UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

                                    FORM 10-K

|X|   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934

For the fiscal year ended December 31, 2005

                                       OR

|_|   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934

For the transition period from _________ to _________

                           Commission File No. 0-22219

                           FIRST SOUTH BANCORP, INC.
             (Exact name of registrant as specified in its charter)

           VIRGINIA                                            56-1999749
-------------------------------                           -------------------
(State or other jurisdiction of                            (I.R.S. Employer
incorporation or organization)                            Identification No.)

1311 CAROLINA AVENUE, WASHINGTON, NORTH CAROLINA               27889-2047
------------------------------------------------         ---------------------
(Address of principal executive offices)                       (Zip Code)

Registrant's telephone number, including area code:  (252) 946-4178

           Securities registered pursuant to Section 12(b) of the Act:

                                      NONE

           Securities registered pursuant to Section 12(g) of the Act:

                     COMMON STOCK, PAR VALUE $0.01 PER SHARE
                                (Title of Class)

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

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

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

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

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

Large accelerated filer |_| Accelerated filer |X| Non-accelerated filer |_|

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

The  aggregate  market  value  of  voting  stock  held by  nonaffiliates  of the
registrant  at June 30, 2005,  was  approximately  $165.1  million  based on the
closing  sale  price of the  registrant's  Common  Stock as listed on the Nasdaq
National  Market as of the last business day of the  registrant's  most recently
completed second fiscal quarter. For purposes of this calculation, it is assumed
that directors,  executive officers and beneficial owners of more than 5% of the
registrant's outstanding voting stock are affiliates.

Number of shares of Common Stock outstanding as of March 2, 2006: 6,392,418.

                       DOCUMENTS INCORPORATED BY REFERENCE

The following lists the documents  incorporated by reference and the Part of the
Form 10-K into which the document is incorporated:

      1.    Portions of the Annual  Report to  Stockholders  for the fiscal year
            ended December 31, 2005. (Parts II and IV)

      2.    Portions of Proxy Statement for 2006 Annual Meeting of Stockholders.
            (Parts II and III)


 <PAGE>

                                      PART I

ITEM 1. BUSINESS

FORWARD-LOOKING STATEMENTS

      The  Private  Securities  Litigation  Reform Act of 1995  states  that the
disclosure  of forward  looking  information  is  desirable  for  investors  and
encourages  such  disclosure  by  providing a safe  harbor for  forward  looking
statements by corporate  management.  This Annual Report on Form 10-K,  contains
forward looking statements that involve risk and uncertainty. In order to comply
with the terms of the safe harbor, the Company notes that a variety of risks and
uncertainties could cause its actual results and experience to differ materially
from the anticipated  results or other  expectations  expressed in the Company's
forward looking  statements.  There are risks and uncertainties  that may affect
the operations, performance,  development, growth projections and results of the
Company's  business.  They  include,  but are not limited to,  economic  growth,
interest rate  movements,  timely  development  of technology  enhancements  for
products,  services and operating systems,  the impact of competitive  products,
services  and pricing,  customer  requirements,  regulatory  changes and similar
matters.  Readers of this report are  cautioned  not to place undue  reliance on
forward  looking  statements that are subject to influence by these risk factors
and unanticipated events. Accordingly, actual results may differ materially from
management's expectations.

GENERAL

      First South Bancorp,  Inc. First South Bancorp,  Inc. (the "Company") is a
Virginia  corporation that serves as the holding company for First South Bank, a
North Carolina chartered  commercial bank (the "Bank").  The Company's principal
business is overseeing the business of the Bank and operating through the Bank a
commercial banking business. The Bank has one significant operating segment, the
providing of general  commercial  banking services to its markets located in the
state of North  Carolina.  The  Company's  common  stock is traded on the Nasdaq
National Market under the symbol "FSBK".

      First South Bank. The Bank is a North Carolina  chartered  commercial bank
headquartered  in Washington,  North Carolina and serves eastern North Carolina.
The Bank received federal insurance of its deposits in 1959.

      The Bank's  principal  business  consists of attracting  deposits from the
general  public and  investing  these funds in  commercial  real  estate  loans,
commercial  business loans,  consumer loans and loans secured by first mortgages
on owner-occupied, single-family residences in the Bank's market area.

      The Bank derives its income  principally from interest earned on loans and
investments and, to a lesser extent,  loan servicing and other fees and gains on
the sale of loans and investments.  The Bank's  principal  expenses are interest
expense on deposits and borrowings and noninterest  expense such as compensation
and  employee  benefits,  office  occupancy  expenses  and  other  miscellaneous
expenses.  Funds for these  activities  are  provided  principally  by deposits,
repayments of outstanding loans and investments and operating revenues.

MARKET AREA

      Although the Company makes loans and obtains deposits  throughout central,
eastern,  northeastern and southeastern North Carolina, where the Bank's offices
are located. As of December 31, 2005, management estimates that more than 95% of
deposits and 90% of loans came from its primary market area.

      The economy of the  Company's  primary  market area is  diversified,  with
employment  distributed among manufacturing,  agriculture and  non-manufacturing
activities.  There are a significant  number of major employers in the Company's
primary  market area.  The  unemployment  rate in the  Company's  market area is
equivalent to the national  average and the  unemployment  rate for the State of
North Carolina.

                                        1
<PAGE>

CRITICAL ACCOUNTING POLICIES

      The Company has  identified the policies below as critical to its business
operations and the  understanding  of its results of operations.  The impact and
any  associated  risks  related  to these  policies  on the  Company's  business
operations  is  discussed  throughout  Management's  Discussion  and Analysis of
Financial  Condition  and  Results  of  Operations  where such  policies  affect
reported and expected financial results.

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

      Loan  Impairment  and  Allowance  for Loan  Losses.  A loan is  considered
impaired,  based on current  information and events,  if it is probable that the
Bank will be unable to collect the  scheduled  payments of principal or interest
when  due   according  to  the   contractual   terms  of  the  loan   agreement.
Uncollateralized loans are measured for impairment based on the present value of
expected future cash flows discounted at the historical effective interest rate,
while all  collateral-dependent  loans are measured for impairment  based on the
fair value of the collateral.

      The Bank uses several  factors in determining  if a loan is impaired.  The
internal  asset   classification   procedures   include  a  thorough  review  of
significant  loans and lending  relationships  and include the  accumulation  of
related data. This data includes loan payment status,  borrowers' financial data
and borrowers'  operating factors such as cash flows,  operating income or loss,
etc.

      The  allowance  for loan  losses is  increased  by  charges  to income and
decreased by charge-offs (net of recoveries).  Management's  periodic evaluation
of the  adequacy  of the  allowance  is  based  on the  Bank's  past  loan  loss
experience,  known and inherent risks in the portfolio,  adverse situations that
may  affect  the  borrower's  ability  to  repay,  the  estimated  value  of any
underlying  collateral,  and  current  economic  conditions.   While  management
believes that it has  established  the allowance in accordance  with  accounting
principles generally accepted in the United States of America and has taken into
account the views of its regulators and the current economic environment,  there
can be no  assurance  that in the future the Bank's  regulators  or risks in its
portfolio will not require further increases in the allowance.

      Income Taxes.  Deferred tax asset and liability balances are determined by
application  to temporary  differences  of the tax rate expected to be in effect
when  taxes  will  become  payable  or  receivable.  Temporary  differences  are
differences  between the tax basis of assets and  liabilities and their reported
amounts in the  financial  statements  that will result in taxable or deductible
amounts in future years.  The effect on deferred  taxes of a change in tax rates
is recognized in income in the period that includes the enactment date.

      Off-Balance  Sheet Risk.  The Company is a party to financial  instruments
with  off-balance  sheet  risk in the  normal  course  of  business  to meet the
financing  needs of its customers and to reduce its own exposure to fluctuations
in interest rates.  These financial  instruments  include  commitments to extend
credit and involve,  to varying  degrees,  elements of credit and interest  rate
risk in excess of the amount recognized in the balance sheet.

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

                                        2
<PAGE>


LENDING ACTIVITIES

      General.  The  Company's  gross  loan  portfolio,  including  real  estate
construction  loans in process,  totaled  $799.0  million at December  31, 2005,
representing  95.9% of total assets at that date. It is the Company's  policy to
concentrate  its  lending  within its market  area.  The  Company  originates  a
significant  amount of  commercial  real estate  loans.  At December  31,  2005,
commercial  real  estate  loans  amounted  to  $570.5  million,  or 71.4% of the
Company's  gross loan  portfolio.  In recent  years,  the  Company has sought to
increase  originations  of  commercial  business  loans and consumer  loans.  At
December 31, 2005,  commercial  business loans totaled $38.5 million, or 4.8% of
the Company's gross loan  portfolio,  and consumer loans totaled $100.5 million,
or 12.6% of the Company's gross loan portfolio.  To a lesser extent, the Company
also  originates  multi-family  residential  real estate loans.  At December 31,
2005, $49.4 million, or 6.2% of the Company's gross loan portfolio, consisted of
single-family,  residential  mortgage loans. The Company's  residential mortgage
construction  loans totaled $25.3 million,  or 3.1% of the Company's  gross loan
portfolio, at December 31, 2005.

                                        3
<PAGE>


      Loan Portfolio  Composition.  The following table sets forth selected data
relating to the  composition  of the Company's loan portfolio by type of loan at
the dates indicated.  At December 31, 2005, the Company had no concentrations of
loans exceeding 10% of gross loans other than as disclosed below.

<TABLE>
<CAPTION>
                                                                         At December 31,
                              -----------------------------------------------------------------------------------------------------
                                     2005                 2004                 2003                 2002                  2001
                              ------------------   ------------------   ------------------   ------------------   -----------------
                               Amount       %       Amount       %       Amount       %       Amount       %       Amount      %
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------
                                                                                   (Dollars in thousands)
<S>                           <C>       <C>        <C>       <C>        <C>       <C>        <C>       <C>        <C>       <C>
 Residential mortgage loans:
  Single-family residential . $ 49,363       6.2%  $ 53,149       7.6%  $ 64,549      10.8%  $103,852      19.6%  $110,217     25.7%
  Multi-family residential ..    2,885       0.4      2,956       0.4      3,650       0.6      6,360       1.2      8,399      2.0
  Construction ..............   25,304       3.1     22,687       3.3      9,921       1.7     17,070       3.2     23,305      5.4
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------
    Total residential
        mortgage loans ......   77,552       9.7     78,792      11.3     78,120      13.1    127,282      24.0    141,921     33.1
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------

Commercial loans and leases:
  Commercial real estate ....  570,469      71.4    470,809      67.4    372,430      62.3    274,564      51.8    172,621     40.3
  Commercial business .......   38,457       4.8     38,891       5.6     47,646       7.9     39,926       7.5     32,450      7.6
  Lease receivables .........   11,981       1.5     11,622       1.6     10,422       1.7      6,624       1.3      3,244      0.8
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------

    Total commercial loans
        and leases ..........  620,907      77.7    521,322      74.6    430,076      71.9    321,114      60.6    208,315     48.7
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------

Consumer loans:
  Automobile ................    4,851       0.6      3,890       0.5      4,045       0.7      4,618       0.8      5,674      1.3
  Savings account loans .....    1,826       0.2      1,394       0.2      1,829       0.3      2,003       0.4      1,438      0.3
  Home equity loans .........   42,084       5.3     42,330       6.1     38,533       6.5     35,471       6.7     34,947      8.2
  Other .....................   51,783       6.5     50,827       7.3     45,072       7.5     39,770       7.5     35,717      8.4
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------
    Total consumer loans ....  100,544      12.6     98,441      14.1     89,479      15.0     81,862      15.4     77,776     18.2
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------
      Total .................  799,003     100.0%   698,555     100.0%   598,097     100.0%   530,258     100.0%   428,012    100.0%
                              --------  --------   --------  --------   --------  --------   --------  --------   --------  -------

Less:
  Construction loans in
        process .............   80,528               57,194               36,280               31,450               16,220
  Deferred fees and discounts    1,433                1,202                  983                  935                  808
  Allowance for loan losses .    9,222                8,343                7,634                6,959                5,371
                              --------             --------             --------             --------             --------
    Total ................... $707,820             $631,816             $553,200             $490,914             $405,613
                              ========             ========             ========             ========             ========
</TABLE>

                                        4
<PAGE>


      Loan  Maturities.  The following  table sets forth certain  information at
December 31, 2005 regarding the dollar amount of loans maturing in the Company's
portfolio  based on their  maturity and  repricing  terms,  including  scheduled
repayments  of  principal.  Demand  loans,  loans  having no stated  schedule of
repayments  and no stated  maturity,  and  overdrafts are reported as due in one
year or less.  The table does not include  any  estimate  of  prepayments  which
significantly  shorten  the  average  life of  mortgage  loans and may cause the
Company's  repayment  experience to differ from that shown below.  Loan balances
are net of construction  loans in process.  Lease balances are included in other
loans.

<TABLE>
<CAPTION>
                                                         Due After          Due After
                                                        1 Through          5 or More
                                         Due One      5 Years After       Years After
                                      Year or Less  December 31, 2005  December 31, 2005     Total
                                      ------------  -----------------  -----------------  ----------
                                                                (In thousands)
<S>                                   <C>           <C>                <C>                <C>
Residential real estate loans ......  $     48,141  $          41,274  $          37,745  $  127,160
Commercial real estate, business and
   other loans .....................       396,128            163,180             32,007     591,315
                                      ------------  -----------------  -----------------  ----------
     Total .........................  $    444,269  $         204,454  $          69,752  $  718,475
                                      ============  =================  =================  ==========
</TABLE>

      The  following  table sets forth at December 31, 2005 the dollar amount of
all loans due one year or more after December 31, 2005 which have  predetermined
interest rates and have floating or adjustable interest rates.


                                       Predetermined       Floating or
                                           Rates        Adjustable Rates
                                      ----------------  ----------------
                                                (In thousands)

Residential real estate loans ......  $         68,419  $         10,600
Commercial real estate, business and
   other loans .....................           194,355               832
                                      ----------------  ----------------
     Total .........................  $        262,774  $         11,432
                                      ================  ================


      Scheduled  contractual  principal  repayments  of loans do not reflect the
actual life of such assets.  The average life of loans can be substantially less
than their  contractual terms because of prepayments.  In addition,  due-on-sale
clauses on loans generally give the Bank the right to declare a loan immediately
due and payable in the event,  among other things,  that the borrower  sells the
real  property  subject to the mortgage and the loan is not repaid.  The average
life of mortgage loans tends to increase when current mortgage loan market rates
are substantially  higher than rates on existing mortgage loans and, conversely,
decrease when current  mortgage loan market rates are  substantially  lower than
rates on existing mortgage loans.

      Originations,  Purchases  and  Sales  of  Loans.  The Bank  generally  has
authority  to  originate  and  purchase  loans  secured by real  estate  located
throughout the state of North Carolina and the United  States.  Consistent  with
its  emphasis  on being a  community-oriented  financial  institution,  the Bank
concentrates its lending activities in its market area.

      The  Bank's  loan  originations  are  derived  from a number  of  sources,
including   referrals  from   depositors  and   borrowers,   repeat   customers,
advertising,   calling  officers  as  well  as  walk-in  customers.  The  Bank's
solicitation  programs consist of  advertisements in local media, in addition to
participation in various community  organizations and events.  Real estate loans
are  originated  by the Bank's  loan  personnel.  A majority  of the Bank's loan
personnel  are  salaried,  and  certain  mortgage  loan  officers  are paid on a
commission basis based on a percentage of closed mortgage loan volume.  With the
exception of applications for boat or recreational  vehicle loans,  which may be
originated  on an indirect  basis  through an  arrangement  with  dealers,  loan
applications  are  accepted at the Bank's  offices.  In all cases,  the Bank has
final  approval of the  application.  Historically,  the Bank  generally has not
purchased  loans.  However,  the Bank may in the future  consider making limited
loan purchases, including purchases of commercial loans.


                                       5
<PAGE>


      In  recent  years,  the  Bank has sold or  exchanged  for  mortgage-backed
securities a significant amount of fixed-rate, single-family mortgage loans that
it originated.  During the years ended December 31, 2005,  2004 and 2003,  these
transactions   totaled  $29.0  million,   $40.5  million  and  $145.8   million,
respectively.  Such loans are sold to or  exchanged  with the Federal  Home Loan
Mortgage  Corporation  ("FHLMC").  The Bank generally retains servicing on loans
sold or exchanged.

      Loan Underwriting  Policies.  The Bank's lending activities are subject to
the  Bank's  written,  non-discriminatory  underwriting  standards  and to  loan
origination  procedures  prescribed  by the Bank's  Board of  Directors  and its
management.  Detailed loan applications are obtained to determine the borrower's
ability  to repay,  and the more  significant  items on these  applications  are
verified  through  the  use  of  credit  reports,   financial   information  and
confirmations. The Bank uses an automated underwriting software program owned by
FHLMC named Loan  Prospector on the majority of loans  underwritten  for sale to
FHLMC. In addition,  loans sold to other investors may be manually  underwritten
by  the  Bank  or  the  respective  investor,   or  the  respective   investor's
representatives,  or through an investor's  automated  underwriting  system,  if
applicable.  All  large  loans  are  presented  weekly  by the  management  loan
committee to a loan committee of the Board of Directors of the Bank,  made up of
three outside  directors who serve on a rotating  basis.  The President does not
serve on the loan  committee of the Board of Directors.  Individual  officers of
the Bank have  been  granted  authority  by the Board of  Directors  to  approve
consumer and commercial loans up to varying specified dollar amounts,  depending
upon the type of loan.  In  addition,  committees  of loan  officers  have  loan
authorities greater than individual authorities.  These authorities are based on
aggregate  borrowings of an individual or entity. All loans to a single borrower
aggregating in excess of $1,500,000 must be approved by the Loan Committee. On a
monthly basis, the full Board of Directors reviews the actions taken by the loan
committee.

      Applications  for  single-family  real estate loans are  underwritten  and
closed in accordance  with the standards of FHLMC or the investor's  guidelines.
Generally,  upon receipt of a loan  application from a prospective  borrower,  a
credit report and  verifications  are ordered,  or obtained,  to verify specific
information  relating  to the loan  applicant's  employment,  income  and credit
standing.  If a proposed loan is to be secured by a mortgage on real estate,  an
appraisal  of the real  estate is  usually  undertaken  either  by an  appraiser
approved by the Bank and licensed by the State of North Carolina or by qualified
Bank personnel. In the case of single-family  residential mortgage loans, except
when the Bank becomes aware of a particular risk of environmental contamination,
the Bank  generally  does not obtain a formal  environmental  report on the real
estate at the time a loan is made. A formal environmental report may be required
in connection with nonresidential real estate loans.

      It is the  Bank's  policy to record a lien on the real  estate  securing a
loan and to obtain title  insurance  which  insures that the property is free of
prior encumbrances and other possible title defects.  Borrowers must also obtain
hazard insurance  policies prior to closing and, when the property is in a flood
plain as designated  by the  Department  of Housing and Urban  Development,  pay
flood insurance policy premiums.

      With respect to single-family residential mortgage loans, the Bank makes a
loan  commitment  of  between  15 and 60 days for  each  loan  approved.  If the
borrower  desires a longer  commitment,  the commitment may be extended for good
cause and upon  written  approval.  Fees of between $175 and $500 are charged in
connection  with the  issuance of a  commitment  letter.  The  interest  rate is
guaranteed for the commitment period.

      If the amount of a residential  loan originated or refinanced  exceeds 80%
of the lesser of the  appraised  value or  contract  price,  the  Bank's  policy
generally is to obtain private mortgage  insurance at the borrower's  expense on
that portion of the principal amount of the loan that exceeds 80%. The Bank will
make a single-family  residential  mortgage loan with up to a 100% loan-to-value
ratio if the required private mortgage insurance is obtained. The Bank generally
limits the loan-to-value  ratio on commercial real estate mortgage loans to 85%,
although  the  loan-to-value  ratio on  commercial  real estate loans in limited
circumstances has been as high as 100%. The Bank limits the loan-to-value  ratio
on multi-family residential real estate loans to 85%.

      The Bank is subject to regulations that limit the amount the Bank can lend
to one borrower. See "-- Depository Institution Regulation -- Limits on Loans to
One Borrower." Under these limits, the Bank's loans-to-one-borrower were limited
to $11.3  million at December  31, 2005.  At that date,  the Bank had no lending
relationships in excess of the loans-to-one-borrower limit.


                                       6
<PAGE>


      Interest  rates charged by the Bank on loans are affected  principally  by
competitive factors, the demand for such loans and the supply of funds available
for lending purposes.  These factors are, in turn,  affected by general economic
conditions,  monetary policies of the federal government,  including the Federal
Reserve Board, legislative tax policies and government budgetary matters.

      Single-Family  Residential Real Estate Lending.  The Bank historically has
been and continues to be an originator of single-family, residential real estate
loans in its market  area.  At December  31,  2005,  single-family,  residential
mortgage loans, excluding home improvement loans, totaled $49.4 million, or 6.2%
of the Company's gross loan portfolio.

      The Bank  originates  fixed-rate  mortgage loans at  competitive  interest
rates.  At  December  31,  2005,  $24.8  million,  or  32.0%,  of the  Company's
residential  mortgage loan  portfolio  was  comprised of fixed-rate  residential
mortgage  loans.  Generally,  the  Company  retains  fixed-rate  mortgages  with
maturities of 15 years or less while fixed-rate loans with longer maturities may
be retained in portfolio or sold in the secondary  market.  The Bank also offers
FHA and VA mortgage loans in its market area, which are underwritten, closed and
sold to a correspondent investor.

      The Bank also  offers  adjustable-rate  residential  mortgage  loans.  The
adjustable-rate  loans  currently  offered by the Bank have interest rates which
adjust every one, three or five years from the closing date of the loan or on an
annual basis commencing after an initial fixed-rate period of one, three or five
years in accordance  with a designated  index (the primary index utilized by the
Bank is the weekly  average  yield on U.S.  Treasury  securities  adjusted  to a
constant  comparable  maturity  equal to the  loan  adjustment  period,  as made
available by the Federal Reserve Board (the "Treasury Rate")), plus a stipulated
margin. The Bank offers adjustable-rate loans that meet FHLMC standards, as well
as  loans  that  do  not  meet  such  standards.   The  Bank's   adjustable-rate
single-family  residential  real estate  loans that do not meet FHLMC  standards
have  a cap of  generally  2% on  any  increase  in  the  interest  rate  at any
adjustment date, and include a cap on the maximum interest rate over the life of
the loan,  which cap  generally is 3% to 4.5% above the initial  rate. In return
for providing a relatively  low cap on interest rate  increases over the life of
the loan,  the Bank's  adjustable-rate  loans provide for a floor on the minimum
interest  rate over the life of the loan,  which floor  generally is the initial
rate.  Further,  the Bank generally does not offer "teaser" rates, i.e., initial
rates below the fully indexed rate, on such loans. The adjustable-rate  mortgage
loans  offered by the Bank that do conform to FHLMC  standards  have a cap of 6%
above the initial  rate over the life of a loan but do not include a floor,  may
be offered  with a teaser rate and have a 25 basis point lower  margin above the
index on which the  interest  rate is based.  All of the Bank's  adjustable-rate
loans  require  that any  payment  adjustment  resulting  from a  change  in the
interest  rate  of an  adjustable-rate  loan be  sufficient  to  result  in full
amortization  of the loan by the end of the loan term and,  thus,  do not permit
any of the increased payment to be added to the principal amount of the loan, or
so-called negative amortization.  At December 31, 2005, $52.8 million, or 68.0%,
of the Company's residential mortgage loans were adjustable-rate loans.

      The retention of  adjustable-rate  loans in the Company's  portfolio helps
reduce the  Company's  exposure to increases or decreases in  prevailing  market
interest rates.  However,  there are unquantifiable  credit risks resulting from
potential  increases in costs to  borrowers in the event of upward  repricing of
adjustable-rate  loans.  It is possible that during  periods of rising  interest
rates,  the  risk of  default  on  adjustable-rate  loans  may  increase  due to
increases in interest  costs to  borrowers.  Further,  although  adjustable-rate
loans allow the  Company to increase  the  sensitivity  of its  interest-earning
assets to changes in interest rates, the extent of this interest  sensitivity is
limited by the initial  fixed-rate  period before the first  adjustment  and the
lifetime  interest rate  adjustment  limitations.  Accordingly,  there can be no
assurance that yields on the Company's  adjustable-rate  loans will fully adjust
to compensate for increases in the Company's cost of funds.

      Construction  Lending.  The Bank also offers  residential  and  commercial
construction  loans, with a substantial portion of such loans originated to date
being for the  construction of  owner-occupied,  single-family  dwellings in the
Bank's primary market area. Residential construction loans are offered primarily
to individuals  building their primary,  investment or secondary  residence,  as
well  as  to  selected  local  developers  to  build  single-family   dwellings.
Generally,  loans to  owner/occupants  for the  construction of  owner-occupied,
single-family  residential  properties  are  originated in  connection  with the
permanent loan on the property and have a construction term of six to 18 months.
Such loans are offered on a fixed-rate or adjustable-rate  basis. Interest rates
on residential construction loans made to the owner/occupant have interest rates
during the  construction  period of 0.5% or more  above the rate  offered by the
Bank on the permanent loan product selected by the borrower.  Upon completion of
construction,  the  permanent  loan rate will be set at the rate then offered by
the  Bank on that  permanent  loan  product,  not to  exceed  the  predetermined
permanent rate cap. Interest rates on residential construction loans to builders
are  set at the  prime  rate  plus a  margin  of  between  0% and 1% and  adjust
annually. Interest rates on commercial construction loans are based on the prime
rate plus a  negotiated  margin of  between  0% and 1% and  adjust  daily,  with
construction  terms  generally not  exceeding 18 months.  Advances are made on a
percentage of completed basis. At December 31, 2005, $25.3 million,  or 3.1%, of
the Company's gross loan portfolio  consisted of construction  loans,  virtually
all of which was secured by single-family residences.


                                       7
<PAGE>


      Prior to making a commitment  to fund a loan,  the Bank  requires  both an
appraisal of the property by appraisers approved by the Board of Directors and a
study of the  feasibility  of the  proposed  project.  The Bank also reviews and
inspects  each project at the  commencement  of  construction  and  periodically
during the term of the construction  loan. The Bank generally charges a 0.50% to
1.25%  construction  loan fee for speculative  builder loans.  For  construction
loans to owner-occupants,  the Bank generally charges a 1% construction loan fee
and a commitment fee ranging from $275 to $425.

      Construction  financing generally is considered to involve a higher degree
of risk of loss than long-term financing on improved, occupied real estate. Risk
of loss on a  construction  loan is  dependent  largely upon the accuracy of the
initial  estimate of the  property's  value at  completion  of  construction  or
development and the estimated cost (including interest) of construction.  During
the  construction  phase,  a number of factors  could  result in delays and cost
overruns.  If the estimate of construction costs proves to be inaccurate and the
borrower  is unable to meet the Bank's  requirements  of  putting up  additional
funds to cover extra costs or change orders,  then the Bank will demand that the
loan be paid  off and,  if  necessary,  institute  foreclosure  proceedings,  or
refinance the loan. If the estimate of value proves to be  inaccurate,  the Bank
may be  confronted,  at or prior to the  maturity of the loan,  with  collateral
having a value  which is  insufficient  to assure full  repayment.  The Bank has
sought to  minimize  this risk by  limiting  construction  lending to  qualified
borrowers (i.e.,  borrowers who satisfy all credit  requirements and whose loans
satisfy  all  other  underwriting  standards  which  would  apply to the  Bank's
permanent mortgage loan financing for the subject property) in the Bank's market
area. On loans to builders, the Bank works only with selected builders with whom
it has experience and carefully monitors the  creditworthiness  of the builders.
Builder  relationships  are  analyzed  and  underwritten  annually by the Bank's
credit administration department.

      Multi-Family  Residential  and Commercial  Real Estate  Lending.  The Bank
originates  commercial  real  estate  loans,  as well  as a  limited  amount  of
multi-family residential real estate loans, generally limiting such originations
to loans secured by properties in its primary  market area and to borrowers with
whom it has other loan  relationships.  The Company's  multi-family  residential
loan portfolio consists primarily of loans secured by small apartment buildings,
and the  commercial  real estate loan  portfolio  includes  loans to finance the
acquisition of small office  buildings and  commercial and industrial  buildings
with a preference to owner  occupied.  Such loans  generally  range in size from
$100,000 to $2.0 million.  At December 31, 2005,  multi-family  residential  and
commercial   real  estate  loans  totaled  $2.9  million  and  $570.5   million,
respectively,  which amounted to 0.4% and 71.4%, respectively,  of the Company's
gross  loan  portfolio.  Multi-family  and  commercial  real  estate  loans  are
originated  either for three to seven year terms with interest rates that adjust
based on either  the prime  rate as quoted  in The Wall  Street  Journal  plus a
negotiated  margin  of  between  0% and  1%  for  shorter  term  loans,  or on a
fixed-rate  basis  with  interest  calculated  on a 15 to 25  year  amortization
schedule generally with a balloon payment due after three to seven years.

      Multi-family  residential  and  commercial  real  estate  lending  entails
significant additional risks as compared with single-family residential property
lending.  Multi-family  residential  and commercial  real estate loans typically
involve larger loan balances to single borrowers or groups of related borrowers.
The payment  experience on such loans  typically is dependent on the  successful
operation of the real estate project,  retail  establishment or business.  These
risks can be  significantly  affected  by supply  and demand  conditions  in the
market for office, retail and residential space, and, as such, may be subject to
a greater  extent to adverse  conditions in the economy  generally.  To minimize
these risks, the Bank generally limits itself to its market area or to borrowers
with which it has prior  experience or who are  otherwise  known to the Bank. It
has been the Bank's policy to obtain annual financial statements of the business
of the borrower or the project for which commercial or multi-family  residential
real estate loans are made.  In  addition,  in the case of  commercial  mortgage
loans  made  to a  partnership  or a  corporation,  the  Bank  obtains  personal
guarantees and annual financial  statements of the principals of the partnership
or corporation.


                                       8
<PAGE>


      Commercial  Lending.  The  Company's  commercial  loans  consist  of loans
secured by commercial real estate and commercial  business loans,  which are not
secured by real estate. For a discussion of the Company's commercial real estate
lending see "-- Multi-Family and Commercial Real Estate Lending."

      In recent years, the Bank has emphasized  commercial business lending. The
Bank originates  commercial  business loans to small and medium sized businesses
in its  market  area.  The  Bank's  commercial  borrowers  are  generally  small
businesses  engaged in  manufacturing,  distribution  or  retailing,  or service
professionals in healthcare,  accounting and law.  Commercial business loans are
generally  made to finance the purchase of inventory,  new or used  equipment or
commercial  vehicles,  to  support  trading  assets and for  short-term  working
capital.  Such loans  generally are secured by equipment and inventory,  and, if
possible,  cross-collateralized  by a real estate mortgage,  although commercial
business loans are sometimes granted on an unsecured basis. Such loans generally
are made for terms of five years or less,  depending  on the purpose of the loan
and the collateral,  with loans to finance operating  expenses made for one year
or less, with interest rates that typically  either adjust daily at a rate equal
to the prime rate as stated in The Wall Street  Journal plus a margin of between
0% and 2% or at a negotiated fixed rate. Generally, commercial loans are made in
amounts ranging between $5,000 and $2,000,000.  At December 31, 2005, commercial
business  loans  totaled  $38.5  million,  or 4.8% of the  Company's  gross loan
portfolio.

      The Bank  underwrites  its  commercial  business loans on the basis of the
borrower's  cash flow and ability to service the debt from earnings  rather than
on the basis of  underlying  collateral  value,  and the Bank seeks to structure
such loans to have more than one source of  repayment.  The borrower is required
to provide the Bank with  sufficient  information  to allow the Bank to make its
lending determination.  In most instances, this information consists of at least
two years of financial statements,  a statement of projected cash flows, current
financial  information  on any guarantor and any  additional  information on the
collateral.  For loans over $20,000 with maturities exceeding one year, the Bank
requires that borrowers and guarantors provide updated financial  information at
least annually throughout the term of the loan.

      The Bank's  commercial  business  loans may be  structured  as  short-term
loans, term loans or as lines of credit.  Short-term  commercial  business loans
are for  periods of 12 months or less and are  generally  self-liquidating  from
asset conversion  cycles.  Commercial  business term loans are generally made to
finance  the  purchase  of assets  and have  maturities  of five  years or less.
Commercial  business  lines of credit  are  typically  made for the  purpose  of
supporting trading assets and providing working capital.  Such loans are usually
approved  with a term of 12  months  and are  reviewed  annually.  The Bank also
offers secured standby letters of credit for its commercial borrowers. The terms
of standby  letters  of credit  generally  do not exceed one year,  and they are
underwritten  as  stringently  as any  commercial  loan and  generally  are of a
performance nature.

      Commercial  business  loans are often larger and may involve  greater risk
than other types of lending.  Because payments on such loans are often dependent
on successful operation of the business involved, repayment of such loans may be
subject to a greater extent to adverse conditions in the economy. The Bank seeks
to minimize these risks through its underwriting guidelines,  which require that
the loan be supported by adequate  cash flow of the borrower,  profitability  of
the  business,  collateral  and personal  guarantees of the  individuals  in the
business.  In addition,  the Bank limits this type of lending to its market area
and to borrowers  with which it has prior  experience or who are otherwise  well
known to the Bank.

      Consumer  Lending.  In recent years,  the Bank has been  successful in its
strategy of  increasing  its  portfolio of consumer  loans.  The consumer  loans
originated by the Bank include  automobile loans,  certificate of deposit loans,
home equity loans and miscellaneous  other consumer loans,  including  unsecured
loans. At December 31, 2005,  consumer loans totaled $100.5 million, or 12.6% of
the Company's gross loan portfolio.

      The Bank's  automobile  loans are generally  underwritten in amounts up to
90% of the lesser of the purchase  price of the  automobile  or, with respect to
used automobiles, the loan value as published by the National Automobile Dealers
Association.  The terms of most such  loans do not  exceed 60  months.  The Bank
requires  that the  vehicles  be insured and the Bank be listed as loss payee on
the insurance policy.


                                       9
<PAGE>


      The  Bank  makes  certificate  of  deposit  loans  for  up to  95%  of the
depositor's  account balance.  The interest rate is normally 2% above the annual
percentage  yield  paid on the  account  and the  account  must  be  pledged  as
collateral  to secure  the loan.  Interest  generally  is billed on a  quarterly
basis.  At December  31, 2005,  loans on  certificates  of deposit  totaled $1.8
million, or 0.2% of the Company's gross loan portfolio.

      At December 31, 2005, the Company had approximately  $42.1 million in home
equity line of credit loans,  representing  approximately 5.3% of its gross loan
portfolio.  The Company's home equity lines of credit have  adjustable  interest
rates tied to the prime  interest  rate plus a margin.  The home equity lines of
credit  require  monthly  payments  until the loan is paid in full.  Home equity
lines of credit are generally secured by subordinate  liens against  residential
real  property.  The Bank  requires  that fire and  extended  coverage  casualty
insurance (and, if appropriate,  flood  insurance) be maintained in an amount at
least  sufficient to cover its loan. Home equity loans are generally  limited so
that the amount of such  loans,  along with any  senior  indebtedness,  does not
exceed 85% of the value of the real estate security.

      Consumer lending affords the Company the opportunity to earn yields higher
than those obtainable on single-family  residential lending.  However,  consumer
loans entail greater risk than do residential  mortgage  loans,  particularly in
the case of loans which are unsecured (as is the case with credit card loans) or
secured  by  rapidly   depreciable  assets  such  as  automobiles.   Repossessed
collateral for a defaulted  consumer loan may not provide an adequate  source of
repayment of the outstanding loan balance as a result of the greater  likelihood
of damage, loss or depreciation. The remaining deficiency often does not warrant
further  substantial  collection  efforts  against the  borrower.  In  addition,
consumer  and credit  card loan  collections  are  dependent  on the  borrower's
continuing  financial  stability,  and  thus  are more  likely  to be  adversely
affected by events such as job loss,  divorce,  illness or personal  bankruptcy.
Further,  the application of various state and federal laws,  including  federal
and state  bankruptcy  and  insolvency  law,  may limit the amount  which may be
recovered.  In underwriting  consumer  loans,  the Bank considers the borrower's
credit  history,  an analysis of the borrower's  income and ability to repay the
loan, and the value of the collateral.

      Loan Fees and  Servicing.  The Bank receives fees in connection  with late
payments  and for  miscellaneous  services  related to its loans.  The Bank also
charges fees in  connection  with loan  originations.  These fees can consist of
origination,  discount,  construction  and/or commitment fees,  depending on the
type of loan. The Bank generally does not service loans for others except as set
forth below and except for mortgage  loans  originated and sold by the Bank with
servicing retained.

