**Exhibit 13**

**CONTENTS**

| **REPORT OF INDEPENDENT REGISTERED  PUBLIC ACCOUNTING FIRM**                                                   |   | 2      |
|----------------------------------------------------------------------------------------------------------------|--------|--------|
| **CONSOLIDATED  FINANCIAL STATEMENTS**                                                                         |   |   |
| Balance sheets                                                                                                 |   | 3      |
| Statements of income                                                                                           |   | 4      |
| Statements of changes in stockholders’ equity                                                             |   | 5      |
| Statements of cash flows                                                                                       |   | 6-7    |
| Notes to consolidated financial statements                                                                     |   | 8-30   |
| **ACCOMPANYING  FINANCIAL INFORMATION**                                                                        |   |   |
| Selected five year financial data                                                                              |   | 31     |
| Summary of quarterly financial data                                                                            |   | 32     |
| Distribution of assets, liabilities and stockholders’  equity, interest rates and interest differential   |   | 33     |
| Changes in net interest income                                                                                 |   | 34     |
| Management’s discussion and analysis of consolidated  financial condition and results of operations  |   | 35-51  |
| Stock market analysis and dividends                                                                            |   | 51     |

 

1

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders of Fulton Bancshares CorporationMcConnellsburg, Pennsylvania

We have audited the accompanying consolidated balancesheets of the Fulton Bancshares Corporation and its wholly-owned subsidiariesas of December 31, 2005 and 2004 and the related consolidated statementsof income, changes in stockholders’ equity, and cash flows for each of theyears in the three year period ended December 31, 2005. These consolidatedfinancial statements are the responsibility of the Corporation’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the consolidated financial statements are free ofmaterial misstatement. The Corporation is not required to have, nor were weengaged to perform, an audit of its internal control over financial reporting. Ouraudit included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCorporation’s internal control over financial reporting. Accordingly, weexpress no such opinion. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the consolidated financial statements.An audit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of the FultonBancshares Corporation and its wholly-owned subsidiaries as of December 31,2005 and 2004, and the results of their operations and their cash flows foreach of the years in the three year period ended December 31, 2005 inconformity with accounting principles generally accepted in the United Statesof America.

|                       | /S/ Smith Elliott  Kearns & Company, LLC |
|----------------------------|---------------------------------------------------|
|                       | Smith Elliott Kearns & Company, LLC      |
| Chambersburg, Pennsylvania |                                              |
| February 16, 2006     |                                              |

 

2

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**FULTON BANCSHARES CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSDecember 31, 2005 and 2004**

| ** **                                                    | ** ** | **2005**    | ** **  | **2004**    | ** ** | ** **  |
|---------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|
| **ASSETS**                                                    |       |        |        |        |       |        |
| Cash and due from  banks                                      |       | $           | 4,225,655   |        | $          | 12,808,875  |   |   |
| Interest bearing  deposits in other banks                     |       | 665,164     |        | 55,079      |       |        |
| Federal funds  sold                                           |       | 7,850,000   |        | 3,500,000   |       |        |
| Cash and cash equivalents                                     |       | 12,740,819  |        | 16,363,954  |       |        |
| Investment  securities available for sale                     |       | 34,791,977  |        | 18,985,202  |       |        |
| Federal Reserve, Atlantic Central Bankers Bank                |       |        |        |        |       |        |
| and Federal Home Loan Bank stocks                             |       | 988,250     |        | 1,207,150   |       |        |
| Loans, net of reserve for loan losses                         |       |        |        |        |       |        |
| 2005—$1,354,090; 2004—$1,821,164                    |       | 78,425,613  |        | 92,648,992  |       |        |
| Premises and  equipment                                       |       | 3,509,192   |        | 3,596,316   |       |        |
| Cash surrender  value of life insurance                       |       | 5,609,639   |        | 5,429,963   |       |        |
| Accrued interest  receivable                                  |       | 626,704     |        | 659,723     |       |        |
| Real estate owned  other than premises                        |       | 670,850     |        | 1,534,000   |       |        |
| Other assets                                                  |       | 1,768,065   |        | 1,331,608   |       |        |
| Total assets                                                  |       | $           | 139,131,109 |        | $          | 141,756,908 |   |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                |       |        |        |        |       |        |
| Deposits                                                      |       |        |        |        |       |        |
| Noninterest bearing                                           |       | $           | 18,365,151  |        | $          | 16,524,406  |   |   |
| Interest bearing                                              |       | 89,120,642  |        | 93,096,879  |       |        |
|                                                          |       | 107,485,793 |        | 109,621,285 |       |        |
| Other borrowed funds                                          |       | 15,000,000  |        | 15,000,000  |       |        |
| Accrued interest  payable                                     |       | 269,707     |        | 243,221     |       |        |
| Other liabilities                                             |       | 1,473,834   |        | 1,374,307   |       |        |
| Total liabilities                                             |       | 124,229,334 |        | 126,238,813 |       |        |
| **Stockholders’ Equity**                                 |       |        |        |        |       |        |
| Common stock: par value $.625 per share; 4,000,000  shares    |       |        |        |        |       |        |
| authorized; 495,000  shares issued 492,790 shares outstanding |       | 309,375     |        | 309,375     |       |        |
| Additional paid-in  capital                                   |       | 2,051,337   |        | 2,051,337   |       |        |
| Retained earnings                                             |       | 12,938,141  |        | 13,226,245  |       |        |
| Accumulated other  comprehensive income (loss)                |       | (307,867    | )           | 20,349      |       |        |
| Treasury stock;  at cost—2,210 shares                    |       | (89,211     | )           | (89,211     | )          |        |
|                                                          |       | 14,901,775  |        | 15,518,095  |       |        |
| Total liabilities  and stockholders’ equity              |       | $           | 139,131,109 |        | $          | 141,756,908 |   |   |

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

3

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOMEYears Ended December 31, 2005, 2004, and 2003**

| ** **                                                                  | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**  | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------|------------|-----------|------------|
| **Interest Income**                                                         |       |       |       |       |       |      |       |
| Interest and fees on loans                                                  |       | $          | 5,738,951  |       | $          | 6,350,516 |       | $ | 6,913,532 |   |
| Interest and dividends  on investment securities:                           |       |       |       |       |       |      |       |
| Other U.S. Government agencies                                              |       | 299,977    |       | 278,873    |       | 352,657   |       |
| Mortgage-backed s ecurities                                                 |       | 586,586    |       | 91,624     |       | 126,030   |       |
| Obligations of state and political  subdivisions—tax exempt       |       | 207,375    |       | 207,462    |       | 75,232    |       |
| FNMA and FHLMC preferred stock                                              |       | 0          |       | 585,207    |       | 820,877   |       |
| Other interest and dividends                                                |       | 36,761     |       | 27,629     |       | 77,127    |       |
| Interest on federal funds sold                                              |       | 254,063    |       | 13,160     |       | 0         |       |
| Total interest income                                                       |       | 7,123,713  |       | 7,554,471  |       | 8,365,455 |       |
| **Interest Expense**                                                        |       |       |       |       |       |      |       |
| Interest on deposits                                                        |       | 1,998,927  |       | 1,972,493  |       | 2,132,148 |       |
| Interest on federal funds purchased                                         |       | 0          |       | 636        |       | 726       |       |
| Interest on other borrowed money                                            |       | 901,109    |       | 917,822    |       | 1,042,110 |       |
| Total interest expense                                                      |       | 2,900,036  |       | 2,890,951  |       | 3,174,984 |       |
| Net interest income before provision for loan losses                        |       | 4,223,677  |       | 4,663,520  |       | 5,190,471 |       |
| **Provision  for Loan Losses**                                              |       | 316,667    |       | 260,841    |       | 1,265,000 |       |
| Net interest income after provision for loan losses                         |       | 3,907,010  |       | 4,402,679  |       | 3,925,471 |       |
| **Other Income (Loss)**                                                     | ** ** | ** ** |       |       |       |      |       |
| Service charges on deposit accounts                                         |       | 166,881    |       | 172,526    |       | 217,159   |       |
| Other service charges and fees                                              |       | 179,961    |       | 155,616    |       | 221,896   |       |
| Earnings—Cash surrender value of life insurance                        |       | 225,016    |       | 243,188    |       | 258,209   |       |
| Trust services                                                              |       | 2,807      |       | 6,366      |       | 19,453    |       |
| Gain (loss) on sale of investment securities                                |       | 0          |       | (1,264,993 | )          | 86,472    |       |
| Gain on sale of OREO property                                               |       | 19,263     |       | 5,481      |       | 0         |       |
| Gain on sale of premises and equipment                                      |       | 9,347      |       | 0          |       | 0         |       |
| Gain on sale of loans                                                       |       | 0          |       | 12,952     |       | 24,012    |       |
| Other income                                                                |       | 9,556      |       | 13,299     |       | 9,515     |       |
| Total other income (loss)                                                   |       | 612,831    |       | (655,565   | )          | 836,716   |       |
| **Other Expenses**                                                          |       |       |       |       |       |      |       |
| Salaries , fees and employee benefits                                       |       | 1,968,058  |       | 1,682,754  |       | 1,707,844 |       |
| Net occupancy expense of bank premises and furniture  and equipment expense |       | 837,025    |       | 806,466    |       | 833,377   |       |
| Professional and loan-related fees                                          |       | 850,445    |       | 358,548    |       | 184,447   |       |
| Data processing                                                             |       | 311,627    |       | 289,143    |       | 259,915   |       |
| FDIC insurance premiums                                                     |       | 194,064    |       | 32,751     |       | 17,515    |       |
| Other expenses                                                              |       | 1,006,225  |       | 1,049,394  |       | 1,001,919 |       |
| Total other expenses                                                        |       | 5,167,444  |       | 4,219,056  |       | 4,005,017 |       |
| Income (loss)  before income taxes                                          |       | (647,603   | )          | (471,942   | )          | 757,170   |       |
| Applicable income  tax (benefit)                                            |       | (359,499   | )          | (7,110     | )          | (9,977    | )          |
| Net income (loss)                                                           |       | $          | (288,104   | )          | $          | (464,832  | )          | $ | 767,147 |   |
| Earnings (loss) per  common share                                           |       | $          | (0.58      | )          | $          | (0.94     | )          | $ | 1.56 |   |

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

4

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYYears Ended December 31, 2005, 2004, and 2003**

| ** **                                                                                            | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|-----------------------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
| 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 |   |
| Comprehensive income:                                                                                 |       |              |       |                             |       |                   |       |                                                      |       |                |       |                                  |       |   |   |
| Net loss                                                                                              |       |              |       |                             |       | (288,104               | )          |                                                      |       |                |       |                                  |       | (288,104 | ) |
| Change in unrealized (loss) on investment securities  available for sale, net of tax of $169,081      |       |              |       |                             |       |                   |       |                                                      | (328,216   | )                   |       |                                  |       | (328,216 | ) |
| Total comprehensive income   (loss)                                                                   |       |              |       |                             |       |                   |       |                                                      |       |                |       |                                  |       | (616,320 | ) |
| Cash dividends                                                                                        |       |              |       |                             |       |                   |       |                                                      |       |                |       |                                  |       | 0 |   |
| Balance, December 31,  2005                                                                           |       | $                 | 309,375    |                             | $          | 2,051,337              |       | $                                                         | 12,938,141 |                |       | ($307,867                             | )          |   | ($89,211 | ) | $ | 14,901,775 |   |

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

5

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSYears Ended December 31, 2005, 2004, and 2003**

| ** **                                                                                | ** ** | **2005**    | ** ** | **2004**   | ** ** | **2003**    | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|-------------|------------|
| **Cash flows from operating  activities**                                                 |       |        |       |       |       |        |       |
| Net income (loss)                                                                         |       | $           | (288,104   | )          | $          | (464,832    | )          | $ | 767,147 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |        |       |       |       |        |       |
| Compensation via treasury stock issued                                                    |       | 0           |       | 0          |       | 245         |       |
| Depreciation and amortization                                                             |       | 350,171     |       | 369,695    |       | 385,655     |       |
| Investment amortization                                                                   |       | 7,701       |       | 23,468     |       | 90,548      |       |
| Provision for loan losses                                                                 |       | 316,667     |       | 260,841    |       | 1,265,000   |       |
| Deferred income taxes                                                                     |       | (183,290    | )          | 11,811     |       | (378,030    | )          |
| Increase in CSV- life insurance                                                           |       | (179,676    | )          | (200,037   | )          | (219,131    | )          |
| Loss (gain) on sale of investment securities                                              |       | 0           |       | 1,264,993  |       | (86,472     | )          |
| (Gain) on sale of premises and equipment                                                  |       | (9,347      | )          | 0          |       | 0           |       |
| (Gain) on sale of OREO property                                                           |       | (19,263     | )          | (5,481     | )          | 0           |       |
| (Gain) on sale of student loans                                                           |       | 0           |       | (12,952    | )          | (24,012     | )          |
| (Increase)decrease in other assets                                                        |       | (84,092     | )          | 70,177     |       | 18,048      |       |
| Decrease in accrued interest receivable                                                   |       | 33,019      |       | 1,372      |       | 282,447     |       |
| Increase (decrease) in accrued interest payable                                           |       | 26,486      |       | (11,378    | )          | (59,125     | )          |
| Increase in other liabilities                                                             |       | 99,527      |       | 115,751    |       | 227,194     |       |
| Net cash provided  by operating activities                                                |       | 69,799      |       | 1,423,428  |       | 2,269,514   |       |
| **Cash  flows from investing activities**                                                 |       |        |       |       |       |        |       |
| Sales of inves tment securities available for sale                                        |       | 0           |       | 10,939,235 |       | 6,299,942   |       |
| Maturities of investment securities available for  sale                                   |       | 11,426,380  |       | 5,374,058  |       | 20,568,343  |       |
| Purchases of investment securities available for  sale                                    |       | (27,738,154 | )          | (6,532,381 | )          | (19,867,112 | )          |
| Net decreas e in loans                                                                    |       | 13,906,716  |       | 6,269,788  |       | 2,716,329   |       |
| Purchases of property and equipment                                                       |       | (279,191    | )          | (206,504   | )          | (206,891    | )          |
| Purchases of FRB, ACBB and FHLB stock                                                     |       | (73,500     | )          | (507,000   | )          | (295,500    | )          |
| Redemptions of FRB, ACBB and FHLB stock                                                   |       | 292,400     |       | 700,700    |       | 666,600     |       |
| Purchases of officers’ life insurance                                                |       | 0           |       | 0          |       | (353,000    | )          |
| Proceeds from sale of OREO property                                                       |       | 882,413     |       | 211,680    |       | 0           |       |
| Proceeds from sale of fixed assets                                                        |       | 25,494      |       | 0          |       | 0           |       |
| Proceeds from sale of student loans                                                       |       | 0           |       | 688,177    |       | 1,683,784   |       |
| Net cash provided  (used) by investing activities                                         |       | (1,557,442  | )          | 16,937,753 |       | 11,212,495  |       |
| **Cash  flows from financing activities**                                                 |       |        |       |       |       |        |       |
| Net (decrease) in deposits                                                                |       | (2,135,492  | )          | (1,506,205 | )          | (1,900,547  | )          |
| Dividends paid                                                                            |       | 0           |       | (517,425   | )          | (517,450    | )          |
| Purchase of treasury stock                                                                |       | 0           |       | (1,299     | )          | 0           |       |
| Net (decrease) in line-of-credit borrowings                                               |       | 0           |       | (3,825,000 | )          | (12,425,000 | )          |
| Net cash (used)  by financing activities                                                  |       | (2,135,492  | )          | (5,849,929 | )          | (14,842,997 | )          |
| Net increase (decrease) in cash and cash equivalents                                      |       | (3,623,135  | )          | 12,511,252 |       | (1,360,988  | )          |
| Cash and cash equivalents at beginning of year                                            |       | 16,363,954  |       | 3,852,702  |       | 5,213,690   |       |
| Cash and cash  equivalents at end of year                                                 |       | $           | 12,740,819 |       | $          | 16,363,954  |       | $ | 3,852,702 |   |

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

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**FULTON BANCSHARES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEM ENTS OF CASH FLOWS (Continued) Years Ended December 31, 2005, 2004, and 2003**

** **

| ** **                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|--------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| **Supplemental disclosure of cash  flow information:** |       |     |       |     |       |      |       |
| Cash paid during  the year for:                        |       |     |       |     |       |      |       |
| Interest                                               |       | $        | 2,873,550  |     | $          | 2,902,329 |       | $ | 3,324,108 |   |
| Income taxes                                           |       | $        | 0          |     | $          | 0         |       | $ | 424,500 |   |
| **Supplemental  disclosure of cash flow information:** |       |     |       |     |       |      |       |
| Unrealized holding gain (loss), net of tax             |       | $        | (328,216   | )        | $          | 397,992   |       | $ | (803,942 | ) |
| Treasury stock issued as compensation                  |       | $        | 0          |     | $          | 0         |       | $ | 245 |   |
| Other real estate  acquired in settlement of loans     |       | $        | 0          |     | $          | 1,534,000 |       | $ | 206,199 |   |

 

The Notes to Consolidated Financial Statements are an integral part of these statements.

7

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Note 1.**        SignificantAccounting Policies

***Nature of Operations***

Fulton BancsharesCorporation’s primary activity consists of owning and supervising itssubsidiaries:

·       TheFulton County National Bank and Trust Company (“Bank”), which is engaged inproviding banking and bank related services, principally in Fulton, southernHuntingdon, Bedford, and western Franklin Counties. Its seven branches arelocated in McConnellsburg (2), Warfordsburg, Hustontown, Orbisonia, St. Thomasand Breezewood.

·       Fulton County CommunityDevelopment Corporation was formed on June 7, 1996 to support efforts ofthe local downtown business revitalization project by making low interest loansto eligible small businesses for the purpose of facade improvement. Futureprojects may include small business marketing, new business creation, smallbusiness education, and housing for low-to-moderate income individuals.

***Principles of Consolidation***

The consolidated financial statements include theaccounts 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”). Allsignificant intercompany transactions and accounts have been eliminated.

See Note 12 for parent company financial statements.

***Basis of Accounting***

The Corporation uses theaccrual basis of accounting.

***Use of estimates***

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates 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. Actual results could differ from those estimates.

Material estimates that are particularly susceptibleto significant change relate to the determination of the allowance for losseson loans and the valuation of real estate acquired in connection withforeclosures or in satisfaction of loans. In connection with the determinationof the allowances for losses on loans and foreclosed real estate, managementobtains independent appraisals for significant properties.

