | $ | (89,211 | ) | $ | 15,518,095 |   |

 

*The Notesto Consolidated Financial Statements are an integral part of these statement.*

 

4

----

 

**FULTON BANCSHARESCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Years Ended December 31,2004, 2003 and 2002**

 
| ** **                                                                                | ** ** | **2004**   | ** ** | **2003**          | ** ** | **2002**          | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                | ** ** | ** ** | ** ** | **(As Restated)** | ** ** | **(As Restated)** | ** ** |
| **Cash  flows from operating activities**                                                 |       |       |       |              |       |              |       |
| Net income  (loss)                                                                        |       | $          | (464,832   | )                 | $          | 767,147           |       | $ | 1,454,928 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |       |       |              |       |              |       |
| Compensation  via treasury stock issued                                                   |       | 0          |       | 245               |       | 1,800             |       |
| Depreciation  and amortization                                                            |       | 369,695    |       | 385,655           |       | 333,070           |       |
| Investment  amortization                                                                  |       | 23,468     |       | 90,548            |       | 53,463            |       |
| Provision for  loan losses                                                                |       | 260,841    |       | 1,265,000         |       | 255,000           |       |
| Deferred  income taxes                                                                    |       | 11,811     |       | (378,030          | )          | (78,685           | )          |
| Increase in  CSV- life insurance                                                          |       | (200,037   | )          | (219,131          | )          | (226,892          | )          |
| Loss (gain)  on sale of investment securities                                             |       | 1,264,993  |       | (86,472           | )          | (705              | )          |
| (Gain) on  sale of OREO property                                                          |       | (5,481     | )          | 0                 |       | (8,516            | )          |
| (Gain) on  sale of student loans                                                          |       | (12,952    | )          | (24,012           | )          | 0                 |       |
| (Increase)  decrease in other assets                                                      |       | 70,177     |       | 18,048            |       | (329,997          | )          |
| (Increase)  decrease in accrued interest receivable                                       |       | 1,372      |       | 282,447           |       | (36,284           | )          |
| (Decrease)  in accrued interest payable                                                   |       | (11,378    | )          | (59,125           | )          | (111,019          | )          |
| Increase in  other liabilities                                                            |       | 115,751    |       | 227,194           |       | 211,180           |       |
| Net cash  provided by operating activities                                                |       | 1,423,428  |       | 2,269,514         |       | 1,517,343         |       |
|                                                                                      |       |       |       |              |       |              |       |
| **Cash  flows from investing activities**                                                 |       |       |       |              |       |              |       |
| Sales of  investment securities available for sale                                        |       | 10,939,235 |       | 6,299,942         |       | 825,158           |       |
| Maturities  of investment securities available for sale                                   |       | 5,374,058  |       | 20,568,343        |       | 20,021,820        |       |
| Purchases of  investment securities available for sale                                    |       | (6,532,381 | )          | (19,867,112       | )          | (27,077,051       | )          |
| Net  (increase) decrease in loans                                                         |       | 6,269,788  |       | 2,716,329         |       | (4,077,176        | )          |
| Purchases of  property and equipment                                                      |       | (206,504   | )          | (206,891          | )          | (596,779          | )          |
| Purchases of  FRB, ACBB and FHLB stock                                                    |       | (507,000   | )          | (295,500          | )          | (1,123,600        | )          |
| Redemptions  of FRB, ACBB and FHLB stock                                                  |       | 700,700    |       | 666,600           |       | 452,500           |       |
| Purchases of  officers’ life insurance                                               |       | 0          |       | (353,000          | )          | 0                 |       |
| Proceeds  from sale of OREO property                                                      |       | 211,680    |       | 0                 |       | 332,684           |       |
| Proceeds  from sale of student loans                                                      |       | 688,177    |       | 1,683,784         |       | 0                 |       |
| Net cash  provided (used) by investing activities                                         |       | 16,937,753 |       | 11,212,495        |       | (11,242,444       | )          |
|                                                                                      |       |       |       |              |       |              |       |
| **Cash  flows from financing activities**                                                 |       |       |       |              |       |              |       |
| Net  (decrease) in deposits                                                               |       | (1,506,205 | )          | (1,900,547        | )          | (4,013,003        | )          |
| Dividends  paid                                                                           |       | (517,425   | )          | (517,450          | )          | (502,626          | )          |
| Purchase of  treasury stock                                                               |       | (1,299     | )          | 0                 |       | 0                 |       |
| Net increase  (decrease) in line-of-credit borrowings                                     |       | (3,825,000 | )          | (12,425,000       | )          | 13,925,000        |       |
| Net cash  provided (used) by financing activities                                         |       | (5,849,929 | )          | (14,842,997       | )          | 9,409,371         |       |
|                                                                                      |       |       |       |              |       |              |       |
| Net increase  (decrease) in cash and cash equivalents                                     |       | 12,511,252 |       | (1,360,988        | )          | (315,730          | )          |
|                                                                                      |       |       |       |              |       |              |       |
| Cash and  cash equivalents at beginning of year                                           |       | 3,852,702  |       | 5,213,690         |       | 5,529,420         |       |
|                                                                                      |       |       |       |              |       |              |       |
| Cash and  cash equivalents at end of year                                                 |       | $          | 16,363,954 |              | $          | 3,852,702         |       | $ | 5,213,690 |   |

 

*The Notesto Consolidated Financial Statements are an integral part of these statements.*

 

5

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| ** **                                             | ** ** | **2004**   | ** ** | **2003**          | ** ** | **2002**          | ** ** |
|--------------------------------------------------------|------------|------------|------------|-------------------|------------|-------------------|------------|
| ** **                                             | ** ** | ** ** | ** ** | **(As Restated)** | ** ** | **(As Restated)** | ** ** |
| **Supplemental  disclosure of cash flow information:** |       |       |       |              |       |              |       |
|                                                   |       |       |       |              |       |              |       |
| Cash paid  during the year for:                        |       |       |       |              |       |              |       |
| Interest                                               |       | $          | 2,902,329  |              | $          | 3,324,108         |       | $ | 4,382,026 |   |
| Income taxes                                           |       | $          | 0          |              | $          | 424,500           |       | $ | 645,000 |   |
|                                                   |       |       |       |              |       |              |       |
| **Supplemental  disclosure of cash flow information:** |       |       |       |              |       |              |       |
| Unrealized  holding gain (loss), net of tax            |       | $          | 397,992    |              | $          |  (803,942    | )          | $ | 486,870 |   |
|                                                   |       |       |       |              |       |              |       |
| Treasury  stock issued as compensation                 |       | $          | 0          |              | $          | 245               |       | $ | 1,800 |   |
|                                                   |       |       |       |              |       |              |       |
| Other real  estate acquired in settlement of loans     |       | $          | 1,534,000  |              | $          | 206,199           |       | $ | 241,645 |   |

 

*The Notesto Consolidated Financial Statements are an integral part of these statements.*

 

6

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#### *** ***

#### ***NOTES TO CONSOLIDATED FINANCIAL STATEMENTS***

#### *** ***

**Note 1.****                      SignificantAccounting Policies**

 

***Nature of Operations***

*** ***

Fulton Bancshares Corporation’s primaryactivity consists of owning and supervising its subsidiaries:

 

•                  The Fulton County National Bank andTrust Company (“Bank”), which is engaged in providing banking and bank relatedservices, principally in Fulton, southern Huntingdon, Bedford, and westernFranklin Counties.  Its seven branchesare located in McConnellsburg (2), Warfordsburg, Hustontown, Orbisonia, St.Thomas and Breezewood.

 

•                  Fulton County Community Development Corporation was formedon June 7, 1996 to support efforts of the local downtown businessrevitalization project by making low interest loans to eligible smallbusinesses for the purpose of facade improvement.  Future projects are expected to include smallbusiness marketing, new business creation, small business education, andhousing for low-to-moderate income individuals.

 

***Principles of Consolidation***

 

The consolidated financial statements includethe accounts of the Corporation and its wholly-owned subsidiaries, The FultonCounty National Bank and Trust Company and the Fulton County CommunityDevelopment Corporation (collectively referred to as the “Corporation”).  All significant intercompany transactions andaccounts have been eliminated.

 

See Note 12 for parent company financialstatements.

 

***Basis of Accounting***

 

The Corporation uses the accrual basis ofaccounting.

 

***Use of estimates***

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the reporting period.  Actualresults could differ from those estimates.

 

Material estimates that are particularlysusceptible to significant change relate to the determination of the allowancefor losses on loans and the valuation of real estate acquired in connectionwith foreclosures or in satisfaction of loans. In connection with the determination of the allowances for losses onloans and foreclosed real estate, management obtains independent appraisals forsignificant properties.

 

While management uses available information to recognizelosses on loans and foreclosed real estate, future additions to the allowancesmay be necessary based on changes in local economic conditions.  In addition, regulatory agencies, as anintegral part of their examination process, periodically review the Corporation’sallowances for losses on loans and foreclosed real estate.  Such agencies may require the Corporation torecognize additions to the allowances based on their judgments aboutinformation available to them at the time of their examination.  Because of these factors, management’sestimate of credit losses inherent in the loan portfolio and the relatedallowance may change in the near term.

 

7

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***Investment Securities***

*** ***

The Corporation’s investments in securities are classifiedin three categories and accounted for as follows:

 

•                  ***Trading Securities***.  Securities held principally for resale in thenear term are classified as trading securities and recorded at their fairvalues.  Unrealized gains and losses ontrading securities are included in other income.

 

•                  ***Securities to be Held to Maturity***.  Bonds and notes for which the Corporation hasthe positive intent and ability to hold to maturity are reported at cost,adjusted for amortization of premiums and accretion of discounts, which arerecognized in interest income using the interest method over the period tomaturity.

 

•                  ***Securities Available for Sale***.  Securities available for sale consist ofequity securities, bonds and notes not classified as trading securities nor assecurities to be held to maturity.  Theseare securities that management intends to use as a part of its asset andliability management strategy and may be sold in response to changes ininterest rates, resultant prepayment risk and other related factors.

 

Purchase premiums and discounts are amortizedto earnings by the interest method from purchase date to maturity date.  Unrealized holding gains and losses, net oftax, on securities available for sale are reported as a net amount in othercomprehensive income.  Gains and losseson the sale of securities available for sale are determined using thespecific-identification method.  Fairvalues for investment securities are based on quoted market prices.

 

The Corporation has classified all of itsinvestment securities as “available for sale” at December 31, 2004 and2003, and during the years then ended.

 

***Loans and Reserve for PossibleLoan Losses***

 

Loans are stated at the amount of unpaidprincipal, reduced by a reserve for loan losses and increased or decreased bynet deferred loan origination fees and costs. Interest on loans is calculated by using the simple interest method ondaily balances of the principal amount outstanding.  The reserve for loan losses is establishedthrough a provision for loan losses charged to expense.  Loans are charged against the reserve forloan losses when management believes that the collectibility of the principalis unlikely.  Subsequent recoveries, ifany, are credited to the reserve.  Thereserve is an amount that management believes will be adequate to absorbpossible losses on existing loans that may become uncollectible, based onevaluations of the collectibility of loans and prior loan loss experience.  The evaluations are performed regularly andtake into consideration such factors as changes in the nature and volume of theloan portfolio, overall portfolio quality, review of specific problem loans,and current economic conditions that may affect the borrowers’ ability topay.  This evaluation is inherentlysubjective as it requires estimates that are susceptible to significantrevision as more information becomes available.

 

The reserve consists of specific and generalloss components.  The specific losscomponent relates to loans that are classified as either doubtful, substandardor special mention.  For such loans thatare also classified as impaired, an allowance is established when thediscounted cash flows (or collateral value or observable market price) of theimpaired loan is lower than the carrying value of that loan.  The general component covers non-classifiedloans and is based on historical loss experience adjusted for qualitativefactors.

 

8

----

 

***Nonaccrual/ImpairedLoans***

 

The accrual of interest income on loans, including impairedloans, ceases when principal or interest is past due 90 days or more andcollateral is inadequate to cover principal and interest or immediately if, inthe opinion of management, full collection is unlikely.  Interest accrued but not collected as of thedate of placement on nonaccrual status is reversed and charged against currentincome unless fully collateralized. Subsequent payments received either are applied to the outstandingprincipal balance or recorded as interest income, depending on management’sassessment of the ultimate collectibility of principal.

 

A loan is considered impaired when, based on currentinformation and events, it is probable that the Corporation will be unable tocollect the scheduled payments of principal or interest when due according tothe contractual terms of the loan agreement. Impairment is measured on a loan by loan basis by either the presentvalue of expected future cash flows discounted at the loan’s effective interestrate, the loan’s obtainable market price, or the fair value of the collateralif the loan is collateral dependent.

 

Consumer loans, comprised of smaller balance homogeneousloans, are collectively evaluated for impairment.

 

***Premises and Equipment***

 

Premises and equipment are carried at cost lessaccumulated depreciation.  Depreciationis calculated on primarily the straight-line method over the estimated usefullives of the various assets as follows:

 
| ** **              | ** ** | **Years** | ** ** |
|-------------------------|------------|-----------|------------|
|                    |       |      |       |
| Computer  software      |       | 3 - 5     |       |
| Premises                |       | 15 - 50   |       |
| Equipment  and vehicles |       | 3 - 25    |       |

 

Repairs and maintenance are charged to operations asincurred.

 

##### ***Real Estate Owned Other Than Premises***

##### *** ***

Other real estate owned includes foreclosedproperties for which the institution has taken physical possession inconnection with loan foreclosure proceedings. Assets received in foreclosure are recorded at the lower of theoutstanding principal balance of the related loans or the estimated fair valueof collateral held, less estimated costs to sell.  Any adjustment required to write down theproperty to net realizable value is charged to the allowance for loanlosses.  Costs of holding and maintainingthe property and subsequent adjustments to the carrying amount of the propertyare charged to expense when incurred.

 

***Earnings per Share***

 

Earnings per common share were computed basedon weighted averages of shares of common stock outstanding as follows:

 
| **Year** | ** ** | **Shares** | ** ** |
|----------|------------|------------|------------|
|     |       |       |       |
| 2004     |       | 492,799    |       |
| 2003     |       | 492,810    |       |
| 2002     |       | 492,772    |       |

 

9

----

 

***Federal Income Taxes***

 

As a result of certain timing differencesbetween financial statement and federal income tax reporting, includingdepreciation, loan losses, and deferred compensation, deferred income taxes areprovided in the financial statements. Deferred tax assets and liabilities are included in the financialstatements at currently enacted income tax rates applicable to the period inwhich the deferred tax assets and liabilities are expected to be realized orsettled.  As changes in tax laws or ratesare enacted, deferred tax assets and liabilities are adjusted through theprovision for income taxes.  See Note 9for further details.

 

***Statements of Cash Flows***

 

For purposes of the Statements of Cash Flows,cash and cash equivalents include those amounts in the balance sheet captions “cashand due from banks” and “federal funds sold”. The Corporation has elected to present the net change in interestbearing deposits with banks, deposits, and loans in the Statements of CashFlows.

 

***Fair values of financialinstruments***

 

The Corporation meets the requirements fordisclosure of fair value information about financial instruments, whether ornot recognized in the balance sheet.  Incases where quoted market prices are not available, fair values are based onestimates using present value or other valuation techniques.  Those techniques are significantly affectedby the assumptions used, including the discount rate and estimates of futurecash flows.  In that regard, the derivedfair value estimates cannot be substantiated by comparison to independentmarkets and, in many cases, could not be realized in immediate settlement ofthe instruments.  Certain financialinstruments and all nonfinancial instruments are excluded from the disclosurerequirements.  Accordingly, the aggregatefair value amounts presented do not represent the underlying value of theCorporation.

 

The following methods and assumptions were used by theCorporation in estimating fair values of financial instruments as disclosedherein:

 

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

 

***Securities Available for Sale.***  Fair values for investment securities arebased on quoted market prices.

 

***Federal Reserve, AtlanticCentral Banker’s Bank, and Federal Home Loan Bank Stocks.***  The carrying amount for these stocksapproximates their fair value since they are not actively traded and have noreadily determinable market value.

 

***Loans Receivable.***  For variable-rate loans that repricefrequently and have no significant change in credit risk, fair values are basedon carrying values.  Fair values forfixed rate loans are estimated using discounted cash flow analyses, usinginterest rates currently being offered for loans with similar terms toborrowers of similar credit quality. Fair values for impaired loans are estimated using discounted cash flowanalyses or underlying collateral values, where applicable.

 

***Deposit Liabilities.***  The fair values disclosed for demand depositsare, by definition, equal to the amount payable on demand at the reporting date(that is, their carrying amounts).  Thecarrying amounts of variable-rate, fixed-term money market accounts andcertificates of deposit approximate their fair values at the reportingdate.  Fair values for fixed-rate certificatesof deposit and IRA’s are estimated using a discounted cash flow calculationthat applies interest rates currently being offered to a schedule ofaggregated expected monthly maturities on time deposits.

