SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K

                        FOR ANNUAL AND TRANSITION REPORTS
                     PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934
(Mark One)
[ ]  ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE
     ACT OF 1934

For the fiscal year ended ___________________

                                   OR

[X]  TRANSITION  REPORT  PURSUANT  TO  SECTION  13 OR  15(d)  OF THE  SECURITIES
     EXCHANGE ACT OF 1934

For the transition period from October 1, 2001 to December 31, 2001

                           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 $.01 per share
                     --------------------------------------
                                (Title of Class)

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. [ ]

As of March 6, 2002,  the  aggregate  market  value of the  2,176,682  shares of
Common Stock of the registrant  issued and outstanding held by non-affiliates on
such date was  approximately  $81.6  million  based on the closing sale price of
$37.51  per share of the  registrant's  Common  Stock as  listed  on the  Nasdaq
National Market. 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 6, 2002:  2,954,617.

                       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 Proxy Statement for 2002 Annual Meeting of Stockholders.  (Part
     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. (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  investing  the  portion  of the net stock  conversion
proceeds retained by it.

     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 loans secured by first mortgages on
owner-occupied,  single-family  residences in the Bank's market area, commercial
real estate loans, commercial business loans and consumer loans.

     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  eastern
North Carolina, the Company's primary market area consists of Beaufort,  Craven,
Cumberland,  Edgecombe,  Lenoir, Nash, Pasquotank,  Pitt and Robeson Counties in
North Carolina,  which are the counties in which the Bank's offices are located.
As of December 31, 2001, 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.  Major  employers  in the area include PCS  Phosphate,  Weyerhaeuser
Company,  Dupont, Abbott Laboratories,  East Carolina University,  Pitt Memorial
Hospital,  Kelly  Springfield  Tire  Company,  Fort Bragg,  Pope Air Force Base,
Converse,  Campbell Soup and Kaiser-Roth  Hosiery among others. 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>

LENDING ACTIVITIES

     General.  The Company's  gross loan  portfolio  totaled  $428.0  million at
December 31, 2001,  representing  77.9% of total assets at that date.  It is the
Company's  policy to concentrate its lending within its market area. At December
31,  2001,  $110.2  million,  or 25.7% of the  Company's  gross loan  portfolio,
consisted  of   single-family,   residential   mortgage  loans.   The  Company's
residential  construction loans totaled $23.3 million,  or 5.4% of the Company's
gross loan  portfolio,  at December  31,  2001.  The Company  also  originates a
significant  amount of  commercial  real estate  loans.  At December  31,  2001,
commercial  real  estate  loans  amounted  to  $172.6  million,  or 40.3% 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, 2001,  commercial  business loans totaled $35.7 million, or 8.4% of
the Company's gross loan portfolio, and consumer loans totaled $77.8 million, or
18.2% of the Company's  gross loan  portfolio.  To a lesser extent,  the Company
also originates multi-family residential real estate loans.


                                       2
<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, 2001, the Company had no concentrations of
loans exceeding 10% of gross loans other than as disclosed below.


<TABLE>
<CAPTION>
                                            At December 31,                     At September 30,
                                         -------------------     -------------------------------------------
                                                   2001                     2001                  2000
                                         -------------------     -------------------     -------------------
                                           Amount        %         Amount         %        Amount        %
                                         ----------     ----     ----------     ----     ----------   ------
                                                              (Dollars in thousands)
<S>                                      <C>            <C>      <C>            <C>      <C>            <C>
Residential mortgage loans:
  Single-family residential............  $  110,217     25.7%    $   99,620     25.1%    $  135,572     34.5%
  Multi-family residential.............       8,399      2.0          9,470      2.4          6,747      1.7
  Construction.........................      23,305      5.4         23,829      6.0         29,332      7.5
                                         ----------    -----     ----------    -----     ----------    -----
    Total residential mortgage loans...     141,921     33.1        132,919     33.5        171,651     43.7
                                         ----------    -----     ----------    -----     ----------    -----

Commercial loans:
  Commercial real estate...............     172,621     40.3        149,821     37.7        111,062     28.3
  Commercial business..................      35,694      8.4         36,107      9.1         34,914      8.9
                                         ----------    -----     ----------    -----     ----------    -----
    Total commercial loans.............     208,315     48.7        185,928     46.8        145,976     37.2
                                         ----------    -----     ----------    -----     ----------    -----

Consumer loans:
  Automobile...........................       5,674      1.3          6,259      1.6          5,718      1.4
  Savings account loans................       1,438       .3          1,258       .3            997       .3
  Home equity loans....................      34,947      8.2         36,826      9.3         35,845      9.1
  Other................................      35,717      8.4         33,842      8.5         32,442      8.3
                                         ----------    -----     ----------    -----     ----------    -----
    Total consumer loans...............      77,776     18.2         78,185     19.7         75,002     19.1
                                         ----------    -----     ----------    -----     ----------    -----
      Total............................     428,012    100.0%       397,032    100.0%       392,629    100.0%
                                         ----------    =====     ----------    =====     ----------    =====

Less:
  Loans in process.....................      16,220                  16,795                  20,357
  Deferred fees and discounts..........         808                     749                     903
  Allowance for loan losses............       5,371                   5,401                   5,159
                                         ----------              ----------              ----------
    Total..............................  $  405,613              $  374,087              $  366,210
                                         ==========              ==========              ==========

<CAPTION>

                                                              At September 30,
                                            --------------------------------------------------------------------
                                                     1999                    1998                   1997
                                             ---------------------      ------------------       ----------------
                                               Amount       %            Amount       %           Amount      %
                                             ---------    -----         ----------   -----       --------   -----
                                                                     (Dollars in thousands)

<S>                                            <C>           <C>       <C>           <C>       <C>          <C>
Residential mortgage loans:
  Single-family residential............        $  62,422     27.2%     $   91,546    37.8%     $  67,959    31.7%
  Multi-family residential.............              379       .2             848      .4            946      .4
  Construction.........................           25,809     11.3          27,817    11.5         33,249    15.5
                                               ---------    -----      ----------   -----       --------   -----
    Total residential mortgage loans...           88,610     38.7         120,211    49.7        102,154    47.6
                                               ---------    -----      ----------   -----       --------   -----

Commercial loans:
  Commercial real estate...............           68,403     29.9          51,480    21.3         45,990    21.4
  Commercial business..................           21,106      9.2          21,823     9.0         16,449     7.7
                                               ---------    -----      ----------   -----       --------   -----
    Total commercial loans.............           89,509     39.1          73,303    30.3         62,439    29.1
                                               ---------    -----      ----------   -----       --------   -----

Consumer loans:
  Automobile...........................            4,291      1.9           4,575     1.9          4,611     2.2
  Savings account loans................              620       .3             470      .2            617      .3
  Home equity loans....................           23,795     10.4          22,898     9.5         21,665    10.1
  Other................................           22,141      9.6          20,443     8.4         22,996    10.7
                                               ---------    -----      ----------   -----       --------   -----
    Total consumer loans...............           50,847     22.2          48,386    20.0         49,889    23.3
                                               ---------    -----      ----------   -----       --------   -----
      Total............................          228,966    100.0%        241,900   100.0%       214,482   100.0%
                                               ---------    =====      ----------   =====       --------   =====

Less:
  Loans in process.....................           13,102                   12,930                 12,717
  Deferred fees and discounts..........              513                      606                    731
  Allowance for loan losses............            3,297                    3,365                  3,249
                                               ---------               ----------              ---------
    Total..............................        $ 212,054               $  224,999              $ 197,785
                                               =========               ==========              =========
</TABLE>

                                       3
<PAGE>

     Loan  Maturities.  The following  table sets forth certain  information  at
December 31, 2001 regarding the dollar amount of loans maturing in the Company's
portfolio  based on their  contractual  terms to maturity,  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 loans in process.



<TABLE>
<CAPTION>
                                                             Due After               Due After
                                                             1 Through               5 or More
                                       Due One             5 Years After            Years After
                                    Year or Less         December 31, 2001       December 31, 2001        Total
                                    ------------         -----------------       -----------------        -----
                                                                       (In thousands)
<S>                                  <C>                  <C>                       <C>                <C>
Real estate loans.................   $  169,674           $   118,305               $  68,629          $  356,608
Commercial........................       23,472                12,063                     159              35,694
Other.............................        9,323                 9,971                     196              19,490
                                     ----------           -----------               ---------          ----------
     Total........................   $  202,469           $   140,339               $  68,984          $  411,792
                                     ==========           ===========               =========          ==========
</TABLE>

     The  following  table sets forth at December 31, 2001 the dollar  amount of
all loans due one year or more after December 31, 2001 which have  predetermined
interest rates and have floating or adjustable interest rates.

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

Real estate loans......................  $  149,319            $   37,615
Commercial.............................      10,175                  2,047
Other..................................      10,167                     --
                                         ----------             ----------
     Total.............................  $  169,661             $   39,662
                                         ==========             ==========


     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.  All of the Bank's loan personnel
are  salaried,  and  though the Bank does not  compensate  loan  personnel  on a
commission basis for loans  originated,  it does pay an incentive  percentage of
closed  mortgage  loan volume once a defined  threshold has been achieved by the
participant. 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.

                                       4
<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 transition  period ended December 31, 2001 and during
the years ended September 30, 2001, 2000 and 1999,  these  transactions  totaled
$12.0  million,  $49.4 million,  $62.8 million and $86.1 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   statements  and
confirmations.  In addition,  the Bank uses an automated  underwriting  software
program  owned  by  FHLMC  named  Loan  Prospector  on  the  majority  of  loans
underwritten  for sale to FHLMC  and  other  investor  programs.  All  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
$500,000  must be approved by the full Board of Directors.  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.  Generally,  upon receipt of a
loan application from a prospective  borrower, a credit report and verifications
are ordered 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 30 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 $425 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 97% 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 80%,
although  the  loan-to-value  ratio on  commercial  real estate loans in limited
circumstances has been as high as 85%. The Bank limits the  loan-to-value  ratio
on multi-family residential real estate loans to 80%.

     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 $7.0  million at  December  31,  2001.  At that date the Bank had no
lending relationships in excess of the loans-to-one-borrower limit.

     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

                                       5
<PAGE>

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,  2001,  single-family,  residential
mortgage loans,  excluding home improvement  loans,  totaled $110.2 million,  or
25.7% of the Company's gross loan portfolio.

     The Bank  originates  fixed-rate  mortgage  loans at  competitive  interest
rates.  At  December  30,  2001,  $96.1  million,  or  67.7%,  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 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 and closed by a
correspondent lender.

     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, 2001, $45.8 million, or 32.3%,
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 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 1% 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,  except that if the permanent  loan rate would be above
the  construction  loan rate then the  borrower can maintain the same rate as

                                       6
<PAGE>

on the construction  loan.  Interest rates on residential  construction loans to
builders  are set at the prime rate plus a margin of  between  .50% and 1% or at
the  Treasury  Rate plus a margin of between 3% and 4.5%,  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 annually,  with construction
terms  generally not  exceeding 18 months.  Advances are made on a percentage of
completed basis. At December 31, 2001, $23.3 million,  or 5.4%, of the Company's
gross loan portfolio consisted of construction loans, virtually all of which was
secured by single-family residences.

     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 either weekly or
biweekly during the term of the construction  loan. The Bank generally charges a
..50% to 1% 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, 2001,  multi-family  residential  and
commercial   real  estate  loans  totaled  $8.4  million  and  $172.6   million,
respectively,  which amounted to 2.0% and 40.3%, 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 year  amortization  schedule
with a balloon payment due after five 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.

                                       7
<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 adjust at least  annually at a rate equal to
the prime rate as stated in The Wall Street  Journal plus a margin of between 0%
and 2%.  Generally,  commercial loans are made in amounts ranging between $5,000
and  $250,000.  At December 31, 2001,  commercial  business  loans totaled $35.7
million, or 8.4% 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, 2001,  consumer loans totaled $77.8 million,  or 18.2% 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.

     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

                                       8
<PAGE>

collateral  to secure  the loan.  Interest  generally  is billed on a  quarterly
basis.  At December  31, 2001,  loans on  certificates  of deposit  totaled $1.4
million, or .3% of the Company's gross loan portfolio.

     At December 31, 2001, the Company had  approximately  $34.9 million in home
equity line of credit loans,  representing  approximately 8.2% 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.

     The Company  offers credit card loans through its  participation  as a Visa
and MasterCard issuer.  Management  believes that providing credit card services
to its  customers  helps the Bank remain  competitive  by offering  customers an
additional service,  and the Bank does not actively solicit credit card business
beyond its customer base and market area. The rate currently charged by the Bank
on its credit card loans  ranges from 12% to 17%,  and the Bank is  permitted to
change the interest rate on 30 days notice.  Processing of bills and payments is
contracted  to an outside  servicer.  At December  31,  2001,  the Company had a
commitment  to fund an  aggregate of $10.1  million of credit card loans,  which
represented the aggregate  credit limit on credit cards, and had $1.7 million of
credit card loans outstanding, representing .4% of its gross loan portfolio.

     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 .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.

                                       9
<PAGE>

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 5 of  Notes to
Consolidated Financial Statements for the Three Months Ended December 31, 2001.

     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 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 5 of
Notes to Consolidated  Financial  Statements for the Three Months Ended December
31, 2001.

     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                          At September 30,
                                                December 31,  -------------------------------------------------------------
                                                    2001        2001         2000         1999          1998       1997
                                                 -------      --------     ---------    ---------    ---------     --------
                                                                                   (Dollars in thousands)
<S>                                              <C>          <C>          <C>          <C>          <C>           <C>
Loans accounted for on a nonaccrual basis:
  Residential mortgage:
    Single-family............................    $   864      $    570     $   1,110    $     487    $     323     $    298
    Construction.............................         --            --           258           --          406          916
  Commercial real estate.....................        200           132            --           --           --           16
  Commercial business........................         83           228           139           48           25           14
  Consumer...................................        106           132           139           33           48           18
                                                 -------      --------     ---------    ---------    ---------     --------
    Total nonperforming loans................    $ 1,253      $  1,062     $   1,646    $     567    $     802     $  1,262
                                                 =======      ========     =========    =========    =========     ========
Percentage of total loans, net...............        .31%          .28%          .45%         .27%         .36%         .64%
                                                 =======      ========     =========    =========    =========     ========
Real estate owned............................    $   677      $    530     $     220    $     591    $     412     $    358
                                                 =======      ========     =========    =========    =========     ========

</TABLE>

     During the three months ended December 31, 2001,  additional gross interest
income of approximately  $51,000 would have been recorded on loans accounted for
on a  nonaccrual  basis if the loans had been  current  throughout  this period.
Interest  on such  loans  included  in income  during  the  period  amounted  to
approximately $18,000.

     At December 31, 2001,  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, 2001,  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.

                                       10
<PAGE>

     At December 31, 2001,  the Company had $1.3  million of  nonaccrual  loans,
which  consisted of 23  single-family  residential  real estate  loans  totaling
$864,000,  two commercial real estate loans totaling  $200,000,  four commercial
business loans totaling $83,000, and 22 consumer loans totaling $106,000.

     At December 31, 2001,  the Bank had  $677,000 of real estate  owned,  which
consisted of ten single-family  residences totaling $439,000 and four commercial
real estate properties totaling $238,000.

     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 three
classifications  for  problem  assets:  "substandard,"  "doubtful"  and  "loss."
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,  2001,  the  Company  had $10.9  million in
classified  assets,  including  $5.5  million  in assets  classified  as special
mention,  $4.7 million in assets  classified as substandard,  $680,000 in assets
classified as doubtful and no assets classified as loss.

     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.

                                       11
<PAGE>


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

<TABLE>
<CAPTION>
                                               Three Months
                                                  Ended                                   Year Ended September 30,
                                                December 31,  -------------------------------------------------------------
                                                  2001          2001         2000         1999         1998         1997
                                                 -------      --------     ---------    ---------    ---------     --------
                                                                                    (Dollars in thousands)
<S>                                              <C>          <C>          <C>          <C>          <C>           <C>
Balance at beginning of period...............    $ 5,401      $  5,159     $   3,297    $   3,365    $   3,249     $  2,351
                                                 -------      --------     ---------    ---------    ---------     --------

Loans charged-off:
Commercial business..........................         --           423            58          206          128           --
  Consumer...................................         42           233            99           58           74           72
                                                 -------      --------     ---------    ---------    ---------     --------
      Total charge-offs......................         42           656           157          264          202           72
                                                 -------      --------     ---------    ---------    ---------     --------

Recoveries:
  Residential real estate mortgage:
    Single-family residential................         --            --            --           --           --           33
  Commercial.................................          2            49            70           65           --           --
  Consumer...................................         10            19             9           11            8            6
                                                 -------      --------     ---------    ---------    ---------     --------
      Total recoveries.......................         12            68            79           76            8           39
                                                 -------      --------     ---------    ---------    ---------     --------
Net loans charged-off........................         30           588            78          188          194           33
                                                 -------      --------     ---------    ---------    ---------     --------

Additions:
Balance transferred in acquisition...........         --            --           963           --           --           --
Provision for loan losses....................         --           830           977          120          310          931
                                                 -------      --------     ---------    ---------    ---------     --------
      Total additions........................         --           830         1,940          120          310          931
                                                 -------      --------     ---------    ---------    ---------     --------
Balance at end of period.....................    $ 5,371      $  5,401     $   5,159    $   3,297    $   3,365     $  3,249
                                                 =======      ========     =========    =========    =========     ========
Ratio of net charge-offs to average
  loans outstanding during the period........        .01%          .16%          .02%         .08%         .09%         .02%
                                                 =======      ========     =========    =========    =========     ========
</TABLE>


                                       12
<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 September 30,
                                         At December 31,       ----------------------------------------------
                                             2001                    2001                    2000
                                        --------------------   --------------------   ----------------------
                                                  Percent of             Percent of              Percent of
                                                   Loans in               Loans in                Loans in
                                                 Category to             Category to             Category to
                                        Amount   Total Loans   Amount   Total Loans   Amount    Total Loans
                                        ------   -----------   ------   -----------   ------    -----------
                                                             (Dollars in thousands)
<S>                                   <C>            <C>      <C>          <C>        <C>          <C>
Residential mortgage................  $ 1,034        33.1%    $  1,034     33.5%      $  1,034     43.7%
Commercial (1)......................    3,243        48.7        3,241     46.8          3,125     37.2
Consumer............................    1,094        18.2        1,126     19.7          1,000     19.1
                                      -------       -----     --------    -----       --------    -----
  Total allowance for loan losses...  $ 5,371       100.0%    $  5,401    100.0%      $  5,159    100.0%
                                      =======       =====     ========    =====       ========    =====

<CAPTION>
                                                                 At September 30,
                                      -----------------------------------------------------------------------
                                              1999                 1998                       1997
                                       ----------------------- ---------------------     --------------------
                                                  Percent of             Percent of               Percent of
                                                   Loans in               Loans in                 Loans in
                                                  Category to             Category to             Category to
                                         Amount   Total Loans   Amount   Total Loans     Amount   Total Loans
                                         ------   -----------   ------   ----------      ------   -----------
                                                                (Dollars in thousands)
<S>                                    <C>           <C>      <C>            <C>        <C>           <C>
Residential mortgage................   $  1,071      38.7%    $   1,071      49.7%      $  1,070      47.6%
Commercial (1)......................      1,577      39.1         1,598      30.3          1,456      29.1
Consumer............................        649      22.2           696      20.0            723      23.3
                                       --------     -----     ---------     -----       --------     -----
  Total allowance for loan losses...   $  3,297     100.0%    $   3,365     100.0%      $  3,249     100.0%
                                       ========     =====     =========     =====       ========     =====
</TABLE>
---------------
(1)      Includes commercial real estate and commercial business loans.


                                       13
<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, 2001,  the  Company's  mortgage-backed  securities  and  investment
securities portfolio amounted to $43.9 million and $54.1 million,  respectively.
At such  date,  the  Company  had an  unrealized  gain of $2.6  million,  net of
deferred taxes,  with respect to its securities,  all of which are classified as
available for sale.

     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,  2001,   the   Company's
mortgage-backed  securities  amounted to $43.9 million, or 8.0% 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  collaterize  borrowings or
other  obligations  of the Bank.  At December  31,  2001,  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  and
owned by the 12 FHLBs and  federally  insured  savings  institutions.  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
$275,000.

     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, 2001,  mortgage-backed securities with an amortized cost of
$43.1  million and a carrying  value of $43.9 million were held as available for
sale, and no  mortgage-backed  securities  were  classified as held to maturity.
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

                                       14
<PAGE>

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 and 4 of the Notes to Consolidated  Financial  Statements in
the Annual Report. At December 31, 2001, the Bank's  mortgage-backed  securities
had a weighted average yield of 6.64%.