While management usesavailable information to recognize losses on loans and foreclosed real estate,future additions to the allowances may be necessary based on changes in localeconomic conditions. In addition, regulatory agencies, as an integral part oftheir examination process, periodically review the Corporation’s allowances forlosses on loans and foreclosed real estate and may require the Corporation torecognize additions to the allowances based on their judgments aboutinformation available to them at the time of their examination. Because ofthese factors, management’s estimate of credit losses inherent in the loanportfolio and the related allowance may change in the near term.

8

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**Note 1.   Significant Accounting Policies(Continued)**

***Investment Securities***

The Corporation’sinvestments in securities are classified in three categories and accounted foras follows:

·       ***Trading Securities***. Securities heldprincipally for resale in the near term are classified as trading securitiesand recorded at their fair values. Unrealized gains and losses on tradingsecurities are included in other income.

·       ***Securities to be Held to Maturity***. Bondsand notes for which the Corporation has the positive intent and ability to holdto maturity are reported at cost, adjusted for amortization of premiums andaccretion of discounts, which are recognized in interest income using theinterest method over the period to maturity.

·       ***Securities Available for Sale***. Securitiesavailable for sale consist of equity securities, bonds and notes not classifiedas trading securities nor as securities to be held to maturity. These aresecurities that management intends to use as a part of its asset and liabilitymanagement strategy and may be sold in response to changes in interest rates,resultant prepayment risk and other related factors.

Purchase premiums and discounts are amortized toearnings by the interest method from purchase date to maturity date. Unrealizedholding gains and losses, net of tax, on securities available for sale arereported as a net amount in other comprehensive income. Gains and losses on thesale of securities available for sale are determined using thespecific-identification method. Fair values for investment securities are basedon quoted market prices.

The Corporation hasclassified all of its investment securities as “available for sale” at December 31,2005 and 2004, and during the years then ended.

***Loans and Reserve for Possible Loan Losses***

Loans are stated at the amount of unpaid principal,reduced by a reserve for loan losses and increased or decreased by net deferredloan origination fees and costs. Interest on loans is calculated by using thesimple interest method on daily balances of the principal amount outstanding. Thereserve for loan losses is established through a provision for loan lossescharged to expense. Loans are charged against the reserve for loan losses whenmanagement believes that the collectibility of the principal is unlikely, or atthe direction of regulators. Subsequent recoveries, if any, are credited to thereserve. The reserve is an amount that management believes will be adequate toabsorb possible losses on existing loans that may become uncollectible, basedon evaluations of the collectibility of loans and prior loan loss experience. Theevaluations are performed regularly and take into consideration such factors aschanges in the nature and volume of the loan portfolio, overall portfolioquality, review of specific problem loans, and current economic conditions thatmay affect borrowers’ ability to pay. This evaluation is inherently subjectiveas it requires estimates that are susceptible to significant revision as moreinformation becomes available.

The reserve consists ofspecific and general loss components. The specific loss component relates toloans that are classified as doubtful or substandard. For loans that are alsoclassified as impaired, an allowance is established when the discounted cashflows (or collateral value or observable market price) of the impaired loan islower than the carrying value of that loan. The general component coversnon-classified loans and is based on historical loss experience adjusted forqualitative factors.

***Nonaccrual/Impaired Loans***

The accrual of interest income on loans, includingimpaired loans, ceases when principal or interest is past due 90 days or moreand collateral is inadequate to cover principal and interest or immediately if,in the opinion of management, full collection is unlikely. Interest accrued butnot collected as of the date of 

9

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**Note 1.   Significant Accounting Policies (Continued)**

placement on nonaccrualstatus is reversed and charged against current income unless fullycollateralized. Subsequent payments received 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 aloan-by-loan basis by comparing the contractual principal and interest paymentsto the present value of expected future cash flows discounted at the loan’seffective interest rate, the loan’s obtainable market price, or the fair valueof the collateral if the loan is collateral dependent.

Consumer loans, comprisedof smaller balance homogeneous loans, are collectively evaluated forimpairment.

**Loans Held for Sale**

Loans originated and held for sale in the secondarymarket or to other parties are carried at the lower of cost or estimated fairvalue in the aggregate. Net realized losses, if any, are recognized through avaluation allowance by charges to income.

From time to time, the Corporation originates loanswith the intent to sell them in the secondary market. These loans are typicallysold concurrent with the closing of the loan. In 2005, 2004 and 2003 theCorporation originated and sold 0, 4 and 30 loans, respectively, to FHLB in thesecondary market. There were no loans held for sale in the secondary market at December 31,2005, 2004, or 2003.

The Corporation sold aportion of its PHEAA loans in 2003, and sold the remainder of its PHEAA loansin 2004. However, there were no PHEAA loans held for sale at December 31,2003.

***Premises and Equipment***

Premisesand equipment are carried at cost less accumulated depreciation. Depreciationis calculated primarily using the straight-line method over the estimateduseful lives of the various assets as follows:

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

 

Repairs and maintenanceare charged to operations as incurred.

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

Other real estate ownedincludes foreclosed properties for which the institution has taken physicalpossession in connection with loan foreclosure proceedings. Assets received inforeclosure are recorded at the lower of the outstanding principal balance ofthe related loans or the estimated fair value of collateral held, lessestimated costs to sell. Any adjustment required to write down the property tonet realizable value is charged to the allowance for loan losses. Costs ofholding and maintaining the property and subsequent adjustments to the carryingamount of the property are charged to expense when incurred.

10

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**Note 1.   Significant Accounting Policies (Continued)**

***Earnings per Share***

Earningsper common share were computed based on weighted averages of shares of commonstock outstanding as follows:

| **Year** | ** ** | ** ** | ** ** | **Shares** | ** ** |
|----------|------------|------------|------------|------------|------------|
| 2005     |       | 492,790    |       |
| 2004     |       | 492,799    |       |
| 2003     |       | 492,810    |       |

 

***Federal Income Taxes***

As a result of certaintiming differences between financial statement and federal income taxreporting, including depreciation, loan losses, nonaccrual interest,contributions, and deferred compensation, deferred income taxes are provided inthe financial statements. Deferred tax assets and liabilities are included inthe financial statements at currently enacted income tax rates applicable tothe period in which the deferred tax assets and liabilities are expected to berealized or settled. As changes in tax laws or rates are enacted, deferred taxassets and liabilities are adjusted through the provision for income taxes. SeeNote 9 for further details.

***Statements of Cash Flows***

For purposes of theStatements of Cash Flows, cash and cash equivalents include those amounts inthe balance sheet captions “cash and due from banks” and “federal funds sold”. TheCorporation has elected to present the net change in interest bearing depositswith banks, deposits, and loans in the Statements of Cash Flows.

***Fair values of financial instruments***

The Corporation meets the requirements for disclosureof fair value information about financial instruments, whether or notrecognized in the balance sheet. In cases where quoted market prices are notavailable, fair values are based on estimates using present value or othervaluation techniques. Those techniques are significantly affected by theassumptions used, including the discount rate and estimates of future cashflows. In that regard, the derived fair value estimates cannot be substantiatedby comparison to independent markets and, in many cases, could not be realizedin immediate settlement of the instruments. Certain financial instruments andall nonfinancial instruments are excluded from the disclosure requirements. Accordingly,the aggregate fair value amounts presented do not represent the underlyingvalue of the Corporation.

The followingmethods and assumptions were used by the Corporation in estimating fair valuesof financial instruments as disclosed herein:

***Cash and CashEquivalents.******  ***Thecarrying amounts of cash and short-term instruments approximate their fairvalue.

***SecuritiesAvailable for Sale.******  ***Fairvalues for investment securities are based on quoted market prices.

***Federal Reserve,Atlantic Central Bankers Bank, and Federal Home Loan Bank Stocks.******  ***Thecarrying amount for these stocks approximates their fair value since they arenot actively traded and have no readily determinable market value.

***Loans.******  ***Forvariable-rate loans that reprice frequently and have no significant change incredit risk, fair values are based on carrying values. Fair values for fixedrate loans are estimated using 

11

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**Note 1.   Significant Accounting Policies (Continued)**

discounted cash flowanalyses at interest rates currently being offered for loans with similar termsto borrowers of similar credit quality. Fair values for impaired loans areestimated using discounted cash flow analyses or underlying collateral values,where applicable.

***Cash surrendervalue of life insurance.***   Thecarrying amounts of cash surrender value of life insurance approximate theirfair values.

***Deposits.******  ***Thefair values disclosed for demand deposits are, by definition, equal to theamount payable on demand at the reporting date (that is, their carryingamounts). The carrying amounts of variable-rate, fixed-term money marketaccounts and certificates of deposit approximate their fair values at thereporting date. Fair values for fixed-rate certificates of deposit and IRA’sare estimated using a discounted cash flow calculation that applies interestrates currently being offered to a schedule of aggregated expected monthlymaturities on time deposits.

***Short-TermBorrowings.***   The carryingamounts of federal funds purchased and other short-term borrowings maturingwithin 90 days approximate their fair values. Fair values of other short-termborrowings are estimated using discounted cash flow analyses based on theCorporation’s current incremental borrowing rates for similar types ofborrowing arrangements.

***Long-TermBorrowings.***   The fair values ofthe Corporation’s long-term borrowings are estimated using discounted cash flowanalyses based on the Corporation’s current incremental borrowing rates forsimilar types of borrowing arrangements.

***Accrued Interest.******  ***Thecarrying amounts of accrued interest approximate their fair values.

***Off-Balance SheetInstruments.******  ***TheCorporation generally does not charge commitment fees. Fees for standby lettersof credit and their off-balance-sheet instruments are not significant.

***Advertising***

The Corporation expenses advertising costs as incurred.Advertising expenses for the years ended December 31, 2005, 2004, and2003, were $49,724; $93,633; and $ 93,876, respectively.

12

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**Note 1.**        SignificantAccounting Policies (Continued)

***Comprehensive income***

Comprehensive income is defined as the change inequity from transactions and other events from nonowner sources. It includesall changes in equity except those resulting from investments by stockholdersand distributions 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 elected to report itscomprehensive income in the statement of stockholders’ equity. The only elementof “other comprehensive income” that the Corporation has is the unrealized gainor loss on available for sale securities.

Thecomponents of the change in net unrealized gains (losses) on securities were asfollows:

| ** **                                                                   | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Gross unrealized  holding gains (losses) arising during the year             |       | ($497,297 | )          | ($843,215 | )          | ($902,808 | )          |
| Reclassification  adjustment for (gains) losses realized in net income  |       | 0         |       | 1,264,993 |       | (86,472   | )          |
| Net unrealized  holding gains (losses) before taxes                          |       | (497,297  | )          | 421,778   |       | (989,280  | )          |
| Tax effect                                                                   |       | 169,081   |       | (23,786   | )          | 185,338   |       |
| Net change                                                                   |       | ($328,216 | )          | $         | 397,992    |      | ($803,942  | ) |
|                                                                              |            |           |            |           |            |           |            |  |

 

**Note 2.**        Investments

Theamortized cost and fair value of investment securities available for sale at December 31were:

| ** **                                                | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|-----------------------------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| ** **                                                | ** ** | ** **          | ** ** | **2005**                     | ** ** | ** **                    | ** ** |
| Obligations of  U.S. Government corporations and agencies |       | $                   | 13,937,757 |                         |       | $                             | 0          |            |       |   | $ | 172,892 |   |   | $ | 13,764,865 |   |
| Obligations of  states and political subdivisions         |       | 5,393,856           |       |                         | 26,138     |                          |       |            | 29,489     |   |   | 5,390,505 |   |
| Mortgage-backed  securities                               |       | 15,867,764          |       |                         | 14,126     |                          |       |            | 318,428    |   |   | 15,563,462 |   |
| Other stock                                               |       | 59,064              |       |                         | 14,500     |                          |       |            | 420        |   |   | 73,144 |   |
|                                                      |       | $                   | 35,258,441 |                         |       | $                             | 54,765     |            |       |   | $ | 521,229 |   |   | $ | 34,791,977 |   |

 

| ** **                                                | ** ** | ** ** | ** ** | **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 |   |

 

13

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**Note 2.   Investments (Continued)**

The amortized cost andfair value of investment securities available for sale at December 31,2005, by contractual maturity, are shown below. Contractual maturities willdiffer from expected maturities because borrowers may have the right to call orprepay obligations with or without call or prepayment penalties.

| ** **                              | ** ** | **Amortized** | ** ** | **Fair**   | ** ** |
|-----------------------------------------|------------|---------------|------------|------------|------------|
| ** **                              | ** ** | **Cost**      | ** ** | **Value**  | ** ** |
| Due in one year  or less                |       | $             | 3,000,000  |       | $          | 2,970,463 |   |
| Due after one  year through five years  |       | 9,784,811     |       | 9,642,664  |       |
| Due after five  years through ten years |       | 5,921,802     |       | 5,914,506  |       |
| Due after ten  years                    |       | 625,000       |       | 627,738    |       |
| Mortgage-backed  securities             |       | 15,867,764    |       | 15,563,462 |       |
| Other stocks                            |       | 59,064        |       | 73,144     |       |
|                                    |       | $             | 35,258,441 |       | $          | 34,791,977 |   |

 

Proceeds from the maturities of investment securitiesduring 2005 were $ 11,426,380, resulting in no gains or losses. Includedin stockholders’ equity at December 31, 2005 is $ 307,867 ofunrealized holding losses on securities available for sale, net of $ 158,598in deferred taxes.

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

Proceeds from sales of securities available for saleduring 2003 were $6,299,942. Gross gains and losses on those sales were$151,028 and $64,556, respectively. Proceeds from maturities of investmentsecurities during 2003 were $20,568,343, resulting in no gains or losses. Includedin stockholders’ equity at December 31, 2003 is $377,643 of unrealizedholding losses on securities available for sale, net of $34,270 in deferredtaxes.

14

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**Note 2.   Investments (Continued)**

Information pertaining tosecurities with gross unrealized losses at December 31, 2005 and 2004,aggregated by investment category and length of time that individual securitieshave been in a continuous loss position follows:

| ** **                                                | ** ** | **Less Than Twelve Months:** | ** ** | **2005  Over Twelve Months** | ** ** | **Total**                     | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|-------------------------------|------------|
| ** **                                                | ** ** | **Gross  Unrealized  Losses**               | ** ** | **Fair  Value**                        | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Obligations of  U.S. Government corporations and agencies |       |                                        | $          | 25,967                                 |       |                          | $          | 5,672,952 |   |   | $ | 146,925 |   |   | $ | 8,091,913 |   |   | 172,892 |   |   | $ | 13,764,865 |   |
| Obligations of states  and political subdivisions         |       |                                        | 11,955     |                                   |       | 1,635,500                     |       |   | 17,534 |   |   | 1,238,349 |   |   | 29,489 |   |   | 2,873,849 |   |
| Mortgage-backed  securities                               |       |                                        | 284,297    |                                   |       | 10,533,823                    |       |   | 34,131 |   |   | 1,366,463 |   |   | 318,428 |   |   | 11,900,286 |   |
| Other stock                                               |       |                                        | 0          |                                   |       | 0                             |       |   | 420 |   |   | 1,644 |   |   | 420 |   |   | 1,644 |   |
|                                                      |       |                                        | $          | 322,219                                |       |                          | $          | 17,842,275 |   |   | $ | 199,010 |   |   | 10,698,369 |   |   | $ | 521,229 |   |   | $ | 28,540,644 |   |
|                                                           |            |                                             |            |                                        |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                | ** ** | **Less Than Twelve Months:** | ** ** | **2004  Over Twelve Months** | ** ** | **Total**                     | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|-------------------------------|------------|
| ** **                                                | ** ** | **Gross  Unrealized  Losses**               | ** ** | **Fair  Value**                        | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  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. Considerationis given to (1) the length of time and the extent to which the fair valuehas been less than cost, (2) the financial condition and near-termprospects of the issuer for a period of time sufficient to allow for anyanticipated recovery in fair value, and (3) the intent and ability of theCorporation to retain its investment for a period of time sufficient to allowfor any anticipated recovery in fair value.

At December 31, 2005, 13 obligations of U.S.Government corporations and agencies, 5 obligations of states and politicalsubdivisions, 19 mortgage-backed securities and 1 other stock had unrealizedlosses. At December 31, 2005, no debt security had unrealized losses withdepreciation of 5% or more of the Corporation’s amortized cost. At December 31,2005, one marketable equity security, with a cost basis of $2,064 had anunrealized loss of $420, exceeding 20% of the Corporation’s cost basis. Thisunrealized loss existed for more than 12 months. It is a thinly traded stock ofa local financial institution.

15

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**Note 2.   Investments (Continued)**

At December 31, 2004, 7 obligations of U. S. Governmentcorporations and agencies, 2 obligations of states and political subdivisions,7 mortgage-backed securities and 2 other stocks had unrealized losses. At December 31,2004, no debt security had unrealized losses with depreciation of 5% or morefrom the Corporation’s amortized cost, while one marketable equity security hadan unrealized loss of 9% from the Corporation’s cost basis. This unrealizedloss relates primarily to a local financial institution in which there is a lowvolume of stock activity. In analyzing the issuer’s financial condition,management considers industry analysts’ reports, financial performance andfirst hand knowledge of the issuer’s operations and reputation.

TheCorporation is required to maintain minimum investments in certain stocks,which are recorded at cost since they are not actively traded and therefore,have no readily determinable market value. Consequently, the Corporation ownsthe following equity securities at December 31:

| ** **                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Federal Home Loan  Bank        |       | $        | 907,400    |     | $          | 1,126,300 |   |
| Atlantic Central  Bankers Bank |       | 10,000   |       | 10,000   |       |
| Federal Reserve  Bank          |       | 70,850   |       | 70,850   |       |
|                           |       | $        | 988,250    |     | $          | 1,207,150 |   |

 

Securities with a costbasis of $ 10,588,673 (fair value of $ 10,426,881) and$ 8,234,049 (fair value of $ 8,195,363) at December 31, 2005 and2004, respectively, were pledged to secure public funds and for other purposesas required or permitted by law.

