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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-K



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(Mark One)

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

For the fiscal year ended December 31, 2006



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

For the transition period from  to

Commission File No. 000-21383



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APPALACHIAN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)



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|                         |  |                                        
|------------------------ |  | ---------------------------------------
|Georgia                  |  | 58-2242407                             
|(State of Incorporation) |  | (I.R.S. Employer Identification Number)



|                                          |  |           
|----------------------------------------- |  | ----------
|822 Industrial Boulevard Ellijay, Georgia |  | 30540     
|(Address of Principal Executive Offices)  |  | (Zip Code)

(706) 276-8000

(Registrants telephone number, including area code)

Securities registered under
Section 12(b) of the Act:



|                              |  |                                          
|----------------------------- |  | -----------------------------------------
|Title of Each Class           |  | Name of each exchange on which registered
|Common Stock, $0.01 par value |  | The NASDAQ Stock Market LLC              

Securities registered under Section 12(g) of the Exchange Act:

None

(Title of class)



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

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

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

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.    Yes ̈No  x

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer ̈Accelerated filer ̈Non-accelerated filer  x

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

The aggregate market value of the voting common stock held by non-affiliates of the registrant (computed by reference to the closing sales price as reported on the NASDAQ
Global Market System) was $71.2 million as of the last business day of the registrants most recently completed second fiscal quarter. For the purpose of this response, officers, directors and holders of 5% or more of the registrants
common stock are considered to be affiliates of the registrant at that date.

There were 5,205,311 shares of the registrants common stock outstanding
as of March 21, 2007.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants definitive proxy statement to be delivered to shareholders in connection with the registrants 2007 Annual Meeting of Shareholders are incorporated by reference in response to
Part III of this report.



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APPA
LACHIAN BANCSHARES, INC.

2006 Form 10-K Annual Report

TABLE OF CONTENTS



|                         |  |                                                                                                                  |  |                 
|------------------------ |  | ---------------------------------------------------------------------------------------------------------------- |  | ----------------
|Item Number In Form 10-K |  | Description                                                                                                      |  | Page or Location
|                         |  |                                                                                                                 
|Part I                   |  |                                                                                                                  |  |                 
|                         |  |                                                                                                                 
|Item 1.                  |  | Business                                                                                                         |  | 1               
|                         |  |                                                                                                                 
|Item 1A.                 |  | Risk Factors                                                                                                     |  | 12              
|                         |  |                                                                                                                 
|Item 1B                  |  | Unresolved Staff Comments                                                                                        |  | 15              
|                         |  |                                                                                                                 
|Item 2.                  |  | Properties                                                                                                       |  | 16              
|                         |  |                                                                                                                 
|Item 3.                  |  | Legal Proceedings                                                                                                |  | 16              
|                         |  |                                                                                                                 
|Item 4.                  |  | Submission of Matters to a Vote of Security Holders                                                              |  | 16              
|                         |  |                                                                                                                 
|PART II                  |  |                                                                                                                  |  |                 
|                         |  |                                                                                                                 
|Item 5.                  |  | Market for the Registrants Common Equity, Related Stockholder Matters and issuer purchases of equity securities |  | 17              
|                         |  |                                                                                                                 
|Item 6.                  |  | Selected Financial Data                                                                                          |  | 19              
|                         |  |                                                                                                                 
|Item 7.                  |  | Managements Discussion and Analysis of Financial Condition and Results of Operation                             |  | 21              
|                         |  |                                                                                                                 
|Item 7A.                 |  | Quantitative and Qualitative Disclosures About Market Risk                                                       |  | 42              
|                         |  |                                                                                                                 
|Item 8.                  |  | Financial Statements and Supplementary Data                                                                      |  | 42              
|                         |  |                                                                                                                 
|Item 9.                  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                             |  | 77              
|                         |  |                                                                                                                 
|Item 9A.                 |  | Controls and Procedures                                                                                          |  | 77              
|                         |  |                                                                                                                 
|Item 9B.                 |  | Other Information                                                                                                |  | 77              
|                         |  |                                                                                                                 
|PART III                 |  |                                                                                                                  |  |                 
|                         |  |                                                                                                                 
|Item 10.                 |  | Directors, Executive Officers and Corporate Governance                                                           |  | 77              
|                         |  |                                                                                                                 
|Item 11.                 |  | Executive Compensation                                                                                           |  | 77              
|                         |  |                                                                                                                 
|Item 12.                 |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                   |  | 77              
|                         |  |                                                                                                                 
|Item 13.                 |  | Certain Relationships and Related Transactions, and Director Independence                                        |  | 77              
|                         |  |                                                                                                                 
|Item 14.                 |  | Principal Accountant Fees and Services                                                                           |  | 77              
|                         |  |                                                                                                                 
|PART IV                  |  |                                                                                                                  |  |                 
|                         |  |                                                                                                                 
|Item 15.                 |  | Exhibits and Financial Statement Schedules                                                                       |  | 78              
|                         |  |                                                                                                                 
|Signatures               |  |                                                                                                                  |  | 81              



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PART I



|ITEM 1. | BUSINESS
|------- | --------

This Report contains
forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, such as statements relating to future plans and expectations, and are thus prospective. These statements are based on many assumptions
and estimates and are not guarantees of future performance. Our actual results may differ materially from those projected in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which
are beyond our control. The words may, would, could, will, expect, anticipate, believe, intend, plan, and estimate, as well as
similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties include, but are not limited to, those described below under Item 1A, entitled Risk Factors.