     At December 31, 2001,  the average  contractual  maturity of the  Company's
fixed-rate  mortgage-backed  securities was  approximately  14 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, 2001, the Company's  entire  portfolio of investment  securities
was  classified  available for sale and amounted to $54.1  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,
2001,  the  estimated  average  life  of  the  Company's  investment  securities
portfolio was  approximately  3.5 years. In addition,  at December 31, 2001, the
Company had $2.7 million of FHLB stock.


                                       15
<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, 2001.


<TABLE>
<CAPTION>
                              One Year or Less       One to Five Years   Five to Ten Years
                             -------------------    ------------------   ------------------
                              Carrying  Average     Carrying   Average    Carrying  Average
                               Value     Yield        Value     Yield      Value     Yield
                              --------   ------      --------   ------     -------   ------
                                                  (Dollars in thousands)
<S>                           <C>        <C>          <C>        <C>        <C>       <C>
Securities available for sale:
   U.S. government and
    agency  securities......  $     --       --%     $ 48,510   6.33%      $ 5,551   7.21%
   Mortgage-backed
    securities..............        --       --           451   6.57         3,075   6.40
Securities held to maturity:
   FHLB stock (1)...........        --       --            --     --            --     --
                              --------   ------      --------   ----       -------   ----

      Total.................  $     --       --%     $ 48,961   6.33%      $ 8,626   6.92%
                              ========   ======      ========   ====       =======   ====


<CAPTION>

                                More than Ten Years         Total Investment Portfolio
                              ---------------------    --------------------------------
                               Carrying     Average    Carrying     Amortized   Average
                                 Value       Yield       Value         Cost       Yield
                                ---------    ----       --------     ---------   -------
                                                  (Dollars in thousands)
<S>                              <C>         <C>        <C>           <C>         <C>
Securities available for sale
   U.S. government and
    agency  securities......    $      --      --%      $ 54,061      $ 50,508    6.42%
   Mortgage-backed
    securities..............       40,378    6.66         43,904        43,054    6.64
Securities held to maturity:
   FHLB stock (1)...........        2,713    6.25          2,713         2,713    6.25
                                ---------    ----       --------     ---------    ----

      Total.................    $  43,091    6.63%      $100,678     $  96,275    6.51%
                                =========    ====       ========     =========    ====
</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.


                                       16
<PAGE>

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

<TABLE>
<CAPTION>
                                                           At               At September 30,
                                                       December 31,    -----------------------------------
                                                           2001           2001        2000         1999
                                                       ---------       ---------    ---------    ---------
                                                                           (In thousands)
<S>                                                    <C>             <C>          <C>          <C>
Securities available for sale:
   U.S. government and agency securities...........    $  54,061       $  54,742    $  45,186    $   3,024
   Mortgage-backed securities......................       43,904          48,603      108,519       56,326
                                                       ---------       ---------    ---------    ---------
      Total........................................       97,965         103,345      153,705       59,350

Securities held to maturity:
                            -
   FHLB stock......................................        2,713           2,713        2,651        1,460
                                                       ---------       ---------    ---------    ---------
      Total........................................    $ 100,678       $ 106,058    $ 156,356    $  60,810
                                                       =========       =========    =========    =========
</TABLE>


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 borrow 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 seventeen office
locations.

                                       17
<PAGE>

     The  following  tables set forth the  distribution  of the  Bank's  deposit
accounts at the dates  indicated,  the weighted  average  interest rates and the
change in dollar  amounts for each  category of deposits  presented.  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>
                                                      As of and for the            As of and for the
                                                      Three Months Ended        Year Ended September 30,
                                                          December 31,         -------------------------
                                                              2001                       2001
                                                      ---------------------    -------------------------
                                                                   Weighted                    Weighted
                                                                    Average                     Average
                                                      Amount         Rate          Amount        Rate
                                                     ---------       -----        --------      -----
                                                                    (Dollars in thousands)
<S>                                                  <C>               <C>        <C>            <C>
Demand accounts:
  Checking.........................................  $ 111,077         .80%       $ 98,551       1.00%
  Money market.....................................     41,487        2.07          41,557       2.52
Savings accounts...................................     18,865        1.00          19,175       1.00
                                                     ---------       -----        --------      -----
     Total.........................................    171,429        1.13         159,283       1.40

Certificate accounts:
  Less than 12 months (1)..........................     91,915        3.60          93,176       4.33
  12 - 14 months (1)...............................    143,101        4.14         152,622       5.01
  15 - 72 months (1)...............................     69,144        4.88          66,858       5.09
                                                     ---------       -----        --------      -----
     Total.........................................    304,160        4.14         312,656       4.82
                                                     ---------       -----        --------      -----
Total deposits.....................................  $ 475,589        3.06%       $471,939       3.67%
                                                     =========       =====        ========      =====

<CAPTION>
                                                               As of and for the Year Ended September 30,
                                                     ----------------------------------------------------
                                                              2000                          1999
                                                     -------------------------     ----------------------
                                                                      Weighted                  Weighted
                                                                      Average                    Average
                                                        Amount         Rate          Amount        Rate
                                                       ---------       -----        ---------      -----
                                                                         (Dollars in thousands)
<S>                                                    <C>               <C>         <C>             <C>
Demand accounts:
  Checking.........................................    $  62,322         .26%        $ 31,151        .28%
  Money market.....................................       48,271        4.29           22,375       3.92
Savings accounts...................................       22,069        1.49            7,220       1.50
                                                       ---------       -----        ---------      -----
     Total.........................................      132,662        1.93           60,746       1.76

Certificate accounts:
  Less than 12 months (1)..........................      112,553        5.99           50,671       5.05
  12 - 14 months (1)...............................      121,941        6.25           82,655       5.06
  15 - 72 months (1)...............................      104,786        5.73           40,546       5.44
                                                       ---------       -----        ---------      -----
     Total.........................................      339,280        6.00          173,872       5.15
                                                       ---------       -----        ---------      -----
Total deposits.....................................    $ 471,942        4.85%       $ 234,618       4.27%
                                                       =========       =====        =========      =====
</TABLE>

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



                                       18
<PAGE>

     The following table  indicates the amount of the Company's  certificates of
deposit of $100,000 or more (in thousands) by time  remaining  until maturity as
of December 31, 2001.  At such date,  such deposits  represented  13.3% of total
deposits and had a weighted average rate of 4.12%.

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

      Three months or less.......................  $    3,278
      Over three through six months..............       6,040
      Over six through 12 months.................      39,922
      Over 12 months.............................      14,078
                                                   ----------
            Total................................  $   63,318
                                                   ==========


     At December 31, 2001,  mortgage-backed securities with an amortized cost of
$5.1 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 Bank has a Blanket  Agreement  for advances with the FHLB under
which the Bank may borrow up to 20% of assets  subject to normal  collateral and
underwriting requirements.  Advances from the FHLB of Atlanta are secured by the
Bank's stock in the FHLB of Atlanta and other eligible assets.  During the three
months ended  December 31, 2001 and during the years ended  September  30, 2001,
2000 and 1999,  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.

     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
                                                       Three Months        At or for the Year Ended
                                                           Ended                  September 30,
                                                        December 31,  --------------------------------------
                                                            2001        2001           2000       1999
                                                     ----------------   -----          -----      -----
                                                                                (In thousands)
<S>                                                        <C>             <C>          <C>          <C>
Amounts outstanding at end of period:
  FHLB advances....................................    $   1,000       $      --    $  24,000    $      --
  Federal funds purchased and securities
    sold under repurchase agreements...............        4,441           4,909        6,388        1,318
Weighted average rate paid on:
  FHLB advances....................................         1.83%           0.00%        6.94%        0.00%
  Federal funds purchased and securities sold under
    agreements to repurchase.......................          .43%           1.43%        4.38%        3.13%
Maximum amount of borrowings outstanding
at any month end:
  FHLB advances....................................    $   1,000       $  45,700    $  60,200    $  19,000
  Federal funds purchased and securities
    sold under repurchase agreements...............        5,073           6,381        6,388        2,374

</TABLE>


                                       19
<PAGE>

<TABLE>
<CAPTION>
                                                      At or for the
                                                       Three Months        At or for the Year Ended
                                                           Ended                  September 30,
                                                        December 31,  --------------------------------------
                                                            2001        2001           2000       1999
                                                     ----------------   -----          -----      -----
                                                                                (In thousands)
<S>                                                        <C>             <C>          <C>          <C>
Approximate average short-term borrowings
  outstanding with respect to:
  FHLB advances....................................    $     250       $  13,638    $   9,168    $  10,558
  Federal funds purchased and securities
    sold under repurchase agreements...............        4,808           5,419        3,306        1,773
Approximate weighted average rate paid on: (1)
  FHLB advances....................................         1.60%           6.03%        6.09%        5.19%
  Federal funds purchased and securities
    sold under repurchase agreements...............          .92%           3.48%        4.30%        2.69%

----------
(1)      Based on month-end balances.

</TABLE>

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
originating  loans to be Beaufort,  Craven,  Lenoir,  Nash,  Pasquotank and Pitt
Counties in eastern North  Carolina,  which are the counties in which the Bank's
offices  are  located.  The  Bank  originates  loans  throughout  eastern  North
Carolina.

EMPLOYEES

     As of  December  31,  2001,  the Bank had 203  full-time  and 15  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.

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

                                       20
<PAGE>

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.

     Financial  Modernization  Legislation.  On  November  12,  1999,  President
Clinton  signed  legislation  which  could  have a  far-reaching  impact  on the
financial services  industry.  The  Gramm-Leach-Bliley  ("G-L-B") Act authorizes
affiliations between banking, securities and insurance firms and authorizes bank
holding  companies  and national  banks to engage in a variety of new  financial
activities.  Among the new  activities  that will be  permitted  to bank holding
companies are  securities  and  insurance  brokerage,  securities  underwriting,
insurance  underwriting  and merchant  banking.  The Federal  Reserve Board,  in
consultation  with  the  Secretary  of  the  Treasury,  may  approve  additional
financial activities.  The G-L-B Act, however,  prohibits future acquisitions of
existing  unitary savings and loan holding  companies by firms which are engaged
in  commercial  activities  and limits  the  permissible  activities  of unitary
savings and loan holding companies formed after May 4, 1999.

     The G-L-B Act imposes  new  requirements  on  financial  institutions  with
respect to customer  privacy.  The G-L-B Act generally  prohibits  disclosure of
customer information to nonaffiliated third parties unless the customer has been
given  the  opportunity  to  object  and has not  objected  to such  disclosure.
Financial  institutions  are further required to disclose their privacy policies
to customers  annually.  Financial  institutions,  however,  will be required to
comply  with state law if it is more  protective  of customer  privacy  than the
G-L-B Act.  The G-L-B Act directs the federal  banking  agencies,  the  National
Credit Union Administration,  the Secretary of the Treasury,  the Securities and
Exchange  Commission and the Federal Trade Commission,  after  consultation with
the National Association of Insurance Commissioners,  to promulgate implementing
regulations  within six  months of  enactment.  The  privacy  provisions  became
effective in July 2001.

     The G-L-B Act contains significant  revisions to the FHLB System. The G-L-B
Act imposes new capital  requirements  on the FHLBs and authorizes them to issue
two classes of stock with differing dividend rates and redemption  requirements.
The G-L-B Act deletes the current requirement that the FHLBs annually contribute
$300 million to pay interest on certain government obligations in favor of a 20%
of net  earnings  formula.  The G-L-B Act expands the  permissible  uses of FHLB
advances by community  financial  institutions (under $500 million in assets) to
include   funding   loans  to  small   businesses,   small   farms   and   small
agri-businesses.  The G-L-B  Act  makes  membership  in the FHLB  voluntary  for
federal savings associations.

     The  G-L-B  Act  contains  a  variety  of  other  provisions   including  a
prohibition  against ATM surcharges  unless the customer has first been provided
notice of the  imposition  and  amount of the fee.  The  G-L-B Act  reduces  the
frequency of Community  Reinvestment Act  examinations for smaller  institutions
and imposes certain reporting requirements on depository  institutions that make
payments  to   nongovernmental   entities  in  connection   with  the  Community
Reinvestment  Act.  The  G-L-B  Act  eliminates  the SAIF  special  reserve  and
authorizes a federal  savings  association  that converts to a national or state
bank charter to continue to use the term "federal" in its name and to retain any
interstate branches.

     The  Company  is  unable  to  predict  the  impact  of the G-L-B Act on its
operations at this time.

     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

                                       21
<PAGE>

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  companies  experiencing  or  anticipating  significant  growth would be
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. 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.

     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

                                       22
<PAGE>

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"  savings  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 savings 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 savings  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.

     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,  and asset growth.  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

                                       23
<PAGE>

needs  of  their   entire   communities,   including   the   needs  of   low-and
moderate-income  neighborhoods.  During the Bank's last compliance  examination,
the Bank received an "outstanding" 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 will be 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 in an amount at
least equal to 1% of the aggregate  unpaid principal of its home mortgage loans,
home purchase contracts,  and similar obligations at the beginning of each year,
or 1/20 of its  advances  (borrowings)  from the FHLB of Atlanta,  whichever  is
greater.  The Bank was in compliance  with this  requirement  with investment in
FHLB of Atlanta stock at December 31, 2001, of $2.7 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  against  their  transaction  accounts.
Reserves  equal to 3% must be  maintained  on  transaction  accounts up to $42.8
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, 2001, 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.

     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

                                       24
<PAGE>

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 ranges from zero for well  capitalized
institutions   in  Subgroup  A  to  0.27%  of  deposits   for   undercapitalized
institutions in Subgroup C. Both BIF and SAIF members are assessed an amount for
Financing  Corporation bond payments.  Until December 31, 1999, BIF members were
assessed  approximately  1.3 basis points while the SAIF rate was  approximately
6.4 basis  points.  As of January 1, 2000,  BIF and SAIF members  began pro rata
sharing of the payment at a rate of 2.43 basis points.

     Liquidity Requirements. FDIC policy requires that banks maintain an average
daily  balance  of  liquid  assets  (cash,   certain  time  deposits,   bankers'
acceptances  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 20.9% of total assets at December 31, 2001,  which management
believes is adequate.

     North Carolina banks must maintain a reserve fund in an amount and/or ratio
set by the Banking Commission to account for the level of liquidity necessary to
assure the safety and soundness of the State banking system.  As of December 31,
2001,  the  Bank's   liquidity  ratio  was  in  excess  of  the  North  Carolina
regulations.

     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 $7.0  million at
December 31, 2001. 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 $4.6 million.  At December 31,
2001, the Bank's largest lending  relationship  was a $3.9 million  relationship
consisting of three  commercial real estate loans and five unsecured  loans. All
loans within this  relationship  were current and performing in accordance  with
their terms at December 31, 2001.

     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.  In addition to the restrictions imposed by
Sections 23A and 23B, no state  nonmember bank may (i) loan or otherwise  extend
credit  to an  affiliate,  except  for  any  affiliate  which  engages  only  in
activities which are

                                       25
<PAGE>

permissible  for bank  holding  companies,  or (ii)  purchase  or  invest in any
stocks, bonds, debentures, notes or similar obligations of any affiliate, except
for affiliates which are subsidiaries of the state nonmember bank.

     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 Federal Reserve's  Regulation O 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 (up to $500,000). 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 loans to executive officers of
depository  institutions not be made on terms more favorable than those afforded
to other borrowers,  requires approval by the board of directors of a depository
institution  for  such  extensions  of  credit  to  executive  officers  of  the
institution,  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
activities and  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.
Further, 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.

     The FDIC has adopted  regulations to clarify the foregoing  restrictions on
activities of FDIC-insured  state-chartered banks and their subsidiaries.  Under
the  regulations,  the term  "activity"  refers to the conduct of business by an
insured  state  bank and  includes  acquiring  or  retaining  an equity or other
investment as defined by regulation. An activity permissible for a national bank
includes  any activity  expressly  authorized  for national  banks by statute or
recognized as permissible in regulations,  official circulars, bulletins, orders
or  written  interpretations  issued  by the  Office of the  Comptroller  of the
Currency.  In its regulations,  the FDIC indicates that it will not permit state
banks to directly engage in commercial ventures or directly or indirectly engage
in any insurance  underwriting activity other than to the extent such activities
are  permissible for a national bank or a national bank subsidiary or except for
certain  other  limited  forms of  insurance  underwriting  permitted  under the
regulations.  Further,  the  FDIC  regulations

                                       26
<PAGE>

permit state banks that meet applicable  minimum capital  requirements to engage
as principal in certain  activities  that are not  permissible to national banks
including  guaranteeing  obligations  of others,  activities  which the  Federal
Reserve Board has found by regulation or order to be closely  related to banking
and certain securities activities conducted through subsidiaries.

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,  (satisfactory
financial  condition,  particularly  with  respect  to capital  adequacy,  and a
satisfactory  CRA  rating  generally  are  prerequisites  to  obtaining  federal
regulatory approval to make acquisitions).

     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 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.

     Interstate  Banking.  The  Riegle-Neal  Interstate  Banking  and  Branching
Efficiency  Act of 1994 (the "Riegle Act") was enacted to ease  restrictions  on
interstate  banking.  Effective  September  29, 1995,  the Riegle Act allows

                                       27
<PAGE>

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 Riegle  Act also  prohibits  the  Federal  Reserve  Board 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.  The
Riegle Act does not affect a state's  authority to limit 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 contained in the Riegle Act.

     Additionally,  the Riegle Act  authorizes the federal  banking  agencies to
approve   interstate  merger   transactions   without  regard  to  whether  such
transaction  is prohibited  by the law of any state that applies  equally to all
out-of-state  banks  and  expressly  prohibits  merger  transactions   involving
out-of-state  banks, unless the home state of one of the banks has adopted a law
opting  out of the Riegle  Act.  Interstate  acquisitions  of  branches  will be
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
transactions.

     The Riegle Act authorizes the FDIC to approve interstate  branching de novo
by state  banks  only in states  which  specifically  allow for such  branching.
Pursuant  to  the  Act,  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.


                                       28
<PAGE>

TAXATION - GENERAL

     The Bank  previously  filed its federal income tax return based on a fiscal
year ending  September 30. Effective as of December 31, 2001, the Bank will file
its federal income tax return based on a fiscal year ending December 31.

FEDERAL INCOME TAXATION

     The Bank is subject to the provisions of the Internal Revenue Code of 1986,
as amended (the  "Internal  Revenue  Code") in the same general  manner as other
corporations.  In its form as a savings bank until April 1997, through tax years
beginning  before  December  31, 1995,  institutions  such as the Bank which met
certain  definitional  tests and other  conditions  prescribed  by the  Internal
Revenue  Code  benefited  from  certain  favorable  provisions  regarding  their
deductions  from taxable income for annual  additions to their bad debt reserve.
For  purposes  of the bad debt  reserve  deduction,  loans  are  separated  into
"qualifying real property loans," which generally are loans secured by interests
in certain real property,  and "nonqualifying loans", which are all other loans.
The bad debt reserve deduction with respect to nonqualifying loans must be based
on actual loss  experience.  The amount of the bad debt reserve  deduction  with
respect  to  qualifying  real  property  loans  may be based  upon  actual  loss
experience  (the  "experience   method")  or  a  percentage  of  taxable  income
determined  without regard to such deduction (the  "percentage of taxable income
method"). Under the experience method, the bad debt deduction for an addition to
the reserve for qualifying real property loans was an amount  determined under a
formula  based  generally  on the bad  debts  actually  sustained  by a  savings
institution  over a period of years.  Under the  percentage  of  taxable  income
method,  the bad debt reserve  deduction for qualifying  real property loans was
computed  as  8%  of  a  savings  institution's  taxable  income,  with  certain
adjustments.  The Bank generally elected to use the method which has resulted in
the greatest deductions for federal income tax purposes in any given year.

     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 11 of Notes
to Consolidated Financial Statements in the Annual Report.

                                       29
<PAGE>

ITEM 2.  PROPERTIES
-------------------

     The  following  table  sets  forth  the  location  and  certain  additional
information regarding the Bank's offices at December 31, 2001.