**Note 3.**        Loans

Loansconsist of the following at December 31 (in thousands):

| ** **                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Real estate loans                                                           |       |     |       |     |       |
| Secured by farmland                                                         |       | $        | 10,924     |     | $          | 12,754 |   |
| Secured by 1-4 family residential                                           |       | 38,101   |       | 45,545   |       |
| Secured by multifamily (5 or more) residential  properties                  |       | 417      |       | 563      |       |
| Secured by nonfarm nonresidential                                           |       | 14,873   |       | 16,999   |       |
| Loans to finance  agricultural production:                                  |       |     |       |     |       |
| Loans to farmers                                                            |       | 5,018    |       | 5,715    |       |
| Commercial and  industrial loans                                            |       | 7,284    |       | 9,816    |       |
| Loans to  individuals for household, family and other personal expenditures |       | 2,213    |       | 2,524    |       |
| Obligations of  state and political subdivisions in the U.S.                |       | 873      |       | 523      |       |
| All other loans                                                             |       | 77       |       | 31       |       |
|                                                                        |       | 79,780   |       | 94,470   |       |
| Less: reserve for loan losses                                               |       | (1,354   | )          | (1,821   | )          |
|                                                                        |       | $        | 78,426     |     | $          | 92,649 |   |

 

16

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**Note 3.   Loans (Continued)**

Loans 90 days or more pastdue (still accruing interest) and those on nonaccrual status were as follows atDecember 31 (in thousands):

| ** **                    | ** ** | **90 Days or More  Past Due** | ** ** | **Nonaccrual  Status** | ** ** |
|-------------------------------|------------|---------------------------------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **2005**                                          | ** ** | **2004**               | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Loans secured by  real estate |       | $                                                 | 207        |                   |       | $ | 41 |   |   |   | $ | 0 |   |   | $ | 915 |   | $ | 699 |   | $ | 3,314 |   |
| Personal loans                |       | 0                                                 |       |                   | 7          |   |   |   | 0 |   |   | 30 |   | 0 |   | 74 |   |
| Commercial and  other loans   |       | 123                                               |       |                   | 0          |   |   |   | 0 |   |   | 649 |   | 1,030 |   | 771 |   |
| Total                         |       | $                                                 | 330        |                   |       | $ | 48 |   |   |   | $ | 0 |   |   | $ | 1,594 |   | $ | 1,729 |   | $ | 4,159 |   |

 

Foregonerevenue on nonaccrual loans was as follows (in thousands):

| ** **                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest income  that would have been accrued at original loan rates |       | $        | 180        |     | $          | 260      |       | $ | 147 |   |
| Amount recognized  as interest income                                |       | 124      |       | 178      |       | 3        |       |
| Foregone revenue                                                     |       | $        | 56         |     | $          | 82       |       | $ | 144 |   |

 

At December 31, 2005, the total recordedinvestment in impaired loans, all of which had allowances determined inaccordance with SFAS No. 114, amounted to approximately $2,457,000. Theaverage recorded investment in impaired loans amounted to approximately$ 2,157,000 for the year ended December 31, 2005. The allowance forloan losses related to impaired loans amounted to approximately $ 176,896at December 31, 2005. Interest income on impaired loans of $ 59,289was recognized for cash payments received in 2005. The Bank has no commitmentsat December 31, 2005 to loan additional funds to borrowers whose loanshave been modified.

At December 31, 2004, the total recordedinvestment in impaired loans, all of which had allowances determined inaccordance with SFAS No. 114, amounted to approximately $ 1,857,000.The average recorded investment in impaired loans amounted to approximately$ 1,299,000 for the year ended December 31, 2004. The allowance forloan losses related to impaired loans amounted to approximately $ 925,000at December 31, 2004. Interest income on impaired loans of $ 6,815was recognized for cash payments received in 2004. The Bank has no commitmentsat December 31, 2004 to loan additional funds to borrowers whose loanshave been modified.

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. Theaverage recorded investment in impaired loans amounted to approximately$ 1,064,000 for the year ended December 31, 2003. The allowance forloan losses related to impaired loans amounted to approximately $ 250,000at December 31, 2003. Interest income on impaired loans of $ 1,043was recognized for cash payments received in 2003. The Bank has no commitmentsat December 31, 2003to loan additional funds to borrowers whose loans havebeen modified.

During 2004 and 2003, the Corporation sold its studentloan portfolio. Proceeds from the sale of these loans were $ 688,177 and$ 1,683,784, which resulted in gains of $ 12,952 and $ 24,012for the years ended December 31, 2004 and 2003, respectively.

The Corporation has soldcertain mortgage loans to the Federal Home Loan Bank (FHLB), but theCorporation continues to service these loans for FHLB. The outstanding balanceof these loans was $ 2,518,510 and $ 2,737,322 at December 31,2005 and 2004, respectively.

17

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**Note 4.**        Reservefor Loan Losses

Activityin the reserve for loan losses is summarized as follows:

| ** **                                | ** ** | **2005**  | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|-------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Balance at  beginning of period           |       | $         | 1,821,164  |      | $          | 1,899,643 |       | $ | 1,030,713 |   |
| Recoveries                                |       | 10,655    |       | 24,135    |       | 15,036    |       |
| Current year  provision charged to income |       | 316,667   |       | 260,841   |       | 1,265,000 |       |
| Total                                     |       | 2,148,486 |       | 2,184,619 |       | 2,310,749 |       |
| Losses                                    |       | 794,396   |       | 363,455   |       | 411,106   |       |
| Balance at end of period                  |       | $         | 1,354,090  |      | $          | 1,821,164 |       | $ | 1,899,643 |   |

 

**Note 5.**        Loansto Related Parties

The Corporation has granted loans to its officers anddirectors and to their associates. Corporate policy requires that related partyloans are made on substantially the same terms, including interest rates andcollateral, as those prevailing at the time for comparable transactions withunrelated persons and do not involve more than normal risk of collectibility. Theaggregate dollar amount of these loans was $ 4,533,652 and$ 3,944,179 at December 31, 2005 and 2004, respectively. During 2005,$ 2,483,178 of new loans were made, repayments totaled $ 1,758,424,and changes in officer status resulted in a $ 135,281 reduction in officerloan balances.  During 2004,$ 3,260,392 of new loans were made and repayments totaled$ 2,954,761.

Outstanding loans to employees totaled $ 758,872and $ 754,733 at December 31, 2005 and 2004, respectively.

18

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**Note 6. Premises and Equipment**

Asummary of premises and equipment is as follows:

| ** **                                                 | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | **Depreciated** | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------------|------------|-----------------|------------|
| ** **                                                 | ** ** | **Cost**   | ** ** | **Depreciation** | ** ** | **Cost**        | ** ** |
| ** **                                                 | ** ** | ** ** | ** ** | **2005**         | ** ** | ** **      | ** ** |
| Premises and  improvements (including land $500,207)  |       | $          | 3,833,345  |             | $          | 1,046,551       |       | $ | 2,786,793 |   |
| Equipment,  furniture and fixtures                         |       | 3,551,121  |       | 2,910,360        |       | 640,761         |       |
| Vehicles                                                   |       | 98,296     |       | 76,314           |       | 21,983          |       |
| Deposits on  equipment                                     |       | 59,655     |       | 0                |       | 59,655          |       |
|                                                       |       | $          | 7,542,417  |             | $          | 4,033,225       |       | $ | 3,509,192 |   |
| ** **                                                 |       |       |       | **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 |   |

 

Depreciation and amortization expense on property andequipment and other real estate owned amounted to $ 350,171;$ 369,695; and $ 385,655, for the years end December 31, 2005,2004, and 2003, respectively.

During 2005, theCorporation entered into an agreement to purchase computer software andhardware. The total contract amount is $ 84,855, of which $ 59,655had been paid at December 31, 2005.

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

The Corporation is a party to financial instrumentswith off-balance-sheet risk in the normal course of business to meet thefinancial needs of its customers and to reduce its own exposure to fluctuationsin interest rates. These financial instruments include commitments to extendcredit and standby letters of credit. Those instruments involve, to varyingdegrees, elements of credit and interest rate risk in excess of the amountrecognized in the balance sheets. The contract amounts of those instrumentsreflect the extent of involvement the corporation has in particular classes offinancial instruments.

TheCorporation’s exposure to credit loss in the event of nonperformance by theother party to the financial instrument for commitments to extend credit andstandby letters of credit and financial guarantees written is represented bythe contractual amounts of those instruments. The Corporation uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance-sheet instruments.

| ** **                                                                               | ** ** | **Contract or Notional** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                               | ** ** | **Amount**                         | ** ** |
| ** **                                                                               | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| Financial Instruments  whose contract amounts represent credit risk at December 31: |       |                               |       |   |   |
| Commitments to  extend credit                                                            |       | $                                  | 10,174,000 |   | $ | 11,142,000 |   |
| Standby letters of  credit and financial guarantees written                              |       | 21,000                             |       | 171,000 |   |
|                                                                                          |            |                                    |            |  |  |  |  |

 

19

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**Note 7. Financial Instruments With Off-Balance-SheetRisk/Commitments (Continued)**

Commitments to extend credit are agreements to lend toa customer as long as there is no violation of any condition established in thecontract. Commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee. Since many of thecommitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements. TheCorporation evaluates each customer’s credit worthiness on a case-by-case basis.The amount of collateral obtained, if deemed necessary by the Corporation uponextension of credit, is based on management’s credit evaluation of the customer.Collateral held varies but may include accounts receivable, inventory, realestate, equipment, and income-producing commercial properties.

Standby letters of creditand financial guarantees written are conditional commitments issued by theCorporation to guarantee the performance of a customer to a third party. Thoseguarantees are primarily issued to support public and private borrowingarrangements. The credit risk involved in issuing letters of credit isessentially the same as that involved in extending loans to customers. Thecorporation holds collateral supporting those commitments when deemed necessaryby management.

**Note 8. Retirement Plan**

The Corporation maintainsa 401-K profit-sharing plan covering substantially all full-timeemployees. The plan allows contributions of up to 15% of eligible compensationby employees. Additional Corporation contributions can be made at thediscretion of the board of directors. The Corporation’s contributions made tothe plan were $ 25,849; $ 85,168; and $ 110,100, for the yearsended December 31, 2005, 2004 and 2003, respectively.

**Note 9. Federal Income Taxes**

Thecomponents of federal income tax expense are summarized as follows:

| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current year  provision                       |       | $        | (176,209   | )        | $          | (20,967  | )          | $ | 305,342 |   |
| Deferred income  taxes (benefits)             |       | (183,290 | )          | 11,811   |       | (378,030 | )          |
| Income tax effect  of securities transactions |       | 0        |       | 2,046    |       | 62,711   |       |
| Applicable income taxes  (benefits)           |       | $        | (359,499   | )        | $          | (7,110   | )          | $ | (9,977 | ) |

 

Taxable losses were incurred in 2005 and 2004, whichwere carried back to prior years to generate refunds of $ 176,209 and$ 20,967, respectively.

Federal income taxes were computed after reducingpretax accounting income for nontaxable interest and dividend income in theamount of $ 235,522, $ 646,060, and $ 670,932, for 2005, 2004,and 2003, respectively.

Areconciliation of the effective income tax rate to the federal statutory rateis as follows:

| ** **                                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Applicable  federal income tax rate                                                 |       | (34.0    | )%         | (34.0    | )%         | 34.0     | %          |
| Changes resulting from:                                                             |       |     |       |     |       |     |       |
| Nontaxable investment income and other items, net of  nondeductible expenses/losses |       | (21.5    | )%         | 32.5     | %          | (35.3    | )%         |
| Effective income tax  rate                                                          |       | (55.5    | )%         | (1.5     | )%         | (1.3     | )%         |

 

20

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**Note 9. FederalIncome Taxes (Continued)**

Net deferred tax assetsare included in other assets on the balance sheet as follows:

| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Total deferred  tax assets (net of allowance) |       | $        | 1,305,744  |     | $          | 997,985 |   |
| Total deferred  tax liabilities               |       | (186,718 | )          | (231,330 | )          |
| Net deferred tax asset                        |       | $        | 1,119,026  |     | $          | 766,655 |   |

 

The Corporation has recorded a valuation allowance forthe deferred tax assets related to realized and unrealized losses on FNMA andFHLMC preferred stocks as management believes it is not likely they will beultimately realized through future offsetting capital gains.

During 2004 and 2003, these preferred stocks were soldat a loss of $ 1,271,012 and $ 97,972, respectively, which isconsidered a capital loss for federal income tax purposes that can only berealized when offset by capital gains and not ordinary income. This tax benefitof $ 432,144 for 2004 and $ 33,310 for 2003 can be carried forwardfor five years and will expire at December 31, 2009 and 2008,respectively.

At December 31, 2005, the Corporation also had acontribution carryover of $ 1,858 that could not be realized for taxpurposes due to net losses in 2005. A valuation allowance was not establishedfor this amount as management believes the benefit will ultimately be realized.This tax benefit can be carried forward for five years and will expire on December 31,2010.

Thetax effects of each type of significant item that give rise to deferred taxesare:

| ** **                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Capital loss  carryover                                         |       | $        | 432,144    |     | $          | 432,144 |   |
| Net unrealized  (gains) losses on securities available for sale |       | 158,598  |       | (10,483  | )          |
| Deferred  compensation                                          |       | 472,097  |       | 433,779  |       |
| Allowance for  loan losses                                      |       | 626,252  |       | 554,953  |       |
| Depreciation                                                    |       | (186,718 | )          | (220,847 | )          |
| Foregone interest  on non-accrua loans                          |       | 46,939   |       | 9,253    |       |
| Contribution  carryover                                         |       | 1,858    |       | 0        |       |
| Valuation allowance                                             |       | (432,144 | )          | (432,144 | )          |
| Net deferred tax  asset                                         |       | $        | 1,119,026  |     | $          | 766,655 |   |
| Increase (decrease)  in valuation allowance during year         |       | $        | 0          |     | $          | 247,817 |   |

 

**Note10. Leases**

The Corporation is party to real estate leases withbase monthly rental charges of $ 3,775. These charges are to be adjusted onspecified dates and by agreed upon amounts or by the net change in the consumerprice index. The leases expire on January 7, 2011 (as extended) and December 31,2006, respectively. Each lease contains a provision for renewal under variousterms at the Corporation’s option. In addition, the Corporation leases certainequipment on 54 month leases which expire on January 12, 2009 and April 8,2010. Total rental expense charged to operations for the years ended December 31,2005, 2004, and 2003 was $64,177; $66,458; and $ 68,131, respectively.

21

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**Note 10. Leases(Continued)**

Based on the currentmonthly rent, future minimum rental payments for the next five years are as follows:

| 2006 |   | $      | 72,948 |   |
|------|--------|--------|--------|--------|
| 2007 |   | 72,948 |   |
| 2008 |   | 72,948 |   |
| 2009 |   | 62,883 |   |
| 2010 |   | 50,856 |   |

 

**Note 11. Deposits**

Included in interest bearing deposits at December 31are NOW and Money Market Account balances totaling $ 17,958,548 and$ 18,304,499 at December 31, 2005 and 2004, respectively.

Time deposits of $ 100,000 and over aggregated$ 13,995,273 and $ 14,121,775 at December 31, 2005 and 2004,respectively. Interest expense on time deposits of $ 100,000 and over was$ 480,000; $ 468,000; and $ 504,000 for the years ended December 31,2005, 2004, and 2003, respectively.

Theamount of time deposits maturing over the next 5 years as of December 31,2005 is as follows:

| 2006   |   | $          | 28,820,272 |   |
|--------|--------|------------|------------|--------|
| 2007   |   | 11,366,614 |       |
| 2008   |   | 9,251,035  |       |
| 2009   |   | 3,710,323  |       |
| 2010   |   | 891,137    |       |
|   |   | $          | 54,039,381 |   |

 

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 aggregate dollar amount of deposits of officers anddirectors totaled approximately $ 3,681,032 and $ 3,441,064 at December 31,2005 and 2004, respectively.

Overdrafts of $76,967 and $ 31,145 at December 31,2005 and 2004, respectively, were reclassified as loans for financial reportingpurposes.

22

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**Note 12.**                                                  FultonBancshares Corporation (Parent Company Only) Financial Information

The following are thecondensed balance sheets, income statements and statements of cash flows forthe parent company as of and for the years ended December 31:

**Balance Sheets**

| ** **                                                                                   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Assets**                                                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash                                                                                         |       | $          | 21,729     |       | $          | 94,293 |   |
| Investment in  Fulton County National Bank and Trust Company                                 |       | 14,771,949 |       | 15,340,870 |       |
| Investment in  Fulton County Community Development Corporation                               |       | 1,769      |       | 27,202     |       |
| Securities  available for sale                                                               |       | 73,144     |       | 54,023     |       |
| Deferred taxes  and prepaid expenses                                                         |       | 33,184     |       | 1,714      |       |
| Total assets                                                                                 |       | $          | 14,901,775 |       | $          | 15,518,102 |   |
| **Liabilities**                                                                              |       |       |       |       |       |
| Accounts payable                                                                             |       | $          | 0          |       | $          | 7 |   |
| Total liabilities                                                                            |       | 0          |       | 7          |       |
| **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                                                                            |       | 12,938,141 |       | 13,226,245 |       |
| Accumulated other  comprehensive income (loss)                                               |       | (307,867   | )          | 20,349     |       |
| Treasury stock;  shares at cost—2,210 shares                                            |       | (89,211    | )          | (89,211    | )          |
| Total stockholders’ equity                                                              |       | 14,901,775 |       | 15,518,095 |       |
|                                                                                         |       | $          | 14,901,775 |       | $          | 15,518,102 |   |

 

**Statements of Income**

**Years EndedDecember 31**

| ** **                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash dividends  from wholly-owned subsidiary               |       | $        | 25,000     |     | $          | 605,000  |       | $ | 575,000 |   |
| Investment income                                          |       | 1,593    |       | 1,986    |       | 1,580    |       |
| Gain on sale of  investment securities                     |       | 0        |       | 6,019    |       | 0        |       |
| Equity in  undistributed income (loss) of subsidiaries     |       | (253,518 | )          | (981,877 | )          | 241,264  |       |
| Legal, printing,  supplies, amortization and other expense |       | (92,454  | )          | (95,960  | )          | (50,697  | )          |
|                                                       |       | (319,379 | )          | (464,832 | )          | 767,147  |       |
| Applicable income  tax (benefit)                           |       | (31,275  | )          | 0        |       | 0        |       |
| Net Income (loss)                                          |       | $        | (288,104   | )        | $          | (464,832 | )          | $ | 767,147 |   |

 

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**Note 12.**                                                   Fulton Bancshares Corporation (Parent Company Only) FinancialInformation (Continued)

**Statements of CashFlows**

**Years EndedDecember 31**

| ** **                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash flows form  operating activities:                                         |       |     |       |     |       |     |       |
| Net Income (loss)                                                              |       | $        | (288,104   | )        | $          | (464,832 | )          | $ | 767,147 |   |
| Adjustments to  reconcile net income to cash provided by operating activities: |       |     |       |     |       |     |       |
| Equity in undistributed (income) loss of subsidiary                            |       | 253,518  |       | 981,877  |       | (241,264 | )          |
| Gain on sale of investment securities                                          |       | 0        |       | (6,019   | )          | 0        |       |
| Compensation-treasury stock issued                                             |       | 0        |       | 0        |       | 245      |       |
| Increase (decrease) in accounts payable                                        |       | (7       | )          | (12      | )          | 7        |       |
| Increase in prepaid expenses                                                   |       | (37,971  | )          | 0        |       | 0        |       |
| Net cash provided  (used) by operating activities                              |       | (72,564  | )          | 511,014  |       | 526,135  |       |
| Cash flows from  investing activities:                                         |       |     |       |     |       |     |       |
| Sales of investment securities available for sale                              |       | 0        |       | 78,954   |       | 0        |       |
| Net cash provided  by investing activities                                     |       | 0        |       | 78,954   |       | 0        |       |
| Cash flows from  financing activities                                          |       |     |       |     |       |     |       |
| Dividends paid                                                                 |       | 0        |       | (517,425 | )          | (517,450 | )          |
| Purchase of treasury stock                                                     |       | 0        |       | (1,299   | )          | 0        |       |
| Net cash (used)  by financing activities                                       |       | 0        |       | (518,724 | )          | (517,450 | )          |
| Net increase in cash and cash equivalents                                      |       | (72,564  | )          | 71,244   |       | 8,685    |       |
| Cash and cash equivalents at beginning of year                                 |       | 94,293   |       | 23,049   |       | 14,364   |       |
| Cash and cash  equivalents at end of year                                      |       | $        | 21,729     |     | $          | 94,293   |       | $ | 23,049 |   |

 

**Note 13.**                                                  CompensatingBalances

The Corporation isrequired to maintain certain compensating balances with its correspondent banksto cover processing costs and service charges. The balances with thesecorrespondent banks may exceed federally insured limits, which managementconsiders a normal business risk. Required compensating balances were$ 125,000 at December 31, 2005 and 2004.