General Overview

We are a Georgia corporation
organized in 1996 to serve as the bank holding company for Appalachian Community Bank (formerly Gilmer County Bank), a state-chartered bank located in the foothills of the Blue Ridge Mountains in North Georgia. We are headquartered in Ellijay,
Georgia, and, in March 2006, we opened our new headquarters and operations center, also located in Ellijay. In 1995, Gilmer County Bank opened its first branch office in Ellijay, Georgia. In November 1998, we acquired a bank with one location in
Blairsville, Georgia, and changed its name to Appalachian Community Bank to reflect our strategy to build a community bank franchise in our geographic market area. In May 2000, we opened a branch office in East Ellijay, Georgia, and in August 2001,
we opened a loan production office in Blue Ridge, Georgia, which we converted to a full-service branch in February 2002. In August 2001, we merged Appalachian Community Bank into Gilmer County Bank, although we continue to operate our branches in
Ellijay and East Ellijay under the trade name Gilmer County Bank. During 2006, we opened full-service branches in Chatsworth, McCaysville, and Dawsonville, Georgia, as well as loan production offices in Murphy, North Carolina and
Ducktown, Tennessee. Also, in the last quarter of 2006 we opened a second branch in East Ellijay, Georgia, and, in January 2007, we opened a second branch in Dawsonville, Georgia.

In February 2007 we received conditional approval from the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC) to
form a federally chartered thrift subsidiary, which will operate under the name Appalachian Community Bank, F.S.B., as a wholly-owned subsidiary of our company. Additionally, we have filed an application with the Federal Reserve Bank of Atlanta to
acquire and operate the thrift. In accordance with the OTS approval conditions, the thrift will acquire, as its headquarters, our branch in McCaysville, Georgia, and we will convert our loan production offices in Murphy, North Carolina, and
Ducktown, Tennessee, into full-service branches of the thrift. Satisfaction of the standard charter approval conditions and the conversion of the bank offices are expected by the end of April 2007.

We provide a full range of retail and commercial banking products and services to individuals and small- to medium- sized businesses through our
community banking relationship model. Such products and services include the receipt of demand and time deposit accounts, the extension of personal and commercial loans and the furnishing of personal and commercial checking accounts. As of
December 31, 2006, we had total assets of approximately $758.2 million, total loans of approximately $631.8 million, total deposits of approximately $651.1 million and total shareholders equity of approximately $66.8 million. Our website
is located at www.acbanks.net.

Our Market Area

Our market area is located approximately 80 miles north of Atlanta and is primarily comprised of Gilmer, Fannin, Union, Murray and Dawson counties in Georgia, as well as Cherokee county North Carolina and Polk county Tennessee. Our market
area includes both North Georgia and the Tri-State Area, the latter consisting of the contiguous three-county area (Fannin, Polk and Cherokee Counties) where Georgia, Tennessee and North Carolina come together. Our market
area provides a number of outdoor recreational activities, including hiking, canoeing, fishing, swimming, rafting, hunting and mountain biking. We believe that the natural resources of our market area and its proximity to metropolitan Atlanta are
two of the main reasons that our market area has recently experienced significant population growth. Our market areas abundant outdoor and recreational activities has made it a popular area for second-home buyers and retirees. We believe that
the demographic trends and growth characteristics of our market area will continue to provide us with significant growth opportunities in the future.



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Operating and Growth Strategy

Our strategy is to build a community bank franchise servicing real estate developers, small business owners and primary and second home buyers in our market area and surrounding fast-growing communities. We believe we
can execute this strategy and grow our business by building personal relationships with our customers, emphasizing superior customer service and communicating a consistent set of operating principles to our employees. Further, we believe that the
continued growth in our market area offers us the opportunity for growth at our current branches and the potential for new branches in our existing markets. We are always looking for qualified bankers and new markets that fit with our culture.

Lending Activities

General. We
offer a variety of loans, including real estate, construction, commercial and consumer loans to individuals and small- to mid-size businesses that are located or conduct a substantial portion of their business in our market area. Although we offer a
variety of types of loans, we emphasize the use of real estate as collateral and our underwriting standards vary for each type of loan, as described below. As of December 31, 2006, 89.0% of the loans in our loan portfolio were secured by real
estate. At December 31, 2006, we had total loans of $631.8 million, representing 83.3% of our total assets. We have focused our lending activities primarily on small business owners and residential real estate developers. At December 31,
2006, loans to the construction and development industry amounted to $320.4 million, or approximately 50.7% of our total loan portfolio, loans to the poultry industry amounted to $18.7 million, or approximately 3.0% of our total loan portfolio and
loans to the hospitality (hotel/motel) industry amounted to $19.7 million, or approximately 3.1% of our total loan portfolio.

Our
underwriting standards vary for each type of loan. In underwriting all of our real estate related loans, we seek to minimize our risks by giving careful consideration to the propertys operating history, future operating projections, current
and projected occupancy, location and physical condition. Our underwriting analysis also includes credit checks, reviews of appraisals and environmental hazards and a review of the financial condition of the borrower. We attempt to limit our risk by
analyzing our borrowers cash flow and collateral value on a regular basis. After a loan is approved, our credit administration group focuses on the loan portfolio, including regularly monitoring the quality of the loan portfolio. Further, we
also engage outside firms to evaluate our loan portfolio on a quarterly basis for credit quality and compliance issues.

In addition, we
engage in secondary-market mortgage activities by obtaining commitments from secondary mortgage purchasers for loans originated by our bank. Based on these commitments, we originate mortgage loans on comparable terms and generate commissions to
supplement our interest income.