      In addition,  the Bank has  developed a program to  originate  loans for a
local credit union.  The Bank receives a $600  origination  fee for each loan as
well as an annual servicing fee of 0.375% of the loan amount. All of these loans
are funded and closed in the name of the credit union. The Bank has explored the
possibility of developing similar arrangements with other institutions, although
none are currently planned.

      Nonperforming Loans and Other Problem Assets. It is management's policy to
continually  monitor its loan portfolio to anticipate and address  potential and
actual  delinquencies.  When a borrower  fails to make a payment on a loan,  the
Bank takes immediate  steps to have the delinquency  cured and the loan restored
to current status. Loans which are delinquent more than 15 days incur a late fee
of 4% of the  monthly  payment of  principal  and  interest  due. As a matter of
policy, the Bank will contact the borrower after the loan has been delinquent 15
days. If payment is not promptly received,  the borrower is contacted again, and
efforts  are made to  formulate  an  affirmative  plan to cure the  delinquency.
Generally,  after any loan is  delinquent  45 days or more, a default  letter is
sent to the  borrower.  If the default is not cured after 30 days,  formal legal
proceedings are commenced to collect amounts owed.

      Loans  generally are placed on nonaccrual  status,  and accrued but unpaid
interest is reversed,  when, in management's judgment, it is determined that the
collectibility  of  interest,  but  not  necessarily  principal,   is  doubtful.
Generally, this occurs when payment is delinquent in excess of 90 days. Consumer
loans are generally  charged off, or any expected  loss is reserved  for,  after
they  become  more than 120 days past due.  All other loans are charged off when
management  concludes  that  they  are  uncollectible.  See  Note 4 of  Notes to
Consolidated Financial Statements for the Year Ended December 31, 2005.


                                       10
<PAGE>


      Real estate  acquired by the Bank as a result of foreclosure is classified
as real estate acquired through foreclosure until such time as it is sold and is
recorded at the lower of the estimated fair value (less estimated costs to sell)
of the underlying real estate or the carrying amount of the loan. Costs relating
to holding or  improving  such real  estate are  charged  against  income in the
current  period.  Any  required  write-down  of the loan to its fair  value less
estimated  selling costs upon  foreclosure is charged  against the allowance for
loan losses.  See Note 4 of Notes to Consolidated  Financial  Statements for the
Year Ended December 31, 2005.

      The  following  table sets forth  information  with  respect to the Bank's
nonperforming assets at the dates indicated. At the dates shown, the Bank had no
restructured  loans  within the meaning of  Statement  of  Financial  Accounting
Standards No. 15.


<TABLE>
<CAPTION>
                                                               At December 31,
                                            -----------------------------------------------
                                              2005      2004      2003      2002      2001
                                            -------   -------   -------   -------   -------
                                                              (Dollars in thousands)
<S>                                         <C>       <C>       <C>       <C>       <C>
Loans accounted for on a nonaccrual basis:
  Residential mortgage:
    Single-family ........................  $ 1,362   $   814   $ 1,057   $   460   $   864
  Commercial real estate .................      555     1,241     1,334       427       200
  Commercial business ....................      220        49        19       219        83
  Consumer ...............................      122       245       215       247       106
                                            -------   -------   -------   -------   -------
    Total nonperforming loans ............  $ 2,259   $ 2,349   $ 2,625   $ 1,496   $ 1,253
                                            =======   =======   =======   =======   =======
Percentage of total loans, net ...........     0.32%     0.37%     0.47%     0.30%     0.31%
                                            =======   =======   =======   =======   =======
Real estate owned ........................       14        89       131       402       677
                                            =======   =======   =======   =======   =======
</TABLE>


      During the year ended December 31, 2005,  additional gross interest income
of  approximately  $143,189 would have been recorded on loans accounted for on a
nonaccrual basis if the loans had been current throughout this period.

      At December 31, 2005,  the Bank had no loans not classified as nonaccrual,
90 days past due or restructured  loans where known  information  about possible
credit problems of borrowers  caused  management to have serious  concerns as to
the ability of the borrowers to comply with present loan repayment terms and may
result in disclosure as nonaccrual, 90 days past due or restructured.

      There were no loans accruing interest which were contractually past due 90
days or more at the end of any reported period.

      At December 31, 2005,  an analysis of the Bank's  portfolio did not reveal
any  impaired  loans that needed to be  classified  under SFAS No. 114 or 118. A
loan is considered  impaired,  based on current information and events, if it is
probable  that the Bank will be unable to  collect  the  scheduled  payments  of
principal and interest when due according to the  contractual  terms of the loan
arrangement.  Uncollateralized  loans are measured for  impairment  based on the
present  value of  expected  future  cash  flows  discounted  at the  historical
effective  interest rate, while all collateral  dependent loans are measured for
impairment  based on the fair  value of the  collateral.  The Bank uses  several
factors in determining if a loan is impaired.  The internal asset classification
procedures   include  a  thorough  review  of  significant   loans  and  lending
relationships  and include the  accumulation of related data. This data includes
loan payments status, borrowers' financial data and borrowers' operating factors
such as cash flows, operating income or loss, and various other matters.

      At December 31, 2005,  the Company had $2.3 million of  nonaccrual  loans,
which  consisted of  twenty-seven  single-family  residential  real estate loans
totaling $1.4 million, six commercial real estate loans totaling $555,000,  five
commercial  business  loans  totaling  $220,000 and ten consumer  loans totaling
$122,000.

      At December 31,  2005,  the Bank had $14,000 of real estate  owned,  which
consisted of one single-family residential lot.


                                       11
<PAGE>


      Classified Assets.  Federal regulations require that the Bank classify its
assets on a regular  basis.  In addition,  in connection  with  examinations  of
insured institutions, examiners have authority to identify problem assets and if
appropriate,  classify  them in their  reports  of  examination.  There are four
classifications for problem assets: "special mention," "substandard," "doubtful"
and "loss."  Special  mention  assets contain some weakness as defined under the
substandard  category,  but do not  contain  the risk level  associated  with an
adverse  classification.  Special  mention  assets are noted for a watch list to
indicate  that a  potential  weakness or risk  exists,  which could cause a more
serious  problem if not corrected.  Substandard  assets have one or more defined
weaknesses and are  characterized  by the distinct  possibility that the insured
institution  will  sustain  some  loss if the  deficiencies  are not  corrected.
Doubtful  assets have the weaknesses of  substandard  assets with the additional
characteristic  that the weaknesses  make  collection or liquidation in full, on
the basis of currently existing facts, conditions and values, questionable,  and
there is a high  possibility  of loss.  An asset  classified  loss is considered
uncollectible  and of such  little  value  that  continuance  as an asset of the
institution  is not  warranted.  Assets  classified as  substandard  or doubtful
require a bank to establish  general  allowances for loan losses. If an asset or
portion  thereof is  classified  loss,  a bank must either  establish a specific
allowance for loss in the amount of the portion of the asset classified loss, or
charge off such  amount.  The Bank  regularly  reviews  its assets to  determine
whether any assets require classification or re-classification.  At December 31,
2005,  the Company  had $19.2  million in  classified  assets,  including  $11.0
million  in  assets  classified  as  special  mention,  $8.2  million  in assets
classified as substandard and no assets classified as doubtful or loss, compared
to $19.1  million  in  classified  assets,  including  $10.8  million  in assets
classified as special mention, $7.9 million in assets classified as substandard,
$62,000 in assets  classified  as doubtful and $251,000 in assets  classified as
loss at December 31, 2004.

      Allowance for Loan Losses.  The Company's policy is to establish  reserves
for estimated probable losses on delinquent loans when it determines that losses
are expected to be incurred on such loans.  The allowance for losses on loans is
maintained at a level believed  adequate by management to absorb probable losses
in the portfolio. Management's determination of the adequacy of the allowance is
based on an evaluation of the portfolio, past loss experience,  current economic
conditions,  volume, growth and composition of the portfolio, and other relevant
factors.  The  allowance is increased  by  provisions  for loan losses which are
charged against income.

      Although  management  believes it uses the best  information  available to
make  determinations with respect to the allowances for losses and believes such
allowances  are  adequate,  future  adjustments  may be  necessary  if  economic
conditions differ  substantially from the economic conditions in the assumptions
used in making  the  initial  determinations.  Management  anticipates  that the
Company's allowance for loan losses will increase in the future as it implements
the Board of Directors'  strategy of continuing existing lines of business while
gradually  expanding  commercial  business  and  consumer  lending,  which loans
generally entail greater risks than single-family residential mortgage loans.


                                       12
<PAGE>


      The following table sets forth an analysis of the Company's  allowance for
loan losses for the periods indicated.


<TABLE>
<CAPTION>
                                                                                Three Months
                                                    Year Ended                     Ended        Year Ended
                                                    December 31,                December 31,   September 30,
                                        ------------------------------------    ------------  --------------
                                          2005     2004       2003      2002        2001           2001
                                        -------   -------   -------   -------      -------       -------
                                                                          (Dollars in thousands)

<S>                                     <C>       <C>       <C>       <C>          <C>           <C>
Balance at beginning of period .......  $ 8,343   $ 7,634   $ 6,959   $ 5,371      $ 5,401       $ 5,159
                                        -------   -------   -------   -------      -------       -------
Loans charged-off:
Commercial business ..................      691        55       125        60           --           423
  Consumer ...........................      157       247       232       133           42           233
                                        -------   -------   -------   -------      -------       -------
      Total charge-offs ..............      848       302       358       193           42           656
                                        =======   =======   =======   =======      =======       =======

Recoveries:
  Residential real estate mortgage:
    Single-family residential ........        1         4        --        --           --            --
  Commercial .........................        5         2        24        11            2            49
  Consumer ...........................       10        37        21        14           10            19
                                        -------   -------   -------   -------      -------       -------
      Total recoveries ...............       16        43        45        25           12            68
                                        -------   -------   -------   -------      -------       -------
Net loans charged-off ................      832       259       313       168           30           588
                                        -------   -------   -------   -------      -------       -------
Additions:
Balance transferred in acquisition ...       --        --        --        --           --            --
Provision for loan losses ............    1,711       968       988     1,756           --           830
                                        -------   -------   -------   -------      -------       -------
      Total additions ................    1,711       968       988     1,756           --           830
                                        -------   -------   -------   -------      -------       -------
Balance at end of period .............  $ 9,222   $ 8,343   $ 7,634   $ 6,959      $ 5,371       $ 5,401
                                        =======   =======   =======   =======      =======       =======
Ratio of net charge-offs to average
  loans outstanding during the period      0.12%     0.04%     0.06%     0.04%        0.01%         0.16%
                                        =======   =======   =======   =======      =======       =======
</TABLE>


                                       13
<PAGE>


      The  following  table  allocates  the  allowance  for loan  losses by loan
category  at the  dates  indicated.  The  allocation  of the  allowance  to each
category is not  necessarily  indicative  of future losses and does not restrict
the use of the allowance to absorb losses in any category.

<TABLE>
<CAPTION>
                                                                          At December 31,
                   ----------------------------------------------------------------------------------------------------------------
                           2005                   2004                  2003                   2002                   2001
                   --------------------   --------------------   --------------------   --------------------   --------------------
                            Percent of             Percent of             Percent of             Percent of             Percent of
                             Loans in               Loans in               Loans in               Loans in               Loans in
                            Category to            Category to            Category to            Category to            Category to
                   Amount   Total Loans   Amount   Total Loans   Amount   Total Loans   Amount   Total Loans   Amount   Total Loans
                   -------  -----------   -------  -----------   -------  -----------   -------  -----------   -------  -----------
                                                                       (Dollars in thousands)

<S>                <C>      <C>           <C>      <C>           <C>      <C>           <C>      <C>           <C>      <C>
Residential
 mortgage......... $   510          8.6%  $ 1,034         11.3%  $ 1,034         13.1%  $ 1,034         24.0%  $ 1,034         33.1%
Commercial (1)(2)    7,388         73.4     6,362         74.6     5,487         71.9     4,726         60.6     3,243         48.7
Consumer .........   1,324         18.0       947         14.1     1,113         15.0     1,199         15.4     1,094         18.2
                   -------  -----------   -------  -----------   -------  -----------   -------  -----------   -------  -----------
  Total allowance
   for loan losses $ 9,222        100.0%  $ 8,343        100.0%  $ 7,634        100.0%  $ 6,959        100.0%  $ 5,371        100.0%
                   =======  ===========   =======  ===========   =======  ===========   =======  ===========   =======  ===========
</TABLE>

---------------
   (1)      Includes commercial real estate, commercial business loans and
            lease receivables.
   (2)      Includes $82,000 of specific allowance for loan losses on two
            commercial business loans.


                                       14
<PAGE>


INVESTMENT ACTIVITIES

      General.  Interest income from  mortgage-backed  securities and investment
securities generally provides the second largest source of income to the Company
after interest on loans. The Bank's Board of Directors has authorized investment
in  U.S.  Government  and  agency  securities,   state  government  obligations,
municipal  securities,  obligations  of the Federal Home Loan Bank  ("FHLB") and
mortgage-backed  securities.  The Bank's objective is to use such investments to
reduce interest rate risk,  enhance yields on assets and provide  liquidity.  At
December 31, 2005,  the  Company's  mortgage-backed  securities  and  investment
securities portfolio amounted to $22.7 million and $41.8 million,  respectively.
At such date,  the Company had an unrealized  loss of $371,000,  net of deferred
taxes, with respect to its securities.

      Investment  and  aggregate  investment   limitations  and  credit  quality
parameters of each class of investment are  prescribed in the Bank's  investment
policy. The Bank performs analyses on mortgage-backed  securities and investment
securities  prior to forming mortgage pools and on an ongoing basis to determine
the  impact on  earnings  and  market  value  under  various  interest  rate and
prepayment conditions.  Securities purchases are subject to the oversight of the
Bank's Investment Committee consisting of four directors and are reviewed by the
Board of Directors on a monthly  basis.  The Bank's  President  has authority to
make specific investment decisions within the parameters determined by the Board
of Directors.

      Mortgage-Backed   Securities.   At  December  31,  2005,   the   Company's
mortgage-backed  securities amounted to $22.7 million, or 2.72% of total assets.
Mortgage-backed  securities  represent  a  participation  interest  in a pool of
single-family or multi-family mortgages,  the principal and interest payments on
which are passed from the mortgage originators through  intermediaries that pool
and repackage the participation  interest in the form of securities to investors
such as the Bank. Such  intermediaries may include  quasi-governmental  agencies
such as FHLMC,  FNMA and GNMA  which  guarantee  the  payment of  principal  and
interest to investors. Mortgage-backed securities generally increase the quality
of the Bank's assets by virtue of the guarantees that back them, are more liquid
than individual  mortgage loans and may be used to  collateralize  borrowings or
other  obligations  of the Bank.  At December  31,  2005,  all of the  Company's
mortgage-backed  securities  were  backed  by loans  originated  by the Bank and
swapped with the FHLMC in exchange for such mortgage-backed securities.

      The FHLMC is a public corporation  chartered by the U.S.  Government.  The
FHLMC issues  participation  certificates  backed  principally  by  conventional
mortgage  loans.  The FHLMC  guarantees  the timely  payment of interest and the
ultimate return of principal on participation certificates. FHLMC securities are
not backed by the full faith and credit of the  United  States,  however,  these
securities  are  considered  to be among the highest  quality  investments  with
minimal  credit  risks.  The maximum loan limit for FNMA and FHLMC  currently is
$359,650.

      Mortgage-backed  securities  typically  are issued with  stated  principal
amounts,  and the  securities  are backed by pools of mortgages  that have loans
with interest rates that are within a range and having varying  maturities.  The
underlying   pool  of  mortgages  can  be  composed  of  either   fixed-rate  or
adjustable-rate  loans. As a result, the risk  characteristics of the underlying
pool of mortgages,  (i.e.,  fixed-rate or adjustable-rate) as well as prepayment
risk, are passed on to the  certificate  holder.  The life of a  mortgage-backed
pass-through security thus approximates the life of the underlying mortgages.

      Mortgage-backed  securities  generally  yield  less than the  loans  which
underlie  such  securities   because  of  their  payment  guarantees  or  credit
enhancements  which offer  nominal  credit risk.  In  addition,  mortgage-backed
securities  are more liquid than  individual  mortgage  loans and may be used to
collateralize  borrowings  of the Bank in the event that the Bank  determined to
utilize  borrowings as a source of funds.  Mortgage-backed  securities issued or
guaranteed  by the  FHLMC  (except  interest-only  securities  or  the  residual
interests  in CMOs)  are  weighted  at no more than 20% for  risk-based  capital
purposes,  compared  to a  weight  of 50% to 100%  for  residential  loans.  See
"Depository Institution Regulation -- Capital Requirements."

      At December 31, 2005, mortgage-backed securities with an amortized cost of
$21.0  million and a carrying  value of $20.6 million were held as available for
sale, and mortgage-backed  securities with an amortized cost of $2.1 million and
a  carrying  value of $2.1  million  were held for  investment.  Mortgage-backed
securities  which are held to  maturity  are carried at cost,  adjusted  for the
amortization  of premiums and the  accretion  of discounts  using a method which
approximates a level yield.  Mortgage-backed  securities classified as available
for sale are carried at fair value. Unrealized gains and losses on available for
sale mortgage-backed  securities are recognized as direct increases or decreases
in equity,  net of applicable income taxes. See Notes 1, 2 and 3 of the Notes to
Consolidated  Financial  Statements  in the  Annual  Report  filed as Exhibit 13
hereto.  At December  31,  2005,  the Bank's  mortgage-backed  securities  had a
weighted average yield of 5.26%.


                                       15
<PAGE>


      At December 31, 2005,  the average  contractual  maturity of the Company's
fixed-rate mortgage-backed securities  available-for-sale was approximately 17.7
years, while the average contractual maturity of mortgage-backed securities held
for  investment  was   approximately   7.8  years.  The  actual  maturity  of  a
mortgage-backed  security  varies,  depending on when the  mortgagors  prepay or
repay the underlying  mortgages.  Prepayments  of the  underlying  mortgages may
shorten the life of the  investment,  thereby  adversely  affecting its yield to
maturity and the related market value of the mortgage-backed security. The yield
is based  upon the  interest  income  and the  amortization  of the  premium  or
accretion of the discount related to the mortgage-backed security.  Premiums and
discounts on  mortgage-backed  securities  are  amortized  or accreted  over the
estimated  term of the  securities  using a level yield method.  The  prepayment
assumptions used to determine the amortization period for premiums and discounts
can significantly  affect the yield of the mortgage-backed  security,  and these
assumptions  are reviewed  periodically  to reflect the actual  prepayment.  The
actual prepayments of the underlying mortgages depend on many factors, including
the  type  of  mortgage,  the  coupon  rate,  the  age  of  the  mortgages,  the
geographical  location  of  the  underlying  real  estate   collateralizing  the
mortgages and general levels of market  interest rates.  The difference  between
the interest  rates on the  underlying  mortgages  and the  prevailing  mortgage
interest rates is an important  determinant in the rate of  prepayments.  During
periods of falling mortgage interest rates, prepayments generally increase, and,
conversely,  during  periods  of rising  mortgage  interest  rates,  prepayments
generally decrease. If the coupon rate of the underlying mortgage  significantly
exceeds  the  prevailing  market  interest  rates  offered for  mortgage  loans,
refinancing generally increases and accelerates the prepayment of the underlying
mortgages.   Prepayment   experience   is  more   difficult   to  estimate   for
adjustable-rate mortgage-backed securities.

      Investment   Securities.   The  Company's  investment  securities  consist
primarily of securities issued by the U.S.  government and government  agencies.
At December 31, 2005, the Company's  entire  portfolio of investment  securities
was  classified  available for sale and amounted to $41.8  million.  The Company
attempts to maintain a high degree of  liquidity  in its  investment  securities
portfolio  by choosing  those that are readily  marketable.  As of December  31,
2005,  the  estimated  average  life  of  the  Company's  investment  securities
portfolio was  approximately  2.3 years. In addition,  at December 31, 2005, the
Company had $1.7 million of FHLB stock.


                                       16
<PAGE>


      The following table sets forth the scheduled maturities,  carrying values,
amortized  cost and average yields for the Company's  investment  securities and
mortgage-backed securities portfolio at December 31, 2005.

<TABLE>
<CAPTION>

                                 One Year or Less    One to Five Years    Five to Ten Years  More than Ten Years
                                ------------------   ------------------   -----------------  -------------------
                                Carrying   Average   Carrying   Average   Carrying  Average   Carrying  Average
                                  Value     Yield      Value     Yield      Value    Yield     Value     Yield
                                --------   -------   --------   -------   --------  -------  ---------  --------
                                                                      (Dollars in thousands)
<S>                             <C>        <C>       <C>        <C>       <C>       <C>      <C>        <C>
Securities available for sale:
   U.S. government and
       agency  securities       $ 10,092      6.23%  $ 31,735      4.54%  $     --       --%   $    --       --%
   Mortgage-backed securities         --        --        260      6.54      4,345     6.24     16,034     4.99
Securities held to maturity:
   FHLB stock (1) ............        --        --         --        --         --       --      1,689     4.60
Mortgaged-backed securities ..        --        --         --        --      2,063     4.00         --       --
                                --------   -------   --------   -------   --------  -------   --------  -------
   securities
Total ........................  $ 10,092      6.23%  $ 31,995      4.56%  $  6,408     5.52%  $ 17,723     4.95%
                                ========             ========             ========            ========
<CAPTION>

                                 Total Investment Portfolio
                                ----------------------------
                                Carrying  Amortized  Average
                                 Value      Cost      Yield
                                --------  ---------  -------

<S>                             <C>       <C>           <C>
Securities available for sale:
   U.S. government and
       agency  securities
                                $ 41,827  $  42,041     4.94%
   Mortgage-backed securities     20,639     21,011     5.26
Securities held to maturity:
   FHLB stock (1) ............     1,689      1,689     4.60
Mortgaged-backed .............     2,063      2,063     4.00
securities                      --------  ---------   ------

Total ........................  $ 66,218  $  66,804     5.00%
                                ========  =========
</TABLE>


---------------
(1) As a member of the FHLB of Atlanta, the Bank is required to maintain an
investment in FHLB stock, which has no stated maturity.


                                       17
<PAGE>


      The following table sets forth the carrying value of the Company's
investment securities and mortgage-backed securities portfolio at the dates
indicated.



                                                             At December 31,
                                                       -------------------------
                                                          2005     2004     2003
                                                       -------  -------  -------
                                                             (In thousands)
Securities available for sale:
   U.S. government and agency securities ............  $41,827  $32,058  $50,072
   Mortgage-backed securities .......................   20,639    6,639   11,715
                                                       -------  -------  -------
      Total .........................................  $62,466  $38,697  $61,787
                                                       =======  =======  =======

Securities held to maturity:
   FHLB stock .......................................  $ 1,689  $ 1,825  $ 2,127
   Mortgage-backed securities .......................    2,063    2,569       --
                                                       -------  -------  -------
      Total .........................................  $ 3,752  $ 4,394  $63,914
                                                       =======  =======  =======

DEPOSIT ACTIVITY AND OTHER SOURCES OF FUNDS

      General.  Deposits are the primary source of the Bank's funds for lending,
investment activities and general operational purposes. In addition to deposits,
the Bank derives funds from loan principal and interest  repayments,  maturities
of investment  securities and  mortgage-backed  securities and interest payments
thereon.  Although  loan  repayments  are a relatively  stable  source of funds,
deposit inflows and outflows are  significantly  influenced by general  interest
rates and money market conditions.  Borrowings may be used on a short-term basis
to compensate for reductions in the  availability  of funds, or on a longer term
basis for general operational  purposes.  The Bank has access to borrowings from
the FHLB of Atlanta.

      Deposits.  The Bank attracts  deposits  principally from within its market
area by offering a variety of deposit instruments,  including checking accounts,
money market  accounts,  statement  and passbook  savings  accounts,  Individual
Retirement  Accounts,  and  certificates of deposit which range in maturity from
seven days to five years.  Deposit terms vary  according to the minimum  balance
required,  the length of time the funds must remain on deposit and the  interest
rate.  Maturities,  terms, service fees and withdrawal penalties for its deposit
accounts are established by the Bank on a periodic  basis.  The Bank reviews its
deposit  pricing on a weekly basis. In determining  the  characteristics  of its
deposit   accounts,   the  Bank   considers   the  rates  offered  by  competing
institutions,  lending  and  liquidity  requirements,  growth  goals and federal
regulations.  Management  believes it prices its  deposits  comparably  to rates
offered by its competitors. The Bank does not accept brokered deposits.

      The Bank attempts to compete for deposits with other  institutions  in its
market  area by  offering  competitively  priced  deposit  instruments  that are
tailored  to the needs of its  customers.  Additionally,  the Bank seeks to meet
customers'  needs by providing  convenient  customer  service to the  community,
efficient  staff and  convenient  hours of  service.  Substantially,  all of the
Bank's  depositors  are  North  Carolina   residents.   To  provide   additional
convenience,  the Bank  participates  in the  Cirrus and STAR  Automatic  Teller
Machine  networks at  locations  throughout  the United  States,  through  which
customers  can gain access to their  accounts at any time.  To better  serve its
customers,  the Bank has installed  automatic  teller  machines at  twenty-three
office locations.


                                       18
<PAGE>


      The  following  tables set forth the  distribution  of the Bank's  deposit
accounts and corresponding weighted average interest rates.  Management does not
believe that the use of year-end  balances instead of average balances  resulted
in any material difference in the information presented.

<TABLE>
<CAPTION>
                                                                       At December 31,
                                       -----------------------------------------------------------------------------
                                               2005                         2004                       2003
                                       --------------------------  ----------------------     ----------------------
                                                      Weighted                   Weighted                   Weighted
                                                       Average                   Average                     Average
                                        Amount          Rate        Amount        Rate         Amount         Rate
                                        ------       ----------     ------      ---------     -------      --------
                                                                              (Dollars in thousands)
<S>                                     <C>              <C>       <C>              <C>       <C>              <C>
Demand accounts:
   Checking ....................        $223,358         0.45%     $215,349         0.45%     $202,627         0.49%
   Money market ................          21,521         1.35        20,971         0.72        25,237         0.69
Savings accounts ...............          21,510         0.15        22,018         0.15        20,292         0.15
                                        --------     --------      --------     --------      --------     --------
   Total .......................        $266,389         0.50%     $258,338         0.45%     $248,156         0.48%
                                        ========                   ========                   ========

Certificate accounts:
  Less than 12 months (1) ......        $ 64,456         3.21%     $ 86,133         1.77%     $139,312         1.82%
  12 - 14 months (1) ...........         203,127         3.87        98,958         2.15        91,481         1.70
  15 - 72 months (1) ...........         199,781         3.47       185,107         2.89       104,224         3.06
                                        --------     --------      --------     --------      --------     --------
     Total .....................         467,364         3.61       370,198         2.43       335,017         2.18
                                        --------     --------      --------     --------      --------     --------
Total deposits                          $733,753         2.48%     $628,536         1.62%     $583,173         1.46%
                                        ========                   ========                   ========
</TABLE>

--------------
(1) Original term.


      The following  table  indicates the amount (in thousands) of the Company's
certificates  of deposit of $100,000 or more by time remaining until maturity as
of December 31, 2005.  At such date,  such deposits  represented  21.0% of total
deposits and had a weighted average rate of 3.75%.

                                   Maturity Period
                                   ---------------
                                    (In thousands)

Three months or less ...........     $  3,821
Over three through six months ..        5,029
Over six through 12 months .....       65,156
Over 12 months .................       79,948
                                     --------
      Total ....................     $153,954
                                     ========

      At December 31, 2005,  U.S.  Agency Bonds with an amortized  cost of $17.0
million were pledged as collateral for deposits from public entities.

      Borrowings.  Savings deposits historically have been the primary source of
funds for the Bank's lending,  investment and general operating activities.  The
Bank is  authorized,  however,  to use  advances  from  the FHLB of  Atlanta  to
supplement  its  supply  of  lendable  funds  and  to  meet  deposit  withdrawal
requirements.  The FHLB of Atlanta functions as a central reserve bank providing
credit for savings institutions and certain other member financial institutions.
As a member of the FHLB System, the Bank is required to own stock in the FHLB of
Atlanta  and is  authorized  to apply for  advances.  Advances  are  pursuant to
several different programs, each of which has its own interest rate and range of
maturities.  The  FHLB  capital  stock  requirement  is  based  on the  sum of a
membership  stock  component  totaling  0.20% of the Bank's total assets plus an
activity-based  stock component of 4.5% of outstanding  FHLB advances.  Advances
from the FHLB of Atlanta are secured by the Bank's  stock in the FHLB of Atlanta
and other eligible  assets.  During the years ended December 31, 2005,  2004 and
2003,  the Bank's  borrowings  consisted of FHLB advances and retail  repurchase
agreements. Retail repurchase agreements represent agreements to sell securities
under  terms  which  require the Bank to  repurchase  the same or  substantially
similar securities by a specified date.

                                       19
<PAGE>


      The following table sets forth certain  information  regarding  short-term
borrowings by the Company at the dates and for the periods indicated:
<TABLE>
<CAPTION>
                                                                    At or for the
                                                                Year Ended December 31,
                                                     ----------------------------------------------
                                                          2005              2004          2003
                                                     -------------    -------------   -------------
                                                                      (In thousands)
<S>                                                        <C>             <C>             <C>
Amounts outstanding at end of period:
  FHLB advances ...................................        $ 5,500         $10,500         $16,000
  Federal funds purchased and securities
    sold under repurchase agreements ..............          6,288           4,292           3,338
Rate paid on:
  FHLB advances ...................................           4.44%           2.44%           1.38%
  Federal funds purchased and securities sold under
    agreements to repurchase ......................           3.59%           1.62%           0.58%
Maximum amount of borrowings outstanding
at any month end:
  FHLB advances ...................................         24,500          46,500          19,000
  Federal funds purchased and securities
    sold under repurchase agreements ..............          7,012           4,960           6,872
Approximate average short-term borrowings
  outstanding with respect to:
  FHLB advances ...................................          4,068          19,108           6,240
  Federal funds purchased and securities
    sold under repurchase agreements ..............          6,182           4,019           4,674
Approximate weighted average rate paid on: (1)
  FHLB advances ...................................           2.97%           1.46%           1.38%
  Federal funds purchased and securities
    sold under repurchase agreements ..............           2.71%           0.92%           0.60%
</TABLE>

(1) Based on month-end balances.

COMPETITION

      The  Company  faces  strong   competition  in  originating   real  estate,
commercial  business and consumer  loans and in  attracting  deposits.  The Bank
competes  for real estate and other loans  principally  on the basis of interest
rates, the types of loans it originates,  the deposit products it offers and the
quality of services it provides to borrowers. The Bank also competes by offering
products  which  are  tailored  to  the  local  community.  Its  competition  in
originating  real estate  loans comes  primarily  from other  commercial  banks,
savings institutions,  mortgage bankers and mortgage brokers.  Commercial banks,
credit unions and finance  companies  provide  vigorous  competition in consumer
lending.  Competition  may  increase  as a result  of the  recent  reduction  of
restrictions on the interstate operations of financial institutions.

      The Bank attracts its deposits  through its branch offices  primarily from
the local  communities.  Consequently,  competition  for deposits is principally
from other commercial banks, savings institutions,  credit unions and brokers in
the Bank's  primary  market  area.  The Bank  competes for deposits and loans by
offering  what it  believes to be a variety of deposit  accounts at  competitive
rates,  convenient business hours, a commitment to outstanding  customer service
and  a  well-trained   staff.   The  Bank  believes  it  has  developed   strong
relationships with local realtors and the community in general.

      Management considers its primary market area for gathering deposits and/or
originating loans to be central,  eastern,  northeastern and southeastern  North
Carolina,  where the Bank's  offices  are  located.  The Bank  originates  loans
throughout eastern North Carolina.

EMPLOYEES

      As of December  31,  2005,  the Bank had 252  full-time  and 37  part-time
employees,  none of whom were represented by a collective  bargaining agreement.
Management considers the Bank's relationships with its employees to be good.

                                       20
<PAGE>

DEPOSITORY INSTITUTION REGULATION

      General.  The Bank is a North Carolina  chartered  commercial bank and its
deposit accounts are insured by the Savings Association  Insurance Fund ("SAIF")
administered by the Federal Deposit Insurance Corporation ("FDIC").  The Bank is
subject to supervision,  examination and regulation by the  Commissioner and the
FDIC and to North  Carolina  and federal  statutory  and  regulatory  provisions
governing such matters as capital standards, mergers, subsidiary investments and
establishment  of branch  offices.  The FDIC also has the  authority  to conduct
special examinations. The Bank is required to file reports with the Commissioner
and the FDIC  concerning  its  activities  and  financial  condition and will be
required  to  obtain   regulatory   approval  prior  to  entering  into  certain
transactions,  including  mergers with,  or  acquisitions  of, other  depository
institutions.

      As a  federally  insured  depository  institution,  the Bank is subject to
various regulations promulgated by the Board of Governors of the Federal Reserve
System  ("Federal  Reserve  Board"),   including   Regulation  B  (Equal  Credit
Opportunity),  Regulation D (Reserve  Requirements),  Regulations  E (Electronic
Fund Transfers), Regulation Z (Truth in Lending), Regulation CC (Availability of
Funds and Collection of Checks) and Regulation DD (Truth in Savings).

      The  system  of  regulation  and   supervision   applicable  to  the  Bank
establishes a  comprehensive  framework for the  operations of the Bank,  and is
intended  primarily  for the  protection  of the FDIC and the  depositors of the
Bank.  Changes in the regulatory  framework  could have a material effect on the
Bank that in turn, could have a material effect on the Company.

      Capital  Requirements.  The  Federal  Reserve  Board  and  the  FDIC  have
established  guidelines with respect to the maintenance of appropriate levels of
capital by bank holding  companies with  consolidated  assets of $150 million or
more and state nonmember banks, respectively. The regulations impose two sets of
capital  adequacy  requirements:  minimum  leverage  rules,  which  require bank
holding  companies  and state  nonmember  banks to maintain a specified  minimum
ratio of capital to total assets,  and risk-based  capital rules,  which require
the  maintenance  of  specified  minimum  ratios of capital  to  "risk-weighted"
assets.  The  regulations of the FDIC and the Federal Reserve Board require bank
holding companies and state nonmember banks, respectively, to maintain a minimum
leverage ratio of "Tier 1 capital" to total assets of 3.0%.  Although  setting a
minimum  3.0%  leverage  ratio,  the  capital  regulations  state  that only the
strongest bank holding companies and banks, with composite  examination  ratings
of 1 CAMELS  under the rating  system used by the federal bank  regulators,  are
permitted  to operate at or near such minimum  level of capital.  All other bank
holding  companies and banks must maintain a leverage ratio of at least 4%. Tier
1 capital is the sum of common  stockholders'  equity,  noncumulative  perpetual
preferred  stock  (including  any related  surplus),  and minority  interests in
consolidated  subsidiaries;  minus all  intangible  assets  (other than  certain
purchased  mortgage  servicing  rights and purchased  credit card  receivables),
identified  losses and investments in certain  subsidiaries.  As a SAIF-insured,
state-chartered  bank,  the Bank must also  deduct from Tier 1 capital an amount
equal to its investments in, and extensions of credit to,  subsidiaries  engaged
in activities that are not  permissible for national banks,  other than debt and
equity investments in subsidiaries engaged in activities undertaken as agent for
customers  or  in  mortgage  banking  activities  or  in  subsidiary  depository
institutions  or  their  holding  companies.  Any bank or bank  holding  company
experiencing or anticipating  significant growth is expected to maintain capital
well above the  minimum  levels.  In  addition,  the Federal  Reserve  Board has
indicated  that  whenever  appropriate,  and in  particular  when a bank holding
company  is  undertaking  expansion,  seeking  to  engage in new  activities  or
otherwise facing unusual or abnormal risks, it will consider,  on a case-by-case
basis, the level of an organization's  ratio of tangible Tier 1 capital to total
assets in making an overall assessment of capital.