**Note 14.**                                                  RegulatoryMatters and Contingencies

On March 23, 2005, the Bank’s Board of Directorsentered into a “Stipulation and Consent to the Issuance of a Consent Order”(the “Consent Order”) with the Office of the Comptroller of the Currency (OCC).The Consent Order includes 24 articles that commence by requiring the Bank toform a Compliance Committee and develop an action plan (“Plan”) to comply withthe remaining articles. The Plan requires the development of a strategic plan,the appointment of certain management and officers and the commission of amanagement and board supervision study. The Plan also requires the developmentof a three-year profit plan and capital plan, the requirement to maintaincertain capital ratios, improvement in interest rate risk management, aconsultant study of compliance with Truth-In-Lending and RESPA, and a reviewof  the methodology of determining ALLL. ThePlan further requires the Bank to engage and retain a qualified third-partyloan review, to develop a criticized assets improvement program, to implement aloan portfolio management improvement program and to implement improvedreporting and information systems for the loan portfolio. Further articles ofthe Plan 

24

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**Note 14.**                                                   Regulatory Matters and Contingencies(Continued)

require a qualified,independent consultant to assess compliance with the Bank Secrecy Act (“BSA”),Money Laundering Control Act, suspicious activities, and the rules andregulations of the Office of Foreign Assets and Control, the development of aBSA compliance program, a study of the audit function with emphasis on BSAcompliance, and a written program on Suspicious Activity Reports. Otherarticles of the Plan require the development of a customer information securityprogram, a disaster recovery plan, and a liquidity contingency plan. Finally,an article requires the Board to take all necessary steps to ensure that theBank corrects each violation of law, rule or regulation cited in Reportsof Examination. The remaining articles are administrative in nature.

Under the Consent Order, the Bank must obtain OCCapproval before any executive officers or directors can be added to the Bank’smanagement. The payment of dividends has also been temporarily suspendedwithout prior OCC approval.

Similar restrictions have been placed on the holdingcompany, Fulton Bancshares Corporation, by the Federal Reserve Bank. TheCorporation is considered to be in “troubled” condition, as that term isdefined in Regulation Y, 12 C.F.R.225.71(d). The designation was due to seriousconcerns in a Federal Reserve Inspection Report commenced January 31, 2005and concluded February 17, 2005 and the Office of the Comptroller of theCurrency (OCC) Report of Examination on the Corporation’s wholly-owned banksubsidiary commenced August 10, 2004 and received in the final form inFebruary, 2005. The OCC, the Bank’s primary regulator, provided a letter ofconcern based on the preliminary findings of the Examination dated November 23,2004. The concerns in the OCC Report of Examination were reflected in theConsent Order referenced above.

On May 9, 2005 the Board of Directors of theCorporation signed a Memorandum of Understanding (“MOU”) dated May 9, 2005issued by Federal Reserve Bank (“Reserve Bank”). The principle elements of theMOU are as follows:  The Corporation maynot issue dividends nor incur debt not in the ordinary course of businesswithout approval of the Reserve Bank, the Corporation may not repurchase itsown stock without approval of the Reserve Bank, the Corporation must appoint acompliance committee and conduct an assessment of the external audit firm’sability to audit an organization, such as the Corporation, which is subject tothe Sarbanes Oxley Act and the Corporation is required to ensure that itswholly owned subsidiary, The Fulton County National Bank & TrustCompany, complies with the supervisory actions imposed by the Office of theComptroller of the Currency.

The OCC has also informed the Bank of possibleviolations of laws and regulations with regard to the Bank Secrecy Act, theTruth-In-Lending Act, and the Real Estate Settlement Procedures Act which couldresult in future fines and penalties to the Bank and possible reimbursements. Theamount of any future fines or reimbursements cannot be reasonably estimated at December 31,2005.

Because compliance with the Order will requirereallocation and increases in internal resources and the engagement of variousvendors and consultants, the cost of compliance and the effect on results ofoperations is expected to be material; however the cost of compliance with theOrder cannot be reasonably estimated at this time.

The Bank continues to take actions required by theOrder to remediate the identified weaknesses through the Board ComplianceCommittee that directs and monitors the completion of the specific requirementsof Order by use of internal resources and the retention of qualified vendorsand consultants.

In addition, on March 4,2005, the Bank terminated its President. The Boards of Directors ofFulton Bancshares Corporation and The Fulton County National Bank and TrustCompany entered into a Settlement Agreement and General Release with its formerPresident which became effective on June 15, 2005. The terms of theSettlement Agreement are summarized as follows.

25

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**Note 14.**                                                   Regulatory Matters and Contingencies (Continued)

The former President’s termination on March 4,2005 from employment as an officer or employee of the Bank remained in effect.The former President resigned as a member of the Boards of Directors and anyother officer or employment position he held with the Corporation and the Bank,effective June 15, 2005. The former President acknowledged his March 4,2005 separation from employment by the Corporation and the Bank and agreed thathe will not challenge the legal validity of that separation. The formerPresident agreed not to seek employment with the Corporation or the Bank.

The principal balances of a loan to the formerPresident and two other loans in the aggregate approximate amount of$ 185,000 were paid to the Bank in full with interest and other charges asrequired by the applicable loan documents. In addition, the former Presidentassigned Pittsburgh Steelers ticket licensing rights for six seats to the Bank.

The Bank agreed to no longer take the position underthe Salary Continuation Agreement, known generically as a Supplemental EmployeeRetirement Plan, dated September 1, 1995 and subsequently amended(together, “SERP”) that the former President’s termination was for cause,thereby allowing the former President to apply to the OCC and the FederalDeposit Insurance Corporation (“FDIC”) for permission to obtain such part ofhis SERP as the regulators or the courts determine that the Bank must pay. Ifthe SERP payments are not approved by the OCC and FDIC, and such regulatorydisapproval is upheld by any subsequent judicial review, then the Bank agreedto pay the former President only one year of severance pay at his final annualsalary, if authorized by the regulators to do so. The former President agreedto not challenge the legal validity of the Bank’s payment under the SERP of theamount determined by the regulators or a final valid court order. The Bankagreed to not file a civil action requesting the return by the former Presidentof monies paid to him under the Bank’s 401(k) plan or the SERP.

The Directors as individuals and shareholders releasedthe former President from liability related to his employment with theCorporation and the Bank. The former President released the Corporation, Bank,and Directors from any liability related to termination of his employment withthe Corporation and the Bank.

Under capital adequacy guidelines, the Corporation isrequired to maintain minimum capital ratios. The “leverage ratio”, whichcompares capital to adjusted total balance sheet assets is required to be atleast 4%. “Tier I” and “Tier II” capital ratios compare capital torisk-weighted assets and off-balance sheet activity. The Tier I ratio isrequired to be at least 4%. The combined Tier I and Tier II ratio is requiredto be at least 8%. Failure to meet minimum capital requirements can initiatecertain mandatory, and possibly additional discretionary actions by regulatorsthat, if undertaken, could have a direct material effect on the Corporation’s financialstatements.

Under the Order, the Bank is required to maintainhigher minimum capital ratios than the normal industry minimums:  14% Tier I capital to risk-weighted assetsand 10% Tier I capital to adjusted total assets.

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

| ** **                                                                         | ** ** | **Industry**     | ** ** | **Consent Order** | ** ** | **Actual** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                         | ** ** | **Requirements** | ** ** | **Requirements**       | ** ** | **2005**   | ** ** | **2004** | ** ** |
| Leverage (total  adjusted capital/total average assets)                            |       |             | 4.0        | %                      |       |       | 10.0       | % |   | 10.9 | % | 10.8 | % |
| Tier 1 (Tier 1  core capital/risk weighted assets)                                 |       |             | 4.0        | %                      |       |       | 14.0       | % |   | 18.1 | % | 17.1 | % |
| Total capital (total  capital plus allowance for loan losses/risk weighted assets) |       |             | 8.0        | %                      |       |       |       |   |   | 19.4 | % | 18.4 | % |

 

26

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**Note 14.**                                                   Regulatory Matters and Contingencies (Continued)

As of December 31,2005, the most recent notification form the Comptroller of the Currencycategorized the Bank as adequately capitalized under the regulatory frameworkfor prompt corrective action. There are no conditions or events since thatnotification that management believes have changed the Bank’s category.

**Note 15.**                                                  Liabilitiesfor Borrowed Money

At December 31, 2005 and 2004, the Corporationhad an outstanding ten year, $ 15,000,000 loan with Federal Home Loan Bankof Pittsburgh. The interest rate can increase quarterly depending on marketrates based on the 3 month LIBOR plus .1%, but any change is at the discretionof the FHLB. The rate is currently fixed at 5.93% at December 31, 2005 and2004 and interest is payable monthly. The loan matures on July 12, 2010. Thereare significant penalties for prepayment. On March 29, 2005, theCorporation was notified by Federal Home Loan Bank that it will be required toidentify and deliver specific assets as collateral equal to outstandingborrowings, plus accrued interest and any penalties for early payment. Theamount of investments collateralizing the ten year borrowing is approximately$ 18,423,000, which exceeds the required collateral of $ 16,067,000at December 31, 2005.

The Corporation has established credit at Federal HomeLoan Bank (FHLB) of Pittsburgh. The Corporation may borrow up to approximately$ 54,577,000 from FHLB under the terms of certain commitment agreements,less any borrowings outstanding. The rates and terms of the commitments areflexible and are not fixed until the funds are withdrawn, but funds may not beborrowed for more than one year. The interest rate is variable and can changedaily based on FHLB’s cost of funds. There were no borrowings from this line atDecember 31, 2005 and 2004. Eligible collateral for the borrowingsconsisted of certain investments and mortgages approximating $ 54,755,000at December 31, 2005.

The Corporation also hasestablished a line of credit for Fed Funds purchases with the Atlantic CentralBankers Bank. The Corporation may borrow up to $4,000,000 under the terms ofthe borrowing agreements. The terms of Fed Funds purchases are generallyovernight and the rates can change daily. At December 31, 2005, theCorporation had no borrowings from this line.

**Note 16.**                                                  RealEstate Owned Other Than Premises

At December 31, 2005, real estate owned otherthan premises consisted of one property that the Corporation foreclosed on in2004, which is carried at fair value less costs to sell of $ 670,850. Netproceeds from sales of other real estate owned in 2005 were $ 882,413,which resulted in a net gain of $ 19,263, after writing down the fairvalue of the remaining property by $ 50,000.

At December 31, 2004, real estate owned otherthan premises consisted of four related properties that the Corporationforeclosed on in 2004, which were carried at a fair value of $ 1,534,000. Netproceeds from sales of other real estate owned in 2004 were $ 211,680,which resulted in a gain of $ 5,481.

27

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**Note 17. Fair Value of Financial Instruments**

Theestimated fair values of the Corporation’s financial instruments were asfollows at December 31, 2005 and 2004:

| ** **                                                                           | ** ** | **2005**             | ** ** | **2004**        | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|-----------------|------------|
| ** **                                                                           | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| ** **                                                                           | ** ** | **(000 Omitted)**    | ** ** |
| **FINANCIAL ASSETS**                                                                 |       |                 |       |            |       |   |   |   |   |
| Cash and cash  equivalents                                                           |       | $                    | 4,256      |            | $          | 4,256 |   | $ | 16,364 |   | $ | 16,364 |   |
| Securities  available for sale                                                       |       | 34,792               |       | 34,792          |       | 18,985 |   | 18,985 |   |
| Federal Reserve,  Atlantic Central Bankers Bank,   and Federal Home Loan Bank stocks |       | 988                  |       | 988             |       | 1,207 |   | 1,207 |   |
| Loans receivable  (net)                                                              |       | 78,426               |       | 80,668          |       | 92,649 |   | 93,409 |   |
| Cash surrender  value of life insurance                                              |       | 5,610                |       | 5,610           |       | 5,430 |   | 5,430 |   |
| Accrued interest  receivable                                                         |       | 627                  |       | 627             |       | 660 |   | 660 |   |
| **FINANCIAL  LIABILITIES**                                                           |       |                 |       |            |       |   |   |   |   |
| Time certificates                                                                    |       | 55,684               |       | 54,969          |       | 56,860 |   | 56,610 |   |
| Other deposits                                                                       |       | 51,802               |       | 51,802          |       | 52,761 |   | 52,761 |   |
| Accrued interest  payable                                                            |       | 270                  |       | 270             |       | 243 |   | 243 |   |
| Other borrowed funds                                                                 |       | 15,000               |       | 15,702          |       | 15,000 |   | 16,463 |   |
|                                                                                      |            |                      |            |                 |            |  |  |  |  |  |  |  |  |

 

**Note 18. Deferred Compensation and Other BenefitPrograms**

The Bank hasadopted several benefit programs, some of which result in the deferral ofpayments for services rendered:

(1)         The SupplementalExecutive Retirement Plan—This Plan is funded by single premium life insuranceon certain Corporation executives, with the Corporation as beneficiary. Actualpayments to the executives will not begin until their retirement, except in thecase of a change of control.

(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 whoqualified were eligible at age 75 to receive $ 4,000 annually for up to 10years under this program. No additional directors will be added to the DirectorEmeritus program.

(3)         The Director DeferredCompensation Plan—This plan, also funded by life insurance, allows directors todefer up to 100% of directors fees annually. The amounts deferred will be paidout over a period of up to 10 years beginning when the director reaches the ageof 75.

(4)         The Officer SupplementalLife Insurance Plan provides for officer life insurance coverage to named thirdparties of generally double their current salary level, and is also funded bysingle premium life insurance.

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**Note 18. DeferredCompensation and Other Benefit Programs (Continued)**

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

| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| **Asset**                                           |       |     |       |     |       |      |       |
| Cash surrender  value of life insurance             |       | $        | 5,609,639  |     | $          | 5,429,963 |       | $ | 5,229,926 |   |
| **Liabilities**                                     |       |     |       |     |       |      |       |
| Supplemental  executive retirement plan             |       | 884,598  |       | 860,524  |       | 798,930   |       |
| Deferred  directors fees liability                  |       | 503,921  |       | 415,296  |       | 328,592   |       |
| **Income**                                          |       |     |       |     |       |      |       |
| Earnings on cash  surrender value of life insurance |       | 225,016  |       | 243,188  |       | 258,209   |       |
| **Expenses**                                        |       |     |       |     |       |      |       |
| Life insurance  expense                             |       | 45,341   |       | 39,553   |       | 39,078    |       |
| Supplemental  executive retirement expense          |       | 24,074   |       | 61,594   |       | 145,145   |       |
| Deferred  directors fees                            |       | 89,012   |       | 87,166   |       | 63,711    |       |
| Director emeritus  fees                             |       | 12,000   |       | 12,000   |       | 12,000    |       |
| Payments made to retired  director                  |       | 1,685    |       | 1,685    |       | 1,685     |       |
|                                                     |            |          |            |          |            |           |            |  |  |  |

 

**Note 19. 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 adiversified loan portfolio, a significant portion of its customers’ ability tohonor their contracts is dependent upon the agribusiness economic sector at December 31,2005 (approximately 20% of the loan portfolio and 107% of stockholders’equity).

Management evaluates each customer’s creditworthinesson a case-by-case basis. The amount of collateral obtained, if deemed necessaryupon the extension of credit, is based on management’s credit evaluation of thecustomer. Collateral held varies but generally includes equipment and realestate.

The Corporation maintainsdeposit balances at correspondent banks, which provide check collection anditem processing services to the corporation. At times, the balances with thesecorrespondent banks may exceed federally insured limits, which managementconsiders a normal business risk.

**Note 20. Subsequent Events**

On January 23, 2006, the Corporation entered intoan Agreement and Plan of Merger (the “Merger Agreement”) with Franklin FinancialServices Corporation (“Franklin”) pursuant to which the Corporation will mergewith and into Franklin (the “Merger”) with Franklin being the survivingcorporation in the Merger. In connection with the Merger, the Corporation willalso cause its wholly-owned subsidiary, the Bank, to merge with and intoFranklin’s wholly-owned subsidiary, Farmers and Merchants Trust Company ofChambersburg (“F&M Trust”), (the “Bank Merger”) with F&M Trust beingthe surviving bank in the Bank Merger. Under the terms of the Merger Agreement,shareholders of the Corporation will have the right to elect to receive, foreach share of the Corporation’s common stock they own: (1) 1.864 shares ofvalidly issued, fully paid and nonassessable shares of Franklin’s common stock,or (2) $ 48.00 in cash. Each shareholder of the Corporation will beentitled to elect all cash, all Franklin common stock or a mix of cash andFranklin common stock for their shares of the Corporation’s common stock. Shareholderelections, however, will be subject to allocation procedures designed to ensurethat the aggregate number of shares of Franklin common stock to be issued andthe aggregate amount of cash to be paid shall not exceed 492,790 shares and$ 10,964,577 in cash. Consummation of the Merger is subject to 

29

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**Note 20. SubsequentEvents (Continued)**

certain customary termsand conditions, including, but not limited to, receipt of various regulatoryapprovals and approval by the Corporation’s shareholders.