Real Estate Loans. Loans secured by real estate are the primary component of our loan portfolio. To
increase the likelihood of the ultimate repayment of the loan, we obtain a security interest in the real estate whenever possible, in addition to the other available collateral. At December 31, 2006, loans secured by real estate amounted to
$561.9 million, or 89.0%, of our total loan portfolio.

These loans consist primarily of construction and development loans, commercial
real estate loans and residential real estate loans. Interest rates for all categories may be fixed or adjustable. We generally charge an origination fee for each loan and may collect renewal and late charge fees. Real estate loans are subject to
the same general risks as other loans and are particularly sensitive to fluctuations in the value of real estate. Fluctuations in the value of real estate, as well as other factors arising after a loan has been made, could negatively affect a
borrowers cash flow, creditworthiness and ability to repay the loan.



| |  |  | Construction and Development Real Estate Loans.We offer adjustable and fixed rate real estate residential and commercial loans to builders and developers
for both construction and development and to consumers wishing to build their own homes. The duration of our construction and development loans is typically 12 months, although payments may be structured on a longer amortization basis. Construction
and development loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and usually on the sale of the property. Specific risks include:
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | cost overruns;
| | - |  | --------------



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| |  |  | mismanaged construction;
| | - |  | ------------------------



| |  |  | inferior or improper construction techniques;
| | - |  | ---------------------------------------------



| |  |  | economic changes or downturns during construction;
| | - |  | --------------------------------------------------



| |  |  | a downturn in the real estate market;
| | - |  | -------------------------------------



| |  |  | rising interest rates which may prevent sale of the property; and
| | - |  | -----------------------------------------------------------------



| |  |  | failure to sell completed projects in a timely manner.
| | - |  | ------------------------------------------------------

We attempt to reduce the risk associated with construction and development loans by obtaining personal guarantees where possible and by keeping the loan-to-value ratio of the completed project at or below 80%. At
December 31, 2006, total construction and development loans amounted to $320.4 million, or 50.7% of our loan portfolio. Of this amount, commercial construction loans represented $45.7 million, or 7.2% of our loan portfolio, and residential
construction and development loans totaled $274.7 million, or 43.5% of our loan portfolio.



| |  |  | Commercial Real Estate Loans. Our commercial real estate loans generally have terms of five years or less, although payments can be structured over a longer
amortization period. We evaluate each borrower on an individual basis and attempt to determine the business risks and credit profile of each borrower. We attempt to reduce credit risk in the commercial real estate portfolio by emphasizing loans on
owner-occupied properties where the loan-to-value ratio, established by independent appraisals, does not exceed 80%. We also generally require that a borrowers cash flow exceeds 110% of monthly debt service obligations. In order to ensure
secondary sources of payment and liquidity, we typically review all of the personal financial statements of the principal owners and require their personal guarantees. These commercial real estate loans include various types of business purpose
loans secured by farmland and nonresidential commercial real estate. At December 31, 2006, commercial real estate loans (other than commercial construction loans) amounted to $125.6 million, or approximately 19.9% of our loan portfolio.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Residential Real Estate Loans. At December 31, 2006, our residential real estate loans consisted primarily of loans secured by one- to- four family
residences and multi-family (five or more) residences. These loans are generally secured by residential real estate. We also offer, through our mortgage banking department, fixed and adjustable-rate residential real estate loans which we sell under
fixed price commitments to third party lenders rather than originating and retaining these loans ourselves. We will not close these residential real estate loans without a fixed price commitment to sell from a corresponding lender, and we do not
service these loans. At December 31, 2006, total residential real estate loans amounted to $116.0 million, or 18.4% of our loan portfolio. Of this amount, loans secured by one-to-four family residences totaled $107.3 million, or 17.0% of our
loan portfolio, and loans secured by multi-family residences totaled $8.7 million, or 1.4% of our loan portfolio.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Commercial Business Loans. We make loans for commercial purposes to various lines of businesses. Commercial loans are generally considered to have greater risk than first or second mortgages on real estate because commercial loans
may be unsecured or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease than real estate. At December 31, 2006, commercial business loans amounted to $40.5 million, or 6.4% of our total loan
portfolio, excluding for these purposes commercial loans secured by real estate which are included in the real estate category above.

Consumer Loans. We make a variety of loans to individuals for personal and household purposes, including secured and unsecured installment and term loans, home equity loans and lines of credit and revolving lines of credit such as
credit cards. Consumer loans are underwritten based on the individual borrowers income, current debt level, past credit history and value of any available collateral. Consumer loan rates are both fixed and variable, with negotiable terms. Our
installment loans typically amortize over periods up to 60 months. We will offer consumer loans with a single maturity date when a specific source of repayment is available. We typically



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require monthly payments of interest and a portion of the principal on our revolving loan products. Consumer loans are generally considered to have greater
risk than first or second mortgages on real estate because they may be unsecured or, if they are secured, the value of the collateral may be difficult to assess and more likely to decrease in value than real estate. At December 31, 2006,
consumer loans amounted to $25.4 million, or 4.0% of our loan portfolio.