      In addition to the leverage ratio,  the regulations of the Federal Reserve
Board and the FDIC require bank holding companies and state chartered  nonmember
banks to maintain a minimum ratio of qualifying  total capital to  risk-weighted
assets  of at  least  8.0% of  which  at  least  4.0%  must  be Tier 1  capital.
Qualifying   total   capital   consists  of  Tier  1  capital  plus  Tier  2  or
"supplementary  capital"  items which include  allowances  for loan losses in an
amount of up to 1.25% of risk-weighted  assets,  cumulative  preferred stock and
preferred  stock  with a maturity  of 20 years or more,  certain  other  capital
instruments  and  up to  45% of  unrealized  gains  on  equity  securities.  The
includible  amount of Tier 2 capital  cannot  exceed  the  institution's  Tier 1
capital. Qualifying total capital is further reduced by the amount of the bank's
investments in banking and finance  subsidiaries  that are not  consolidated for
regulatory  capital purposes,  reciprocal  cross-holdings of capital  securities
issued by other banks and  certain  other  deductions.  The  risk-based  capital
regulations  assign  balance sheet assets and the credit  equivalent  amounts of
certain  off-balance  sheet  items to one of four broad risk  weight  categories
ranging  from 0% to 100%.  The  aggregate  dollar  amount  of each  category  is
multiplied by the risk weight assigned to that category based principally on the
degree of credit risk  associated  with the obligor.  The sum of these  weighted
values equals the bank holding company or the bank's risk-weighted assets.

                                       21
<PAGE>

      In addition to FDIC regulatory  capital  requirements,  the North Carolina
Bank Commissioner  requires that the Bank have adequate  capitalization which is
determined based upon each Bank's particular set of  circumstances.  The Bank is
subject  to  the  Commissioner's   capital  surplus  regulation  which  requires
commercial  banks to  maintain  a  capital  surplus  of at least  50% of  common
capital. Common capital is defined as the total of the par value of shares times
the number of shares outstanding.

      Prompt Corrective  Regulatory  Action.  Under FDICIA,  the federal banking
regulators  are  required  to  take  prompt  corrective  action  if  an  insured
depository  institution  fails to satisfy certain minimum capital  requirements,
including a leverage  limit,  a risk-based  capital  requirement,  and any other
measure deemed  appropriate by the federal banking  regulators for measuring the
capital  adequacy  of  an  insured  depository  institution.  All  institutions,
regardless  of their  capital  levels,  are  restricted  from making any capital
distribution or paying any management fees if the institution  would  thereafter
fail to satisfy  the  minimum  levels for any of its  capital  requirements.  An
institution  that  fails to meet the  minimum  level  for any  relevant  capital
measure (an  "undercapitalized  institution")  may be: (i) subject to  increased
monitoring by the appropriate federal banking regulator; (ii) required to submit
an acceptable  capital  restoration  plan within 45 days; (iii) subject to asset
growth  limits;  and (iv)  required  to obtain  prior  regulatory  approval  for
acquisitions,  branching and new lines of  businesses.  The capital  restoration
plan must  include a guarantee  by the  institution's  holding  company that the
institution  will comply with the plan until it has been adequately  capitalized
on average for four consecutive quarters,  under which the holding company would
be liable up to the lesser of 5% of the institution's total assets or the amount
necessary to bring the  institution  into capital  compliance  as of the date it
failed  to  comply  with  its  capital   restoration   plan.  A   "significantly
undercapitalized"  institution, as well as any undercapitalized institution that
does not  submit an  acceptable  capital  restoration  plan,  may be  subject to
regulatory demands for recapitalization,  broader application of restrictions on
transactions  with  affiliates,  limitations on interest rates paid on deposits,
asset  growth  and other  activities,  possible  replacement  of  directors  and
officers,  and restrictions on capital distributions by any bank holding company
controlling the institution. Any company controlling the institution may also be
required  to divest the  institution  or the  institution  could be  required to
divest   subsidiaries.   The  senior  executive   officers  of  a  significantly
undercapitalized   institution   may  not  receive   bonuses  or   increases  in
compensation  without prior  approval and the  institution  is  prohibited  from
making  payments of principal  or interest on its  subordinated  debt.  In their
discretion,  the  federal  banking  regulators  may also  impose  the  foregoing
sanctions on an  undercapitalized  institution if the regulators  determine that
such actions are  necessary  to carry out the purposes of the prompt  corrective
provisions.  If an institution's ratio of tangible capital to total assets falls
below the  "critical  capital  level"  established  by the  appropriate  federal
banking  regulator,  the  institution  will be  subject  to  conservatorship  or
receivership within specified time periods.

      Under  the  implementing  regulations,  the  federal  banking  regulators,
including the FDIC,  generally measure an institution's  capital adequacy on the
basis of its total  risk-based  capital ratio (the ratio of its total capital to
risk-weighted  assets),  Tier 1 risk-based  capital ratio (the ratio of its core
capital  to  risk-weighted  assets)  and  leverage  ratio (the ratio of its core
capital to adjusted total assets).  The following table shows the capital ratios
required for the various prompt corrective action categories.

<TABLE>
<CAPTION>
                                                Adequately                                Significantly
                       Well Capitalized        Capitalized         Undercapitalized     Undercapitalized
                       ----------------        -----------         ----------------     ----------------

<S>                    <C>                   <C>                  <C>                   <C>
Total risk-based
    capital ratio      10.0% or more         8.0% or more          Less than 8.0%        Less than 6.0%
Tier 1 risk-based
    capital ratio      6.0% or more          4.0% or more          Less than 4.0%        Less than 3.0%
Leverage ratio ..      5.0% or more          4.0% or more *        Less than 4.0% *      Less than 3.0%
</TABLE>

----------------
*  3.0% if institution has a composite 1 CAMELS rating.

      A "critically  undercapitalized"  institution is defined as an institution
that  has a ratio of  "tangible  equity"  to total  assets  of less  than  2.0%.
Tangible equity is defined as core capital plus cumulative  perpetual  preferred
stock  (and  related  surplus)  less  all  intangibles   other  than  qualifying
supervisory  goodwill and certain purchased  mortgage servicing rights. The FDIC
may reclassify a well capitalized  institution as adequately capitalized and may
require an adequately capitalized or undercapitalized institution to comply with
the  supervisory  actions  applicable to  institutions in the next lower capital
category (but may not reclassify a significantly undercapitalized institution as
critically  undercapitalized)  if  the  FDIC  determines,  after  notice  and an
opportunity  for a  hearing,  that the  institution  is in an unsafe or  unsound
condition  or  that  the   institution   has   received  and  not   corrected  a
less-than-satisfactory rating for any CAMELS rating category.

                                       22
<PAGE>

      Safety and Soundness  Guidelines.  Under FDICIA,  as amended by the Riegle
Community  Development and Regulatory  Improvement Act of 1994 (the "CDRI Act"),
each  federal  banking  agency was required to  establish  safety and  soundness
standards for  institutions  under its  authority.  The  interagency  guidelines
require  depository  institutions to maintain  internal controls and information
systems and internal audit systems that are appropriate for the size, nature and
scope of the institution's business. The guidelines also establish certain basic
standards  for loan  documentation,  credit  underwriting,  interest  rate  risk
exposure,  asset growth and information security. The guidelines further provide
that depository  institutions  should maintain safeguards to prevent the payment
of  compensation,  fees and  benefits  that are  excessive or that could lead to
material financial loss, and should take into account factors such as comparable
compensation  practices at comparable  institutions.  If the appropriate federal
banking  agency  determines  that a depository  institution is not in compliance
with the safety and  soundness  guidelines,  it may require the  institution  to
submit  an  acceptable  plan  to  achieve  compliance  with  the  guidelines.  A
depository  institution must submit an acceptable compliance plan to its primary
federal  regulator  within  30 days of  receipt  of a  request  for such a plan.
Failure to submit or implement a compliance  plan may subject the institution to
regulatory sanctions.  Management believes that the Bank substantially meets all
the standards adopted in the interagency guidelines.

      Community  Reinvestment Act. The Bank, like other financial  institutions,
is subject to the Community  Reinvestment Act ("CRA"). The purpose of the CRA is
to  encourage  financial  institutions  to help meet the  credit  needs of their
entire   communities,   including   the   needs   of   low-and   moderate-income
neighborhoods.  During the Bank's last compliance examination, the Bank received
a satisfactory rating with respect to CRA compliance.

      The federal banking  agencies have  implemented an evaluation  system that
rates an institution based on its actual performance in meeting community credit
needs.  Under these  regulations,  an institution  is first  evaluated and rated
under three  categories:  a lending test, an investment test and a service test.
For each of these  three  tests,  the  institution  is given a rating  of either
"outstanding," "high  satisfactory," "low satisfactory,"  "needs to improve," or
"substantial  non-compliance."  A set of  criteria  for  each  rating  has  been
developed and is included in the regulation.  If an institution disagrees with a
particular  rating,  the institution has the burden of rebutting the presumption
by clearly establishing that the quantitative measures do not accurately present
its actual performance, or that demographics, competitive conditions or economic
or legal  limitations  peculiar to its service  area should be  considered.  The
ratings  received  under the three tests will be used to  determine  the overall
composite CRA rating. The composite ratings currently given are:  "outstanding,"
"satisfactory," "needs to improve" or "substantial non-compliance."

      The Bank's CRA rating  would be a factor to be  considered  by the Federal
Reserve Board and the FDIC in considering  applications submitted by the Bank to
acquire branches or to acquire or combine with other financial  institutions and
take other  actions  and,  if such  rating was less than  "satisfactory,"  could
result in the denial of such applications.

      Federal  Home Loan Bank  System.  The FHLB System  consists of 12 district
FHLBs subject to supervision and regulation by the Federal Housing Finance Board
("FHFB").  The FHLBs  provide a central  credit  facility  primarily  for member
institutions.  As a member  of the FHLB of  Atlanta,  the  Bank is  required  to
acquire and hold shares of capital stock in the FHLB of Atlanta. The Bank was in
compliance  with this  requirement  with  investment in FHLB of Atlanta stock at
December 31, 2005, of $1.7 million.  The FHLB of Atlanta  serves as a reserve or
central bank for its member  institutions  within its assigned  district.  It is
funded primarily from proceeds derived from the sale of consolidated obligations
of the FHLB System.  It offers  advances to members in accordance  with policies
and procedures established by the FHFB and the Board of Directors of the FHLB of
Atlanta.  Long-term advances may only be made for the purpose of providing funds
for  residential  housing  finance,  small  businesses,  small  farms  and small
agribusinesses.

      Reserves.  Pursuant to regulations of the Federal Reserve Board,  the Bank
must maintain average daily reserves equal to 3% on transaction accounts of $7.8
million up to $40.5  million,  plus 10% on the  remainder.  This  percentage  is
subject to adjustment by the Federal Reserve Board.  Because  required  reserves
must be maintained in the form of vault cash or in a noninterest bearing account
at a Federal  Reserve Bank,  the effect of the reserve  requirement is to reduce
the amount of the  institution's  interest-earning  assets.  As of December  31,
2005, the Bank met its reserve requirements.

      The Bank is also  subject to the reserve  requirements  of North  Carolina
commercial banks. North Carolina law requires state nonmember banks to maintain,
at all times, a reserve fund in an amount set by the State Banking Commission.

                                       23
<PAGE>


      Deposit  Insurance.  The Bank is  required to pay  assessments  based on a
percentage of its insured  deposits to the FDIC for insurance of its deposits by
the SAIF. Under the FDIC's risk-based  deposit insurance  assessment system, the
assessment rate for an insured depository  institution depends on the assessment
risk classification assigned to the institution by the FDIC, which is determined
by the  institution's  capital level and supervisory  evaluations.  Based on the
data reported to regulators  for the date closest to the last day of the seventh
month preceding the semi-annual assessment period,  institutions are assigned to
one of three  capital  groups -- well  capitalized,  adequately  capitalized  or
undercapitalized  --  using  the  same  percentage  criteria  as in  the  prompt
corrective action  regulations.  See "-- Prompt Corrective  Regulatory  Action."
Within each capital group,  institutions  are assigned to one of three subgroups
on the basis of supervisory evaluations by the institution's primary supervisory
authority and such other  information  as the FDIC  determines to be relevant to
the  institution's  financial  condition  and  the  risk  posed  to the  deposit
insurance fund.  Subgroup A consists of financially sound institutions with only
a few minor  weaknesses.  Subgroup B consists of institutions  that  demonstrate
weaknesses which, if not corrected, could result in significant deterioration of
the  institution  and  increased  risk of loss to the  deposit  insurance  fund.
Subgroup C consists of institutions that pose a substantial  probability of loss
to the deposit insurance fund unless effective corrective action is taken.

      The assessment rate for SAIF members  currently  ranges from zero for well
capitalized institutions in Subgroup A to 0.27% of deposits for undercapitalized
institutions  in  Subgroup  C. SAIF  members  are also  assessed  an amount  for
Financing Corporation bond payments,  which for fiscal 2005, averaged 1.39 basis
points.

      Liquidity  Requirements.  FDIC  policy  requires  that banks  maintain  an
average  daily  balance  of  liquid   assets  (cash,   certain  time   deposits,
mortgage-backed securities, loans available for sale and specified United States
government,  state,  or federal agency  obligations) in an amount which it deems
adequate to protect  safety and soundness of the bank. The FDIC currently has no
specific  level  which  it  requires.   Under  the  FDIC's  calculation  method,
management  calculated the Bank's  liquidity ratio as 13.0% of total deposits at
December 31, 2005, which management believes is adequate.

      Dividend Restrictions. Under FDIC regulations, the Bank is prohibited from
making any capital  distributions  if after  making the  distribution,  the Bank
would have: (i) a total risk-based  capital ratio of less than 8.0%; (ii) a Tier
1 risk-based  capital ratio of less than 4.0%; or (iii) a leverage ratio of less
than 4.0%.

      Earnings of the Bank  appropriated  to bad debt  reserves and deducted for
federal  income tax purposes are not available for payment of cash  dividends or
other distributions to stockholders without payment of taxes at the then current
tax  rate by the Bank on the  amount  of  earnings  removed  from  the  pre-1988
reserves  for such  distributions.  The Bank  intends  to make  full use of this
favorable tax treatment and does not contemplate use of any earnings in a manner
which would create federal tax liabilities.

      Limits on Loans to One  Borrower.  The Bank  generally  is subject to both
FDIC  regulations  and North  Carolina law regarding  loans to any one borrower,
including  related   entities.   Under  applicable  law,  with  certain  limited
exceptions,  loans and extensions of credit by a state chartered  nonmember bank
to a person outstanding at one time and not fully secured by collateral having a
market  value at least  equal to the amount of the loan or  extension  of credit
shall not exceed 15% of the unimpaired capital of the Bank. Loans and extensions
of credit fully secured by readily  marketable  collateral having a market value
shall not exceed 10% of the  unimpaired  capital  fund of the Bank.  Under these
limits,  the Bank's  loans to one  borrower  were  limited  to $12.8  million at
December 31, 2005. At that date, the Bank had no lending relationships in excess
of   the    loans-to-one-borrower    limit.    Notwithstanding   the   statutory
loans-to-one-borrower    limitations,    the   Bank    has   a   self    imposed
loans-to-one-borrower  limit,  which  currently  is $5.5  million,  which it has
exceeded from time to time as approved in advance by the Board of Directors.  At
December 31, 2005, the Bank's largest  lending  relationship  was a $6.1 million
relationship consisting of twelve commercial real estate loans. All loans within
this  relationship were current and performing in accordance with their terms at
December 31, 2005.

      Transactions with Related Parties.  Transactions between a state nonmember
bank and any  affiliate  are  governed  by  Sections  23A and 23B of the Federal
Reserve  Act. An affiliate  of a state  nonmember  bank is any company or entity
which  controls,  is  controlled  by or is under  common  control with the state
nonmember  bank. In a holding company  context,  the parent holding company of a
state  nonmember  bank  (such  as the  Company)  and  any  companies  which  are
controlled  by  such  parent  holding  company  are  affiliates  of the  savings
institution or state nonmember bank.  Generally,  Sections 23A and 23B (i) limit
the extent to which an  institution or its  subsidiaries  may engage in "covered
transactions"  with  any  one  affiliate  to an  amount  equal  to 10%  of  such
institution's  capital stock and surplus,  and contain an aggregate limit on all
such  transactions with all affiliates to an amount equal to 20% of such capital
stock  and  surplus  and (ii)  require  that all such  transactions  be on terms
substantially  the  same,  or at  least  as  favorable,  to the  institution  or
subsidiary as those provided to a non-affiliate.  The term "covered transaction"
includes the making of loans,  purchase of assets,  issuance of a guarantee  and
similar other types of transactions.

                                       24
<PAGE>

      Loans to Directors,  Executive Officers and Principal Stockholders.  State
nonmember banks also are subject to the restrictions  contained in Section 22(h)
of the Federal Reserve Act and the applicable regulations thereunder on loans to
executive officers,  directors and principal stockholders.  Under Section 22(h),
loans to a director,  executive officer and to a greater than 10% stockholder of
a state nonmember bank and certain affiliated interests of such persons, may not
exceed,  together with all other outstanding loans to such person and affiliated
interests, the institution's  loans-to-one-borrower  limit and all loans to such
persons  may not exceed the  institution's  unimpaired  capital  and  unimpaired
surplus.  Section 22(h) also prohibits  loans,  above amounts  prescribed by the
appropriate federal banking agency, to directors, executive officers and greater
than  10%  stockholders  of  a  depository  institution,  and  their  respective
affiliates,  unless  such loan is approved in advance by a majority of the board
of directors of the institution with any "interested" director not participating
in the voting. Regulation O prescribes the loan amount (which includes all other
outstanding  loans to such  person)  as to which such  prior  board of  director
approval  is  required  as being the  greater of  $25,000  or 5% of capital  and
surplus (or any loans  aggregating  $500,000 or more).  Further,  Section  22(h)
requires that loans to directors,  executive officers and principal stockholders
be made on terms substantially the same as offered in comparable transactions to
other persons.  Section 22(h) also generally prohibits a depository  institution
from paying the overdrafts of any of its executive officers or directors.

      State   nonmember  banks  also  are  subject  to  the   requirements   and
restrictions  of Section 22(g) of the Federal  Reserve Act on loans to executive
officers.  Section  22(g) of the Federal  Reserve Act  requires  approval by the
board of directors of a depository institution for such extensions of credit and
imposes  reporting  requirements  for and additional  restrictions  on the type,
amount and terms of credits to such  officers.  In addition,  Section 106 of the
BHCA  prohibits  extensions  of credit to  executive  officers,  directors,  and
greater  than  10%  stockholders  of  a  depository  institution  by  any  other
institution which has a correspondent banking relationship with the institution,
unless  such  extension  of credit is on  substantially  the same terms as those
prevailing at the time for comparable  transactions  with other persons and does
not involve more than the normal risk of repayment or present other  unfavorable
features.

      Additionally,  North Carolina statutes set forth  restrictions on loans to
executive  officers of  state-chartered  banks,  which  provide that no bank may
extend  credit to any of its  executive  officers nor a firm or  partnership  of
which such executive officers is a member, nor a company in which such executive
officer owns a controlling  interest,  unless the extension of credit is made on
substantially the same terms, including interest rates and collateral,  as those
prevailing at the time for comparable  transactions by the bank with persons who
are not employed by the bank, and provided  further that the extension of credit
does not involve more than the normal risk of repayment.

      Restrictions on Certain  Activities.  State chartered nonmember banks with
deposits  insured by the FDIC are generally  prohibited  from engaging in equity
investments  that  are  not  permissible  for a  national  bank.  The  foregoing
limitation,  however,  does not prohibit FDIC-insured state banks from acquiring
or  retaining  an  equity  investment  in a  subsidiary  in which  the bank is a
majority  owner.  State  chartered  banks are also prohibited from engaging as a
principal in any type of activity  that is not  permissible  for a national bank
and, subject to certain exceptions, subsidiaries of state chartered FDIC-insured
state  banks may not engage as a principal  in any type of activity  that is not
permissible for a subsidiary of a national bank, unless in either case, the FDIC
determines  that the activity would pose no significant  risk to the appropriate
deposit  insurance fund and the bank is, and continues to be, in compliance with
applicable capital standards.

      Patriot  Act.  The  Patriot  Act  is  intended  to  strengthen   U.S.  law
enforcement's and the intelligence  communities' abilities to work cohesively to
combat terrorism on a variety of fronts. The potential impact of the Patriot Act
on financial  institutions  of all kinds is  significant  and wide ranging.  The
Patriot Act contained sweeping anti-money laundering and financial  transparency
laws and imposes various  regulations  including  standards for verifying client
identification  at  account  opening,  and rules to  promote  cooperation  among
financial  institutions,  regulators and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering.

REGULATION OF THE COMPANY

      General.  The  Company,  as the sole  shareholder  of the Bank,  is a bank
holding company and is registered  with the Federal Reserve Board.  Bank holding
companies are subject to  comprehensive  regulation by the Federal Reserve Board
under the Bank Holding  Company Act of 1956,  as amended (the  "BHCA"),  and the
regulations of the Federal Reserve Board. As a bank holding company, the Company
is required  to file with the  Federal  Reserve  Board  annual  reports and such
additional  information as the Federal Reserve Board may require, and is subject
to regular  examinations by the Federal Reserve Board. The Federal Reserve Board
also has extensive enforcement authority over bank holding companies, including,
among other things, the ability to assess civil money penalties,  to issue cease
and  desist or  removal  orders and to  require  that a holding  company  divest
subsidiaries (including its bank subsidiaries).  In general, enforcement actions
may be initiated  for  violations of law and  regulations  and unsafe or unsound
practices.

      Under the BHCA, a bank holding  company must obtain Federal  Reserve Board
approval before: (i) acquiring, directly or indirectly,  ownership or control of
any  voting  shares of  another  bank or bank  holding  company  if,  after such
acquisition,  it would own or  control  more than 5% of such  shares  (unless it
already owns or controls the majority of such  shares);  (ii)  acquiring  all or
substantially  all of the assets of another  bank or bank  holding  company;  or
(iii) merging or consolidating with another bank holding company.  In evaluating
applications for  acquisitions,  the Federal Reserve Board considers such things
as the financial  condition and  management of the target and the acquirer,  the
convenience  and needs of the communities  involved  (including CRA ratings) and
competitive factors.

                                       25
<PAGE>

      The BHCA also prohibits a bank holding company,  with certain  exceptions,
from  acquiring  direct or indirect  ownership or control of more than 5% of the
voting  shares of any company  which is not a bank or bank holding  company,  or
from engaging  directly or indirectly in activities other than those of banking,
managing or controlling banks, or providing  services for its subsidiaries.  The
principal  exceptions to these  prohibitions  involve certain nonbank activities
which,  by statute or by Federal  Reserve Board  regulation or order,  have been
identified as activities  closely related to the business of banking or managing
or controlling  banks.  The list of activities  permitted by the Federal Reserve
Board includes,  among other things,  operating a savings institution,  mortgage
company,  finance company, credit card company or factoring company;  performing
certain data processing  operations;  providing certain investment and financial
advice;  underwriting  and acting as an  insurance  agent for  certain  types of
credit-related  insurance;  leasing  property  on a  full-payout,  non-operating
basis; selling money orders,  travelers' checks and United States Savings Bonds;
real  estate and  personal  property  appraising;  providing  tax  planning  and
preparation services; and, subject to certain limitations,  providing securities
brokerage services for customers.  The Company has no present plans to engage in
any of these activities.

      The  Gramm-Leach-Bliley Act of 1999 authorized bank holding companies that
meet  specified  qualitative  standards  to opt to become a  "financial  holding
company."  A  financial  holding  company  may  engage  in  activities  that are
permissible  for bank holding  companies in addition to activities  deemed to be
financial  in  nature or  incidental  to  financial  activities.  These  include
insurance  underwriting  and investment  banking.  The Company has not up to now
opted to become a financial holding company.

      The Federal  Reserve  Board has adopted  guidelines  regarding the capital
adequacy of bank holding  companies,  which  require  bank holding  companies to
maintain  specified  minimum  ratios of capital to total  assets and  capital to
risk-weighted  assets.  See "--  Depository  Institution  Regulation  -- Capital
Requirements."

      Acquisition  of Bank  Holding  Companies  and Banks.  Under the BHCA,  any
company  must obtain  approval of the Federal  Reserve  Board prior to acquiring
control of the  Company or the Bank.  For  purposes  of the BHCA,  "control"  is
defined as ownership of more than 25% of any class of voting  securities  of the
Company or the Bank,  the ability to control  the  election of a majority of the
directors,  or the  exercise  of a  controlling  influence  over  management  or
policies of the Company or the Bank. In addition, the Change in Bank Control Act
and the related  regulations of the Federal  Reserve Board require any person or
persons  acting in concert,  to file a written  notice with the Federal  Reserve
Board  before such  person or persons may acquire  control of the Company or the
Bank. The Change in Bank Control Act defines "control" as the power, directly or
indirectly,  to vote  25% or more of any  voting  securities  or to  direct  the
management or policies of a bank holding company or an insured bank;  however, a
rebuttable  presumption of control exists upon the  acquisition of power to vote
10% or more of a class of voting securities for a company,  such as the Company,
whose securities are registered under the Securities Exchange Act of 1934.

      Interstate  Banking.  Federal  law allows  the  Federal  Reserve  Board to
approve an application of an adequately  capitalized and adequately managed bank
holding  company to acquire control of, or acquire all or  substantially  all of
the assets of, a bank located in a state other than the holding  company's  home
state,  without  regard to whether the  transaction is prohibited by the laws of
any state.  The Federal  Reserve Board may not approve the acquisition of a bank
that has not been in existence for a minimum of five years without  regard for a
longer  minimum  period  specified  by the law of the host  state.  The  Federal
Reserve Board is prohibited  from approving an application if the applicant (and
its depository  institution  affiliates) controls or would control (i) more than
10% of the  insured  deposits in the United  States,  or (ii) 30% or more of the
deposits  in the  target  bank's  home state or in any state in which the target
bank  maintains  a branch.  Federal  law does not limit a state's  authority  to
restrict the percentage of total insured deposits in the state which may be held
or  controlled by a bank or bank holding  company to the extent such  limitation
does not  discriminate  against  out-of-state  banks or bank holding  companies.
Individual states may also waive the 30% state-wide concentration limit.

                                       26
<PAGE>

      Additionally,  the federal  banking  agencies  are  authorized  to approve
interstate  merger  transactions  without regard to whether such  transaction is
prohibited  by the law of any  state,  unless the home state of one of the banks
has adopted a law opting out of the interstate mergers.  Interstate acquisitions
of branches  are  permitted  only if the law of the state in which the branch is
located permits such acquisitions.  Interstate  mergers and branch  acquisitions
are  subject to the  nationwide  and  statewide  insured  deposit  concentration
amounts  described  above.  North  Carolina has enacted  legislation  permitting
interstate banking acquisitions.

      Federal law authorizes the FDIC to approve interstate branching de novo by
state banks only in states  which  specifically  allow for such  branching.  The
appropriate  federal banking  agencies  adopted  regulations  which prohibit any
out-of-state bank from using the interstate  branching  authority  primarily for
the purpose of deposit  production.  These  regulations  include  guidelines  to
ensure that interstate branches operated by an out-of-state bank in a host state
are reasonably  helping to meet the credit needs of the  communities  which they
serve.

      Dividends.  The Federal Reserve Board has issued a policy statement on the
payment of cash dividends by bank holding companies, which expresses the Federal
Reserve  Board's view that a bank holding company should pay cash dividends only
to the extent that the  company's  net income for the past year is sufficient to
cover  both  the  cash  dividends  and a rate  of  earnings  retention  that  is
consistent with the company's capital needs, asset quality and overall financial
condition.   The  Federal   Reserve  Board  also  indicated  that  it  would  be
inappropriate for a company  experiencing  serious financial  problems to borrow
funds  to  pay  dividends.  Furthermore,  under  the  prompt  corrective  action
regulations  adopted by the Federal Reserve Board, the Federal Reserve Board may
prohibit a bank  holding  company  from  paying  any  dividends  if the  holding
company's  bank  subsidiary  is  classified  as   "undercapitalized".   See  "--
Depository Institution Regulation -- Prompt Corrective Regulatory Action."

      Bank  holding  companies  are required to give the Federal  Reserve  Board
prior written  notice of any purchase or redemption  of its  outstanding  equity
securities  if the gross  consideration  for the  purchase or  redemption,  when
combined with the net  consideration  paid for all such purchases or redemptions
during  the  preceding  12  months,  is  equal  to 10%  or  more  of  the  their
consolidated net worth. The Federal Reserve Board may disapprove such a purchase
or redemption if it determines  that the proposal would  constitute an unsafe or
unsound  practice or would violate any law,  regulation,  Federal  Reserve Board
order,  directive,  or any condition  imposed by, or written agreement with, the
Federal Reserve Board.  Bank holding companies whose capital ratios exceeded the
thresholds for well  capitalized  banks on a consolidated  basis are exempt from
the foregoing  requirement if they were rated CAMELS 1 or 2 in their most recent
regulatory  inspection  and are not the  subject of any  unresolved  supervisory
issues.

TAXATION - GENERAL

      The  Company  files its federal  income tax return  based on a fiscal year
ending December 31.

FEDERAL INCOME TAXATION

      Legislation  that became  effective for tax years beginning after December
31, 1995  requiring the Bank to recapture into taxable income over a six taxable
year period the portion of the tax loan  reserve  that  exceeds the pre-1988 tax
loan loss reserve.  The Bank will no longer be allowed to use the reserve method
for tax loan loss provisions,  but would be allowed to use the experience method
of accounting  for bad debts.  There will be no future effect on net income from
the  recapture  because the taxes on these bad debts  reserves  has already been
accrued as a deferred tax liability.

      The Bank's federal  income tax returns have been audited  through the year
ended September 30, 1992.

STATE INCOME TAXATION

      Under North  Carolina law, the corporate  income tax currently is 6.90% of
federal taxable income as computed under the Internal  Revenue Code,  subject to
certain  prescribed  adjustments.  An annual state franchise tax is imposed at a
rate of .15%  applied to the  greatest of the  institutions  (i) capital  stock,
surplus and undivided  profits,  (ii)  investment in tangible  property in North
Carolina or (iii) appraised valuation of property in North Carolina.

      For additional information regarding taxation, see Notes 1 and 10 of Notes
to Consolidated Financial Statements in the Annual Report.

                                       27
<PAGE>

ITEM 1A. RISK FACTORS

      CERTAIN INTEREST RATE MOVEMENTS MAY IMPACT EARNINGS AND ASSET VALUE.

      Prior to 2005,  interest  rates have  recently  been at  historically  low
levels.  However,  since December 31, 2004, the prime lending rate has increased
from 5.25% to 7.25% at  December  31,  2005.  Short-term  and  intermediate-term
market  interest  rates  are used as a guide  to  price  the  Bank's  loans  and
deposits.  The recent  increase in such interest rates has had a positive impact
on the Bank's  interest rate spread and net interest margin to date, as a result
of the asset  sensitive  nature of the Bank's balance sheet.  Should  short-term
interest  rates  decline  dramatically  in the near future,  and if rates on the
Bank's  loans and  investments  reprice  downwards  faster than the rates on the
Bank's deposits and  borrowings,  the Bank could  experience  compression of its
interest rate spread and net interest margin, which could have a negative effect
on the Bank's profitability.

      Changes  in   interest   rates  also   affect  the  value  of  the  Bank's
interest-earning  assets,  and in particular  the Bank's  securities  portfolio.
Generally,  the value of fixed-rate securities fluctuates inversely with changes
in interest rates.  Unrealized gains and losses on securities available for sale
are  reported as a separate  component of equity,  net of tax.  Decreases in the
fair value of securities available for sale resulting from increases in interest
rates could have an adverse effect on stockholders' equity.

      STRONG  COMPETITION  WITHIN THE BANK'S  MARKET AREA COULD HURT PROFITS AND
SLOW GROWTH.

      The Bank faces  intense  competition  both in making loans and  attracting
deposits.  This  competition  makes it more  difficult  for the Bank to make new
loans and at times has required the Bank to offer higher  deposit  rates.  Price
competition  for loans and  deposits  could  result in the Bank  earning less on
loans and paying more on  deposits,  which  could  reduce net  interest  income.
Competition also makes it more difficult to grow loans and deposits, and to hire
and retain experienced  employees.  Some of the institutions with which the Bank
competes have  substantially  greater resources and lending limits than the Bank
has and may offer  services that the Bank does not provide.  Management  expects
competition to continue in the future as a result of legislative, regulatory and
technological changes and the continuing trend of consolidation in the financial
services industry.  The Bank's profitability  depends upon its continued ability
to compete successfully in its market area.

      THE COMPANY AND THE BANK OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND MAY
BE ADVERSELY AFFECTED BY CHANGES IN LAWS AND REGULATIONS.

      The Bank is subject to extensive  regulation,  supervision and examination
by the North Carolina Commissioner of Banks and the FDIC, as its primary federal
regulator.  The Company also is subject to  regulation  and  supervision  by the
Board of Governors of the Federal Reserve System and by the  Commissioner.  Such
regulation and supervision govern the activities in which an institution and its
holding company may engage, and are intended primarily for the protection of the
insurance  fund and the  depositors  and  borrowers  of the Bank rather than for
holders of the Company's  common stock.  Regulatory  authorities  have extensive
discretion  in their  supervisory  and  enforcement  activities,  including  the
imposition of  restrictions  on  operations,  the  classification  of the Bank's
assets and  determination of the level of allowance for loan losses.  Any change
in such  regulation  and  oversight,  whether in the form of regulatory  policy,
regulations,  legislation or supervisory  action,  may have a material impact on
operations.

      THE BANK  EMPHASIZES  COMMERCIAL  REAL  ESTATE,  COMMERCIAL  BUSINESS  AND
CONSUMER LENDING, WHICH GENERALLY ARE RISKIER THAN RESIDENTIAL MORTGAGE LENDING.

      The Bank currently operates as a North Carolina chartered commercial bank.
Prior to its  conversion  to a commercial  bank in 1997,  the Bank operated as a
traditional savings and loan association,  primarily emphasizing the origination
of loans secured by  single-family  residences.  Upon converting to a commercial
bank, the Board of Directors  determined there was a local demand for commercial
real estate,  commercial  business and consumer loans. As a result, the Board of
Directors determined to refocus the Bank's strategy.  Pursuant to this strategy,
while  continuing to pursue its existing  business of originating  single-family
residential   mortgage   loans,   the  Bank  took   advantage  of  the  business
opportunities  identified by the Board of Directors by gradually  expanding into
commercial real estate, commercial business and consumer lending. In furtherance
of this strategy,  the Bank  recruited  experienced  commercial  real estate and
consumer  loan and consumer  lending  officers  and  developed  commercial  real
estate,  commercial  business and consumer loan  products.  As a result of these
efforts over the years,  at December 31, 2005, the Company had  commercial  real
estate,  commercial  business and consumer loans totaling $570.5 million,  $38.5
million and $100.5 million,  respectively,  which  represented  71.4%,  4.8% and
12.6%,  respectively,  of total loans. As December 31, 2005,  $77.6 million,  or
9.7% of total loans, consisted of residential real estate mortgage loans.

                                       28
<PAGE>

      While commercial real estate,  commercial  business and consumer loans are
generally  more  interest  rate  sensitive  and  carry  higher  yields  than  do
residential  mortgage loans, they generally carry a higher degree of credit risk
than residential mortgage loans.

      Commercial real estate lending  entails  significant  additional  risks as
compared with single-family residential property lending. Commercial real estate
loans  typically  involve larger loan balances to single  borrowers or groups of
related  borrowers.  The payment experience on such loans typically is dependent
on the successful operation of the real estate project,  retail establishment or
business.  These  risks  can be  significantly  affected  by supply  and  demand
conditions in the market for office, retail and residential space, and, as such,
may be  subject  to a  greater  extent  to  adverse  conditions  in the  economy
generally.  To minimize  these risks,  the Bank  generally  limits itself to its
market  area or to  borrowers  with  which it has  prior  experience  or who are
otherwise  known to the Bank.  It has been the  Bank's  policy to obtain  annual
financial  statements  of the  business of the borrower or the project for which
commercial  real estate loans are made.  In addition,  in the case of commercial
mortgage loans made to a partnership of a corporation,  the Bank seeks, whenever
possible,  to obtain personal guarantees and annual financial  statements of the
principals of the partnership or corporation.

      Commercial  business  loans are often larger and may involve  greater risk
than other types of lending.  Because payments on such loans are often dependant
on successful operation of the business involved, repayment of such loans may be
subject to a greater extent to adverse conditions in the economy.  The Bank will
seek to minimize  these risks  through its  underwriting  guidelines,  which may
require certain safeguards,  such as the loan be supported by adequate cash flow
of  the  borrower,  profitability  of  the  business,  collateral  and  personal
guarantees of the  individual in the business.  In addition,  the Bank generally
limits this type of lending to its market area and to borrowers with whim it has
prior experience or who are otherwise well known to the Bank.