On January 24, 2006, the Corporation filed theMerger Agreement on a Form 8-K with the Securities and ExchangeCommission. Franklin will file a Registration Statement on Form S-4with the Securities and Exchange Commission addressing the proposed Merger andissuance of Franklin Common Stock in the Merger, which may be subsequentlyamended and which includes the Corporation’s proxy statement to be used for itsannual meeting of shareholders to consider and vote on adoption of the MergerAgreement.

Under the Merger Agreement, the Corporation agreed totake all reasonable efforts to close the Breezewood branch office, located at200 South Breezewood Road, Breezewood, Pennsylvania  15536 as soon as practicable after the dateof the Merger Agreement in accordance with all applicable regulatoryrequirements.

Notices of the closing of the branch office were sentto customers on February 24, 2006. The anticipated closing date is June 3,2006.

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIESSELECTED FIVE-YEAR FINANCIAL DATA**

| ** **                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| **Income Statement (000 omitted)**                    |       |     |       |     |       |     |       |     |       |     |       |
| Interest income                                                      |       | $        | 7,124      |     | $          | 7,555    |       | $        | 8,365      |     | $          | 9,449 |   | $ | 10,105 |   |
| Interest expense                                                     |       | 2,900    |       | 2,891    |       | 3,175    |       | 4,271    |       | 5,432    |       |
| Provision for loan losses                                            |       | 317      |       | 261      |       | 1,265    |       | 255      |       | 15       |       |
| Net interest income after provision for loan losses                  |       | 3,907    |       | 4,403    |       | 3,925    |       | 4,923    |       | 4,658    |       |
| Securities gains (losses)                                            |       | 0        |       | (1,265   | )          | 86       |       | 1        |       | 57       |       |
| Other operating income                                               |       | 613      |       | 609      |       | 751      |       | 640      |       | 582      |       |
| Other operating expense                                              |       | 5,167    |       | 4,219    |       | 4,005    |       | 3,774    |       | 3,450    |       |
| Income (loss before income taxes (benefit)                           |       | (647     | )          | (472     | )          | 757      |       | 1,790    |       | 1,847    |       |
| Applicable income tax (benefit)                                      |       | (359     | )          | (7       | )          | (10      | )          | 335      |       | 415      |       |
| Net income (loss)                                                    |       | $        | (288       | )        | $          | (465     | )          | $        | 767        |     | $          | 1,455 |   | $ | 1,432 |   |
| **Per  share amounts based on weighted averages shares outstanding** |       | 492,790  |       | 492,799  |       | 492,810  |       | 492,772  |       | 492,747  |       |
| Income (loss) before income taxes (benefit)                          |       | $        | (1.31      | )        | $          | (0.96    | )          | $        | 1.54       |     | $          | 3.63 |   | $ | 3.75 |   |
| Income taxes (benefit)                                               |       | (0.73    | )          | (0.01    | )          | (0.02    | )          | 0.68     |       | 0.84     |       |
| Net Income (loss)                                                    |       | (0.58    | )          | (0.94    | )          | 1.56     |       | 2.95     |       | 2.91     |       |
| Cash dividend paid                                                   |       | 0.00     |       | 1.05     |       | 1.05     |       | 1.02     |       | 0.95     |       |
| Book value                                                           |       | 30.24    |       | 31.49    |       | 32.68    |       | 33.80    |       | 30.88    |       |
| **Year-End Balance Sheet (000  omitted)**                            |       |     |       |     |       |     |       |     |       |     |       |
| Total assets                                                         |       | $        | 139,131    |     | $          | 141,757  |       | $        | 147,569    |     | $          | 162,492 |   | $ | 150,828 |   |
| Loans                                                                |       | 79,780   |       | 94,470   |       | 103,288  |       | 108,267  |       | 104,501  |       |
| Reserve for loan losses                                              |       | (1,354   | )          | (1,821   | )          | (1,889   | )          | (1,031   | )          | (845     | )          |
| Net loans                                                            |       | 78,426   |       | 92,649   |       | 101,389  |       | 107,236  |       | 103,656  |       |
| Total investment securities                                          |       | 34,792   |       | 20,192   |       | 31,081   |       | 39,447   |       | 31,899   |       |
| Deposits-noninterest bearing                                         |       | 18,365   |       | 16,524   |       | 13,927   |       | 16,156   |       | 13,486   |       |
| Deposits-interest bearing                                            |       | 89,121   |       | 93,097   |       | 97,200   |       | 96,870   |       | 103,552  |       |
| Total deposits                                                       |       | 107,486  |       | 109,621  |       | 111,127  |       | 113,025  |       | 117,038  |       |
| Liabilities for borrowed money                                       |       | 15,000   |       | 15,000   |       | 18,825   |       | 31,250   |       | 17,325   |       |
| Total stockholders’ equity                                      |       | 14,902   |       | 15,518   |       | 16,104   |       | 16,658   |       | 15,217   |       |
| **Ratios**                                                           |       |     |       |     |       |     |       |     |       |     |       |
| Average equity/average assets                                        |       | 10.73    |  %    | 11.23    |  %    | 11.05    | %          | 10.19    | %          | 10.17    | %          |
| Return on average equity                                             |       | (1.94    | )%         | (2.85    | )%         | 4.52     | %          | 9.18     | %          | 9.76     | %          |
| Return on average  assets                                            |       | (0.21    | )%         | (0.32    | )%         | 0.50     | %          | 0.94     | %          | 0.99     | %          |

 

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIES SUMMARY OF QUARTERLY FINANCIAL DATA**

The unaudited quarterly results of operations for theyears ended December 31, 2005 and 2004 are as follows:

| ** **                                               | ** ** | **2005  Quarter Ended** | ** ** | **2004  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)                                       |       | $                       | 1,783      |                    | $          | 1,779 |   | $ | 1,793 |   | 1,769 |   | $ | 1,915 |   | $ | 1,877 |   | $ | 1,879 |   | $ | 1,884 |   |
| Interest expense                                         |       | 696                     |       | 711                     |       | 735 |   | 758 |   | 734 |   | 730 |   | 717 |   | 710 |   |
| Net interest income                                      |       | 1,087                   |       | 1,068                   |       | 1,058 |   | 1,011 |   | 1,181 |   | 1,147 |   | 1,162 |   | 1,174 |   |
| Provision for  loan   losses                             |       | 70                      |       | 17                      |       | 80 |   | 150 |   | 0 |   | 261 |   | 0 |   | 0 |   |
| Net interest  income after provision for loan losses     |       | 1,017                   |       | 1,051                   |       | 978 |   | 861 |   | 1,181 |   | 886 |   | 1,162 |   | 1,174 |   |
| Securities gains   (losses)                              |       | 0                       |       | 0                       |       | 0 |   | 0 |   | 4 |   | 6 |   | 0 |   | (1,275 | ) |
| Other income                                             |       | 181                     |       | 154                     |       | 150 |   | 128 |   | 159 |   | 163 |   | 134 |   | 153 |   |
| Other expenses                                           |       | 1,144                   |       | 1,375                   |       | 1,300 |   | 1,348 |   | 1,014 |   | (1,089 |   | 1,004 |   | 1,112 |   |
| Operating income before income taxes                |       | 54                      |       | (170                    | )          | (172 | ) | (359 | ) | 330 |   | (34 | ) | 292 |   | (1,060 | ) |
| Applicable income    taxes                               |       | (17                     | )          | (95                     | )          | (73 | ) | (174 | ) | 48 |   | (7 | ) | ((13 | ) | (35 | ) |
| Net income                                               |       | $                       | 71         |                    | $          | (75 | ) | $ | (99 | ) | (185 | ) | $ | 282 |   | $ | (27 | ) | $ | 305 |   | $ | (1,025 | ) |
| Net income applicable to  common stock                   |       |                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Per share data:                                          |       |                    |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                               |       | $                       | 0.14       |                    | $          | (0.15 | ) | $ | (0.20 | ) | $ | (0.37) |   | $ | 0.57 |   | $ | (0.05 | ) | $ | 0.62 |   | $ | (2.08 | ) |
|                                                          |            |                         |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIESDISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS’ EQUITYINTEREST RATES AND INTEREST DIFFERENTIALYears Ended December 31,**
| (000 omitted)                                       | ** ** | **2005**    | ** ** | **2004**     | ** ** | **2003**   | ** ** |
|----------------------------------------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| ** **                                               | ** ** | **Average** | ** ** | ** **   | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **ASSETS**                                               | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate**   | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate** | ** ** |
| Investment securities:                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable interest income                                  |       | $           | 22,972     |         | $          | 924        |       |   | 4.0 | % |   | $ | 25,479 |   | $ | 981 |   |   | 3.9 | % |   | $ | 32,341 |   | $ | 1,377 |   |   | 4.3 | % |   |
| Nontaxable interest  income                              |       | 5,394       |       | 207          |       |       | 3.8        | % |   | 5,395 |   | 207 |   |   | 3.8 | % |   | 1,657 |   | 75 |   |   | 4.5 | % |   |
| Total investment  securities                             |       | 28,366      |       | 1,131        |       |       | 4.0        | % |   | 30,874 |   | 1,189 |   |   | 3.9 | % |   | 33,998 |   | 1,452 |   |   | 4.3 | % |   |
| Loans (net of unearned  discounts)                       |       | 87,210      |       | 5,739        |       |       | 6.6        | % |   | 99,808 |   | 6,351 |   |   | 6.4 | % |   | 107,140 |   | 6,913 |   |   | 6.5 | % |   |
| Other short-term  investments                            |       | 8,224       |       | 254          |       |       | 3.1        | % |   | 1,129 |   | 15 |   |   | 1.3 | % |   | 0 |   | 0 |   |   | 0.0 | % |   |
| Total interest earning  assets                           |       | 123,800     |       | 7,124        |       |       | 5.8        | % |   | 131,811 |   | 7,554 |   |   | 5.7 | % |   | 141,138 |   | 8,365 |   |   | 5.9 | % |   |
| Allowance for loan  losses                          |       | (1,877      | )          |         |       |       |       |   |   | (1,700 | ) |   |   |   |   |   |   | (1,159 | ) |   |   |   |   |   |   |
| Cash and due from banks                             |       | 3,892       |       |         |       |       |       |   |   | 4,122 |   |   |   |   |   |   |   | 3,748 |   |   |   |   |   |   |   |
| Bank premises and  equipment                             |       | 3,564       |       |         |       |       |       |   |   | 3,694 |   |   |   |   |   |   |   | 3,869 |   |   |   |   |   |   |   |
| Other assets                                             |       | 9,315       |       |         |       |       |       |   |   | 7,363 |   |   |   |   |   |   |   | 6,025 |   |   |   |   |   |   |   |
| Total assets                                             |       | $           | 138,694    |         |       |       |       |   |   |   | $ | 145,290 |   |   |   |   |   |   |   | $ | 153,621 |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCHOLDERS’ EQUITY**             | ** ** | ** **  | ** ** | ** **   | ** ** |       |       |   | ** ** | ** ** | ** ** | ** ** | ** ** |   |   |   | ** ** | ** ** | ** ** | ** ** | ** ** |   |   |   |   |
| Interest bearing demand  deposits                        |       | 13,050      |       | 55           |       |       | 0.4        | % |   | 13,202 |   | 71 |   |   | 0.5 | % |   | 11,925 |   | 76 |   |   | 0.6 | % |   |
| Savings deposits                                         |       | 21,932      |       | 150          |       |       | 0.7        | % |   | 24,188 |   | 169 |   |   | 0.7 | % |   | 22,579 |   | 198 |   |   | 0.9 | % |   |
| Time deposits                                            |       | 55,452      |       | 1,794        |       |       | 3.2        | % |   | 58,816 |   | 1,732 |   |   | 2.9 | % |   | 61,069 |   | 1,858 |   |   | 3.0 | % |   |
| Borrowings                                               |       | 15,002      |       | 901          |       |       | 6.0        | % |   | 16,202 |   | 918 |   |   | 5.7 | % |   | 25,290 |   | 1,043 |   |   | 4.1 | % |   |
| Total  interest bearing   liabilities                    |       | 105,436     |       | 2,900        |       |       | 2.8        | % |   | 112,408 |   | 2,891 |   |   | 2.6 | % |   | 120,863 |   | 3,175 |   |   | 2.6 | % |   |
| Demand deposits                                          |       | 16,686      |       |         |       |       |       |   |   | 15,081 |   |   |   |   |   |   |   | 14,966 |   |   |   |   |   |   |   |
| Other liabilities                                        |       | 1,690       |       |         |       |       |       |   |   | 1,573 |   |   |   |   |   |   |   | 821 |   |   |   |   |   |   |   |
| Total liabilities                                        |       | 123,812     |       |         |       |       |       |   |   | 129,062 |   |   |   |   |   |   |   | 136,650 |   |   |   |   |   |   |   |
| Stockholders’ equity                                |       | 14,882      |       |         |       |       |       |   |   | 16,329 |   |   |   |   |   |   |   | 16,971 |   |   |   |   |   |   |   |
| Total liabiliites and  stockholders’ equity         |       | $           | 138,694    |         |       |       |       |   |   |   | $ | 145,391 |   |   |   |   |   |   |   | $ | 153,621 |   |   |   |   |   |   |   |
| Net interest income/net yield  on average earning assets |       |        |       | $            | 4,224      |       |       | 3.4 | % |   |   |   | $ | 4,664 |   |   | 3.5 | % |   |   |   | $ | 5,190 |   |   | 3.7 | % |   |
|                                                          |            |             |            |              |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**FULTONBANCSHARES CORPORATION AND SUBSIDIARIESCHANGES IN NET INTEREST INCOME**

| ** **                             | ** ** | **2005 Versus 2004**      | ** ** | **2004 Versus 2003**      | ** ** |
|----------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                             | ** ** | **Increase (Decrease)**        | ** ** | **Increase (Decrease)**        | ** ** |
| ** **                             | ** ** | **Due to Change in** | ** ** | **Due to Change in** | ** ** |
| ** **                             | ** ** | **Average**                         | ** ** | **Average**                         | ** ** | **Total Increase** | ** ** | **Average** | ** ** | **Average** | ** ** | **Total Increase** | ** ** |
| **(000) omitted)**                | ** ** | ** **                          | ** ** | **Volume**                          | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| **Interest Income**                    |       |                                |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (net of unearned discounts)      |       |                                | $          | (802                                | )          |   |   | $ | 190 |   |   |   | $ | (612 | ) |   |   | $ | (469 | ) |   |   | $ | (95 | ) |   |   | $ | (563 | ) |   |
| Taxable investment securities          |       |                                | (96        | )                                   |       |   | 39 |   |   |   | (57 | ) |   |   | (273 | ) |   |   | (123 | ) |   |   | (396 | ) |   |
| Nontaxable investment securities  |       |                                | 0          |                                |       |   | 0 |   |   |   | 0 |   |   |   | 145 |   |   |   | (13 | ) |   |   | 132 |   |   |
| Other short-term investment            |       |                                | 199        |                                |       |   | 40 |   |   |   | 239 |   |   |   | 15 |   |   |   | 0 |   |   |   | 15 |   |   |
| Total interest income                  |       |                                | (699       | )                                   |       |   | 269 |   |   |   | (430 | ) |   |   | (581 | ) |   |   | (230 | ) |   |   | (811 | ) |   |
| **Interest  Expense**                  |       |                                |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing demand                |       |                                | (1         | )                                   |       |   | (15 | ) |   |   | (16 | ) |   |   | 8 |   |   |   | (12 | ) |   |   | (5 | ) |   |
| Savings deposits                       |       |                                | (19        | )                                   |       |   | 0 |   |   |   | (19 | ) |   |   | 13 |   |   |   | (43 | ) |   |   | (29 | ) |   |
| Time deposits                          |       |                                | (95        | )                                   |       |   | 157 |   |   |   | 62 |   |   |   | (67 | ) |   |   | (58 | ) |   |   | (126 | ) |   |
| Borrowings                             |       |                                | (68        | )                                   |       |   | 51 |   |   |   | (17 | ) |   |   | (444 | ) |   |   | 319 |   |   |   | (125 | ) |   |
| Total interest expense                 |       |                                | (183       | )                                   |       |   | 193 |   |   |   | 10 |   |   |   | (498 | ) |   |   | 218 |   |   |   | (284 | ) |   |
| **Net  interest income**               | ** ** |                                |       |                                |       |   |   |   |   |   | $ | (440 | ) |   |   |   |   |   |   |   |   |   |   | $ | (527 | ) |   |
|                                        |            |                                     |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

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**MANAGEMENT’S DISCUSSION AND ANALYSIS OF CONSOLIDATEDFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

The following is management’s discussion and analysisof the significant changes in the financial condition and results of operationsof Fulton Bancshares Corporation (the “Corporation”) and its wholly ownedsubsidiaries, The Fulton County National Bank and Trust Company (the “Bank”)and Fulton County Community Development Corporation (“FCCDC”). The consolidatedfinancial condition and results of operations consist almost entirely of theBank’s financial condition and results of operations. This discussion should beread in conjunction with the financial tables, consolidated financialstatements and notes to consolidated financial statements appearing elsewherein this report. Current performance does not guarantee, assure or may not beindicative of similar performance in the future.

We have made forward-looking statements in thisdocument and in documents that we incorporated by reference that are subject torisk and uncertainties. Forward-looking statements include the informationconcerning possible or assumed future results of operations of the Corporation,the Bank, and FCCDC. When we used words such as “believes”, “expects”, “anticipates”or other similar expressions, we are making forward-looking statements.

Stockholders shouldnote that many factors, some of which are discussed elsewhere in this documentand in the documentation that we incorporate by reference, could affect thefuture financial results of the Corporation and could cause those results todiffer materially from those expressed in our forward-looking statementscontained or incorporated by reference in this document. These factors includethe following:

·       Operating,legal and regulatory risks;

·       Economic,political and competitive forces affecting our banking business; and

·       Therisk that our analysis of these risks and forces could be incorrect and/or thestrategies developed to address them could be unsuccessful.

The Corporation undertakesno obligation to publicly revise or update these forward-looking statements toreflect events or circumstances that arise after the date of this report. Readersshould carefully review the risk factors described in other documents that theCorporation files periodically with the Securities and Exchange Commission.