 

10

----

 

***Short-Term Borrowings***.  The carrying amounts of federal fundspurchased and other short-term borrowings maturing within 90 days approximatetheir fair values.  Fair values of othershort-term borrowings are estimated using discounted cash flow analyses basedon the Corporation’s current incremental borrowing rates for similar types ofborrowing arrangements.

 

***Long-TermBorrowings***. The fair values of the Corporation’s long-term borrowings are estimatedusing discounted cash flow analyses based on the Corporation’s currentincremental borrowing rates for similar types of borrowing arrangements.

 

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

 

***Off-Balance-Sheet Instruments.***  The Corporation generally does not chargecommitment fees. Fees for standby letters of credit and their off-balance-sheetinstruments are not significant.

 

***Advertising***

 

The Corporation expenses advertising costs as incurred.  Advertising expenses for the years ended December 31,2004, 2003, and 2002, were $ 93,633, $ 93,876, and $ 93,217,respectively.

 

***Comprehensive income***

 

Comprehensive income isdefined as the change in equity from transactions and other events fromnonowner sources.  It includes allchanges in equity except those resulting from investments by stockholders anddistributions to stockholders. Comprehensive income includes net income andcertain elements of “other comprehensive income” such as foreign currencytransactions; accounting for futures contracts; employers accounting forpensions; and accounting for certain investments in debt and equity securities.

 

The Corporation has electedto report its comprehensive income in the statement of stockholders’equity.  The only element of “othercomprehensive income” that the Corporation has is the unrealized gain or losson available for sale securities.

 

The components of the changein net unrealized gains (losses) on securities were as follows:

 
| **Comprehensive income**                                               | ** ** | **2004**  | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------|------------|-----------|------------|----------|------------|----------|------------|
|                                                                   |       |      |       |     |       |     |       |
| Gross  unrealized holding gains (losses) arising during the year       |       | $         | (843,215   | )        | $          | (902,808 | )          | $ | 738,386 |   |
| Reclassification  adjustment for (gains) losses realized in net income |       | 1,264,993 |       | (86,472  | )          | (705     | )          |
| Net  unrealized holding gains (losses) before taxes                    |       | 421,778   |       | (989,280 | )          | 737,681  |       |
| Tax effect                                                             |       | (23,786   | )          | 185,338  |       | (250,811 | )          |
| Net change                                                             |       | $         | 397,992    |     | $          | (803,942 | )          | $ | 486,870 |   |

 

***Reclassifications***

 

Certain reclassificationshave been made to the 2003 and 2002 financial statements in order to conform tothe 2004 presentation.

 

11

----

 

**Note 2.****                      Investments**

# ** **

The amortized cost and fair value ofinvestment securities available for sale at December 31 were:

 
| ** **                                                | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|-----------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                                                | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| ** **                                                | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
| ** **                                                | ** ** | **2004**      | ** ** |
|                                                      |       |          |       |           |       |           |       |       |       |
| Obligations  of U.S. Government corporations and agencies |       | $             | 8,234,049  |           | $          | 4,647          |       | $          | 43,334     |   | $ | 8,195,362 |   |
| Obligations  of states and political subdivisions         |       | 5,394,721     |       | 65,929         |       | 5,804          |       | 5,454,846  |       |
| Mortgage-backed  securities                               |       | 5,266,536     |       | 18,967         |       | 4,531          |       | 5,280,972  |       |
| Other stock                                               |       | 59,064        |       | 0              |       | 5,042          |       | 54,022     |       |
|                                                      |       | $             | 18,954,370 |           | $          | 89,543         |       | $          | 58,711     |   | $ | 18,985,202 |   |
|                                                      |       |          |       |           |       |           |       |       |       |
| ** **                                                |       | **2003**      |       |
|                                                      |       |          |       |           |       |           |       |       |       |
| Obligations  of U.S. Government corporations and agencies |       | $             | 9,237,758  |           | $          | 50,640         |       | $          | 14,654     |   | $ | 9,273,744 |   |
| Obligations  of states and political subdivisions         |       | 5,395,500     |       | 77,886         |       | 10,444         |       | 5,462,942  |       |
| Mortgage-backed  securities                               |       | 3,127,194     |       | 4,536          |       | 7,571          |       | 3,124,159  |       |
| FNMA and  FHLMC preferred stock                           |       | 12,131,292    |       | 18,000         |       | 462,167        |       | 11,687,125 |       |
| Other stock                                               |       | 132,000       |       | 5,400          |       | 5,000          |       | 132,400    |       |
|                                                      |       | $             | 30,023,744 |           | $          | 156,462        |       | $          | 499,836    |   | $ | 29,680,370 |   |

 

The amortized cost and fair value ofinvestment securities available for sale at December 31, 2004, bycontractual maturity, are shown below. Contractual maturities will differ from expected maturities becauseborrowers may have the right to call or prepay obligations with or without callor prepayment penalties.

 
| ** **                              | ** ** | **Amortized** | ** ** | ** **     | ** ** |
|-----------------------------------------|------------|---------------|------------|----------------|------------|
| ** **                              | ** ** | **Cost**      | ** ** | **Fair Value** | ** ** |
|                                    |       |          |       |           |       |
| Due in one  year or less                |       | $             | 0          |           | $          | 0 |   |
| Due after  one year through five years  |       | 8,333,843     |       | 8,297,140      |       |
| Due after  five years through ten years |       | 2,266,542     |       | 2,314,388      |       |
| Due after  ten years                    |       | 3,028,385     |       | 3,038,680      |       |
| Mortgage-backed  securities             |       | 5,266,536     |       | 5,280,972      |       |
| Other stocks                            |       | 59,064        |       | 54,022         |       |
|                                    |       | $             | 18,954,370 |           | $          | 18,985,202 |   |

 

Proceeds from sales of securities availablefor sale during 2004 were $ 10,939,235. Gross gains and losses on those sales were $ 10,382 and$ 1,275,375, respectively.  Proceedsfrom maturities of investment securities during 2004 were $ 5,374,058,resulting in no gains or losses. Included in stockholders’ equity at December 31, 2004 is$ 20,349 of unrealized holding gains on securities available for sale, netof $ 10,483 in deferred taxes.

 

12

----

 

Proceeds from sales of securities availablefor sale during 2003 were $ 6,299,942. Gross gains and losses on those sales were $ 151,028 and$ 64,556, respectively.  Proceedsfrom maturities of investment securities during 2003 were $ 20,568,343,resulting in no gains or losses. Included in stockholders’ equity at December 31, 2003 is$ 377,643 of unrealized holding losses on securities available for sale,net of $ 34,270 in deferred taxes.

 

Proceeds from sales of securities availablefor sale during 2002 were $ 825,158. Gross gains and losses on those sales were $ 705 and $ 0,respectively.  Proceeds from maturitiesof investment securities during 2002 were $ 20,021,820, resulting in nogains or losses.  Included in stockholders’equity at December 31, 2002 is $ 426,299 of unrealized holding gainson securities available for sale, net of $ 219,609 in deferred taxes.

 

Information pertaining to securities with grossunrealized losses at December 31, 2004, aggregated by investment categoryand length of time that individual securities have been in a continuous lossposition follows:

 
| ** **                                                | ** ** | **Less Than Twelve Months:** | ** ** | **Over Twelve Months** | ** ** | **Total**      | ** ** |
|-----------------------------------------------------------|------------|------------------------------|------------|------------------------|------------|----------------|------------|
| ** **                                                | ** ** | **Gross**                    | ** ** | ** **             | ** ** | **Gross**      | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                                | ** ** | **Unrealized**               | ** ** | **Fair**               | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                                                | ** ** | **Losses**                   | ** ** | **Value**              | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Obligations of U.S. Government corporations and  agencies |       | $                            | 36,469     |                   | $          | 6,460,463      |       | $ | 6,865 |   | $ | 986,100 |   | $ | 43,334 |   | $ | 7,446,563 |   |
| Obligations of states and political subdivisions          |       | 0                            |       | 0                      |       | 5,804          |       | 1,251,033 |   | 5,804 |   | 1,251,033 |   |
| Mortgage-backed securities                                |       | 4,334                        |       | 1,681,583              |       | 197            |       | 46,512 |   | 4,531 |   | 1,728,095 |   |
| Other stock                                               |       | 42                           |       | 2,023                  |       | 5,000          |       | 52,000 |   | 5,042 |   | 54,023 |   |
|                                                      |       | $                            | 40,845     |                   | $          | 8,144,069      |       | $ | 17,866 |   | $ | 2,335,645 |   | $ | 58,711 |   | $ | 10,479,714 |   |

 

Management evaluates securities forother-than-temporary impairment at least on a quarterly basis, and morefrequently when economic or market concerns warrant such evaluation.  Consideration is given, to (1) thelength of time and the extent to which the fair value has been less than cost, (2) thefinancial condition and near-term prospects of the issuer for a period of timesufficient to allow for any anticipated recovery in fair value, and (3) theintent and ability of the Corporation to retain its investment for a period oftime sufficient to allow for any anticipated recovery in fair value.

 

At December 31, 2004, 7 obligations of U. S.Government corporations and agencies, 2 obligations of states and politicalsubdivisions, 7 mortgage-backed securities and 2 other stocks had unrealizedlosses.  At December 31, 2004, nodebt security had unrealized losses with depreciation of 5% or more from theCorporation’s amortized cost, while one marketable equity security had anunrealized loss of 9% from the Corporation’s cost basis.  This unrealized loss relates primarily to alocal financial institution in which there is a low volume of stockactivity.  In analyzing the issuer’sfinancial condition, management considers industry analysts’ reports, financialperformance and first hand knowledge of the issuer’s operations and reputation.

 

The Corporation is required to maintainminimum investments in certain stocks, which are recorded at cost since theyare not actively traded and therefore, have no readily determinable marketvalue. Consequently, the Corporation owns the following equity securities at December 31:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Federal Home  Loan Bank        |       | $        | 1,126,300  |     | $          | 1,320,000 |   |
| Atlantic  Central Bankers Bank |       | 10,000   |       | 10,000   |       |
| Federal  Reserve Bank          |       | 70,850   |       | 70,850   |       |
|                           |       | $        | 1,207,150  |     | $          | 1,400,850 |   |

 

13

----

 

Securities with a cost basis of$ 8,234,049 (fair value of $ 8,195,363) and $ 9,237,758 (fairvalue of $ 9,273,744) at December 31, 2004 and 2003, respectively,were pledged to secure public funds and for other purposes as required orpermitted by law.

 

**Note 3.****                      Loans**

 

Loans consist of the following at December 31 (inthousands):

 
| ** **                                                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                        |       |     |       |     |       |
| Real estate  loans                                                          |       |     |       |     |       |
| Secured by  farmland                                                        |       | $        | 12,754     |     | $          | 13,359 |   |
| Secured by 1-4  family residential                                          |       | 45,545   |       | 48,063   |       |
| Secured by  multifamily (5 or more) residential properties                  |       | 563      |       | 351      |       |
| Secured by  nonfarm nonresidential                                          |       | 16,999   |       | 18,625   |       |
| Loans to  finance agricultural production:                                  |       |     |       |     |       |
| Loans to  farmers                                                           |       | 5,715    |       | 8,850    |       |
| Commercial  and industrial loans                                            |       | 9,816    |       | 9,773    |       |
| Loans to  individuals for household, family and other personal expenditures |       | 2,524    |       | 3,784    |       |
| Obligations  of state and political subdivisions in the U.S.                |       | 523      |       | 475      |       |
| All other  loans                                                            |       | 31       |       | 9        |       |
|                                                                        |       | 94,470   |       | 103,289  |       |
| Less:  reserve for loan losses                                              |       | (1,821   | )          | (1,900   | )          |
|                                                                        |       | $        | 92,649     |     | $          | 101,389 |   |

 

Loans 90 days or more past due (stillaccruing interest) and those on nonaccrual status were as follows at December 31(in thousands):

 
| ** **                    | ** ** | **90 Days or More** | ** ** | **Nonaccrual** | ** ** |
|-------------------------------|------------|---------------------|------------|----------------|------------|
| ** **                    | ** ** | **Past Due**        | ** ** | **Status**     | ** ** |
| ** **                    | ** ** | **2004**            | ** ** | **2003**       | ** ** | **2002** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Loans  secured by real estate |       | $                   | 41         |           | $          | 0 |   | $ | 59 |   | $ | 699 |   | $ | 3,314 |   | $ | 1,525 |   |
|                          |       |                |       |           |       |   |   |   |   |   |   |   |   |
| Personal  loans               |       | 7                   |       | 0              |       | 11 |   | 0 |   | 74 |   | 0 |   |
|                          |       |                |       |           |       |   |   |   |   |   |   |   |   |
| Commercial  and other loans   |       | 0                   |       | 0              |       | 0 |   | 1,030 |   | 771 |   | 71 |   |
| Total                         |       | $                   | 48         |           | $          | 0 |   | $ | 70 |   | $ | 1,729 |   | $ | 4,159 |   | $ | 1,596 |   |

 

Foregone revenue on nonaccrualloans was as follows:

 
| ** **                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                 |       |     |       |     |       |     |       |
| Interest  income that would have been accrued at original loan rates |       | $        | 260,167    |     | $          | 147,128  |       | $ | 6,503 |   |
| Amount  recognized as interest income                                |       | 177,971  |       | 3,198    |       | 0        |       |
| Foregone  revenue                                                    |       | $        | 82,196     |     | $          | 143,930  |       | $ | 6,503 |   |

 

At December 31, 2004, the total recordedinvestment in impaired loans, all of which had allowances determined in accordancewith SFAS No. 114, amounted to approximately $ 1,857,000. The averagerecorded investment in impaired loans amounted to approximately$ 1,299,000 for the year ended December 31, 2004.  The allowance for loan losses related toimpaired loans amounted to approximately $ 925,000 at December 31,2004.  Interest income on impaired loansof $ 6,815 was recognized for cash payments received in 2004.  The Bank has no commitments to loanadditional funds to borrowers whose loans have been modified.  

 

14

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At December 31, 2003, the total recordedinvestment in impaired loans, all of which had allowances determined inaccordance with SFAS No. 114, amounted to approximately$ 740,000.  The average recordedinvestment in impaired loans amounted to approximately $ 1,064,000 for theyear ended December 31, 2003. The allowance for loan losses related toimpaired loans amounted to approximately $ 250,000 at December 31,2003.  Interest income on impaired loansof $ 1,043 was recognized for cash payments received in 2003.  The Bank has no commitments to loanadditional funds to borrowers whose loans have been modified.  There was no recorded investment in impairedloans at December 31, 2002.

 

During 2004 and 2003, the Corporation sold itsstudent loan portfolio.  Proceeds fromthe sale of these loans were $ 688,177 and $ 1,683,784, whichresulted in gains of $ 12,952 and $ 24,012 for the years ended December 31,2004 and 2003, respectively.

 

During 2004 and 2003, the Corporation sold certainmortgage loans to the Federal Home Loan Bank (FHLB), but the Corporationcontinues to service these loans for FHLB. The outstanding balance of these loans was $ 2,737,322 and  $ 2,228,413 at December 31, 2004and 2003, respectively.

 

**Note 4.****                      Reserve forLoan Losses**

 

Activity in the reserve for loan losses is summarized asfollows:

 
| ** **                                | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|-------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                      |       |      |       |      |       |      |       |
| Balance at  beginning of period           |       | $         | 1,899,643  |      | $          | 1,030,713 |       | $ | 845,045 |   |
| Recoveries                                |       | 24,135    |       | 15,036    |       | 7,441     |       |
| Current year  provision charged to income |       | 260,841   |       | 1,265,000 |       | 255,000   |       |
| Total                                     |       | 2,184,619 |       | 2,310,749 |       | 1,107,486 |       |
| Losses                                    |       | 363,455   |       | 411,106   |       | 76,773    |       |
| Balance at  end of period                 |       | $         | 1,821,164  |      | $          | 1,899,643 |       | $ | 1,030,713 |   |

 

**Note 5.****                      Loans toRelated Parties**

 

The Corporation has granted loans to its officersand directors and to their associates. Corporate policy requires that related party loans are made onsubstantially the same terms, including interest rates and collateral, as thoseprevailing at the time for comparable transactions with unrelated persons anddo not involve more than normal risk of collectibility.  The aggregate dollar amount of these loanswas $ 3,944,179 and $ 3,638,548 at December 31, 2004 and 2003,respectively.  During 2004,$ 3,260,392 of new loans were made and repayments totaled$ 2,954,761.  During 2003,$ 1,050,033 of new loans were made and repayments totaled $ 786,514.

 

Outstanding loans to employees totaled$ 754,733 and $ 1,148,163 at December 31, 2004 and 2003,respectively.