Loan Approval. Certain credit risks are inherent in making
loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions and risks inherent in dealing with individual borrowers. We attempt to
mitigate these risks by adhering to internal credit policies and procedures. Our policies and procedures include officer and client lending limits, a multi-layered approval process for larger loans, documentation examination and follow-up procedures
for any exceptions to credit policies. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds an individual officers lending authority, and is below
$500,000, the loan request will be considered by senior lending officers. The members of our officers loan committee can approve loans up to $1.0 million. If total aggregate loans to a single borrower exceeds $1.0 million, then the board of
directors loan committee may approve the loan. On a monthly basis, any actions of the board of directors loan committee are further ratified by the banks entire board of directors. We do not make any loans to directors or executive
officers of the bank unless the loan is approved by the board of directors of the bank and is on terms not more favorable to such person than would be available to a person not affiliated with the bank.

Credit Administration and Loan Review. We maintain a continuous loan review system and use an independent consultant to review the loan files on a
quarterly basis. Each loan officer is responsible for rating each loan he or she makes and for reviewing those loans on a periodic basis. Our credit underwriting and credit administration groups assist us in strengthening our credit review processes
and establishing performance benchmarks in the areas of nonperforming assets, charge-offs, past dues and loan documentation.

Lending
Limits. Our lending activities are subject to a variety of lending limits imposed by state and federal law. In general, the bank is subject to a legal limit on loans to a single borrower equal to 15% of the banks capital and unimpaired
surplus for unsecured loans and 25% of the banks capital and unimpaired surplus for secured loans. This limit will increase or decrease as the banks capital increases or decreases. Based on the capitalization of the bank at
December 31, 2006, our legal lending limits were approximately $12.0 million for secured loans and $7.2 million for unsecured loans. We sell participations in our larger loans to other financial institutions, which allows us to manage the risk
involved in these loans and to meet the lending needs of our customers requiring extensions of credit in excess of this limit. At December 31, 2006, we had participations totaling $45.8 million.

Deposit Services

Our principal source of funding is
core deposits, supplemented by brokered deposits, Federal Home Loan Bank (FHLB) advances, federal funds purchased and securities sold under agreements to repurchase. We offer a full range of deposit services, including checking accounts,
commercial accounts, savings accounts and other time deposits of various types, ranging from daily money market accounts to long-term certificates of deposit. All deposit accounts are insured by the FDIC up to the maximum amount allowed by law.



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Other Products and Services

We provide a full range of additional retail and commercial banking products and services, including checking, savings and money market accounts; certificates of deposit; internet banking and bill payment; credit
cards; safe-deposit boxes; money orders; electronic funds transfer services; travelers checks and automatic teller machine access. We are also a member of the STAR ATM network, which permits our customers to perform certain banking
transactions, both within and outside of our market area. We currently do not offer trust or fiduciary services.

We are committed to
modifying existing, or developing new, products and services that are responsive to the banking demands of our customers. For example, we have recently begun offering an internet-based cash management system for small businesses, as well as an
enhancement to personal checking accounts that improves the overdraft process. In the future we intend to upgrade and expand our services to ensure that we remain competitive in our product offerings.

Competition

The banking business is highly
competitive, and we experience competition in our market from many other financial institutions. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and
service charges relating to loans, the quality and scope of the services offered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative lending limits. We compete with commercial banks, credit unions,
savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial
institutions that operate offices within our market area and beyond.

As of June 30, 2006, the most recent date for deposit data
complied by the Federal Deposit Insurance Corporation (FDIC), three locally owned banks and three non-locally-owned banks had offices in Gilmer County, one locally-owned bank and three non-locally-owned bank had offices in Union County,
seven non-locally-owned banks had offices in Fannin County, two locally owned banks and three non-locally-owned banks in Murray County, and two locally owned banks and five non-locally-owned banks in Dawson County. Many of our competitors, such as
BB&T and United Community Bank, are well-established, larger financial institutions which have substantially greater resources and lending limits. These institutions offer some services, such as extensive and established branch networks and
trust services, that we do not provide. We also compete with small banks and thrifts in our markets. In addition, many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and
federally insured banks. In addition, we have loan production offices located in Cherokee County, North Carolina, and Polk County, Tennessee, which will be converted into full service branches of our thrift. As of June 30, 2006, there were six
non-locally-owned banks in Cherokee County, North Carolina and there were four non-locally-owned banks in Polk County, Tennessee

Market Share

As of June 30, 2006, according to the most recent data compiled by the FDIC, our North Georgia market area (Gilmer,
Fannin, Union, Murray and Dawson Counties) had total deposits of approximately $3.0 billion, which represented a 24.3% deposit increase from 2005. As of June 30, 2006, we had over 57% market share in Gilmer County, a 17% share in Fannin County,
a 7% share in Union County, and almost 2% share in Murray County. Our Dawsonville branch did not open until August 2006.

Employees

As of December 31, 2006, we had 262 full-time equivalent employees.

Monetary Policies

The operations of the bank are significantly affected by the credit policies of
monetary authorities, particularly the Board of Governors of the Federal Reserve System (the Federal Reserve). The instruments of monetary policy employed by the Federal Reserve include open market operations in U.S. government
securities, changes in discount rates on member bank borrowings, and changes in reserve requirements against bank deposits.



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In view of changing conditions in the national economy and in the money markets, as well as the effect of action by monetary and fiscal authorities,
including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand, or the business and earnings of the bank.