                                                  Book Value at
                              Year      Owned or   December 31,     Approximate
                            Opened       Leased        2001       Square Footage
                            ------      --------      -------     --------------
                                        (Dollars in thousands)
MAIN OFFICE:
1311 Carolina Avenue
Washington, NC                 1986       Owned      $   675         10,200

BRANCH OFFICES:
300 North Market Street
Washington, NC                 1959       Owned          169          4,680

1328 John Small Avenue
Washington, NC                 2001      Leased           61          1,916

301 E. Arlington Blvd.
Greenville, NC                 1993       Owned          347          2,600

604 E. Ehringhaus Street
Elizabeth City, NC             1980       Owned          363          2,500

827 Hardee Road
Kinston, NC                    1996      Leased           40          2,000

2430 Heritage Street
Kinston, NC                    2001      Leased           41          2,145

1725 Glenburnie Road
New Bern, NC                   1990       Owned          363          2,600

202 Craven Street
New Bern, NC                   1995      Leased           47          2,500

300 Sunset Avenue
Rocky Mount, NC                1994       Owned          343          4,948

241 Green Street
Fayetteville, NC               1999       Owned          899         10,000

3107 Raeford Road
Fayetteville, NC               1999       Owned          437          2,400

600 N. Chestnut Street
Lumberton, NC                  1999       Owned          438          6,100

3000 N. Elm Street
Lumberton, NC                  2001      Leased          133          2,128

2999 Hwy. 17S.
Chocowinity, NC                1999        **            320          2,530

                                     30
<PAGE>

                                                   Book Value at
                              Year      Owned or   December 31,     Approximate
                            Opened       Leased        2001       Square Footage
                            ------      --------      -------     --------------
                                       (Dollars in thousands)
3635 North Halifax Road
Dortches, NC                   2000      Leased           59            396

1378 Benvenue Road
Rocky Mount, NC                2000        **            409          5,376

2901 Sunset Avenue
Rocky Mount, NC                2000       Owned        1,171          5,635

450 North Winstead Avenue
Rocky Mount, NC                2000      Leased            6          2,845

100 East Hope Lodge Street
Tarboro, NC                    2000      Leased           36          1,350

CREDIT ADMINISTRATION:
239 West Main Street
Washington, NC  27889          1994       Owned          531          7,600

OPERATIONS CENTER:
220 Creekside Drive
Washington, NC                 2001       Owned          744         10,000

FUTURE EXPANSION SITES:
Cypress Landing
Chocowinity, NC                           Owned          126

Taberna
New Bern, NC                              Owned          176

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

     The book value of the Bank's  investment in premises and equipment was $7.9
million at December 31, 2001. See Note 6 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,  2001,  there were no
legal  proceedings to which 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.


                                       31
<PAGE>

                                     PART II

ITEM 5. MARKET FOR THE  REGISTRANT'S  COMMON  EQUITY AND  RELATED  STOCKHOLDERS'
--------------------------------------------------------------------------------
MATTERS
-------

STOCK LISTING INFORMATION

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

STOCK PRICE INFORMATION

     The following table sets forth the high and low trade price information and
dividends declared per share for the periods indicated.


Quarter Ended                       High             Low            Dividends
-------------                       ----             ---            ---------
December 31, 1999                  $18.875          $17.125           $.10
March 31, 2000                      18.875           17.375           .10
June 30, 2000                       20.00            18.375           .13
September 30, 2000                  23.25            19.25            .13

December 31, 2000                   24.78            21.75            .13
March 31, 2001                      25.00            23.0625          .18
June 30, 2001                       27.50            24.6875          .18
September 30, 2001                  36.25            26.50            .18

December 31, 2001                   37.90            31.65            .18

RECORD HOLDERS

     As of  January 8,  2002,  there were 1,945  holders of record of the Common
Stock.


                                       32
<PAGE>

ITEM 6.  SELECTED FINANCIAL DATA
--------------------------------

<TABLE>
<CAPTION>
                                              At or for the
                                           Three Months Ended
                                               December 31,               At or For the Year Ended September 30,
                                           ------------------ --------------------------------------------------------------
                                                 2001           2001         2000          1999         1998         1997
                                               ---------      --------     ---------    ---------    ---------     ---------
                                                                       (dollars in thousands, except per share data)
<S>                                      <C>                <C>           <C>          <C>          <C>          <C>
Selected Financial Condition Data
---------------------------------
Total assets                             $    549,318       $  541,195    $ 559,719    $  292,305   $  281,479   $  249,281
Loans receivable, net                         405,613          374,087      366,210       212,054      224,999      197,785
Cash and investment securities                 75,745           95,191       59,927        12,435       20,119       18,856
Mortgage-backed securities                     43,904           48,603      108,519        56,326       27,017       24,818
Deposits                                      475,589          471,939      471,942       234,618      204,635      175,116
Borrowings                                      5,441            4,909       30,388         1,318       11,933       12,621
Stockholders' equity                           51,031           50,769       44,835        48,763       56,714       57,856

Selected Operations Data
------------------------
Interest income                          $      9,467       $   42,159    $  36,865    $   23,129   $   21,867   $   18,515
Interest expense                                4,092           22,168       19,013         9,979        9,240        8,346
                                           ------------       ---------     --------     ---------    ---------    ---------
Net interest income                             5,375           19,991       17,852        13,150       12,627       10,169
Provision for loan losses                           0              830          977           120          310          931
Noninterest income                              1,625            6,776        3,432         2,874        2,646        1,685
Noninterest expenses                            3,832           16,047       14,100        10,255        9,940        6,941
ESOP termination                                3,143                0            0             0            0            0
                                           ------------       ---------     --------     ---------    ---------    ---------
Income before income taxes                         25            9,890        6,207         5,649        5,023        3,982
Income taxes                                    1,165            4,060        2,658         2,453        1,900        1,719
                                           ------------       ---------     --------     ---------    ---------    ---------
Net income (loss)                        $     (1,140)      $    5,830    $   3,549    $    3,196   $    3,123   $    2,263
                                           ============       =========     ========     =========    =========    =========
Earnings per share - basic (1)(2)        $      (0.40)      $     2.01    $    1.14    $     0.91   $     0.80   $     0.35
Earnings per share - diluted (1)(2)             (0.40)            1.95         1.13          0.91         0.80         0.35
Dividends per share (2)                          0.18             0.67         0.46          0.31         0.27         0.13

Selected Financial Ratios and Other Data
----------------------------------------
Performance Ratios:
Return on average assets (3)                    1.46 %            1.06 %       0.76 %        1.09 %       1.19 %       1.00 %
Return on average equity (3)                   15.70             12.31         7.71          6.03         5.40         6.57
Interest rate spread                            4.05              3.67         3.73          3.95         4.03         4.10
Net interest margin                             4.24              3.90         4.05          4.69         5.05         4.67
Average earning assets/average
  interest bearing liabilities                116.27            114.06       115.51        131.01       127.57       115.00
Noninterest expense/average assets (4)          2.80              2.92         3.03          3.50         3.80         3.06
Efficiency ratio (4)                           54.74             59.95        66.25         63.99        65.08        58.55
Dividend payout ratio (3)                      25.71             33.33        40.35         34.07        33.75        37.14
Quality Ratios:
Nonperforming assets/total assets               0.35 %            0.29 %       0.33 %        0.40 %       0.43 %       0.65 %
Nonperforming loans/total loans                 0.31              0.28         0.45          0.27         0.36         0.64
Loan loss reserves/total loans                  1.31              1.42         1.39          1.53         1.50         1.64
Provision for loan losses/total loans            .00              0.22         0.27          0.06         0.14         0.47
Capital Ratios:
Equity/total assets, end of period              9.29 %            9.38 %       8.02 %       16.69 %      19.95 %      23.23 %
Average equity/average assets                   9.33              8.62         9.89         18.09        22.14        15.17
Other Data:
Full service offices                              20                19           17             9            8            8
Loans serviced for others                $   274,240    $   $  295,216   $  300,006    $  275,255   $  250,202   $  253,647

</TABLE>

--------------
(1)  Applies to net income of $1,395,900  earned for the period April 8, 1997 to
     September 30, 1997.
(2)  Adjusted for three-for-two stock split on August 19, 1998.
(3)  Based on net income of  $2,003,494  earned before the  $3,143,467  one-time
     ESOP termination charge.
(4)  Excludes $3,143,467 one-time ESOP termination charge.


                                       33
<PAGE>

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

GENERAL

     First South  Bancorp,  Inc.  was formed for the  purpose of issuing  common
stock,  owning 100% of the stock of First South Bank and  operating  through the
Bank a commercial  banking  business.  The Company has engaged in no  activities
other  than  holding  the  stock of the  Bank,  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,  credit cards and other loans.  The
Bank's  earnings  depend  primarily  on its net  interest  income,  which is the
difference  between interest earned on interest earning assets and interest paid
on  interest-bearing  liabilities.  The  level  of its  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,
influenced 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.

SIGNIFICANT ACTIVITIES AND EVENTS

     The Company  recorded a net loss for the three  months  ended  December 31,
2001 of $1.1 million,  compared to net income of $1.3 for the three months ended
December 31,  2000.  Comparative  diluted  earnings per share was $(.40) for the
three months ended December 31, 2001 compared to $.45 for the three months ended
December 31, 2000.

     Effective  as of December  31, 2001,  the Company  terminated  its Employee
Stock Ownership Plan ("ESOP") and incurred a one-time non-tax  deductible charge
of $3.1 million related to the ESOP termination. During the year ended September
30, 2001, the Company  incurred a pre-tax expense of $1.2 million related to the
ESOP.  As a result of the ESOP  termination,  the Company was able to reduce its
after-tax  ESOP expense to $73,000 for the three months ended  December 31, 2001
from $216,000 for the three months ended December 31, 2000. For future  periods,
the Company will not incur any further  charges related to the ESOP. The Company
believes  the  benefits of the ESOP were not  sufficient  to justify the ongoing
annual expense  incurred to maintain it and the cost savings  achieved in future
periods will more than  compensate for the one-time charge incurred to terminate
it.

     After adjusting for the one-time ESOP termination  expense,  net income for
the three  months  ended  December  31,  2001  would  have  been  $2.0  million,
representing  a 49.0% increase over the net income of $1.3 million earned in the
three months ended December 31, 2000.  Diluted  earnings per share on net income
for  the  three  months  ended  December  31,  2001  before  the  one-time  ESOP
termination charge would have been $.67 per share, representing a 48.9% increase
over the $.45 diluted earnings per share for the three months ended December 31,
2000.

     On November 30, 1999,  the Company  consummated  the  acquisition  of Green
Street  Financial  Corp ("Green  Street"),  the parent  holding  company of Home
Federal  Savings and Loan  Association of  Fayetteville,  North Carolina  ("Home
Federal"),  with full service  offices  located in  Fayetteville  and Lumberton,
North  Carolina.  The acquisition was accounted for using the purchase method of
accounting for a cash purchase price of $59.2 million,  representing  $15.25 per
share of Green Street common stock.  Summary  financial  information  related to
Green Street  acquisition was as follows  (unaudited):  assets - $162.2 million;
loans  receivable - $125.4 million;  deposits - $101.7  million;  and goodwill -
$288,000.

                                       34
<PAGE>

     On February 18, 2000,  the Bank completed the purchase of six Triangle Bank
("Triangle") branch offices located in Rocky Mount and Tarboro,  North Carolina.
This  acquisition  was accounted for using the purchase method of accounting and
the Bank assumed the deposits of the six Triangle  branch  offices for a premium
of approximately  4.0% of the assumed deposits.  Summary  financial  information
related to the Triangle branches purchase was as follows (unaudited): deposits -
$147.5 million; cash and other assets - $113.4 million; loans receivable - $26.3
million;  deposit  premium - $5.0  million;  and premises  and  equipment - $2.8
million.

     Concurrent with the Green Street acquisition,  the Bank changed its name to
First South Bank. These acquisitions enabled the Company to leverage its capital
base,  represent a significant  growth in the Bank's  branch office  network and
have benefited the Company's earnings.

CHANGE IN FISCAL YEAR END

     On January 4, 2002, the Board of Directors of the Company announced that it
approved a change in the Company's fiscal year end from September 30 to December
31,  effective  December 31,  2001.  Adopting a December 31 fiscal year end will
eliminate  the  duplication  of  work  the  Company  previously  did to  convert
information  from a  fiscal  year to a  calendar  year  and  will  simplify  the
Company's internal and external communications. It will also bring the Company's
fiscal year end in  conformity  with the fiscal year end used by the majority of
banks in North  Carolina  and  throughout  the United  States.  The Bylaws  were
amended to reflect this change in fiscal year. As a result,  the Company's  next
annual meeting of shareholders is May 15, 2003.

BASIS OF PRESENTATION

     Based on the  change in the  Company's  fiscal  year from  September  30 to
December 31, the management's discussion and analysis of financial condition and
results of operations will:

     o    compare the audited  results of operations  for the three months ended
          December 31, 2001 to the unaudited results of operations for the three
          months ended December 31, 2000;

     o    compare the results of operations for the fiscal year ended  September
          30,  2001 to the  results  of  operations  for the  fiscal  year ended
          September 30, 2000;

     o    compare the results of operations for the fiscal year ended  September
          30,  2000 to the  results  of  operations  for the  fiscal  year ended
          September 30, 1999; and

     o    discuss the Company's  liquidity and sources of capital as of December
          31,  2001,  and where  applicable,  comparing  the three  months ended
          December 31, 2001 to the three months ended  December 31, 2000 and the
          fiscal  years  ended  September  30,  2001 to  September  30, 2000 and
          September 30, 2000 to September 30, 1999.

LIQUIDITY AND CAPITAL RESOURCES

     As a  state  chartered  commercial  bank,  the  Bank  must  meet  liquidity
requirements  established by the North Carolina  Office of the  Commissioner  of
Banks (the  "Commissioner").  Savings banks,  which convert to commercial banks,
are required to maintain 15%  liquidity  pursuant to the  conversion  guidelines
adopted by the Commissioner. The Bank's liquidity ratio, as computed under these
guidelines,  was 20.9% at December 31, 2001  compared to 24.0% at September  30,
2001.

     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 mortgage  prepayments  are greatly  influenced by interest  rates,  economic
conditions and local  competition.  The Bank's primary investing activity is the
origination of commercial,  consumer and mortgage loans. During the three months
ended  December 31, 2001 and the years ended  September  30, 2001 and 2000,  the
Bank had loan originations of $68.8 million,  $204.6 million and $176.5 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  is  dependent  on the  Bank's
operating,  financing, lending and investing activities during any given period.
At December 31, 2001 and September 30, 2001, cash and cash

                                       35
<PAGE>

equivalents totaled $21.7 million and $40.4 million,  respectively. The Bank has
other sources of liquidity if a need for  additional  funds  arises.  During the
three months ended December 31, 2001 and the years ended  September 30, 2001 and
2000, the Bank sold or exchanged real estate loans totaling $12.0 million, $49.4
million and $62.8 million, respectively. Borrowing's consisting of FHLB advances
and retail  repurchase  agreements  were $5.4  million  at  December  31,  2001,
compared to $4.9  million at  September  30,  2001.  Other  sources of liquidity
include investment and  mortgage-backed  securities  designated as available for
sale,  which totaled  $98.0  million at December 31, 2001 and $103.3  million at
September 30, 2001.

     At December 31, 2001  stockholders'  equity was $51.0  million  compared to
$50.8 million at September  30, 2001. At December 31, 2001 there were  2,964,337
shares of common stock  outstanding,  net of 1,399,707 treasury shares. Net loss
was $1.1 million for the three months  ended  December 31, 2001.  Net income for
the year ended September 30, 2001 was $5.8 million, compared to $3.5 million for
the year ended September 30, 2000.

     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 $46.7  million at December 31,  2001,  compared to $49.2
million at September 30, 2001,  substantially  in excess of all such  regulatory
requirements.  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 capital  requirements of both the  Commissioner and the FDIC at December 31,
2001 and September 30, 2001.

OFF-BALANCE SHEET ARRANGEMENTS

     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.

     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.

     A  summary  of  the  contractual  amounts  of  the  Company's  exposure  to
off-balance sheet risk as of December 31, 2001 is as follows:

                                                           At December 31, 2001
                                                           --------------------
                                                          (Dollars in thousands)
Commitments to extend credit:
  Commitments to originate loans                                $    50,204
  Undrawn balances on lines of credit and undrawn
      balances on credit reserves (overdraft protection)             48,627
                                                                -----------
  Total commitments to extend credit                            $    98,831
                                                                ===========

     Included in the commitments to originate loans as of December 31, 2001, are
fixed interest rate loan  commitments of $11.7 million.  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.

                                       36
<PAGE>

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

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 overall yield on the Bank's earning assets will
generally increase when interest rates rise over an extended period of time, and
conversely,  yields will  decrease  when  interest  rates  decline.  In general,
interest  expense will increase when interest rates rise over an extended period
of time,  and  conversely  interest  expense 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.

     The  President  of the Bank  reports  interest  rate risk and trends to the
Board of Directors on a regular  basis,  as well as liquidity  and capital ratio
requirements. The Board of Directors 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 of Directors 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 and consumer  loans. At
December 31, 2001,  the Bank had $200.6  million of  commercial  loans and $77.8
million  of  consumer  loans  compared  to $178.9  million  and  $78.2  million,
respectively,  at September  30, 2001.  The Bank had $29.3 million of loans held
for sale at December 31, 2001,  compared to $20.5 million at September 30, 2001.
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,  the Bank has emphasized that all purchases of 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 $98.0 million of
investment and  mortgage-backed  securities  classified as available for sale at
December 31, 2001, compared to $103.3 million at September 30, 2001.

                                       37
<PAGE>

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 1 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  Bank'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).


TABLE 1 - RATE/VOLUME ANALYSIS

<TABLE>
<CAPTION>
                                        Three Months Ended December 31,                 Year Ended September 30,
                                    -------------------------------------------   --------------------------------------------
                                      2001             vs.          2000              2001         vs.        2000
                                    -------------------------------------------   ------------------------------------------
                                           Increase (Decrease) Due to                      Increase (Decrease) Due to
                                    -------------------------------------------   ------------------------------------------
                                                            Rate/                                          Rate/
                                     Volume       Rate     Volume       Total      Volume       Rate      Volume      Total
                                    -------     --------   ------      --------   --------    --------    -------    -------
                                                                                       (In thousands)
Interest income:
<S>                                 <C>        <C>         <C>         <C>        <C>         <C>         <C>        <C>
 Loans receivable................   $   462    $ (1,173)   $  (64)     $   (775)  $  4,103    $   145     $    21    $ 4,269
 Investment securities...........       115         (93)      (12)           10      2,285        (39)        (69      2,177
 Mortgage-backed securities......    (1,048)        (46)       25        (1,069)      (439)      (344)         24       (759)
 Other interest-earning assets...       200         (47)     (123)           30        (63)      (350)         20       (393)
                                    -------     --------   ------      --------   --------    --------    -------    -------
 Total interest-earning assets...      (271)      (1,359)    (174)       (1,804)     5,886       (588)        (4)     5,294
                                    -------     --------   ------      --------   --------    -------     -------    -------


Interest expense:
 Deposits........................        25      (1,694)       (6)       (1,675)     3,363       (437)        (81)      2,845
 FHLB advances...................      (513)       (383)      380          (516)       131        108          25         264
 Other interest-bearing
    liabilities..................       (13)        (57)       10           (60)        82        (23)        (13)         46
                                    -------     --------   ------      --------   --------    -------     -------    -------
 Total interest-bearing
     liabilities.................      (501)     (2,134)      384        (2,251)     3,576       (352)        (69)     3,155
                                    -------     --------   ------      --------   --------    -------     -------    -------
Change in net interest income....   $   230     $    775   $ (558)     $    447   $  2,310    $  (236)    $    65    $ 2,139
                                    =======     ========   ======      ========   ========    =======     =======    =======


<CAPTION>

                                           Year Ended September 30,
                                -----------------------------------------
                                    2000           vs.           1999
                                -----------------------------------------
                                         Increase (Decrease) Due to
                                -----------------------------------------
                                                         Rate/
                                 Volume       Rate      Volume     Total
                                 -------    --------   --------   -------
                                          (In thousands)
<S>                              <C>        <C>        <C>        <C>
Interest income:
 Loans receivable...............    $ 9,019    $    143   $     67   $ 9,229
 Investment securities..........        994          (7)       (22)      965
 Mortgage-backed securities.....      2,598          88         71     2,757
 Other interest-earning assets..        215         342        228       785
                                    -------    --------   --------   -------
 Total interest-earning assets..     12,826         566        344    13,736
                                    -------    --------   --------   -------


Interest expense:
 Deposits.......................      7,584         744        601     8,929
 FHLB advances..................          8           1         --         9
 Other interest-bearing
    liabilities.................         46          26         24        96
                                    -------    --------   --------   -------
 Total interest-bearing
     liabilities................      7,638         771        625     9,034
                                    -------    --------   --------   -------
Change in net interest income...    $ 5,188    $   (205)  $   (281)  $ 4,702
                                    =======    ========   ========   =======