 

15

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**Note 6.****                      Premises andEquipment**

 

A summary of premises and equipment is as follows:

 
| ** **                                                 | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | **Depreciated** | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------------|------------|-----------------|------------|
| ** **                                                 | ** ** | **Cost**   | ** ** | **Depreciation** | ** ** | **Cost**        | ** ** |
| ** **                                                 | ** ** | **2004**   | ** ** |
| Premises and  improvements (including land $ 500,207) |       | $          | 3,837,739  |             | $          | 957,744         |       | $ | 2,879,995 |   |
| Equipment,  furniture and fixtures                         |       | 3,320,314  |       | 2,670,863        |       | 649,451         |       |
| Vehicles                                                   |       | 98,296     |       | 55,333           |       | 42,963          |       |
| Deposits on  equipment                                     |       | 23,907     |       | 0                |       | 23,907          |       |
|                                                       |       | $          | 7,280,256  |             | $          | 3,683,940       |       | $ | 3,596,316 |   |

 
| ** **                                                 |   | **2003**  |      |
|------------------------------------------------------------|--------|-----------|-----------|
| Premises and  improvements (including land $ 500,207) |   | $         | 3,810,227 |   | $ | 864,541 |   | $ | 2,945,686 |   |
| Equipment,  furniture and fixtures                         |   | 3,165,230 |      | 2,415,284 |   | 749,946 |   |
| Vehicles                                                   |   | 98,296    |      | 34,420 |   | 63,876 |   |
|                                                       |   | $         | 7,073,753 |   | $ | 3,314,245 |   | $ | 3,759,508 |   |

 

Depreciation and amortization expense on property andequipment and other real estate owned amounted to $ 369,695,$ 385,655, and $ 333,070 for the years end December 31, 2004,2003, and 2002, respectively.

 

During 2004, the Corporation entered into an agreement topurchase computer software.  The totalcontract amount is $ 47,815 of which $ 23,907 had been paid at December 31,2004.

 

**Note 7.****                      FinancialInstruments With Off-Balance-Sheet Risk/Commitments**

 

The Corporation is a party to financialinstruments with off-balance-sheet risk in the normal course of business tomeet the financial needs of its customers and to reduce its own exposure tofluctuations in interest rates.  Thesefinancial instruments include commitments to extend credit and standby lettersof credit.  Those instruments involve, tovarying degrees, elements of credit and interest rate risk in excess of theamount recognized in the balance sheets. The contract amounts of those instruments reflect the extent ofinvolvement the corporation has in particular classes of financial instruments.

 

The Corporation’s exposure to credit loss inthe event of nonperformance by the other party to the financial instrument forcommitments to extend credit and standby letters of credit and financialguarantees written is represented by the contractual amounts of thoseinstruments.  The Corporation uses thesame credit policies in making commitments and conditional obligations as itdoes for on-balance-sheet instruments.

 
| ** **                                                                               | ** ** | **Contract or Notional   Amount** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                               | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| Financial  instruments whose contract amounts represent credit risk at December 31: |       |                              |       |   |   |
| Commitments  to extend credit                                                            |       | $                                 | 11,142,000 |   | $ | 12,389,000 |   |
| Standby  letters of credit and financial guarantees written                              |       | 171,000                           |       | 91,000 |   |
|                                                                                          |            |                                   |            |  |  |  |  |

 

16

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Commitments to extend credit are agreementsto lend to a customer as long as there is no violation of any conditionestablished in the contract.  Commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee.  Since many ofthe commitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements.  The Corporation evaluates each customer’scredit worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Corporationupon extension of credit is based on management’s credit evaluation of thecustomer.  Collateral held varies but mayinclude accounts receivable, inventory, real estate, equipment, andincome-producing commercial properties.

 

Standby letters of credit and financialguarantees written are conditional commitments issued by the Corporation toguarantee the performance of a customer to a third party.  Those guarantees are primarily issued tosupport public and private borrowing arrangements.  The credit risk involved in issuing lettersof credit is essentially the same as that involved in extending loans tocustomers.  The corporation holdscollateral supporting those commitments when deemed necessary by management.

 

**Note 8.****                      RetirementPlan**

 

The Corporation maintains a 401-Kprofit-sharing plan covering substantially all full-time employees. The planallows contributions of up to 15% of eligible compensation by employees.  Additional Corporation contributions can bemade at the discretion of the board of directors.  The Corporation’s contributions made to theplan were $ 85,168, $ 110,100, and $ 104,206 for the years endedDecember 31, 2004, 2003 and 2002, respectively.

 

**Note 9.****                      FederalIncome Taxes**

 

The components of federal income tax expense are summarizedas follows:

 
| ** **                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current year  provision                       |       | $        | (20,967    | )        | $          | 305,342  |       | $ | 413,850 |   |
| Deferred  income taxes (benefits)             |       | 11,811   |       | (378,030 | )          | (78,685  | )          |
| Income tax  effect of securities transactions |       | 2,046    |       | 62,711   |       | 240      |       |
| Applicable  income taxes (credits)            |       | $        | (7,110     | )        | $          | (9,977   | )          | $ | 335,405 |   |

 

Federal income taxes were computed after reducing pretaxaccounting income for nontaxable interest and dividend income in the amount of$ 646,060, $ 670,932, and $ 593,555, for 2004, 2003, and 2002,respectively.

 

A reconciliation of the effective income tax rate to thefederal statutory rate is as follows:

 
| ** **                                                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Applicable  federal income tax rate                                          |       | 34.0     | %          | 34.0     | %          | 34.0     | %          |
| Reductions  resulting from:                                                  |       |     |       |     |       |     |       |
| Nontaxable  investment income and other items, net of nondeductible expenses |       | (35.5    | ) %        | 35.3     | %          | (14.8    | )%         |
| Effective  income tax rate                                                   |       | (1.5     | )%         | (1.3     | )%         | 19.2     | %          |

 

17

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Net deferred tax assets are included in other assets on thebalance sheet as follows:

 
| ** **                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Total  deferred tax assets (net of allowance) |       | $        | 997,985    |     | $          | 1,014,691 |   |
| Total  deferred tax liabilities               |       | (231,330 | )          | (260,012 | )          |
| Net deferred  tax asset                       |       | $        | 766,655    |     | $          | 754,679 |   |

 

The Corporation has recorded a valuation allowance for thedeferred tax assets related to realized and unrealized losses on FNMA and FHLMCpreferred stocks as management believes that it is not likely that they will beultimately realized.

 

During 2004 and 2003, these preferred stocks were sold at aloss of $ 1,271,012 and $ 97,972, respectively, which is considered acapital loss for federal income tax purposes that can only be realized whenoffset by capital gains and not ordinary income.  This tax benefit of $ 432,144 for 2004and $ 33,310 for 2003 can be carried forward for five years and willexpire at December 31, 2009 and 2008, respectively.

 

The tax effects of each type of significant item that giverise to deferred taxes are:

 
| ** **                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Capital loss  carryover                                         |       | $        | 432,144    |     | $          | 33,310 |   |
| Net  unrealized (gains) losses on securities available for sale |       | (10,483  | )          | 116,747  |       |
| Deferred  compensation                                          |       | 433,779  |       | 383,358  |       |
| Allowance  for loan losses                                      |       | 554,953  |       | 582,398  |       |
| Depreciation                                                    |       | (220,847 | )          | (225,743 | )          |
| Foregone  interest on non-accrual loans                         |       | 9,253    |       | 48,936   |       |
| Valuation  allowance                                            |       | (432,144 | )          | (184,327 | )          |
| Net deferred  tax asset                                         |       | $        | 766,655    |     | $          | 754,679 |   |
|                                                            |       |     |       |     |       |
| Increase  (decrease) in valuation allowance during year         |       | $        | 247,817    |     | $          | 184,327 |   |

 

**Note 10.****               Leases**

 

The Corporation is party to real estate leases withbase monthly rental charges of $ 3,662. These charges are to be adjusted on specified dates and by agreed uponamounts or by the net change in the consumer price index.  The leases expire on January 7, 2011 (asextended) and December 31, 2005, respectively.  Each lease contains a provision for renewalunder various terms at the Corporation’s option.  In addition, the Corporation leases certainequipment on a 54 month lease which expires on April 30, 2009.  Total rental expense charged to operationsfor the years ended December 31, 2004, 2003, and 2002 was $66,458,$68,131, and $ 64,195, respectively.

 

Based on the current monthly rent, futureminimum rental payments for the next five years are as follows:

 
| 2005 |   | $      | 66,408 |   |
|------|--------|--------|--------|--------|
| 2006 |   | 64,908 |   |
| 2007 |   | 64,908 |   |
| 2008 |   | 64,908 |   |
| 2009 |   | 49,932 |   |

 

18

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**Note 11.****               Deposits**

 

Included in interest-bearing deposits at December 31are NOW and Money Market Account balances totaling $ 18,304,499 and$ 20,476,269 at December 31, 2004 and 2003, respectively.

 

Time deposits of $ 100,000 and over aggregated$ 14,121,775 and $ 16,526,248 at December 31, 2004 and 2003,respectively.  Interest expense on timedeposits of $ 100,000 and over was $ 468,000, $ 504,000, and$ 1,009,000 for the years ended 2004, 2003, and 2002, respectively.

 

The amount of time deposits maturing over the next 5years as of December 31, 2004 is as follows:

 
| 2005   |   | $         | 29,992,624 |   |
|--------|--------|-----------|------------|--------|
| 2006   |   | 2,882,328 |       |
| 2007   |   | 9,261,695 |       |
| 2008   |   | 9,480,828 |       |
| 2009   |   | 3,956,520 |       |
|   |   | $         | 55,573,995 |   |

 

The Corporation accepts deposits of the officers anddirectors of the Corporation and its subsidiaries on the same terms, includinginterest rates, as those prevailing at the time for comparable transactionswith unrelated persons.  The aggregatedollar amount of deposits of officers and directors totaled approximately$ 3,441,000 and $ 3,137,000 at December 31, 2004 and 2003,respectively.

 

Overdrafts of $ 31,145 and $ 5,843 at December 31,2004 and 2003, respectively, were reclassified as loans for financial reportingpurposes.

 

19

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**Note 12.****               Fulton BancsharesCorporation (Parent Company Only) Financial Information**

 

The following are the condensed balancesheets, income statements and statements of cash flows for the parent companyas of and for the years ended December 31:

 

**Balance Sheets**

 
| ** **                                                                                    | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                    |       |       |       |       |       |
| Cash                                                                                          |       | $          | 94,293     |       | $          | 23,049 |   |
| Investment  in Fulton County National Bank and Trust Company                                  |       | 15,340,870 |       | 15,917,169 |       |
| Investment  in Fulton County Community Development Corporation                                |       | 27,202     |       | 31,196     |       |
| Securities  available for sale                                                                |       | 54,023     |       | 132,400    |       |
| Deferred  taxes & other assets                                                       |       | 1,714      |       | 0          |       |
| Total assets                                                                                  |       | $          | 15,518,102 |       | $          | 16,103,814 |   |
|                                                                                          |       |       |       |       |       |
| **Liabilities**                                                                               |       |       |       |       |       |
| Accounts  payable                                                                             |       | $          | 7          |       | $          | 19 |   |
| Deferred  taxes                                                                               |       | 0          |       | 136        |       |
| Total  liabilities                                                                            |       | 7          |       | 155        |       |
|                                                                                          |       |       |       |       |       |
| **Stockholders’  Equity**                                                                |       |       |       |       |       |
| Common  stock: par value $.625 per share; 4,000,000 shares authorized; 495,000 shares  issued |       | 309,375    |       | 309,375    |       |
| Additional  paid-in capital                                                                   |       | 2,051,337  |       | 2,051,337  |       |
| Retained  earnings                                                                            |       | 13,226,245 |       | 14,208,502 |       |
| Accumulated  other comprehensive income (loss)                                                |       | 20,349     |       | (377,643   | )          |
| Treasury  stock; shares at cost- 2004 - 2,210; 2003 - 2,185                                   |       | (89,211    | )          | (87,912    | )          |
| Total  stockholders’ equity                                                              |       | 15,518,095 |       | 16,103,659 |       |
|                                                                                          |       | $          | 15,518,102 |       | $          | 16,103,814 |   |

 

**Statements of Income**

**Years Ended December 31**

 
| ** **                                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash  dividends from wholly-owned subsidiary               |       | $        | 605,000    |     | $          | 575,000  |       | $ | 555,000 |   |
| Investment  income                                         |       | 1,986    |       | 1,580    |       | 1,360    |       |
| Gain on sale  of investment securities                     |       | 6,019    |       | 0        |       | 0        |       |
| Equity in  undistributed income of subsidiaries            |       | (981,877 | )          | 241,264  |       | 948,538  |       |
| Legal,  printing, supplies, amortization and other expense |       | (95,960  | )          | (50,697  | )          | (49,970  | )          |
| Net Income  (loss)                                         |       | $        | (464,832   | )        | $          | 767,147  |       | $ | 1,454,928 |   |

 

20

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**Statementsof Cash Flows**

**YearsEnded December 31**

 
| Cash flows  form operating activities:                                                |   |     |           |     |    |     |    |
|---------------------------------------------------------------------------------------|--------|----------|----------------|----------|---------|----------|---------|
| Net Income  (loss)                                                                    |   | $        |  (464,832 | )        | $       | 767,147  |    | $ | 1,454,928 |   |
| Adjustments  to reconcile net income to cash  provided  by operating activities: |   |     |           |     |    |     |    |
| Equity in  undistributed (income) loss of subsidiary                                  |   | 981,877  |           | (241,264 | )       | (948,538 | )       |
| Gain on sale  of investment securities                                                |   | (6,019   | )              | 0        |    | 0        |    |
| Compensation-treasury  stock issued                                                   |   | 0        |           | 245      |    | 1,800    |    |
| Increase  (decrease) in accounts payable                                              |   | (12      | )              | 7        |    | 12       |    |
| Net cash  provided by operating activities                                            |   | 511,014  |           | 526,135  |    | 508,202  |    |
|                                                                                  |   |     |           |     |    |     |    |
| Cash flows  form investing activities:                                                |   |     |           |     |    |     |    |
| Sales of  investment securities available for sale                                    |   | 78,954   |           | 0        |    | 0        |    |
| Net cash  provided by investing activities                                            |   | 78,954   |           | 0        |    | 0        |    |
|                                                                                  |   |     |           |     |    |     |    |
| Cash flows  from financing activities                                                 |   |     |           |     |    |     |    |
| Dividends  paid                                                                       |   | (517,425 | )              | (517,450 | )  | (502,626 | )  |
| Purchase of  treasury stock                                                           |   | (1,299   | )              | 0        |    | 0        |    |
| Net cash  (used) by financing activities                                              |   | (518,724 | )              | (517,450 | )  | (502,626 | )  |
|                                                                                  |   |     |           |     |    |     |    |
| Net increase  in cash and cash equivalents                                            |   | 71,244   |           | 8,685    |    | 5,576    |    |
|                                                                                  |   |     |           |     |    |     |    |
| Cash and  cash equivalents at beginning of year                                       |   | 23,049   |           | 14,364   |    | 8,788    |    |
|                                                                                  |   |     |           |     |    |     |    |
| Cash and  cash equivalents at end of year                                             |   | $        | 94,293         |     | $       | 23,049   |    | $ | 14,364 |   |

 

**Note 13.****               CompensatingBalances**

 

The Corporation is required to maintain certaincompensating balances with its correspondent banks to cover processing costsand service charges.  The balances withthese correspondent banks may exceed federally insured limits, which managementconsiders to be a normal business risk. Required compensating balances were $ 125,000 at December 31,2004 and 2003.

 

**Note 14.****               Dividends/RegulatoryMatters/Contingencies**

 

Dividends paid by Fulton BancsharesCorporation are generally provided from the Fulton County National Bank andTrust Company’s dividends to it.  TheFederal Reserve Board, which regulates bank holding companies, establishesguidelines which indicate that cash dividends should be covered by current yearearnings and the debt to equity ratio of the holding company must be belowthirty percent.

 

21

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Fulton County National Bank and Trust Company, as aNational Bank, is subject to the dividend restrictions set forth by theComptroller of the Currency.  Retainedearnings available for the payment of dividends without approval of theComptroller amounted to approximately $ 0, $ 1,171,000, and$ 1,946,000 at January 1, 2005, 2004, and 2003, respectively.  The Corporation is also subject to variousregulatory capital requirements administered by federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory, and possibly additional discretionary actionsby regulators that, if undertaken, could have a direct material effect on theCorporation’s financial statements. Under capital adequacy guidelines, the Corporation is required tomaintain minimum capital ratios.  The “leverageratio”, which compares capital to adjusted total balance sheet assets isrequired to be at least 4%.  “Tier I” and“Tier II” capital ratios compare capital to risk-weighted assets andoff-balance sheet activity.  The Tier Iratio is required to be at least 4%.  Thecombined Tier 1 and Tier II ratio is required to be at least 8%.