SUPERVISION AND REGULATION

The company and the bank are subject to extensive
state and federal banking laws and regulations that impose specific requirements or restrictions on, and provide for general regulatory oversight of, virtually all aspects of our operations. These laws and regulations are generally intended to
protect depositors, not shareholders. The following summary is qualified by reference to the statutory and regulatory provisions discussed. Changes in applicable laws or regulations may have a material effect on our business and prospects. Beginning
with the enactment of the Financial Institutions Reform Recovery and Enforcement Act in 1989 and followed by the FDIC Improvement Act in 1991, the Gramm-Leach-Bliley Act in 1999, and including the USA PATRIOT ACT of 2002, numerous additional
regulatory requirements have been placed on the banking industry in the past several years, and additional changes have been proposed. Our operations may be affected by legislative changes and the policies of various regulatory authorities. We
cannot predict the effect that fiscal or monetary policies, economic control, or new federal or state legislation may have on our business and earnings in the future.

The following discussion is not intended to be a complete list of all the activities regulated by the banking laws and regulations or of the impact of such laws and regulations on our operations. It is intended only
to briefly summarize some material provisions.

Appalachian Bancshares, Inc.

We own 100% of the outstanding capital stock of the bank, and therefore we are considered to be a bank holding company under the federal Bank Holding
Company Act of 1956. As a bank holding company registered with the Federal Reserve under the Bank Holding Company Act and the Georgia Department of Banking and Finance under the Financial Institutions Code of Georgia, we are subject to supervision,
examination and reporting by the Federal Reserve and the Georgia Department of Banking and Finance.

The Bank Holding Company Act.
Under the Bank Holding Company Act, we are subject to periodic examination by the Federal Reserve and are required to file periodic reports of our operations and any additional information that the Federal Reserve may require. Our activities at the
bank and holding company levels are limited to:



| |  |  | banking and managing or controlling banks;
| | - |  | ------------------------------------------



| |  |  | furnishing services to or performing services for our subsidiaries; and
| | - |  | -----------------------------------------------------------------------



| |  |  | engaging in other activities that the Federal Reserve determines to be so closely related to banking and managing or controlling banks as to be a proper incident
thereto.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

With certain limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the
prior approval of the Federal Reserve before:



| |  |  | acquiring substantially all the assets of any bank;
| | - |  | ---------------------------------------------------



| |  |  | acquiring direct or indirect ownership or control of any voting shares of any bank if after the acquisition it would own or control more than 5% of the voting
shares of such bank (unless it already owns or controls the majority of such shares); or
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | merging or consolidating with another bank holding company.
| | - |  | -----------------------------------------------------------

In addition, and subject to certain exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with regulations promulgated thereunder, require Federal Reserve approval prior to any person
or company acquiring control of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of a bank holding company. Control is rebuttably
presumed to exist if a person acquires 10% or more, but less than 25%, of any class of voting securities and either the company has registered securities under Section 12 of the Securities Exchange Act of 1934 or no other person owns a greater
percentage of that class of voting securities immediately after the transaction. Our common stock is registered under the Securities Exchange Act of 1934. The regulations provide a procedure for rebutting control when ownership of any class of
voting securities is below 25%.



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Under the Bank Holding Company Act, a bank holding company is generally prohibited from engaging in, or
acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in, nonbanking activities unless the Federal Reserve, by order or regulation, has found those activities to be so closely related to banking or managing
or controlling banks as to be a proper incident thereto. Some of the activities that the Federal Reserve has determined by regulation to be proper incidents to the business of a bank holding company include:



| |  |  | making or servicing loans and certain types of leases;
| | - |  | ------------------------------------------------------



| |  |  | engaging in certain insurance and discount brokerage activities;
| | - |  | ----------------------------------------------------------------



| |  |  | performing certain data processing services;
| | - |  | --------------------------------------------



| |  |  | acting in certain circumstances as a fiduciary or investment or financial adviser;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | owning savings associations; and
| | - |  | --------------------------------



| |  |  | making investments in certain corporations or projects designed primarily to promote community welfare.
| | - |  | -------------------------------------------------------------------------------------------------------

The Federal Reserve imposes certain capital requirements on the company under the Bank Holding Company Act, including a minimum leverage ratio and a
minimum ratio of qualifying capital to risk-weighted assets. These requirements are described below under Appalachian Community BankCapital Regulations. Subject to our capital requirements and certain other
restrictions, we are able to borrow money to make a capital contribution to the bank, and these loans may be repaid from dividends paid from the bank to the company. Our ability to pay dividends will be subject to regulatory restrictions as
described below in Appalachian Bancshares, Inc. Subsidiary Dividends. We are also able to raise capital for contribution to the bank by issuing securities without having to receive regulatory approval, subject to compliance
with federal and state securities laws.

Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 permits nationwide interstate banking and branching under certain circumstances. As a result, the company, and any other bank holding company located in Georgia, is able to acquire a bank located in any other state, and a bank
holding company located outside of Georgia can acquire any Georgia-based bank, in either case subject to certain deposit percentage and other restrictions. De novo branching by an out-of-state bank is permitted only if it is expressly permitted by
the laws of the host state. Georgia law generally authorizes the acquisition of an in-state bank by an out-of-state bank by merger with a Georgia financial institution that has been in existence for at least 3 years prior to the acquisition. With
regard to interstate bank branching, out-of-state banks that do not already operate a branch in Georgia may not establish de novo branches in Georgia.

Source of Strength; Cross-Guarantee. In accordance with Federal Reserve policy, we are expected to act as a source of financial strength to the bank and to commit resources to support the bank in circumstances
in which we might not otherwise do so. Under the Bank Holding Company Act, the Federal Reserve may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary, other than a nonbank subsidiary of a bank,
upon the Federal Reserves Board determination that such activity or control constitutes a serious risk to the financial soundness or stability of any depository institution subsidiary of the bank holding company. Further, federal bank
regulatory authorities have additional discretion to require a bank holding company to divest itself of any bank or nonbank subsidiaries if the agency determines that divestiture may aid the depository institutions financial condition.