      Consumer  loans entail greater risk than do  residential  mortgage  loans,
particularly  in the case of loans  which are  unsecured  or  secured by rapidly
depreciable assets. Repossessed collateral for a defaulted consumer loan may not
provide an adequate  source of  repayment of the  outstanding  loan balance as a
result of the greater likelihood of damage, loss or depreciation.  The remaining
deficiency often does not warrant further substantial collection efforts against
the  borrower.  In addition,  consumer  loan  collections  are  dependent on the
borrower's  continuing  financial  stability,  and this are  more  likely  to be
adversely  affected  by events  such as job loss,  divorce,  illness or personal
bankruptcy.  See "Business of the Bank - Lending Activities - Consumer and Other
Lending."

      THE COMPANY'S  FINANCIAL CONDITION AND RESULTS OF OPERATIONS ARE DEPENDANT
ON THE ECONOMY IN THE BANK'S MARKET AREA.

      The Bank's  market area  consists of central,  eastern,  northeastern  and
southeastern  North  Carolina,  where the  Bank's  offices  are  located.  As of
December 31, 2005,  management  estimates that more than 95% of deposits and 90%
of loans came from its primary market area. Because of the Bank's  concentration
of business  activities  in its primary  market area,  the  Company's  financial
condition  and results of  operations  depend upon  economic  conditions  in its
market area.

      PROVISIONS IN THE COMPANY'S  CERTIFICATE OF  INCORPORATION  AND BYLAWS AND
STATUTORY PROVISIONS COULD DISCOURAGE A HOSTILE ACQUISITION OF CONTROL.

      The Company's  Certificate of  Incorporation  and Bylaws  contain  certain
provisions that could discourage  nonnegotiated  takeover  attempts that certain
stockholders  might deem to be in their interests or through which  stockholders
might otherwise  receive a premium for their shares over the then current market
price and that may tend to  perpetuate  existing  management.  These  provisions
include:  the  classification  of the  terms  of the  members  of the  Board  of
Directors;  supermajority  provisions  for  the  approval  of  certain  business
combinations;  elimination of cumulative  voting by stockholders in the election
of  directors;   certain  provisions   relating  to  meetings  of  stockholders;
restrictions  on  the  acquisition  of  the  Company's  equity  securities;  and
provisions  allowing the Board of Directors to consider  nonmonetary  factors in
evaluating a business  combination or a tender or exchange offer. The provisions
in the Company's Certificate of Incorporation requiring a supermajority vote for
the approval of certain  business  combinations  and containing  restrictions on
acquisitions of the Company's equity  securities  provide that the supermajority
voting  requirements  or  acquisition  restrictions  do not  apply  to  business
combinations  or  acquisitions  meeting  specified  Board of Directors  approval
requirements.  The Certificate of Incorporation  also authorizes the issuance of
1,000,000 shares of preferred stock as well as additional shares of Common Stock
up to a total of  25,000,000  outstanding  shares.  These shares could be issued
without  stockholder  approval on terms or in  circumstances  that could deter a
future takeover attempt.

                                       29
<PAGE>

      In addition, Virginia law provides for certain restrictions an acquisition
of the Company, and federal and North Carolina laws contain various restrictions
on acquisitions of control of banks and their holding companies.

      The Certificate of Incorporation,  Bylaw and statutory provisions, as well
as certain other  provisions of state and federal law and certain  provisions in
the Company's and the Bank's  employee  benefit plans are employment  agreements
and change in control severance agreements,  may have the effect of discouraging
or preventing a future  takeover  attempt in which  stockholders  of the Company
otherwise might receive a substantial premium for their shares over then current
market prices.

ITEM 1B. UNRESOLVED STAFF COMMENTS

      Not Applicable.

ITEM 2. PROPERTIES

      The  following  table  sets  forth the  location  and  certain  additional
information regarding the Bank's offices at December 31, 2005.

<TABLE>
<CAPTION>
                                                                       Book Value at
                                                Year      Owned or      December 31,     Approximate
                                               Opened      Leased          2005          Square Footage
                                           ------------- ------------- --------------    --------------
                                                                       (Dollars in thousands)
          <S>                                  <C>         <C>             <C>           <C>
          MAIN OFFICE:
          1311 Carolina Avenue
          Washington, NC                        1986        Owned           $1,231          10,200

          BRANCH OFFICES:
          300 North Market Street
          Washington, NC                        1959        Owned              114           4,680

          1328 John Small Avenue
          Washington, NC                        2001        Leased              16           1,916

          2999 Hwy. 17S
          Chocowinity, NC                       1999        **                 304           2,530

          301 E. Arlington Boulevard
          Greenville, NC                        1993        Owned              325           2,600

          907 E. Firetower Road
          Greenville, NC                        2005        Owned              829           2,245

          604 E. Ehringhaus Street
          Elizabeth City, NC                    1980        Owned              141           2,500

          1906 S. Croatan Street
          Kill Devil Hills, NC                  2002        Leased              85           2,000

          2600 N. Croatan Street
          Kill Devil Hills, NC                  2004        Leased               8             688
</TABLE>

                                       30
<PAGE>

<TABLE>
<CAPTION>
                                                                          Book Value at
                                                Year      Owned or        December 31,    Approximate
                                               Opened      Leased           2005         Square Footage
                                               ------     --------         -------       --------------
                                                                         (Dollars in thousands)
        <S>                                    <C>          <C>                 <C>           <C>
          40894 NC Highway 12
          Suites 1 & 2
          Avon, NC 27915                       2005          Leased               2             120

          2430 Heritage Street
          Kinston, NC                          2001          Leased              50           2,145

          1725 Glenburnie Road
          New Bern, NC                         1990          Owned              469           2,600

          202 Craven Street
          New Bern, NC                         1995          Leased               2           2,500

          2019 S. Glenburnie Road
          Crossroads Shopping Center
          New Bern, NC                         2004          Leased              71             435

          241 Green Street
          Fayetteville, NC                     1999          Owned              747          10,000

          3107 Raeford Road
          Fayetteville, NC                     1999          Owned              384           2,400

          600 N. Chestnut Street
          Lumberton, NC                        1999          Owned              333           6,100

          3000 N. Elm Street
          Lumberton, NC                        2001          Leased              65           2,128

          3103 N. Main Street
          Hope Mills, NC                       2004          Owned              558           2,200

          100 East Hope Lodge Street
          Tarboro, NC                          2000          Leased              14           1,350

          300 Sunset Avenue
          Rocky Mount, NC                      1994          Owned              311           4,948

          2901 Sunset Avenue
          Rocky Mount, NC                      2000          Owned            1,058           5,635

          450 North Winstead Avenue
          Rocky Mount, NC                      2000          Leased              35           2,845

          1378 Benvenue Road
          Rocky Mount, NC                      2000          **                 332           5,376

          3635 North Halifax Road
          Dortches, NC                         2000          Leased              38             396

          4800 Six Forks Road
          Six Forks III, Suite #115
          Raleigh, NC                          2004          Leased             139           4,501
</TABLE>

                                       31
<PAGE>

<TABLE>
<CAPTION>
                                                                          Book Value at
                                                Year      Owned or        December 31,    Approximate
                                               Opened      Leased          2005          Square Footage
                                               ------     --------         -------       --------------
                                                                         (Dollars in thousands)
<S>                                            <C>         <C>                 <C>          <C>
          1802 Martin Luther King
          Jr. Parkway
          Suite 108
          Durham, NC                           2004          Leased               6             950

          CREDIT ADMINISTRATION:
          239 West Main Street
          Washington, NC                       1994          Owned              346           7,600

          OPERATIONS CENTER:
          220 Creekside Drive
          Washington, NC                       2001          Owned              610          10,000

          FIRST SOUTH LEASING:
          1035 Director Court
          Suite C
          Greenville, NC                       2001          Leased              18           1,146

          DEVELOPED BUILDING LOT:
          Taberna
          New Bern, NC                                       Owned              176
</TABLE>

         -----------
         **       Lease land, own building.

      The book value of the Bank's investment in premises and equipment was $8.8
million at December 31, 2005. See Note 5 to Consolidated Financial Statements.

ITEM 3. LEGAL PROCEEDINGS

      From time to time, the Company and/or the Bank is a party to various legal
proceedings  incident to their  business.  At December 31,  2005,  there were no
legal  proceedings  to which  either the Company or the Bank was a party,  or to
which any of their  property was subject,  which were  expected by management to
result in a  material  loss to the  Company  or the Bank.  There are no  pending
regulatory  proceedings  to which the Company or the Bank is a party or to which
either of their properties is subject which are currently  expected to result in
a material loss.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      Not applicable.

                                     PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY,  RELATED STOCKHOLDERS MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES

      (a)  The   information   contained  in  the  section   captioned   "Market
Information" in the Company's  Annual Report to Stockholders for the Fiscal Year
Ended  December  31, 2005 (the  "Annual  Report")  filed as Exhibit 13 hereto is
incorporated herein by reference.

      (b) Not applicable.

      (c) The  following  table sets forth  information  regarding the Company's
repurchases  of its common  stock  during the fourth  quarter of the fiscal year
covered by this Annual Report.

                                       32
<PAGE>

<TABLE>
<CAPTION>
                                                                                                              (d)
                                                                                  (c)
                              (a)                      (b)                                                  MAXIMUM
                                                                            TOTAL NUMBER OF            NUMBER OF SHARES
                             TOTAL                                          SHARES PURCHASED           THAT MAY YET BE
                           NUMBER OF                 AVERAGE              AS PART OF PUBLICLY          PURCHASED UNDER
                             SHARES                 PRICE PAID            ANNOUNCED PLANS OR             THE PLANS OR
       PERIOD              PURCHASED                PER SHARE                   PROGRAMS                   PROGRAMS
       ------              ---------                ---------                   --------                   --------
<S>                        <C>                        <C>                     <C>                        <C>
October 2005
Beginning date:
October 1
Ending date:                    --                      $ --                        --                     149,163
October 31

November 2005
Beginning date:
November 1                   8,297                     36.79                     8,297                     140,866
Ending date:
November 30

December  2005
Beginning date:
December 1
Ending date:                   169                     35.58                       169                     140,697
December 31
                      ---------------------    ---------------------     -----------------------    -----------------------
                             8,466                    $36.77                     8,466                     140,697
Total                       =======                   =======                   =======                    =======
</TABLE>


ITEM 6. SELECTED FINANCIAL DATA

      The information  contained in the table captioned  "Selected  Consolidated
Financial and Other Data" on page 3 in the Annual Report is incorporated  herein
by reference.

ITEM 7. MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

      The  information   contained  in  the  section   captioned   "Management's
Discussion  and Analysis of Financial  Condition and Results of  Operations"  on
pages 4 through 14 in the Annual Report is incorporated herein by reference.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      The information contained in the section captioned "Market Risk" on page 6
in the Annual Report is incorporated herein by reference.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      The Report of Independent  Auditors,  Consolidated  Financial  Statements,
Notes to Consolidated Financial Statements and Selected Financial Data contained
on pages 15  through  40 in the Annual  Report,  which are listed  under Item 15
herein, are incorporated herein by reference.

The  report  of  PricewaterhouseCoopers  LLP with  respect  to the  consolidated
statements of operations,  changes in stockholders' equity and cash flows of the
Company for the year ended December 31, 2003 follows.

                                       33
<PAGE>

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

                   [Letterhead of PricewaterhouseCoopers LLP]

To the Board of Directors and Shareholders of First South Bancorp, Inc.:

      In our opinion, the accompanying consolidated statements of operations, of
changes in  stockholders'  equity,  and of cash  flows  present  fairly,  in all
material  respects,  the  results of  operations  and cash flows of First  South
Bancorp,  Inc.  and its  subsidiaries  for the  year  ended  December  31,  2003
(appearing on pages 15 through 40 of the First South  Bancorp,  Inc. 2005 Annual
Report to  Shareholders  which has been  incorporated  by reference in this Form
10-K) in conformity with accounting  principles generally accepted in the United
States of America.  These  financial  statements are the  responsibility  of the
Company's  management;  our  responsibility  is to  express  an opinion on these
financial  statements  based  on our  audit.  We  conducted  our  audit of these
statements  in  accordance  with auditing  standards  generally  accepted in the
United  States of America,  which  require that we plan and perform the audit to
obtain reasonable  assurance about whether the financial  statements are free of
material  misstatement.  An audit includes examining,  on a test basis, evidence
supporting the amounts and  disclosures in the financial  statements,  assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall  financial  statement  presentation.  We believe that our
audit provides a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

Raleigh, North Carolina
March 4, 2004

ITEM  9.  CHANGES  IN  AND  DISAGREEMENTS  WITH  INDEPENDENT  REGISTERED  PUBLIC
ACCOUNTING FIRMS ON ACCOUNTING AND FINANCIAL DISCLOSURE

      The information  contained under the section captioned  "Relationship with
Independent Registered Public Accounting Firm" in the Company's definitive proxy
statement  for the Company's  2006 Annual  Meeting of  Stockholders  (the "Proxy
Statement") is incorporated herein by reference.

ITEM 9A. CONTROLS AND PROCEDURES

      As of the end of the period  covered  by this  report,  management  of the
Company  carried  out  an  evaluation,   under  the  supervision  and  with  the
participation  of  the  Company's  principal  executive  officer  and  principal
financial officer, of the effectiveness of the Company's disclosure controls and
procedures.  Based on this evaluation, the Company's principal executive officer
and principal financial officer concluded that the Company's disclosure controls
and  procedures  are  effective  in  ensuring  that  information  required to be
disclosed  by the  Company  in  reports  that it  files  or  submits  under  the
Securities Exchange Act of 1934, as amended, is recorded, processed,  summarized
and reported,  within the time periods  specified in the Securities and Exchange
Commission's  rules  and  forms.  It  should  be noted  that the  design  of the
Company's  disclosure  controls  and  procedures  is based in part upon  certain
reasonable  assumptions about the likelihood of future events,  and there can be
no reasonable  assurance  that any design of disclosure  controls and procedures
will  succeed  in  achieving  its  stated  goals  under  all  potential   future
conditions,  regardless of how remote, but the Company's principal executive and
financial  officers have  concluded that the Company's  disclosure  controls and
procedures are, in fact, effective at a reasonable assurance level.

      The annual report of management on the  effectiveness  of internal control
over  financial  and the  attestation  report  thereon  issued by the  Company's
independent  registered  public  accounting  firm  are  set  forth  below  under
"Management's  Report on Internal Control Over Financial  Reporting" and "Report
of Independent Registered Public Accounting Firm".

                                       34
<PAGE>

MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

                    [Letterhead of First South Bancorp, Inc.]

      Management of First South Bancorp,  Inc. and subsidiary (the "Company") is
responsible for  establishing  and maintaining  effective  internal control over
financial  reporting  as  defined in Rules  13a-15(f)  and  15d-15(f)  under the
Securities  Exchange Act of 1934. Internal control over financial reporting is a
process designed to provide  reasonable  assurance  regarding the reliability of
financial  reporting and the  preparation  of financial  statements for external
purposes in accordance with U.S. generally accepted accounting principles.

Under the supervision and with the  participation  of management,  including the
principal  executive  officer  and  principal  financial  officer,  the  Company
conducted an evaluation of the  effectiveness of internal control over financial
reporting  based on the  framework  in  INTERNAL  CONTROL--INTEGRATED  FRAMEWORK
issued by the Committee of Sponsoring  Organizations of the Treadway Commission.
Based on this  evaluation  under the  framework in INTERNAL  CONTROL--INTEGRATED
FRAMEWORK,  management  of the Company  has  concluded  the  Company  maintained
effective internal control over financial reporting as of December 31, 2005.

      Internal   control  over  financial   reporting  cannot  provide  absolute
assurance of achieving  financial  reporting  objectives because of its inherent
limitations.  Internal  control  over  financial  reporting  is a  process  that
involves human diligence and compliance and is subject to lapses in judgment and
breakdowns  resulting  from human  failures.  Internal  control  over  financial
reporting can also be circumvented by collusion or improper management override.
Because of such limitations, there is a risk that material misstatements may not
be prevented or detected on a timely  basis by internal  control over  financial
reporting.

      Management is also  responsible  for compliance  with laws and regulations
relating  to  safety  and  soundness  which are  designated  by the FDIC and the
appropriate  federal  banking  agency.  Management  assessed its compliance with
these  designated  laws and  regulations  relating to safety and  soundness  and
believes that the Company complied, in all significant respects,  with such laws
and during the year ended December 31, 2005.

      Dixon Hughes PLLC, an independent,  registered public accounting firm, has
audited the Company's  consolidated  financial statements as of and for the year
ended December 31, 2005,  and has issued an attestation  report on the Company's
assessment of the effectiveness of the Company's internal control over financial
reporting as of December 31, 2005, which is included herein.

First South Bancorp, Inc.
March 7, 2006

/s/ Thomas A. Vann                                  /s/ William L. Wall
------------------------------------                ----------------------------
Thomas A. Vann                                     William L. Wall
President and Chief Executive Officer              Executive Vice President and
                                                   Chief Financial Officer

                                       35
<PAGE>

             ATTESTATION REPORT OF REGISTERED PUBLIC ACCOUNTING FIRM

                        [Letterhead of Dixon Hughes PLLC]

             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders
First South Bancorp, Inc.
Washington, North Carolina

      We have  audited  management's  assessment,  included in the  accompanying
Management's  Annual Report on Internal Control Over Financial  Reporting,  that
First South Bancorp,  Inc. (the "Company") maintained effective internal control
over financial reporting as of December 31, 2005, based on criteria  established
in INTERNAL CONTROL--INTEGRATED  FRAMEWORK issued by the Committee of Sponsoring
Organizations  of  the  Treadway   Commission.   The  Company's   management  is
responsible for maintaining  effective internal control over financial reporting
and for its assessment of the  effectiveness  of internal control over financial
reporting.   Our  responsibility  is  to  express  an  opinion  on  management's
assessment and an opinion on the effectiveness of the Company's internal control
over financial reporting based on our audit.

      We  conducted  our audit in  accordance  with the  standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and  perform  the audit to obtain  reasonable  assurance  about  whether
effective  internal  control over  financial  reporting  was  maintained  in all
material  respects.  Our audit included  obtaining an  understanding of internal
control over financial reporting,  evaluating management's  assessment,  testing
and evaluating the design and operating  effectiveness of internal control,  and
performing   such  other   procedures   as  we   considered   necessary  in  the
circumstances.  We believe that our audit  provides a  reasonable  basis for our
opinion.

      A  company's  internal  control  over  financial  reporting  is a  process
designed to provide reasonable  assurance regarding the reliability of financial
reporting and the preparation of financial  statements for external  purposes in
accordance with generally accepted accounting  principles.  Because management's
assessment and our audit were conducted to also meet the reporting  requirements
of  Section  112  of the  Federal  Deposit  Insurance  Company  Improvement  Act
(FDICIA),  management's  assessment  and our  audit  of the  Company's  internal
control over  financial  reporting  included  controls over the  preparation  of
financial  statements in accordance with the  instructions  to the  Consolidated
Financial  Statements  for Bank Holding  Companies  (form FR Y-9 C). A company's
internal control over financial reporting includes those policies and procedures
that (1) pertain to the  maintenance  of records  that,  in  reasonable  detail,
accurately and fairly reflect the transactions and dispositions of the assets of
the company;  (2) provide reasonable assurance that transactions are recorded as
necessary to permit  preparation  of financial  statements  in  accordance  with
generally accepted accounting principles,  and that receipts and expenditures of
the company are being made only in accordance with  authorizations of management
and directors of the company;  and (3) provide  reasonable  assurance  regarding
prevention or timely detection of unauthorized acquisition,  use, or disposition
of the  company's  assets  that could have a  material  effect on the  financial
statements.

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

      In our opinion,  management's  assessment  that First South Bancorp,  Inc.
maintained  effective  internal control over financial  reporting as of December
31,  2005,  is  fairly  stated,  in all  material  respects,  based on  criteria
established in INTERNAL CONTROL--INTEGRATED FRAMEWORK issued by the Committee of
Sponsoring  Organizations of the Treadway  Commission.  Also in our opinion, the
Company  maintained,  in all material respects,  effective internal control over
financial  reporting as of December 31, 2005,  based on criteria  established in
INTERNAL  CONTROL--INTEGRATED  FRAMEWORK  issued by the  Committee of Sponsoring
Organizations of the Treadway Commission.

                                       36
<PAGE>

      We have also  audited,  in  accordance  with the  standards  of the Public
Company Accounting Oversight Board (United States),  the consolidated  statement
of  financial  condition  of the Company as of December 31, 2005 and the related
consolidated statements of operations,  changes in stockholders' equity and cash
flows for the year then ended  December 31, 2005,  and our report dated March 7,
2006,   expressed  an  unqualified  opinion  on  those  consolidated   financial
statements.

      We  do  not  express  an  opinion  or  any  other  form  of  assurance  on
management's   statement  referring  to  compliance  with  designated  laws  and
regulations related to safety and soundness.

/s/ Dixon Hughes PLLC
---------------------
Sanford, North Carolina
March 7, 2006

CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

      There  have  been  no  changes  in the  Company's  internal  control  over
financial reporting  identified in connection with the evaluation required under
paragraph (d) of Securities  and Exchange  Commission  Rule 13a-15 that occurred
during the Company's last fiscal quarter,  that has materially  affected,  or is
reasonably  likely to materially  affect,  the Company's  internal  control over
financial reporting.

ITEM 9B. OTHER INFORMATION

      Not applicable.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

      The  information  contained  under the sections  captioned  "Proposal I --
Election  of  Directors"  and  "Section  16(a)  Beneficial  Ownership  Reporting
Compliance" in the Proxy Statement is incorporated herein by reference.

      The Company has  adopted a Code of Ethics  that  applies to the  Company's
principal   executive  officer,   principal   financial  officer  and  principal
accounting  officer.  The Company has posted such Code of Ethics on its Internet
Web site and intends to satisfy the disclosure requirement under Item 10 of Form
8-K  regarding  an amendment  to, or waiver from,  the Code of Ethics by posting
such information on its Internet website.  The Company's Internet website may be
accessed as follows: http://www.firstsouthnc.com.

ITEM 11. EXECUTIVE COMPENSATION

      The  information  contained  under the sections  captioned  "Proposal I --
Election  of  Directors,"  "--   Compensation   Committee  Report  on  Executive
Compensation,"   "--  Comparative  Stock   Performance   Graph,"  "--  Executive
Compensation"  and  "--  Director   Compensation"  in  the  Proxy  Statement  is
incorporated herein by reference.

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

      (a)   SECURITY  OWNERSHIP  OF  CERTAIN   BENEFICIAL  OWNERS.   Information
            required by this item is  incorporated  herein by  reference  to the
            section captioned "Voting Securities and Security  Ownership" in the
            Proxy Statement.

      (b)   SECURITY OWNERSHIP OF MANAGEMENT.  Information required by this item
            is  incorporated  herein  by  reference  to the  sections  captioned
            "Voting  Securities  and  Security  Ownership"  and  "Proposal  I --
            Election of Directors" in the Proxy Statement.

      (c)   CHANGES  IN  CONTROL.   Management   of  the  Company  knows  of  no
            arrangements,  including  any pledge by any person of  securities of
            the Company,  the operation of which may at a subsequent date result
            in a change in control of the registrant.


      (d)   EQUITY  COMPENSATION  PLANS.  The following table sets forth certain
            information with respect to the Company's equity  compensation plans
            as of December 31, 2005.


                                       37
<PAGE>


<TABLE>
<CAPTION>

                                                (a)                         (b)                            (c)
                                                                                                Number of securities remaining
                                    Number of securities to be                                   available for future issuance
                                      issued upon exercise of       Weighted-average exercise     under equity compensation
                                       outstanding options,           price of outstanding        plans (excluding securities
                                        warrants and rights       options, warrants and rights     reflected in column (a))
                                        -------------------       ----------------------------     ------------------------

<S>                                          <C>                    <C>                              <C>
Equity compensation plans                    703,772                 $        11.00                     669,318
  approved by security holders

Equity compensation plans not                     --                             --                           --

  approved by security holders
                                              703,772                $        11.00                     669,318
                                            ===========                   ===========                 ===========
Total
</TABLE>

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

      The information  required by this item is incorporated herein by reference
to the section  captioned  "Proposal I -- Election of Directors --  Transactions
with Management" in the Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

      Information  required by this item is incorporated  herein by reference to
the section  captioned "Audit and Other Fees Paid to Independent  Accountant" in
the Proxy Statement.

                                     PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)   LIST OF DOCUMENTS FILED AS PART OF THIS REPORT

      (1) Financial Statements.  The following consolidated financial statements
are incorporated by reference from Item 8 hereof:

      Report of Independent Registered Public Accounting Firm
      Consolidated Statements of Financial Condition as of December 31, 2005
      and 2004 Consolidated Statements of Operations for the Years Ended
      December 31, 2005, 2004 and 2003 Consolidated Statements of Changes in
      Stockholders  Equity for the Years  Ended  December  31, 2005 and 2004
      2003

      Consolidated  Statements  of Cash Flows for the Years Ended  December  31,
2005 and 2004 and 2003 Notes to Consolidated Financial Statements

      (2) Financial  Statement  Schedules.  All schedules for which provision is
made in the  applicable  accounting  regulations  of the Securities and Exchange
Commission are omitted because of the absence of conditions under which they are
required or because the  required  information  is included in the  consolidated
financial statements and related notes thereto.

      (3) Exhibits.  The  following is a list of exhibits  filed as part of this
Annual Report on Form 10-K and is also the Exhibit Index.


                                       38
<PAGE>


      NO. DESCRIPTION

      3.1   Certificate  of   Incorporation   of  First  South   Bancorp,   Inc.
            (Incorporated  herein by reference from Exhibit 3.1 to the Company's
            Registration Statement on Form S-1 (File No. 333-16335))

      3.2   Bylaws of First South Bancorp, Inc., as amended (Incorporated herein
            by reference  from the Company's  Annual Report on Form 10-K for the
            Year Ended December 31, 2004 (File No. 0-22219))

      4.1   Form of  Common  Stock  Certificate  of First  South  Bancorp,  Inc.
            (Incorporated  herein by reference  from Exhibit 1 to the  Company's
            Registration Statement on Form 8-A)

      4.2   Junior Subordinated  Indenture between First South Bancorp, Inc. and
            The Bank of New York dated September 26, 2004  (Incorporated  herein
            by reference  from the Company's  Annual Report on Form 10-K for the
            Year Ended December 31, 2003 (File No. 0-22219))

    10.1(a) Employment Agreement between First South Bancorp,  Inc. and Thomas
            A.  Vann,  as amended  (Incorporated  herein by  reference  from the
            Company's Annual Report on Form 10-K for the Year Ended December 31,
            2003 (File No. 0-22219))*

    10.1(b) Employment  Agreement between First South Bank and Thomas A. Vann,
            as amended  (Incorporated  herein by  reference  from the  Company's
            Annual  Report on Form 10-K for the Year  Ended  December  31,  2003
            (File No. 0-22219))*

      10.2  Change in Control  Protective  Agreements between Home Savings Bank,
            SSB, First South Bancorp,  Inc. and Mary R. Boyd,  Sherry L. Correll
            and  Kristie  W.  Hawkins  (Incorporated  herein by  reference  from
            Exhibit  10.4 to the  Company's  Registration  Statement on Form S-1
            (File No. 333-16335))*

      10.3  Supplemental  Income Agreements as Amended and Restated December 14,
            1995 between Home Savings Bank, SSB and Sherry L. Correll and Thomas
            A.  Vann and the 1996  Amendment  Thereto  (Incorporated  herein  by
            reference from Exhibit 10.5 to the Company's  Registration Statement
            on Form S-1 (File No. 333-16335))*

      10.4  Supplemental Income Plan Agreements as Amended and Restated December
            14, 1995 between Home Savings Bank, SSB and James F. Buckman, Thomas
            A.  Vann  and  William  L.  Wall  and  the  1996  Amendment  Thereto
            (Incorporated herein by reference from Exhibit 10.6 to the Company's
            Registration Statement on Form S-1 (File No. 333-16335))*

      10.5  Home  Savings  Bank,  SSB  Director's  Deferred   Compensation  Plan
            Agreements as Amended and Restated  December 14, 1995 with Edmund T.
            Buckman, Jr., Linley H. Gibbs, Jr., Frederick N. Holscher, Frederick
            H. Howdy,  Charles E. Parker,  Jr., Marshall T. Singleton and Thomas
            A.  Vann and the 1996  Amendment  Thereto  (Incorporated  herein  by
            reference from Exhibit 10.7 to the Company's  Registration Statement
            on Form S-1 (File No. 333-16335))*

      10.6  First South Bank  Director's  Retirement  Plan Agreements as Amended
            and Restated  December 14, 1995 with Edmund T. Buckman,  Jr., Linley
            H. Gibbs, Jr., Frederick N. Holscher, Frederick H. Howdy, Charles E.
            Parker,  Jr. and Thomas A. Vann, the 1996 Amendment  thereto and the
            2004 Amendment  thereto  (Incorporated  herein by reference from the
            Company's Annual Report on Form 10-K for the Year Ended December 31,
            2003 (File No. 0-22219))*

      10.7  Home Savings Bank, SSB Director's  Retirement  Payment Agreements as
            Amended and Restated December 14, 1995 with Edmund T. Buckman,  Jr.,
            Linley H. Gibbs,  Jr.,  Frederick N.  Holscher,  Frederick H. Howdy,
            Charles E. Parker,  Jr.,  and Thomas A. Vann and the 1996  Amendment
            Thereto  (Incorporated  herein by reference from Exhibit 10.9 to the
            Company's Registration Statement on Form S-1 (File No. 333-16335))*

      10.8  Home Savings Bank,  SSB Directors  Retirement  Plan  Agreement  with
            Marshall  Singleton  and the 2004  Amendment  thereto  (Incorporated
            herein by reference  from the  Company's  Annual Report on Form 10-K
            for the Year Ended December 31, 2003 (File No. 0-22219))*

      10.9  First  South  Bancorp,  Inc.  1997  Stock  Option  Plan,  as amended
            (Incorporated   herein  by  reference  from  Exhibit  10.10  to  the
            Company's  Annual  Report on Form 10-K for the Year Ended  September
            30, 1999 (File No. 0-22219))*

      10.10 Supplemental  Income  Plan  Agreement  between  First South Bank and
            Robert E. Branch dated September 21, 2004

      10.11 Change-in-Control  Protective  Agreement  between  First South Bank,
            First South  Bancorp,  Inc. and Robert E. Branch  dated  January 27,
            2005

      10.12 Change-in-Control  Protective  Agreement  between  First South Bank,
            First South Bancorp,  Inc. and William L. Wall dated January 1, 2001
            (Incorporated   herein  by  reference  from  Exhibit  10.12  to  the
            Company's  Annual  Report on Form 10-K for the Year Ended  September
            30, 2001 (File No. 0-22219))*

                                       39
<PAGE>

      10.13 Trust Preferred  Securities  Guarantee Agreement between First South
            Bancorp,  Inc.,  and The Bank of New York dated  September  26, 2003
            (Incorporated  herein by reference from the Company's  Annual Report
            on Form  10-K  for the  Year  Ended  December  31,  2003  (File  No.
            0-22219))

      13    Annual Report to Stockholders for the Fiscal Year Ended December 31,
            2005

      21    Subsidiaries of the Registrant

      23.1  Consent of PricewaterhouseCoopers LLP

      23.2  Consent of Dixon Hughes PLLC

      31.1  Rule 13a-14(a) Certification of Chief Executive Officer

      31.2  Rule 13a-14(a) Certification of Chief Financial Officer

      32    Certification pursuant to 18 U.S.C. Section 1350

---------------------------
      * Compensatory plan or arrangement

(b) EXHIBITS.  The exhibits  required by Item 601 of  Regulation  S-K are either
filed as part of this Annual  Report on Form 10-K or  incorporated  by reference
herein.

(c) FINANCIAL STATEMENTS AND SCHEDULES EXCLUDED FROM ANNUAL REPORT. There are no
other financial statements and financial statement schedules which were excluded
from the Annual  Report to  Stockholders  pursuant  to Rule  14a-3(b)  which are
required to be included herein.

 <PAGE>




                                   SIGNATURES

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

                                                       FIRST SOUTH BANCORP, INC.

March 15, 2006
                                                       By: /s/Thomas A. Vann
                                                       ---------------------
                                                       Thomas A. Vann
                                                       President

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

/s/Thomas A. Vann                                                March 15, 2006
--------------------------------------------
Thomas A. Vann
President and Director
(Principal Executive Officer)

/s/William L. Wall                                               March 15, 2006
--------------------------------------------
William L. Wall
Executive Vice President, Chief Financial
  Officer and Secretary
(Principal Financial and Accounting Officer)

/s/Edmund T. Buckman, Jr.                                        March 15, 2006
--------------------------------------------
Edmund T. Buckman, Jr.
Director

/s/Linley H. Gibbs, Jr.                                          March 15, 2006
--------------------------------------------
Linley H. Gibbs, Jr.
Director

/s/Frederick N. Holscher                                         March 15, 2006
--------------------------------------------
Frederick N. Holscher
Director

/s/Frederick H. Howdy                                            March 15, 2006
--------------------------------------------
Frederick H. Howdy
Director

/s/Charles E. Parker, Jr.                                        March 15, 2006
--------------------------------------------
Charles E. Parker, Jr.
Director

/s/Marshall T. Singleton                                         March 15, 2006
--------------------------------------------
Marshall T. Singleton
Director

/s/H.D. Reaves, Jr.                                              March 15, 2006
--------------------------------------------
H. D. Reaves, Jr.
Director

                                       40
<PAGE>



                                                              2005 Annual Report






        First South Bancorp

 <PAGE>

                                 TABLE OF CONTENTS

Letter to Stockholders                                                         1

Mission Statement                                                              2

Selected Consolidated Financial Information and Other Data                     3

Management's Discussion and Analysis of Financial Condition
         and Results of Operations                                             4

Report of Independent Registered Public Accounting Firm                       15

Consolidated Statements of Financial Condition                                16

Consolidated Statements of Operations                                         17

Consolidated Statements of Changes in Stockholders' Equity                    18

Consolidated Statements of Cash Flows                                         19

Notes to Consolidated Financial Statements                                    20

Board of Directors                                                            41

Executive Officers                                                            41

Area Executives & Subsidiary Executives                                       41

City & Branch Executives                                                      41

First South Bank Office Locations                                             42

Stockholder Information                                                       43

<PAGE>

                             LETTER TO STOCKHOLDERS

To Our Stockholders:

The financial  results  achieved by First South Bancorp  ("First South") and its
wholly  owned  subsidiary,  First  South  Bank  ("Bank")  during  the year ended
December 31, 2005 were extremely positive for our stockholders.  We accomplished
both our  financial  and  strategic  objectives,  set a new earnings  record and
continued to enhance shareholder value.

For 2005, we are pleased to report record earnings of $14.1 million representing
a 20.6%  increase over the $11.7 million  earned in 2004.  The  significance  of
these  earnings is reflected in the Bank's ability to reprice its assets quickly
and manage its operating  cost.  Diluted  earnings per share  increased 18.4% to
$2.12 per share for 2005 from $1.79 per share for 2004.

The assets of First South grew by 15.4% to $833.1 million at year end 2005, from
$722.1 million at year end 2004. In addition, total loans and leases were $707.8
million  and  deposits  were  $733.8  million,  respectively,  at year end 2005.
Internal  growth was  strong in a very  competitive  environment  and the Bank's
reliance on borrowings was minimal.

The  total  return  to our  stockholders  increased  dramatically  in  2005.  We
increased the quarterly cash dividend  payment rate by 17.7%,  and combined with
the market appreciation of our common stock, resulted in a 40.9% total return to
our stockholders.

We enjoyed many positive events during 2005. U.S. Banker  recognized First South
as 3rd among the top 200 publicly  traded  community  banks in the United States
with assets of $1 billion or less,  ranked by 3-year  average  return on equity.
The American  Banker ranked First South as the 54th most  efficient bank holding
company  among the  largest  500 in the  United  States  and as having  the 77th
largest net interest  margin among all banking  companies in the United  States.
Business North Carolina ranked the top 75 public  companies in North Carolina by
twelve measures,  and First South was ranked 2nd in net interest margin,  5th in
return on  average  equity,  8th in total  one-year  return and 9th in return on
capital. We are pleased with these  recognitions,  as they further exemplify the
visibility  of First South and the Bank among both the business  and  investment
communities.

During 2005,  the Bank opened three new full  service  banking  offices in Avon,
Durham,  and Greenville,  North Carolina allowing us to better serve the banking
needs in our growing  market area and allowing us to expand our customer base in
existing  markets.  Many of our future  strategies  will focus on enhancing  the
franchise value of First South. Our goal is to be a high performance  bank, both
in profitability and growth without  compromising  service.  We are committed to
our shareholders, our customers and our employees.