 

On March 23, 2005, the Bank’s Board ofDirectors entered into a “Stipulation and Consent to the Issuance of a ConsentOrder” (the “Order”) with the Office of the Comptroller of the Currency(OCC).  The Order requires the Bank toimplement and improve operating procedures and processes within stipulatedtimeframes. Under the Order, the Bank is required prospectively to maintain higherminimum capital ratios than the normal industry minimums.

 

At December 31 the Corporation’s actualratios and required levels were as follows:

 
| ** **                                                                               | ** ** | ** **   | ** ** | **Actual** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------|------------|------------|------------|
| ** **                                                                               | ** ** | **Required** | ** ** | **2004**   | ** ** | **2003** | ** ** |
| Leverage  (total adjusted capital/total average assets)                                  |       | 4.0          | %          | 10.8       | %          | 11.3 | % |
| Tier 1 (Tier  1 core capital/risk weighted assets)                                       |       | 4.0          | %          | 17.1       | %          | 15.7 | % |
| Total  capital (total capital plus allowance for loan  losses/risk weighted assets) |       | 8.0          | %          | 18.4       | %          | 16.9 | % |

 

As of  December 31,2004, the most recent notification from the Comptroller of the Currencycategorized the Bank as adequately capitalized under the regulatory frameworkfor prompt corrective action.  There areno conditions or events since that notification that management believes havechanged the Bank’s category, although the OCC has, through the Order, raisedthe Bank’s required ratios from the normal minimums shown above to thefollowing:

 
| Leverage |   | 10.0 | % |
|----------|--------|------|---|
| Tier I   |   | 14.0 | % |

 

Under the Order, the Bank must obtain OCCapproval before any executive officers or directors can be added to the Bank’smanagement.  The payment of dividends hasalso been temporarily suspended without prior OCC approval.

 

Effective March 22, 2005, similarrestrictions have been placed on the holding company, Fulton BancsharesCorporation, by the Federal Reserve Bank. The Bank is considered to be in “troubled” condition, as that term isdefined in Regulation Y, 12 C.F.R.225.71(d) and separate enforcementaction is also being considered by the Federal Reserve Bank.

 

The OCC has also informed the Bank ofpossible violations of laws and regulations with regard to the Bank SecrecyAct, the Truth-In-Lending Act, and the Real Estate Settlement Procedures Actwhich could result in future fines and penalties to the Bank and possiblereimbursements.  The amount of any futurefines or reimbursements cannot be reasonably estimated at December 31,2004.

 

Because of the possible regulatory violationsand other OCC scrutiny, the Bank’s FDIC insurance premiums and OCC assessmentfees will increase by approximately $ 168,000 in 2005.  Other costs of compliance with the Ordercannot be reasonably estimated at this time.

 

22

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In addition, on March 4, 2005, the Bankterminated its President.  While nolitigation has been initiated through March 23, 2005, litigation may ensueif certain matters are not amicably resolved between the Bank and its formerPresident.

 

**Note 15.****               Liabilities forBorrowed Money**

 

At December 31, 2004 and 2003, the Corporationhad an outstanding ten year, $ 15,000,000 loan with Federal Home Loan Bankof Pittsburgh.  The interest rate canincrease quarterly depending on market rates based on the 3 month LIBOR plus..1%, but any change is at the discretion of the FHLB.  The rate is currently fixed at 5.93% at December 31,2004 and 2003 and is payable monthly. The loan matures on July 12, 2010. There are significant penalties for prepayment.

 

The Corporation has established credit at FederalHome Loan Bank (FHLB) of Pittsburgh to improve liquidity.  The Corporation may borrow up toapproximately $ 57 million from FHLB under the terms of certain commitmentagreements, less any borrowings outstanding. The rates and terms of the commitments are flexible and are not fixeduntil the funds are withdrawn, but funds may not be borrowed for more than oneyear. Borrowings were $ 0 and $ 3,825,000 at December 31, 2004and 2003, respectively.  The variableinterest rate was 1.03% at December 31, 2003, and can change daily basedon FHLB’s cost of funds.  Collateral forthe borrowings consists of certain investments and mortgages approximating $ 65million at December 31, 2004.

 

On March 29, 2005, the Corporation was notifiedby Federal Home Loan Bank that it will be required to identify and deliverspecific assets as collateral equal to outstanding borrowings, plus accruedinterest and any penalties for early payment. This amount is approximately $ 16,063,000 at March 29, 2005.

 

**Note16.****               RealEstate Owned Other Than Premises**

## ** **

At December 31, 2004, real estate owned other thanpremises consisted of four related properties that the Corporation foreclosedon in 2004, which are carried at fair value less costs to sell of$ 1,534,000.  At December 31,2003, real estate owned other than premises consisted of four other propertiesthat the Corporation foreclosed on in 2003. These properties, which were carried at $ 206,199, were sold in2004.  Net proceeds from the sales in2004 were $ 211,680, which resulted in a gain of $5,481.

 

During 2002, the Corporation foreclosed on propertywith a value of $ 241,644, which was sold in 2002 for $ 154,471.  Proceeds of $ 87,173 were also receivedfrom an insurance company to satisfy the balance due from the foreclosure.

 

The Corporation also sold a rental property in2002.  Net proceeds from the sale were$ 91,040, which resulted in a gain of $ 8,516.

 

23

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**Note 17.****        ****Fair Value of FinancialInstruments**

 

The estimated fair values of the Corporation’sfinancial instruments were as follows at December 31, 2004 and 2003:

 
| ** **                                                                         | ** ** | **2004**             | ** ** | **2003**        | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------|------------|-----------------|------------|
| ** **                                                                         | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| ** **                                                                         | ** ** | **(000 Omitted)**    | ** ** |
| **FINANCIAL  ASSETS**                                                              |       |                 |       |            |       |   |   |   |   |
| Cash and due  from banks                                                           |       | $                    | 16,364     |            | $          | 16,364 |   | $ | 3,853 |   | $ | 3,853 |   |
| Securities  available for sale                                                     |       | 18,985               |       | 18,985          |       | 29,680 |   | 29,680 |   |
| Federal  Reserve, Atlantic Central Bankers Bank, and Federal Home Loan Bank stocks |       | 1,207                |       | 1,207           |       | 1,401 |   | 1,401 |   |
| Loans  receivable (net)                                                            |       | 92,649               |       | 93,409          |       | 101,389 |   | 101,529 |   |
| Accrued  interest receivable                                                       |       | 660                  |       | 660             |       | 661 |   | 661 |   |
|                                                                               |       |                 |       |            |       |   |   |   |   |
| **FINANCIAL  LIABILITIES**                                                         |       |                 |       |            |       |   |   |   |   |
| Time  certificates                                                                 |       | 56,860               |       | 56,610          |       | 59,628 |   | 60,791 |   |
| Other  deposits                                                                    |       | 52,761               |       | 52,761          |       | 51,497 |   | 51,497 |   |
| Accrued  interest payable                                                          |       | 243                  |       | 243             |       | 255 |   | 255 |   |
| Other  borrowed funds                                                              |       | 15,000               |       | 16,463          |       | 18,825 |   | 20,258 |   |
|                                                                                    |            |                      |            |                 |            |  |  |  |  |  |  |  |  |

 

**Note 18.****        ****Deferred Compensation and OtherBenefit Programs**

 

The Bank has adopted several benefit programs, someof which result in the deferral of payments for services rendered:

 

(1)   The SupplementalExecutive Retirement Plan - This Plan is funded by single premium lifeinsurance on the CEO and certain other Corporation executives, with theCorporation as beneficiary.  Actualpayments to the executives will not begin until their retirement.

 

(2)   The Director EmeritusProgram - This plan, funded by life insurance, will allow the Corporation toreward its directors for longevity of service to the Board.  Directors who qualify would be eligible atage 75 to receive $ 4,000 annually for up to 10 years under this program.

 

(3)   The Director DeferredCompensation Plan - This plan, also funded by life insurance, will allowdirectors to defer up to 100% of directors fees annually.  The amounts deferred will be paid out over aperiod of up to 10 years beginning when the director reaches the age of 75.

 

(4)   The OfficerSupplemental Life Insurance Plan provides for officer life insurance coverageto named third parties of generally double their current salary level, and isalso funded by single premium life insurance.

 

24

----

 

As a result of theseplans, the following items are recognized in the financial statements:

 
| ** **                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002**  | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| **Asset**                                           |       |     |       |     |       |      |       |
| Cash  surrender value of life insurance             |       | $        | 5,429,963  |     | $          | 5,229,926 |       | $ | 4,657,795 |   |
|                                                |       |     |       |     |       |      |       |
| **Liabilities**                                     |       |     |       |     |       |      |       |
| Supplemental  executive retirement plan             |       | 860,524  |       | 798,930  |       | 653,785   |       |
| Deferred  directors fees liability                  |       | 415,296  |       | 328,592  |       | 272,818   |       |
|                                                |       |     |       |     |       |      |       |
| **Income**                                          |       |     |       |     |       |      |       |
| Earnings on  cash surrender value of life insurance |       | 243,188  |       | 258,209  |       | 258,203   |       |
|                                                |       |     |       |     |       |      |       |
| **Expenses**                                        |       |     |       |     |       |      |       |
| Life  insurance expense                             |       | 39,553   |       | 39,078   |       | 31,311    |       |
| Supplemental  executive retirement expense          |       | 61,594   |       | 145,145  |       | 151,839   |       |
| Deferred  directors fees                            |       | 87,166   |       | 63,711   |       | 54,695    |       |
| Director  emeritus fees                             |       | 12,000   |       | 12,000   |       | 12,000    |       |
| Payments  made to retired director                  |       | 1,685    |       | 1,685    |       | 1,685     |       |
|                                                     |            |          |            |          |            |           |            |  |  |  |

 

## **Note19.**         Concentrations of Credit Risk

## ** **

The Corporation grants agribusiness, commercial andresidential loans to customers primarily in Fulton County, Pennsylvania andadjoining counties in Pennsylvania and Maryland.  Although the Corporation has a diversifiedloan portfolio, a significant portion of its customers’ ability to honor theircontracts is dependent upon the agribusiness economic sector at December 31,2004 (approximately 20% of loan portfolio and 119% of stockholders’ equity).

 

Management evaluates each customer’screditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon theextension of credit, is based on management’s credit evaluation of thecustomer.  Collateral held varies butgenerally includes equipment and real estate.

 

The Corporation maintains deposit balances atcorrespondent banks, which provide check collection and item processingservices to the corporation.  At times,the balances with these correspondent banks may exceed federally insuredlimits, which management considers to be a normal business risk.

 

The Corporation also had a significant concentrationin FNMA and FHLMC preferred stocks, representing 37% of total investments and72% of stockholders’ equity, at December 31, 2003.  All of these investments were sold in 2004.

 

25

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## **Note20.**         Prior Period Adjustments

## ** **

During the year ended December 31, 2004,management determined that prior years accounting treatment of premiums anddiscounts on certain investments was incorrectly applied.  Consequently, changes were made to theCorporation’s prior years financial statements to restate them as follows:

 
| ** **                                      | ** ** | **As originally reported** | ** ** | **Change** | ** ** | **As restated** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|------------|------------|-----------------|------------|
| Other  assets:                                  |       |                       |       |       |       |            |       |
| 12/31/2003                                      | *          | $                          | 1,563,882  |       | $          | (174,076        | )          | $ | 1,389,806 |   |
|                                            |       |                       |       |       |       |            |       |
| Accumulated  other comprehensive income (loss): |       |                       |       |       |       |            |       |
| 12/31/2001                                      |       | (62,672                    | )          | 2,101      |       | (60,571         | )          |
| 12/31/2002                                      |       | 124,003                    |       | 302,296    |       | 426,299         |       |
| 12/31/2003                                      |       | (570,538                   | )          | 192,895    |       | (377,643        | )          |
|                                            |       |                       |       |       |       |            |       |
| Retained  earnings:                             |       |                       |       |       |       |            |       |
| 12/31/2001                                      |       | 13,035,796                 |       | (29,293    | )          | 13,006,503      |       |
| 12/31/2002                                      |       | 14,262,722                 |       | (303,917   | )          | 13,958,805      |       |
| 12/31/2003                                      |       | 14,575,473                 |       | (366,971   | )          | 14,208,502      |       |
|                                            |       |                       |       |       |       |            |       |
| Interest and  dividends on preferred stock:     |       |                       |       |       |       |            |       |
| 2002                                            |       | 1,102,811                  |       | (416,097   | )          | 686,714         |       |
| 2003                                            |       | 883,930                    |       | (63,053    | )          | 820,877         |       |
|                                            |       |                       |       |       |       |            |       |
| Income  taxes:                                  |       |                       |       |       |       |            |       |
| 2002                                            |       | 476,878                    |       | (141,473   | )          | 335,405         |       |
| 2003                                            |       | (9,977                     | )          | 0          |       | (9,977          | )          |
|                                            |       |                       |       |       |       |            |       |
| Net Income:                                     |       |                       |       |       |       |            |       |
| 2002                                            |       | 1,729,552                  |       | (274,624   | )          | 1,454,928       |       |
| 2003                                            |       | 830,201                    |       | (63,054    | )          | 767,147         |       |
|                                            |       |                       |       |       |       |            |       |
| Earnings per  share:                            |       |                       |       |       |       |            |       |
| 2002                                            |       | 3.51                       |       | (0.56      | )          | 2.95            |       |
| 2003                                            |       | 1.68                       |       | (0.12      | )          | 1.56            |       |
|                                                 |            |                            |            |            |            |                 |            |  |  |  |

 

----

*  Afterreclassification of $ 4,454 to accrued interest receivable.

 

26

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIES**

 

**SELECTED FIVE-YEAR FINANCIAL DATA**

 
| ** **                                                            | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| **Income  Statement (000 omitted)**                                   |       |     |       |     |       |     |       |     |       |     |       |
| Interest  income                                                      |       | $        | 7,555      |     | $          | 8,365    |       | $        | 9,449      |     | $          | 10,142 |   | $ | 9,992 |   |
| Interest  expense                                                     |       | 2,891    |       | 3,175    |       | 4,271    |       | 5,432    |       | 5,210    |       |
| Provision  for loan losses                                            |       | 261      |       | 1,265    |       | 255      |       | 15       |       | 45       |       |
| Net interest  income after provision for loan losses                  |       | 4,403    |       | 3,925    |       | 4,923    |       | 4,695    |       | 4,737    |       |
| Securities  gains (losses)                                            |       | (1,265   | )          | 86       |       | 1        |       | 57       |       | 6        |       |
| Other  operating income                                               |       | 609      |       | 751      |       | 640      |       | 582      |       | 516      |       |
| Other operating  expense                                              |       | 4,219    |       | 4,005    |       | 3,774    |       | 3,450    |       | 3,370    |       |
| Income  (loss) before income taxes (benefit)                          |       | (472     | )          | 757      |       | 1,790    |       | 1,884    |       | 1,889    |       |
| Applicable  income tax (benefit)                                      |       | (7       | )          | (10      | )          | 335      |       | 428      |       | 450      |       |
| Net income  (loss                                                     |       | $        | (465       | )        | $          | 767      |       | $        | 1,455      |     | $          | 1,456 |   | $ | 1,439 |   |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| **Per  share amounts** based on weighted averages shares  outstanding |       | 492,799  |       | 492,810  |       | 492,772  |       | 492,747  |       | 494,054  |       |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| Income  (loss) before income taxes (benefit)                          |       | $        | (0.96      | )        | $          | 1.54     |       | $        | 3.63       |     | $          | 3.82 |   | $ | 3.82 |   |
| Income taxes  (benefit)                                               |       | (0.01    | )          | (0.02    | )          | 0.68     |       | 0.87     |       | 0.91     |       |
| Net Income  (loss)                                                    |       | (0.94    | )          | 1.56     |       | 2.95     |       | 2.95     |       | 2.91     |       |
| Cash  dividend paid                                                   |       | 1.05     |       | 1.05     |       | 1.02     |       | 0.95     |       | 0.86     |       |
| Book value                                                            |       | 31.49    |       | 32.68    |       | 33.80    |       | 30.88    |       | 28.75    |       |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| **Year-End  Balance Sheet (000 omitted)**                             |       |     |       |     |       |     |       |     |       |     |       |
| Total assets                                                          |       | $        | 141,757    |     | $          | 147,569  |       | $        | 162,492    |     | $          | 150,828 |   | $ | 140,480 |   |
| Loans                                                                 |       | 94,470   |       | 103,288  |       | 108,267  |       | 104,501  |       | 102,905  |       |
| Reserve for  loan losses                                              |       | (1,821   | )          | (1,899   | )          | (1,031   | )          | (845     | )          | (847     | )          |
| Net loans                                                             |       | 92,649   |       | 101,389  |       | 107,236  |       | 103,656  |       | 102,058  |       |
| Total  investment securities                                          |       | 20,192   |       | 31,081   |       | 39,447   |       | 31,899   |       | 24,643   |       |
| Deposits-noninterest  bearing                                         |       | 16,524   |       | 13,927   |       | 16,156   |       | 13,486   |       | 13,025   |       |
| Deposits-interest  bearing                                            |       | 93,097   |       | 97,200   |       | 96,870   |       | 103,552  |       | 92,107   |       |
| Total  deposits                                                       |       | 109,621  |       | 111,127  |       | 113,025  |       | 117,038  |       | 105,132  |       |
| Liabilities  for borrowed money                                       |       | 15,000   |       | 18,825   |       | 31,250   |       | 17,325   |       | 20,000   |       |
| Total  stockholders’ equity                                      |       | 15,518   |       | 16,104   |       | 16,658   |       | 15,217   |       | 14,204   |       |
|                                                                  |       |     |       |     |       |     |       |     |       |     |       |
| Ratios                                                                |       |     |       |     |       |     |       |     |       |     |       |
| Average  equity/average assets                                        |       | 11.23    | %          | 11.05    | %          | 10.19    | %          | 10.17    | %          | 9.82     | %          |
| Return on  average equity                                             |       | (2.85    | )%         | 4.52     | %          | 9.18     | %          | 9.92     | %          | 10.94    | %          |
| Return on  average assets                                             |       | (0.32    | )%         | 0.50     | %          | 0.94     | %          | 1.01     | %          | 1.07     | %          |