Transactions with Affiliates. The company and the bank are deemed to be affiliates within the meaning of the Federal
Reserve Act, and transactions between affiliates are subject to certain restrictions. Generally, the Federal Reserve Act limits the extent to which a financial institution or its subsidiaries may engage in covered transactions with an
affiliate. Section 23A of the Federal Reserve Act defines covered transactions, which include extensions of credit, and limits a banks covered transactions with any affiliate to 10% of such banks capital and surplus and
with all affiliates to 20% of such banks capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their
subsidiaries are prohibited from purchasing low-quality assets from the banks affiliates. Finally, Section 23A requires that all of a banks extensions of credit to an affiliate be appropriately secured by acceptable collateral,
generally United States government or agency securities. The company and the bank are also subject to Section 23B of the Federal Reserve Act, which generally limits covered and other transactions between a bank and its affiliates to terms and
under circumstances, including credit standards, that are substantially the same or at least as favorable to the bank as prevailing at the time for transactions with unaffiliated companies.



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The Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act was signed into law on November 12,
1999. Among other things, the Act repealed the restrictions on banks affiliating with securities firms contained in sections 20 and 32 of the Glass-Steagall Act. The Act also permits bank holding companies that become financial holding companies to
engage in a statutorily provided list of financial activities, including insurance and securities underwriting and agency activities, merchant banking and insurance company portfolio investment activities. The Act also authorizes activities that are
complementary to financial activities. We have not elected to become a financial holding company.

The Gramm-Leach-Bliley Act
is intended, in part, to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, the Act may have the result of increasing the amount of competition that we face from
larger institutions and other types of companies. In fact, it is not possible to predict the full effect that the Act will have on us.

Subsidiary Dividends. We are a legal entity separate and distinct from the bank. We are entitled to receive dividends when, and as declared by the bank. The approval of the Georgia Department of Banking and Finance must be
obtained before the bank may pay cash dividends out of retained earnings if (i) the total classified assets at the most recent examination of the bank exceeded 80% of the equity capital, (ii) the aggregate amount of dividends declared or
anticipated to be declared in the calendar year exceeds 50% of the net profits, after taxes but before dividends for the previous calendar year, or (iii) the ratio of equity capital to adjusted assets is less than 6%.

In addition, we are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to
maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a bank or bank holding company that the payment of
dividends would be an unsafe or unsound practice and to prohibit payment thereof. The appropriate federal regulatory authorities have indicated that paying dividends that deplete a banks capital base to an inadequate level would be an unsound
and unsafe banking practice and that banking organizations should generally pay dividends only out of current operating earnings.

Georgia State Regulation.As a Georgia bank holding company under the Financial Institutions Code of Georgia, we are subject to limitations on sale or merger and to regulation by the Georgia Department of Banking and Finance.
We must obtain approval by the Department prior to engaging in the acquisition of other banks and financial institutions. Further, as a Georgia corporation, we may be subject to certain limitations and restrictions under applicable Georgia corporate
law.

Appalachian Community Bank

General. The bank, as a Georgia state-chartered bank, is subject to regulation and examination by the Georgia Department of Banking and Finance, as well as the FDIC. Georgia state laws regulate, among other things, the
scope of the banks business, its investments, its payment of dividends to the company, its required legal reserves and the nature, lending limit, maximum interest charged and amount of and collateral for loans. The laws and regulations
governing the bank generally have been promulgated by Georgia to protect depositors and not to protect shareholders of the company or the bank.

Deposit Insurance.The FDIC has adopted a risk-based assessment system for determining an insured depository institutions insurance assessment rate. The system takes into account the risks attributable to
different categories and concentrations of assets and liabilities. An institution is placed into one of three capital categories: (1) well capitalized; (2) adequately capitalized; or (3) undercapitalized. The FDIC also assigns an
institution to one of three supervisory subgroups, based on the FDICs determination of the institutions financial condition and the risk posed to the deposit insurance funds. Assessments generally range from 5 to 7 cents per $100 of
deposits, depending on the institutions capital group and supervisory subgroup. Our risk-based assessment rate is currently [1A] or 0.00330% per million of insured deposits, but may change in the future. The FDIC may increase or decrease the
assessment rate schedule on a semiannual basis. An increase in the assessment rate could have a material adverse effect on our earnings, depending on the amount of the increase. In early 2006, Congress passed the Federal Deposit Insurance Reform Act
of 2005, which made certain changes to the Federal deposit insurance program. These changes included increasing retirement account coverage to $250,000 and providing for inflationary adjustments to general coverage beginning in 2010, providing the
FDIC with authority to set the funds reserve ratio within a specified range, and requiring dividends to banks if the reserve ratio exceeds certain levels.



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Community Reinvestment Act. The Community Reinvestment Act requires that, in
connection with examinations of financial institutions within their respective jurisdictions, the FDIC shall evaluate the record of each financial institution in meeting the credit needs of its local community, including low and moderate income
neighborhoods. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on our bank.