We will  continue to review the structure of the assets and  liabilities  of the
Bank in order to meet the challenges of a changing  world.  We will use internal
and  external  growth  to meet our  strategic  plan.  The  consolidation  of our
industry  will  continue and this should create  significant  opportunities  for
First South.  We will continue to look for  acquisition  opportunities  and will
expand our operations into new markets.

The  outstanding  financial  results  achieved  this  year  would  not have been
possible  without  the  hard  work  and  dedication  of  our  employees.  We are
appreciative  and proud of their  accomplishments.  They are  committed to First
South,  its principles  and to providing  their  customers the highest  possible
level of  service.  We will  continue  to invest in our  employees,  which  will
ultimately result in improved service to our customers and enhanced  shareholder
value.

                                       1
<PAGE>

I want to thank Mr.  Edmund "Eddie Buck" Buckman for his thirty years of service
on the Bank's Board of Directors. Eddie Buck joined the Bank in 1975 and was its
Chairman  from  1991 to 1996 and  served on  numerous  committees.  His  wisdom,
insight and warm smile will be missed.  We thank him for all he has done to make
First South so successful and we wish him the best in his retirement.

Each member of your Board of Directors  along with our  officers  and  employees
join me in thanking you for  supporting  First South  Bancorp.  As always,  your
comments or  suggestions  are  welcomed  and we look  forward to your  continued
support.

                                   Sincerely,

                                   /s/ Tom Vann
                                   Tom Vann
                                   President and
                                   Chief Executive Officer



                                 MISSION STATEMENT

      "Our  mission is to become  the  premier  community  bank in eastern
      North  Carolina.  We will enhance  shareholder  value by serving the
      personal  and  business  needs of our  markets,  providing  superior
      customer  service,  investing in the communities  that we serve, and
      enriching the lives of our employees."

                                        2
<PAGE>

           SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA

<TABLE>
<CAPTION>
                                                  Ator For the Years Ended December 31, 2005, 2004, 2003 and 2002,
                                                          Three Months Ended December 31, 2001, and
                                                                    Year Ended September 30, 2001
                                             ----------------------------------------------------------------------------
                                             12/31/05      12/31/04     12/31/03     12/31/02     12/31/01     9/30/01
                                             ----------   -----------  -----------  -----------  -----------  -----------
                                                               (dollars in thousands, except per share data)
Selected Financial Condition Data
<S>                                        <C>          <C>          <C>          <C>          <C>          <C>
Total assets                               $   833,125  $    722,051 $    675,836 $    628,473 $    549,318 $    541,195
Loans receivable, net                          707,820       631,816      553,200      490,914      405,613      374,087
Cash and investment securities                  74,771        52,997       84,996       90,259       75,745       95,191
Mortgage-backed securities                      22,702         9,209       11,715       23,526       43,904       48,603
Deposits                                       733,753       628,537      583,173      526,327      475,589      471,939
Borrowings                                      22,098        25,102       29,648       38,195        5,441        4,909
Stockholders' equity                            68,190        59,695       55,164       50,100       51,031       50,769

Selected Operations Data
Interest income                            $    53,176  $     40,180 $     36,905 $     36,826 $      9,467 $     42,159
Interest expense                                15,464         9,692       10,186       12,473        4,092       22,168
                                             ----------   -----------  -----------  -----------  -----------  -----------
Net interest income                             37,712        30,488       26,719       24,353        5,375       19,991
Provision for loan losses                        1,711           968          988        1,756            0          830
Noninterest income                               8,207         8,750       10,502        8,462        1,625        6,776
Noninterest expenses                            21,132        19,592       17,979       16,337        3,832       16,047
ESOP Termination                                     0             0            0            0        3,143            0
                                             ----------   -----------  -----------  -----------  -----------  -----------
Income before income taxes                      23,076        18,678       18,254       14,722           25        9,890
Income taxes                                     8,947         6,966        6,841        5,210        1,165        4,060
                                             ----------   -----------  -----------  -----------  -----------  -----------
Net income (loss)                          $    14,129  $     11,712 $     11,413 $      9,512 $     (1,140)$      5,830
                                             ==========   ===========  ===========  ===========  ===========  ===========
Earnings (loss) per share - basic      (1) $      2.23  $       1.87 $       1.83 $       1.45 $      (0.17)$       0.89
Earnings (loss) per share - diluted    (1)        2.12          1.79         1.73         1.37        (0.17)        0.87
Dividends per share                    (1)        0.80          0.68         0.52         0.44         0.08         0.30

Selected Financial Ratios and Other Data
Performance Ratios:
Return on average assets               (2)        1.78 %        1.64 %       1.76 %       1.64 %         NM %       1.06 %
Return on average equity               (2)       21.92         20.50        22.06        18.39           NM        12.31
Interest rate spread                              5.04          4.63         4.46         4.43         4.05         3.67
Net interest margin                               5.11          4.66         4.49         4.54         4.24         3.90
Average earning assets/average
  interest bearing liabilities                  118.66        116.63       114.16       116.03       116.27       114.06
Noninterest expense/average assets     (2)        2.67          2.75         2.77         2.81           NM         2.92
Efficiency ratio                       (2)       45.95         49.87        48.30        49.79           NM        59.95
Dividend payout ratio                  (2)       35.87         36.36        29.09        31.19           NM        33.33

Quality Ratios:
Nonperforming assets/total assets                 0.27 %        0.34 %       0.41 %       0.31 %       0.35 %       0.29 %
Nonperforming loans/total loans                   0.32          0.37         0.47         0.31         0.31         0.28
Loan loss reserves/total loans                    1.29          1.30         1.36         1.40         1.31         1.42
Provision for loan losses/total loans             0.24          0.15         0.18         0.36         0.00         0.22

Capital Ratios and Other Data:
Equity/total assets, end of period                8.18 %        8.28 %       8.16 %       7.97 %       9.29 %       9.38 %
Average equity/average assets                     8.13          8.02         7.96         8.90         9.33         8.62
Full service offices                                26            25           22           21           20           19
Loans serviced for others                  $   260,632  $    277,252 $    288,917 $    262,504 $    274,240 $    295,216

--------------
(1)   Adjusted for three-for-two stock splits on April 23, 2004 and April 19,
      2002.
(2)   Due to a one-time ESOP terminination charge of $3,143,467 during the
      12/31/01 period, certain ratios and percentages presented are considered
      not meaningful (NM) for comparison with other periods presented and
      therefore are not included herein.
</TABLE>

                                       3
<PAGE>


                      MANAGEMENT'S DISCUSSION AND ANALYSIS
                OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General. First South Bancorp, Inc. (the "Company") was formed for the purpose of
issuing common stock, owning 100% of First South Bank (the "Bank") and operating
through the Bank a commercial  banking business,  therefore,  this discussion of
consolidated  financial  condition and results of operations relates principally
to the  Bank.  The  business  of the Bank  consists  principally  of  attracting
deposits  from the  general  public  and using  them to  originate  secured  and
unsecured  commercial and consumer loans,  permanent  mortgage and  construction
loans secured by  single-family  residences and other loans. The Bank's earnings
depend  primarily on its net interest  income,  the difference  between interest
earned  on  interest  earning  assets  and  interest  paid  on  interest-bearing
liabilities.  The level of  noninterest  income and  expenses  also  affects the
Bank's earnings.

Prevailing economic conditions, as well as federal and state regulations, affect
the  operations of the Bank.  The Bank's cost of funds is influenced by interest
rates  paid on  competing  investments,  rates  offered  on  deposits  by  other
financial  institutions in the Bank's market area and by general market interest
rates.  Lending  activities  are  affected by the demand for  financing  of real
estate and various types of commercial and consumer loans, and by interest rates
at which such  financing  may be  offered.  The Bank's  business  emphasis is to
operate as a  well-capitalized,  profitable and independent  community  oriented
financial  institution  dedicated  to  providing  quality  customer  service and
meeting the financial  needs of the communities it serves.  Management  believes
the Bank can be more  effective  in  serving  its  customers  than  many  larger
competitors  because of its  ability  to  respond  quickly  and  effectively  to
customer  needs and  inquiries.  The Bank's ability to provide these services is
enhanced by the stability of the Bank's senior management team.

The Company's common stock is listed and trades on the Nasdaq Stock Market under
the symbol FSBK.

Stock Split. On April 23, 2004 the Company paid a three-for-two  stock split, in
the form of a 50% stock dividend, to stockholders of record as of April 2, 2004.
Stockholders  received one additional share of common stock for every two shares
held on the record  date.  All prior  period  share and per share data have been
adjusted for the split.

Liquidity  and  Capital  Resources.  The  Bank's  primary  sources  of funds are
deposits,  principal  and  interest  payments on loans,  proceeds  from loan and
securities  sales,  and advances from the Federal Home Loan Bank of Atlanta (the
"FHLB").  While  maturities and scheduled  amortization of loans are predictable
sources of funds,  deposit flows and loan prepayments are influenced by interest
rates,  economic conditions and local competition.  The Bank's primary investing
activity is the origination of commercial, consumer and mortgage loans and lease
financing receivables.  During fiscal 2005 and 2004,  originations of loans held
for sale and investment,  net of principal  repayments,  were $107.3 million and
$117.5 million,  respectively.  The Bank's primary financing  activities are the
attraction of checking,  certificate  and savings  deposits,  and obtaining FHLB
advances.

The  levels  of cash  and  cash  equivalents  depend  on the  Bank's  operating,
financing, lending and investing activities during any given period. At December
31, 2005 and 2004,  cash and cash  equivalents  totaled  $32.9 million and $20.9
million,  respectively.  The Bank has other  sources of  liquidity if a need for
additional funds arises. Investment and mortgage-backed securities available for
sale totaled  $62.5  million at December 31, 2005 and $38.7  million at December
31, 2004.  During the years ended  December 31, 2005 and 2004,  the Bank sold or
exchanged  real estate loans of $29.0 million and $40.5  million,  respectively.
Borrowings  consisting of FHLB  advances,  junior  subordinated  debentures  and
retail repurchase agreements were $22.1 million at December 31, 2005 compared to
$25.1 million at December 31, 2004.  The Bank has pledged its FHLB Atlanta stock
and certain loans as collateral for actual or potential FHLB advances.  The Bank
has a  minimum  credit  availability  with the FHLB of 40% of the  Bank's  total
assets.  At December 31, 2005 the Bank had unused credit  availability  with the
FHLB of $327.1 million.

In 2003,  the Company  completed the private  placement in a pooled  offering of
$10.3 million of trust  preferred  securities,  issued by First South  Preferred
Trust I, a  Delaware  statutory  trust.  The  trust  preferred  securities  bear
interest at a rate of 2.95% over  three-month  LIBOR payable  quarterly,  have a
30-year  maturity  and are first  redeemable,  in whole or in part,  on or after
September 30, 2008, with certain exceptions.  For regulatory purposes, the $10.3
million total of trust preferred  securities qualifies as Tier 1 capital for the
Company and the Bank, to the extent such proceeds have been invested in the Bank
and the Company.  Proceeds from the trust preferred  securities were used by the
statutory  trust  to  purchase  junior  subordinated  debentures  issued  by the
Company.  For  additional  information,  see Note 19 of  Notes  to  Consolidated
Financial Statements.

                                       4
<PAGE>

As a North Carolina  chartered  commercial bank and a Federal Deposit  Insurance
Corporation  (the  "FDIC")  insured  institution,  the Bank is  required to meet
various state and federal regulatory  capital standards.  The Bank's stand-alone
equity was $75.5  million at December  31,  2005,  compared to $68.1  million at
December  31,  2004.  The  Commissioner  requires the Bank to maintain a capital
surplus of not less than 50% of common capital stock. The FDIC requires the Bank
to meet a minimum leverage capital  requirement of Tier I capital (consisting of
retained earnings and common  stockholders'  equity, less any intangible assets)
to assets  ratio of at least 4%,  and a total  capital to  risk-weighted  assets
ratio of 8%, of which 4% must be in the form of Tier I capital.  The Bank was in
compliance  with all regulatory  capital  requirements  at December 31, 2005 and
2004.

At December 31, 2005, stockholders' equity was $68.2 million,  compared to $59.7
million at December  31,  2004.  Net income for fiscal  2005 was $14.1  million,
compared to $11.7  million  for fiscal  2004.  At  December  31, 2005 there were
6,339,548 shares of common stock outstanding, net of 1,660,452 treasury shares.

Contractual Obligations and Commitments.  In the normal course of business there
are various outstanding contractual obligations of the Company that will require
future  cash  outflows.  In  addition,  there  are  commitments  and  contingent
liabilities,  such as commitments to extend credit, which may or may not require
future cash  outflows.  Table 1 below  reflects  contractual  obligations of the
Company outstanding as of December 31, 2005.

Table 1 - Contractual Obligations and Commitments

<TABLE>
<CAPTION>
                                                                     Payments Due by Period
                                          -------------------------------------------------------------------------
                                                         Less Than                                         Over
    Contractual Obligations                   Total         1 Year        1-3 Years       4-5 Years       5 Years
----------------------------------        ------------   ------------   ------------   -------------   ------------
                                                                       (In thousands)
<S>                                       <C>            <C>            <C>            <C>             <C>
Borrowed money                            $     11,788   $      5,500   $      6,288   $           -   $          -
Junior subordinated debentures                  10,310              -              -               -         10,310
Lease obligations                                1,121            379            650              92              -
Deposits                                       733,753        640,041         86,518           7,194              -
                                          ------------   ------------   ------------   ----------------------------

     Total contractual cash obligations   $    756,792   $    645,920   $     93,456   $       7,286   $     10,310
                                          ============   ============   ============   =============   ============

                                                           Amount of Commitment Expiration Per Period
                                              Total
                                             Amounts       Less than                                       Over
       Other Commitments                    Committed       1 Year        1-3 Years       4-5 Years       5 Years
----------------------------------        ------------   ------------   ------------   -------------   ------------
                                                                         (In thousands)
Commitments to originate loans            $    156,852   $    140,194   $     16,658   $           -   $          -
Undrawn balances on lines of credit and
   undrawn balances on credit reserves          53,637            276          2,544           3,943         46,874
Standby letters of credit                        2,031          2,031              -               -              -
                                          ------------   ------------   ------------   -------------   ------------

     Total other commitments              $    212,520   $    142,501   $     19,202   $       3,943   $     46,874
                                          ============   ============   ============   =============   ============
</TABLE>

In the normal course of business, the Company may enter into purchase agreements
for goods or  services.  In  management's  opinion,  the  dollar  amount of such
agreements  at December 31, 2005 is not  material  and has not been  included in
Table 1 above.

Asset/Liability Management. The Bank strives to maintain consistent net interest
income and reduce its exposure to adverse  changes in interest rates by matching
the terms to repricing of its interest-sensitive assets and liabilities. Factors
beyond the Bank's control,  such as market interest rates and  competition,  may
also impact interest income and interest expense. The Bank's net interest income
will  generally  increase  when interest  rates rise over an extended  period of
time, and  conversely,  will decrease when interest rates decline.  The Bank can
significantly influence its net interest income by controlling the increases and
decreases  in its  interest  income and  interest  expense,  which are caused by
changes in market interest rates.  See Table 2 below for additional  information
on the effects of net interest income caused by changes in interest rates.

                                       5
<PAGE>

The President of the Bank reports  interest rate risk and trends,  liquidity and
capital ratio  requirements  to the Board on a regular basis.  The Board reviews
the maturities of the Bank's assets and liabilities and establishes policies and
strategies designed to regulate the flow of funds and to coordinate the sources,
uses and pricing of such funds.  The first priority in  structuring  and pricing
assets and  liabilities is to maintain an acceptable  interest rate spread while
reducing the net effects of changes in interest rates. The Bank's  management is
responsible for administering the policies and  determinations of the Board with
respect to the Bank's asset and liability goals and strategies.

A  principal  strategy  in managing  the Bank's  interest  rate risk has been to
increase  interest  sensitive assets such as commercial  loans,  lease financing
receivables  and  consumer  loans.  At December  31,  2005,  the Bank had $548.6
million of commercial loans and lease receivables and $101.8 million of consumer
loans, compared to $475.4 million and $98.4 million,  respectively,  at December
31,  2004.  The Bank had $10.8  million of loans held for sale at  December  31,
2005,  compared to $6.0 million at December 31,  2004.  Depending on  conditions
existing  at a given time,  the Bank may sell  fixed-rate  residential  mortgage
loans  in  the  secondary  market.  In  managing  its  portfolio  of  investment
securities, a majority of investment and mortgage-backed  securities are held as
available  for sale,  allowing  the Bank to sell a security  in a timely  manner
should  an  immediate  liquidity  need  arise.  The Bank had  $62.5  million  of
investment and  mortgage-backed  securities  classified as available for sale at
December 31, 2005, compared to $38.7 million at December 31, 2004.

Market Risk.  Market risk  reflects  the risk of economic  loss  resulting  from
changes in market prices and interest  rates.  The risk of loss can be reflected
in diminished current market values and/or reduced potential net interest income
in future periods. Market risk arises primarily from interest rate risk inherent
in lending and deposit taking  activities.  The Bank does not maintain a trading
account for any class of  financial  instruments,  nor does it engage in hedging
activities or purchase high-risk derivative instruments.  Furthermore,  the Bank
is not subject to foreign currency exchange risk or commodity price risk.

The Bank  measures  interest  rate risk by  computing  estimated  changes in net
interest  income  and the net  portfolio  value  ("NPV")  of its cash flows from
assets,  liabilities  and  off-balance  sheet  items in the  event of a range of
assumed changes in market interest rates.  The Bank's exposure to interest rates
is  reviewed  on a  quarterly  basis by  management  and the Board.  Exposure to
interest  rate  risk is  measured  with  the use of  interest  rate  sensitivity
analysis to determine the change in NPV in the event of hypothetical  changes in
interest  rates,  while  interest  rate  sensitivity  gap  analysis  is  used to
determine the repricing characteristics of assets and liabilities.  If estimated
changes to NPV and net interest income are not within the limits  established by
the Board, it may direct management to adjust the Bank's asset and liability mix
to bring interest rate risk within Board approved limits.

NPV represents  the market value of portfolio  equity and is equal to the market
value of assets minus the market value of liabilities, with adjustments made for
off-balance  sheet items.  This  analysis  assesses the  potential  loss in risk
sensitive  instruments  in the event of sudden and  sustained 1% to 3% increases
and decreases in market interest  rates.  The Board has adopted an interest rate
risk policy that  establishes  maximum  increases in NPV of 17%, 36% and 56% and
decreases in NPV of 15%, 36% and 61% in the event of sudden and  sustained 1% to
3% increases or decreases in market interest  rates.  Table 2 below presents the
Bank's  projected  changes in NPV and net interest income in the event of sudden
and sustained  increases or decreases in market  interest  rates for the various
rate shock  levels at December  31,  2005.  At  December  31,  2005,  the Bank's
estimated  changes  in NPV and net  interest  income  were  within  the  targets
established by the Board.

Table 2 - Projected Change in NPV and Net Interest Income

<TABLE>
<CAPTION>
                       Net Portfolio Value                Net Interest  Income
 Change                -------------------                -------------------
in Rates    $ Amount      $ Change  % Change       $ Amount    $ Change    % Change
--------    --------      --------   --------      --------    --------    --------
                                     (Dollars in thousands)

<S>         <C>         <C>           <C>        <C>          <C>            <C>
+ 300  bp   $ 110,315   $  (5,664)    (4.9)%     $  45,537    $   6,308      13.9%
+ 200  bp     112,281      (3,698)    (3.2)         43,547        4,318      11.0
+ 100  bp     114,124      (1,855)    (1.6)         41,422        2,193       5.6
Base          115,979          --       --          39,229           --        --
- 100  bp     115,544        (435)     (.4)         37,049       (2,180)     (5.6)
- 200  bp     113,749      (2,230)    (1.9)         34,659       (4,660)    (11.9)
- 300  bp     113,371      (2,608)    (2.3)         32,241       (6,988)    (17.8)
</TABLE>

The NPV  calculation is based on the net present value of discounted  cash flows
utilizing market prepayment assumptions.  Computations of prospective effects of
hypothetical interest rate changes are based on numerous assumptions,  including
relative  levels of market interest  rates,  loan  prepayments and deposit decay
rates,  and should not be relied upon as indicative of actual results.  Further,
the  computations  do not  contemplate  any  actions the Bank may  undertake  in
response to changes in interest rates.

                                       6
<PAGE>

Certain  shortcomings are inherent in the method of analysis  presented in Table
2. For  example,  although  certain  assets  and  liabilities  may have  similar
maturities  to  repricing,  they may react in  differing  degrees  to changes in
market  interest  rates.  The  interest  rates on  certain  types of assets  and
liabilities may fluctuate in advance of changes in market interest rates,  while
interest  rates on other types may lag behind  changes in market rates.  Certain
assets,  such as  adjustable-rate  loans, have features that restrict changes in
interest  rates  on a  short-term  basis  and over  the  life of the  asset.  In
addition,  the proportion of adjustable-rate loans in the Bank's portfolio could
decrease in future periods if market  interest rates remain at or decrease below
current levels due to refinance  activity.  Further, in the event of a change in
interest rates, prepayment and early withdrawal levels would likely deviate from
those assumed in the table.  Also,  the ability of many borrowers to repay their
adjustable-rate debt may decrease in the event of an increase in interest rates.

In  addition,  the Bank uses  interest  sensitivity  gap analysis to monitor the
relationship between the maturity and repricing of its  interest-earning  assets
and interest-bearing liabilities,  while maintaining an acceptable interest rate
spread. Interest sensitivity gap is defined as the difference between the amount
of  interest-earning  assets maturing or repricing within a specific time period
and the amount of interest-bearing liabilities maturing or repricing within that
time period. A gap is considered positive when the amount of  interest-sensitive
assets exceeds the amount of interest-sensitive  liabilities,  and is considered
negative  when the amount of  interest-rate-sensitive  liabilities  exceeds  the
amount of interest-rate-sensitive  assets. Generally,  during a period of rising
interest rates, a negative gap would adversely affect net interest income, while
a positive gap would result in an increase in net interest  income.  Conversely,
during a period of falling  interest  rates,  a negative  gap would result in an
increase in net interest income,  while a positive gap would  negatively  affect
net interest income. The Bank's goal is to maintain a reasonable balance between
exposure to interest rate fluctuations and earnings.

Rate/Volume  Analysis.  Net interest income can also be analyzed in terms of the
impact of changing interest rates on average interest-earning assets and average
interest-bearing  liabilities, and the changing volume or amount of these assets
and liabilities.

Table 3 below  represents  the  extent to which  changes in  interest  rates and
changes  in  the  volume  of  average   interest-earning   assets  and   average
interest-bearing  liabilities  have affected the Company's  interest  income and
interest  expense  during the periods  indicated.  For each  category of average
interest-earning asset and average  interest-bearing  liability,  information is
provided on changes  attributable  to: (i) changes in volume  (changes in volume
multiplied by old rate);  (ii) changes in rate (change in rate multiplied by old
volume); (iii) changes in rate-volume (changes in rate multiplied by the changes
in volume); and (iv) net change (total of the previous columns).

Analysis of Net Interest Income.  Net interest income  primarily  represents the
difference  between  income  derived from  interest-earning  assets and interest
expense on interest-bearing liabilities. Net interest income is affected by both
the difference between the yield on earning assets and the average cost of funds
("interest rate spread"),  and the relative volume of  interest-earning  assets,
interest-bearing liabilities and noninterest-bearing deposits.

Table  4  below  sets  forth  certain  information  relating  to  the  Company's
Statements  of Financial  Condition and  Statements of Operations  for the three
years ended December 31, 2005,  2004, and 2003,  reflecting the yield on average
earning assets and the average cost of funds for the periods indicated.  Average
balances are derived from month end balances.  The Company does not believe that
using month end  balances  rather than  average  daily  balances  has caused any
material difference in the information presented.


                                       7
<PAGE>
Table 3 - Rate/Volume Analysis

<TABLE>
<CAPTION>
                                                    Year Ended December 31,                     Year Ended December 31,
                                      --------------------------------------------   ------------------------------------------
                                                     2005  vs.  2004                              2004  vs.  2003
                                      --------------------------------------------   ------------------------------------------

                                                  Increase (Decrease) Due to                   Increase (Decrease) Due to
                                      --------------------------------------------   ------------------------------------------
                                                                             (In thousands)
                                                              Rate/                                          Rate/
                                       Volume       Rate      Volume      Total       Volume      Rate      Volume     Total
                                      ---------   ---------  ---------------------   ---------  ----------  -------------------
Interest income:
<S>                                     <C>         <C>       <C>        <C>           <C>         <C>         <C>      <C>
Loans receivable                        $5,483      $7,067    $ 1,055    $ 13,605      $4,853      $ (430)     $(65)    $4,358
Investment securities                     (535)       (349)        67        (817)       (649)        123       (24)      (550)
Mortgage-backed securities                 (36)        (23)         2         (57)       (478)        (47)       21       (504)
Other interest-earning assets              108          72         85         265         (34)          7        (2)       (29)
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------
     Total earning assets                5,020       6,767      1,209      12,996       3,692        (347)      (70)     3,275
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------

Interest expense:
Deposits                                 1,233       3,840        530       5,603         477      (1,433)      (69)    (1,025)
FHLB advances                             (184)        133        (93)       (144)         62          68        49        179
Other interest-bearing liabilities          63         221         28         312         118         125       109        352
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------
     Total interest-bearing liabilities  1,112       4,194        465       5,771         657      (1,240)       89       (494)
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------
Change in net interest income           $3,908      $2,573      $ 744     $ 7,225      $3,035       $ 893     $(159)    $3,769
                                      =========   =========  =========  ==========   =========  ==========  ========  =========


                                                Year Ended December 31,                        Year Ended December 31,
                                      --------------------------------------------   ------------------------------------------
                                                     2003  vs.  2002                              2002  vs.  2001
                                      --------------------------------------------   ------------------------------------------

                                                Increase (Decrease) Due to                   Increase (Decrease) Due to
                                      --------------------------------------------   ------------------------------------------
                                                                             (In thousands)
                                                              Rate/                                          Rate/
                                       Volume       Rate      Volume      Total      Volume       Rate      Volume     Total
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------
Interest income:
Loans receivable                        $5,737     $(3,586)    $ (666)    $ 1,485      $5,280    $ (5,454)    $(902)   $(1,076)
Investment securities                      (79)        (62)         1        (140)         90         (97)       (3)       (10)
Mortgage-backed securities              (1,057)       (126)        61      (1,122)     (1,858)       (120)       54     (1,924)
Other interest-earning assets             (114)        (52)        22        (144)       (372)       (281)      133       (520)
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------
     Total earning assets                4,487      (3,826)      (582)         79       3,140      (5,952)     (718)    (3,530)
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------

Interest expense:
Deposits                                 1,275      (3,369)      (346)     (2,440)        366      (7,300)     (141)    (7,075)
FHLB advances                              184         (17)      (109)         58        (241)       (174)      137       (278)
Other interest-bearing liabilities          30          38         27          95         (21)        (83)       13        (91)
                                      ---------   ---------  ---------  ----------   ---------  ----------  --------  ---------
     Total interest-bearing liabilities  1,489      (3,348)      (428)     (2,287)        104      (7,557)        9     (7,444)
                                                  ---------  ---------               ---------  ----------  --------  ---------
Change in net interest income           $2,998      $ (478)    $ (154)    $ 2,366      $3,036      $1,605     $(727)    $3,914
                                      =========   =========  =========  ==========   =========  ==========  ========  =========
</TABLE>

                                       8
<PAGE>

Table 4 - Yield/Cost Analysis

<TABLE>
<CAPTION>
                                        Year Ended December 31,        Year Ended December 31,        Year Ended December 31,
                                      ----------------------------   ----------------------------   ----------------------------
                                                  2005                           2004                           2003
                                      ----------------------------   ----------------------------   ----------------------------
                                                                               (In thousands)
                                                           Average                        Average                        Average
                                       Average            Yield/      Average            Yield/      Average             Yield/
                                      Balance   Interest   Cost      Balance   Interest   Cost      Balance    Interest   Cost
                                      --------  --------- --------   --------- --------- --------   ---------  --------  -------
Interest earning assets:
<S>               <C>                 <C>        <C>         <C>     <C>        <C>         <C>     <C>        <C>         <C>
Loans receivable  (1)                $686,357    $50,357     7.34 %  $597,260   $36,752     6.15 %  $519,461   $32,394     6.24 %
Investment securities                  34,596      1,954     5.65      42,881     2,771     6.46      53,302     3,321     6.23
Mortgage-backed securities              9,303        508     5.46       9,927       565     5.69      17,949     1,069     5.96
Other interest-earning assets           7,817        357     4.57       3,586        92     2.57       5,002       121     2.42
                                      --------  --------- --------   --------- --------- --------   ---------  --------  -------
     Total earning assets             738,073     53,176     7.20     653,654    40,180     6.15     595,714    36,905     6.20
                                                --------- --------             --------- --------              --------  -------

Nonearning assets                      53,826                          58,511                         54,064
                                      --------                       ---------                      ---------
     Total assets                    $791,899                        $712,165                       $649,778
                                      ========                       =========                      =========

Interest bearing liabilities:
Time deposits                        $429,127     13,247     3.08    $347,217     7,734     2.23    $333,532     8,567     2.57
Demand deposits                       147,852      1,260     0.85     158,543     1,172     0.74     149,965     1,359     0.91
Savings                                23,028         35     0.15      21,553        33     0.15      19,726        38     0.19
FHLB advances                           5,808        121     2.08      19,108       265     1.39      11,092        86     0.78
Junior subordinated debentures         10,310        633     6.14      10,310       448     4.48       3,077       108     3.51
Repurchase agreements                   5,863        167     2.85       4,019        40     1.00       4,432        28     0.63
                                      --------  --------- --------   --------- --------- --------   ---------  --------  -------
 Total interest-bearing liabilities   621,988     15,463     2.49     560,750     9,692     1.73     521,824    10,186     1.95

Noninterest bearing demand deposits    94,719          0     0.00      78,996         0     0.00      64,776         0     0.00
                                      --------  --------- --------   --------- --------- --------   ---------  --------  -------
 Total sources of funds               716,707     15,463     2.16     639,746     9,692     1.52     586,600    10,186     1.74
                                                --------- --------             --------- --------              --------  -------

Other liabilities and stockholders'equity:
Other liabilities                      10,748                          15,288                         11,436
Stockholders' equity                   64,444                          57,131                         51,742
                                      --------                       ---------                      ---------
 Total liabilities and stockholders' $791,899                        $712,165                       $649,778
    equity                            ========                       =========                      =========
Net interest income                              $37,713                        $30,488                        $26,719
                                                =========                      =========                       ========
Interest rate spread  (2)                                    5.04 %                         4.63 %                         4.46 %
                                                          ========                       ========                        =======
Net yield on earning assets  (3)                             5.11 %                         4.66 %                         4.49 %
                                                          ========                       ========                        =======

Ratio of earning assets to interest bearing liabilities    118.66 %                       116.63 %                       114.16 %
                                                          ========                       ========                        =======
</TABLE>
---------------------------------
(1) Includes classified loans.
(2) Represents the difference between the yield on earning assets and the
average cost of funds.
(3) Represents the net interest income divided by average earning assets.

                                       9
<PAGE>

 Results of Operations

Comparison of Financial Condition at December 31, 2005 and 2004

Total assets  increased 15.4% to $833.1 million at December 31, 2005 from $722.1
million at December 31, 2004.  Earning assets  increased 14.6% to $774.5 million
at December  31,  2005 from $676.0  million at  December  31,  2004,  reflecting
continued  net growth in the loan and leases  receivable  portfolio  and opening
three new full  service  banking  offices.  Earning  assets  were 93.0% of total
assets at December 31, 2005, compared to 93.7 % at December 31, 2004.

Loans and lease receivables,  net of allowance for loan losses and deferred loan
fees, increased 12.0% to $707.8 million at December 31, 2005 from $631.8 million
at December 31, 2004.  The Bank  continues to emphasize the  origination of both
secured and unsecured  commercial and consumer loans, in order to take advantage
of shorter  terms to maturity in managing  its  exposure to market and  interest
rate  risk due to  changes  in  interest  rates.  The Bank also  sells  selected
mortgage loans in the secondary  mortgage market in order to reduce its exposure
to  interest  rate and  credit  risk,  while  retaining  servicing  to  generate
additional  fee income.  Loans  serviced for others  totaled  $260.6  million at
December 31, 2005 compared to $277.3 million serviced at December 31, 2004.

Commercial  loans and lease  receivables  increased  15.4% to $548.6  million at
December  31, 2005 from $475.4  million at December  31,  2004.  Consumer  loans
increased  3.4% to $101.8  million at December  31,  2005 from $98.4  million at
December 31, 2004. This growth reflects the Bank's increased focus of the growth
and  development  of its  commercial  and  consumer  loan and lease  receivables
portfolio.  Commercial  and consumer  loans and lease  receivables  originations
increased to $474.1  million  during  fiscal 2005,  from $394.1  million  during
fiscal 2004.

Residential  real estate  mortgage loans  increased to $68.0 million at December
31,  2005  from  $67.5  million  at  December  31,  2004,  reflecting  the  loan
origination  volume,  net of loan sales and  exchanges.  During fiscal 2005, the
Bank originated $119.3 million of residential mortgage loans, compared to $115.8
million during fiscal 2004. The Bank sold $12.7 million of mortgage loans during
fiscal 2005,  compared to $37.6 million during fiscal 2004,  reflecting the slow
down in origination and  refinancing  volumes due to the rise in interest rates.
In addition,  during  fiscal 2005 the Bank  implemented a strategy to securitize
current held for sale mortgage loan originations into mortgage-backed securities
in order to support future liquidity management needs.

Investment and  mortgage-backed  securities  increased 66.8% to $64.5 million at
December 31, 2005, from $38.7 million at December 31, 2004.  During 2005,  $16.0
million of investment  maturities were reinvested in a total of $27.0 million of
investment   securities  available  for  sale,  compared  to  $16.0  million  of
investment  maturities used to fund loan originations and banking  operations in
2004.  The Bank exchanged  $16.4 million of mortgage  loans for  mortgage-backed
securities during fiscal 2005,  compared to $2.8 million during fiscal 2004. The
Bank sold no investment or mortgage-backed  securities available for sale during
the 2005, compared to $2.3 million sold during fiscal 2004.

Pursuant to adopting the provisions of financial accounting standards,  goodwill
related to prior period  acquisitions is not amortized.  The unamortized balance
of the  Company's  goodwill  is tested for  impairment  at least  annually.  The
Company has performed its annual  impairment  test and has determined that there
has been no  impairment  of goodwill as of December 31, 2005 and 2004.  Goodwill
related to prior period  acquisitions  was $4.2 million at December 31, 2005 and
2004.

Deposits  increased  16.7% to $733.8  million at  December  31, 2005 from $628.5
million at December 31, 2004.  Certificates of deposit increased 26.2% to $467.4
million at December 31, 2005 from $370.2  million at December 31, 2004. The Bank
continued  to market  lower cost core  deposits  during  2005,  resulting in net
checking  account  growth of 3.6% to $244.9  million at  December  31, 2005 from
$236.3  million at December 31,  2004.  The Bank manages its cost of deposits by
constantly  monitoring the volume and rates being paid on maturing  certificates
of deposits in  relationship  to current  funding needs and  competitive  market
interest  rates.  During  fiscal  2005 and  2004,  the Bank  repricing  maturing
certificates  of deposits at  competitive  market  rates,  and combined with the
growth of lower costing  checking  accounts,  has provided an effective means of
managing its deposit cost.

Total  borrowings  were $22.1  million at December  31,  2005  compared to $25.1
million at December 31, 2004. FHLB advances and junior  subordinated  debentures
were $15.8  million at December 31, 2005,  compared to $20.8 million at December
31, 2004.  Borrowings in the form of repurchase  agreements were $6.3 million at
December 31, 2005,  compared to $4.3 million at December 31, 2004,  representing
funds held in cash management accounts for commercial banking customers.

                                       10
<PAGE>

Stockholders'  equity was $68.2 million at December 31, 2005,  compared to $59.7
million at December 31, 2004. The  consolidated  equity to assets ratio was 8.2%
and 8.3% at December 31, 2005 and December 31, 2004,  respectively.  Accumulated
other  comprehensive  loss  was  $371,000  at  December  31,  2005  compared  to
accumulated  other  comprehensive  income of  $873,000  at  December  31,  2004,
reflecting  a decrease in  unrealized  gains on  available  for sale  securities
resulting from an increase in interest rates during the respective periods.