 

27

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***FULTON BANCSHARES CORPORATION ANDSUBSIDIARIES***

 

***SUMMARY OF QUARTERLY FINANCIAL DATA***

 

The unaudited quarterly results of operations forthe years ended December 31, 2004 and 2003 are as follows:

 
| ** **                                           | ** ** | **2004**          | ** ** | **2003**          | ** ** |
|------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                           | ** ** | **Quarter Ended** | ** ** | **Quarter Ended** | ** ** |
| **($ 000 omitted except per share)**            | ** ** | **Mar. 31**       | ** ** | **June 30**  | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** | **Mar. 31** | ** ** | **June 30** | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** |
|                                                 |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  income                                     |       | $                 | 1,916      |              | $          | 1,878 |   | $ | 1,880 |   | $ | 1,881 |   | $ | 2,305 |   | $ | 2,035 |   | $ | 2,115 |   | $ | 1,910 |   |
| Interest  expense                                    |       | 734               |       | 730               |       | 717 |   | 710 |   | 849 |   | 807 |   | 776 |   | 743 |   |
| Net interest  income                                 |       | 1,182             |       | 1,148             |       | 1,163 |   | 1,171 |   | 1,456 |   | 1,228 |   | 1,339 |   | 1,167 |   |
| Provision  for loan losses                           |       | 0                 |       | 261               |       | 0 |   | 0 |   | 30 |   | 1,235 |   | 0 |   | 0 |   |
| Net interest  income after provision for loan losses |       | 1,182             |       | 887               |       | 1,163 |   | 1,171 |   | 1,426 |   | (7 | ) | 1,339 |   | 1,167 |   |
| Securities  gains (losses)                           |       | 4                 |       | 6                 |       | 0 |   | (1,275 | ) | 0 |   | 150 |   | 0 |   | (64 | ) |
| Other income                                         |       | 159               |       | 163               |       | 134 |   | 153 |   | 194 |   | 199 |   | 183 |   | 175 |   |
| Other  expenses                                      |       | 1,014             |       | 1,089             |       | 1,004 |   | 1,112 |   | 969 |   | 970 |   | 1,002 |   | 1,064 |   |
| Operating  income before income taxes                |       | 331               |       | (33               | )          | 293 |   | (1,063 | ) | 651 |   | (628 | ) | 520 |   | 214 |   |
| Applicable  income taxes                             |       | 48                |       | (7                | )          | (13 | ) | (35 | ) | 144 |   | (230 | ) | 70 |   | 6 |   |
| Net income                                           |       | $                 | 283        |              | $          | (26 | ) | $ | 306 |   | $ | (1,028 | ) | $ | 507 |   | $ | (398 | ) | $ | 450 |   | $ | 208 |   |
|                                                 |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income  applicable to common stock               |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Per share  data:                                     |       |              |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                           |       | $                 | 0.57       |              | $          | (0.05 | ) | $ | 0.62 |   | $ | (2.09 | ) | $ | 1.03 |   | $ | (0.81 | ) | $ | 0.91 |   | $ | 0.42 |   |

 

28

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**FULTON BANCSHARES CORPORATION AND SUBSIDIARIES**

 

**DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS’ EQUITYINTEREST RATES AND INTEREST DIFFERENTIAL****Years Ended December 31,**

 
| ** **                                               | ** ** | **2004**             | ** ** | **2003**     | ** **  | **2002** | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|--------------|-------------|----------|------------|
| **(000  omitted)**                                       | ** ** | **Average  Balance** | ** ** | **Interest** | ** **  | **Rate** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| **ASSETS**                                               |       |                 |       |         |        |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment securities:                                   |       |                 |       |         |        |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable interest income                                  |       | $                    | 25,479     |         | $           | 981      |       | 3.9 | % | $ | 32,341 |   | $ | 1,377 |   | 4.3 | % | $ | 34,783 |   | $ | 1,714 |   | 4.9 | % |
| Nontaxable interest income                               |       | 5,395                |       | 207          |        | 3.8      | %          | 1,657 |   | 75 |   | 4.5 | % | 2,240 |   | 102 |   | 4.6 | % |
| Total investment securities                              |       | 30,874               |       | 1,189        |        | 3.9      | %          | 33,998 |   | 1,452 |   | 4.3 | % | 37,023 |   | 1,816 |   | 4.9 | % |
| Loans (net of unearned discounts)                        |       | 99,808               |       | 6,351        |        | 6.4      | %          | 107,140 |   | 6,913 |   | 6.5 | % | 105,219 |   | 7,621 |   | 7.2 | % |
| Other short-term investments                             |       | 1,129                |       | 15           |        | 1.3      | %          | 0 |   | 0 |   | 0.0 | % | 723 |   | 12 |   | 0.0 | % |
| Total interest earning assets                            |       | 131,811              |       | 7,554        |        | 5.7      | %          | 141,138 |   | 8,365 |   | 5.9 | % | 142,965 |   | 9,449 |   | 6.6 | % |
| Allowance for loan losses                                |       | (1,700               | )          |         |        |     |       | (1,159 | ) |   |   |   |   | (920 | ) |   |   |   |   |
| Cash and due from banks                                  |       | 4,122                |       |         |        |     |       | 3,748 |   |   |   |   |   | 3,667 |   |   |   |   |   |
| Bank premises and equipment                              |       | 3,694                |       |         |        |     |       | 3,869 |   |   |   |   |   | 3,861 |   |   |   |   |   |
| Other assets                                             |       | 7,464                |       |         |        |     |       | 6,025 |   |   |   |   |   | 5,990 |   |   |   |   |   |
| Total assets                                             |       | $                    | 145,391    |         |        |     |       |   | $ | 153,621 |   |   |   |   |   | $ | 155,563 |   |   |   |   |   |
| **LIABILITIES AND STOCHOLDERS’ EQUITY**             |       |                 |       |         |        |     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing demand deposits                         |       | 13,202               |       | 71           |        | 0.5      | %          | 11,925 |   | 76 |   | 0.6 | % | 11,431 |   | 85 |   | 0.7 | % |
| Savings deposits                                         |       | 24,188               |       | 169          |        | 0.7      | %          | 22,579 |   | 198 |   | 0.9 | % | 18,438 |   | 237 |   | 1.3 | % |
| Time deposits                                            |       | 58,816               |       | 1,732        |        | 2.9      | %          | 61,069 |   | 1,858 |   | 3.0 | % | 74,238 |   | 2,967 |   | 4.0 | % |
| Borrowings                                               |       | 16,202               |       | 918          |        | 5.7      | %          | 25,290 |   | 1,043 |   | 4.1 | % | 19,464 |   | 982 |   | 5.0 | % |
| Total interest bearing liabilities                       |       | 112,408              |       | 2,891        |        | 2.6      | %          | 120,863 |   | 3,175 |   | 2.6 | % | 123,571 |   | 4,271 |   | 3.5 | % |
| Demand deposits                                          |       | 15,081               |       |         |        |     |       | 14,966 |   |   |   |   |   | 15,237 |   |   |   |   |   |
| Other liabilities                                        |       | 1,573                |       |         |        |     |       | 821 |   |   |   |   |   | 905 |   |   |   |   |   |
| Total liabilities                                        |       | 129,062              |       |         |        |     |       | 136,650 |   |   |   |   |   | 139,713 |   |   |   |   |   |
| Stockholders’ equity                                |       | 16,329               |       |         |        |     |       | 16,971 |   |   |   |   |   | 15,850 |   |   |   |   |   |
| Total liabiliites and stockholders’ equity          |       | $                    | 145,391    |         |        |     |       |   | $ | 153,621 |   |   |   |   |   | $ | 155,563 |   |   |   |   |   |
| Net interest income/net yield on average earning  assets |       |                 |       | $            |  4,664 |     | 3.5        | % |   |   | $ | 5,190 |   | 3.7 | % |   |   | $ | 5,178 |   | 3.6 | % |

 

29

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIES**

 

**CHANGES INNET INTEREST INCOME**

 
| ** **                         | ** ** | **2004 Versus 2003**                      | ** ** | **2003 Versus 2002**                      | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                         | ** ** | **Increase (Decrease)  Due to Change in** | ** ** | **Increase (Decrease)  Due to Change in** | ** ** |
| **(000) omitted)**                 | ** ** | **Average  Volume**                       | ** ** | **Average  Rate**                         | ** ** | **Total Increase  (Decrease)** | ** ** | **Average  Volume** | ** ** | **Average  Rate** | ** ** | **Total Increase  (Decrease)** | ** ** |
| **Interest  Income**               |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Loans (net  of unearned discounts) |       | $                                         | (469       | )                                         | $          | (95 | ) | $ | (563 | ) | $ | 127 |   | $ | (834 | ) | $ | (707 | ) |
| Taxable  investment securities     |       | (273                                      | )          | (123                                      | )          | (396 | ) | (109 | ) | (228 | ) | (337 | ) |
| Nontaxable  investment securities  |       | 145                                       |       | (13                                       | )          | 132 |   | (27 | ) | (0 | ) | (27 | ) |
| Other  short-term investment       |       | 15                                        |       | 0                                         |       | 15 |   | (12 | ) | 0 |   | (12 | ) |
| Total  interest income             |       | (581                                      | )          | (230                                      | )          | (811 | ) | (21 | ) | (1,062 | ) | (1,083 | ) |
|                               |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| **Interest  Expense**              |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| Interest  bearing demand           |       | 8                                         |       | (12                                       | )          | (5 | ) | 3 |   | (12 | ) | (9 | ) |
| Savings  deposits                  |       | 13                                        |       | (43                                       | )          | (29 | ) | 41 |   | (80 | ) | (39 | ) |
| Time  deposits                     |       | (67                                       | )          | (58                                       | )          | (126 | ) | (452 | ) | (657 | ) | (1,109 | ) |
| Borrowings                         |       | (444                                      | )          | 319                                       |       | (125 | ) | 268 |   | (207 | ) | 61 |   |
| Total  interest expense            |       | (498                                      | )          | 218                                       |       | (284 | ) | (143 | ) | (944 | ) | (1,096 | ) |
|                               |       |                                      |       |                                      |       |   |   |   |   |   |   |   |   |
| **Net  interest income**           |       |                                      |       |                                      |       | $ | (527 | ) |   |   |   |   | $ | 13 |   |
|                                    |            |                                           |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

30

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# ***MANAGEMENT’SDISCUSSION AND ANALYSIS OF CONSOLIDATEDFINANCIAL CONDITION AND RESULTS OF OPERATIONS***

# ** **

Thefollowing is management’s discussion and analysis of the significant changes inthe financial condition and results of operations of Fulton BancsharesCorporation (the “Corporation”) and its wholly owned subsidiaries, The FultonCounty National Bank and Trust Company (the “Bank”) and Fulton County CommunityDevelopment Corporation (“FCCDC”).  Theconsolidated financial condition and results of operations consist almostentirely of the Bank’s financial condition and results of operations.  This discussion should be read in conjunctionwith the financial tables, consolidated financial statements and notes toconsolidated financial statements appearing elsewhere in this report.  Current performance does not guarantee,assure or may not be indicative of similar performance in the future.

 

Wehave made forward-looking statements in this document and in documents that weincorporated by reference that are subject to risk and uncertainties.  Forward-looking statements include theinformation concerning possible or assumed future results of operations of theCorporation, the Bank, and FCCDC.  Whenwe used words such as “believes”, “expects”, “anticipates” or other similarexpressions, we are making forward-looking statements.

 

Stockholdersshould note that many factors, some of which are discussed elsewhere in thisdocument and in the documentation that we incorporate by reference, couldaffect the future financial results of the Bank and could cause those resultsto differ materially from those expressed in our forward-looking statementscontained or incorporated by reference in this document.  These factors include the following:

 

•      Operating, legal and regulatory risks;

 

•      Economic, political and competitive forcesaffecting our banking business; and

 

•      The risk that our analysis of these risks andforces could be incorrect and/or the strategies developed to address them couldbe unsuccessful.

 

TheCorporation undertakes no obligation to publicly revise or update theseforward-looking statements to reflect events or circumstances that arise afterthe date of this report.  Readers shouldcarefully review the risk factors described in other documents that theCorporation files periodically with the Securities and Exchange Commission.

 

**RESULTS OF OPERATIONS**

 

**Restatement of Prior Years’ Results**

 

Duringthe year ended December 31, 2004, changes were made to the Corporation’sretained earnings to correct errors in the accounting of the amortization andaccretion of premiums and discounts on certain investments.  The prior years’ financials statements wererestated to reflect the effects of the amortization on each year.  Net income for the years ended December 31,2003 and 2002 were reduced by $ 63,000 and $ 275,000 respectively.  Earnings per share for the years ended December 31,2003 and 2002 were reduced by $ .12 and $ .56 per share respectively.  All discussion that follows is based onrestated results.

 

**Net Income (Loss)**

 

Netloss was ( $ 465,000) for 2004 compared to net income $ 767,000 for2003, representing a decrease of $ 1,232,000, or (161%).  Net income on an average share basis (fullydiluted) for 2004 was ($ .94), a decrease of $ 2.50 from the $ 1.56per share realized during 2003.

 

Netincome was $ 767,000 for 2003 compared to $ 1,455,000 for 2002,representing a decrease of $ 688,000 or (47%).  Net income on an average per share basis(fully diluted) for 2003 was $ 1.56, a decrease of $ 1.39 from the$ 2.95 per share realized during 2002.

 

31

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**Net Interest Income**

 

Totalinterest income for 2004 was $ 7,554,000 compared with $ 8,365,000earned during 2003, a decrease of $ 811,000, or 10%.  A decrease in average volume of loans andinvestments in 2004 reduced interest income by $ 581,000 while a decreasein average rates on earning assets reduced interest income an additional$ 230,000.  Loans decreased as aresult of customers refinancing to other institutions due to rate, due toworkouts of nonperforming loans and due to the departure of the senior lenderin 2004.  The lower rates earned on loanswas a result of local and national market forces.  Investments average balance decreased due tothe decline in deposits (which fund investments and other assets) and lower useof borrowings to fund investments in 2004. The rates on investments decreased due to national market forces and achange in the mix of investment types.

 

Totalinterest income for 2003 was $ 8,365,000 compared with $ 9,449,000earned during 2002, for a decrease of $ 1,084,000, or 12%.  The decrease was primarily a result of asignificant decrease in interest rates earned on loans and investments due tolocal and national market forces.  Loweraverage balance of investments was mostly offset by an increase in averageloans in 2003 compared with the same period in 2002.

 

Averageearning assets decreased 7% in 2004 and decreased 1% in 2003.  Average investments decreased 9% in2004.  The Corporation sold its entireposition in FNMA/FHLMC preferred stocks during the fourth quarter of 2004 dueto concerns about protracted market value impairment in an expected return torising rates environment and due to regulatory concerns about the Bank’sconcentration in this investment type.  Dueto the timing of the sales, the majority of the proceeds were in cash atyear-end.  Subsequent reinvestments werein shorter duration agency mortgage-backed securities that were purchased afteranalysis of the Corporation’s overall interest rate risk position.  The preferred stock sale resulted in a loss of$ 1.3 million and was a material cause of the Corporation’s net lossbefore taxes.  The loss on sale of thepreferred stock is considered a capital loss by applicable tax code and acurrent tax benefit was not available. The 2003 decrease in investments was a result of a decrease in depositfunding and an increase in the average loans outstanding.