The Gramm-Leach-Bliley Act.Under the Gramm-Leach-Bliley Act, subject to certain conditions imposed by their respective banking
regulators, state-chartered banks are permitted to form financial subsidiaries that may conduct financial or incidental activities, thereby permitting bank subsidiaries to engage in certain activities that previously were impermissible.
The Gramm-Leach-Bliley Act imposes several safeguards and restrictions on financial subsidiaries, including that the parent banks equity investment in the financial subsidiary be deducted from the banks assets and tangible equity for
purposes of calculating the banks capital adequacy. In addition, the Gramm-Leach-Bliley Act imposes new restrictions on transactions between a bank and its financial subsidiaries similar to restrictions applicable to transactions between banks
and nonbank affiliates.

The Gramm-Leach-Bliley Act also contains provisions regarding consumer privacy. These provisions require financial
institutions to disclose their policy for collecting and protecting confidential information. Customers generally may prevent financial institutions from sharing personal financial information with nonaffiliated third parties except for third
parties that market an institutions own products and services. Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other
marketing to the consumer.

Other Regulations.Interest and other charges collected or contracted for by the bank are
subject to state usury laws and certain federal laws concerning interest rates. The banks loan operations are also subject to federal laws applicable to credit transactions, such as:



| |  |  | the federal Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | the Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a
financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the Fair Credit Reporting Act of 1978, governing the use and provision of information to credit reporting agencies;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | the Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | the rules and regulations of the various federal agencies charged with the responsibility of implementing such federal laws.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------

In addition, the deposit operations of the bank are subject to:



| |  |  | the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with
administrative subpoenas of financial records;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve Board to implement that Act, which govern automatic deposits to and withdrawals
from deposit accounts and customers rights and liabilities arising from the use of automated teller machines and other electronic banking services; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the Check Clearing for the 21st Century Act, also known as Check 21, which gives substitute checks, such as a digital image of a check and copies made
from that image, the same legal standing as the original paper check.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Capital Regulations. The federal bank regulatory authorities have adopted risk-based capital
guidelines for banks and bank holding companies that are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies and account for off-balance sheet items. The guidelines
are minimums, and the federal regulators have noted that banks and bank holding companies contemplating significant expansion programs should not allow expansion to diminish their capital ratios and should maintain ratios in excess of the minimums.
We have not received any notice indicating that either the company or the bank is subject to higher capital requirements. The current guidelines require all bank holding companies and federally-regulated banks to maintain a minimum risk-based total
capital ratio equal to 8%, of which at least 4% must be Tier 1 capital. Tier 1 capital includes common shareholders equity, qualifying perpetual preferred stock, and minority interests in equity accounts of consolidated subsidiaries, but
excludes goodwill and most other intangibles and excludes the allowance for loan and lease losses. Tier 2 capital includes the excess of any preferred stock not included in Tier 1 capital, mandatory convertible securities, hybrid capital
instruments, subordinated debt and intermediate term-preferred stock, and general reserves for loan and lease losses up to 1.25% of risk-weighted assets.

Under these guidelines, banks and bank holding companies assets are given risk-weights of 0%, 20%, 50% or 100%. In addition, certain off-balance sheet items are given credit conversion factors to convert
them to asset equivalent amounts to which an appropriate risk-weight applies. These computations result in the total risk-weighted assets. Most loans are assigned to the 100% risk category, except for first mortgage loans fully secured by
residential property and, under certain circumstances, residential construction loans, both of which carry a 50% rating. Most investment securities are assigned to the 20% category, except for municipal or state revenue bonds, which have a 50%
rating, and direct obligations of or obligations guaranteed by the United States Treasury or United States Government agencies, which have a 0% rating.

The federal bank regulatory authorities have also implemented a leverage ratio, which is equal to Tier 1 capital as a percentage of average total assets less intangibles, to be used as a supplement to the risk-based
guidelines. The principal objective of the leverage ratio is to place a constraint on the maximum degree to which a bank holding company may leverage its equity capital base. The minimum required leverage ratio for top-rated institutions is 3%, but
most institutions are required to maintain an additional cushion of at least 100 to 200 basis points.

In addition, the FDIC Improvement
Act established a new capital-based regulatory scheme designed to promote early intervention for troubled banks, which requires the FDIC to choose the least expensive resolution of bank failures. The new capital-based regulatory framework contains
five categories of compliance with regulatory capital requirements, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically
undercapitalized. To qualify as a well capitalized institution, a bank must have a leverage ratio of no less than 5%, a Tier 1 risk-based ratio of no less than 6% and a total risk-based capital ratio of no less than 10%, and the
bank must not be under any order or directive from the appropriate regulatory agency to meet and maintain a specific capital level. At December 31, 2005, based on our calculations, we qualified as well capitalized.

Under the FDIC Improvement Act regulations, the applicable agency can treat an institution as if it were in the next lower category if the agency
determines (after notice and an opportunity for hearing) that the institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice. The degree of regulatory scrutiny of a financial institution increases, and the
permissible activities of the institution decreases, as it moves downward through the capital categories. Institutions that fall into one of the three undercapitalized categories may be required to do some or all of the following:



| |  |  | submit a capital restoration plan;
| | - |  | ----------------------------------



| |  |  | raise additional capital;
| | - |  | -------------------------



| |  |  | restrict their growth, deposit interest rates and other activities;
| | - |  | -------------------------------------------------------------------



| |  |  | improve their management;
| | - |  | -------------------------



| |  |  | eliminate management fees; or
| | - |  | -----------------------------



| |  |  | divest themselves of all or a part of their operations.
| | - |  | -------------------------------------------------------



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These capital guidelines can affect us in several ways. If we grow at a rapid pace, our capital may be
depleted too quickly, and a capital infusion from the holding company may be necessary, which could impact our ability to pay dividends. Our capital levels currently are more than adequate; however, rapid growth, poor loan portfolio performance,
poor earnings performance or a combination of these factors could change our capital position in a relatively short period of time.