During the years ended  December 31, 2005 and 2004,  the Company  declared  four
quarterly cash dividends each,  totaling $0.80 and $0.68 per share respectively.
These cash dividend payments reflect dividend payout ratios on basic earnings of
35.9% for fiscal 2004 and 36.4% for fiscal 2004. Future quarterly dividends will
be determined at the  discretion of the Board of Directors  based upon earnings,
the  capital and  financial  condition  of the  Company,  and  general  economic
conditions.

Pursuant to stock repurchase programs adopted by the Company during fiscal years
2005 and 2004, the Company acquired 9,303 and 78,400 shares of its common stock,
respectively,  through both open market and private  purchases.  Shares acquired
under the  repurchase  program are being held as  treasury  stock,  at cost.  At
December  31, 2005,  treasury  shares were  1,660,452  totaling  $28.8  million,
compared to 1,735,324  shares  totaling  $29.7 million at December 31, 2004. The
Company  will use the  repurchased  shares of its  outstanding  common stock for
general  corporate  purposes  including the future exercise of stock options and
funding shares issued pursuant to potential future stock splits.

During  fiscal 2005 and 2004,  101,652  and 84,983  shares,  respectively,  were
issued on the exercise of stock  options.  In addition,  during  fiscal 2005 and
2004,  17,477 and 14,569 shares were  tendered to pay for the exercise  price of
stock options  being  exercised.  During  fiscal 2004,  the Company used 628,610
treasury shares to issue common stock for a three-for-two stock split.

Comparison of Operating Results for the Years Ended December 31, 2005 and 2004

Net  Income.  Net income  increased  20.6% to $14.1  million  for the year ended
December 31, 2005 from $11.7 million for the year ended December 31, 2004. Basic
earnings  per  share  increased  19.3% to $2.23  per  share  for the year  ended
December  31, 2005 from $1.87 per share for the year ended  December  31,  2004.
Diluted earnings per share increased 18.4% to $2.12 per share for the year ended
December 31, 2005 from $1.79 per share for the year ended December 31, 2004. The
average  numbers of basic shares were  6,325,382  and  6,251,866 and the average
numbers of diluted shares were 6,653,481 and  6,557,149,  respectively,  for the
years ended  December 31, 2005 and 2004.  Return on average assets and return on
average  equity were 1.8% and 21.9%  respectively  for fiscal 2005,  compared to
1.6% and 20.5% for fiscal 2004.

Interest  Income.  Interest  income  increased 32.3% to $53.2 million for fiscal
2005 from $40.2  million for fiscal  2004.  During 2005 the increase in interest
income  resulted  from a  combination  of an increase in interest  rates and the
increase in the volume of interest-earning  assets, enabling the Bank to earn an
increased  level of interest  income.  The average  balance of  interest-earning
assets  increased  12.9% to $738.1 million for fiscal 2005,  from $653.7 million
for fiscal 2004. The yield on average  interest-earning assets was 7.2% and 6.2%
for 2005 and 2004, respectively.

Interest  Expense.  Interest expense increased 59.5% to $15.5 million for fiscal
2005 from $9.7  million for fiscal 2004.  The increase in interest  expense also
reflects the increase in interest  rates and the increase in the volume  average
interest-bearing  liabilities,  offset  by an  increase  in  noninterest-bearing
checking accounts. The average balance of interest-bearing liabilities increased
10.9% to $622.0 million for fiscal 2005 from $560.8 million for fiscal 2004. The
average balance of noninterest-bearing deposits increased 19.9% to $94.7 million
for fiscal 2005 from $79.0  million for fiscal  2004.  The average cost of funds
(including noninterest-bearing deposits) was 2.2% for 2005, compared to 1.5% for
2004, reflecting a rising interest rate environment during 2005.

Net Interest  Income.  Net interest income  increased 23.7% to $37.7 million for
fiscal 2005 from $30.5  million for fiscal  2004.  The  increase in net interest
income during 2005 is attributable to a 37.9% greater  increase in the volume of
average  interest-earning  assets as compared  to the  increase in the volume of
interest-bearing  liabilities, and the increase in noninterest-bearing deposits.
The net yield on interest-earning assets (net interest income divided by average
interest-earning assets) was 5.1% for fiscal 2005, compared to 4.7% fiscal 2004.
The Bank's interest rate spread (the  difference  between the effective yield on
average  interest-earning  assets and the  effective  average cost of funds) was
5.0% for fiscal 2005, compared to 4.4% for fiscal 2004.

See Table 3 - Rate/Volume  Analysis and Table 4 - Yield/Cost  Analysis above for
additional  information  on interest  income,  interest  expense,  net  interest
income, average balances and yield/cost ratios.

                                       11
<PAGE>

Provision  for Loan  Losses.  The  Bank  maintains  both  general  and  specific
allowances for losses on loans based upon management's evaluation of risk in the
loan  portfolio  and past loan  loss  experience.  The  Bank's  methodology  for
evaluating its general and specific  allowance for loan losses includes  amounts
specifically allocated to loans that are individually determined to be impaired,
as well as general  reserve  amounts  allocated to groups of loans that have not
been  individually  assessed for impairment.  The Bank provided $1.7 million for
general and specific loan losses  during  fiscal 2005,  compared to $968,000 for
fiscal  2004.  These  provisions  were  necessary  to absorb  losses in the loan
portfolio  and to  support  the  inherent  risks  associated  with the growth in
commercial  and  consumer  loans  discussed  above.  The  general  and  specific
allowance for loan losses was $9.2 million at December 31, 2005 and $8.3 million
at December 31,  2004,  which the Bank  believes is  adequate.  The ratio of the
general  and  specific  allowance  for loan  losses  to total  loans was 1.3% at
December 31, 2005 and 2004, respectively.

The Bank uses an analytical  approach through a classification of assets program
to  determine  the  adequacy  of its  loan  loss  allowances  and the  necessary
provision for loan losses.  The loan portfolio is reviewed on a quarterly  basis
and delinquent  loans are individually  analyzed.  Consideration is given to the
loan status, payment history,  repayment ability,  probability of repayment, and
loan-to-value  percentages.  Loans  are  classified  in  appropriate  categories
applicable to their circumstances as a result of this review and analysis. After
reviewing current economic conditions, changes in delinquency status, and actual
loan losses incurred by the Bank, management  establishes an appropriate reserve
percentage  applicable to each category of assets, and provision for loan losses
is recorded when  necessary to bring the allowances to a level  consistent  with
this  analysis.  The  ratio of  non-performing  loans to total  loans was .3% at
December 31, 2005 and .4% at December 31, 2004.

Noninterest Income.  Noninterest income declined 6.2% to $8.2 million for fiscal
2005 from $8.8 million for fiscal 2004.  Other income consists of fees,  service
charges and servicing  fees earned on loans,  service  charges and  insufficient
funds  fees  collected  on  deposit  accounts,  gains  from  sales of loans  and
mortgage-backed  securities  and other  miscellaneous  income.  Fees and service
charges  declined  5.6% to $6.1  million for fiscal  2005 from $6.5  million for
fiscal 2004. Fees,  service charges earned and insufficient funds fees collected
during the respective  periods is  attributable  to the volume of loan,  deposit
account,  and insufficient funds transactions  processed during each period, and
the  collection  of related fees and service  charges.  Servicing  fee income on
loans  serviced  for others  declined  5.6% to  $684,000  for  fiscal  2005 from
$724,000  for fiscal  2004,  as loans  serviced  for others  declined  to $260.6
million at year end 2005 from $277.3 million at year end 2004.

Gains from sales of loans,  investments and mortgage-backed  securities declined
to $199,000 for fiscal 2005 from  $597,000 for fiscal 2004.  The volume of loans
and  mortgage-backed  securities  sold  during  fiscal  2005 was $29.1  million,
compared to $39.9  million  sold during  fiscal  2004,  reflecting  the strategy
previously  discussed to retain current held for sale mortgage loan originations
for  securitization  into  available  for sale  mortgage-backed  securities.  In
addition,  these  sales  provide  liquidity  necessary  to  support  the  Bank's
operating, financing and lending activities.

Noninterest  Expenses.  Noninterest expenses increased 7.7% to $21.1 million for
fiscal 2005 from $19.6 million in fiscal 2004.  The Company's  efficiency  ratio
(noninterest  expenses as a percentage of net interest  income plus  noninterest
income) improved to 46.0% for fiscal 2005 compared to 49.9% for fiscal 2004. The
efficiency  ratio  measures the  proportion of net  operating  revenues that are
absorbed by overhead expenses.

The  largest  single  component  of these  expenses is  compensation  and fringe
benefits,  which  increased  5.7% to $12.7  million  for fiscal  2005 from $12.0
million for fiscal  2004.  Full-time  equivalent  employees  increased to 270 at
December  31,  2005  from  250 at  December  31,  2004.  This  growth  is due to
additional  personnel resulting from opening three full-service  banking offices
and  administrative  staff  required to support the $111.1 million net growth in
assets during fiscal 2005.

Data processing  expense has grown  proportionately  with the growth in customer
accounts  and  transaction  activity  primarily  attributable  to the  growth in
earning assets and deposits.  Other noninterest expenses including  advertising,
deposit insurance,  premises and equipment, payroll and other taxes, repairs and
maintenance,  and  office  expenses  have also  grown  from  period to period in
conjunction with the growth in earning assets and deposit accounts.

Income Taxes. The provision for income taxes increased 28.4% to $8.9 million for
fiscal 2005 from $7.0  million for fiscal 2004.  The  increase in provision  for
income taxes is primarily the result of the 23.5% increase of pretax earnings to
$23.1  million  for fiscal  2005 from $18.7  million  for  fiscal  2004,  and an
increase  in the  federal  tax rate  from  34% to 35%  during  2005  based on an
increased volume of federal taxable income.  Changes in the amount of income tax
provisions  reflect  changes in pretax income and expenses,  the  application of
permanent and temporary  differences,  and the income tax rates in effect during
each period.  The effective income tax rates for fiscal 2005 and 2004 were 38.8%
and 37.3%, respectively.

                                       12
<PAGE>

Comparison of Operating Results for the Years Ended December 31, 2004 and 2003

Net  Income.  Net  income  increased  2.6% to $11.7  million  for the year ended
December  30, 2004 from $11.4  million  for the year ended  December  31,  2003.
Diluted  earnings per share increased 3.5% to $1.79 per share for the year ended
December 31, 2004 from $1.73 per share for the year ended December 31, 2003. The
average number diluted  shares were 6,557,149 and 6,604,392,  respectively,  for
the years ended December 31, 2004 and 2003.  Return on average assets and return
on average equity were 1.6% and 20.5% respectively for fiscal 2004,  compared to
1.8% and 22.1% for fiscal 2003.

Interest Income. Interest income increased 8.9% to $40.2 million for fiscal 2004
from $36.9 million for fiscal 2003.  During 2004 the increase in interest income
resulted primarily from the increase in the volume of  interest-earning  assets,
enabling the Bank to maintain a more consistent  level of interest  income.  The
average balance of interest-earning  assets increased 9.7% to $653.7 million for
fiscal  2004,  from  $595.7  million  for  fiscal  2003.  The  yield on  average
interest-earning assets was 6.2% for 2004 and 2003, respectively.

Interest Expense. Interest expense declined 4.9% to $9.7 million for fiscal 2004
from $10.2 million for fiscal 2003. The decline in interest  expense  reflects a
lower cost of average interest-bearing liabilities due to the general decline in
interest rates, offset by a $4.4 million growth in noninterest-bearing  checking
accounts. The average balance of interest-bearing  liabilities increased 7.4% to
$560.4  million for fiscal 2004 from $521.8 million for fiscal 2003. The average
balance of  noninterest-bearing  deposits  increased  21.9% to $79.0 million for
fiscal 2004 from $64.8  million for fiscal  2003.  The average cost of funds was
1.5% for 2004,  compared  to 1.7% for 2003,  reflecting  a lower  interest  rate
environment during 2004.

Net Interest  Income.  Net interest income  increased 14.2% to $30.5 million for
fiscal 2004 from $26.7  million for fiscal  2003.  The  increase in net interest
income  during  2004 is  attributable  to an  increase  in the volume of average
interest-earning  assets, lower interest rates on interest-bearing  liabilities,
and  the   increase   in   noninterest-bearing   deposits.   The  net  yield  on
interest-earning  assets was 4.7% for fiscal 2004, compared to 4.5% fiscal 2003.
The Bank's  interest rate spread was 4.6% for fiscal 2004,  compared to 4.5% for
fiscal 2003.

Provision for Loan Losses.  The Bank  maintains an allowance for losses on loans
based upon  management's  evaluation of risk in the loan portfolio and past loan
loss experience.  The Bank provided $968,000 for loan losses during fiscal 2004,
compared to $988,000 for fiscal 2003.  These provisions were necessary to absorb
losses in the loan portfolio and to support the inherent risks  associated  with
the growth in commercial and consumer loans discussed  above.  The allowance for
loan losses was $8.3  million at December  31, 2004 and $7.6 million at December
31, 2003,  which the Bank  believes is adequate.  The ratio of the allowance for
loan losses to total loans was 1.3% at December  31,  2004,  compared to 1.4% at
December 31, 2003. The ratio of  non-performing  loans to total loans was .4% at
December 31, 2004 and .5% at December 31, 2003.

Noninterest Income. Noninterest income declined 16.7% to $8.8 million for fiscal
2004 from $10.5  million for fiscal  2003.  Fees and service  charges  increased
11.2% to $6.5  million  for  fiscal  2004 from $5.8  million  for  fiscal  2003,
reflecting  the growth of the  commercial  and consumer loan  portfolios and the
growth in checking  accounts  during fiscal 2003.  Servicing fee income on loans
serviced for others  increased  10.5% to $724,000 for fiscal 2004 from  $656,000
for fiscal 2003.

Gains from sales of loans,  investments and mortgage-backed  securities declined
80.2% to $597,000 for fiscal 2003 from $3.0 million for fiscal 2003. During 2004
the Bank  experienced  much less  dependence  on gains from mortgage loan sales,
unlike 2003, due to decreased origination and refinance volumes caused primarily
by rising  interest  rates  during  the  current  year.  The volume of loans and
mortgage-backed  securities sold during fiscal 2004 was $39.9 million,  compared
to $147.0 million sold during fiscal 2003.

Noninterest  Expenses.  Noninterest expenses increased 8.9% to $19.6 million for
fiscal 2004 from $18.0 million in fiscal 2003.  The Company's  efficiency  ratio
(noninterest  expenses divided by net interest income plus  noninterest  income)
was 49.9% compared to fiscal 2004 from 48.3% for fiscal 2003.

The  largest  single  component  of these  expenses is  compensation  and fringe
benefits,  which  increased  13.2% to $12.0  million  for fiscal 2004 from $10.6
million for fiscal  2003.  Full-time  equivalent  employees  increased to 250 at
December  31,  2004  from  236 at  December  31,  2003.  This  growth  is due to
additional  personnel resulting from purchasing two full-service banking offices
and  administrative  staff  required to support the $45.4  million net growth in
assets during fiscal 2004.

                                       13
<PAGE>

Data processing  expense has grown  proportionately  with the growth in customer
accounts  and  transaction  activity  primarily  attributable  to the  growth in
earning assets and deposits.  Other noninterest expenses including  advertising,
deposit insurance,  premises and equipment, payroll and other taxes, repairs and
maintenance,  and  office  expenses  have also  grown  from  period to period in
conjunction with the growth in earning assets and deposit accounts.

Income Taxes.  The provision for income taxes increased 1.8% to $7.0 million for
fiscal 2004 from $6.8  million for fiscal 2003.  The  increase in provision  for
income taxes is primarily the result of the 2.3% increase of pretax  earnings to
$18.7 million for fiscal 2004 from $18.3 million for fiscal 2003.  The change in
the amount of income tax provisions also reflects changes in other pretax income
and expenses,  the application of permanent and temporary  differences,  and the
income tax rates in effect during each period.  The  effective  income tax rates
for fiscal 2004 and 2003 were 37.3% and 37.5%, respectively.

Impact of Inflation and Changing  Prices.  The financial  statements of the Bank
and  accompanying  footnotes  have been  prepared in accordance  with  generally
accepted  accounting  principles.  They  require the  measurement  of  financial
position  and  operating   results  in  terms  of  historical   dollars  without
considering the change in the relative  purchasing  power of money over time and
due to inflation.  The impact of inflation is reflected in the increased cost of
the Bank's operations.  Unlike most industrial companies,  nearly all the assets
and  liabilities  of the Bank are monetary.  As a result,  interest rates have a
greater impact on the Bank's  performance  than do the effects of general levels
of inflation. Interest rates do not necessarily move in the same direction or to
the same extent as the price of goods and services.

Forward Looking Statements. The Private Securities Litigation Reform Act of 1995
states that the  disclosure  of forward  looking  information  is desirable  for
investors and encourages  such disclosure by providing a safe harbor for forward
looking statements by corporate  management.  This Annual Report,  including the
Letter to  Stockholders  and  Management's  Discussion and Analysis of Financial
Condition and Results of Operations,  contains  forward looking  statements that
involve  risk and  uncertainty.  In order to  comply  with the terms of the safe
harbor, the Company notes that a variety of risks and uncertainties  could cause
its actual  results and  experience to differ  materially  from the  anticipated
results  or  other  expectations  expressed  in the  Company's  forward  looking
statements.  There are risks and  uncertainties  that may affect the operations,
performance,  development,  growth  projections  and  results  of the  Company's
business.  They include, but are not limited to, economic growth,  interest rate
movements,  timely development of technology enhancements for products, services
and operating systems, the impact of competitive products, services and pricing,
customer requirements,  regulatory changes and similar matters.  Readers of this
report are cautioned not to place undue reliance on forward  looking  statements
that are subject to influence by these risk  factors and  unanticipated  events.
Accordingly,   actual   results   may  differ   materially   from   management's
expectations.

Off-Balance  Sheet  Arrangements.  See  Note 14 of the  "Notes  to  Consolidated
Financial  Statements"  for a full  description  of financial  instruments  with
off-balance  sheet  risk to which  the Bank is a party in the  normal  course of
business  to meet the  financing  needs of its  customers  and to reduce its own
exposure to fluctuations in interest rates. These financial  instruments include
commitments to extend credit and involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount  recognized  in the  consolidated
balance sheet.

Recent  Accounting  Pronouncements.  See Note 1 of the  "Notes  to  Consolidated
Financial Statements" for a full description of recent accounting pronouncements
including the respective  effective  dates of adoption and effects on results of
operations and financial condition.

                                       14
<PAGE>

                                DIXON HUGHES PLLC

                   Certified Public Accountants and Advisors

             Report of Independent Registered Public Accounting Firm

To the Stockholders and the Board of Directors
First South Bancorp, Inc.
Washington, North Carolina

We have audited the accompanying  consolidated statements of financial condition
of First South  Bancorp,  Inc. and  Subsidiary as of December 31, 2005 and 2004,
and the related consolidated statements of operations,  changes in stockholders'
equity  and cash  flows  for  each of the  years in the  two-year  period  ended
December  31,   2005.   These   consolidated   financial   statements   are  the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these  consolidated  financial  statements  based on our audits.  The
consolidated financial statements of First South Bancorp, Inc and Subsidiary for
the year then ended  December  31,  2003 were  audited by other  auditors  whose
report dated March 4, 2004 expressed an unqualified opinion on those statements.

We conducted our audits in accordance  with the standards of the Public  Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.  An audit includes examining, on a
test basis,  evidence  supporting  the amounts and  disclosures in the financial
statements.  An audit also includes assessing the accounting principles used and
significant  estimates  made by  management,  as well as evaluating  the overall
financial  statement  presentation.   We  believe  that  our  audits  provide  a
reasonable basis for our opinion.

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material respects, the financial position of First South Bancorp,
Inc.  and  Subsidiary  at  December  31,  2005 and 2004 and the results of their
operations  and their  cash flows for each of the years in the  two-year  period
ended  December 31, 2005 in  conformity  with  accounting  principles  generally
accepted in the United States of America.

We have also  audited,  in accordance  with the standards of the Public  Company
Accounting  Oversight Board (United  States),  the  effectiveness of First South
Bancorp,  Inc.'s  internal  control over financial  reporting as of December 31,
2005, based on criteria  established in Internal Control - Integrated  Framework
issued by the Committee of Sponsoring  Organizations of the Treadway Commission,
and our  report  dated  March 7, 2006  expressed  unqualified  opinions  on both
management's  assessment  of  the  Company's  internal  control  over  financial
reporting and the effectiveness of the Company's internal control over financial
reporting.

/s/ Dixon Hughes PLLC
Sanford, North Carolina
March 7, 2006

                                       15
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, 2005 and 2004
<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------

                                                                                  2005                  2004
                                                                           ------------------    ------------------
ASSETS
<S>                                                                        <C>                   <C>
Cash and due from banks                                                    $       32,523,922    $       19,873,210
Interest-bearing deposits in financial institutions                                   419,470             1,065,138
Investment securities - available for sale                                         41,827,690            32,058,152
Mortgage-backed securities - available for sale                                    20,639,067             6,639,381
Mortgage-backed securities - held for investment                                    2,063,310             2,569,358
Loans receivable, net
   Held for sale                                                                   10,845,783             5,961,691
   Held for investment                                                            696,974,135           625,854,344
Premises and equipment, net                                                         8,831,170             8,578,990
Real estate owned                                                                      13,886                89,449
Federal Home Loan Bank of Atlanta stock, at cost
   which approximates market                                                        1,689,200             1,825,200
Accrued interest receivable                                                         4,288,600             3,311,187
Goodwill                                                                            4,218,576             4,218,576
Mortgage servicing rights                                                           1,402,085             1,698,778
Identifiable intangible assets                                                        259,380               290,820
Income tax receivable                                                               1,145,814               820,087
Prepaid expenses and other assets                                                   5,982,857             6,039,773
Note receivable                                                                             -             1,156,557
                                                                           ------------------    ------------------

         Total assets                                                      $      833,124,945    $      722,050,691
                                                                           ==================    ==================

LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
   Demand                                                                  $      244,879,590    $      236,319,937
   Savings                                                                         21,509,653            22,018,388
   Large denomination certificates of deposit                                     153,954,109           120,757,331
   Other time                                                                     313,409,713           249,441,049
                                                                           ------------------    ------------------

         Total deposits                                                           733,753,065           628,536,705

Borrowed money                                                                     11,787,528            14,791,900
Junior subordinated debentures                                                     10,310,000            10,310,000
Deferred income taxes                                                                 540,021             1,302,501
Other liabilities                                                                   8,543,859             7,414,238
                                                                           ------------------    ------------------

         Total liabilities                                                        764,934,473           662,355,344
                                                                           ------------------    ------------------

Commitments and contingencies (Note 15)
Common stock, $.01 par value, 25,000,000, shares authorized,
 6,339,548, and 6,264,676 shares issued and outstanding, respectively                  63,395                62,647
Additional paid-in capital                                                         37,624,894            37,815,715
Retained earnings, substantially restricted                                        59,661,079            50,597,651
Treasury stock at cost                                                            (28,787,979)          (29,653,794)
Accumulated other comprehensive income (loss), net                                   (370,917)              873,128
                                                                           ------------------    ------------------

         Total stockholders' equity                                                68,190,472            59,695,347
                                                                           ------------------    ------------------

         Total liabilities and stockholders' equity                        $      833,124,945    $      722,050,691
                                                                           ==================    ==================
</TABLE>

The  accompanying  notes are an integral  part of these  consolidated  financial
statements.

                                       16
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
December 31, 2005, 2004 and 2003
<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------

                                                                  2005               2004                2003
                                                            ----------------   ----------------    ----------------
Interest income
<S>                                                         <C>                <C>                 <C>
  Interest and fees on loans                                $     50,357,203   $     36,751,526    $     32,394,236
  Interest and dividends on investments and deposits               2,818,847          3,428,131           4,510,861
                                                            ----------------   ----------------    ----------------

         Total interest income                                    53,176,050         40,179,657          36,905,097
                                                            ----------------   ----------------    ----------------

Interest expense
  Interest on deposits                                            14,542,548          8,938,856           9,964,663
  Interest on borrowings                                             288,329            304,846             113,742
  Interest on junior subordinated debentures                         632,629            448,319             107,930
                                                            ----------------   ----------------    ----------------

         Total interest expense                                   15,463,506          9,692,021          10,186,335
                                                            ----------------   ----------------    ----------------

Net interest income before provision for loan losses              37,712,544         30,487,636          26,718,762
Provision for loan losses                                          1,711,197            968,000             987,919
                                                            ----------------   ----------------    ----------------

  Net interest income                                             36,001,347         29,519,636          25,730,843
                                                            ----------------   ----------------    ----------------

Other income
  Fees and service charges                                         6,116,949          6,479,309           5,827,002
  Loan servicing fees                                                684,135            724,363             655,759
  Gain on sale of real estate, net                                   215,928             23,037             167,322
  Gain on sale of mortgage loans                                     199,414            508,218           2,717,078
  Gain on sale of mortgage-backed securities                               -             88,844             291,738
  Other income                                                       990,165            926,699             842,643
                                                            ----------------   ----------------    ----------------

         Total other income                                        8,206,591          8,750,470          10,501,542
                                                            ----------------   ----------------    ----------------

General and administrative expenses
  Compensation and fringe benefits                                12,682,779         12,000,690          10,601,978
  Federal insurance premiums                                          89,523             86,666              86,858
  Premises and equipment                                           1,761,934          1,618,024           1,522,456
  Advertising                                                        187,536            185,468             204,614
  Payroll and other taxes                                          1,143,214          1,023,813             955,050
  Data processing                                                  2,270,449          2,060,986           1,920,239
  Amortization of intangible assets                                  403,999            300,745             242,012
  Other                                                            2,592,604          2,315,233           2,445,475
                                                            ----------------   ----------------    ----------------

         Total general and administrative expenses                21,132,038         19,591,625          17,978,682
                                                            ----------------   ----------------    ----------------

Income before income taxes                                        23,075,900         18,678,481          18,253,703
Income taxes                                                       8,947,196          6,966,040           6,840,707
                                                            ----------------   ----------------    ----------------

NET INCOME                                                        14,128,704         11,712,441          11,412,996
Other comprehensive loss, net of taxes                            (1,244,045)        (1,383,503)         (1,541,828)
                                                            -----------------  ----------------    ----------------

Comprehensive income                                        $     12,884,659   $     10,328,938    $      9,871,168
                                                            ================   ================    ================

Net income per common share
  Basic                                                     $           2.23   $           1.87    $           1.83
  Diluted                                                   $           2.12   $           1.79    $           1.73
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.

                                       17
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
December 31, 2005, 2004 and 2003
<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------------------------

                                                                            Retained                     Accumulated
                                                           Additional       earnings,                       other
                                             Common         paid-in      substantially    Treasury      comprehensive
                                             stock          capital       restricted       stock       income(loss),net     Total
                                         ------------    ------------    ------------   ------------    ------------   ------------

<S>                                      <C>             <C>             <C>            <C>             <C>            <C>
BALANCE, DECEMBER 31, 2002               $     41,903    $ 48,490,124    $ 35,086,795   $(37,317,469)   $  3,798,459   $ 50,099,812

Net income                                         --              --      11,412,996             --              --     11,412,996
Other comprehensive loss, net of taxes             --              --              --             --      (1,541,828)    (1,541,828)
Exercise of stock options                          --         530,508              --      1,454,189              --      1,984,697
Acquisition of treasury shares                     --              --              --     (3,463,652)             --     (3,463,652)
Dividends ($.52 per share)                         --              --      (3,328,473)            --              --     (3,328,473)
                                         ------------    ------------    ------------   ------------    ------------   ------------

BALANCE, DECEMBER 31, 2003                     41,903      49,020,632      43,171,318    (39,326,931)      2,256,631     55,163,553

Net income                                         --              --      11,712,441             --              --     11,712,441
Other comprehensive loss, net of taxes             --              --              --             --      (1,383,503)    (1,383,503)
Exercise of stock options                         834        (980,779)             --      1,418,734              --        438,789
Tax benefit of stock options exercised             --         279,334              --             --              --        279,334
Shares traded to exercise options                (145)        329,517              --       (366,669)             --        (37,297)
Acquisition of treasury shares                   (773)             --              --     (2,211,917)             --     (2,212,690)
Dividends ($.68 per share)                         --              --      (4,265,280)            --              --     (4,265,280)
3 for 2 stock split                            20,828     (10,832,989)        (20,828)    10,832,989              --             --
                                         ------------    ------------    ------------   ------------    ------------   ------------

BALANCE, DECEMBER 31, 2004                     62,647      37,815,715      50,597,651    (29,653,794)        873,128     59,695,347

Net income                                         --              --      14,128,704             --              --     14,128,704
Other comprehensive loss, net of taxes             --              --              --             --      (1,244,045)    (1,244,045)
Exercise of stock options                       1,017      (1,060,993)             --      1,741,721              --        681,745
Tax benefit of stock options exercised             --         490,923              --             --              --        490,923
Shares traded to exercise options                (176)        379,249              --       (539,273)             --       (160,200)
Acquisition of treasury shares                    (93)             --              --       (336,633)             --       (336,726)
Dividends ($0.80 per share)                        --              --      (5,065,276)            --              --     (5,065,276)

BALANCE, DECEMBER 31, 2005               $     63,395    $ 37,624,894    $ 59,661,079   $(28,787,979)   $   (370,917)  $ 68,190,472
                                         ============    ============    ============   ============    ============   ============
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

                                       18
<PAGE>

 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
December 31, 2005, 2004 and 2003
<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------

                                                                  2005               2004                2003
                                                            ----------------   ----------------    ----------------
Operating activities
<S>                                                            <C>              <C>              <C>
  Net income                                                   $  14,128,704    $  11,712,441    $  11,412,996
  Adjustments to reconcile net income to net
    cash provided by (used in) operating activities
     Provision for loan losses                                     1,711,197          968,000          987,919
     Depreciation                                                    839,387          754,332          686,047
     Amortization of intangibles                                     403,999          325,741          244,350
     Impairment of real estate owned                                      --           19,178          125,000
     Accretion of discounts on securities, net                       (84,657)        (101,337)        (160,598)
     Deferred income taxes                                          (546,141)       1,141,688               --
     Gain on disposal of premises and equipment
      and real estate owned                                         (258,741)         (21,745)        (163,391)
     Gain on loans held for sale and mortgage-
      backed securities                                             (199,414)        (597,062)      (3,008,816)
     Originations of loans held for sale, net                    (33,898,697)     (34,985,086)    (115,312,138)
     Proceeds from sale of loans held for sale                    12,859,144       37,614,277      136,817,940
     Other operating activities                                       58,120       (1,586,199)      (7,956,637)
                                                               -------------    -------------    -------------

         Net cash provided by (used in) operating activities      (4,987,099)      15,244,228       23,672,672
                                                               -------------    -------------    -------------

Investing activities
  Proceeds from maturities of investment securities
    available for sale                                            16,000,000       16,000,000        4,000,000
  Purchases of investment securities available for sale          (27,000,000)              --               --
  Proceeds from principal repayments and sales of
    mortgage-backed securities available for sale                  1,663,783        4,941,963       20,444,317
  Proceeds from principal repayments of
    mortgage-backed securities held for investment                   506,048          272,126               --
  Originations of loans held for investment, net
    of principal repayments                                      (73,624,172)     (82,539,233)     (91,482,955)
  Proceeds from disposal of premises and equipment
    and real estate owned                                          1,229,700          262,152          781,975
  Sales of FHLB stock                                                136,000          302,000          275,300
  Purchases of premises and equipment                             (1,193,777)      (1,183,726)        (788,182)
  Repayment of note receivable                                     1,156,557           96,146           83,491
  Net cash received in branch acquisition                                 --       15,771,621               --
                                                               -------------    -------------    -------------

    Net cash used in investing activities                        (81,125,861)     (46,076,951)     (66,686,054)
                                                               -------------    -------------    -------------

Financing activities
  Net increase in deposit accounts                               105,216,360       27,017,259       56,846,009
  Net (decrease) in FHLB borrowings                               (5,000,000)      (5,500,000)     (18,000,000)
  Purchase of treasury shares                                       (336,726)      (2,212,690)      (3,463,652)
  Proceeds from junior subordinated debentures                            --               --       10,310,000
  Proceeds from exercise of stock options                          1,012,468          680,826        1,984,697
  Cash paid for dividends and fractional shares                   (4,867,849)      (4,032,865)      (3,328,473)
  Net change in escrow accounts                                       98,123          (59,904)         (26,087)
  Net change in repurchase agreements                              1,995,628          953,841         (856,668)
                                                               -------------    -------------    -------------

      Net cash provided by financing activities                   98,118,004       16,846,467       43,465,827
                                                               -------------    -------------    -------------

Increase (decrease) in cash and cash equivalents                  12,005,044      (13,986,256)         452,445

Cash and cash equivalents, beginning of year                      20,938,348       34,924,604       34,472,159
                                                               -------------    -------------    -------------

Cash and cash equivalents, end of year                         $  32,943,392    $  20,938,348    $  34,924,604
                                                               =============    =============    =============
</TABLE>

The accompanying notes are an integral part of these consolidated financial
statements.

                                       19
<PAGE>

 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES

ORGANIZATION AND NATURE OF OPERATIONS

First South Bancorp, Inc. (the "Company") is a bank holding company incorporated
under the laws of the State of  Virginia.  First  South Bank (the  "Bank"),  the
wholly owned subsidiary of the Company,  is organized and incorporated under the
laws of the state of North  Carolina.  The Federal  Reserve Board  regulates the
Company and the Federal  Deposit  Insurance  Corporation  and the North Carolina
Office of the Commissioner of Banks regulate the Bank.

The consolidated  financial  statements include the accounts of the Company, the
Bank,  and the Bank's wholly owned  subsidiary,  First South  Leasing,  LLC. All
significant  intercompany  balances and  transactions  have been  eliminated  in
consolidation.

The  Company  follows  accounting  principles  generally  accepted in the United
States of America and general  practices within the financial  services industry
as summarized below:

USE OF ESTIMATES

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

CASH AND CASH EQUIVALENTS

Cash and cash  equivalents  include  demand and time  deposits  (with  remaining
maturities  of  ninety  days or less at time of  purchase)  at  other  financial
institutions.

INVESTMENTS AND MORTGAGE-BACKED SECURITIES

Investments  in certain  securities  are  classified  into three  categories and
accounted for as follows:  (1) debt  securities that the entity has the positive
intent and the ability to hold to maturity are  classified  as  held-to-maturity
and reported at amortized  cost; (2) debt and equity  securities that are bought
and held  principally  for the  purpose  of  selling  them in the near  term are
classified as trading  securities  and reported at fair value,  with  unrealized
gains and  losses  included  in  earnings;  (3) debt and equity  securities  not
classified  as either  held-to-maturity  securities  or trading  securities  are
classified as available  for sale  securities  and reported at fair value,  with
unrealized  gains and losses  excluded from earnings and reported as accumulated
other comprehensive income, a separate component of equity.

A decline  in the  market  value of any AFS or HTM  security  below cost that is
deemed to be  other-than-temporary  results in a reduction in carrying amount to
fair value.  The  impairment is charged to earnings and a new cost basis for the
security   is   established.    To   determine    whether   an   impairment   is
other-than-temporary,  the  Company  considers  whether it has the  ability  and
intent  to hold the  investment  until a market  price  recovery  and  considers
whether evidence indicating the cost of the investment is recoverable  outweighs
evidence to the contrary.  Evidence  considered in this assessment  includes the
reasons for the impairment, the severity and duration of the impairment, changes
in value subsequent to year-end, and forecasted performance of the investee.

Premiums and  discounts on debt  securities  are  recognized as  adjustments  to
interest income using the interest method over the period to maturity. Gains and
losses  on  the  sale  of   securities   are   determined   using  the  specific
identification method.

Mortgage-backed   securities  represent  participating  interests  in  pools  of
long-term first mortgage  loans.  Premiums and discounts are amortized using the
interest method over the remaining period to contractual maturity,  adjusted for
anticipated prepayments.

                                       20
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)

LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES

Loans  receivable  held for  investment  are  stated  at the  amount  of  unpaid
principal,  reduced by an allowance for probable loan losses and net of deferred
origination  fees.  Interest on loans is accrued based on the  principal  amount
outstanding and is recognized using the interest method.

Loan  origination  fees, as well as certain direct loan  origination  costs, are
deferred.  Such costs and fees are recognized as an adjustment to yield over the
contractual lives of the related loans.