 

Loans,the highest earning assets decreased on average by 7% in 2004.  Average loans, which typically produce higheryields than investments, increased 2% in 2003.

 

Totalinterest expense was $ 2,891,000 for 2004, a decrease of $ 284,000,or 9%, from the $ 3,175,000 for 2003. The decrease was a result of lower use of borrowings for funding in 2004and lower balances and rates on time and savings products.  Lower funding sources were required in 2004due to lower loan production.  Totalinterest expense was $ 3,175,000 for 2003, a decrease of $ 1,096,000,or 26%, from the $ 4,271,000 for 2002. The decrease was due primarily to a significant decrease in interestrates paid on deposits and short-term borrowings as a result of national andlocal market interest rates.

 

Averageinterest-bearing liabilities decreased 7% in 2004 and decreased 2% in2003.  Average borrowings decreased 36%in 2004 as there was less use of overnight borrowing to fund longer durationassets because of the interest rate risk involved.  Average time deposits decreased 4% as aconservative rate posture was maintained in light of the lack of loanproduction.  Core deposits increased as aresult of improving economic conditions, varying levels of local governmentfunds, and customers temporarily deploying funds while waiting for time depositrates to increase.  Average borrowingsincreased 30% in 2003 to take advantage of a steep yield curve in a low rateenvironment.  Time deposits decreased dueto customer reaction to the low rate environment.

 

Netinterest income is the difference between total interest income and totalinterest expense.  Interest income is generatedthrough earning assets, which include loans, deposits with other banks, andinvestments.  Interest income isdependent on many factors including the volume of earning assets; level ofinterest rates; changes in interest rates; and volumes of nonperformingloans.  The cost of funds varies with thevolume of funds necessary to support earning assets; rates paid to maintaindeposits; rates paid on borrowed funds; and level of interest-free deposits.

 

32

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Netinterest income for 2004 totaled $ 4,664,000, down $ 526,000, or 10%from 2003.  Net interest income for 2003totaled $ 5,190,000, up $ 12,000, or .2% from 2002.  Liquidity and interest rate risk aremonitored on a regular basis for management and board of director action.  Management intends to stabilize its netinterest margin by competitively pricing loans and deposits and by structuringinterest-earning assets and liabilities to maintain a desired net interestmargin while maintaining the safety and soundness of the Corporation.

 

**Other Income and Expenses**

 

Otherincome represents service charges on deposit accounts, commissions on loaninsurance, fees for official checks and other services, safe deposit boxrentals, fees for trust services, securities gains (losses), gains(losses) onsales of loans and other real estate owned, and earnings on cash surrendervalue of directors and officers life insurance.

 

In2004 the liquidation of the Corporation’s investment in preferred stockresulted in a loss of $1.3 million and was a material cause of the Corporation’snet loss before taxes.  In addition, theloss on sale of the preferred stock is considered a capital loss by applicabletax code and a current tax benefit was not available on the loss.  Partially offsetting this loss was a gain on abank stock investment held by the holding company of $6,000.  In 2003 the bank realized a net gain of $86,000 on the sale of investment securities.

 

Besidesthe loss on sales of investments, other income decreased $ 141,000, or 19%in 2004 compared to 2003.  Servicecharges on deposits decreased $ 45,000 or 21% in 2004 due to the closing ofaccounts that were providing significant fee income.  Service charges increased $14,000 or 7% in2003 due to higher overdraft fee occurrences. Other fee income decreased $ 66,000 or 30% due to lower mortgage feeincome, printed check upcharges and settlement services income.  Other fees sources increased $87,000, or 65%in 2003 due to increases in mortgage fee and settlement services revenue.  These fees are sensitive to interest ratelevels, generally increasing in declining rate environments due to refinancingactivity.  Trust services and sale offinancial product revenue decreased in both 2004 and 2003 due to the bankoutsourcing these services which typically have high direct cost and complianceand legal risks.  The Corporation hadgains on sales of student loans of $11,000 and $24,000 in 2004 and 2003respectively as it exited direct origination and administration in favor of a referralprocess that entails no direct costs. Earnings on bank-owned life insurance decreased $ 15,000 or 6% in 2004due to decreases in crediting rates that reflect, but generally lag, othermarket rates.

 

Noninterestexpenses are classified into six main categories:  salaries and employee benefits; occupancy andfurniture and equipment expenses that include depreciation, maintenance,utilities, taxes, insurance and rents; professional and other fees involved inoriginating and collecting loans; data processing expenses; FDIC insurancepremiums; and other operating expenses that include all other expenses incurredin normal operations.

 

Salariesand benefits for 2004 decreased by $ 25,000 or 2% compared 2003.  New hires, merit pay increases and a significantincrease in health insurance costs (up 21%) were offset by the eliminatedsalary and deferred benefit reversals attributable to the departure of certainsenior officers and by a lower elective contribution to the 401 K plan.  Salaries and benefits expenses decreased 1% in2003 due to staff turnover and attendant difference in salary levels.  Occupancy and furniture and equipmentexpenses decreased $ 27,000 or 3% due to lower maintenance, utilities anddepreciation expense in 2004. In 2003, occupancy and furniture and equipmentexpenses increased $ 87,000 or 12% due to higher maintenance, utilitiesand technology upgrades that increased depreciation.  Professional and other loan-related expensesincreased $ 174,000 or 94% in 2004 as the Corporation incurred materialexpenses to work problem credits, to deal with regulatory compliance concernsand to outsource certain functions on a temporary basis due to the departure ofcertain staff.  Professional and otherloan-related expenses increased $ 83,000 or 82% in 2003 due to outsourcedloan

 

33

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functionsand collection efforts.  In 2004, dataprocessing expenses increased $ 29,000; one cause was the cost attendant tooffering Internet banking.  Dataprocessing expense in 2003 was similar to the prior year.  FDIC premium expense increased $ 15,000or 87% in 2004 due to a higher risk rating assigned by regulators.  FDIC premiums declined 14% in 2003 due to alower deposit base.  FDIC premiums willmaterially increase in 2005 as a result of a higher regulatory risk ratingassigned to the Bank.  Other operatingexpenses increased $ 47,000 or 5% for 2004 and $ 84,000 or 9% for 2003.Theincrease in 2004 included supply costs to establish customer identificationfiles required by regulations, increased director oversight costs and highershares tax.  The increase in 2003 was inpart due to increases in communication expenses, check losses, increased sharestax and community support costs.

 

**Income Taxes**

 

Applicableincome taxes changed between 2004, 2003, and 2002 because of changes in pretaxaccounting income and taxable income. The effective tax (benefit) rate for 2004 was (1.5%) compared to (1.3%)and 19.2% for 2003 and 2002, respectively. The less favorable effective income tax (benefit) rate for 2004reflected the loss on sale of the preferred stock which is considered a capitalloss by applicable tax code.  Because theCorporation did not have material capital gains in the past nor can capitalgains be predicted in the future, the 2004 capital loss does not produce acurrent tax benefit.  The tax rate ineach year is reduced by the dividends received deduction for FNMA/FHLMCpreferred stock and tax-exempt interest on obligations of state and politicalsubdivisions.  See Note to FinancialStatement number 9 for more information on the components of federal income taxexpense.

 

**The following table presents a summary of significant earnings andcapital ratios:**

 
| ** **                | ** ** | **2004**   | ** ** | **2003**          | ** ** | **2002**          | ** ** |
|---------------------------|------------|------------|------------|-------------------|------------|-------------------|------------|
| ** **                | ** ** | ** ** | ** ** | **(as restated)** | ** ** | **(as restated)** | ** ** |
| Average  assets           |       | $          | 145,391    |              | $          | 153,621           |       | $ | 155,563 |   |
| Net income  (loss)        |       | $          | (465       | )                 | $          | 767               |       | $ | 1,455 |   |
| Average  equity           |       | $          | 16,329     |              | $          | 16,971            |       | $ | 15,850 |   |
| Cash  dividends paid      |       | $          | 517        |              | $          | 517               |       | $ | 503 |   |
| Return on  average assets |       | (.32       | )%         | 0.50              | %          | .94               | %          |
| Return on  average equity |       | (2.85      | )%         | 4.52              | %          | 9.18              | %          |
| Dividend  payout ratio    |       | 211.18     | %          | 67.41             | %          | 34.57             | %          |
| Equity to  asset ratio    |       | 11.23      | %          | 11.05             | %          | 10.19             | %          |

 

**FINANCIAL CONDITION**

 

Totalassets at December 31, 2004 were $ 141,757,000, a 4% decrease from December 31,2003.  Assets declined due to a reductionin deposits (which fund asset levels), down $1,506,000, or 1% and due to theelimination of $ 3,825,000 in short-term borrowings which required a reductionin investments.  Investments declined by$10,695,000 or 36% in 2004.  The Corporationsold its entire position in FNMA/FHLMC preferred stocks during the fourthquarter of 2004 due to concerns about protracted market value impairment in anexpected return to a rising rates environment and due to regulatory concernsabout the Bank’s concentration in this investment type.  Due to the timing of the sales, the majorityof the proceeds were in cash at year-end. Subsequent reinvestments were in shorter duration agency mortgage-backedsecurities that were purchased after analysis of the Corporation’s overallinterest rate risk position.

 

34

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Thefollowing table shows the maturities of investment securities at book value asof December 31, 2004, and weighted average yields of such securities.  Yields are shown on a tax equivalent basis,assuming a 34% federal income tax rate.

 
| **(000 omitted)**            | ** ** | **Within 1  year** | ** ** | **After 1  year but  within 5  years** | ** ** | **After 5 years  but within  10 years** | ** ** | **After 10  years** | ** **  | **Total** | ** ** |
|------------------------------|------------|--------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|---------------------|-------------|-----------|------------|
| Bonds:                       |       |               |       |                                   |       |                                    |       |                |        |      |       |
|                         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| U. S. Government  agencies   |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Book value                   |       | $                  | 0          |                                   | $          | 8,234                                   |       | $                   | 0           |      | $          | 0 |   | $ | 8,234 |   |
| Yield                        |       | 0                  | %          | 3.04                                   | %          | 0                                       | %          | 0                   | %           | 3.04      | %          |
|                         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| State and  municipal         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Book value                   |       | 0                  |       | 100                                    |       | 2,267                                   |       | 3,028               |        | 5,395     |       |
| Yield                        |       | 0                  | %          | 6.44                                   | %          | 5.91                                    | %          | 5.77                | %           | 5.84      | %          |
|                         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Mortgage-Backed              |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Book value                   |       | 0                  |       | 0                                      |       | 0                                       |       | 5,266               |        | 5,266     |       |
| Yield                        |       | 0                  | %          | 0                                      | %          | 0                                       | %          | 3.89                | %           | 3.89      | %          |
|                         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Total book  value            |       | $                  |  0    |                                   | $          |  8,334                             |       | $                   |  2,267 |      | $          |  8,294 |   | $ |  18,895 |   |
|                         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Yield                        |       | 0                  | %          | 3.08                                   | %          | 5.91                                    | %          | 4.57                | %           | 4.07      | %          |
|                         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Equity  Securities:          |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Total Equity  Securities     |       |               |       |                                   |       |                                    |       |                |        | $         |  59   |   |
| Yield                        |       |               |       |                                   |       |                                    |       |                |        | 2.88      | %          |
|                         |       |               |       |                                   |       |                                    |       |                |        |      |       |
| Total  Investment Securities |       |               |       |                                   |       |                                    |       |                |        | $         | 18,954     |   |
| Yield                        |       |               |       |                                   |       |                                    |       |                |        | 4.06      | %          |

 

Totalassets at December 31, 2003 were $ 147,569,000, down$ 14,923,000 or 9% compared to December 31, 2002.  The decrease was due to a 2% reduction indeposit funding and a reduction of $ 12,425,000 in short-termborrowings.  Investments decreased $ 8,366,000or 21% because of sales taken to recognize gains in the portfolio.

 

**Loans**

 

Grossloans receivable at December 31, 2004 totaled $ 94,470,000 comparedto $ 103,289,000, a decrease of $ 8,819,000 or 9%.  Most significant loan categories declined asa result of the absence of a senior commercial lender during the year,increased regulatory scrutiny, loans paid off in troubled loan workout effortsand mortgage refinancing to mass market lenders.

 

Grossloans receivable at December 31, 2003 decreased $ 4,978,000 or 5% fromDecember 31, 2002. Mortgage and personal loan refinancing to other lenderswas responsible for much of the decrease because of a low rate environment.

 

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Thefollowing table presents the loan portfolio at the end of each of the last fiveyears:

 
| **(000 omitted)**                                                | ** ** | **2004** | ** **   | **2003** | ** ** | **2002**      | ** ** | **2001** | ** **    | **2000** | ** ** |
|------------------------------------------------------------------|------------|----------|--------------|----------|------------|---------------|------------|----------|---------------|----------|------------|
| Commercial,  financial and agricultural                          |       | $        | 15,531       |     | $          | 18,623        |       | $        | 15,171        |     | $          | 17,418 |   | $ | 13,097 |   |
| Real estate  - Construction                                      |       | 0        |         | 0        |       | 0             |       | 0        |          | 0        |       |
| Real estate  - Mortgage                                          |       | 75,861   |         | 80,398   |       | 82,098        |       | 78,796   |          | 80,020   |       |
| Installment  and other personal loans (net of unearned discount) |       | 3,078    |         | 4,268    |       | 10,998        |       | 8,287    |          | 9,788    |       |
| Total loans                                                      |       | $        |  94,470 |     | $          |  103,289 |       | $        |  108,267 |     | $          |  104,501 |   | $ |  102,905 |   |

 

Presentedbelow are the approximate maturities of the loan portfolio (excluding realestate mortgages and installments) at December 31, 2004:

 
| **(000 omitted)**                       | ** ** | **Under One  Year** | ** ** | **One to Five  Years** | ** ** | **Over Five  Years** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|---------------------|------------|------------------------|------------|----------------------|------------|-----------|------------|
|                                    |       |                |       |                   |       |                 |       |      |       |   |   |   |   |
| Commercial,  financial and agricultural |       | $                   | 12,179     |                   | $          | 1,522                |       | $         | 1,830      |   | $ | 15,531 |   |
|                                    |       |                |       |                   |       |                 |       |      |       |
| Real estate  - Construction             |       | 0                   |       | 0                      |       | 0                    |       | 0         |       |
| Total                                   |       | $                   | 12,179     |                   | $          | 1,522                |       | $         | 1,830      |   | $ | 15,531 |   |

 

Thefollowing table presents the approximate amount of fixed rate loans andvariable rate loans due as of December 31, 2004:

 
| **(000 omitted)**                    | ** ** | **Fixed Rate  Loans** | ** ** | **Variable Rate  Loans** | ** ** |
|--------------------------------------|------------|-----------------------|------------|--------------------------|------------|
|                                 |       |                  |       |                     |       |   |   |
| Due within  one year                 |       | $                     | 3,338      |                     | $          | 20,916 |   |
| Due after  one but within five years |       | 8,908                 |       | 8,862                    |       |
| Due after  five years                |       | 19,279                |       | 33,167                   |       |
| Total                                |       | $                     | 31,525     |                     | $          | 62,945 |   |

 

**Allowance for Loan Losses and Related Provision**

 

Theprovision for loan losses was $ 261,000 in 2004 compared to$ 1,265,000 in 2003 and $ 255,000 in 2002. The provision expense ineach year was based on management’s evaluation of the adequacy of the allowancefor loan losses and represent amounts deemed necessary to maintain theallowance at the appropriate level based on the quality of the loan portfolioand economic conditions.  Actualcharge-offs (net of recoveries) were $ 339,000 in 2004, $ 396,000 in2003 and $ 70,000 in 2002.  The allowancefor loan losses was deemed to adequately reflect the risk inherent in the loanportfolio at December 31, 2004.