</TABLE>


                                       38
<PAGE>

TABLE 2 - YIELD/COST ANALYSIS

<TABLE>
<CAPTION>

                                                             Three Months Ended December 31,           Year Ended September 30,
                                                        -------------------------------------------   ------------------------------
                                                                           2001                                 2001
                                                        -------------------------------------------   ------------------------------
                                                                                        Average
                                                          Average                       Yield/          Average
                                                          Balance        Interest       Cost (2)        Balance        Interest
                                                        -------------  -------------  -------------   -------------  -------------
<S>                                                         <C>              <C>              <C>         <C>             <C>
Interest earning assets:
Loans receivable    (1)                                     $389,746         $7,715           7.92 %      $369,735        $32,760
Investment securities                                         54,583            865           6.34          51,386          3,461
Mortgage-backed securities                                    46,586            781           6.71          77,422          5,223
Other interest-earning assets                                 16,501            106           2.57          14,547            715
                                                        -------------  -------------  -------------   -------------  -------------
     Total earning assets                                    507,416          9,467           7.46         513,090         42,159
                                                                       -------------  -------------                  -------------
Nonearning assets                                             39,658                                        36,225
                                                        -------------                                 -------------
     Total assets                                           $547,074                                      $549,315
                                                        =============                                 =============

Interest bearing liabilities:
Time deposits                                               $309,391          3,567           4.61        $323,037         18,496
Demand deposits                                              102,827            465           1.81          87,309          2,396
Savings                                                       19,126             48           1.00          20,450            262
FHLB advances                                                    250              1           1.60          13,638            822
Repurchase agreements                                          4,808             11           0.92           5,419            192
                                                        -------------  -------------  -------------   -------------  -------------
     Total interest-bearing liabilities                      436,402          4,092           3.75         449,853         22,168
Noninterest bearing demand deposits                           43,035              0           0.00          37,383              0
                                                        -------------  -------------  -------------   -------------  -------------
     Total sources of funds                                  479,437          4,092           3.41         487,236         22,168
                                                                       -------------  -------------                  -------------

Other liabilities and stockholders' equity
Other liabilities                                             16,584                                        14,707
Stockholders' equity                                          51,053                                        47,372
                                                        -------------                                 -------------
     Total liabilities and stockholders' equity             $547,074                                      $549,315
                                                        =============                                 =============
Net interest income                                                          $5,375                                       $19,991
                                                                       =============                                 =============
Interest rate spread  (3)                                                                     4.05 %
                                                                                      =============
Net yield on earning assets (4)                                                               4.24 %
                                                                                      =============

Ratio of earning assets to interest bearing liabilities                                     116.27 %
                                                                                      =============
<CAPTION>

                                                                     Year Ended September 30,
                                                       ----------------------------------------------------------
                                                           2001                     2000
                                                       -------------  -------------------------------------------
                                                         Average                                      Average
                                                          Yield/        Average                        Yield/
                                                           Cost         Balance        Interest         Cost
                                                       -------------  -------------  -------------  -------------
<S>                                                           <C>        <C>             <C>               <C>
Interest earning assets:
Loans receivable    (1)                                        8.86 %     $323,178        $28,491           8.81 %
Investment securities                                          6.74         18,487          1,284           6.95
Mortgage-backed securities                                     6.75         83,535          5,982           7.16
Other interest-earning assets                                  4.92         15,409          1,108           7.19
                                                       -------------  -------------  -------------  -------------
     Total earning assets                                      8.22        440,609         36,865           8.37
                                                       -------------                 -------------  -------------
Nonearning assets                                                           25,194
                                                                      -------------
     Total assets                                                         $465,803
                                                                      =============

Interest bearing liabilities:
Time deposits                                                  5.72       $282,159         16,048           5.69
Demand deposits                                                2.74         66,015          1,987           3.01
Savings                                                        1.28         18,771            274           1.46
FHLB advances                                                  6.03         11,046            558           5.05
Repurchase agreements                                          3.54          3,471            146           4.21
                                                       -------------  -------------  -------------  -------------
     Total interest-bearing liabilities                        4.93        381,462         19,013           4.98
Noninterest bearing demand deposits                            0.00         28,530              0           0.00
                                                       -------------  -------------  -------------  -------------
     Total sources of funds                                    4.55        409,992         19,013           4.64
                                                       -------------                 -------------  -------------

Other liabilities and stockholders' equity
Other liabilities                                                            9,753
Stockholders' equity                                                        46,058
                                                                      -------------
     Total liabilities and stockholders' equity                           $465,803
                                                                      =============
Net interest income                                                                       $17,852
                                                                                     =============
Interest rate spread  (3)                                      3.67 %                                       3.73 %
                                                       =============                                =============
Net yield on earning assets (4)                                3.90 %                                       4.05 %
                                                       =============                                =============

Ratio of earning assets to interest bearing liabilities      114.06 %                                     115.51 %
                                                       =============                                =============
</TABLE>

     (1)  Includes classified loans.
     (2)  Ratio calculations have been annualized.
     (3)  Represents the difference  between the yield on earning assets and the
          average cost of funds.
     (4)  Represents the net interest income divided by average earning assets.


                                       39
<PAGE>

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 2  above  sets  forth  certain  information  relating  to the  Bank's
statements  of financial  condition and  statements of operations  for the three
months ended December 31, 2001 and for the three years ended  September 30, 2001
and 2000 and reflects 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 Bank does not believe that the use of month end balances  instead
of average daily balances has caused any material  difference in the information
presented.

RESULTS OF OPERATIONS

COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2001 AND SEPTEMBER 30, 2001

     Total assets  increased to $549.3  million at December 31, 2001 from $541.2
million at September 30, 2001,  reflecting a 6.0% annualized  growth rate during
the three months ended December 31, 2001.

     Earning  assets  grew at an  annualized  rate of 4.7% to $507.7  million at
December 31, 2001 from $501.8  million at September  30,  2001,  reflecting  the
Bank's current loan demand.  Earning assets amounted to 92.4% of total assets at
December 31, 2001,  compared to 92.7% at  September  30, 2001.  Interest-bearing
deposits in financial institutions declined to $1.4 million at December 31, 2001
from $21.7 million at September 30, 2001,  reflecting the loan portfolio  growth
discussed below.  These deposits are primarily used to support the funding needs
of the Bank, liquidity management activities and daily banking operations.

     The Bank has  implemented  various  strategies  to increase its  regulatory
liquidity  levels,  including  the  securitization  of  certain  mortgage  loans
previously  held for sale into  mortgage-backed  securities  and the purchase of
U.S. Government and Agency securities. The Bank's mortgage-backed securities and
investment securities portfolio was $98.0 million at December 31, 2001, compared
to $103.3 million at September 30, 2001.

     Loans held for sale  increased  to $29.3  million at December 31, 2001 from
$20.5 million at September 30, 2001,  while loans and leases held for investment
increased  to $376.3  million  at  December  31,  2001 from  $353.6  million  at
September 30, 2001,  reflecting internal portfolio growth generated from current
loan demand.  To support the risk associated  with its loan portfolio,  the Bank
had reserves for potential  loan losses of $5.4 million at December 31, 2001 and
September 30, 2001, respectively. The ratio of reserves for loan losses to loans
outstanding,  net of  loans in  process  and  deferred  loan  fees,  was 1.3% at
December 31, 2001 and 1.4 % at September 30, 2001.

     Total deposits and  borrowings  increased to $481.0 million at December 31,
2001 from $476.8  million at September  30, 2001.  Deposits  increased to $475.6
million at  December  31,  2001 from  $471.9  million  at  September  30,  2001,
reflecting a 3.1% annualized  growth rate during the three months ended December
31, 2001. Borrowings primarily in the form of repurchase agreements representing
funds  held  in  cash  management  accounts  for  commercial  banking  customers
increased  to $5.4  million at December  31, 2001 from $4.9 million at September
30, 2001.

     Stockholders'  equity was $51.0  million at December 31, 2001,  compared to
$50.8 million at September  30, 2001. At December 31, 2001,  the ratio of equity
to total assets was 9.3%, compared to 9.4% at September 30, 2001.

     As a result  of the ESOP  termination,  the  Company's  $1.3  million  note
receivable  from the ESOP was repaid in full via a treasury  stock  purchase  of
39,785  unallocated  ESOP shares,  resulting in the release of all the remaining
unallocated 93,695 shares to ESOP participants. In settlement of the termination
expense of these  remaining  shares,  $3.2  million was  recorded as  additional
paid-in-capital as of December 31, 2001.

                                       40
<PAGE>

     During the three months ended December 31, 2001,  the Company  recognized a
decline in other  comprehensive  income  resulting  from a decline in unrealized
gains on available for sale securities due to a recent increase in market rates.
Accumulated other comprehensive  income declined to $2.6 million at December 31,
2001 from $3.5 million at September 30, 2001.  See  "Consolidated  Statements of
Stockholders' Equity".

     As a North Carolina  chartered  commercial bank, the Bank must meet various
capital standards required by federal and state banking regulatory agencies. The
Bank's stand-alone capital was $47.9 million at December 31, 2001, substantially
in excess of all  regulatory  capital  requirements.  See "Liquidity and Capital
Resources" below.

     Pursuant to a stock  repurchase  plan  adopted by the  Company,  during the
three months ended December 31, 2001 the Company  acquired  57,709 shares of its
common  stock  through  both open market and private  purchases,  totaling  $1.9
million. These shares are being held as treasury stock at cost.

     During the three  months ended  December  31, 2001,  5,500 shares of common
stock were issued from  treasury  stock upon the exercise of stock  options.  At
December 31, 2001,  1,399,707  shares  totaling  $28.7 million are being held as
treasury stock, compared to 1,347,498 shares totaling $26.9 million at September
30, 2001.

     On December 20, 2001,  the Company  declared a quarterly  cash  dividend of
$0.18 per share totaling  $534,000,  payable January 18, 2002 to stockholders of
record as of January 3, 2002. This dividend payment is the Company's  nineteenth
consecutive quarterly cash dividend.

COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 2001 AND 2000

     Total assets were $541.2  million at September  30, 2001 compared to $559.7
million at September  30, 2000.  Earning  assets  declined to $501.7  million at
September  30, 2001 from $524.2  million at September 30, 2000,  reflecting  the
sales of certain mortgage loans and mortgage-backed  securities.  Earning assets
were 92.7% of total assets at September  30, 2001  compared to 93.8% a September
30, 2000.

     The Bank has  implemented  various  strategies  to sell  certain  loans and
securities  during favorable  interest rate cycles,  and the  securitization  of
certain mortgage loans held for sale into mortgage-backed  securities.  The year
ended September 30, 2001 was an advantageous  period to execute these strategies
due to declining interest rates.

     Loans  receivable,  net of loan  loss  reserves  and  deferred  loan  fees,
increased  to $374.1  million at  September  30,  2001,  from $366.2  million at
September  30, 2000.  The Bank  continues to emphasize the  origination  of both
secured and unsecured  commercial  and consumer loans in order to take advantage
of generally  higher yields as well as shorter  terms to maturity.  From time to
time, the Bank sells selected mortgage loans in the secondary market in order to
reduce  interest  rate and credit risk,  while  retaining  servicing to generate
additional fee income.

     Commercial  loans  increased 29.7% to $178.9 million at September 30, 2001,
from $137.9  million at September 30, 2000.  Consumer  loans  increased  4.2% to
$78.2  million at September  30, 2001 from $75.0  million at September 30, 2000.
This growth reflects the Bank's  emphasis of structuring  itself as a commercial
banking entity.  Commercial and consumer loan  originations  increased to $144.1
million during fiscal 2001, from $122.4 million during fiscal 2000.

     Residential  real estate mortgage loans declined 22.7% to $123.2 million at
September 30, 2001,  from $159.3  million at September 30, 2000,  reflecting the
sales  and  exchanges  of loans,  net of  origination  volume.  The Bank sold or
exchanged $49.4 million of mortgage loans during fiscal 2001,  compared to $62.8
million  during fiscal 2000.  Loans  serviced for others were $295.2  million at
September  30, 2000  compared to $300.0  million at September  30, 2000.  During
fiscal 2001, the Bank  originated  $60.4 million of residential  mortgage loans,
compared to $54.1 million during fiscal 2000.

     Investment  securities  and  mortgage-backed  securities  declined 32.8% to
$103.3 million at September 30, 2001, from $153.7 million at September 30, 2000.
During the year ended  September 30, 2001,  the Bank  increased  its  investment
securities portfolio (primarily U. S. Government and Agency securities) to $54.7
million from $45.2  million at September  30,  2000.  Due to declining  interest
rates during  fiscal 2001 and 2000,  the Bank has  executed  its  aforementioned
strategies of  securitizing  loans into  mortgage-backed  securities and selling
certain  mortgage-

                                       41
<PAGE>

backed securities.  During the years ended September 30, 2001 and 2000, the Bank
exchanged $12.3 million and $62.8 million of mortgage loans  previously held for
sale  into   mortgage-backed   securities.   The  Bank  sold  $63.2  million  of
mortgage-backed securities during the year ended September 30, 2001, compared to
no sales during the year ended September 30, 2000. Net of sales, securitizations
and principal repayments,  the mortgage-backed  securities portfolio declined to
$48.6 million at September 30, 2001 from $108.5 million at September 30, 2000.

     Deposits were $471.9 million at September 30, 2001 and 2000,  respectively.
Certificates  of deposit  declined to $312.7 million at September 30, 2000, from
$339.3 million at September 30, 2000. The Bank continued to emphasize attracting
lower cost core deposits, as checking accounts increased 26.7% to $140.1 million
at September 30, 2001, from $110.6 million at September 30, 2000.  During fiscal
2001,  the Bank  implemented  a strategy  of  managing  its cost of  deposits by
allowing certain high rate  certificates of deposit to mature amid  increasingly
competitive  market interest rates,  offset by the growth in checking  accounts.
The Bank is also  repricing  higher  costing  certificates  of deposits at lower
rates,  which combined with the growth of lower costing core checking  accounts,
has been an effective tool in managing its deposit cost.

     Total borrowings declined to $4.9 million at September 30, 2001, from $30.4
million at September 30, 2000.  During fiscal 2001,  the Bank used proceeds from
the  mortgage-backed  securities  sales to repay $24.0 million of FHLB advances.
Borrowings in the form of repurchase  agreements  were $4.9 million at September
30, 2001 compared to $6.4 million at September 30, 2000, representing funds held
in cash management accounts for commercial banking customers.

     Stockholders'  equity was $50.8 million at September 30, 2001,  compared to
$44.8  million  at  September  30,  2000.  The ratio of  equity to total  assets
increased  to 9.4% at  September  30,  2001,  from 8.0% at  September  30, 2000,
reflecting current fiscal year earnings and a significant increase in unrealized
gains on available for sale  securities,  due primarily to the recent decline in
market  rates.  Accumulated  other  comprehensive  income  was $3.5  million  at
September  30, 2001  compared  to other  comprehensive  loss of $1.3  million at
September 30, 2000.

     During the years ended  September 30, 2001 and 2000,  the Company  declared
four  quarterly  cash  dividends  each,  totaling  $0.67  and  $0.46  per  share
respectively.  These cash dividend  payments  reflect  dividend payout ratios on
basic earnings of 33.3% and 40.4% respectively.  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.

     The  Company's  note  receivable  from the Employee  Stock  Ownership  Plan
("ESOP")  declined to $1.4 million at September  30, 2001,  from $1.8 million at
September   30,  2000,   reflecting   the  release  of  45,932  shares  to  ESOP
participants.  The note is reported as a reduction of  stockholders'  equity and
requires an annual  $349,000  principal  payment plus interest at prime plus one
percent.  Although  shares of common stock of the Company  secure the ESOP note,
the Bank expects to make  discretionary  contributions to the ESOP in amounts at
least equal to the required  principal and interest  payments.  At September 30,
2000, 135,926  unallocated  shares remained in the ESOP,  compared to 181,858 at
September 30, 2000.

     Pursuant to stock repurchase  programs adopted by the Company during fiscal
years 2001 and 2000,  the Company  acquired  143,929  and 390,066  shares of its
common stock,  respectively,  through open market and private purchases.  Shares
acquired under the repurchase program are being held as treasury stock, at cost.
At September 30, 2001,  treasury  shares were 1,347,498  totaling $26.9 million,
compared to 1,203,569  shares  totaling $23.0 million at September 30, 2000. The
Company  believes the repurchase of its  outstanding  common stock will increase
per share  earnings and book value,  provide an  attractive  investment  for the
Company's excess funds and decrease the potential  dilutive effect caused by the
future exercise of stock options.

COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED DECEMBER 31, 2001 AND
2000

     Interest  Income.  Interest  income was $9.5  million for the three  months
ended  December 31, 2001,  compared to $11.3  million for the three months ended
December 31, 2000. This decline in volume is primarily  attributable to a series
of interest  rate  reductions by the Federal  Reserve  since  December 31, 2000.
Average  interest-earning  assets were $507.4 million for the three months ended
December  31,  2001,  compared  to $529.8  million  for

                                       42
<PAGE>

the three months ended December 31, 2000. The yield on average  interest-earning
assets was 7.5% for the three months ended  December 31, 2001,  compared to 8.5%
for the three months ended December 31, 2000.

     Interest Expense.  Interest expense on deposits and borrowings  declined to
$4.1 million for the three months ended  December 31, 2001 from $6.3 million for
the three months ended December 31, 2000. Average  interest-bearing  liabilities
declined to $436.4  million for the three  months  ended  December 31, 2000 from
$468.8 million for the three months ended December 31, 2000. The average cost of
funds  declined to 3.4% for the three months  ended  December 31, 2001 from 5.0%
for the  quarter  ended  December  31,  2000,  reflecting  a general  decline in
interest  rates since  December 31, 2000.  The Bank has  increased  its checking
account  base to $152.6  million at December  31,  2001 from  $115.0  million at
December 31, 2000, reflecting its continuing efforts of attracting lower costing
core deposits.

     Net Interest Income.  Net interest income increased to $5.4 million for the
three  months  ended  December  31, 2001 from $4.9  million for the three months
ended  December 31, 2000. The Bank's net yield on  interest-earning  assets (net
interest  income  divided by average  interest-earning  assets) was 4.2% for the
three  months ended  December  31,  2001,  compared to 3.7% for the three months
ended December 31, 2000. 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 4.2% for the three months ended  December 31, 2001,  compared
to 3.5% for the three months ended December 31, 2000.

     See Table 1 (Rate/Volume  Analysis) and Table 2 (Yield/Cost Analysis) above
for additional  information on interest income,  interest expense,  net interest
income, average balances and yield/cost ratios.

     Provision for Loan Losses. During the three months ended December 31, 2001,
the Bank  recorded no provisions  for loan losses,  compared to $240,000 for the
three months ended December 31, 2000. The Bank believes the current level of its
reserves  for loan losses is adequate to provide  for  probable  future  losses,
although there are no assurances that probable  future losses,  if any, will not
exceed  estimated  amounts.   Provisions  are  necessary  to  support  the  risk
associated  with the growth in the loan  portfolio.  Provisions  are  charged to
operations  and the Bank  believes the  resulting  allowance  for loan losses is
adequate  to absorb  probable  losses on loans  that may  become  uncollectible.
Additions  to  the  allowance  for  loan  losses  are  based  on  a  review  and
classification of the loan portfolio and other factors,  such as past collection
experience,  changes  in the  nature  and  volume  of the loan  portfolio,  risk
characteristics  of individual  loans or groups of similar loans and  underlying
collateral,  overall  portfolio  quality and current  and  prospective  economic
conditions.

     Noninterest  Income.  Noninterest  income increased to $1.6 million for the
three  months  ended  December  31, 2001 from $1.3  million for the three months
ended December 31, 2000. Noninterest income consists of fees and service charges
earned on loans, service charges on deposit accounts,  gains from sales of loans
and  mortgage-backed  securities and other  miscellaneous  income.  The increase
during the  current  period is  attributable  to the growth in fees and  service
charges from a greater  volume of  commercial  and  consumer  loans and checking
accounts, and from the sale of loans and mortgage-backed securities.

     During the three months  ended  December  31, 2001 the Bank  recorded  $1.1
million of loan fees and services charges,  compared to $751,000 recorded during
the three months ended  December 31, 2000. In addition,  during the three months
ended  December  31,  2001,  the Bank  recorded  gains  from  sales of loans and
mortgage-backed securities of $192,000, compared to $164,000 recorded during the
three months ended December 31, 2000.

     Noninterest  Expense.  Noninterest expenses were $6.9 million for the three
months  ended  December  31, 2001  compared to $3.7 million for the three months
ended December 31, 2000. The largest single  component of these expenses was the
$3.1  million  one-time  non-tax   deductible  ESOP  termination   charge.   See
"Significant Activities and Events" above for additional information.

     Compensation  and fringe  benefits,  was $2.2  million for the three months
ended  December  31,  2001  and  the  three  months  ended  December  31,  2000,
respectively.  Comparatively,  all other noninterest expenses including premises
and equipment,  advertising, and office supplies were $1.6 million for the three
months  ended  December  31, 2001  compared to $1.5 million for the three months
ended December 31, 2000,  reflecting the Bank's efforts to control its operating
expenses.