**SUBSEQUENT EVENTS:**

On January 23, 2006, the Corporation entered intoan Agreement and Plan of Merger (the “Merger Agreement”) with FranklinFinancial Services Corporation (“Franklin”) pursuant to which the Corporationwill merge with and into Franklin (the “Merger”) with Franklin being thesurviving corporation in the Merger. In connection with the Merger, theCorporation will also cause its wholly-owned subsidiary, the Bank, to mergewith and into Franklin’s wholly-owned subsidiary, Farmers and Merchants TrustCompany of Chambersburg (“F&M Trust”), (the “Bank Merger”) with F&MTrust being the surviving bank in the Bank Merger. Under the terms of theMerger Agreement,  shareholders of theCorporation will have the right to elect to receive, for each share of theCorporation’s common stock they own:  (1) 1.864shares of validly issued, fully paid and nonassesable shares of Franklin’scommon stock, or (2) $48.00 in cash. Eachshareholder of the Corporation will be entitled to elect all cash, all Franklincommon stock or a mix of cash and Franklin common stock for their shares of theCorporation’s common stock. Shareholder elections, however, will be subject toallocation procedures designed to ensure that the aggregate number of shares ofFranklin common stock to be issued and the aggregate amount of cash to be paidshall not exceed 492,790 shares and $10,964,577 in cash. Consummationof the Merger is subject to certain customary terms and conditions, includingbut not limited to, receipt of various regulatory approvals and approval by theCorporation’s shareholders.

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On January 24, 2006, the Corporation filed theMerger Agreement on the Form 8-K with the Securities and ExchangeCommission. Franklin will file a Registration Statement on Form S-4with the Securities and Exchange Commission addressing the proposed Merger andissuance of Franklin common stock in the Merger, which may be subsequentlyamended and which includes the Corporation’s proxy statement to be used for itsannual meeting of shareholders to consider and vote on adoption of the MergerAgreement.

The Board of Directors and Management of FultonBancshares Corporation believe this merger is in the best interests of ourshareholders, customers, employees and the communities served by theCorporation.

Under the MergerAgreement, the Corporation agreed to take all reasonable efforts to close theBreezewood branch office, located at 200 South Breezewood Road, Breezewood,Pennsylvania  15536 as soon aspracticable after the date of the Merger Agreement in accordance with allapplicable regulatory requirements. Notices of the closure were sent tocustomers on February 24, 2006. The anticipated closing date is June 3,2006.

**RESULTS OF OPERATIONS**

**Net Income (Loss)**

The net loss for 2005 was ($288,000), compared to anet loss of ($465,000) for 2004, representing an increase of $177,000 or 38% tothe bottom line. The net loss on an average per share basis (fully diluted) for2005 was ($.58), an increase of $.36 from the loss of ($.94) realized during2004. The net loss before applicable income tax (benefit) was ($648,000) in2005, a reduction of $176,000 from the net loss before applicable income tax(benefit) of ($472,000) in 2004. The tax benefit for 2005 was ($359,000),compared to ($7,000) in 2004. The greater tax benefit resulted from a change inthe cause of the net loss from operations which provided larger tax deductions.In 2005, the loss was generated from lower net interest income, higherprovision for loan losses, and greatly increased operating expenses caused bythe need to comply with the Consent Order from the OCC and MOU from the ReserveBank. The loss in 2004 resulted primarily from the sale of investmentsecurities at a loss of ($1,265,000).

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

**Net Interest Income**

Total interest income for 2005 was $7,124,000,compared with $7,554,000 in 2004, a decrease of $431,000 or 5.7%. Total averageearnings assets declined $8 million, or 6.1%, from 2004 to 2005. This drop anda change in the mix from higher yielding loans to lower yielding investmentsecurities were the cause of the decrease in total interest income. Loanscontinued to decline in 2005 as a result of customers refinancing with otherinstitutions and a reduction in new loan originations due to the lack of asenior lender on staff. The average yield on loans and investment securitiesremained fairly consistent from 2004 to 2005, while short-term investment ratesincreased with the changes in short-term yields in the market. Though primerate increased throughout 2005, the average balance of nonaccrual loans as apercentage of total loans also increased, offsetting the potential interestincome improvement for loans.

Total interest income for 2004 was $7,554,000compared with $8,365,000earned during 2003, a decrease of $811,000, or 10%. Adecrease in average volume of loans and investments in 2004 reduced interestincome by $581,000while a decrease in average rates on earning assets reduced interest income anadditional $230,000.Loans decreased as a result of customers refinancing to other institutions dueto rate, due to workouts of nonperforming loans, and due to the departure ofthe senior lender in 2004. The lower 

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rates earned on loans wasa result of local and national market forces. The average balance in investmentsecurities decreased due to the decline in deposits (which fund investments andother assets) and lower use of borrowings to fund investments in 2004. Therates on investments decreased due to national market forces and a change inthe mix of investment types.

Average earning assets decreased 7% in 2004 anddecreased 1% in 2003. Loans, the highest yielding earning assets, decreased onaverage by 7% in 2004. Average investments decreased 9% in 2004. TheCorporation sold its entire position in FNMA/FHLMC preferred stocks during thefourth quarter of 2004 due to concerns about protracted market value impairmentin an environment of rising rates and due to regulatory concerns about the Bank’sconcentration in this investment type. Due to the timing of the sales, themajority of the proceeds were in cash at year-end. Subsequent reinvestmentswere in shorter duration agency mortgage-backed securities. The preferred stocksale resulted in a loss of $1.3 million and was a materialcause of the Corporation’s net loss before 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 aresult of a decrease in deposit funding and an increase in the average loansoutstanding.

Total interest expense for 2005 was $2,900,000, amodest increase of $9,000, or 0.3%, from$2,891,000 in 2004. The average balance of interest bearing liabilities in 2005declined $6,972,000 or 6.2%, and the cost of interest bearing liabilitiesincreased from 2.6% to 2.8%. The primary cause of the increase in rates was theneed to be more competitive on time deposit rates in an attempt to retaincustomers. Market competition for rates on certificates of deposit and othertime deposits increased significantly throughout 2005. The Corporation did notuse short-term borrowings during 2005.

Total interest expense was $2,891,000for 2004, a decrease of $284,000, or 9%, from the $3,175,000for 2003. The decrease resulted from less use of borrowings for funding in 2004and lower balances and rates on time and savings products. Lower fundingsources were required in 2004 due to lower loan production.

Average interest-bearing liabilities decreased 7% in2004. Average borrowings decreased 36% in 2004 as there was less use ofovernight borrowing to fund longer duration assets because of the interest raterisk involved. Average time deposits decreased 4% as a conservative rateposture was maintained in light of the lack of loan production. Core depositsincreased as a result of improving economic conditions, varying levels of localgovernment funds, and customers temporarily deploying funds while waiting fortime deposit rates to increase.

Net interest income is the difference between totalinterest income and total interest expense. Interest income is generatedthrough earning assets, which include loans, deposits with other banks, andinvestments. Interest income is dependent on many factors including the volumeof earning assets; level of interest rates; changes in interest rates; andvolumes of nonperforming loans. The cost of funds varies with the volume offunds necessary to support earning assets; rates paid to maintain deposits;rates paid on borrowed funds; and level of interest-free deposits.

Net interest income for2005 totaled $4,224,000, a decline of $440,000, or 9.4%, from 2004. Netinterest income for 2004 totaled $4,664,000, down $526,000,or 10% from 2003. Liquidity and interest rate risk are monitored on a regularbasis through ALCO modeling. Management strives to stabilize net interestmargin while competitively pricing loans and deposits and by structuring thematurities of interest-earning assets and liabilities to maintain a desired netinterest margin and liquidity.

**Other Income and Expenses**

Other income represents service charges on depositaccounts, commissions on loan insurance, fees for official checks and otherservices, safe deposit box rentals, fees for trust services, securities gains(losses), 

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gains(losses) on sales ofloans and other real estate owned, and earnings on cash surrender value ofdirectors and officers life insurance.

The Corporation sold no investment securities in 2005,resulting in zero loss or gain. In 2004 the liquidation of the Corporation’sinvestment in preferred stock resulted in a loss of $1.3 million and was amaterial cause of the Corporation’s net 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.

Other income increased slightly, by $4,000, to$613,000 in 2005, compared to $609,000 before the loss on sales of investmentssecurities in 2004. Besides the loss on sales of investment securities in 2004,other income decreased $141,000, or 19% in 2004compared to 2003. Service charges on deposits decreased $6,000, or 3.3%, in2005 and $ 45,000, or 21%, in 2004 due to the closings of accounts that wereproviding fee income. Other service charges and fees increased $24,000, or15.6% in 2005. Other service charges and fees decreased $ 66,000, or 30%, in2004 due to lower mortgage fee income, printed check upcharges and settlementservices income. Trust services and revenue from the sales of financialproducts decreased in both 2005 and 2004 due to the bank outsourcing theseservices which typically have high direct cost and compliance and legal risks. TheCorporation sold no loans in 2005, resulting in zero gains or losses. TheCorporation had gains on sales of student loans of $11,000 in 2004 as it exiteddirect origination and administration in favor of a referral process thatentails no direct costs. Earnings on bank-owned life insurance decreased$18,172, or 7.5% in 2005 and $15,000, or 6%, in 2004 dueto decreases in crediting rates. Gain on the sale of OREO properties was$19,000 in 2005 versus $5,000 in 2004. No additional OREO properties wereacquired during 2005. The Corporation sold real estate and fixtures at itsWarfordsburg branch office location during 2005, resulting in a gain of $9,000.

Noninterest expenses are classified into six maincategories:  salaries and employeebenefits; occupancy and furniture and equipment expenses that includedepreciation, maintenance, utilities, taxes, insurance and rents; professionaland other fees; data processing expenses; FDIC insurance premiums; and otheroperating expenses that include all other expenses incurred in normaloperations.

Salaries and benefits increased $285,000,or 16.9%, during 2005 as a result of the hiring of contract individuals to fillroles vacated by senior executives during the year and to compensate the addedstaff required for compliance with the Consent Order and MOU. Salaries andbenefits for 2004 decreased by $25,000 or 2% compared 2003.New hires, merit pay increases and a significant increase in health insurancecosts (up 21%) were offset by the eliminated salary and deferred benefitreversals attributable to the departure of certain senior officers and by alower elective contribution to the 401 K plan. Net occupancy and furnitureand equipment expenses increased $31,000 in 2005 due tocharges for network maintenance and enhancements to the ATMs required to bringthem into compliance with new security requirements. Net occupancy andfurniture and equipment expenses decreased $27,000, or 3%, due tolower maintenance, utilities, and depreciation expense in 2004. Professionaland other loan-related expenses increased $492,000, or 137.2% in 2005 and $174,000or 94% in 2004 as the Corporation incurred material expenses to work problemcredits, handle legal costs associated with the departure of the CEO , andcomply with the Consent Order and MOU.

Data processing expensesincreased $22,000 in 2005 and $29,000 in 2004, primarily due to theimplementation of Internet Banking in 2004. FDIC premium expense increased$161,000, or 492.5%, in 2005 and $15,000, or 87%, in 2004due to a higher risk rating assigned by regulators. Other operating expensesdeclined $43,000 or 4.1% in 2005 due to expense savings programs implemented inall areas except those required for compliance with regulatory orders. Otheroperating expenses increased $47,000 or 5% for 2004 due to supply costs toestablish customer identification files required by regulations, increaseddirector oversight costs and higher shares tax.

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**Income Taxes**

Applicable income taxes changed between 2005, 2004,and 2003 because of changes in pretax accounting income and taxable income. Theeffective tax (benefit) rate for 2005 was (55.5%) compared to (1.5%) and (1.3%)for 2005, 2004 and 2003, respectively. The more favorable effective income taxbenefit for 2005 reflected the loss resulting from tax deductible increases inexpenses without a corresponding change in the mix of tax-free loans andinvestments. The loss on sale of the preferred stock which occurred in 2004 isconsidered a capital loss under the IRS tax code. Because the Corporation didnot have material capital gains in the past nor can capital gains be predictedin the future, the 2004 capital loss does not produce a current tax benefit. Thetax rate in 2004 and 2003 was reduced by the dividends received deduction forFNMA/FHLMC preferred stock and is reduced in all years by tax-exempt intereston obligations of state and political subdivisions (carried as both loans andinvestments). See Note 9 to the Financial Statements for more informationon the components of federal income tax expense.

The following table presents a summary of significantearnings and capital ratios:

| ** **               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Average assets           |       | $        | 138,694    |     | $          | 145,391  |       | $ | 153,621 |   |
| Net income (loss)        |       | (288     | )          | (465     | )          | 767      |       |
| Average equity           |       | 14,882   |       | 16,329   |       | 16,971   |       |
| Cash dividends paid      |       | 0        |       | 517      |       | 517      |       |
| Return on average assets |       | (0.21    | %)         | (0.32    | %)         | (0.20    | %)         |
| Return on average equity |       | (1.94    | %)         | (2.85    | %)         | (4.52    | %)         |
| Dividend payout ratio    |       | 0.00     | %          | 211.18   | %          | 67.41    | %          |
| Equity to asset ratio    |       | 10.73    | %          | 11.23    | %          | 11.05    | %          |
| Loan to deposit ratio    |       | 72.96    | %          | 84.52    | %          | 91.24    | %          |
|                          |            |          |            |          |            |          |            |  |  |  |

 

**FINANCIAL CONDITION**

Total assets at December 31, 2005 were $139,131,000,a 1.8% decrease from December 31, 2004. The balance sheet mix changedsignificantly in 2005. Loans decreased $14,690,000, or 18.4%, and investmentsecurities increased $15,807,000 or 83.3%, fromyear-end 2004 to year-end 2005. Total deposits declined only 1.9% from December 31,2004 to December 31, 2005. The Corporation sold its entire position inFNMA/FHLMC preferred stocks during the fourth quarter of 2004 due to concernsabout protracted market value impairment in an expected return to a risingrates environment and due to regulatory concerns about the Bank’s concentrationin this investment type. Due to the timing of the sales, the majority of theproceeds were in cash at year-end. Subsequent reinvestments were made toshorter duration agency mortgage-backed securities.

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Thefollowing table shows the maturities of investment securities at book value asof December 31, 2005, and weighted average yields of such securities. Yieldsare shown on a tax equivalent basis, assuming a 34% federal income tax rate.

| ** **                   | ** ** | ** **        | ** ** | **After 1**  | ** ** | **After 5**    | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------|------------|-------------------|------------|-------------------|------------|---------------------|------------|-------------------|------------|------------|------------|
| ** **                   | ** ** | ** **        | ** ** | **year but** | ** ** | **years**           | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **Within 1** | ** ** | **within 5** | ** ** | **but within** | ** ** | **After 10** | ** ** | ** ** | ** ** |
| **(000 omitted)**       | ** ** | ** **        | ** ** | **year**          | ** ** | **years**           | ** ** | **10 years** | ** ** | **years**  | ** ** | **Total** | ** ** |
| Bonds:                       |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   |   |   |
| U.S. Government  agencies    |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   |   |   |
| Book value                   |       |              | $          | 5,749             |       |                | $          | 8,189             |       |       | $          | 0 |   |   |   | $ | 0 |   |   | $ | 13,938 |   |
| Yield                        |       |              | 3.65       | %                 |       | 4.12                | %          |              | 0.00       | %          |       |   | 0.00 | % |   | 3.93 | % |
| State and  municipal         |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   |   |   |
| Book value                   |       |              | 300        |              |       | 4,414               |       |              | 680        |       |       |   | 0 |   |   | 5,394 |   |
| Yield                        |       |              | 8.52       | %                 |       | 6.95                | %          |              | 6.10       | %          |       |   | 0.00 | % |   | 6.93 | % |
| Mortgage-backed              |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   |   |   |
| Book value                   |       |              | 0          |              |       | 10,229              |       |              | 5,526      |       |       |   | 112 |   |   | 15,867 |   |
| Yield                        |       |              | 0.00       | %                 |       | 4.35                | %          |              | 4.55       | %          |       |   | 4.70 | % |   | 4.42 | % |
| Total book value             |       |              | $          | 6,049             |       |                | $          | 22,832            |       |       | $          | 6,206 |   |   |   | $ | 112 |   |   | $ | 35,199 |   |
| Yield                        |       |              | 3.89       | %                 |       | 4.77                | %          |              | 4.72       | %          |       |   | 4.70 | % |   | 4.61 | % |
| Equity securities:           |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   |   |   |
| Total equity securities      |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   | $ | 59 |   |
| Yield                        |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   | 2.70 | % |
| Total Investment  securities |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   |   |   |
| Total Yield                  |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   | $ | 35,258 |   |
|                         |       |              |       |              |       |                |       |              |       |       |       |   |   |   |   | 4.61 | % |
|                              |            |                   |            |                   |            |                     |            |                   |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Loans**

Gross loans receivable at December 31, 2005totaled $79,780,000, compared to $94,470,000 a decrease of $14,690,000 or18.4%. This decrease, which occurred across all significant loan categories,was the result of the absence of a senior commercial lender during the year,increased regulatory scrutiny, loans paid off in troubled loan workout efforts,and mortgage refinancing to mass market lenders.

Gross loans receivable at December 31, 2004decreased $8,819,000 or 9% from December 31, 2003. Mortgage and personalloan refinancing to other lenders was responsible for much of the decrease.

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

| **(000 omitted)**                                           | ** ** | ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial,  financial and agricultural                          |       | $          | 13,175     |     | $          | 15,531   |       | $        | 18,623     |     | $          | 15,171   |       | $ | 17,418 |   |
| Real estate—Construction                                    |       | 0          |       | 0        |       | 0        |       | 0        |       | 0        |       |
| Real estate—Mortgage                                        |       | 64,315     |       | 75,861   |       | 80,398   |       | 82,098   |       | 78,796   |       |
| Installment and  other personal loans (net of unearned discount) |       | 2,290      |       | 3,078    |       | 4,268    |       | 10,998   |       | 8,287    |       |
| Total loans                                                      |       | $          | 79,780     |     | $          | 94,470   |       | $        | 103,289    |     | $          | 108,267  |       | $ | 104,501 |   |

 

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Presentedbelow are the approximate maturities of the loan portfolio (excluding realestate mortgages and installments) at December 31, 2005:

| **(000 omitted)**                  | ** ** | ** ** | ** ** | **Under  One  Year** | ** ** | **One to  Five  Years** | ** ** | **Over  Five  Years** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|------------|------------|----------------------|------------|------------------------------|------------|-----------------------|------------|-----------|------------|
| Commercial,  financial and agricultural |       | $          | 7,767      |                 | $          | 4,865                        |       | $                     | 543        |      | $          | 13,175 |   |
| Real estate—Construction           |       | 0          |       | 0                    |       | 0                            |       | 0                     |       |
| Total                                   |       | $          | 7,767      |                 | $          | 4,865                        |       | $                     | 543        |      | $          | 13,175 |   |

 

Thefollowing table presents the approximate amount of fixed rate loans andvariable rate loans due as of December 31, 2005:

| **(000 omitted)**               | ** ** | ** ** | ** ** | **Fixed  Rate  Loans** | ** ** | **Variable  Rate  Loans** | ** ** |
|--------------------------------------|------------|------------|------------|------------------------|------------|---------------------------|------------|
| Due within one  year                 |       | $          | 5,479      |                   | $          | 36,083                    |       |
| Due after one but  within five years |       | 15,096     |       | 15,164                 |       |
| Due after five  years                |       | 7,958      |       | 0                      |       |
| Total                                |       | $          | 28,533     |                   | $          | 51,247                    |       |

 

**Allowancefor Loan Losses and Related Provision**

The provision for loan losses was $317,000 in 2005compared to 261,000 in 2004 and $1,265,000 in 2003. The provision expensein each year was based on management’s evaluation of the adequacy of theallowance for loan losses and represents amounts deemed necessary to maintainthe allowance at the appropriate level based on the quality of the loanportfolio and economic conditions. Actual charge-offs (net of recoveries) were $784,000in 2005, $339,000 in 2004;and $396,000 in 2003. The allowance for loan losseswas deemed to adequately reflect the risk inherent in the loan portfolio at December 31,2005.