 

36

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Thefollowing table is a summary of loan loss experience for the past five years.

 
| ** **                                                    | ** ** | **Years Ended December 31** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|
| **(000 omitted)**                                             | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|                                                          |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Average  total loans outstanding (net of unearned income)     |       | $                                | 99,808     |   | $ | 107,140 |   | $ | 105,219 |   | $ | 105,028 |   | $ | 98,052 |   |
|                                                          |       |                             |       |   |   |   |   |   |   |   |   |
| Allowance  for loan losses, beginning of period               |       | $                                | 1,900      |   | $ | 1,031 |   | $ | 845 |   | $ | 847 |   | $ | 800 |   |
| Additions to  provision for loan losses charged to operations |       | 261                              |       | 1,265 |   | 255 |   | 15 |   | 45 |   |
| Loans  charged off during the year                            |       |                             |       |   |   |   |   |   |   |   |   |
| Real estate                                                   |       | 2                                |       | 25 |   | 0 |   | 0 |   | 0 |   |
| Commercial  and agricultural                                  |       | 343                              |       | 363 |   | 3 |   | 20 |   | 3 |   |
| Installment                                                   |       | 19                               |       | 23 |   | 73 |   | 14 |   | 29 |   |
| Total  charge-off’s                                      |       | 364                              |       | 411 |   | 76 |   | 34 |   | 32 |   |
|                                                          |       |                             |       |   |   |   |   |   |   |   |   |
| Recoveries  of loans previously charged off:                  |       |                             |       |   |   |   |   |   |   |   |   |
| Real estate                                                   |       | 3                                |       | 6 |   | 0 |   | 0 |   | 0 |   |
| Commercial  and agricultural                                  |       | 7                                |       | 0 |   | 1 |   | 2 |   | 24 |   |
| Installment                                                   |       | 14                               |       | 9 |   | 6 |   | 15 |   | 10 |   |
| Total  recoveries                                             |       | 24                               |       | 15 |   | 7 |   | 17 |   | 34 |   |
|                                                          |       |                             |       |   |   |   |   |   |   |   |   |
| Net loans  charged off                                        |       | 339                              |       | 396 |   | 69 |   | 17 |   | (2 | ) |
|                                                          |       |                             |       |   |   |   |   |   |   |   |   |
| Allowance  for loan losses,                                   |       | $                                | 1,821      |   | $ | 1,900 |   | $ | 1,031 |   | $ | 845 |   | $ | 847 |   |
|                                                          |       |                             |       |   |   |   |   |   |   |   |   |
| Ratio of net  loans charged off to average loans outstanding  |       | .34                              | %          | .37 | % | .06 | % | .02 | % | (.01 | )% |

 

The provision is based on an evaluation of the adequacy ofthe allowance for possible loan losses. The evaluation includes, but is not limited to, review of net loanlosses for the year, the present and prospective financial condition of theborrowers and evaluation of current and projected economic conditions.

 

Thefollowing table sets forth the outstanding balances of those loans on anonaccrual status and those on accrual status which are contractually past dueas to principal or interest payments for 30 days or more at December 31.

 
| **(000 omitted)**            | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
|                         |       |     |       |     |       |     |       |     |       |     |       |   |   |   |   |   |
| Nonaccrual  loans            |       | $        | 1,729      |     | $          | 4,159    |       | $        | 1,596      |     | $          | 289 |   | $ | 0 |   |
|                         |       |     |       |     |       |     |       |     |       |     |       |
| Accrual  loans:              |       |     |       |     |       |     |       |     |       |     |       |
| Restructured                 |       | $        | 0          |     | $          | 0        |       | $        | 0          |     | $          | 0 |   | $ | 0 |   |
| 30 through  89 days past due |       | 3,778    |       | 3,362    |       | 3,692    |       | 4,121    |       | 1,787    |       |
| 90 days or  more past due    |       | 48       |       | 0        |       | 70       |       | 922      |       | 549      |       |
| Total  accrual loans         |       | $        | 3,826      |     | $          | 3,326    |       | $        | 3,762      |     | $          | 5,043 |   | $ | 2,336 |   |

 

See Note 3 of the notes to consolidated financialstatements for details of income recognized and foregone revenue on nonaccrualloans for the past three years, as well as loan impairment details for 2002through 2004.

 

37

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There were no restructured loans for any of the timeperiods set forth above.

 

The Corporation utilizes a systematic review of its loanportfolio on a quarterly basis in order to determine the adequacy of theallowance for loan losses.  The allowancefor loan losses consists of a component for individual loan impairmentprimarily based on the loan’s collateral fair value and other observabledata.  A watch list of loans isidentified for evaluation based on regulatory examinations and internal andexternal loan grading and reviews.  Loansother than those determined to be impaired are grouped into pools of loans withsimilar credit risk characteristics. These loans are evaluated as groups with allocations made to theallowance based on historical loss experience adjusted for current trends indelinquencies, trends in underwriting and oversight, concentrations of creditand general economic conditions within the Corporation’s trading area. Thedecrease in the provision for loan losses expense for 2004 compared to 2003 wasa result of the measurement of the adequacy of the allowance for loan losses ateach period.  The 2004 measurement was lowerbased on fewer additions to the watch list in 2004 than in 2003, a decrease inthe loan portfolio and lower net charge-offs.

 

The reason for the increase in the provision for loanlosses for 2003 compared to 2002 was significant additions to nonaccrual andadverse loan classifications based on the credits’ non performance, regulatoryreview, and internal evaluation.

 

The Corporation has identified farm loans as aconcentration of credit.  At December 31,2004, watch list farm loans comprised $ 4,004,000, or 34% of the totalloan watch list.

 

Thefollowing is an allocation by loan categories of the allowance for loan lossesat December 31 for the last five years. In retrospect the specific allocation in any particular category mayprove excessive or inadequate and consequently may be reallocated in the futureto reflect the then current conditions. Accordingly, the entire allowance is available to absorb losses in anycategory:

 
| ** **                              | ** ** | **Years Ended December 31** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| **(000 omitted)**                       | ** ** | **Allowance  Amount**            | ** ** | **Percentage of  Loans to  Total Loans** | ** ** | **Allowance  Amount** | ** ** | **Percentage of  Loans to  Total Loans** | ** ** |
| Commercial,  financial and agricultural |       | $                                | 1,565      |   | 85.94 | % | $ | 1,507 |   | 79.34 | % |
| Real estate  - Construction             |       | 0                                |       | 0.00 |   | 0 |   | 0.00 |   |
| Real estate –  Mortgage            |       | 240                              |       | 13.18 |   | 351 |   | 18.46 |   |
| Installment                             |       | 16                               |       | .88 |   | 42 |   | 2.20 |   |
| Total                                   |       | $                                | 1,821      |   | 100.00 | % | $ | 1,900 |   | 100.00 | % |

 
| ** **                              | ** ** | **Years Ended December 31** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **2002**                         | ** ** | **2001** | ** ** |
| **(000 omitted)**                       | ** ** | **Allowance  Amount**            | ** ** | **Allowance  Amount** | ** ** | **Allowance  Amount** | ** ** | **Percentage of  Loans to  Total Loans** | ** ** |
| Commercial,  financial and agricultural |       | $                                | 561        |   | 54.41 | % | $ | 141 |   | 12.73 | % |
| Real estate  - Construction             |       | 0                                |       | 0.00 |   | 0 |   | 0.00 |   |
| Real estate –  Mortgage            |       | 333                              |       | 32.30 |   | 637 |   | 77.76 |   |
| Installment                             |       | 137                              |       | 13.29 |   | 67 |   | 9.51 |   |
| Total                                   |       | $                                | 1,031      |   | 100.00 | % | $ | 845 |   | 100.00 | % |

 

38

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| ** **                              | ** ** | **Years Ended December 31** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **2000**                         | ** ** |
| **(000 omitted)**                       | ** ** | **Allowance  Amount**            | ** ** | **Percentage of Loans to  Total Loans** | ** ** |
| Commercial,  financial and agricultural |       | $                                | 108        |   | 12.73 | % |
| Real estate  - Construction             |       | 0                                |       | 0.00 |   |
| Real estate –  Mortgage            |       | 659                              |       | 77.76 |   |
| Installment                             |       | 80                               |       | 9.51 |   |
| Total                                   |       | $                                | 847        |   | 100.00 | % |

 

**Deposits**

 

Total deposits decreased 1% to $ 109,621,000 at December 31,2004 compared with $ 111,127,000 at December 31, 2003.  Non-interest-bearing demand deposits increased19% year-end to year-end; however the average balances for each year weresimilar.  Interest-bearing depositsdecreased 4% due to a conservative rate position because of the lack of loanproduction.  Total deposits decreased$1,899,000 or 2% at December 31, 2003 compared with December 31,2002.  Non-interest-bearing demanddeposits decreased 14%; however average balance decreased 2%.  Interest-bearing deposits at December 31,2003 were similar to previous year end.

 

Theaverage amounts of deposits are summarized below:

 
| ** **                        | ** ** | **Years Ended December 31** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|
| **(000 omitted)**                 | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Demand deposits                   |       | $                                | 15,081     |   | $ | 14,966 |   | $ | 15,237 |   |
| Interest bearing demand  deposits |       | 13,202                           |       | 11,925 |   | 11,431 |   |
| Savings deposits                  |       | 24,188                           |       | 22,579 |   | 18,438 |   |
| Time deposits                     |       | 58,816                           |       | 61,069 |   | 74,238 |   |
| Total deposits                    |       | $                                | 111,287    |   | $ | 110,539 |   | $ | 119,344 |   |

 

Thefollowing is a breakdown of maturities of time deposits of $ 100,000 ormore as of December 31, 2004:

 
| **Maturity**                           | ** ** | **(000 omitted)** | ** ** |
|----------------------------------------|------------|-------------------|------------|
|                                   |       |              |       |
| Certificates  of Deposit               |       |              |       |
| Three months  or less                  |       | $                 | 4,196      |   |
| Over three  months through six months  |       | 685               |       |
| Over six  months through twelve months |       | 1,473             |       |
| Over twelve  months                    |       | 7,768             |       |
|                                   |       | $                 | 14,122     |   |

 

39

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**Stockholders’ Equity**

 

Stockholders’ equity was $ 15,518,000 at December 31,2004 compared with $16,104,000 at December 31, 2003, a decrease of$586,000 or 4%.  December 31, 2003was down 3% compared to December 31, 2002. The decrease in 2004 was a result of the net loss of $465,000 anddividends paid of $ 517,000, partially offset by a positive change of$ 398,000 in accumulated other comprehensive income.  The decrease in 2003 was a result of the netincome of $767,000 offset by dividends paid of $ 517,000 and a negativechange of $ 804,000 in accumulated other comprehensive income.  Total stockholders’ equity represented 11.0%of total assets at the end of both 2004 and 2003.  Cash dividends of $ 1.05 per share werepaid in both 2004 and 2003.  On July 20,2000, the Board of Directors announced the approval of a plan to purchase up to2% of its shares of outstanding common stock. As of December 31, 2004, the company had repurchased 2,210 shares,representing 0.45% of its shares of outstanding common stock.  The repurchase plan has been suspended.

 

Dividends from the Bank to the Corporation are thepredominant source for the Corporation to pay dividends.  National banks must obtain regulatoryapproval before declaring dividends that exceed its current net profits andprior two years’ retained net profits. Because of the 2004 net loss and in response to the OCC, dividends havebeen suspended in upcoming periods until approval from the regulators.

 

**CRITICAL ACCOUNTING POLICIES**

 

Bankpolicy related to the allowance for loan losses is considered to be a criticalaccounting policy because the allowance for loan losses represents aparticularly sensitive accounting estimate. The amount of the allowance is based on management’s evaluation of thecollectibility of the loan portfolio, including the nature of the loanportfolio, credit concentrations, trends in historical loss experience,specific impaired loans, and economic conditions.

 

Theallowance for loan losses is established through a provision for loan lossescharged to expense.  Loans are charged againstthe allowance for loan losses when management believes the collectibility ofthe principal is unlikely.  The allowanceis an amount management believes will be adequate to absorb possible losses onexisting loans that may become uncollectible, based on evaluations of thecollectibility of loans and prior loan loss experience.  The evaluations take into consideration suchfactors as changes in the nature and volume of the loan portfolio, overallportfolio quality, review of specific problem loans, and current economicconditions that may affect the borrowers’ ability to pay.

 

**LIQUIDITY**

 

Liquidityand interest rate sensitivity are related to, but distinctly different from,one another.

 

Liquidityinvolves the bank’s ability to meet cash withdrawal needs of customers andtheir credit needs in the form of loans. Liquidity is provided by certain balances held at correspondentbanks.  Adequate liquidity to meet creditdemands and/or adverse deposit flows is also made available from sales ormaturities of short-term assets. Additional sources of funds to meet credit needs is provided by accessto the marketplace to obtain interest-bearing deposits and other borrowings,including special programs available through Federal Home Loan Bank.  At December 31, 2004 and 2003, the Bankhad borrowings of $ 15,000,000 and $ 18,825,000, respectively.  At December 31, 2004, the Bank hadadditional borrowing capacity available of $ 42,000,000.

 

OnMarch 29, 2005, the Corporation was notified by Federal Home Loan Bankthat it will be required to identify and deliver specific assets as collateralequal to outstanding borrowings, plus accrued interest and any penalties forearly payment.  This amount isapproximately $ 16,063,000 at March 29, 2005.

 

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Interestrate sensitivity is the matching or mismatching of the maturity and ratestructure of the interest-bearing assets and liabilities.  It is the objective of management to controlthe difference in the timing of the rate changes for these assets andliabilities to preserve a satisfactory net interest margin.  The following table approximately reflectsthe matching of assets and liabilities maturing within one year and thereafter,which management feels is adequate to meet customer cash and credit needs whilemaintaining a desired interest rate spread.

 
| **(000 Omitted)**                           | ** ** | **Due  0 – 30 Days** | ** ** | **Due  31 – 90 Days** | ** ** | **Due  91 – 180 Days** | ** ** | **Due  181 – 360 Days** | ** ** | **Due  After  1 Year** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|---------------------------|------------|----------------------------|------------|-----------------------------|------------|------------------------------|------------|------------------------|------------|-----------|------------|
| **Rate  Sensitive Assets**                  |       |                      |       |                       |       |                        |       |                         |       |                   |       |      |       |
| Investment  securities                      |       | $                         | 224        |                       | $          | 447                         |       | $                            | 565        |                   | $          | 1,130     |       | $ | 16,619 |   | $ | 18,985 |   |
| Real estate,  commercial and consumer loans |       | 6,898                     |       | 13,795                     |       | 3,158                       |       | 6,316                        |       | 64,303                 |       | 94,470    |       |
|                                        |       | $                         | 7,122      |                       | $          | 14,242                      |       | $                            | 3,723      |                   | $          | 7,446     |       | $ | 80,922 |   | $ | 113,455 |   |
|                                        |       |                      |       |                       |       |                        |       |                         |       |                   |       |      |       |
| **Rate  Sensitive Liabilities**             |       |                      |       |                       |       |                        |       |                         |       |                   |       |      |       |
| Short-term  borrowings                      |       | $                         | 0          |                       | $          | 0                           |       | $                            | 0          |                   | $          | 0         |       | $ | 0 |   | $ | 0 |   |
| Long-term  borrowings                       |       | 0                         |       | 0                          |       | 0                           |       | 0                            |       | 15,000                 |       | 15,000    |       |
| Certificates  of deposit over $100,000      |       | 3,616                     |       | 533                        |       | 684                         |       | 1,463                        |       | 7,826                  |       | 14,122    |       |
| Other  certificates of deposit              |       | 11,648                    |       | 2,863                      |       | 3,512                       |       | 5,674                        |       | 17,756                 |       | 41,453    |       |
| Money market  deposit accounts              |       | 0                         |       | 0                          |       | 1,210                       |       | 2,422                        |       | 1,210                  |       | 4,842     |       |
| Other  interest-bearing deposits            |       | 0                         |       | 0                          |       | 3,267                       |       | 13,072                       |       | 16,342                 |       | 32,681    |       |
|                                        |       | 15,264                    |       | 3,396                      |       | 8,673                       |       | 22,631                       |       | 58,134                 |       | 108,098   |       |
| Cumulative  GAP - 12/31/04                  |       | $                         | (8,142     | )                          | $          | 2,704                       |       | $                            | (2,246     | )                      | $          | (17,431   | )          | $ | 5,357 |   | $ | 5,357 |   |
|                                        |       |                      |       |                       |       |                        |       |                         |       |                   |       |      |       |
| Cumulative  GAP - 12/31/03                  |       | $                         | 15,133     |                       | $          | 16,700                      |       | $                            | 14,571     |                   | $          | 7,127     |       | $ | 18,345 |   | $ | 18,345 |   |

 

Inmonitoring and evaluating liquidity, management generally does not considerregular savings or interest-bearing checking accounts to be particularly ratesensitive based on past experience in various interest rate cycles.  Therefore, management has assessedprobabilities to each time period and proportionately included these funds inrate sensitive liabilities of one year or less.