                                       43
<PAGE>

     Income  Taxes.  Income tax  expense was $1.2  million for the three  months
ended  December  31,  2001,  compared to  $941,000  for the three  months  ended
December 31, 2000. The changes in the amounts of income tax provisions  reflects
the impact of the non-tax deductible ESOP termination  charge,  changes in other
pretax  income  and  expenses,   the  application  of  permanent  and  temporary
differences,  and the estimated income tax rates in effect during the respective
periods.

COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED SEPTEMBER 30, 2001 AND 2000

     Net  Income.  Net  income  increased  to $5.8  million  for the year  ended
September  30, 2001,  from $3.5 million for the year ended  September  30, 2000.
Basic and diluted  earnings  per share  increased  to $2.01 and $1.95 per share,
respectively, for the year ended September 30, 2001, compared to $1.14 and $1.13
per share,  respectively,  for the year ended  September  30, 2000.  The average
number of basic shares  outstanding  (net of unearned ESOP and treasury  shares)
was 2,899,846 and  3,115,768,  respectively,  for the years ended  September 30,
2001 and 2000, reflecting the impact of the stock repurchase program.

     Interest  Income.  Interest  income  increased  14.4% to $42.2  million for
fiscal 2001, from $36.9 million for fiscal 2000. The increase in interest income
on loans and  investments  during 2001 results from the growth in earning assets
from  internal  growth and the  completion of two prior year  acquisitions.  The
average balance of interest-earning assets increased 16.5% to $513.1 million for
fiscal  2001,  from  $440.6  million  for  fiscal  2000.  The  yield on  average
interest-earning  assets was 8.2% for 2001 compared to 8.4% for 2000, reflecting
the decline in interest rates during 2001.

     Interest  Expense.  Interest  expense  increased 16.6% to $22.2 million for
fiscal  2001,  from $19.0  million  for fiscal  2000.  The  increase in interest
expense on deposits and  borrowings  during 2001 also results from the increased
volume of average  interest-bearing  liabilities  resulting from internal growth
and the  completion  of the prior  year  acquisitions.  The  average  balance of
interest-bearing  liabilities increased 17.9% to $449.9 million for fiscal 2001,
from $381.5 million for fiscal 2000. The average cost of funds was 4.5% for 2001
compared to 4.6% for 2000, reflecting the decline in interest rates during 2001.

     Net Interest  Income.  Net interest income increased 12.0% to $20.0 million
for fiscal  2001,  from $17.9  million  for fiscal  2000.  The  increase  in net
interest  income is  primarily  due to an increase in both the volume of average
interest-earning  assets,  offset by an increase in interest bearing liabilities
and a decline in interest rates during 2001.  The net yield on  interest-earning
assets was 4.1% for fiscal 2001 and 2000, respectively. See Table 2 (Rate/Volume
Analysis) and Table 3 (Yield/Cost Analysis) above for additional  information on
interest income,  interest  expense,  net interest income,  average balances and
yield/cost ratios.

     Provision  for Loan Losses.  The Bank  maintains an allowance for losses on
loans  based  upon  management's  evaluation  of  existing  risks  in  the  loan
portfolio,   the  Bank's  past  loan  loss  experience,   and  current  economic
conditions.  The Bank  provided  $830,000  for loan losses  during  fiscal 2001,
compared to $977,000 for fiscal 2000. These provisions were necessary to support
the  risks  associated  with the  growth of the  commercial  and  consumer  loan
portfolios and the volume of loans acquired in the prior year acquisitions.  The
allowance  for loan losses was $5.4 million at September  30, 2001,  compared to
$5.2  million at  September  30,  2000,  which the Bank  believes is adequate to
absorb  probable  losses in its loan  portfolio.  The ratio of the allowance for
loan losses to total loans, net of loans-in-process  and deferred loan fees, was
1.4% at September 30, 2001 and 2000.

     The Bank uses an  analytical  approach in  determining  the adequacy of its
loan loss  allowance  and the  necessary  provision  for loan losses,  through a
classification  of assets program.  On a quarterly  basis, the loan portfolio is
generally   reviewed,   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.  As a result of this
review and analysis,  loans are classified in appropriate  categories applicable
to their circumstances.  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
allowance to a level consistent with this analysis.  The ratio of non-performing
loans to total loans was .3% at September 30, 2001, compared to .5% at September
30, 2000.

                                       44
<PAGE>

     Other Income. Other income increased 97.4% to $6.8 million for fiscal 2001,
from $3.4  million for fiscal 2000.  Other  income  consists of fees and service
charges earned on loans,  service charges on deposit accounts,  gains from sales
of  loans,  and  other  miscellaneous  income.  Loan  fees and  service  charges
increased  78.3% to $3.4 million for fiscal  2001,  from $1.9 million for fiscal
2000, reflecting the growth of the commercial and consumer loan portfolios,  the
growth in checking accounts and the impact of the prior year acquisitions. Gains
from sales of loans and mortgage-backed securities increased to $1.8 million for
fiscal 2001 from $2,000 for fiscal 2000. The volume of loans and mortgage-backed
securities sold or exchanged  during 2001 was $112.6 million,  compared to $62.8
million for 2000,  reflecting  an increased  volume of sales or exchanges due to
declining  interest rates and more favorable  pricing in the secondary  mortgage
market.  Servicing fee income on loans serviced for others was $766,000 for 2001
compared to $771,000 for 2000, as loans  serviced for others  declined to $295.2
million at September 30, 2001, from $300.0 million at September 30, 2000.

     General and Administrative  Expenses.  General and administrative  expenses
increased  13.8% to $16.0 million for fiscal 2001,  from $14.1 million in fiscal
2000.  The  Company's  efficiency  ratio  (noninterest  expenses  divided by net
interest income plus noninterest  income) improved to 59.9% for fiscal 2001 from
66.3%  for  fiscal  2000.  The  largest  single  component  of  these  expenses,
compensation  and fringe  benefits,  increased  12.4% to $9.7 million for fiscal
2001,   from  $8.6  million  for  fiscal  2000.  This  increase  is  principally
attributable to growth in personnel  resulting from two new full-service  branch
offices  opened  during the year  ended  September  30,  2001 and the prior year
acquisitions. In addition, compensation expense related to the ESOP increased to
$1.2 million for fiscal 2001 from  $835,000 for fiscal  2000,  resulting  from a
continuing  increase in the market  value of the  Company's  outstanding  common
stock.

     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 from the prior year acquisitions. The increase in
amortization  of  intangible  assets  is  directly  related  to a full  year  of
amortizing the intangible  assets  associated with the prior year  acquisitions.
Other noninterest expenses including  advertising,  deposit insurance,  premises
and  equipment,  repairs and  maintenance,  and office  expenses have also grown
proportionately  from  period to period  with the growth in  earning  assets and
checking accounts.

     Income Taxes.  The provision for income taxes increased to $4.1 million for
fiscal 2001 from $2.7  million for fiscal 2000.  The  increase in provision  for
income taxes is the result of the increased  pretax earnings of $9.9 million for
fiscal  2001,  from $6.2  million for fiscal 2000 and the  effective  income tax
rates for each period.

COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 2000 AND 1999

     Total assets increased to $559.7 million at September 30, 2000, from $292.3
million  at  September  30,  1999,  reflecting  the Green  Street  and  Triangle
acquisitions.  Loans  receivable  increased 72.7% to $366.2 million at September
30, 2000,  from $212.1 million at September 30, 1999,  also reflecting the Green
Street and Triangle acquisitions.

     Commercial  loans  increased 55.3% to $137.9 million at September 30, 2000,
from $88.8  million at September 30, 1999.  Consumer  loans  increased  47.5% to
$75.0  million at September  30, 2000 from $50.8  million at September 30, 1999.
This growth reflects both the Green Street and Triangle  acquisitions as well as
the  Bank's  emphasis  on  commercial  banking.  Commercial  and  consumer  loan
originations increased to $122.4 million for fiscal 2000, from $86.3 million for
fiscal 1999.

     Residential  real estate mortgage loans increased  109.1% to $159.3 million
at September 30, 2000, from $76.2 million at September 30, 1999,  reflecting the
Green Street acquisition and the Bank's origination volume.  During fiscal 2000,
the Bank originated  $54.1 million of real estate  mortgage  loans,  compared to
$91.2 million  during fiscal 1999.  The Bank sold or exchanged  $62.8 million of
real estate loans during fiscal 1999,  compared to $86.1  million  during fiscal
1999.  Loans  serviced  for others were  $300.0  million at  September  30, 2000
compared to $275.3 million at September 30, 1999.

     Investment  securities and mortgage-backed  securities  increased to $153.7
million at September  30, 2000,  from $59.4  million at September  30, 1999.  To
support  its  acquisition   growth,  the  Bank  implemented  various  investment
strategies  for increasing  required  regulatory  levels.  During the year ended
September 30, 2000,  the Bank

                                       45
<PAGE>

increased its investment  securities  portfolio  (primarily U. S. Government and
Agency  securities) to $45.2 million,  compared to $3.0 million at September 30,
1999.  In addition,  during 2000 the Bank  securitized  certain  mortgage  loans
previously  held  for  sale  into  mortgage-backed  securities,  resulting  in a
mortgage-backed  securities  portfolio of $108.5  million at September 30, 2000,
compared to $56.3 million at September 30, 1999.

     Deposits  increased to $471.9  million at September  30, 2000,  from $234.6
million  at  September  30,  1999,  reflecting  the Green  Street  and  Triangle
acquisitions  and the Bank's annual  internal  growth.  Certificates  of deposit
increased  95.1% to $339.3 million at September 30, 2000, from $173.9 million at
September 30, 1999, while checking  accounts  increased 106.6% to $110.6 million
at September 30, 2000, from $53.5 million at September 30, 1999.

     Total  borrowings  increased to $30.4 million at September  30, 2000,  from
$1.3 million at September 30, 1999. Due to the volatility of short-term interest
rates  during  fiscal 2000,  the Bank relied more on FHLB  advances as a funding
source to help  control its exposure to interest  rate risk,  and to support its
operations and liquidity requirements.

     Stockholders'  equity was $44.8 million at September 30, 2000,  compared to
$48.8  million  at  September  30,  1999.  The ratio of  equity to total  assets
decreased to 8.0% at  September  30,  2000,  from 16.7% at  September  30, 1999,
reflecting the leveraging effect of the Green Street and Triangle  acquisitions.
During the years ended  September 30, 2000 and 1999,  the Company  declared four
quarterly cash dividends each,  totaling $0.46 and $0.31 per share respectively.
These cash dividend payments reflect dividend payout ratios on basic earnings of
40.4% and 34.1% respectively.

     The  Company's  note  receivable  from the ESOP declined to $1.8 million at
September  30, 2000,  from $2.3 million at September  30, 1999,  reflecting  the
release of 44,492 shares to ESOP  participants.  At September 30, 2000,  181,858
unallocated  shares  remained in the ESOP,  compared to 226,350 at September 30,
1999.

     During fiscal 2000, the  Management  Recognition  Plan ("MRP"),  a deferred
stock awards plan  established  for the benefit of directors and officers of the
Company and the Bank, was  terminated  upon  distribution  of all remaining plan
shares.  On April 8, 2000,  the  remaining  58,187 of awarded  plan  shares were
vested and  distributed  to  participants.  At September 30, 1999, the 58,187 of
awarded  shares  were  held in trust  for  future  vesting,  and  reported  as a
reduction in stockholders' equity as deferred stock awards.

     Pursuant to stock repurchase  programs adopted by the Company during fiscal
years 2000 and 1999,  the Company  acquired  390,066  and 595,301  shares of its
common stock,  respectively,  and are being held as treasury  stock, at cost. At
September 30, 2000,  treasury  shares were  1,203,569  totaling  $23.0  million,
compared to 813,503 shares totaling $15.8 million at September 30, 1999.

COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED SEPTEMBER 30, 2000 AND 1999

     Net  Income.  Net  income  increased  to $3.5  million  for the year  ended
September  30, 2000,  from $3.2 million for the year ended  September  30, 1999.
Basic and diluted  earnings  per share  increased  to $1.14 and $1.13 per share,
respectively,  for the year ended  September  30,  2000,  compared  to $0.91 per
share,  respectively,  for the year ended September 30, 1999. The average number
of basic shares  outstanding (net of unearned ESOP, MRP and treasury shares) was
3,115,768 and 3,530,811,  respectively,  for the years ended  September 30, 2000
and 1999.

     Interest  Income.  Interest  income  increased  59.4% to $36.9  million for
fiscal 2000, from $23.1 million for fiscal 1999. The increase in interest income
on loans and  investments  during 2000  results  principally  from the growth in
volume of average  interest-earning  assets attributable to the Green Street and
Triangle acquisitions.  The average balance of interest-earning assets increased
57.2% to $440.6  million for fiscal 2000,  from $280.1  million for fiscal 1999.
The yield on average  interest-earning  assets  increased to 8.4% for 2000, from
8.3% for 1999, reflecting an increase in interest rates during 2000.

     Interest  Expense.  Interest  expense  increased 90.5% to $19.0 million for
fiscal  2000,  from $10.0  million  for fiscal  1999.  The  increase in interest
expense on deposits  and  borrowings  during 2000 results  principally  from the
increased  volume of average  interest-bearing  liabilities  attributable to the
Green  Street  Triangle  acquisitions  and

                                       46
<PAGE>

rising  interest  rates.  The average  balance of  interest-bearing  liabilities
increased  78.4% to $381.50  million for fiscal  2000,  from $213.8  million for
fiscal 1999. The average cost of funds increased to 4.6% for 2000, from 4.3% for
1999, reflecting an increase in interest rates during 2000.

     Net Interest  Income.  Net interest income increased 35.8% to $17.9 million
for fiscal 2000,  from $13.2 million for fiscal 1999.  See Table 2  (Rate/Volume
Analysis) and Table 3 (Yield/Cost Analysis) above for additional  information on
interest income,  interest  expense,  net interest income,  average balances and
yield/cost ratios.

     Provision  for Loan  Losses.  The Bank  provided  $977,000  for loan losses
during fiscal 2000,  compared to $120,000 for fiscal 1999. These provisions were
necessary  to  support  the  volume of loans  acquired  in the Green  Street and
Triangle  transactions,  and  the  risks  associated  with  the  growth  of  the
commercial and consumer loan  portfolio.  The allowance for loan losses was $5.2
million at September  30, 2000,  compared to $3.3 million at September 30, 1999.
The ratio of the  allowance for loan losses to total loans was 1.4% at September
30, 2000,  compared to 1.5% at September 30, 1999.  The ratio of  non-performing
loans to total  loans was .5% at  September  30, 2000 and .3% at  September  30,
1999.

     Other Income. Other income increased 19.4% to $3.4 million for fiscal 2000,
from $2.9 million for fiscal 1999. Loan fees and service charges increased 48.8%
to $1.9 million for fiscal 2000,  from $1.3 million for fiscal 1999,  reflecting
the impact of the Green  Street and Triangle  acquisitions  on the growth of the
commercial and consumer loan portfolios and checking accounts.  Gains from sales
of loans and mortgage-backed  securities declined to $2,000 for fiscal 2000 from
$566,000 for fiscal  1999.  The volume of loans and  mortgage-backed  securities
sold or exchanged  during 2000 was $62.8 million,  compared to $86.1 million for
1999,  reflecting less sales or exchanges due to the competitive  pricing in the
secondary  mortgage  market.  Servicing fee income on loans  serviced for others
increased to $771,000 for 2000 from  $762,000  for 1999,  as loans  serviced for
others increased to $300.0 million at September 30, 2000, from $275.3 million at
September 30, 1999.

     General and Administrative  Expenses.  General and administrative  expenses
increased  37.5% to $14.1 million for fiscal 2000,  from $10.3 million in fiscal
1999.  The  Company's  efficiency  ratio was 66.2% for fiscal 2000,  compared to
63.9% for fiscal 1999. Compensation and fringe benefits, increased 24.3% to $8.6
million for fiscal 2000,  from $6.9 million for fiscal 1999,  reflecting a 50.0%
growth in personnel  resulting from the Green Street and Triangle  acquisitions,
as full time  equivalent  employees  increased to 198 at September 30, 2000 from
132 at September 30, 1999.

     Other noninterest  expenses  including data processing,  deposit insurance,
premises and  equipment,  repairs,  advertising  and office  expenses  sustained
proportionate  incremental  increases  from 1999 to 2000,  supporting  the 91.5%
growth in assets from  September 30, 1999 to September  30, 2000.  During fiscal
2000,  the Bank recorded  amortization  of  intangible  assets and certain other
noninterest  expenses in connection  with the completion of the Green Street and
Triangle  acquisitions,  as well as  completing  its name  change to First South
Bank.

     Income Taxes.  The provision for income taxes increased to $2.7 million for
fiscal 2000 from $2.5  million for fiscal 1999.  The  increase in provision  for
income taxes is the result of the increased  pretax earnings of $6.2 million for
fiscal  2000,  from $5.6  million for fiscal 1999 and the  effective  income tax
rates for each period.

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.

                                       47
<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.  For a detailed  discussion  on the
application  of these and other  accounting  policies see Note 1 in Notes to the
Consolidated Financial Statements for the Three Months Ended December 31, 2001.

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

     LOANS  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.

     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.

                                       48
<PAGE>

     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.

SEGMENT INFORMATION

     The  Company  adopted  SFAS  No.  131,  "Disclosure  About  Segments  of an
Enterprise and Related Information",  on October 1, 1998. SFAS No. 131 specifies
revised  guidelines for determining an entity's  operating segments and the type
and level of financial information to be disclosed. The adoption of SFAS No. 131
did not  have a  material  effect  on the  Company's  financial  statements,  as
management has determined that the Bank operates in only one business segment.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
--------------------------------------------------------------------

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 of  Directors.
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,  the Board 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 Bank's Board of Directors 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 3 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, 2001. At December 31, 2001, the Bank's estimated  changes
in NPV and net interest income were within the targets  established by the Board
of Directors.

                                       49
<PAGE>

TABLE 3 - 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  $62,981   $(13,773)       (17.9)%  $23,915     $ (325)        (1.3)%
+ 200  bp   67,907     (8,847)       (11.5)    23,963       (277)        (1.1)
+ 100  bp   72,648     (4,106)        (5.3)    24,191        (49)         (.2)
Base        76,754         --           --     24,240         --           --
- 100  bp   79,603      2,849          3.7     24,156        (84)         (.3)
- 200  bp   83,579      6,825          8.9     23,686       (554)        (2.3)
- 300  bp   86,543      9,789         12.8     22,850     (1,390)        (5.7)

</TABLE>

     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. The
NPV  calculation  is based on the net  present  value of  discounted  cash flows
utilizing market prepayment assumptions.

     Certain  shortcomings  are inherent in the method of analysis  presented in
Table 3. 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.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
----------------------------------------------------

                                       50
<PAGE>


                  [LETTERHEAD OF PRICEWATERHOUSECOOPERS, LLP]


                        REPORT OF INDEPENDENT ACCOUNTANTS


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



In our opinion, the accompanying  consolidated statements of financial condition
and the related consolidated  statements of operations,  of stockholders' equity
and of cash flows  present  fairly,  in all  material  respects,  the  financial
position of First South Bancorp, Inc. and Subsidiary (the "Company") at December
31, 2001 and September 30, 2001,  and the results of their  operations and their
cash flows for the three  months  ended  December  31,  2001 and for each of the
three  years  in the  period  ended  September  30,  2001,  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 audits.  We conducted  our audits 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  audits  provide  a
reasonable basis for the opinion expressed above.