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

| ** **                                                    | ** ** | **Years Ended December 31** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(000 omitted)**                                        | ** ** | ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Average total loans  outstanding (net of unearned income)     |       | $                                          | 87,210     |   | $ | 99,808 |   | $ | 107,140 |   | $ | 105,219 |   | $ | 105,028 |   |
| Allowance for loan  losses, beginning of   period             |       | $                                          | 1,821      |   | $ | 1,900 |   | $ | 1,031 |   | $ | 845 |   | $ | 847 |   |
| Additions to provision  for loan losses charged to operations |       | 317                                        |       | 261 |   | 1,265 |   | 255 |   | 15 |   |
| Loans charged off during the year                             |       |                                       |       |   |   |   |   |   |   |   |   |
| Real estate                                                   |       | 0                                          |       | 2 |   | 25 |   | 0 |   | 0 |   |
| Commercial and  agricultural                                  |       | 755                                        |       | 343 |   | 363 |   | 3 |   | 20 |   |
| Installment                                                   |       | 39                                         |       | 19 |   | 23 |   | 73 |   | 14 |   |
| Total charge-off’s                                       |       | 794                                        |       | 364 |   | 411 |   | 76 |   | 34 |   |
| Recoveries of loans previously charged off:                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Real estate                                                   |       | 7                                          |       | 3 |   | 6 |   | 0 |   | 0 |   |
| Commercial and  agricultural                                  |       | 0                                          |       | 7 |   | 0 |   | 1 |   | 2 |   |
| Installment                                                   |       | 3                                          |       | 14 |   | 9 |   | 6 |   | 15 |   |
| Total recoveries                                              |       | 10                                         |       | 24 |   | 15 |   | 7 |   | 17 |   |
| Net loans charged off                                         |       | 784                                        |       | 339 |   | 396 |   | 69 |   | 17 |   |
| Allowance for loan losses                                     |       | $                                          | 1,354      |   | $ | 1,821 |   | $ | 1,900 |   | $ | 1,031 |   | $ | 845 |   |
| Ratio of net loans charged off to average loans  outstanding  |       | .90                                        | %          | .34 | % | .37 | % | .06 | % | .02 | % |
|                                                               |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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The provision is based on an evaluation of theadequacy of the allowance for possible loan losses. The evaluation includes,but is not limited to, review of net loan losses for the year, the present andprospective financial condition of the borrowers and evaluation of current andprojected 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)**       | ** ** | ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Nonaccrual loans             |       | $          | 1,594      |     | $          | 1,729    |       | $        | 4,159      |     | $          | 1,596    |       | $ | 289 |   |
| Accrual loans:               |       |       |       |     |       |     |       |     |       |     |       |
| Restructured                 |       | $          | 0          |     | $          | 0        |       | $        | 0          |     | $          | 0        |       | $ | 0 |   |
| 30 through 89  days past due |       | 1,644      |       | 3,778    |       | 3,362    |       | 3,692    |       | 4,121    |       |
| 90 days or more  past due    |       | 330        |       | 48       |       | 0        |       | 70       |       | 922      |       |
| Total accrual loans          |       | $          | 1,974      |     | $          | 3,826    |       | $        | 3,326      |     | $          | 3,762    |       | $ | 5,043 |   |

 

Foregonerevenue on nonaccrual loans was as follows (in thousands):

| ** **                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest income  that would have been accrued at original loan rates |       | $        | 180        |     | $          | 260      |       | $ | 147 |   |
| Amount recognized  as interest income                                |       | 124      |       | 178      |       | 3        |       |
| Foregone revenue                                                     |       | $        | 56         |     | $          | 82       |       | $ | 144 |   |

 

 

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At December 31, 2005, the total recordedinvestment in impaired loans, all of which had allowances determined inaccordance with SFAS No. 114, amounted to approximately $2,457,000. Theaverage recorded investment in impaired loans amounted to approximately$ 2,157,000 for the year ended December 31, 2005. The allowance forloan losses related to impaired loans amounted to approximately $ 176,896at December 31, 2005. Interest income on impaired loans of $ 59,289was recognized for cash payments received in 2005. The Bank has no commitmentsat December 31, 2005 to loan additional funds to borrowers whose loanshave been modified.

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 allowance for loan losses consists of acomponent for individual loan impairment primarily based on the loan’scollateral fair value and other observable data. A watch list of loans isidentified for evaluation based on regulatory examinations and internal andexternal loan grading and reviews. Loans other than those determined to beimpaired are grouped into pools of loans with similar credit risk characteristics.These loans are evaluated as groups with allocations made to the allowancebased 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. The 2005provision for loan losses increased versus 2004 due primarily to the charge-offof a large commercial relationship. The 2004 provision was lower than 2003based on fewer additions to the watch list in 2004 than in 2003, a decrease inthe loan portfolio and lower net charge-offs.

Theprovision expense increased significantly from 2003 through 2005 compared toprior years for two reasons. First, nonaccrual loans and net charge-offs remainat levels much higher than prior years. The increase in non-accrual loans andcharge-offs resulted from actions taken as required by the Bank’s primaryregulator in response to examinations conducted in 2003 and 2004. Secondly, theexaminations increased the amount of the classified loans which increased theBank’s risk-based allowance on such loans. These loans were tested forimpairment and additional provisions were made as necessary. The examinationsadversely classified loans primarily because of structural weaknesses and lackof adequate financial analysis in underwriting new loans and renewing existingloans. The examinations also cited weaknesses in credit risk practices, changesin lending philosophy and unreliable historical loss trends as cause forrequiring higher allowances. Throughout 2005, management has been workingdiligently with outside consultants to improve underwriting practices and shoreup structural weaknesses and financial analysis for all loans in the portfolio.In addition, the methodology for the analysis for loan losses has been enhancedto correspond more closely with OCC standards for evaluating deficiencies andestimating probable losses.

| ** **                                       | ** ** | **Years Ended December 31** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Nonaccrual loans  as a percentage of total loans |       | 2.00                                       | %          | 1.83 | % | 4.03 | % | 1.47 | % |
| Net charge-offs  to average total loans          |       | 0.90                                       | %          | 0.34 | % | 0.37 | % | 0.06 | % |
| Provision for loan  losses                       |       | $                                          | 317,000    |   | $ | 261,000 |   | $ | 1,265,000 |   | $ | 255,000 |   |
|                                                  |            |                                            |            |  |  |  |  |  |  |  |  |  |  |

 

The Corporation has identified loans dependent on theagribusiness economic sector as a concentration of credit. At December 31,2005, agribusiness loans comprised 43% of criticized and 13% of classifiedassets.

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Thefollowing is an allocation by loan categories of the allowance for loan lossesat December 31 for the last five years. In retrospect the specificallocation in any particular category may prove excessive or inadequate andconsequently may be reallocated in the future to reflect the then currentconditions. Accordingly, the entire allowance is available to absorb losses inany category.

| ** **                              | ** ** | **2005**              | ** ** | **2004**                                                | ** ** |
|-----------------------------------------|------------|-----------------------|------------|---------------------------------------------------------|------------|
| **(000 omitted)**                  | ** ** | **Allowance  Amount** | ** ** | **Percentage of  Loans to  Total Loans** | ** ** | **Allowance  Amount** | ** ** | **Percentage of  Loans to  Total Loans** | ** ** |
| Commercial,  financial and agricultural |       |                  | $          | 1,129                                                   |       |   |   | 16.5 | % |   |   | $ | 1,565 |   |   |   | 16.4 | % |   |
| Real estate—Construction      |       |                  | 0          |                                                    |       |   | 0.0 |   |   |   | 0 |   |   |   | 0.0 |   |   |
| Real  estate—Mortgage              |       |                  | 193        |                                                    |       |   | 80.6 |   |   |   | 240 |   |   |   | 80.3 |   |   |
| Installment                             |       |                  | 32         |                                                    |       |   | 2.9 |   |   |   | 16 |   |   |   | 3.3 |   |   |
| Total                                   |       |                  | $          | 1,354                                                   |       |   |   | 100.00 | % |   |   | $ | 1,821 |   |   |   | 100.00 | % |   |

 

| ** **                              | ** ** | **2003**              | ** ** | **2002**                                                | ** ** |
|-----------------------------------------|------------|-----------------------|------------|---------------------------------------------------------|------------|
| **(000 omitted)**                  | ** ** | **Allowance  Amount** | ** ** | **Percentage of  Loans to  Total Loans** | ** ** | **Allowance  Amount** | ** ** | **Percentage of  Loans to**

**Total Loans** | ** ** |
| Commercial,  financial and agricultural |       |                  | $          | 1,507                                                   |       |   |   | 18.0 | % |   |   | $ | 561 |   |   |   | 14.0 | % |   |
| Real estate—Construction           |       |                  | 0          |                                                    |       |   | 0.0 |   |   |   | 0 |   |   |   | 0.0 |   |   |
| Real  estate—Mortgage              |       |                  | 351        |                                                    |       |   | 77.8 |   |   |   | 333 |   |   |   | 75.8 |   |   |
| Installment                             |       |                  | 42         |                                                    |       |   | 4.2 |   |   |   | 137 |   |   |   | 10.2 |   |   |
| Total                                   |       |                  | $          | 1,900                                                   |       |   |   | 100.00 | % |   |   | $ | 1 031 |   |   |   | 100.00 | % |   |

 

| ** **                              | ** ** | **2001**              | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| **(000 omitted)**                  | ** ** | **Allowance  Amount** | ** ** | **Percentage of  Loans to  Total Loans** | ** ** |
| Commercial,  financial and agricultural |       |                  | $          | 141 |   |   |   | 12.7 | % |   |
| Real estate—Construction           |       |                  | 0          |   |   |   | 0.0 |   |   |
| Real  estate—Mortgage              |       |                  | 637        |   |   |   | 77.8 |   |   |
| Installment                             |       |                  | 67         |   |   |   | 9.5 |   |   |
| Total                                   |       |                  | $          | 845 |   |   |   | 100.00 | % |   |

 

**Deposits**

Totaldeposits decreased 3.4% to $107,486,000 at December 31, 2005, compared to$ 109,621,000 at December 31, 2004. Noninterest bearing demanddeposits increased 11.1% year-end to year-end and average balances were up$1,605,000 for 2005 and $ 115,000 for 2004. Interest bearing depositsdecreased 4.3% due to competitive market pressures and a conservative rateposture. Noninterest bearing demand deposits increased 19% from December 31,2003 to December 31, 2004, while average demand deposit balances remainedsimilar. Interest bearing deposits decreased 4%. The average amounts ofdeposits are summarized below:

| ** **                        | ** ** | **Years Ended December 31** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| **(000 omitted)**            | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Demand deposits                   |       | $                                          | 16,686     |   | $ | 15,081 |   | $ | 14,966 |   |
| Interest bearing  demand deposits |       | 13,050                                     |       | 13,202 |   | 11,925 |   |
| Savings deposits                  |       | 21,932                                     |       | 24,188 |   | 22,579 |   |
| Time deposits                     |       | 55,452                                     |       | 58,816 |   | 61,069 |   |
| Total deposits                    |       | $                                          | 107,120    |   | $ | 111,287 |   | $ | 110,593 |   |

 

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Thefollowing is a breakdown of maturities of time deposits of $ 100,000 ormore as of December 31, 2005:

| **Maturity**                           | ** ** | ** ** | ** ** | **(000 omitted)** | ** ** |
|----------------------------------------|------------|------------|------------|------------------------|------------|
| Certificates of Deposit                |       |       |       |                   |       |
| Three months or  less                  |       |       | $          | 5,578                  |       |   |
| Over three months  through six months  |       |       | 434        |                   |       |
| Over six months  through twelve months |       |       | 808        |                   |       |
| Over twelve  months                    |       |       | 7,175      |                   |       |
|                                   |       |       | $          | 13,995                 |       |   |

 

**Stockholders’ Equity**

Stockholders’ equity was $ 14,902,000 at December 31,2005, compared with $15,518,000 at December 31, 2004, a decrease of$616,000 or 4%. The December 31, 2004 balance was down 4% compared to December 31,2003. The decrease in 2005 was a result of the net loss of $288,000 and areduction of $328,000 in accumulated other comprehensive income. The decreasein 2004 was a result of the net loss of $465,000 and dividends paid of$ 517,000, partially offset by an increase of $ 398,000 inaccumulated other comprehensive income. Total stockholders’ equity represented10.7% of total assets at the end of 2005 and 10.9% at the end of 2004. No cashdividends were paid in 2005. Cash dividends of $ 1.05 per share were paidin both 2004 and 2003. On July 20, 2000, the Board of Directors announcedthe approval of a plan to purchase up to 2% of its shares of outstanding commonstock. As of December 31, 2004, the company had repurchased 2,210 shares,representing 0.45% of its shares of outstanding common stock. The repurchaseplan has been suspended as of April 11, 2005. No shares have beenrepurchased since June 28, 2004.

Dividends from the Bank tothe Corporation are the predominant source for the Corporation to pay dividends.National banks must obtain regulatory approval before declaring dividends thatexceed its current net profits and prior two years’ retained net profits. Becauseof the net losses and pursuant to the Consent Order with the OCC and the MOUwith the Reserve Bank, dividends have been suspended in upcoming periods untilfurther notice.

**CRITICAL ACCOUNTING POLICIES**

Bank policy related to the allowance for loan lossesis considered to be a critical accounting policy because the allowance for loanlosses represents a particularly sensitive accounting estimate. The amount ofthe allowance is based on management’s evaluation of the collectibility of theloan portfolio, including the nature of the loan portfolio, creditconcentrations, trends in historical loss experience, specific impaired loans,and economic conditions.

The allowance for loanlosses is established through a provision for loan losses charged to expense. Loansare charged against the allowance for loan losses when management believes thecollectibility of the principal is unlikely. The allowance is an amountmanagement believes will be adequate to absorb possible losses on existingloans that may become uncollectible, based on evaluations of the collectibilityof loans and prior loan loss experience. The evaluations take intoconsideration such factors as changes in the nature and volume of the loanportfolio, overall portfolio quality, review of specific problem loans, and currenteconomic conditions that may affect the borrowers’ ability to pay.

**LIQUIDITY**

Liquidity and interest rate sensitivity are relatedto, but distinctly different from, one another.

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Liquidity involves the Bank’s ability to meet cashwithdrawal needs of customers and their credit needs in the form of loans. Liquidityis provided by certain balances held at correspondent banks. Adequate liquidityto meet credit demands and/or adverse deposit flows is also made available fromsales or maturities of short-term assets. Additional sources of funds to meetcredit needs are provided by access to the marketplace to obtaininterest-bearing deposits and other borrowings, including special programsavailable through Federal Home Loan Bank. At both December 31, 2005 and2004, the Bank had borrowings of $ 15,000,000 from the Federal Home LoanBank. At December 31, 2005, the Bank had total borrowing capacityavailable of $ 54.6 million.

On March 29, 2005, the Corporation was notifiedby Federal Home Loan Bank that it was required to identify and deliver specificassets as collateral equal to outstanding borrowings, plus accrued interest andany penalties for early payment. The amount required to cover the $15 millionborrowing at December 31, 2005 was approximately $ 16.1 millionat December 31, 2005.

Interestrate sensitivity is the matching or mismatching of the maturity and ratestructure of the interest bearing assets and liabilities. It is the objectiveof management to control the difference in the timing of the rate changes forthese assets and liabilities to preserve a satisfactory net interest margin andmanage changes in the market value of equity. The following table approximatelyreflects the matching of assets and liabilities maturing within one year andthereafter, which management feels is adequate to meet customer cash and creditneeds while maintaining a desired interest rate spread.

| **(000 omitted)**                      | ** ** | ** ** | ** ** | **Due  0-30  Days** | ** ** | **Due  31-90  Days** | ** ** | **Due  90-180  Days** | ** ** | **Due  181-360  Days** | ** ** | **Due  After  1 Year** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|------------|------------|---------------------|------------|----------------------|------------|-----------------------|------------|------------------------|------------|-----------------------------|------------|-----------|------------|
| **Rate Sensitive Assets**              |       |       |       |                |       |                 |       |                  |       |                   |       |                        |       |
| Investment  securities                 |       | $          | 645        |                | $          | 590                  |       | $                     | 2,675      |                   | $          | 3,705                       |       | $         | 27,643     |   | $ | 35,258 |   |
| Real estate, commercial  and           |       |       |       |                |       |                 |       |                  |       |                   |       |                        |       |
| installment loans                      |       | 16,902     |       | 5,201               |       | 9,725                |       | 9,737                 |       | 38,215                 |       | 79,780                      |       |
|                                   |       | 17,547     |       | 5,791               |       | 12,400               |       | 13,442                |       | 65,858                 |       | 115,038                     |       |
| **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 |       | 3,474      |       | 2,104               |       | 434                  |       | 808                   |       | 7,175                  |       | 13,995                      |       |
| Other  certificates of deposit         |       | 10,999     |       | 2,115               |       | 2,921                |       | 5,965                 |       | 19,689                 |       | 41,689                      |       |
| Money market  deposit accounts         |       | 81         |       | 161                 |       | 243                  |       | 488                   |       | 4,059                  |       | 5,032                       |       |
| Other interest  bearing deposits       |       | 232        |       | 462                 |       | 695                  |       | 1,392                 |       | 25,624                 |       | 28,405                      |       |
|                                   |       | 14,786     |       | 4,842               |       | 4,293                |       | 8,653                 |       | 71,547                 |       | 104,121                     |       |
| Cumulative GAP—12/31/05           |       | $          | 2,761      |                | $          | 3,710                |       | $                     | 11,817     |                   | $          | 16,606                      |       | $         | 10,917     |   | $ | 10,917 |   |
| Cumulative GAP—12/31/04           |       | $          | (8,142     | )                   | $          | 2,704                |       | $                     | (2,246     | )                      | $          | (17,431                     | )          | $         | 5,357      |   | $ | 5,357 |   |

 

During 2005, the Corporation engaged an outside firmto assist with ALCO reporting and simulation analysis. The results of the twoyears are not necessarily comparable in that the assumptions used during 2005were evaluated in much more detail and used data derived directly from the corebanking systems in the 2005 analysis of maturities. In monitoring and evaluatingliquidity, management generally does not consider regular savings orinterest-bearing checking accounts to be particularly rate sensitive based onpast experience in various interest rate cycles.