 

**CONTRACTUAL OBLIGATIONS**

 

Contractualobligations of the Company as of December 31, 2004 are as follows:

 
| ** **                                      | ** ** | ** ** | ** ** | **Payments due by period** | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|------------|------------|----------------------------|------------|------------------|------------|
| **(In thousands)**

**Contractual obligations** | ** ** | **Total**  | ** ** | **Less  than 1  year**     | ** ** | **1 - 3  years** | ** ** | **3 - 5  years** | ** ** | **More  than 5  years** | ** ** |
| FHLB  borrowings                                |       | $          | 15,000     |                       | $          | 0                |       | $ | 0 |   | $ | 0 |   | $ | 15,000 |   |
| Operating  lease obligations                    |       | 311        |       | 66                         |       | 130              |       | 115 |   | 0 |   |
| Total                                           |       | $          | 15,311     |                       | $          | 66               |       | $ | 130 |   | $ | 115 |   | $ | 15,000 |   |

 

**Off-Balance Sheet Arrangements**

 

TheCorporation’s financial statements do not reflect off-balance sheetarrangements that are made in the normal course of business.  Those off-balance sheet arrangements consistof unfunded loans and letters of credit made under the same standards ason-balance sheet instruments.  Thesecommitments, at December 31, 2004 totaled $ 7,153,000.  This consisted of $ 3,725,000 in homeequity lines of credit, $ 171,000 in standby letters of credit and$ 7,417,000 in other unused commitments (primarily commercial andagricultural lines of credit).  Becausethese instruments have fixed maturity dates, and because many of them willexpire without being drawing upon, they do not generally present anysignificant liquidity risk to the Corporation.

 

41

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Managementbelieves that any amounts actually drawn upon can be funded in the normalcourse of operations.  The Corporationhas no investment in or financial relationship with any unconsolidated entitiesthat are reasonably likely to have a material effect on liquidity or theavailability of capital resources.

 

**Capital Funds/Dividends/Regulatory Matters/Contingencies**

 

Dividendspaid by Fulton Bancshares Corporation are generally provided from the FultonCounty National Bank and Trust Company’s dividends to it.  The Federal Reserve Board, which regulatesbank holding companies, establishes guidelines which indicate that cashdividends should be covered by current year earnings and the debt to equityratio of the holding company must be below thirty percent.

 

FultonCounty National Bank and Trust Company, as a National Bank, is subject to thedividend restrictions set forth by the Comptroller of the Currency.  Retained earnings available for the paymentof dividends without approval of the Comptroller amounted to approximately$ 0, $ 1,171,000, and $ 1,946,000 at January 1, 2005, 2004,and 2003, respectively.  The Corporationis also subject to various regulatory capital requirements administered by federalbanking agencies.  Failure to meetminimum capital requirements can initiate certain mandatory, and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Corporation’s financial statements.  Under capital adequacy guidelines, theCorporation is required to maintain minimum capital ratios.  The “leverage ratio”, which compares capitalto adjusted total balance sheet assets is required to be at least 4%.  “Tier I” and “Tier II” capital ratios comparecapital to risk-weighted assets and off-balance sheet activity.  The Tier I ratio is required to be at least4%.  The combined Tier 1 and Tier IIratio is required to be at least 8%.

 

OnMarch 23, 2005, the Bank’s Board of Directors entered into a “Stipulationand Consent to the Issuance of a Consent Order” (the “Order”) with the Officeof the Comptroller of the Currency (OCC). The Order requires the Bank to implement and improve operatingprocedures and processes within stipulated timeframes.  Under the Order, the Bank is requiredprospectively to maintain higher minimum capital ratios than the normalindustry minimums.

 

AtDecember 31 the Corporation’s actual ratios and required levels were asfollows:

 
| ** **                                                                         | ** ** | ** **   | ** ** | **Actual** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------|------------|------------|------------|
| ** **                                                                         | ** ** | **Required** | ** ** | **2004**   | ** ** | **2003** | ** ** |
| Leverage  (total adjusted capital/total average assets)                            |       | 4.0          | %          | 10.8       | %          | 11.3 | % |
| Tier 1 (Tier  1 core capital/risk weighted assets)                                 |       | 4.0          | %          | 17.1       | %          | 15.7 | % |
| Total  capital (total capital plus allowance for loan losses/risk weighted assets) |       | 8.0          | %          | 18.4       | %          | 16.9 | % |

 

Asof December 31, 2004, the most recent notification from the Comptroller ofthe Currency categorized the Bank as adequately capitalized under theregulatory framework for prompt corrective action.  There are no conditions or events since thatnotification that management believes have changed the Bank’s category,although the OCC has, through the Order, raised the Bank’s required ratios fromthe normal minimums shown above to the following:

 
| Leverage |   | 10.0 | % |
|----------|--------|------|---|
| Tier I   |   | 14.0 | % |

 

Underthe Order, the Bank must obtain OCC approval before any executive officers ordirectors can be added to the Bank’s management.  The payment of dividends has also beentemporarily suspended without prior OCC approval.

 

42

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EffectiveMarch 22, 2005, similar restrictions have been placed on the holdingcompany, Fulton Bancshares Corporation, by the Federal Reserve Bank.  The Bank is considered to be in “troubled”condition, as that term is defined in Regulation Y, 12 C.F.R.225.71(d) and separateenforcement action is also being considered by the Federal Reserve Bank.

 

TheOCC has also informed the Bank of possible violations of laws and regulationswith regard to the Bank Secrecy Act, the Truth-In-Lending Act, and the RealEstate Settlement Procedures Act which could result in future fines andpenalties to the Bank and possible reimbursements.  The amount of any future fines orreimbursements cannot be reasonably estimated at December 31, 2004.

 

Becauseof the possible regulatory violations and other OCC scrutiny, the Bank’s FDICinsurance premiums and OCC assessment fees will increase by approximately$ 168,000 in 2005.  Other costs ofcompliance with the Order cannot be reasonably estimated at this time.

 

Inaddition, on March 4, 2005, the Bank terminated its President.  While no litigation has been initiatedthrough March 23, 2005, litigation may ensue if certain matters are notamicably resolved between the Bank and its former President.

 

**MARKET RISK MANAGEMENT**

 

TheBank has risk management policies to monitor and limit exposure to market risk,and works diligently to take advantage of profit opportunities available ininterest rate movements.

 

Managementcontinuously monitors liquidity and interest rate risk through itsAsset-Liability Committee reporting, and reprices products in order to maintaindesired net interest margins.  Managementexpects to continue to direct its marketing efforts toward attracting more lowcost retail deposits while competitively pricing its time deposits in order tomaintain favorable interest spreads, while minimizing structural interest raterisk.

 

Thefollowing table sets forth the projected maturities and average rates for allrate sensitive assets and liabilities based on the following assumptions.  All fixed and variable rate loans were basedon original maturities since the bank has not experienced, and does not expect,a significant rewriting of loans. Investments are based on maturity date except certain long-termagencies, which are classified by call date. The bank has historically experienced very little deposit runoff.  Based on this experience, it was estimatedthat maximum runoff of noninterest-bearing checking, NOW checking and othersavings would be 10%, and maximum runoff of money market deposits would be 33%.It was estimated that maximum runoff of time deposits would be 25% and thesedeposits are classified by original maturity date.

 

43

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| ** **                     | ** ** | **Principal/Notional Amount  Maturing In** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| **(In thousands)**             | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Fair Value** | ** ** |
| Rate  sensitive assets         |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fixed rate  loans              |       | $                                          | 3,338      |   | $ | 2,553 |   | $ | 2,328 |   | $ | 2,104 |   | $ | 1,923 |   | $ | 19,279 |   | $ | 31,525 |   | 32,286 |   |
| Average  interest rates        |       | 7.99                                       | %          | 8.36 | % | 8.02 | % | 7.78 | % | 7.63 | % | 7.30 | % | 7.57 | % |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable  rate loans           |       | 20,916                                     |       | 2,252 |   | 2,289 |   | 2,174 |   | 2,147 |   | 33,167 |   | 62,945 |   | 62,945 |   |
| Average  interest rates        |       | 5.86                                       | %          | 5.87 | % | 5.86 | % | 5.87 | % | 5.84 | % | 6.02 | % | 5.95 | % |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fixed rate  securities         |       | 676                                        |       | 3,976 |   | 4,173 |   | 4,089 |   | 1,314 |   | 2,374 |   | 16,602 |   | 16,619 |   |
| Average  interest rates        |       | 4.25                                       | %          | 3.17 | % | 3.16 | % | 3.70 | % | 4.88 | % | 3.39 | % | 3.51 | % |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable  rate securities      |       | 599                                        |       | 599 |   | 599 |   | 556 |   | 0 |   | 0 |   | 2,354 |   | 2,366 |   |
| Average  interest rates        |       | 3.93                                       | %          | 3.93 | % | 3.93 | % | 3.93 | % |   |   |   |   | 3.93 | % |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Rate  sensitive liabilities    |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  checking  |       | 1,652                                      |       | 1,487 |   | 1,504 |   | 1,502 |   | 1,502 |   | 8,877 |   | 16,524 |   | 16,524 |   |
| Average  interest rates        |       | N/A                                        |       | N/A |   | N/A |   | N/A |   | N/A |   | N/A |   | N/A |   |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings and  interest- bearing |       | 3,624                                      |       | 3,261 |   | 3,298 |   | 3,294 |   | 3,294 |   | 19,466 |   | 36,237 |   | 36,237 |   |
| Average  interest rates        |       | 0.64                                       | %          | 0.64 | % | 0.64 | % | 0.64 | % | 0.64 | % | 0.64 | % | 0.64 | % |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Time  deposits                 |       | 30,687                                     |       | 2,949 |   | 9,476 |   | 9,700 |   | 4,048 |   | 0 |   | 56,860 |   | 56,610 |   |
| Average  interest rates        |       | 2.54                                       | %          | 3.19 | % | 4.09 | % | 3.34 | % | 3.47 | % |   |   | 3.04 | % |   |   |
|                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Variable  rate borrowings      |       | 0                                          |       | 0 |   | 0 |   | 0 |   | 0 |   | 15,000 |   | 15,000 |   | 16,463 |   |
| Average  interest rates        |       | 0                                          |       | 0 |   | 0 |   | 0 |   | 0 |   | 5.93 | % | 5.93 | % |   |   |
|                                |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**FUTURE IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS**

 

In December 2003, theAccounting Standards Executive Committee (“AcSEC”) of the American Institute ofCertified Public Accountants issued Statement of Position (“SOP”) 03-3, *“Accounting for Certain Loans or Debt Securities Acquired in aTransfer.”* The SOP iseffective for loans acquired in fiscal years beginning after December 15,2004. The scope of the SOP applies to unhealthy “problem”  loans that have been acquired, eitherindividually in a portfolio, or in a business acquisition.  The SOP addresses accounting for differencesbetween contractual cash flows and cash flows expected to be collected from aninvestor’s initial investment in loans or debt securities (loans) acquired in atransfer if those differences are attributable, at least in part, to creditquality.  The SOP does not apply to loansoriginated by the Company.  The Companyintends to adopt the provisions of SOP 03-3 effective January 1, 2005, anddoes not expect the initial implementation to have a significant effect on theCompany’s consolidated financial position or consolidated results of operations.

 

On March 9, 2004, the SEC Staff issued StaffAccounting Bulletin No. 105, *“Application ofAccounting Principles to Loan Commitments”*(“SAB 105”). SAB 105clarifies existing accounting practices relating to the valuation of issuedloan commitments, including interest rate lock commitments (“IRLC”), subject toSFAS No. 149 and Derivative Implementation Group Issue C13, “*Scope Exceptions: When a Loan Commitment is includedin the Scope of Statement 133.”* Furthermore, SAB 105 disallows theinclusion of the values of a servicing component and other internally developedintangible assets in the initial and subsequent IRLC valuation.  The provisions of SAB 105 were effective forloan commitments entered into after March 31, 2004. The Company hasadopted the provisions of SAB 105.  Sincethe provisions of SAB 105 affect only the timing of the recognition of mortgagebanking income, management does not anticipate that this guidance will have amaterial adverse effect on either the Company’s consolidated financial positionor consolidated results of operations.

 

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Emerging Issues Task ForceIssue No. (EITF) 03-1 *“The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments”*wasissued and is effective March 31, 2004. The EITF 03-1 provides guidance for determining the meaning of “other–than-temporarily impaired” and its application to certain debt and equitysecurities within the scope of Statement of Financial Accounting Standards No.115 “*Accounting for Certain Investments in Debt andEquity Securities”*(“SFAS No. 115”) and investments accounted forunder the cost method.  The guidancerequires that investments which have declined in value due to credit concernsor solely due to changes in interest rates must be recorded asother-than-temporarily impaired unless the Company can assert and demonstrateits intention to hold the security for a period of time sufficient to allow fora recovery of fair value up to or beyond the cost of the investment which mightmean maturity.  This issue also requiresdisclosures assessing the ability and intent to hold investments in instancesin which an investor determines that an investment with a fair value less thancost is not other-than-temporarily impaired.  On September 30, 2004, the FinancialAccounting Standards Board decided to delay the effective date for themeasurement and recognition guidance contained in Issue 03-1.  This delay does not suspend the requirementto recognize other-than-temporary impairments as required by existingauthoritative literature.  The disclosureguidance in Issue 03-1 was not delayed.

 

EITF No. 03-16, *“Accounting forInvestments in Limited Liability Companies* was ratified by the Boardand is effective for reporting periods beginning after June 15, 2004.*”* APB Opinion No. 18,*“The Equity Method of Accounting Investments inCommon Stock,”* prescribes the accounting for investments in commonstock of corporations that are not consolidated.  AICPA Accounting Interpretation 2, *“Investments in Partnerships Ventures,”*of Opinion 18,indicates that “many of the provisions of the Opinion would be appropriate inaccounting” for partnerships.  In *EITF Abstracts,*Topic No. D-46, *“Accountingfor Limited Partnership Investments,”*the SEC staff clarified itsview that investments of more than 3 to 5 percent are considered to be morethan minor and, therefore, should be accounted for using the equitymethod.  Limited liability companies(LLCs) have characteristics of both corporations and partnerships, but aredissimilar from both in certain respects. Due to those similarities and differences, diversity in practice existswith respect to accounting for non-controlling investments in LLCs.  The consensus reached was that an LLC shouldbe viewed as similar to a corporation or similar to a partnership for purposesof determining whether a non-controlling investment should be accounted forusing the cost method or the equity method of accounting.

 

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004), *“Share-BasedPayment.”*This Statement establishes standards for the accountingfor transactions in which an entity exchanges its equity instruments for goodsor services.  It also addresses transactionsin which an entity incurs liabilities in exchange for goods or services thatare based on the fair value of the entity’s equity instruments or that may besettled by the issuance of those equity instruments.  The Statement focuses primarily on accountingfor transactions in which an entity obtains employee services in share-basedpayment transactions.  The Statementrequires a public entity to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award (with limited exceptions). That cost will be recognized over the period during which an employee isrequired to provide service in exchange for the award – the requisite service period(usually the vesting period). The entity will initially measure the cost ofemployee services received in exchange for an award of liability instrumentsbased on its current fair value; the fair value of that award will beremeasured subsequently at each reporting date through the settlement date.  Changes in fair value during the requisiteservice period will be recognized as compensation cost over that period.  The grant-date fair value of employee shareoptions and similar instruments will be estimated using option-pricing modelsadjusted for the unique characteristics of those instruments (unless observablemarket prices for the same or similar instruments are available).  If an equity award is modified after thegrant date, incremental compensation cost will be recognized in an amount equalto the excess of the fair value of the modified award over the fair value ofthe original award immediately before the modification.  This Statement is effective for publicentities that do not file as small business issuers—as of the beginning of thefirst interim or annual reporting period that begins after June 15, 2005. *For public companies that file as small business issuers – as of thebeginning of the first*

 

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*interim or annual reporting period that begins after December 15,2005.* Under thetransition method, compensation cost is recognized on or after the requiredeffective date for the portion of outstanding awards for which the requisiteservice has not yet been rendered, based on the grant-date fair value of thoseawards calculated under Statement 123 for either recognition or pro formadisclosures.  For periods before therequired effective date, entities may elect to apply a modified version ofretrospective application under which financial statements for prior periodsare adjusted on a basis consistent with the pro forma disclosures required forthose periods by Statement 123.

 

**STOCKMARKET ANALYSIS AND DIVIDENDS**

 

The Corporation’s common stock is traded inactivelyin the over-the-counter market.  As of December 31,2004 the number of shareholders of record was about or around 500.

 
| ** **      | ** ** | **Market  Price** | ** ** | **Cash  Dividend** | ** ** | **Market  Price** | ** ** | **Cash  Dividend** | ** ** |
|-----------------|------------|-------------------|------------|--------------------|------------|-------------------|------------|--------------------|------------|
| ** **      | ** ** | **2004**          | ** ** | **2003**           | ** ** |
| First  Quarter  |       | $                 | 49.17      |               | $          | .23               |       | $                  | 44.15      |   | $ | .23 |   |
| Second  Quarter |       | 43.41             |       | .23                |       | 49.00             |       | .23                |       |
| Third  Quarter  |       | 41.66             |       | .27                |       | 55.05             |       | .27                |       |
| Fourth  Quarter |       | 41.00             |       | .32                |       | 49.20             |       | .32                |       |
|                 |            |                   |            |                    |            |                   |            |                    |            |  |  |  |  |

 

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