Commitment  fees  to  originate  or  purchase  loans  are  deferred,  and if the
commitment is exercised,  recognized  over the life of the loan as an adjustment
of yield. If the commitment expires unexercised,  commitment fees are recognized
in income upon  expiration of the  commitment.  Fees for  originating  loans for
other financial institutions are recognized as loan fee income.

A loan is considered impaired, based on current information and events, if it is
probable  that the Bank will be unable to  collect  the  scheduled  payments  of
principal or interest  when due according to the  contractual  terms of the loan
agreement.  Uncollateralized  loans are  measured  for  impairment  based on the
present  value of  expected  future  cash  flows  discounted  at the  historical
effective interest rate, while all  collateral-dependent  loans are measured for
impairment  based on the fair  value of the  collateral.  The Bank uses  several
factors in  determining  if a loan is impaired.  Internal  asset  classification
procedures   include  a  thorough  review  of  significant   loans  and  lending
relationships  and include the  accumulation of related data. This data includes
loan payment status,  borrowers' financial data and borrowers' operating factors
such as cash flows,  operating  income or loss,  etc.  At December  31, 2005 and
2004, there were no loans,  individually or in the aggregate,  that are material
to the consolidated financial statements which were defined as impaired.

The allowance for loan losses is increased by charges to income and decreased by
charge-offs  (net  of  recoveries).  Management's  periodic  evaluation  of  the
adequacy  of the  allowance  is based on the Bank's  past loan loss  experience,
known and inherent risks in the portfolio,  adverse  situations  that may affect
the  borrower's  ability  to  repay,  the  estimated  value  of  any  underlying
collateral,  and current economic conditions.  While management believes that it
has established the allowance in accordance with accounting principles generally
accepted in the United States of America and has taken into account the views of
its regulators and the current economic  environment,  there can be no assurance
that in the future  the Bank's  regulators  or risks in its  portfolio  will not
require further increases in the allowance.

LOANS HELD FOR SALE

Loans  originated  and  intended  for sale are  carried  at the lower of cost or
aggregate  estimated  market  value.  Net  unrealized  losses are  recognized as
charges to income. Gains and losses on sales of whole or participating interests
in real estate loans are  recognized  at the time of sale and are  determined by
the difference  between net sales proceeds and the Bank's  carrying value of the
loans sold, adjusted for the recognition of any servicing assets retained.

As a part of its normal business operations,  the Bank originates mortgage loans
that have been  approved  by  secondary  investors.  The Bank issues a rate lock
commitment to a borrower and  concurrently  "locks-in"  with a secondary  market
investor, under a best efforts delivery mechanism. The terms of the loan are set
by the secondary investors and are transferred within a short time period of the
Bank  initially  funding  the  loan.  The Bank  receives  origination  fees from
borrowers and servicing release premiums from investors that are recognized when
the loan is sold on the  Statement of  Operations in the line item "Gain on sale
of mortgage loans and mortgage-backed  securities".  Between the initial funding
of the  loans by the Bank and  subsequent  purchase  by the  investor,  the Bank
carries the loans on its  Statement of Financial  Condition at the lower of cost
or fair market value.

                                       21
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)

INCOME RECOGNITION ON IMPAIRED AND NONACCRUAL LOANS

Loans,  including impaired loans, are generally classified as nonaccrual if they
are past due as to maturity or payment of  principal or interest for a period of
more than 90 days,  unless  such loans are  well-secured  and in the  process of
collection.  If a loan or a portion of a loan is  classified  as  doubtful or is
partially  charged off, the loan is generally  classified as  nonaccrual.  Loans
that are on a current  payment  status or past due less than 90 days may also be
classified as nonaccrual if repayment in full of principal and/or interest is in
doubt.

Loans may be returned to accrual status when all principal and interest  amounts
contractually  due (including  arrearages)  are reasonably  assured of repayment
within  an  acceptable  period  of time,  and  there is a  sustained  period  of
repayment  performance  (generally a minimum of six months) by the borrower,  in
accordance with the contractual terms of interest and principal.

While a loan is classified as nonaccrual  and the future  collectibility  of the
recorded  loan balance is doubtful,  collections  of interest and  principal are
generally applied as a reduction to principal outstanding, except in the case of
loans with scheduled  amortization where the payment is generally applied to the
oldest payment due. When the future  collectibility of the recorded loan balance
is expected,  interest  income may be recognized on a cash basis limited to that
which would have been recognized on the recorded loan balance at the contractual
interest  rate.  Receipts in excess of that amount are recorded as recoveries to
the allowance for loan losses until prior charge-offs have been fully recovered.

MORTGAGE SERVICING RIGHTS

When mortgage loans, or mortgage-backed  securities,  are sold, the proceeds are
allocated between the related loans and the retained  mortgage  servicing rights
based on their relative fair values.

Servicing assets and liabilities are amortized on a straight line basis over the
average  period of estimated net servicing  income (if servicing  revenue exceed
servicing  costs) or net  servicing  loss (if servicing  costs exceed  servicing
revenues).  All servicing  assets or liabilities  are assessed for impairment or
increased obligation based on their fair value.

The Company  recorded  amortization  of mortgage  servicing  rights of $372,559,
$277,078 and $242,012 for prepayments  during the years ended December 31, 2005,
2004 and 2003,  respectively.  There were no impairments  recognized  during the
years ended December 31, 2005 and 2004.  Servicing  asset  impairments  totaling
$680,622 were recorded during the year ended December 31, 2003.

PREMISES AND EQUIPMENT

Premises  and  equipment  are stated at cost less  accumulated  depreciation  or
amortization,  if a capital lease.  Depreciation  and  amortization are computed
using the  straight-line  method  based on the  estimated  service  lives of the
assets.  Useful lives range from 10 to 40 years for  substantially  all premises
and from 3 to 20 years for equipment and fixtures.

REAL ESTATE OWNED

Assets  acquired  through loan  foreclosure are recorded as real estate owned at
the  estimated  fair value of the property less  estimated  costs to sell at the
date of foreclosure.  The carrying amount is subsequently  reduced by additional
allowances  which are charged to earnings if the estimated  fair value  declines
below its  initial  value  plus any  capitalized  costs.  Costs  related  to the
improvement  of the property are  capitalized,  whereas costs related to holding
the property are expensed. There were no valuation adjustments recognized during
the year ended December 31, 2005. The Company recognized  valuation  adjustments
of  approximately  $19,178 and $125,000 during the years ended December 31, 2004
and 2003, respectively.

                                       22
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)

INVESTMENT IN FEDERAL HOME LOAN BANK STOCK

The Bank is required to invest in Class B capital stock,  par value $100, of the
Federal Home Loan Bank of Atlanta  ("FHLB").  The FHLB capital stock requirement
is based on the sum of a membership  stock component  totaling 20% of the Bank's
total assets plus an activity based stock component of 4.5% of outstanding  FHLB
advances. At December 31, 2005 and 2004, the Bank owned 16,892 and 18,252 shares
of the FHLB's capital stock, respectively.

The Bank carries this  investment at cost. Due to the  redemption  provisions of
the FHLB,  the  Company  estimated  that fair  value  equals  cost and that this
investment was not impaired at December 31, 2005.

GOODWILL AND INTANGIBLE ASSETS

Net assets of companies  acquired in purchase  transactions are recorded at fair
value  at the  date of  acquisition,  as  such,  the  historical  cost  basis of
individual  assets and  liabilities  are  adjusted to reflect  their fair value.
Identified intangible assets resulting from the branch acquisitions described in
Note 20 are  amortized  on a  straight-line  basis over 10 years,  resulting  in
amortization  expense  of  approximately  $31,000  per  year.  Goodwill  is  not
amortized,  but is reviewed for  potential  impairment on an annual basis at the
reporting unit level. The impairment test is performed in two phases.  The first
step of the goodwill  impairment  test, used to identify  potential  impairment,
compares  the fair  value  of the  reporting  unit  with  its  carrying  amount,
including goodwill. If the fair value of the reporting unit exceeds its carrying
amount,  goodwill of the reporting unit is considered not impaired;  however, if
the carrying  amount of the reporting  unit exceeds its fair value an additional
procedure must be performed. That additional procedure compares the implied fair
value of the  reporting  unit's  goodwill  (as defined in SFAS No. 142) with the
carrying  amount of that goodwill.  An impairment loss is recorded to the extent
that the  carrying  amount of goodwill  exceeds its  implied  fair value.  Other
intangible  assets are  evaluated  for  impairment  if events and  circumstances
indicate a possible  impairment.  Such evaluation of other intangible  assets is
based on undiscounted cash flow projections.

INCOME TAXES

The Company  reports  income  taxes in  accordance  with  Statement of Financial
Accounting  Standards No. 109,  Accounting  for Income  Taxes,  ("SFAS No. 109")
which requires the  recognition of deferred tax assets and  liabilities  for the
temporary  difference between financial statement and tax basis of the Company's
assets and  liabilities  using the  enacted  tax rates in effect in the years in
which the differences are expected to reverse. Valuation allowances are provided
if, based upon the weight of available evidence, it is more likely than not that
some or all of the deferred tax assets will not be realized.

ADVERTISING

Advertising  costs are  expensed as incurred.  For the years ended  December 31,
2005, 2004 and 2003, the Company incurred advertising expense totaling $187,536,
$185,468 and $204,614, respectively.

                                       23
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)

COMPREHENSIVE INCOME

The Company's other comprehensive income relates to unrealized gains (losses) on
available  for sale  securities.  Information  concerning  the  Company's  other
comprehensive income (loss) for the years ended December 31, 2005, 2004 and 2003
is as follows:

<TABLE>
<CAPTION>
                                                    Years ended December 31,
                                     -------------------------------------------------------
                                           2005               2004                2003
                                     ----------------   ----------------    ----------------

Unrealized losses on securities
<S>                                  <C>                <C>                 <C>
   available for sale                $     (2,006,525)  $     (2,248,414)   $     (2,195,082)
Tax benefit                                   762,480            917,500             834,132
Reclassification of net gains
   recognized in net income                         -            (88,844)           (291,738)
Tax expense                                         -             36,255             110,860
                                     ----------------   ----------------    ----------------

Other comprehensive loss, net        $     (1,244,045)  $     (1,383,503)   $     (1,541,828)
                                     =================  ================    ================
</TABLE>

STOCK COMPENSATION PLANS

The Company has adopted SFAS No. 123,  Accounting for Stock Based  Compensation.
As  permitted  by SFAS No. 123,  the Company has chosen to apply APB Opinion No.
25,  Accounting  for Stock  Issued to  Employees,  and related  interpretations.
Accordingly,  no compensation cost has been recognized for options granted under
the Plan. Had compensation  cost for the Company's Plan been determined based on
the fair value at the grant dates for awards under the Plan  consistent with the
methods of SFAS No. 123, the Company's net income and net income per share would
have  been  reduced  to  the  pro  forma  amounts  indicated  below,  reflecting
additional  compensation  expense,  net of applicable income taxes, of $121,291,
$84,675 and  $123,152  for the years ended  December  31,  2005,  2004 and 2003,
respectively.

<TABLE>
<CAPTION>
                                                              Years ended December 31,
                              -------------------------------------------------------------------------------------
                                           2005                        2004                        2003
                              ---------------------------  --------------------------   ---------------------------
                               As Reported     Proforma     As Reported     Proforma     As Reported     Proforma
                              ------------   ------------  ------------   ------------  ------------   ------------

<S>                           <C>            <C>           <C>            <C>           <C>            <C>
Net income                    $ 14,128,704   $ 14,007,413  $ 11,712,441   $ 11,627,766  $ 11,412,996   $ 11,289,844
Earnings per common
  share - basic                       2.23           2.21          1.87           1.86          1.83           1.81
Earnings per common
  share - diluted                     2.12           2.11          1.79           1.77          1.73           1.71
</TABLE>

SEGMENT INFORMATION

The Company follows the provisions of SFAS No. 131, Disclosure About Segments of
an  Enterprise  and  Related   Information,   which  specifies   guidelines  for
determining an entity's  operating  segments and the type and level of financial
information to be disclosed. Based on these guidelines management has determined
that the Bank  operates  in one  business  segment,  the  providing  of  general
commercial  financial  services to customers  located in its market  areas.  The
various products are those generally  offered by community banks. The allocation
of Bank  resources  is based on overall  performance  of the Bank,  rather  than
individual branches or products.

RECLASSIFICATION

Certain amounts in the 2004 and 2003 consolidated financial statements have been
reclassified to conform with the 2005 presentation.  These reclassifications had
no effect on the net income or stockholders' equity as previously reported.

                                       24
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES (Continued)

NEW ACCOUNTING PRONOUNCEMENTS

      In November  2003,  the Emerging  Issues Task Force  ("EITF")  issued EITF
Issue  No.  03-01,  "The  Meaning  of  Other-Than-Temporary  Impairment  and Its
Application to Certain Investments ("EITF 03- 01"). EITF 03-01 provided guidance
for  evaluating  whether an  investment is  other-than-temporarily  impaired and
requires  certain  disclosures with respect to these  investments.  In September
2004, the Financial  Accounting  Standards  Board  ("FASB")  issued a FASB Staff
Position  ("FSP EITF  03-1-b")  to delay the  requirement  to record  impairment
losses in accordance  with EITF 03-01.  The guidance  also  included  accounting
considerations   subsequent  to  the  recognition  of  an   other-than-temporary
impairment and  requirements for disclosures  about unrealized  losses that have
not been recognized as other-than-temporary  impairments.  In November 2005, the
FASB issued FSP FAS 115-1 and FAS 124-1, which addresses the determination as to
when  an  investment  is  considered   impaired.   This  FSP  nullifies  certain
requirements of EITF 03-01 and supersedes  EITF Topic No. D-44,  "Recognition of
Other-Than-Temporary  Impairment  upon the Planned Sale of a Security Whose Cost
Exceeds Fair Value."  This FSP is to be applied to reporting  periods  beginning
after  December 15. 2005.  The Company is in process of evaluating the impact of
this FSP.

      In  December  2004,  the FASB issued  Statement  of  Financial  Accounting
Standards No.  123(r) ("SFAS No.  123(r)"),  "Share-Based  Payment",  which is a
revision of FASB Statement No. 123 "Accounting for Stock-Based Compensation" and
supersedes APB Opinion No. 25 "Accounting  for Stock Issued to Employees".  SFAS
No.  123(r)  requires  companies  to  recognize  in  the  income  statement  the
grant-date  fair  value of stock  options  and other  equity-based  compensation
issued to  employees  over the period  during  which an  employee is required to
provide  service in exchange  for the award,  which will often be the shorter of
the vesting period of the period the employee will be retirement eligible.  SFAS
No.  123(r) sets  accounting  requirements  for  "share-based"  compensation  to
employees,  including  employee-stock  purchase plans ("ESPPs").  Awards to most
nonemployee  directors will be accounted for as employee awards.  This Statement
was to be  effective  for public  companies  that do not file as small  business
issuers as of the  beginning of interim or annual  reporting  periods  beginning
after June 15, 2005.  In April 2005,  the  Securities  and  Exchange  Commission
("SEC") issued Release No. 2005-57,  which defers the effective date of SFAS No.
123(r)  for many  registrants.  Registrants  that do not file as small  business
users must adopt  SFAS No.  123(r) as of the  beginning  of their  first  annual
period beginning after June 15, 2005.  Accordingly,  the Company will adopt SFAS
No.  123(r) on January 1, 2006,  and is currently  evaluating  the effect on its
consolidated financial statements.

      In March 2005,  the SEC issued  Staff  Accounting  Bulletin  No. 107 ("SAB
107"),  which contains guidance on applying the requirements in SFAS No. 123(r).
SAB 107 provides  guidance on valuation  techniques,  development of assumptions
used in valuing employee share options and related MD&A disclosures.  SAB 107 is
effective for the period in which SFAS No.  123(r) is adopted.  The Company will
adopt SAB 107 on January 1, 2006, and is currently  evaluating the effect on its
consolidated financial statements.

      In May 2005, the FASB issued Statement of Financial  Accounting  Standards
No. 154 ("SFAS No.  154"),  "Accounting  Changes and Error  Corrections",  which
replaces  APB Opinion  No. 20  "Accounting  Changes"  and FASB  Statement  No. 3
"Reporting  Accounting  Changes in Interim Financial  Statements".  SFAS No. 154
changes the  requirements for the accounting for and reporting of a change in an
accounting  principle.  SFAS No.  154  requires  retrospective  application  for
voluntary  changes in an accounting  principle  unless it is impracticable to do
so.  SFAS No. 154 is  effective  for  accounting  changes  made in fiscal  years
beginning  after  December  15,  2005.  The  Company  will adopt SFAS No. 154 on
January 1, 2006 with no expected  material effect on its consolidated  financial
statements.

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

                                       25
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 2. INVESTMENT SECURITIES

Investment  securities at December 31, 2005 and 2004 are classified as available
for sale according to management's intent and summarized as follows:

<TABLE>
<CAPTION>
                                                                    Gross              Gross           Estimated
                                                Amortized        unrealized         unrealized          market
                                                  cost              gains             losses             value
                                            ---------------   ----------------   ---------------   ----------------
December 31, 2005:
<S>                                         <C>               <C>                <C>               <C>
   U.S. Treasury and Agency Notes           $    42,041,062   $        227,097   $      (440,469)  $     41,827,690
                                            ===============   ================   ================  =================

December 31, 2004:
   U.S. Treasury and Agency Notes           $    30,956,405   $      1,101,747   $             -   $     32,058,152
                                            ===============   ================   ===============   =================
</TABLE>

The following table shows U.S.  Treasury and Agency Notes unrealized  losses and
fair value, aggregated by length of time that individual securities have been in
a continuous  unrealized  loss position,  at December 31, 2005. The current year
unrealized  losses on these investment  securities are a result of volatility in
the market during 2005 and relate to eight U.S.  Treasury and Agency Notes.  All
unrealized losses on U.S. Treasury and Agency Notes are considered by management
to be temporary given the credit ratings on these investment  securities and the
short duration of the unrealized loss.

<TABLE>
<CAPTION>
                                                                          2005
                                    -------------------------------------------------------------------------------
                                        Less Than 12 Months         12 Months or More                Total
                                    -------------------------   ------------------------ --------------------------
                                        Fair       Unrealized     Fair        Unrealized     Fair      Unrealized
                                        value        losses        value       losses         value       losses
                                    ------------  -----------   ----------   ----------- ------------   -----------
Securities available for sale:
<S>                                <C>           <C>            <C>          <C>         <C>          <C>
  U.S. Treasury and Agency Notes   $  26,584,939 $  (440,469)   $        -   $        -  $ 26,584,939 $   (440,469)
                                   ============= ============   ==========   =========== ============ =============
</TABLE>

U.S. Treasury and Agency notes at December 31, 2005 are contractually scheduled
to mature as follows:

                                                                  Estimated
                                                 Amortized          market
                                                   cost              value
                                             ---------------   ----------------

  Due within one year                        $    10,012,354   $     10,092,354
  Due after one year through five years           32,028,708         31,735,336
                                             ---------------   ----------------

     Total                                   $    42,041,062   $     41,827,690
                                             ===============   ================

There were no sales of U.S.  Treasury  and Agency  Notes  during the years ended
December 31, 2005, 2004 and 2003.

U.S.  Treasury and Agency Notes with an amortized  cost of  approximately  $17.0
million and $13.0 million were pledged to secure  deposits from public  entities
and repurchase agreements at December 31, 2005 and 2004, respectively.

3. MORTGAGE-BACKED SECURITIES

Mortgage-backed  securities  at  December  31, 2005 and 2004 are  classified  as
available for sale according to management's intent and summarized as follows:

<TABLE>
<CAPTION>
                                                                    Gross              Gross           Estimated
                                                Amortized        unrealized         unrealized          market
                                                  cost              gains             losses             value
                                            ---------------   ----------------   ---------------   ----------------
December 31, 2005:
   FHLMC participation certificates,
<S>                      <C>     <C>        <C>               <C>                <C>               <C>
     maturing from years 2007 to 2035       $    21,011,344   $        113,072   $      (485,349)  $     20,639,067
                                            ===============   ================   ================  ================
</TABLE>

                                        26
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 3. MORTGAGE-BACKED SECURITIES (Continued)

<TABLE>
<CAPTION>
                                                                    Gross              Gross           Estimated
                                                Amortized        unrealized         unrealized          market
                                                  cost              gains             losses             value
                                            ---------------   ----------------   ---------------   ----------------
December 31, 2004:
   FHLMC participation certificates,
<S>                      <C>     <C>        <C>               <C>                <C>               <C>
     maturing from years 2005 to 2027       $     6,320,252   $        319,129   $             -   $      6,639,381
                                            ===============   ================   ===============   ================

Mortgage-backed  securities at December 31, 2005 and 2004 classified as held for
investment according to management's intent and summarized as follows:

                                                                    Gross              Gross           Estimated
                                                Amortized        unrealized         unrealized          market
                                                  cost              gains             losses             value
                                            ---------------   ----------------   ---------------   ----------------
December 31, 2005:
   FHLMC participation certificate,
     maturing during 2013                   $     2,063,310   $              -   $       (97,677)  $      1,965,633
                                            ===============   ================   ================  ================

December 31, 2004:
   FHLMC participation certificate,
     maturing from years 2005 to 2013       $     2,569,358   $              -   $       (67,034)  $      2,502,324
                                            ===============   ================   ================  ================
</TABLE>

The following tables present  mortgage-backed  securities  unrealized losses and
fair values,  aggregated by length of time that individual  securities have been
in a continuous  unrealized  loss  position,  at December 31, 2005 and 2004. The
current year unrealized  losses on these  investment  securities are a result of
volatility  in the market  during 2005 and relate to eight  FHLMC  participation
certificates.  All unrealized  losses on FHLMC  participation  certificates  are
considered  by  management  to be  temporary  given the credit  ratings on these
investment securities and the short duration of the unrealized loss.

<TABLE>
<CAPTION>
                                                                          2005
                                    -------------------------------------------------------------------------------
                                        Less Than 12 Months         12 Months or More                Total
                                    -------------------------   ------------------------ --------------------------
                                        Fair       Unrealized      Fair        Unrealized     Fair      Unrealized
                                        value        losses        value       losses         value       losses
                                    ------------  -----------   ----------   ----------- ------------   -----------
Securities available for sale:
<S>                                 <C>           <C>           <C>          <C>         <C>            <C>
  FHLMC participation certificates  $ 15,869,526  $  (485,349)  $        -   $         - $ 15,869,526   $  (485,349)
                                    ============  ============  ==========   =========== ============   ============

Securities held for investment:
  FHLMC participation certificate   $          -  $         -   $1,965,633   $   (97,677) $  1,965,633 $     (97,677)
                                    ============  ===========   ==========   ============ ============= ============

                                                                          2004
                                        Less Than 12 Months         12 Months or More                Total
                                    -------------------------   ------------------------ --------------------------
                                        Fair       Unrealized      Fair      Unrealized      Fair       Unrealized
                                        value        losses        value       losses        value        losses
                                    ------------  -----------   ----------   ----------- ------------   -----------
Securities held for investment:
  FHLMC participation certificate   $  2,502,324  $   (67,034)  $        -   $         - $  2,502,324   $   (67,034)
                                    ============  ============  ==========   =========== ============   ============
</TABLE>

                                       27
<PAGE>

 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 3. MORTGAGE-BACKED SECURITIES (Continued)

Mortgage-backed  securities,  classified  as  available  for  sale or  held  for
investment,  at  December  31,  2005 are  contractually  scheduled  to mature as
follows:

                                                                    Estimated
                                                  Amortized          market
                                                    cost              value
                                              ---------------   ----------------

Due after one year through five years         $       252,988   $        259,782
Due after five years through ten years              6,312,372          6,408,715
Due after ten years                                16,509,294         16,033,880
                                              ---------------   ----------------
                                              $    23,074,654   $     22,702,377
                                              ===============   ================

Expected  maturities may differ from contractual  maturities  because  borrowers
have the right to call or prepay  obligations with or without call or prepayment
penalties.

No mortgage-backed securities were sold in 2005. Mortgage-backed securities with
a carrying  value of  approximately  $2.5  million,  and $10.2 million were sold
during the years ended December 31, 2004 and 2003, respectively.  Gross realized
gains on the sale of  mortgage-backed  securities  were $88,844  during the year
ended  December 31, 2004.  Net  realized  gains on the sales of  mortgage-backed
securities  were $291,738 and $302,315  during the years ended December 31, 2003
and 2002, respectively.

Mortgage-backed  securities with an amortized cost of approximately $476,566 and
$378,284  were pledged as  collateral  for  treasury,  tax, and loan deposits at
December 31, 2005 and 2004, respectively.

4. LOANS RECEIVABLE

Loans receivable at December 31, 2005 and 2004 are summarized as follows:

                                                   2005              2004
                                             ---------------   ----------------

Mortgage loan                                $    68,022,652   $     67,518,036
Consumer loans                                   101,833,555         98,441,200
Commercial loans                                 536,638,140        463,779,519
Leasing                                           11,981,099         11,622,296
                                             ---------------   ----------------

                  Total                          718,475,446        641,361,051
                                             ---------------   ----------------
Less:
   Allowance for loan losses                      (9,222,305)        (8,343,382)
   Deferred loan fees, net                        (1,433,223)        (1,201,634)
                                             ----------------  ----------------

Loans receivable, net                        $   707,819,918   $    631,816,035
                                             ===============   ================

The Bank has pledged its eligible real estate loans to  collateralize  actual or
potential borrowings from the Federal Home Loan Bank of Atlanta (See Note 9).

During the years ended  December 31,  2005,  2004,  and 2003 the Bank  exchanged
loans  with  outstanding  principal  balances  of  $16,354,875,  $2,841,484  and
$8,952,095,  respectively,  with the  Federal  Home  Loan  Mortgage  Corporation
("FHLMC") for mortgage-backed securities of equal value.

The Bank  originates  mortgage  loans for  portfolio  investment  or sale in the
secondary  market.  During  the  period  of  origination,   mortgage  loans  are
designated  as either held for sale or for  investment  purposes.  Transfers  of
loans held for sale to the  investment  portfolio  are  recorded at the lower of
cost or market value on the transfer  date.  Loans  receivable  held for sale at
December  31,  2005 and 2004 are fixed rate  mortgage  loans  with an  estimated
market value of approximately $11,029,237 and $6,298,000, respectively.

                                       28
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 4. LOANS RECEIVABLE (Continued)

Net  gains on sales of loans  receivable  held for sale  amounted  to  $199,414,
$508,218 and $2,717,078  for the years ended  December 31, 2005,  2004 and 2003,
respectively.

The changes in the  allowance  for loan losses for the years ended  December 31,
2005, 2004 and 2003 are as follows:

<TABLE>
<CAPTION>
                                                                            Years ended December 31,
                                                              -----------------------------------------------------
                                                                    2005               2004              2003
                                                              ----------------   ---------------   ----------------

<S>                                                           <C>                <C>               <C>
Balance at beginning of year                                  $      8,343,382   $     7,633,709   $      6,958,587
Provisions for loan losses                                           1,711,197           968,000            987,919
Loans charged off                                                     (845,228)         (301,636)          (357,836)
Recoveries                                                              12,954            43,309             45,039
                                                              ----------------   ---------------   ----------------

Balance at end of year                                        $      9,222,305   $     8,343,382   $      7,633,709
                                                              ================   ===============   ================

The following is a summary of the principal balances of loans on nonaccrual
status and loans past due ninety days or more:
                                                                                             December 31,
                                                                                       2005              2004
                                                                                 ---------------   ----------------
Loans contractually past due 90 days or more and/or on nonaccrual status:
   Residential                                                                   $     1,362,590   $        813,833
   Consumer and commercial                                                               896,254          1,535,161
                                                                                 ---------------   ----------------

                                                                                 $     2,258,844   $      2,348,994
                                                                                 ===============   ================

For the  years  ended  December  31,  2005,  2004 and 2003,  interest  income of
approximately  $143,189,  $121,000 and $58,000,  respectively,  was not recorded
related to loans accounted for on a nonaccrual basis.

5. PREMISES AND EQUIPMENT

Premises and equipment consist of the following:
                                                                                             December 31,
                                                                                       2005              2004
                                                                                 ---------------   ----------------

     Land                                                                        $     2,847,880   $      2,882,838
     Office buildings and improvements                                                 6,601,871          6,270,157
     Furniture, fixtures and equipment                                                 4,281,794          4,599,574
     Vehicles                                                                            403,542            364,198
       Construction In Process                                                            14,303            176,535
                                                                                 ---------------   ----------------

                                                                                      14,149,390         14,293,302
     Less accumulated depreciation                                                     5,318,220          5,714,312
                                                                                 ---------------   ----------------

              Total                                                              $     8,831,170   $      8,578,990
                                                                                 ===============   ================
</TABLE>

                                       29
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 5. PREMISES AND EQUIPMENT (Continued)

The Company  leases  certain  branch  facilities  and equipment  under  separate
agreements  that expire at various  dates  through  September  30, 2010.  Future
rentals under these leases are as follows:

                2006                                              $      378,711
                2007                                                     344,864
                2008                                                     305,113
                2009                                                      67,634
                2010                                                      24,615
             Thereafter                                                        -
                                                                  --------------

                                                                  $    1,120,937

Rental expense amounting to approximately $395,919, $389,000 and $305,000 during
the years ended December 31, 2005, 2004 and 2003, respectively, is included in
premises and equipment expense on the accompanying consolidated statements of
operations.

6. DEPOSITS

At December 31, 2005, the scheduled maturities of time deposits were as follows
(in thousands):

           2006                                                    $ 373,651,511
           2007                                                       56,594,338
           2008                                                       29,934,718
           2009                                                        4,945,618
           2010                                                        2,237,637
           Thereafter                                                          -
                                                                   -------------

                Total time deposits                                $ 467,363,822
                                                                   =============

7. EMPLOYEE BENEFIT PLANS

The Company participated in a multi-employer  defined benefit pension plan which
covered  substantially  all employees;  however,  effective January 31, 2002 the
Company's  Board of  Directors  approved a plan to freeze the  accrual of future
benefits  under the plan.  Consequently,  no new  employees  became  eligible to
participate  in the plan after January 31, 2002.  Effective  October 1, 2004 the
Company withdrew from the plan.  Active employees who were  participating in the
plan  became  100%  vested on that date could  select  from a variety of benefit
payment options based on their age and benefit  payment amount.  Expenses of the
plan for  unfunded  liability,  withdrawal  fees,  administrative  fees and PBGC
premiums the years ended December 31, 2005,  2004 and 2003 were $0, $624,968 and
$0, respectively.

The Company also  participates in a  multi-employer  defined  contribution  plan
which  covers  substantially  all  employees.  Under  the  plan,  employees  may
contribute  from 1% to 15% of  compensation,  subject  to an annual  maximum  as
determined   by  the  Internal   Revenue  Code.   The  Company  makes   matching
contributions  of 100% of employees'  contributions  up to 5% of the  employees'
salaries. The plan provides that employees' contributions are 100% vested at all
times  and the  Bank's  contributions  vest 25% for each  year of  service.  The
expenses related to the Company's contributions to this plan for the years ended
December  31,  2005,  2004  and  2003  were  $326,549,  $283,966  and  $244,474,
respectively.

                                       30
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 7. EMPLOYEE BENEFIT PLANS (Continued)

Directors and certain officers participate in deferred compensation plans. These
plans  generally  provide for fixed  payments  beginning  at  retirement.  These
payments  are earned over  service  periods of up to ten years,  and can include
provisions for deferral of current payments.  The expense related to these plans
during the years ended  December 31, 2005,  2004 and 2003  aggregated  $486,662,
$500,089 and $579,730,  respectively. The plans generally include provisions for
forfeitures of unvested portions of payments,  and vesting in the event of death
or disability.  The total liability under this plan was approximately $3,398,402
at December 31, 2005 and is included in other  liabilities  in the  accompanying
consolidated statements of financial condition.

8. STOCK OPTION PLAN

On April 8, 1998,  the  Shareholders  of the  Company  approved  the First South
Bancorp,  Inc. 1997 Stock Option Plan (the "Plan").  The purpose of this Plan is
to advance the interests of the Company through providing selected key employees
and  Directors  of the Bank and the  Company  with the  opportunity  to purchase
shares.  The Plan  reserves  1,474,742  shares for grant within ten years of the
effective  date.  The option  price is required  to be 100% of the stock's  fair
market value as defined,  with an exception for any shareholder with more than a
10% ownership interest in the Company. The exercise price is required to be 110%
of the  stock's  fair  market  value  for  these  options  holders.  Vesting  is
determined on the date of the grant. Options have a 10-year life; however, there
are  additional  limitations  for  shareholders  with more than a 10%  ownership
interest in the Company.  The Plan also has a change of control  provision under
which all options immediately vest if a change of control, as defined, occurs.

A summary of the status of the Plan as of December 31, 2005,  2004 and 2003, and
changes during the years then ended, including  weighted-average  exercise price
("Price"), is presented below:

<TABLE>
<CAPTION>
                                                              Years ended December 31,
                              -------------------------------------------------------------------------------------
                                           2005                        2004                        2003
                              ---------------------------  --------------------------   ---------------------------
                                 Shares          Price        Shares          Price        Shares          Price
                              ------------   ------------  ------------   ------------  ------------   ------------

Outstanding at beginning
<S>                                <C>       <C>                <C>       <C>                <C>       <C>
  of year                          773,974   $      10.17       852,708   $       9.94       953,441   $       9.25
Granted                             35,450          29.05        13,750          23.29        41,625          23.59
Cancellations                     (105,652)         10.94       (92,484)          9.89      (142,358)          9.27
                              -------------                ------------                 ------------

Outstanding at year end            703,772          11.01       773,974          10.18       852,708           9.94
                              ============                 ============                 ============

Weighted-average fair value of
  options granted during the year            $       4.76                 $       3.46                 $       4.72
                                             ============                 ============                 ============
</TABLE>

The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option-pricing   model  with  the   following   weighted-average
assumptions  used for grants for the years ended  December  31,  2005,  2004 and
2003,  respectively:  dividend  growth  rate of 17% for  each  period;  expected
volatility  of 21.4%,  21.7% and 21.2% ; risk-free  interest  rates ranging from
4.03% to 4.47% during the year ended  December  31, 2005;  3.59% to 4.11% during
the year  ended  December  31,  2004;  and 3.65% to 4.49%  during the year ended
December 31, 2003; and expected lives of 6 years.

                                       31
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 8. STOCK OPTION PLAN (Continued)

The following table summarizes additional information about the Plan at December
31, 2005, including weighted-average remaining contractual life ("Life") and
Price:

<TABLE>
<CAPTION>
                                                      Options Outstanding                   Options Exercisable
                                          ------------------------------------------   ----------------------------
     Range of Exercise Price                 Shares          Life           Price          Shares          Price
-------------------------------           ------------   ------------   ------------   -------------   ------------

<S>   <C>      <C>                             <C>               <C>    <C>                  <C>       <C>
      $8.111 - 8.25                            557,019           2.26   $       8.11         557,019   $       8.11
      $10.306 - 15.56                           39,153           5.48   $      12.60          39,153   $      12.60
      $22.46 - 24.913                           68,900           7.42   $      23.54          54,150   $      23.63
      $25.15 - 37.605                           38,700           9.32   $      28.72           3,250   $      25.15
                                          ------------                                 -------------

                                               703,772                                       653,572
                                          ============                                 =============
</TABLE>

9. BORROWED MONEY

Borrowed  money  represents  advances from the FHLB and  repurchase  agreements.
Advances  outstanding from the FHLB at December 31, 2005 and 2004 had a weighted
average  rate of 4.40% and  2.44%,  respectively,  and  totaled  $5,500,000  and
$10,500,000,  respectively.  These  advances  have a scheduled  maturity date of
January 3, 2007.

At December 31, 2005 and December 31, 2004,  repurchase  agreements  outstanding
had average rates of 3.59% and 1.62%,  and totaled  $6,287,500  and  $4,291,900,
respectively.

At December 31, 2005 and 2004, repurchase agreements were collateralized by U.S.
government  agency  obligations  with a  principal  balance  of  $7,000,000  and
$5,000,000,  respectively.  The Company has pledged all of its stock in the FHLB
and  certain  loans  secured  by one to four  family  residential  mortgages  as
collateral  for actual or potential  borrowings  from the FHLB.  At December 31,
2005 and 2004, the Company had approximately  $160.8 million and $133.7 million,
respectively, of additional credit available with the FHLB.