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**CONTRACTUAL OBLIGATIONS**

Contractualobligations of the Company as of December 31, 2005 are as follows:

| ** **                   | ** ** | **Payments due by period** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| **(000 omitted)**            | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less  than 1  year** | ** ** | **1 - 3  years** | ** ** | **3 - 5  years** | ** ** | **More  than 5  years** | ** ** |
| FHLB borrowings              |       | $                                         | 15,000     |   | $ | 0 |   | $ | 0 |   | $ | 15,000 |   |   | $ | 0 |   |   |
| Operating lease  obligations |       | 333                                       |       | 73 |   | 146 |   | 114 |   |   | 0 |   |   |
| Total                        |       | $15,333                                   |       | $ | 73 |   | $ | 146 |   | $15,114 |   |   | $ | 0 |   |   |
|                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Off-Balance Sheet Arrangements**

The Corporation’s financial statements do not reflectoff-balance sheet arrangements that are made in the normal course of business. Thoseoff-balance sheet arrangements consist of unfunded loans and letters of creditmade under the same standards as on-balance sheet instruments. Thesecommitments totaled $ 10,195,000 at December 31, 2005. This consistedof $ 3,522,000 in home equity lines of credit, $ 21,000 in standbyletters of credit and $ 6,652,000 in other unused commitments (primarilycommercial and agricultural lines of credit). Because these instruments havefixed maturity dates, and because many of them will expire without being drawn,they do not generally present any significant liquidity risk to theCorporation.

Management believes thatany amounts actually drawn upon can be funded in the normal course ofoperations. The Corporation has no investment in or financial relationship withany unconsolidated entities that are reasonably likely to have a materialeffect on liquidity or the availability of capital resources.

**RegulatoryMatters and Contingencies**

Dividends paid by Fulton Bancshares Corporation aregenerally provided from the Fulton County National Bank and Trust Company’supstreamed dividends to it. The Federal Reserve Board, which regulates bank holdingcompanies, establishes guidelines which indicate that cash dividends should becovered by current year earnings and the debt to equity ratio of the holdingcompany must be below thirty percent.

Under capital adequacy guidelines, the Corporation isrequired to maintain minimum capital ratios. In general, the “leverage ratio”,which compares capital to adjusted total balance sheet assets is required to beat least 4%. “Tier I” and “Tier II” capital ratios compare capital torisk-weighted assets and off-balance sheet activity. The Tier I ratio isrequired to be at least 4%. The combined Tier 1 and Tier II ratio is requiredto be at least 8%. Failure to meet minimum capital requirements can initiatecertain mandatory, and possibly additional discretionary actions by regulatorsthat, if undertaken, could have a direct material effect on the Corporation’sfinancial statements.

On March 23, 2005, the Bank’s Board of Directorsentered into a “Stipulation and Consent to the Issuance of a Consent Order”(the “Order”) with the Office of the Comptroller of the Currency (OCC). TheOrder requires the Bank to implement and improve operating procedures andprocesses within stipulated timeframes. Under the Order, the Bank is requiredprospectively to maintain higher minimum capital ratios than the normalindustry minimums: 14% Tier I capital to risk weighted assets and 10% Tier Icapital to adjusted total assets. In furtherance of the Order, dividends havebeen suspended until further regulatory approval.

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

| ** **                                                                         | ** ** | ** **                 | ** ** | ** **                       | ** ** | **Actual** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                                                         | ** ** | **Industry  Requirements** | ** ** | **Consent  Order  Requirements** | ** ** | **2005**   | ** ** | **2004** | ** ** |
| Leverage (total  adjusted capital/total average assets)                            |       | 4.0                        | %          | 10.0                             | %          | 10.9       | %          | 10.8 | % |
| Tier 1 (Tier 1  core capital/risk weighted assets)                                 |       | 4.0                        | %          | 14.0                             | %          | 18.1       | %          | 17.1 | % |
| Total capital (total  capital plus allowance for loan losses/risk weighted assets) |       | 8.0                        | %          | N/A                              |       | 19.4       | %          | 18.4 | % |

 

As of December 31, 2005, the most recentnotification from the Comptroller of the Currency categorized the Bank asadequately capitalized under the regulatory framework for prompt correctiveaction. There are no conditions or events since that notification thatmanagement believes have changed the Bank’s category, although the OCC has,through the Order, raised the Bank’s required ratios from the normal minimumsas shown above.

Under the Order, the Bank must obtain OCC approvalbefore any executive officers or directors can be added to the Bank’smanagement. During 2005, the OCC approved George W. Millward as Interim CEO andDebra A. Goodling as Interim CFO. Stanley J. Kerlin was also approved as anadditional Board member.

Similar restrictions have been placed on the holdingcompany, Fulton Bancshares Corporation, by the Federal Reserve Bank. By letter dated March 15, 2005 the TheCorporation was deemed to be in ““troubled”“ condition, as that term is defined in 12Regulation Y, 12 C.F.R. 225.71(d) by the Federal Reserve Bank of Philadelphia,the Corporation’s primary regulator.). The designation was due toserious concerns in a Federal Reserve Inspection Report commenced January 31,2005 and concluded February 17, 2005 and the Office of the Comptroller ofthe Currency (OCC) Report of Examination on the Corporation’s wholly-owned banksubsidiary commenced August 10, 2004 and received in the final form inFebruary, 2005. The OCC, the Bank’s Bank’sprimary regulator, provided a letter of concern based on the preliminaryfindings of the Examination dated November 23,2004. The concerns in the OCC Report of Examination were reflected in the Orderreferenced above.

On May 9, 2005 the Board of Directors of theCorporation signed a Memorandum of Understanding (“MOU”) dated May 9, 2005issued by Federal Reserve Bank (“Reserve Bank”). The principle elements of theMOU are as follows:  The Corporation maynot issue dividends nor incur debt not in the ordinary course of businesswithout approval of the Reserve Bank, the Corporation may not repurchase itsown stock without approval of the Reserve Bank, the Corporation must appoint acompliance committee and conduct an assessment of the external audit firm’sability to audit an organization, such as the Corporation, which is subject tothe Sarbanes Oxley Act and the Corporation is required to ensure that its whollyowned subsidiary, The Fulton County National Bank & Trust Company,complies with the supervisory actions imposed by the Office of the Comptrollerof the Currency.

The OCC has also informed the Bank of possibleviolations of laws and regulations with regard to the Bank Secrecy Act, theTruth-In-Lending Act, and the Real Estate Settlement Procedures Act which couldresult in future fines and penalties to the Bank and possible reimbursements. Theamount of any future fines or reimbursements cannot be reasonably estimated at December 31,2005.

As discussed previously in the Managements’Discussion, compliance with the Order has required reallocation and increasesin internal resources and the engagement of various vendors and consultants. 

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The future cost ofcompliance and the effect on results of operations is expected to be material;however the cost of compliance with the Order cannot be reasonably estimated atthis time.

The Bank has taken numerous actions required by theOrder to remediate the identified weaknesses. It formed a Board ComplianceCommittee that directs and monitors the completion of the specific requirementsof Order.  A monthly report is filed withthe OCC updating the Bank’s progress in meeting the requirements of the ConsentOrder.

On March 4, 2005, the Bankterminated its President. The Boards of Directors of Fulton BancsharesCorporation and The Fulton County National Bank and Trust Company entered intoa Settlement Agreement and General Release with its former President whichbecame effective on June 15, 2005. The terms of the Settlement Agreementare summarized as follows.

The former President’s termination on March 4,2005 from employment as an officer or employee of the Bank remained in effect.The former President resigned as a member of the Boards of Directors and anyother officer or employment position he held with the Corporation and the Bank,effective June 15, 2005. The former President acknowledged his March 4,2005 separation from employment by the Corporation and the Bank and agreed thathe will not challenge the legal validity of that separation. The formerPresident agreed not to seek employment with the Corporation or the Bank.

The principal balances of a loan to the formerPresident and two other loans in the aggregate approximate amount of $185,000were paid to the Bank in full with interest and other charges as required bythe applicable loan documents. In addition, the former President assignedPittsburgh Steelers ticket licensing rights for six seats to the Bank.

The Bank agreed to no longer take the position underthe Salary Continuation Agreement known generically as a Supplemental EmployeeRetirement Plan dated September 1, 1995 and subsequently amended(together, “SERP”) that the former President’s termination was for cause,thereby allowing the former President to apply to the OCC and the FederalDeposit Insurance Corporation (“FDIC”) for permission to obtain such part ofhis SERP as the regulators or the courts determine that the Bank must pay. Ifthe SERP payments are not approved by the OCC and FDIC, and such regulatorydisapproval is upheld by any subsequent judicial review, then the Bank agreedto pay the former President only one year of severance pay at his final annualsalary, if authorized by the regulators to do so. The former President agreedto not challenge the legal validity of the Bank’s payment under the SERP of theamount determined by the regulators or a final valid court order. The Bankagreed to not file a civil action requesting the return by the former Presidentof monies paid to him under the Bank’s 401(k) plan or the SERP. Theliability for the SERP as of the date of termination is accounted for in totalon the Corporation’s financial statements.

The Directors as individuals and shareholders releasedthe former President from liability related to his employment with theCorporation and the Bank. The former President released the Corporation, Bank,and Directors from any liability related to termination of his employment withthe Corporation and the Bank.

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**Market Risk Management**

The Bank has riskmanagement policies to monitor and limit exposure to market risk, and simulatesrate changes up and down 200 basis points to measure the impact of changingmix, interest rate movements, rates, and yield curves on net interest incomeand the market value of equity. Management continuously monitors liquidity andinterest rate risk through its Asset-Liability Committee, and reprices productsin order to maintain a desired balance sheet mix and 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.

The following table setsforth the projected maturities and average rates for all rate sensitive assetsand liabilities based on the following assumptions. All fixed and variable rateloans were based on original maturities since the bank has not experienced, anddoes not expect, a significant rewriting of loans. Investments are based onmaturity date except certain long-term agencies, which are classified by calldate. The bank has historically experienced very little deposit runoff. Basedon this experience, it was estimated that average runoff of noninterest bearingchecking, interest bearing checking, and other savings would be 10%. It wasestimated that average runoff of time deposits would be 25% and these depositsare classified by original maturity date.
|                                      | ** ** | **Principal/Notional Amount Maturing In** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------|------------|
| **(In thousands)**              | ** ** | **2006**                                                 | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Fair  Value** | ** ** |
| Rate sensitive assets                |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fixed rate loans                     |       | $                                                        | 5,479      |   | $ | 4,738 |   | $ | 4,123 |   | $ | 2,903 |   | $ | 3,332 |   |   | $ | 7,958 |   |   | $ | 28,533 |   | $ | 28,771 |   |
| Average Yield                        |       | 7.56                                                     | %          | 7.61 | % | 7.67 | % | 7.27 | % | 6.93 | % |   | 7.35 | % |   | 7.43 | % |   |   |
| Variable rate  loans                 |       | 36,759                                                   |       | 9,105 |   | 5,115 |   | 527 |   | 414 |   |   | 0 |   |   | 51,920 |   | 51,897 |   |
| Average Yield                        |       | 6.94                                                     | %          | 6.05 | % | 6.61 | % | 6.25 | % | 6.73 | % |   |   |   |   | 6.74 | % |   |   |
| Fixed rate  investment securities    |       | 6,013                                                    |       | 8,338 |   | 4,463 |   | 2,419 |   | 1,797 |   |   | 9,747 |   |   | 32,777 |   | 32,288 |   |
| Average Yield                        |       | 3.68                                                     | %          | 3.81 | % | 4.12 | % | 4.88 | % | 4.50 | % |   | 4.07 | % |   | 4.02 | % |   |   |
| Variable rate  investment securities |       | 1,602                                                    |       | 824 |   |   |   |   |   |   |   |   |   |   |   | 2,426 |   | 2,426 |   |
| Average Yield                        |       | 4.28                                                     | %          | 4.09 | % |   |   |   |   |   |   |   |   |   |   | 4.21 | % |   |   |
| Rate sensitive  liabilities          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing checking         |       | 1,836                                                    |       | 1,836 |   | 1,836 |   | 1,836 |   | 1,836 |   |   | 9,185 |   |   | 18,365 |   | 18,365 |   |
| Interest-bearing checking accounts   |       | 1,269                                                    |       | 1,274 |   | 1,279 |   | 1,285 |   | 1,290 |   |   | 6,531 |   |   | 12,928 |   | 12,928 |   |
| Average Yield                        |       | 0.44                                                     | %          | 0.44 | % | 0.42 | % | 0.42 | % | 0.42 | % |   | 0.44 | % |   | 0.43 | % |   |   |
| Savings accounts                     |       | 2,485                                                    |       | 2,509 |   | 2,534 |   | 2,559 |   | 2,585 |   |   | 7,837 |   |   | 20,509 |   | 20,509 |   |
| Average Yield                        |       | 0.43                                                     | %          | 1.12 | % | 1.09 | % | 1.08 | % | 1.10 | % |   | 0.60 | % |   | 0.91 | % |   |   |
| Time deposits                        |       | 29,311                                                   |       | 11,954 |   | 9,713 |   | 3,808 |   | 853 |   |   | 45 |   |   | 55,684 |   | 54,969 |   |
| Average Yield                        |       | 3.40                                                     | %          | 4.00 | % | 3.49 | % | 3.70 | % | 3.95 | % |   | 2.16 | % |   | 3.57 | % |   |   |
| Variable rate  borrowings            |       |                                                     |       |   |   |   |   |   |   | 15,000 |   |   |   |   |   | 15,000 |   | 15,702 |   |
| Average Yield                        |       |                                                     |       |   |   |   |   |   |   | 5.93 | % |   |   |   |   | 5.93 | % |   |   |
|                                      |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**FutureImpact of Recently Issued Accounting Standards**

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement No. 123(Revised 2004) (SFAS No. 123R) “Share-Based Payment”, which requires thatthe compensation cost relating to share-based payment transactions be recognizedin financial statements. SFAS No. 123R 

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replacesSFAS No. 123, “Accounting for Stock-Based Compensation”, and supersedesAPB Opinion No. 25, “Accounting for Stock Issued to Employees”. Share-basedcompensation arrangements include share options, restricted share plans,performance-based awards, share appreciation rights and employee share purchaseplans. SFAS No. 123R requires all share-based payments to employees to bevalued using a fair value method on the date of grant and expensed based onthat fair value over the applicable vesting period. SFAS No. l23R alsoamends SFAS No. 95 “Statement of Cash Flows” requiring the benefits of taxdeductions in excess of recognized compensation cost be reported as financinginstead of operating cash flows. The Securities and Exchange Commission (“SEC”)issued Staff Accounting Bulletin No. 107 (“SAB 107”), which expressesthe SEC’s views regarding the interaction between SFAS No. 123R andcertain SEC rules and regulations. Additionally, SAB No. 107 providesguidance related to share-based payment transactions for public companies. TheCorporation will be required to apply SFAS No. 123R as of the annualreporting period that begins after September 15, 2005. The Corporationdoes not anticipate that this statement will have a material effect on itsfinancial statements.

In May 2005, theFinancial Accounting Standards Board (“FASB”) issued Statement No. 154, (“SFASNo. 154”) “Accounting Changes and Error Corrections - A Replacement of APBOpinion No. 20 and FASB Statement No. 3”. The new standard changesthe requirements for the accounting for and reporting of a change in accountingprinciple. Among other changes, SFAS No. 154 requires that a voluntarychange in accounting principle be applied retrospectively with all prior periodfinancial statements presented on the new accounting principle, unless it isimpracticable to do so. SFAS No. 154 also provides that (1) a changein method of depreciating or amortizing a long-lived nonfinancial asset beaccounted for as a change in estimate (prospectively) that was effected by achange in accounting principle, and (2) correction of errors in previouslyissued financial statements should be termed a “restatement”. The new standardis effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. The Corporation does notanticipate this statement will have a material effect on its financialstatements.

In November 2005,FASB Staff Position (FSP) 115-1 “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments” was issued. The FSPaddresses the determination as to when an investment is considered impaired,whether that impairment is other than temporary, and the measurement of animpairment loss. This FSP also includes accounting considerations subsequent tothe recognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. The guidance in this FSP amends FASBStatement No. 115, “Accounting for Certain Investments in Debt and EquitySecurities” and APB Opinion No. 18, “The Equity Method of Accounting forInvestments in Common Stock”. The FSP applies to investments in debt and equitysecurities and cost-method investments. The application guidance within the FSPincludes items to consider in determining whether an investment is impaired, inevaluating if an impairment is other than temporary and recognizing impairmentlosses equal to the difference between the investment’s cost and its fair valuewhen an impairment is determined. The FSP is required for all reporting periodsbeginning after December 15, 2005. Earlier application is permitted. TheCorporation does not anticipate the statement will have a material effect onits financial statements.

**StockMarket Analysis and Dividends**

The Corporation’s commonstock is traded inactively in the over-the-counter market. As of December 31,2005 the number of shareholders of record was 562.

| ** **     | ** ** | **Market  Price** | ** ** | **Cash  Dividend** | ** ** | **Market  Price** | ** ** | **Cash  Dividend** | ** ** |
|----------------|------------|-------------------|------------|--------------------|------------|-------------------|------------|--------------------|------------|
| ** **     | ** ** | **2005**          | ** ** | **2004**           | ** ** |
| First Quarter  |       | $                 | 43.50      |               |       | $                 | 0          |               |       | $ | 49.17 |   |   | $ | .23 |   |   |
| Second Quarter |       | 36.50             |       |               | 0          |              |       | 43.41              |       |   | .23 |   |   |
| Third Quarter  |       | 36.40             |       |               | 0          |              |       | 41.66              |       |   | .27 |   |   |
| Fourth Quarter |       | 36.85             |       |               | 0          |              |       | 41.00              |       |   | .32 |   |   |
|                |            |                   |            |                    |            |                   |            |                    |            |  |  |  |  |  |  |  |  |

 

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