/s/ PricewaterhouseCoopers LLP

February 15, 2002

                                       51
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2001 AND SEPTEMBER 30, 2001
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,      SEPTEMBER 30,
                  ASSETS                                             2001              2001

<S>                                                                <C>               <C>
Cash and due from banks                                            $ 20,292,541      $ 18,789,868
Interest-bearing deposits in financial institutions                   1,390,541        21,659,575
Investment securities - available for sale                           54,061,442        54,741,784
Mortgage-backed securities - available for sale                      43,903,624        48,603,336
Loans receivable, net:
    Held for sale                                                    29,283,037        20,450,602
    Held for investment                                             376,330,018       353,636,343
Premises and equipment, net                                           7,934,288         7,925,610
Deferred income taxes                                                   652,566           108,631
Real estate owned                                                       677,399           529,666
Federal Home Loan Bank of Atlanta stock, at cost
      which approximates market                                       2,712,500         2,712,500
Accrued interest receivable                                           3,465,523         3,602,088
Intangible assets                                                     5,248,944         5,273,172
Prepaid expenses and other assets                                     2,000,783         1,791,020
Note receivable                                                       1,364,383         1,371,006
                                                                   ------------      ------------
             Total assets                                          $549,317,589      $541,195,201
                                                                   ============      ============

                      LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
    Demand                                                         $152,563,977      $140,107,605
    Savings                                                          18,864,783        19,174,806
    Large denomination certificates of deposit                       63,318,050        61,416,796
    Other time                                                      240,841,695       251,239,701
                                                                   ------------      ------------
             Total deposits                                         475,588,505       471,938,908
Borrowed money                                                        5,441,340         4,909,497
Other liabilities                                                    17,256,363        13,578,178
                                                                   ------------      ------------
             Total liabilities                                      498,286,208       490,426,583

Commitments and contingencies (Notes 10, 14 and 15)

Common stock, $.01 par value, 8,000,000 shares authorized,
      4,364,044 shares issued and outstanding                            43,640            43,640
Additional paid-in capital                                           48,494,267        45,303,405
Retained earnings, substantially restricted                          28,548,510        30,222,064
Treasury stock at cost, 1,399,707 and 1,347,498 shares
      at December 31, 2001 and September 30, 2001,
      respectively                                                  (28,703,532)      (26,905,629)
Unearned ESOP shares, 0 and 135,926 shares at December 31,
      2001 and September 30, 2001, respectively                               -        (1,359,259)
Accumulated other comprehensive income, net                           2,648,496         3,464,397
                                                                   ------------      ------------
             Total stockholders' equity                              51,031,381        50,768,618
                                                                   ------------      ------------
             Total liabilities and stockholders' equity            $549,317,589      $541,195,201
                                                                   ============      ============

</TABLE>

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


                                       52
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED DECEMBER 31, 2001 AND
YEARS ENDED SEPTEMBER 30, 2001, 2000 AND 1999
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                     DECEMBER 31,      SEPTEMBER 30,    SEPTEMBER 30,     SEPTEMBER 30,
                                                         2001              2001             2000              1999
Interest income:
<S>                                                    <C>               <C>              <C>               <C>
    Interest and fees on loans                         $  7,714,883      $ 32,759,752     $ 28,491,128      $ 19,261,766
    Interest and dividends on investments and deposits    1,752,656         9,399,416        8,373,756         3,867,259
                                                       ------------      ------------     ------------      ------------
             Total interest income                        9,467,539        42,159,168       36,864,884        23,129,025
                                                       ------------      ------------     ------------      ------------
Interest expense:
    Interest on deposits                                  4,080,585        21,154,382       18,309,033         9,379,641
    Interest on borrowings                                   11,630         1,013,660          703,647           599,422
                                                       ------------      ------------     ------------      ------------
             Total interest expense                       4,092,215        22,168,042       19,012,680         9,979,063
                                                       ------------      ------------     ------------      ------------

Net interest income before provision for loan losses      5,375,324        19,991,126       17,852,204        13,149,962
Provision for loan losses                                         -           830,000          977,000           120,000
                                                       ------------      ------------     ------------      ------------
             Net interest income                          5,375,324        19,161,126       16,875,204        13,029,962
                                                       ------------      ------------     ------------      ------------

Other income:
    Loan fees and service charges                         1,108,324         3,357,623        1,883,646         1,265,974
    Loan servicing fees                                     198,358           766,301          771,093           762,125
    Gain on sale of real estate, net                          4,929           261,031          119,331            61,027
    Gain on sale of mortgage loans and mortgage-backed
         securities                                         191,842         1,800,429            1,706           560,469
    Other income                                            121,532           590,218          656,363           224,118
                                                       ------------      ------------     ------------      ------------
             Total other income                           1,624,985         6,775,602        3,432,139         2,873,713
                                                       ------------      ------------     ------------      ------------

General and administrative expenses:
    Compensation and fringe benefits                      2,236,299         9,667,115        8,602,946         6,924,085
    ESOP termination expense                              3,143,467                 -                -                 -
    Federal insurance premiums                               21,470            91,074           95,382           123,431
    Premises and equipment                                  294,588         1,021,167        1,299,158           501,270
    Advertising                                              25,989           208,950          204,735           137,806
    Payroll and other taxes                                 179,738           737,267          709,909           520,656
    Data processing                                         418,539         1,526,827        1,155,713           806,306
    Amortization of intangibles                             156,032           580,078          344,959                 -
    Other                                                   499,520         2,214,423        1,687,683         1,241,262
                                                       ------------      ------------     ------------      ------------
             Total general and administrative expenses    6,975,642        16,046,901       14,100,485        10,254,816
                                                       ------------      ------------     ------------      ------------


Income before income taxes                                   24,667         9,889,827        6,206,858         5,648,859

Income taxes                                              1,164,640         4,059,535        2,657,826         2,452,713
                                                       ------------      ------------     ------------      ------------
NET (LOSS) INCOME                                        (1,139,973)        5,830,292        3,549,032         3,196,146

Other comprehensive (loss) income, net                     (815,901)        4,726,804         (369,877)       (1,378,776)
                                                       ------------      ------------     ------------      ------------
Comprehensive (loss) income                            $ (1,955,874)     $ 10,557,096     $  3,179,155      $  1,817,370
                                                       ============      ============     ============      ============
Net (loss) income per common share:
    Basic                                                $     (.40)       $     2.01       $     1.14         $     .91
                                                       ============      ============     ============      ============
    Diluted                                              $     (.40)       $     1.95       $     1.13         $     .91
                                                       ============      ============     ============      ============
</TABLE>

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

                                       53
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
THREE MONTHS ENDED  DECEMBER 31, 2001 AND
YEARS ENDED  SEPTEMBER 30, 2001,  2000 AND 1999
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                  RETAINED
                                                                ADDITIONAL       EARNINGS,
                                                 COMMON          PAID-IN       SUBSTANTIALLY      TREASURY
                                                  STOCK          CAPITAL         RESTRICTED         STOCK
                                                 ----------      -----------      -----------     -----------
<S>                                              <C>             <C>              <C>             <C>
BALANCE, OCTOBER 1, 1998                         $   43,640      $43,801,987      $22,091,243     $(4,895,754)
Net income                                                -                -        3,196,146               -
Other comprehensive loss, net of taxes                    -                -                -               -
MRP amortization                                          -                -                -               -
Acquisition of treasury shares                            -                -                -     (10,875,208)
Dividends ($.31 per share)                                -                -       (1,089,622)              -
Release of ESOP shares                                    -          430,023                -               -
                                                 ----------      -----------      -----------     -----------
BALANCE, SEPTEMBER 30, 1999                          43,640       44,232,010       24,197,767     (15,770,962)
Net income                                                -                -        3,549,032               -
Other comprehensive loss, net of taxes                    -                -                -               -
MRP amortization                                          -          (57,700)               -               -
Acquisition of treasury shares                            -                -                -      (7,268,139)
Dividends ($.46 per share)                                -                -       (1,418,936)              -
Release of ESOP shares                                    -          409,008                -               -
                                                 ----------      -----------      -----------     -----------
BALANCE, SEPTEMBER 30, 2000                          43,640       44,583,318       26,327,863     (23,039,101)
Net income                                                -                -        5,830,292               -
Other comprehensive income, net of taxes                  -                -                -               -
Exercise of stock options                                 -          (25,823)               -         386,687
Acquisition of treasury shares                            -                -                -      (4,253,215)
Dividends ($.67 per share)                                -                -       (1,936,091)              -
Release of ESOP shares                                    -          745,910                -               -
                                                 ----------      -----------      -----------     -----------
BALANCE, SEPTEMBER 30, 2001                      $   43,640      $45,303,405      $30,222,064    $(26,905,629)
                                                 ----------      -----------      -----------    ------------
Net loss                                                  -                -       (1,139,973)              -
Other comprehensive loss, net of taxes                    -                -                -               -
Exercise of stock options                                 -          (10,235)               -         110,610
Acquisition of treasury shares                            -                -                -      (1,908,513)
Dividends ($.18 per share)                                -                -         (533,581)              -
Release of ESOP shares                                    -        3,201,097                -               -
                                                 ----------      -----------      -----------     -----------
BALANCE, DECEMBER 31, 2001                       $   43,640      $48,494,267      $28,548,510    $(28,703,532)
                                                 ----------      -----------      -----------     -----------


<CAPTION>
                                                                                ACCUMULATED
                                                                                   OTHER
                                               UNEARNED         DEFERRED        COMPREHENSIVE
                                                 ESOP            STOCK          INCOME (LOSS),
                                                SHARES           AWARDS              NET            TOTAL
                                               -----------      -----------       ----------     -----------
<S>                                            <C>              <C>               <C>            <C>
BALANCE, OCTOBER 1, 1998                       $(2,687,093)     $(2,126,299)      $  486,246     $56,713,970
Net income                                               -                -                -       3,196,146
Other comprehensive loss, net of taxes                   -                -       (1,378,776)     (1,378,776)
MRP amortization                                         -        1,342,907                -       1,342,907
Acquisition of treasury shares                           -                -                -     (10,875,208)
Dividends ($.31 per share)                               -                -                -      (1,089,622)
Release of ESOP shares                             423,593                -                -         853,616
                                               -----------      -----------       ----------     -----------
BALANCE, SEPTEMBER 30, 1999                     (2,263,500)        (783,392)        (892,530)     48,763,033
Net income                                               -                -                -       3,549,032
Other comprehensive loss, net of taxes                   -                -         (369,877)       (369,877)
MRP amortization                                         -          783,392                -         725,692
Acquisition of treasury shares                           -                -                -      (7,268,139)
Dividends ($.46 per share)                               -                -                -      (1,418,936)
Release of ESOP shares                             444,922                -                -         853,930
                                               -----------      -----------       ----------     -----------
BALANCE, SEPTEMBER 30, 2000                     (1,818,578)               -       (1,262,407)     44,834,735
Net income                                               -                -                -       5,830,292
Other comprehensive income, net of taxes                 -                -        4,726,804       4,726,804
Exercise of stock options                                -                -                -         360,864
Acquisition of treasury shares                           -                -                -      (4,253,215)
Dividends ($.67 per share)                               -                -                -      (1,936,091)
Release of ESOP shares                             459,319                -                -       1,205,229
                                               -----------      -----------       ----------     -----------
BALANCE, SEPTEMBER 30, 2001                    $(1,359,259)        $      -      $ 3,464,397     $50,768,618
                          -                    -----------         -------       -----------     -----------
Net loss                                                 -                -                -      (1,139,973)
Other comprehensive loss, net of taxes                   -                -         (815,901)       (815,901)
Exercise of stock options                                -                -                -         100,375
Acquisition of treasury shares                           -                -                -      (1,908,513)
Dividends ($.18 per share)                               -                -                -        (533,581)
Release of ESOP shares                           1,359,259                -                -       4,560,356
                                               -----------      -----------       ----------     -----------
BALANCE, DECEMBER 31, 2001                        $      -         $      -      $ 2,648,496     $51,031,381
                                               -----------      -----------       ----------     -----------

</TABLE>

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

                                       54
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED DECEMBER 31, 2001 AND
YEARS ENDED SEPTEMBER 30, 2001, 2000 AND 1999
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                          DECEMBER 31,     SEPTEMBER 30,     SEPTEMBER 30,    SEPTEMBER 30,
                                                              2001              2001             2000              1999

Operating activities:
<S>                                                         <C>              <C>               <C>              <C>
    Net (loss) income                                       $ (1,139,973)    $  5,830,292      $  3,549,032     $  3,196,146
    Adjustments to reconcile net income to net cash
      used in operating activities:
        Provision for loan losses                                      -          830,000           977,000          120,000
        Depreciation                                             145,271          486,194           421,233          289,150
        ESOP compensation                                      3,225,564        1,205,229           853,930          853,616
        MRP compensation                                               -                -           725,692        1,342,907
        Accretion of premium on securities                       (46,632)        (103,388)          692,235              371
        Benefit from deferred income taxes                             -         (376,950)         (321,370)        (825,748)
        Gain on disposal of premises and equipment
             and real estate acquired in settlement
             of loans                                             (4,239)        (261,031)         (119,331)         (64,373)
        Gain on sale of mortgage loans and  mortgage-
             backed securities                                  (191,842)      (1,800,429)           (1,706)        (560,469)
        Originations of loans held for sale, net             (20,657,550)     (36,102,872)      (46,229,695)     (60,777,625)
        Proceeds from sale of loans held for sale             12,016,957       37,087,531                 -       40,597,010
        Other operating activities                             3,530,322        1,517,679         2,415,094         (337,366)
                                                            ------------     ------------      ------------     ------------
             Net cash (used in) provided by operating
               activities                                     (3,122,122)       8,312,255       (37,037,886)     (16,166,381)
                                                            ------------     ------------      ------------     ------------
Investing activities:
    Proceeds from maturities of investment securities
        available for sale                                     4,066,850                -         3,000,000                -
    Purchases of investment securities                                 -       (5,000,000)      (46,050,000)               -
    Proceeds from principal repayments and sales of
        mortgage-backed securities available for sale                  -       76,061,309        10,175,821       14,141,098
    Originations of loans held for investment, net
        of principal repayments                              (23,020,190)     (21,529,591)      (20,480,237)     (12,863,836)
    Proceeds from disposal of premises and equipment
        and real estate acquired in settlement of loans          187,570          705,310           911,869          655,821
    Purchases of FHLB stock                                            -          (61,200)          (43,600)         (96,400)
    Purchases of premises and equipment                         (158,498)      (1,224,834)       (1,614,712)        (312,919)
    Repayment of note receivable                                   6,623           25,045             3,949                -
    Net cash to purchase Green Street Financial Corp.                  -                -       (26,530,907)               -
    Acquisition of Triangle Bancorp, Inc. branches                     -                -       113,760,993                -
                                                            ------------     ------------      ------------     ------------
             Net cash (used in) provided by investing
             activities                                      (18,917,645)      48,976,039        33,133,176        1,523,764
                                                            ------------     ------------      ------------     ------------
Financing activities:
    Net increase (decrease) in deposit accounts                3,649,597           (2,759)       (8,461,007)      29,982,910
    Proceeds from FHLB borrowings                              1,000,000       72,200,000       125,200,000       61,000,000
    Repayments of  FHLB borrowings                                     -      (96,200,000)     (101,200,000)     (70,500,000)
    Purchase of treasury shares                                 (573,721)      (4,253,215)       (7,268,139)     (10,875,208)
    Proceeds from exercise of stock options                      100,375          360,863                 -                -
    Cash dividends paid                                         (518,511)      (1,936,091)       (1,418,936)      (1,089,622)
    Net change in escrow accounts                                 83,823         (271,035)           (4,442)        (362,793)
    Net change in repurchase agreements                         (468,157)      (1,478,054)        2,388,742       (1,114,579)
                                                            ------------     ------------      ------------     ------------
             Net cash provided by (used in) financing
               activities                                      3,273,406      (31,580,291)        9,236,218        7,040,708
                                                            ------------     ------------      ------------     ------------
(Decrease) increase in cash and cash equivalents             (18,766,361)      25,708,003         5,331,508       (7,601,909)
Cash and cash equivalents, beginning of year                  40,449,443       14,741,440         9,409,932       17,011,841
                                                            ------------     ------------      ------------     ------------
Cash and cash equivalents, end of year                      $ 21,683,082     $ 40,449,443      $ 14,741,440     $  9,409,932
                                                            ============     ============      ============     ============
</TABLE>

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


                                       55
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

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 financial  statements  in conformity  with  accounting
     principles  generally  accepted  in the United  States of America  requires
     management  to make  estimates  and  assumptions  that affect the  reported
     amounts of assets and liabilities  and disclosure of contingent  assets and
     liabilities  at the  date of the  financial  statements  and  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 and federal funds sold. Generally, federal funds are purchased
     and sold for one-day periods.

     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.  As of December 31, 2001,  the Bank has classified all
     investments as available for sale.

     Premiums and discounts on debt securities are recognized in interest income
     using the interest method over the period to maturity.

     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.

     Gains and  losses on the sale of  securities  are  determined  by using the
     specific identification method.


                                       56
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     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
     deferred  origination  fees.  Interest  on  loans is  accrued  based on the
     principal  amount  outstanding and is recognized using the interest method.
     The accrual of interest is discontinued, 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 ninety days.

     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  utilizing  the interest
     method.

     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.  At December 31, 2001 and September 30, 2001, and
     during the three months ended  December 31, 2001 and during the three years
     ended  September 30, 2001,  there were no individual  loans material to the
     consolidated financial statements which were defined as impaired.

     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.

     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 in a
     valuation  allowance  by 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  basis  of the  loans  sold,  adjusted  for  the
     recognition of any servicing assets retained.


                                       57
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     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
     In September 2000, the FASB issued SFAS No. 140,  "Accounting for Transfers
     and Servicing of Financial  Assets and  Extinguishments  of Liabilities,  a
     replacement  of SFAS No. 125." It revises the standards for  accounting for
     securitizations  and other transfers of financial assets and collateral and
     requires certain disclosures, but it carries over most of the provisions of
     SFAS No.  125  without  reconsideration.  SFAS  140  requires  a debtor  to
     reclassify  financial  assets pledged as collateral and report these assets
     separately  in the  statement of  financial  position.  It also  requires a
     secured  party  to  disclose  information,   including  fair  value,  about
     collateral  that it has  accepted and is permitted by contract or custom to
     sell or repledge.  SFAS 140 includes specific  disclosure  requirements for
     entities with  securitized  financial  assets and entities that  securitize
     assets.  SFAS 140 is effective  for  transfers  and  servicing of financial
     assets and  extinguishments of liabilities  occurring after March 31, 2000,
     and is effective for recognition and reclassification of collateral and for
     disclosures  relating to  securitization  transactions  and  collateral for
     fiscal years ending after  December 15, 2000.  The adoption of SFAS 140 did
     not have a material effect on financial condition or results of operation.

     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 in proportion to and over
     the period of estimated net servicing  income (if servicing  revenue exceed
     servicing cots) 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.


                                       58
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     During the three months  ended  December  31,  2001,  the Company  recorded
     additional  servicing  assets of  $131,804 as a result of sales of loans or
     mortgage-backed  securities.  Amortization  of servicing  assets during the
     year  ended  December  31,  2001  aggregated  $26,674.  The  fair  value of
     recognized servicing assets amounted to $1,030,368 as of December 31, 2001.
     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.

     There was no valuation  allowance for  impairment  of recognized  servicing
     assets during the three months ended  December 31, 2001 and the three years
     ended September 30, 2001, 2000 and 1999.

     PREMISES AND EQUIPMENT
     Premises and equipment are stated at cost less accumulated depreciation and
     amortization.   Depreciation   and   amortization   are   computed  by  the
     straight-line  and accelerated  methods based on estimated service lives of
     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
     ("REO")  at the lower of the  estimated  fair  value of the  property  less
     estimated  costs to sell at the date of foreclosure or the carrying  amount
     of  the  loan  plus  unpaid  accrued  interest.   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.

     INVESTMENT IN FEDERAL HOME LOAN BANK STOCK
     The Bank is required  to invest in stock of the  Federal  Home Loan Bank of
     Atlanta ("FHLB") in the amount of 1% of its outstanding home loans or 5% of
     its outstanding  advances from the FHLB,  whichever is greater. At December
     31, 2001 and September 30, 2001, the Bank owned 27,125 shares of the FHLB's
     $100 par value capital stock.

     INTANGIBLE ASSETS
     Intangible  assets  consist of goodwill and deposit  premiums and are being
     amortized over ten years using the straight-line method.

     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.


                                       59
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     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 three  months ended
     December 31, 2001 and the years ended September 30, 2001, 2000 and 1999, is
     as follows:

<TABLE>
<CAPTION>
                                            DECEMBER 31,     SEPTEMBER 30,     SEPTEMBER 30,    SEPTEMBER 30,
                                                2001             2001              2000             1999
<S>                                           <C>              <C>                <C>             <C>
Unrealized (losses) gains on securities
    available for sale                        $ (1,359,836)    $  8,299,802       $  (616,463)    $ (2,159,473)

Reclassification of net gains
    recognized in net income                             -         (421,792)                -         (138,881)

Income tax benefit (expense) relating to
    unrealized (losses) gains on available
    for sale securities                            543,935       (3,151,206)          246,586          919,578
                                               -----------     ------------       -----------     ------------
Other comprehensive (loss) income, net         $  (815,901)    $  4,726,804       $  (369,877)    $ (1,378,776)
                                               ===========     ============       ===========     ============
</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.

     NEW ACCOUNTING PRONOUNCEMENTS
     On July 20,  2001 the FASB issued  SFAS No.  141,  "Business  Combinations"
     (SFAS 141), and No. 142, "Goodwill and Other Intangible Assets" (SFAS 142).
     SFAS Nos. 141 and 142 will change the accounting for business  combinations
     and goodwill in two significant ways. First, SFAS No. 141 requires that the
     purchase  method  of  accounting  be  used  for all  business  combinations
     initiated  after June 30, 2001. Use of the  pooling-of-interests  method is
     prohibited.  Second,  SFAS No. 142 changes the accounting for goodwill from
     an amortization  method to an  impairment-only  approach.  Upon adoption of
     SFAS No. 142, the Company will cease  amortization of goodwill  recorded in
     past business transactions. Goodwill presently recorded on the books of the
     Company  amounted  to  $225,055  and  $232,162  at  December  31,  2001 and
     September 30, 2001, respectively.