10. INCOME TAXES

The components of income tax expense for the years ended December 31, 2005, 2004
and 2003 are as follows:

                                        Years Ended December 31,
                         -------------------------------------------------------
                               2005               2004                2003
                         ----------------   ----------------    ----------------
Current
  Federal                $      7,925,068   $      4,817,313    $      4,507,141
  State                         1,568,269          1,007,039             746,935
                         ----------------   ----------------    ----------------

                                9,493,337          5,824,352           5,254,076
                         ----------------   ----------------    ----------------
Deferred
  Federal                        (496,214)         1,004,496           1,448,063
  State                           (49,927)           137,192             138,568
                         -----------------  ----------------    ----------------

                                 (546,141)         1,141,688           1,586,631
                         -----------------  ----------------    ----------------

Total                    $      8,947,196   $      6,966,040    $      6,840,707
                         ================   ================    ================

                                       32
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 10. INCOME TAXES (Continued)

Reconciliations  of the expected  income tax expense at statutory tax rates with
income tax expense  reported in the statements of operations for the years ended
December 31, 2005, 2004 and 2003 are as follows:

<TABLE>
<CAPTION>
                                                                           Years Ended December 31,
                                                            -------------------------------------------------------
                                                                  2005               2004                2003
                                                            ----------------   ----------------    ----------------

Expected income tax expense at 35% for 2005
<S>   <C>     <C>      <C>                                  <C>                <C>                 <C>
  and 34% for 2004 and 2003                                 $      8,076,565   $      6,350,684    $      6,206,259
State income taxes, net of federal
  income tax                                                         986,922            755,192             689,292
Other expenses and adjustments                                      (116,291)          (139,836)            (54,843)
                                                            -----------------  ----------------    ----------------

                                                            $      8,947,196   $      6,966,040    $      6,840,707
                                                            ================   ================    ================

The components of deferred income tax assets and liabilities are as follows:

                                                                                     Years Ended December 31,
                                                                                     2005                2004
                                                                               ----------------    ----------------
Deferred income tax assets
  Deferred directors' fees                                                     $        584,251    $        608,989
  Allowance for loan losses                                                           3,410,155           3,062,980
  Employee benefits                                                                     758,035             762,033
  Loans mark-to-market                                                                   72,464             132,680
  Unrealized losses on securities available for sale                                    214,732                   -
  Other                                                                                  57,419              45,437
                                                                               ----------------    ----------------

                                                                                      5,097,056           4,612,119
                                                                               ----------------    ----------------
Deferred income tax liabilities
  Unrealized gains on securities available for sale                                           -             547,747
  Depreciation and amortization                                                       3,350,886           3,524,004
  Carrying value - land                                                                 395,000             395,000
  Mortgage servicing rights                                                             553,824             671,017
  Deferred loan origination fees and costs                                              598,819             576,589
  FHLB stock                                                                            141,451             200,263
  Other                                                                                  50,958                   -
                                                                               ----------------    ----------------
                                                                                      5,090,938           5,914,620
                                                                               ----------------    ----------------

Net deferred income tax liability                                              $          6,118    $     (1,302,501)
                                                                               ================    ================
</TABLE>

11. REGULATORY CAPITAL REQUIREMENTS

Dividend  payments  made by the Company are subject to  regulatory  restrictions
under Federal  Reserve Board policy as well as to limitations  under  applicable
provisions of Virginia  corporate law. The Federal  Reserve Board may prohibit a
bank holding  company from paying any  dividends if the holding  company's  bank
subsidiary is classified as  "undercapitalized."  Under Virginia law,  dividends
may be paid out of surplus  or, if there is no  surplus,  out of net profits for
the fiscal year in which the dividend is declared and for the  preceding  fiscal
year.  Furthermore,  under FDIC regulations,  the Bank is prohibited from making
any capital  distributions  if,  after making the  distribution,  the Bank would
have:  (i) a total  risk-based  capital  ratio of less than 8.0%;  (ii) a Tier 1
risk-based  capital ratio of less than 4.0%;  or (iii) a leverage  ratio of less
than 4.0%.

                                       33
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 11. REGULATORY CAPITAL REQUIREMENTS (Continued)

The Bank is subject to various regulatory capital  requirements  administered by
the  federal  and  state  banking  agencies.  Failure  to meet  minimum  capital
requirements   can  initiate   certain   mandatory,   and  possibly   additional
discretionary,  actions by regulators  that, if undertaken,  could have a direct
material  effect  on the  Bank's  financial  statements.  Quantitative  measures
established  by  regulation  to  ensure  capital  adequacy  require  the Bank to
maintain minimum amounts and ratios, as set forth in the table below. Management
believes,  as of December  31,  2004,  that the Bank meets all capital  adequacy
requirements to which it is subject. The Company's most significant asset is its
investment in First South Bank. Consequently, the information concerning capital
ratios is essentially the same for the Company and the Bank.

As of December 31, 2005, the most recent  notification from the FDIC categorized
the  Bank  as  well  capitalized  under  the  regulatory  framework  for  prompt
corrective  action. To be categorized as well capitalized the Bank must maintain
minimum  amounts  and  ratios,  as set  forth in the table  below.  There are no
conditions  or events since that  notification  that  management  believes  have
changed the Bank's category.

The Bank's actual regulatory  capital amounts and ratios as of December 31, 2005
and 2004 are presented in the table below (dollars in thousands):

<TABLE>
<CAPTION>
                                                                                               Minimum to be Well
                                                                                               Capitalized under
                                                                     Minimum for Capital       Prompt Corrective
                                                 Actual               Adequacy Purposes        Action Provisions
                                         -----------------------  -----------------------   -----------------------
                                           Amount        Ratio      Amount        Ratio       Amount        Ratio
                                         ----------   ----------  -----------  ----------   ----------  -----------

December 31, 2005:

<S>                                        <C>             <C>       <C>           <C>        <C>           <C>
Total Capital (to Risk Weighted Assets)    $80,015         11.7%     $54,940       8.0%       $68,675       10.0%

Tier I Capital (to Risk Weighted Assets)    71,423         10.4%      27,470       4.0%        41,205
                                                                                                             6.0%

Tier I Capital (to Average Assets)          71,423          8.6%      33,125       4.0%        41,406        5.0%

December 31, 2004:

Total Capital (to Risk Weighted Assets)    $70,240         11.6%     $48,265       8.0%       $60,331       10.0%

Tier I Capital (to Risk Weighted Assets)    62,689         10.4%      24,132       4.0%        36,198
                                                                                                             6.0%

Tier I Capital (to Average Assets)          62,689          8.8%      28,529       4.0%        35,662        5.0%
</TABLE>

12. EARNINGS PER SHARE

The following  table  provides a  reconciliation  of income  available to common
stockholders  and the  average  number  of  shares  outstanding  (less  unearned
deferred  stock  awards and  treasury  shares) for the years ended  December 31,
2005, 2004 and 2003. Options to purchase 703,772,  773,974 and 852,708 shares of
common  stock  were   outstanding   at  December  31,  2005,   2004,  and  2003,
respectively.

<TABLE>
<CAPTION>
                                                                           Years Ended December 31,
                                                            -------------------------------------------------------
                                                                  2005               2004                2003
                                                            ----------------   ------------------------------------

<S>                                                         <C>                <C>                 <C>
Net income (numerator)                                      $     14,128,704   $     11,712,441    $     11,412,996
                                                            ================   ================    ================

Weighted average shares outstanding
  for basic EPS (denominator)                                      6,325,382          6,251,866           6,230,578
Dilutive effect of stock options                                     328,099            305,283             373,813
                                                            ----------------   ----------------    ----------------

Adjusted shares for diluted EPS                                    6,653,481          6,557,149           6,604,391
                                                            ================   ================    ================
</TABLE>

                                       34
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 12. EARNINGS PER SHARE (Continued)

For the year  ended  December  31,  2005,  there were  7,200  options  that were
antidilutive  since the exercise  price exceeded the average market price of the
Company's  common stock for the year.  These  options have been omitted from the
calculation of diluted earnings per share for 2005.

13. MORTGAGE BANKING ACTIVITIES

Mortgage  loans  serviced  for  others  are  not  included  in the  accompanying
consolidated statements of financial condition. The unpaid principal balances of
mortgage  loans  serviced  for  others  were   $260,632,000,   $277,252,000  and
$288,917,000 at December 31, 2005, 2004, and 2003 respectively.  Servicing loans
for others  generally  consists of  collecting  mortgage  payments,  maintaining
escrow  accounts,  disbursing  payment to investors and foreclosure  processing.
Loan  servicing  income is recorded on the accrual basis and includes  servicing
fees from investors and certain charges  collected from borrowers,  such as late
payment fees.

At  December  31,  2005 and 2004,  mortgage  servicing  rights  reported  in the
consolidated  statements  of  financial  condition,  net of  amortization,  were
$1,402,085 and $1,698,778 respectively.

During the years  ended  December  31, 2005 and 2004  respectively,  the Company
recorded  additional  servicing  assets of $75,866  and  $240,305 as a result of
sales of loans or mortgage-backed  securities.  Amortization of servicing assets
during the years ended  December 31, 2005,  2004, and 2003  aggregated  $372,559
$277,077,  and $242,012,  respectively.  The fair value of recognized  servicing
assets  amounted to  approximately  $1,843,000 and $2,036,000 as of December 31,
2005 and 2004,  respectively.  The  Company's  significant  assumptions  used to
estimate their fair value include weighted average life,  prepayment speeds, and
expected costs to transfer servicing to a third party.

14.   FINANCIAL  INSTRUMENT WITH  OFF-BALANCE  SHEET RISK AND SIGNIFICANT  GROUP
      CONCENTRATION OF CREDIT RISK:

The Company is a party to financial  instruments with off-balance  sheet risk in
the normal course of business to meet the  financing  needs of its customers and
to reduce its own exposure to fluctuations  in interest  rates.  These financial
instruments  include  commitments  to extend  credit  and  involve,  to  varying
degrees,  elements  of credit  and  interest  rate risk in excess of the  amount
recognized in the consolidated balance sheet.

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

Commitments  to extend  credit are  agreements  to lend to a customer as long as
there is no violation of any condition established in the contract.  Commitments
generally  have fixed  expiration  dates or other  termination  clauses  and may
require payment of a fee. The Company evaluates each customer's creditworthiness
on a case-by-case basis. The amount of collateral obtained,  if deemed necessary
by the  Company  upon  extension  of  credit,  is based on  management's  credit
evaluation of the borrower.

                                       35
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 14. FINANCIAL INSTRUMENT WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT GROUP
      CONCENTRATION OF CREDIT RISK: (Continued)

A summary of the contractual amounts of the Company's exposure to off-balance
sheet risk as of December 31, 2005 and 2004 is as follows:
<TABLE>
<CAPTION>
                                                                                     Years Ended December 31,
                                                                               ------------------------------------
                                                                                     2005                2004
                                                                               ----------------    ----------------

<S>                                                                            <C>                 <C>
   Commitments to extend credit                                                $    156,852,000    $    166,297,000
   Undrawn balances on lines of credit and undrawn
      balances on credit reserves (overdraft protection)                             53,637,000          58,314,000
   Standby letters of credit                                                          2,031,000           3,661,000
                                                                               ----------------    ----------------

                                                                               $    212,520,000    $    228,272,000
                                                                               ================    ================
</TABLE>

Included in the  commitments  to  originate  loans as of  December  31, 2005 and
December 31, 2004,  are fixed interest rate loan  commitments  of  approximately
$23.8  million  and  $18.4  million,   respectively.  The  shorter  duration  of
interest-sensitive  liabilities,  to the  extent  they  are  used to fund  these
fixed-rate  loans,  indicates  that the Company is exposed to interest rate risk
because,  in a rising rate environment,  liabilities will be repricing faster at
higher interest rates, thereby reducing the market value of fixed-rate long-term
assets and net interest income.

The Company's lending is concentrated primarily in Beaufort, Craven, Cumberland,
Dare, Edgecombe,  Lenoir,  Durham, Nash,  Pasquotank,  Pitt, Robeson,  Wake, and
surrounding  counties in North Carolina.  Credit has been extended to certain of
the Company's customers through multiple lending transactions.

Since many of the  commitments  are expected to expire without being drawn upon,
amounts reported do not necessarily represent future cash requirements.

15. PARENT COMPANY FINANCIAL INFORMATION

The Company's principal asset is its investment in the Bank. Condensed financial
statements of the parent  company as of December 31, 2005,  2004 and 2003 are as
follows:

<TABLE>
<CAPTION>
                                                                           Years Ended December 31,
                                                            -------------------------------------------------------
                                                                  2005               2004                2003
                                                            ----------------   ----------------    ----------------
CONDENSED BALANCE SHEETS
<S>                                                         <C>                <C>                 <C>
Cash                                                        $      1,307,746   $      1,071,439    $        839,895
Due from subsidiary                                                        -                  -                   -
Investment in wholly-owned subsidiary                             75,530,645         68,072,782          64,105,117
Other assets                                                       2,929,991          1,931,609           1,325,197
                                                            ----------------   ----------------    ----------------

      Total assets                                          $     79,768,382   $     71,075,830    $     66,270,209
                                                            ================   ================    ================

Junior subordinated debentures                              $     10,310,000   $     10,310,000    $     10,310,000
Other liabilities                                                  1,267,910          1,070,483             796,656
Stockholders' equity                                              68,190,472         59,695,347          55,163,553
                                                            ----------------   ----------------    ----------------

      Total liabilities and stockholders' equity            $     79,768,382   $     71,075,830    $     66,270,209
                                                            ================   ================    ================

CONDENSED STATEMENTS OF INCOME
Interest income, net                                        $              -   $              -    $            499
Interest on junior subordinated debentures                           632,629            448,319             107,930
Equity in earnings of subsidiary                                  14,597,194         12,074,429          11,530,584
Miscellaneous income (expenses)                                      164,139             86,331             (10,157)
                                                            ----------------   ----------------    ----------------

      Net income                                            $     14,128,704   $     11,712,441    $     11,412,996
                                                            ================   ================    ================
</TABLE>

                                       36
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 15. PARENT COMPANY FINANCIAL INFORMATION (Continued)

<TABLE>
<CAPTION>
                                                                           Years Ended December 31,
                                                            -------------------------------------------------------
                                                                  2005               2004                2003
                                                            ----------------   ----------------    ----------------

CONDENSED STATEMENTS OF CASH FLOWS
Operating activities:
<S>                                                         <C>                <C>                 <C>
  Net income                                                $     14,128,704   $     11,712,441    $     11,412,996
  Adjustments to reconcile net income
    to net cash provided by operating activities:
    Amortization of intangibles                                       24,996             24,996                   -
    Equity in undistributed earnings of subsidiary               (14,597,194)        (5,351,168)         (5,944,592)
    Other operating activities                                    (1,023,368)          (589,996)           (948,705)
                                                            -----------------  ----------------    ----------------

      Net cash provided by (used in) operating activities         (1,466,862)         5,796,273           4,519,699
                                                            -----------------  ----------------    ----------------

Investing activities:
  Payments for investments in and advances to subsidiary                   -                  -          (9,875,000)
  Repayments of advances to subsidiary                                     -                  -             155,172
  Upstream dividend received from First South Bank                 5,895,276                  -                   -
                                                            ----------------   ----------------    ----------------

      Net cash provided by (used in) investing activities          5,895,276                  -          (9,719,828)
                                                            ----------------   ----------------    ----------------

Financing activities:
  Proceeds from exercise of stock options                          1,012,468            680,826           1,984,697
  Proceeds from issuance of junior subordinated debentures                 -                  -          10,000,000
  Purchase of treasury shares                                       (336,726)        (2,212,690)         (3,463,652)
  Cash paid for dividends and fractional shares                   (4,867,849)        (4,032,865)         (3,328,473)
                                                            -----------------  ----------------    ----------------

      Net cash provided by (used in) financing activities         (4,192,107)        (5,564,729)          5,192,572
                                                            -----------------  ----------------    ----------------

Net increase (decrease) in cash                                      236,307            231,544              (7,557)

Cash at beginning of year                                          1,071,439            839,895             847,452
                                                            ----------------   ----------------    ----------------

Cash at end of year                                         $      1,307,746   $      1,071,439    $        839,895
                                                            ================   ================    ================

16. QUARTERLY FINANCIAL DATA (UNAUDITED)

Summarized unaudited quarterly financial data for the years ended December 31,
2005 and 2004 is as follows (in thousands):

                                                  Fourth             Third            Second             First
                                              --------------    --------------    ---------------   ---------------
2005
Interest income                               $       14,931    $       13,912    $        12,602   $        11,732
Interest expense                                       4,560             4,350              3,588             2,965
Provision for loan losses                                266               394                413               638
Noninterest income                                     2,133             2,265              1,909             1,901
Noninterest expense                                    5,507             5,432              5,222             4,973
Income tax expense                                     2,615             2,327              2,057             1,949
                                              --------------    --------------    ---------------   ---------------

Net income                                    $        4,116    $        3,674    $         3,231   $         3,108
                                              ==============    ==============    ===============   ===============

Net income per common share
   Basic                                      $          .65    $          .59    $           .51   $           .49
   Diluted                                    $          .62    $          .56    $           .49   $           .47
</TABLE>

                                       37
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 16. QUARTERLY FINANCIAL DATA (UNAUDITED) (Continued)

<TABLE>
<CAPTION>
                                                  Fourth             Third            Second             First
                                              --------------    --------------    ---------------   ---------------
2004
<S>                                           <C>               <C>               <C>               <C>
Interest income                               $       10,831    $       10,177    $         9,810   $         9,361
Interest expense                                       2,658             2,481              2,289             2,264
Provision for loan losses                                300               268                400                 -
Noninterest income                                     2,071             2,235              2,288             2,156
Noninterest expense                                    5,055             4,880              4,791             4,865
Income tax expense                                     1,847             1,792              1,714             1,612
                                              --------------    --------------    ---------------   ---------------

Net income                                    $        3,042    $        2,991    $         2,904   $         2,776
                                              ==============    ==============    ===============   ===============

Net income per common share
   Basic                                      $          .49    $          .48    $           .47   $           .44
   Diluted                                    $          .46    $          .46    $           .44   $           .42
</TABLE>

17. FAIR VALUES OF FINANCIAL INSTRUMENTS

Statement of Financial  Accounting  Standards No. 107,  "Disclosures  about Fair
Value of Financial  Instruments"  ("SFAS No. 107"),  requires the  disclosure of
estimated  fair values for  financial  instruments.  Quoted  market  prices,  if
available,  are  utilized  as  an  estimate  of  the  fair  value  of  financial
instruments. Because no quoted market prices exist for a significant part of the
Company's  financial  instruments,  the fair value of such  instruments has been
derived  based on  management's  assumptions  with  respect  to future  economic
conditions,  the amount and timing of future cash flows and  estimated  discount
rates  with  respect  to future  economic  conditions,  the amount and timing of
future cash flows and estimated  discount  rates.  Different  assumptions  could
significantly  affect these  estimates.  Accordingly,  the net realizable  value
could be materially  different from the estimates  presented below. In addition,
the estimates are only indicative of individual  financial  instruments'  values
and should not be  considered  an  indication  of the fair value of the  Company
taken as a whole.

Fair values have been  estimated  using data which  management  considers as the
best available,  and estimation  methodologies deemed suitable for the pertinent
category of financial instrument.

The  estimation  methodologies,  resulting  fair values,  and recorded  carrying
amounts at December 31, 2005 and 2004 were as follows:

Cash and cash  equivalents  are by definition  short-term and do not present any
unanticipated  credit  issues.  Therefore,  the carrying  amount is a reasonable
estimate of fair value.  The estimated fair values of investment  securities and
mortgage  backed  securities  are  provided  in  Notes 2 and 3 to the  financial
statements. These are based on quoted market prices, when available. If a quoted
market  price is not  available,  fair value is estimated  using  quoted  market
prices for similar securities.

The fair value of the net loan  portfolio has been  estimated  using the present
value of  expected  cash flows,  discounted  at an interest  rate  adjusted  for
servicing costs and giving consideration to estimated prepayment risk and credit
loss factors, as follows:

<TABLE>
<CAPTION>
                                                      December 31, 2005                    December 31, 2004
                                              --------------------------------    ---------------------------------
                                                 Estimated         Carrying          Estimated         Carrying
                                                fair value          amount          fair value          amount
                                              --------------    --------------    ---------------   ---------------

<C> <C>                                       <C>               <C>               <C>               <C>
1 - 4 family mortgages                        $   67,994,412    $   67,292,687    $    67,490,001   $    66,279,446
Consumer                                          99,701,568       100,544,156         96,368,010        97,559,892
Non-residential                                  539,983,074       539,983,074        467,976,697       467,976,697
                                              --------------    --------------    ---------------   ---------------

                                              $  707,679,054    $  707,819,917    $   631,834,708   $   631,816,035
                                              ==============    ==============    ===============   ===============
</TABLE>

                                       38
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

 17. FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

The  fair  value of  deposit  liabilities  with no  stated  maturities  has been
estimated to equal the carrying amount (the amount payable on demand),  totaling
$266,389,243 and $258,338,325 at December 31, 2005 and 2004,  respectively.  The
fair value  estimates  for these  products do not reflect the benefits  that the
Bank receives from the low-cost,  long-term funding they provide. These benefits
are considered significant.

The  fair  value of  certificates  of  deposits  and  advances  from the FHLB is
estimated by  discounting  the future cash flows using the current rates offered
for similar  deposits  and  advances  with the same  remaining  maturities.  The
carrying  value and estimated  fair values of  certificates  of deposit and FHLB
advances at December 31, 2005 and 2004 are as follows:

                                                    2005              2004
                                               ---------------   ---------------
Certificates of deposits
   Carrying amount                             $   467,363,822   $   370,198,380
   Estimated fair value                            466,326,243       371,886,000

Advances for Federal Home Loan Bank:
   Carrying amount                             $     5,500,000   $    10,500,000
   Estimated fair value                              5,500,000        10,500,000

The carrying amount of accrued interest receivable, FHLB stock, note receivable,
junior  subordinated  debentures,   accrued  interest  payable,  and  repurchase
agreements approximates their fair value.

There is no material  difference  between the carrying amount and estimated fair
value of  off-balance  sheet items totaling  $212,520,000  and  $228,272,000  at
December  31, 2005 and 2004,  respectively,  which are  primarily  comprised  of
unfunded loan commitments.

The Company's  remaining  assets and  liabilities  are not considered  financial
instruments.

18. SUPPLEMENTAL CASH FLOW INFORMATION

Supplemental  cash flow  information for the years ended December 31, 2005, 2004
and 2003 is as follows:

<TABLE>
<CAPTION>
                                                                             Year ended December 31,
                                                                ---------------------------------------------------
                                                                     2005              2004              2003
                                                                --------------    ---------------   ---------------

<S>                                                             <C>               <C>               <C>
Real estate acquired in settlement of loans                     $      793,184    $       193,709   $       468,201
Exchange of loans for mortgage-backed securities                    16,354,875          2,841,484         8,952,095
Cash paid for interest                                              15,443,427          9,741,103        10,217,536
Cash paid for income taxes                                           9,272,923          4,452,185         6,935,904
Dividends declared, not paid                                         1,267,910          1,070,482           838,067
</TABLE>

Noncash assets acquired in branch acquisitions are presented in Note 20.

19.   JUNIOR SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST AND
      CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES OF
      SUBSIDIARY TRUST HOLDING SOLELY DEBENTURES OF THE COMPANY

The Company has sponsored a trust, First South Preferred Trust I (the Trust), of
which 100% of the common  equity is owned by the  Company.  The Trust was formed
for the purpose of issuing  company-obligated  preferred  trust  securities (the
Preferred Trust Securities) to third-party  investors and investing the proceeds
from the sale of such Preferred Trust Securities  solely in junior  subordinated
debt  securities  of the  Company  (the  Debentures).

                                       39
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005, 2004 and 2003
--------------------------------------------------------------------------------

19.   JUNIOR SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST AND
      CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES OF
      SUBSIDIARY TRUST HOLDING SOLELY DEBENTURES OF THE COMPANY (Continued)

The Debentures held by the Trust are the sole assets of the Trust. Distributions
on the Preferred Trust Securities issued by the Trust are payable quarterly at a
rate equal to the interest rate being earned by the Trust on the Debentures held
by  that  Trust.  The  Preferred  Trust  Securities  are  subject  to  mandatory
redemption,  in whole or in part, upon repayment of the Debentures.  The Company
has entered into an agreement,  which fully and  unconditionally  guarantees the
Preferred Trust Securities subject to the terms of the guarantee. The Debentures
held by the Trust are first  redeemable,  in whole or in part, by the Company on
after September 30, 2008.

In the fourth  quarter of 2003,  as a result of applying the  provisions  of FIN
46R,  governing when an equity interest should be consolidated,  the Company was
required to deconsolidate  the subsidiary  Trust from its financial  statements.
The deconsolidation of the net assets and results of operations of the Trust had
virtually no impact on the Company's financial  statements or liquidity position
since the Company  continues to be obligated to repay the Debentures held by the
Trust and guarantees  repayment of the Preferred Trust Securities  issued by the
Trust. The consolidated debt obligation  related to the Trust increased from $10
million to $10.3 million upon deconsolidation  with the difference  representing
the Company's common ownership interest in the Trust.

Subject to certain  limitations,  the Junior Subordinated  Debentures qualify as
Tier I capital for the Company under Federal Reserve Board guidelines.

Consolidated  debt  obligations  as of December 31, 2005 related to a subsidiary
Trust holding solely Debentures of the Company follows:

<TABLE>
<CAPTION>
         LIBOR + 2.95% junior subordinated debentures owed to
<S>                                                  <C> <C>                            <C>
         First South Preferred Trust I due September 26, 2033                           $        10,000,000

         LIBOR + 2.95% junior subordinated debentures owed to
         First South Preferred Trust I due September 26, 2033                                       310,000
                                                                                        -------------------

         Total junior subordinated debentures owed to unconsolidated subsidiary trust   $        10,310,000
                                                                                        ===================

20.     ACQUISITIONS

On February 20,  2004,  the Company  completed  the  acquisition  of two Central
Carolina Bank (CCB) retail banking locations. This acquisition was accounted for
using the purchase method of accounting and the Bank assumed the deposits of the
two CCB branches for a premium of approximately 1.5% of the assumed deposits.

The  fair  value  of  assets,  including  identifiable  intangible  assets,  and
liabilities assumed were as follows (in thousands):

Loans receivable                                                                        $             2,212
Premises and equipment                                                                                   75
Core deposit intangible                                                                                 314
Deposits                                                                                            (18,373)
                                                                                        -------------------

Net cash received in branch acquisitions                                                $           (15,772)
                                                                                        ===================
</TABLE>

The Company recorded $31,440 and $23,668 in core deposit intangible amortization
expense  during  the years  ended  December  31,  2005 and  2004,  respectively.
Amortization   expense   related  to  this   intangible  is  anticipated  to  be
approximately $31,000 per year over the next 5 years, with the remaining balance
totaling approximately $104,000 to be amortized thereafter.  These estimates are
subject to change in future  periods to the extent  management  determines it is
necessary to make  adjustments to the carrying value or estimated useful life of
this amortizing intangible asset.

                                       40

<PAGE>



<TABLE>
<CAPTION>
                                                        BOARD OF DIRECTORS

<C>                               <C>                            <C>                             <C>
FREDERICK N. HOLSCHER             MARSHALL T. SINGLETON          LINLEY H. GIBBS, JR.            FREDERICK H. HOWDY
CHAIRMAN                          VICE CHAIRMAN                  Retired                         President
Partner                           Co-Owner                       Washington, NC                  Drs. Freshwater & Howdy, P.A.
Rodman, Holscher, Francisco,      B. E. Singleton & Sons                                         Washington, NC
& Peck, P.A.                      Washington, NC
Washington, NC

CHARLES E. PARKER, JR.            H. D. REAVES, JR.              THOMAS A. VANN
Senior Vice President             Former President and           President and
Robinson & Stith Insurance        Chief Executive Officer        Chief Executive Officer
New Bern, NC                      Home Federal Savings & Loan    First South Bank
                                  Fayetteville, NC               Washington, NC

                                                         EXECUTIVE OFFICERS

THOMAS A. VANN                    ROBERT E. BRANCH               WILLIAM L. WALL                 JAMES W. HOOSE, JR.
President and                     Executive Vice President       Executive Vice President        Executive Vice President
Chief Executive Officer           Chief Operating Officer        Chief Financial Officer and     Chief Credit Officer
                                                                 Secretary

SHERRY L. CORRELL                 LARRY W. MALLARD               PAUL S. JABER                   MARY R. BOYD
Executive Vice President          Executive Vice President       Executive Vice President        Executive Vice President
Deposit Operations                Retail Banking                 Mortgage Operations             Loan Servicing

KRISTIE W. HAWKINS
Treasurer
Controller

                                                    AREA & SUBSIDIARY EXECUTIVES

JAMES F. BUCKMAN, IV              DENNIS A. NICHOLS              RUSSEL A. LAY                   DONNIE L.G. BUNN
Senior Vice President             Senior Vice President          Senior Vice President           President
Area Executive                    Area Executive                 Area Executive                  First South Leasing, LLC.
Pamlico Region                    Neuse Region                   Albemarle Region                Greenville

                                                      CITY & BRANCH EXECUTIVES

GEORGE R. HAMILTON                PHILLIP B. HARRIS, JR.         JOSEPH M. JOHNSON               THOMAS. S. LEWIS
Senior Vice President             Senior Vice President          Senior Vice President           Vice President
Branch Executive                  City Executive                 City Executive                  Branch Executive
Rocky Mount                       Fayetteville/Hope Mills        Durham                          Rocky Mount

KENNETH W. MARSHALL, JR.          PHILIP W. MCCUMBEE             WILLIAM P. STONE                DONALD B. STRICKLAND, JR.
Assistant Vice President          Senior Vice President          Vice President                  Senior Vice President
City Executive                    Branch Executive               City Executive                  City Executive
Avon                              Tarboro                        Lumberton                       Greenville

CLYLE F. SWANNER, JR.             GUY P. WILLIAMS, JR.           WILLIAM T. WRENN
Vice President                    Senior Vice President          Vice President
City Executive                    City Executive                 City Executive
Washington/Chocowinity            New Bern                       Elizabeth City

                                        41
</TABLE>
<PAGE>

 <TABLE>
<CAPTION>
                            FIRST SOUTH BANK OFFICE LOCATIONS

<C>                               <C>                               <C>
AVON                              LUMBERTON                         WASHINGTON
40894 NC Highway 12, Suite 1      600 North Chestrnut Street*       1311 Carolina Avenue*
Avon, NC 27915                    Lumberton, NC 28359               Washington, NC 27889
(252) 995-3095                    (910) 739-3274                    (252) 946-4178

 CHOCOWINITY                       3000 North Elm Street*            300 North Market Street*
2999 Highway 17 South*            Lumberton, NC 28359               Washington, NC 27889
Chocowinity, NC 27817             (910) 608-5031                    (252) 940-4945
(252) 940-4970

DURHAM                            NEW BERN                          1328 John Small Avenue*
1802 Martin Luther King Jr. Pkwy  202 Craven Street                 Washington, NC 27889
Suite 108                         New Bern, NC 28561                (252) 940-5000
Durham, NC 27707                  (252) 636-2997
(919) 403-1000                                                      CREDIT ADMINISTRATION
                                  1725 Glenburnie Road*             239 West Main Street
                                  New Bern, NC 28561                Washington, NC 27889
ELIZABETH CITY                    (252) 636-3569                    (252) 946-4178
604 East Ehringhaus Street*
Elizabeth City, NC 27906          2019 South Glenburnie Road*       OPERATIONS CENTER
(252) 335-0848                    New Bern, NC 28561                220 Creekside Drive
                                  (252) 637-1111                    Washington, NC 27889
FAYETTEVILLE                                                        (252) 946-4178
241 Green Street*                 ROCKY MOUNT
Fayetteville, NC 28302            300 Sunset Avenue*                LOAN PRODUCTION OFFICE
(910) 438-3681                    Rocky Mount, NC 27804             2600 North Croatan Highway
                                  (252) 972-9661                    Suite 202
3107 Raeford Road*                                                  Kill Devil Hills, NC 27948
Fayetteville, NC 28302            2901 Sunset Avenue*               (252) 441-8743
(910) 484-2116                    Rocky Mount, NC 27804
                                  (252) 451-1259                    FIRST SOUTH LEASING
GREENVILLE                                                          1035 Director Court, Unit C
301 East Arlington Boulevard*     1378 Benvenue Road*               Greevnille, NC 27858
Greenville, NC 27835              Rocky Mount, NC 27804             (252) 355-4536
(252) 321-2600                    (252) 442-8375
                                                                    UVEST INVESTMENT CONSULTANTS
907 East Firetower Road*          450 North Winstead Avenue*
Greenville, NC 27835              Rocky Mount, NC 27804             Steve Wiggins
(252) 355-4644                    (252) 937-1900                    1311 Carolina Avenue
                                                                    Washington, NC 27889
HOPE MILLS                        3635 North Halifax Road*          (252) 940-4904
3103 North Main Street*           Rocky Mount, NC 27804
Hope Mills, NC 28348              (252) 451-8700                    Chris Harp
(910) 423-0952                                                      2901 Sunset Avenue
                                  RALEIGH                           Rocky Mount, NC 27804
KILL DEVIL HILLS                  4800 Six Forks Road, Suite 115*   (252) 451-1259
1906 South Croatan Highway*       Raleigh, NC 27609
Kill Devil Hills, NC 27948        (919) 783-5222                    Brian Tarumoto
(252) 441-9935                                                      241 Green Street
                                  TARBORO                           Fayetteville, NC 28302
KINSTON                           100 East Hope Lodge Street*       (910) 483-3686
2430 Heritage Street*             Tarboro, NC 27886
Kinston, NC 28503                 (252) 823-0157                    * Designates an ATM Location
(252) 523-9449
</TABLE>

                                        42

<PAGE>


                                              STOCKHOLDER INFORMATION

Corporate Headquarters
         First South Bancorp, Inc.             Telephone:  252-946-4178
         1311 Carolina Avenue                        Fax:  252-946-3873
         Washington, NC  27889                    E-mail:  info@firstsouthnc.com
                                                 Website: www.firstsouthnc.com

Stock Listing Information
The Company's common stock is listed and trades on the Nasdaq Stock Market under
the symbol FSBK. As of March 1, 2006, there were 888 registered  stockholders of
record.

 Stock Price Information
The  following  is the high and low  trading  price  information  and  dividends
declared per share for the periods indicated.

         Quarter Ended                  High         Low      Dividends
         -------------                 ------       ------   ----------
         March 31, 2005                $   28.50 $   23.43      $   .20
         June 30, 2005                     36.25     27.31          .20
         September 30, 2005                36.19     31.19          .20
         December 31, 2005                 38.00     29.47          .20

         March 31, 2004 (1)                25.87     21.00          .17
         June 30, 2004                     26.96     21.25          .17
         September 30, 2004                25.09     22.41          .17
         December 31, 2004                 25.94     24.50          .17
         ----------------
         (1) Adjusted for three-for-two stock split on April 23, 2004.

 Registrar and Transfer Agent
Inquiries regarding stock transfer,  registration,  lost certificates or changes
in name and address  should be directed to the  Company's  stock  registrar  and
transfer agent: Registrar and Transfer Company, 10 Commerce Drive, Cranford, New
Jersey 07016; via the Internet at www.rtco.com; or toll-free at (800) 866-1340.

 Form 10-K
The Annual Report on Form 10-K of the Company as filed with the  Securities  and
Exchange  Commission is available  via the Internet on the Company's  website at
www.firstsouthnc.com  under the  headings  "About Us - Newsroom  - SEC  Filings:
EDGAR-Online". Shareholders will be provided a copy without charge by writing to
the Corporate Secretary,  William L. Wall, First South Bancorp,  Inc., P. O. Box
2047, Washington, NC 27889.

 Investor Information

Shareholders,  investors,  and analysts interested in additional information may
contact William L. Wall, Chief Financial Officer,  First South Bancorp, Inc.,
P.O. Box 2047, Washington, NC 27889; or via email to bwall@firstsouthnc.com.

 Annual Meeting
The Annual Meeting of  Stockholders  of First South  Bancorp,  Inc. will be held
Thursday,  May 25, 2006 at 11:00  a.m.,  at the main office of First South Bank,
1311 Carolina Avenue, Washington, North Carolina.

 <TABLE>
<CAPTION>
<S>                                          <C>                                        <C>
General Counsel                              Special Counsel                            Independent Accountants
Rodman, Holscher, Francisco & Peck, PA       Muldoon Murphy & Aguggia LLP               Dixon Hughes PLLC
320 North Market Street                      5101 Wisconsin Avenue, NW                  408 Summit Drive
Washington, NC  27889                        Washington, DC 20016                       Sanford, NC 27331
</TABLE>

                                       43