     The goodwill will be assigned to the related  reporting unit in the Company
     and tested  for  impairment  at least  annually.  The tests will  initially
     involve the  comparison of the  reporting  units fair value to its carrying
     value,  including  goodwill.  If  necessary,  the implied fair value of the
     goodwill  will  be  compared  to the  carrying  value  to  determine  if an
     allowance is  necessary.  The  provisions of SFAS No. 142 are effective for
     fiscal years  beginning  after  December 15, 2001.  The Company has not yet
     completed its impairment test.


                                       60
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     In June  2001,  the  FASB  issued  SFAS  No.  143,  "Accounting  for  Asset
     Retirement  Obligations" (SFAS 143), and in July 2001, the FASB issued SFAS
     No. 144,  "Accounting for the Impairment or Disposal of Long-Lived  Assets"
     (SFAS 144).

     SFAS 143  requires  that  obligations  associated  with the  retirement  of
     tangible   long-lived   assets  be  recorded  as  a  liability  when  those
     obligations are incurred,  with the amount of liability  initially measured
     at  fair  value.  SFAS  143  will be  effective  for  financial  statements
     beginning  after June 15, 2002,  though early adoption is  encouraged.  The
     application of this statement is not expected to have a material  impact on
     the Company's financial statements.

     SFAS 144 supersedes SFAS 121,  "Accounting for the Impairment of Long-Lived
     Assets and for  Long-Lived  Assets to be Disposed  Of." SFAS 144 applies to
     all  long-lived  assets  including  discontinued  operations,   and  amends
     Accounting Principle Board Opinion No 30, "Reporting the Effect of Disposal
     of a Segment of a Business,  and  Extraordinary,  Unusual and  Infrequently
     Occurring  Events and  Transactions."  SFAS 144  requires  that  long-lived
     assets  that are to be disposed of by sale be measured at the lower of book
     or fair  value  less  cost to sell.  SFAS 144 is  effective  for  financial
     statements  issued for fiscal years  beginning  after December 15, 2001 and
     its  provisions  are generally  expected to be applied  prospectively.  The
     application of this statement is not expected to have a material  impact on
     the Company's financial statements.

2.   SIGNIFICANT ACTIVITIES

     During the three months ended December 31, 2001, the Company terminated its
     Employee  Stock  Ownership  Plan (See Note 8 for  further  details  of this
     transaction).

     On November 30, 1999,  the Company  consummated  the  acquisition  of Green
     Street Financial Corp. ("Green Street"), the parent holding company of Home
     Federal Savings and Loan Association of Fayetteville, North Carolina ("Home
     Federal"), with full service offices located in Fayetteville and Lumberton,
     North Carolina. The acquisition was accounted for using the purchase method
     of accounting  for a cash  purchase  price of $59.2  million,  representing
     $15.25 per share of Green Street common stock.

     Concurrently  with the Green Street  acquisition,  the Company  changed its
     name to First South Bancorp, Inc.

     The following  table reflects the unaudited pro forma  combined  results of
     operations,  assuming  the  acquisition  had  occurred at the  beginning of
     fiscal 2000 and 1999:

                                           2000              1999

Net interest income                   $ 17,409,204      $ 16,235,962
Net income                               3,580,032         3,384,146
Net earnings per diluted share                1.14               .96


     In  management's  opinion,  these  unaudited  pro  forma  amounts  are  not
     necessarily  indicative of what the actual  combined  results of operations
     might have been if the  acquisitions had been effective at the beginning of
     fiscal 1998.


                                       61
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     On February 18, 2000,  the Bank  completed the  acquisition of six Triangle
     Bank ("Triangle") branch offices located in Rocky Mount and Tarboro,  North
     Carolina.  This  acquisition was accounted for using the purchase method of
     accounting  and the Bank assumed the  deposits of the six  Triangle  branch
     offices for a premium of approximately 4.0% of the assumed deposits.

     The fair values of assets, including goodwill, and liabilities assumed were
     as follows:


                                             GREEN STREET          TRIANGLE

Loans receivable                             $125,459,235        $ 26,162,062
Premises and equipment                          1,245,957           2,407,409
Intangible assets                                 287,832           4,898,652
Other assets                                    4,548,219             277,790
Deposits                                     (101,648,952)       (144,135,727)
Other liabilities                              (3,361,384)         (3,371,179)
                                             ------------      --------------
Net cash paid (received) for acquisitions    $ 26,530,907      $ (113,760,993)
                                             ============      ==============

3.   INVESTMENT SECURITIES

     Investment  securities  at December 31, 2001 and  September  30, 2001,  are
     classified  as  available  for sale  according to  management's  intent and
     summarized as follows:


<TABLE>
<CAPTION>

                                                           Gross Unrealized             Estimated
                                     Amortized      --------------------------------      Market
                                        Cost            Gains            Losses           Value
                                   ---------------  ---------------  ---------------  ---------------
<S>                                <C>              <C>              <C>              <C>
December 31, 2001:

   U.S. Treasury and Agency Notes  $   50,507,941   $    3,553,501   $            -   $    54,061,442
                                   ---------------  ---------------  ---------------  ---------------
September 30, 2001:

   U.S. Treasury and Agency Notes  $   50,461,308       $4,280,476   $            -   $    54,741,784
                                   ---------------  ---------------  ---------------  ---------------
</TABLE>

     U.S.  Treasury and Agency notes at December  31,  2001,  are  contractually
     scheduled to mature as follows:

                                                                    ESTIMATED
                                                  AMORTIZED          MARKET
                                                    COST              VALUE
                                                  ------------      ------------
Due after one year through five years             $ 45,494,080      $ 48,510,156

Due after five years through ten years               5,013,860         5,551,286
                                                  ------------      ------------
                                                  $ 50,507,940      $ 54,061,442
                                                  ============      ============


                                       62
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

4.   MORTGAGE-BACKED SECURITIES

     Mortgage-backed securities at December 31, 2001 and September 30, 2001, are
     classified  as  available  for sale  according to  management's  intent and
     summarized as follows:

<TABLE>
<CAPTION>
                                                                                                ESTIMATED
                                                AMORTIZED           GROSS UNREALIZED             MARKET
                                                                 -------------------------
                                                  COST            GAINS           LOSSES          VALUE
                                               -----------       --------        ---------       -----------
<S>                                          <C>               <C>             <C>             <C>
December 31, 2001:
   FHLMC participation certificates,
   maturing from years 2003 to 2028            $43,053,970       $867,943        $ (18,289)      $43,903,624
                                               -----------       --------        ---------       -----------

September 30, 2001:
   FHLMC participation certificates,
   maturing from years 2003 to 2030            $47,120,820     $1,482,516           $    -       $48,603,336
                                               -----------       --------        ---------       -----------
</TABLE>


     Mortgage-backed   securities  at  December  31,  2001,  are   contractually
     scheduled to mature as follows:

                                                                   ESTIMATED
                                                 AMORTIZED          MARKET
                                                   COST              VALUE
                                                 ------------      ------------
Due after one year through five years            $    485,026      $    496,453
Due after five years through ten years              2,987,315         3,029,454
Due after ten years                                39,581,629        40,377,717
                                                 ------------      ------------
                                                 $ 43,053,970      $ 43,903,624
                                                 ============      ============

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

     Mortgage-backed  securities with a carrying value of $0,  $63,181,244,  $0,
     and  $5,520,194  were sold during the three months ended  December 31, 2001
     and during the years ended September 30, 2001, 2000 and 1999, respectively.
     Net  realized  gains on the sales of  mortgage-backed  securities  were $0,
     $421,792,  $0, and $138,881 during the three months ended December 31, 2001
     and during the years ended September 30, 2001, 2000 and 1999, respectively.

     Mortgage-backed   securities  with  an  amortized  cost  of   approximately
     $5,103,367  and  $5,492,322  were pledged as  collateral  for deposits from
     public entities at December 31, 2001 and September 30, 2001.


                                       63
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

5.   LOANS RECEIVABLE

     Loans  receivable  at  December  31,  2001  and  September  30,  2001,  are
     summarized as follows:

                                    DECEMBER 31,      SEPTEMBER 30,
                                        2001               2001

Mortgage loans                       $ 133,395,094      $ 123,196,766
Consumer loans                          77,775,818         78,184,965
Commercial loans                       200,621,122        178,856,021
                                     -------------      -------------
           Total                       411,792,034        380,237,752
Less:
    Allowance for loan losses           (5,370,820)        (5,401,358)
    Deferred loan fees                    (808,159)          (749,449)
                                     -------------      -------------
Loans receivable, net                $ 405,613,055      $ 374,086,945
                                     =============      =============



     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 10).

     During the three months ended  December 31, 2001 and during the years ended
     December 31, 2001, 2000 and 1999, the Bank exchanged loans with outstanding
     principal  balances  of  $0,  $12,298,139,  $62,789,209,  and  $45,527,117,
     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, 2001 and  September  30, 2001 are fixed rate  mortgage
     loans with an  estimated  market  value of  approximately  $29,300,000  and
     $20,500,000, respectively.

     Net gains on sales of loans  receivable held for sale amounted to $191,842,
     $1,378,637, $1,706, and $303,324 during the three months ended December 31,
     2001 and  during  the  years  ended  September  30,  2001,  2000 and  1999,
     respectively.

     The changes in the  allowance  for loan losses for the three  months  ended
     December 31, 2001 and the years ended  September  30, 2001,  2000 and 1999,
     are as follows:

<TABLE>
<CAPTION>
                                          DECEMBER 31,     SEPTEMBER 30,     SEPTEMBER 30,    SEPTEMBER 30,
                                             2001              2001             2000              1999
<S>                                          <C>               <C>              <C>               <C>
Balance at beginning of year                 $5,401,358        $5,159,353       $3,297,256        $3,364,588
Provisions for loan losses                            -           830,000          977,000           120,000
Balance transferred in acquisition                    -                 -          962,999                 -
Loans charged off                               (42,376)         (655,506)        (157,092)         (265,384)
Recoveries                                       11,838            67,511           79,190            78,052
                                             ----------        ----------       ----------        ----------
Balance at end of year                       $5,370,820        $5,401,358       $5,159,353        $3,297,256
                                             ==========        ==========       ==========        ==========

</TABLE>


                                       64
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------


     The following is a summary of the principal balances of loans on nonaccrual
     status and loans past due ninety days or more:

                                                DECEMBER 31,    SEPTEMBER 30,
                                                    2001             2001
Loans contractually past due 90 days or more
    and/or on nonaccrual status:
      Residential                                  $   863,724      $   570,704
      Consumer and commercial                          389,225          491,676
                                                   -----------      -----------
                                                   $ 1,252,949      $ 1,062,380
                                                   ===========      ===========

     At December 31, 2001 and at September  30,  2001,  2000 and 1999,  interest
     income  of   approximately   $51,000,   $43,000,   $40,000,   and   $9,000,
     respectively,  was  not  recorded  related  to  loans  accounted  for  on a
     nonaccrual basis.

6.   PREMISES AND EQUIPMENT

     Premises and equipment at December 31, 2001 and September 30, 2001, consist
     of the following:


                                                DECEMBER 31,    SEPTEMBER 30,
                                                    2001             2001

Land                                               $ 2,566,219      $ 2,566,219
Office buildings                                     5,811,385        5,793,501
Furniture, fixtures and equipment                    3,206,671        3,083,963
Vehicles                                               326,082          323,205
                                                   -----------      -----------
                                                    11,910,357       11,766,888
Less accumulated depreciation                        3,976,069        3,841,278
                                                   -----------      -----------
           Total                                   $ 7,934,288      $ 7,925,610
                                                   ===========      ===========


7.   EMPLOYEE BENEFIT PLANS

     The Company  participates in a multi-employer  defined benefit pension plan
     which covers  substantially  all employees.  Effective January 31, 2002 the
     Company's  Board of  Directors  approved  a plan to freeze  the  accrual of
     future benefits. As such, no new employee shall become a participant in the
     plan after January 31, 2002.  However,  employees who were participating in
     the plan as of January 31, 2002 shall continue to participate in accordance
     with the  provisions  of the plan,  however the accrual of future  benefits
     will cease.  Expenses of the plan for the three months  ended  December 31,
     2001 and the years ended  September 30, 2001,  2000 and 1999, were $69,000,
     $69,017, $258,600, and $133,000, 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 50% of employees' contributions up to 6% 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 three months ended December 31, 2001 and the years ended  September
     30, 2001,  2000 and 1999,  were $32,305,  $115,174,  $84,924,  and $76,985,
     respectively.

     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 three months ended  December 31, 2001 and during the
     years  ended  September  30,  2001,  2000 and  1999,  aggregated  $159,373,
     $617,127, $544,327, and $516,985, respectively. The plans generally include
     provisions for forfeitures of unvested portions of payments, and vesting in
     the event of death or disability.



                                       65
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     On  April  8,  1998,  the  Company's  Stockholders  approved  a  Management
     Recognition  Plan ("MRP") for directors and key employees.  The Company was
     authorized to fund the acquisition of and award up to 174,570 shares (4% of
     shares issued in the stock  conversion) to be awarded by a committee of the
     Board of Directors.  The Company  completed the  acquisition  of MRP shares
     during  fiscal 1998.  On April 8, 1998,  174,570  shares  (market  value of
     $4,029,258  and  aggregate  cost of  $3,275,299)  were  awarded  to certain
     officers and employees.  The vesting schedule  provided that 33-1/3% of the
     shares were earned and became  non-forfeitable  on April 8, 1998,  1999 and
     2000.

     The shares issued to the MRP plan were recorded as outstanding  shares, and
     the unvested portion was recorded as unearned compensation through a contra
     equity  account.  The  consolidated  statements of operations for the three
     months ended December 31, 2001 and the years ended September 30, 2001, 2000
     and 1999, include compensation expense of $0, $0, $725,692, and $1,342,907,
     respectively, relating to the scheduled vesting of MRP shares.

8.   EMPLOYEE STOCK OWNERSHIP PLAN

     Effective  December 31, 2001,  the Company  terminated  its Employee  Stock
     Ownership  Plan  ("ESOP").  As a result of this  termination,  the  Company
     recognized an additional $3,143,467 in related compensation expenses.

     Upon adoption,  the ESOP acquired  349,140  shares of the Company's  common
     stock  financed by  $3,491,400  in borrowings by the ESOP from the Company.
     This loan was secured by the shares of Common Stock  purchased and earnings
     thereon.  At December 31, 2001 and September 30, 2001,  281,707 and 213,213
     shares,  respectively,  have  been  allocated  to  participants'  accounts.
     However,  as a  result  of the  termination  there  are no  unallocated  at
     December 31, 2001.  Unallocated  shares at September  30, 2001 were 135,927
     shares, with an estimated market value of $4,322,479.  All allocated shares
     are  considered  outstanding  for  earnings per share  purposes,  while the
     unallocated shares are not included in the calculation.

     As a result of the  termination all debt  outstanding has been repaid.  The
     principal  balance at  September  30,  2001 was  $1,359,259.  The Bank used
     dividends  declared on 2,447  unallocated  shares totaling  $24,467 and the
     sale  of  39,785  unallocated  shares  totaling  $1,334,792  to  repay  the
     outstanding debt. Dividends on allocated shares were treated as a reduction
     of retained earnings.  Dividends on unallocated shares were treated only as
     debt service, and there was no reduction of retained earnings. Compensation
     expense  related to the ESOP was based on the average  fair market value of
     shares during the period since the prior  allocation date through the dates
     shares are committed to be released. The financial statements for the three
     months ended December 31, 2001 and the years ended September 30, 2001, 2000
     and 1999, include compensation expense of $3,225,564, $1,205,229, $835,135,
     and $853,616, respectively, related to the ESOP and its termination.



                                       66
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

9.   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  436,425  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.

     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 Option Plan. Had compensation cost
     for the Company's  Option Plan been  determined  based on the fair value at
     the grant  dates for  awards  under the  Option  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:



<TABLE>
<CAPTION>
                       FOR THE THREE MONTHS ENDED                                 FOR THE YEAR ENDED
                            DECEMBER 31, 2001          SEPTEMBER 30, 2001         SEPTEMBER 30, 2000      SEPTEMBER 30, 1999
                       --------------------------   ------------------------   ------------------------    ------------------------
                      AS REPORTED     PRO FORMA    AS REPORTED   PRO FORMA    AS REPORTED   PRO FORMA    AS REPORTED    PRO FORMA

<S>                  <C>            <C>           <C>           <C>          <C>           <C>           <C>          <C>
Net income           $(1,139,973)   $(1,154,254)  $5,830,292    $5,742,412   $3,549,032    $3,464,965    $3,196,146   $ 3,138,174
Earnings per common
     share - basic          (.40)          (.40)        2.01          1.95         1.14          1.11           .91           .89
Earnings per common
     share - diluted        (.40)          (.40)        1.95          1.92         1.13          1.11           .91           .89

</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 three months  ended  December 31, 2001
     and the years  ended  September  30,  2001,  2000 and  1999,  respectively:
     dividend  growth rate of 22%,  22%,  17%, and 15%;  expected  volatility of
     18.5%, 18.9%, 18.6% and 20.8%; risk-free interest rates of 4.75% during the
     three months ended December 31, 2001;  5.84%,  5.78%,  and 5.05% during the
     year ended  September  30, 2001;  6.0% during the year ended  September 30,
     2000; and 7.1% during the year ended September 30, 1999; and expected lives
     of 7 years.


                                       67
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     A summary of the status of the Plan as of December  31, 2001 and  September
     30, 2001, 2000 and 1999, and changes during the years then ended, including
     weighted-average exercise price ("Price"), is presented below:


<TABLE>
<CAPTION>
                             FOR THE THREE MONTHS ENDED                      FOR THE YEAR ENDED
                                  DECEMBER 31, 2001     SEPTEMBER 30, 2001   SEPTEMBER 30, 2000     SEPTEMBER 30, 1999
                                  -----------------     -----------------    ------------------     -------------------
                                  SHARES      PRICE     SHARES      PRICE     SHARES      PRICE     SHARES     PRICE
                                  -------     -----     -------     -----     -------     -----     -------    ------
<S>                               <C>       <C>         <C>       <C>         <C>       <C>         <C>       <C>
Outstanding at beginning of year  408,903   $ 18.54     413,303   $ 18.25     404,303   $ 18.24     398,303   $ 18.25
Granted                             4,000     32.25      19,000     25.63      21,000     18.26       6,000     17.75
Cancellations                     (10,500)    18.25     (23,400)    18.35     (12,000)    18.25
                                  -------               -------               -------               -------
Outstanding at year end           402,403     18.68     408,903     18.54     413,303     18.25     404,303     18.24
                                  =======               =======               =======               =======

Weighted-average fair value of
   options granted during the year          $  6.89               $  5.14               $  4.02               $  5.04
                                            =======               =======               =======               =======
</TABLE>


     The following table summarizes additional information about the Option Plan
     at December 31, 2001, including weighted-average remaining contractual life
     ("Life") and Price:


                             OPTIONS OUTSTANDING            OPTIONS EXERCISABLE
                    ---------------------------------    -----------------------
                      SHARES       LIFE       PRICE         SHARES      PRICE

$ 17.75 - 32.25      402,403     6.5 years    $ 18.68     388,403      $ 18.41


10.  BORROWED MONEY

     Borrowed money represents advances from the FHLB and repurchase agreements.
     Advances  outstanding  from the FHLB at  December  31,  2001 had a weighted
     average  rate of 1.83%  and  totaled  $1,000,000.  There  were no  advances
     outstanding from the FHLB at September 30, 2001.

     At  December  31,  2001  and  September  30,  2001,  repurchase  agreements
     outstanding  had average rates of 0.43% and 1.43%,  and totaled  $4,441,340
     and $4,909,497, respectively.

     At December 31, 2001,  repurchase  agreements were  collateralized  by U.S.
     government agency  obligations with a principal balance of $7,000,000.  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, 2001, the Company had
     an additional $114,000,000 of credit available with the FHLB.




                                       68
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------


11.  INCOME TAXES

     The  components  of income tax expense for the three months ended  December
     31, 2001 and the years ended  September  30,  2001,  2000 and 1999,  are as
     follows:

               DECEMBER 31,     SEPTEMBER 30,     SEPTEMBER 30,    SEPTEMBER 30,
                  2001             2001              2000             1999
Current:
    Federal    $  1,028,407     $  3,877,218      $  2,665,596     $  2,712,909
    State           136,233          559,267           313,600          565,552
               ------------     ------------      ------------     ------------
                  1,164,640        4,436,485         2,979,196        3,278,461
               ------------     ------------      ------------     ------------
Deferred:
    Federal               -         (310,782)         (287,542)        (719,993)
    State                 -          (66,168)          (33,828)        (105,755)
               ------------     ------------      ------------     ------------
                          -         (376,950)         (321,370)        (825,748)
               ------------     ------------      ------------     ------------
Total          $  1,164,640     $  4,059,535      $  2,657,826     $  2,452,713
               ============     ============      ============     ============


     Reconciliations  of the expected  income tax expense at statutory tax rates
     with income tax expense  reported in the  statements of operations  for the
     three months  ended  December  31, 2001 and the years ended  September  30,
     2001, 2000 and 1999, are as follows:

<TABLE>
<CAPTION>
                                          DECEMBER 31,     SEPTEMBER 30,     SEPTEMBER 30,    SEPTEMBER 30,
                                             2001             2001              2000             1999
<S>                                     <C>            <C>               <C>              <C>
Expected income tax expense at 34%      $      8,387     $  3,362,541      $  2,110,332     $  1,920,612
State income taxes, net of federal
      income tax                             144,153          325,445           296,998          270,298
Non-deductible ESOP, other
      expenses and other adjustments       1,012,100          371,549           250,496          261,803
                                        ------------     ------------      ------------     ------------
                                        $  1,164,640     $  4,059,535      $  2,657,826     $  2,452,713
                                        ============     ============      ============     ============
</TABLE>



                                       69
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

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

                                         DECEMBER 31,       SEPTEMBER 30,
                                            2001                2001
Deferred income tax assets:
    Deferred directors' fees             $  578,037          $  578,037
    Allowance for loan losses             1,752,708           1,752,708
    Employee benefits                       740,189             740,189
    Loans mark-to-market                    315,198             315,198
    Other                                   363,408             363,408
                                         ----------          ----------
                                          3,749,540           3,749,540
                                         ----------          ----------
Deferred income tax liabilities:
    Unrealized gains on securities
      available for sale                  1,754,659           2,298,594
    Depreciation and amortization           347,515             347,515
    Carrying value - land                   386,200             386,200
    Mortgage servicing rights               357,327             357,327
    Deferred loan origination fees
        and costs                            55,472              55,472
    FHLB stock                              195,801             195,801
                                         ----------          ----------
                                          3,096,974           3,640,909
                                         ----------          ----------
Net deferred income tax asset            $  652,566          $  108,631
                                         ==========          ==========


     Retained earnings at December 31, 2001,  include  approximately  $1,850,000
     for which no deferred income tax liability has been recognized. This amount
     represents an allocation  of income to bad debt  deductions  for income tax
     purposes  only.  Reductions of the amount so allocated  for purposes  other
     than for tax bad debt losses or  adjustments  arising from carryback of net
     operating losses could create taxable income,  in certain remote instances,
     which would be subject to the then current corporate income tax rate.

12.  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%.

     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, 2001, that the Bank meets
     all capital adequacy requirements to which it is subject.


                                       70
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     As of  December  31,  2001,  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,
     2001 and September 30, 2001,  are presented in the table below  (dollars in
     thousands):

<TABLE>
<CAPTION>
                                                                                          TO BE WELL
                                                                                          CAPITALIZED
                                                                     FOR CAPITAL         UNDER PROMPT
                                                   ACTUAL         ADEQUACY PURPOSE    ACTION PROVISIONS
                                              -----------------   ----------------    -----------------
                                              AMOUNT    RATIO     AMOUNT      RATIO    AMOUNT      RATIO
                                              ------    -----     ------      -----    ------      -----
<S>                                           <C>         <C>     <C>           <C>    <C>          <C>
December 31, 2001:
Total Capital (to Risk Weighted Assets)       $48,992     12.7%   $ 30,910      8.0%   $ 38,638     10.0%
Tier I Capital (to Risk Weighted Assets)       44,156     11.4%     15,455      4.0%     23,183      6.0%
Tier I Capital (to Average Assets)             44,156      8.1%     21,885      4.0%     27,357      5.0%

September 30, 2001:
Total Capital (to Risk Weighted Assets)       $47,627     12.8%   $ 29,835      8.0%   $ 37,294     10.0%
Tier I Capital (to Risk Weighted Assets)       42,956     11.5%     14,917      4.0%     22,376      6.0%
Tier I Capital (to Average Assets)             42,956      8.1%     21,246      4.0%     26,557      5.0%

</TABLE>


13.  EARNINGS PER SHARE

     The following table provides a reconciliation of income available to common
     stockholders  and the average number of shares  outstanding  (less unearned
     ESOP shares,  unearned  deferred stock awards and treasury  shares) for the
     three months  ended  December  31, 2001 and the years ended  September  30,
     2001,  2000 and 1999.  Options to purchase  402,403,  408,903,  413,303 and
     404,303  shares of common stock were  outstanding  at December 31, 2001 and
     September  30,  2001,  2000,  and 1999,  respectively.  For the year  ended
     September 30, 1999,  none of these options were included in the computation
     of diluted EPS because the  options'  exercise  price was greater  than the
     average  market price of common shares for that year.  For the three months
     ended  December  31,  2001,  none of these  options  were  included  in the
     computation of diluted EPS because the per share amounts  calculated  would
     be anti-dilutive because of the reported loss.

<TABLE>
<CAPTION>
                                          DECEMBER 31,     SEPTEMBER 30,   SEPTEMBER 30,    SEPTEMBER 30,
                                              2001             2001             2000             1999
<S>                                         <C>              <C>              <C>              <C>
Net (loss) income (numerator)               $(1,139,973)     $ 5,830,292      $ 3,549,032      $ 3,196,146
                                            ===========      ===========      ===========      ===========

Weighted average shares outstanding
    for basic EPS (denominator)               2,872,246        2,899,846        3,115,768        3,530,811
Dilutive effect of stock options                      -           85,580           11,104                -
                                            -----------      -----------      -----------      -----------
Adjusted shares for diluted EPS               2,872,246        2,985,426        3,126,872        3,530,811
                                            -----------      -----------      -----------      -----------
</TABLE>

                                       71
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

14.  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  $274,239,995  and
     $295,216,089  at December 31, 2001 and  September  30, 2000,  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, 2001 and  September  30, 2001,  mortgage  servicing  rights
     reported in the  consolidated  statements  of financial  condition,  net of
     amortization, were $1,030,368 and $925,239, respectively.

15.  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 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.

     A  summary  of  the  contractual  amounts  of  the  Company's  exposure  to
     off-balance  sheet risk as of December 31, 2001 and  September 30, 2001, is
     as follows:

<TABLE>
<CAPTION>
                                                                DECEMBER 31,       SEPTEMBER 30,
                                                                    2001                2001
<S>                                                              <C>                <C>
Commitments to extend credit:
    Commitments to originate loans                               $50,204,542        $57,413,601
    Undrawn balances on lines of credit and undrawn
        balances on credit reserves (overdraft protection)        48,626,867         48,197,325
                                                                 -----------      -------------
                                                                 $98,831,409      $ 105,610,926
                                                                 ===========      =============
</TABLE>

                                       72
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     Included in the  commitments to originate loans as of December 31, 2001 and
     September 30, 2001, are fixed interest rate loan commitments of $11,655,067
     and $7,758,283,  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,   Edgecombe,  Lenoir,  Nash,  Pasquotank,  Pitt,  Robeson,  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.

16.  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, 2001 and
     September 30, 2001, 2000, and 1999, and for the three months ended December
     31, 2001 and the three years ended September 30, 2001, are as follows:

<TABLE>
<CAPTION>

                                                    DECEMBER 31,      SEPTEMBER 30,     SEPTEMBER 30,     SEPTEMBER 30,
                                                        2001              2001               2000              1999

<S>                                                    <C>              <C>               <C>               <C>
CONDENSED BALANCE SHEETS
Cash                                                  $    734,906      $  1,902,285      $  1,055,374      $  1,151,744
Due from subsidiary                                      4,157,099           931,535           477,287         5,368,089
Investment in wholly-owned subsidiary                   46,710,200        49,203,538        43,692,079        42,563,204
Other assets                                                28,620             8,856             8,747            12,115
                                                      ------------      ------------      ------------      ------------
        Total assets                                  $ 51,630,825      $ 52,046,214      $ 45,233,487      $ 49,095,152
                                                      ============      ============      ============      ============

Other liabilities                                     $    599,444      $  1,277,596       $   398,752       $   332,119
Stockholders' equity                                    51,031,381        50,768,618        44,834,735        48,763,033
                                                      ------------      ------------      ------------      ------------
        Total liabilities and stockholders' equity    $ 51,630,825      $ 52,046,214      $ 45,233,487      $ 49,095,152
                                                      ============      ============      ============      ============
</TABLE>

<TABLE>
<CAPTION>
                                                    DECEMBER 31,      SEPTEMBER 30,     SEPTEMBER 30,     SEPTEMBER 30,
                                                        2001              2001               2000              1999
<S>                                                     <C>              <C>               <C>               <C>
CONDENSED STATEMENTS OF INCOME
Interest income, net                                    $   21,690       $   166,623       $   204,090       $   234,242
Equity in earnings of subsidiary                        (1,144,436)        5,772,653         3,471,752         3,121,370
Miscellaneous expenses                                      17,227           108,984           126,810           159,466
                                                      ------------      ------------      ------------      ------------
        Net (loss) income                             $ (1,139,973)     $  5,830,292      $  3,549,032      $  3,196,146
                                                      ============      ============      ============      ============
</TABLE>

                                       73
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                    DECEMBER 31,      SEPTEMBER 30,     SEPTEMBER 30,     SEPTEMBER 30,
                                                        2001              2001               2000              1999
<S>                                                  <C>               <C>               <C>               <C>
CONDENSED STATEMENTS OF CASH FLOWS
Operating activities:
    Net (loss) income                                $ (1,139,973)     $  5,830,292      $  3,549,032      $  3,196,146
    Adjustments to reconcile net income to net
        cash provided by operating activities:
      Equity in undistributed earnings of
           subsidiary                                   1,144,436        (5,772,653)       (3,471,752)       (3,121,370)
      ESOP compensation                                 4,560,356         1,205,229           853,930           853,616
      MRP compensation                                         --                --           725,692         1,342,907
      Other operating activities                         (697,915)          878,733            70,001           628,213
                                                     ------------      ------------      ------------      ------------
           Net cash provided by operating
               activities                               3,866,904         2,141,601         1,726,903         2,899,512
                                                     ------------      ------------      ------------      ------------
Investing activities:
    Repayments of advances to subsidiary               (2,692,564)        4,533,752         6,863,802         9,257,445
                                                     ------------      ------------      ------------      ------------
           Net cash (used in) provided by
               investing activities                    (2,692,564)        4,533,752         6,863,802         9,257,445
                                                     ------------      ------------      ------------      ------------
Financing activities:
    Proceeds from exercise of stock options               100,375           360,864                --                --
    Purchase of treasury shares                        (1,908,513)       (4,253,215)       (7,268,139)      (10,875,208)
    Dividends paid                                       (533,581)       (1,936,091)       (1,418,936)       (1,089,622)
                                                     ------------      ------------      ------------      ------------
           Net cash used in financing activities       (2,341,719)       (5,828,442)       (8,687,075)      (11,964,830)
                                                     ------------      ------------      ------------      ------------
Net (decrease) increase in cash                        (1,167,379)          846,911           (96,370)          192,127
Cash at beginning of year                               1,902,285         1,055,374         1,151,744           959,617
                                                     ------------      ------------      ------------      ------------
Cash at end of year                                  $    734,906      $  1,902,285      $  1,055,374      $  1,151,744
                                                     ============      ============      ============      ============
</TABLE>

                                       74
<PAGE>

FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

17.  QUARTERLY FINANCIAL DATA (UNAUDITED)

     Summarized unaudited quarterly financial data for the years ended September
     30, 2001 and 2000, is as follows (in thousands):

                                   FOURTH      THIRD       SECOND      FIRST
                                  -------    --------     --------   --------
2001:
Interest income                   $ 9,794    $ 10,231     $ 10,863   $ 11,271
Interest expense                    4,560       5,298        5,967      6,343
Provision for loan losses              50           -          540        240
Noninterest income                  1,933       1,690        1,853      1,299
Noninterest expense                 4,498       3,949        3,898      3,701
Income tax expense                  1,082       1,090          946        941
                                  -------    --------     --------   --------
Net income                        $ 1,537     $ 1,584      $ 1,365    $ 1,345
                                  =======     =======      =======    =======

Net income per common share:
    Basic                         $   .54     $   .55      $   .47    $   .46
    Diluted                       $   .52     $   .53      $   .46    $   .45
                                  =======     =======      =======    =======



                                   FOURTH      THIRD       SECOND      FIRST
                                  -------    --------     --------   --------
2000:
Interest income                  $ 10,783    $ 10,099      $ 9,178    $ 6,805
Interest expense                    5,921       5,241        4,680      3,171
Provision for loan losses             300         250          200        227
Noninterest income                    950       1,052          815        615
Noninterest expense                 3,768       4,058        3,631      2,643
Income tax expense                    762         699          628        569
                                  -------    --------     --------   --------
Net income                        $   982     $   903      $   854    $   810
                                  =======     =======      =======    =======

Net income per common share:
    Basic and diluted             $   .32     $   .30      $   .27    $   .25
                                  =======     =======      =======    =======

18.  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.

                                       75
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     The estimation methodologies,  resulting fair values, and recorded carrying
     amounts at December 31, 2001 and September 30, 2001, 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 3 and 4 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,                          SEPTEMBER 30,
                                       2001                                   2001
                           --------------------------------   ----------------------------
                             ESTIMATED       CARRYING           ESTIMATED       CARRYING
                             FAIR VALUE       AMOUNT            FAIR VALUE       AMOUNT
                           -------------  -------------       -------------  -------------
<S>                        <C>            <C>                 <C>            <C>
1 - 4 family mortgages     $ 133,116,482  $ 131,934,750       $ 123,737,283  $ 121,735,028
Consumer                      77,001,289     76,812,819          77,088,028     77,193,937
Non-residential              196,865,486    196,865,486         175,157,980    175,157,980
                           -------------  -------------       -------------  -------------
                           $ 406,983,257  $ 405,613,055       $ 375,983,291  $ 374,086,945
                           =============  =============       =============  =============
</TABLE>


     The fair value of deposit  liabilities  with no stated  maturities has been
     estimated  to equal the  carrying  amount (the  amount  payable on demand),
     totaling  $171,428,760  and $159,282,411 at December 31, 2001 and September
     30, 2001, 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, 2001 and September 30, 2001,  are
     as follows:

                                             DECEMBER 31,      SEPTEMBER 30,
                                                 2001               2001
Certificates of deposits:
    Carrying amount                         $ 304,159,745      $ 312,656,497
    Estimated fair value                      307,269,097        317,751,119

Advances for Federal Home Loan Bank:
    Carrying amount                         $   1,000,000      $           -
    Estimated fair value                        1,000,000                  -


     The carrying amount of repurchase  agreements  approximates the fair value.
     The  interest  rate on these  agreements  is a  floating  rate based on the
     federal fund's daily rate.


                                       76
<PAGE>


FIRST SOUTH BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

     There is no material  difference  between the carrying amount and estimated
     fair value of off-balance sheet items totaling $98,831,409 during the three
     months  ended  December  31,  2001 and  $105,610,926  during the year ended
     September  30,  2001,  which  are  primarily  comprised  of  unfunded  loan
     commitments.

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

19.  SUPPLEMENTAL CASH FLOW INFORMATION

     Supplemental  cash flow information for the three months ended December 31,
     2001 and the years ended September 30, 2001, 2000 and 1999, is as follows:



<TABLE>
<CAPTION>
                                                   DECEMBER 31,     SEPTEMBER 30,     SEPTEMBER 30,    SEPTEMBER 30,
                                                      2001             2001              2000             1999
<S>                                               <C>              <C>               <C>              <C>
Real estate acquired in settlement of loans       $   326,515      $   918,091       $   411,040      $   764,023
Exchange of loans for mortgage-backed
    securities                                              -       12,298,139        62,789,209       45,527,117
Cash paid for interest                              4,161,729       22,391,730        19,012,680        9,960,689
Cash paid for income taxes                          1,360,075        3,350,211         2,769,000        2,787,000
Dividends declared, not paid                          533,581          518,511           387,220          332,119
Repurchase of unearned ESOP shares                  1,334,792                -                 -                -

</TABLE>



                                       77
<PAGE>


ITEM 9.  CHANGES  IN  AND  DISAGREEMENTS  WITH  ACCOUNTANTS  ON  ACCOUNTING  AND
--------------------------------------------------------------------------------
         FINANCIAL DISCLOSURE
         --------------------

     Not applicable.




                                       78
<PAGE>



                                    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 Company's  definitive  proxy statement for the Company's 2002
Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by
reference.

ITEM 11.  MANAGEMENT REMUNERATION
---------------------------------

     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
------------------------------------------------------------------------

     (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.

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.


                                     PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
-------------------------------------------------------------------------

     (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:

          Independent Auditors' Report
          Consolidated Statements of Financial Condition as of December 31, 2001
               and September 30, 2001
          Consolidated  Statements  of  Operations  for the Three  Months  Ended
               December 31, 2001 and Years Ended  September  30, 2001,  2000 and
               1999
          Consolidated  Statements of  Stockholders  Equity for the Three Months
               Ended December 31, 2001 and Years Ended  September 30, 2001, 2000
               and 1999
          Consolidated  Statements  of Cash  Flows  for the Three  Months  Ended
               December 31, 2001 and Years Ended  September  30, 2001,  2000 and
               1999
          Notes to Consolidated Financial Statements



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<PAGE>


     (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.

      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
       4      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)
       10.1(a)Employment Agreement between First South Bancorp,  Inc. and Thomas
              A. Vann (Incorporated  herein by reference from Exhibit 10.3(a) to
              the  Company's  Registration  Statement  on  Form  S-1  (File  No.
              333-16335))
       10.1(b)Employment  Agreement between Home Savings Bank, SSB and Thomas A.
              Vann (Incorporated herein by reference from Exhibit 10.3(b) to the
              Company's Registration Statement on Form S-1 (File No. 333-16335))
       10.2   Change in Control Protective Agreements between Home Savings Bank,
              SSB,  First  South  Bancorp,  Inc.  and Mary R.  Boyd,  Sherry  L.
              Correll,  Kristie  W.  Hawkins,  Walter P.  House and  William  R.
              Outland (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,
              William  R.  Outland  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,  Walter P. House,  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   Home Savings Bank, SSB 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 and the 1996
              Amendment Thereto  (Incorporated  herein by reference from Exhibit
              10.8 to the Company's Registration Statement on Form S-1 (File No.
              333-16335))
       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  (Incorporated herein by reference from Exhibit
              10.10 to the  Company's  Registration  Statement on Form S-1 (File
              No. 333-16335))
       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))


                                       80
<PAGE>


       10.10  Employment  Agreement  between NewSouth Bank and H.D. Reaves,  Jr.
              (Incorporated  herein by reference  from Exhibit  10.10  Company's
              Annual  Report on Form 10-K for the Year Ended  September 30, 2000
              (File No. 0-22219))
       10.11  Change-in-Control  Protective  Agreement between First South Bank,
              First South  Bancorp,  Inc. and Jack L. Ashley dated  November 15,
              2001  (Incorporated  herein by reference from Exhibit 10.11 to the
              Company's  Annual Report on Form 10-K for the Year Ended September
              30, 2001)
       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))
       21     Subsidiaries of the Registrant
       23     Consent of PricewaterhouseCoopers LLP

       (B) REPORTS ON FORM 8-K. There were no Current  Reports on Form 8-K filed
           -------------------
by the Company during the three months ended December 31, 2001.

       (C) 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.

       (D) 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.



                                       81
<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 28, 2002
                                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 28, 2002
--------------------------------------------
Thomas A. Vann
President and Director
(Principal Executive Officer)


/s/ William L. Wall                                  March 28, 2002
--------------------------------------------
William L. Wall
Executive Vice President, Chief Financial
  Officer and Secretary
(Principal Financial and Accounting Officer)


/s/ Edmund T. Buckman, Jr.                           March 28, 2002
--------------------------------------------
Edmund T. Buckman, Jr.
Director


/s/ Linley H. Gibbs, Jr.                             March 28, 2002
--------------------------------------------
Linley H. Gibbs, Jr.
Director


/s/ Frederick N. Holscher                            March 28, 2002
--------------------------------------------
Frederick N. Holscher
Director


/s/ Frederick H. Howdy                               March 28, 2002
--------------------------------------------
Frederick H. Howdy
Director


/s/ Charles E. Parker, Jr.                           March 28, 2002
--------------------------------------------
Charles E. Parker, Jr.
Director


/s/ Marshall T. Singleton                            March 28, 2002
--------------------------------------------
Marshall T. Singleton
Director


/s/ H. D. Reaves, Jr.                                March 28, 2002
--------------------------------------------
H. D. Reaves, Jr.
Director