Failure to meet these capital requirements would mean that a bank would be required to develop and file a plan with its primary federal banking regulator describing the means and a schedule for achieving the minimum capital requirements. In
addition, such a bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless the bank could demonstrate a reasonable plan to meet the
capital requirement within a reasonable period of time. A bank that is not well capitalized is also subject to certain limitations relating to so-called brokered deposits. Bank holding companies controlling financial
institutions can be called upon to boost the institutions capital and to partially guarantee the institutions performance under their capital restoration plans.

Enforcement Powers. The Financial Institutions Reform Recovery and Enforcement Act expanded and increased civil and criminal penalties available
for use by the federal regulatory agencies against depository institutions and certain institution-affiliated parties. Institution-affiliated parties primarily include management, employees and agents of a financial institution, as well
as independent contractors and consultants such as attorneys and accountants and others who participate in the conduct of the financial institutions affairs. These practices can include the failure of an institution to timely file required
reports or the filing of false or misleading information or the submission of inaccurate reports. Civil penalties may be as high as $1,000,000 a day for such violations. Criminal penalties for some financial institution crimes have been increased to
20 years. In addition, regulators are provided with greater flexibility to commence enforcement actions against institutions and institution-affiliated parties. Possible enforcement actions include the termination of deposit insurance. Furthermore,
banking agencies power to issue cease-and-desist orders were expanded. Such orders may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement,
indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets, rescind agreements or contracts, or take other actions as determined by the ordering agency to be appropriate.

Effect of Governmental Monetary Policies. Our earnings are affected by domestic economic conditions and the monetary and fiscal
policies of the United States government and its agencies. The Federal Reserves monetary policies have had, and are likely to continue to have, an important impact on the operating results of commercial banks through its power to implement
national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve have major effects upon the levels of bank loans, investments and deposits through its open market
operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature or impact of future
changes in monetary and fiscal policies.

USA PATRIOT Act of 2002. In October 2002, the USA PATRIOT Act of 2002 was enacted in
response to the terrorist attacks in New York, Pennsylvania, and Washington D.C. that occurred on September 11, 2001. The PATRIOT Act is intended to strengthen U.S. law enforcements and the intelligence communities abilities to work
cohesively to combat terrorism on a variety of fronts. The potential impact of the PATRIOT Act on financial institutions is significant and wide ranging. The PATRIOT Act contains sweeping anti-money laundering and financial transparency laws and
imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties who may be
involved in terrorism or money laundering.

Proposed Legislation and Regulatory Action. New regulations and statutes are regularly
proposed that contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of the nations financial institutions. We cannot predict whether or in what form any proposed regulation or statute will be
adopted or the extent to which our business may be affected by any new regulation or statute.



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|ITEM 1A. | RISK FACTORS
|-------- | ------------

The following are certain risks that
management believes are specific to our business. This should not be viewed as an all inclusive list or in any particular order.

An economic
downturn, especially one affecting Gilmer, Union and Fannin counties, could adversely affect our business.

Our success
significantly depends upon the growth in population, income levels, deposits and housing starts in our primary market area of Gilmer, Union, Fannin, Murray, and Dawson counties in Georgia, as well as Polk County, Tennessee and Cherokee County, North
Carolina. If these communities do not grow or if prevailing local or national economic conditions are unfavorable, our business may not succeed. An economic downturn would likely harm the quality of our loan portfolio and reduce the level of our
deposits, which in turn would hurt our business. If an economic downturn occurs, borrowers may be less likely to repay their loans as scheduled. Unlike many larger institutions, we are not able to spread the risks of unfavorable local economic
conditions across a large number of diversified economies. An economic downturn could, therefore, result in losses that materially and adversely affect our business.

If real estate values in our market decline or become stagnant, our business could be adversely affected.

Real estate values in our market area have risen substantially over the last several years. There continues to be a significant amount of speculation that the United States, or at least certain parts of the country,
is in the midst of a real estate bubble, meaning that current real estate prices exceed the true values of the properties. If this is the case, or if the market generally perceives that this is the case, then real estate prices could
become stagnant or decline, and there could be a significant reduction in real estate construction and housing starts.

In addition, the
value and liquidity of the real estate or other collateral securing our loans could be impaired. A significant portion of our loan portfolio is dependent on real estate. At December 31, 2006, real estate served as the principal source of
collateral with respect to approximately 89.0% of our loan portfolio. While we are not a subprime lender, a decline in the value of residential and commercial real estate securing our loans could adversely impact our financial condition. Given our
heavy reliance on real estate lending, this could have a significant adverse affect on our business.

Our loan portfolio includes a substantial
amount of commercial real estate and construction and development loans, which may have more risks than residential or consumer loans.

Our commercial real estate loans and construction and development loans account for a substantial portion of our total loan portfolio. These loans generally carry larger loan balances and involve a greater degree of financial and credit
risk than home equity, residential or consumer loans. The increased financial and credit risk associated with these types of loans is a result of several factors, including the concentration of principal in a limited number of loans and to borrowers
in similar lines of business, the size of loan balances, the effects of general economic conditions on income-producing properties and the increased difficulty of evaluating and monitoring these types of loans.

Furthermore, the repayment of loans secured by commercial real estate in some cases is dependent upon the successful operation, development or sale of
the related real estate or commercial project. If the cash flow from the project is reduced, the borrowers ability to repay the loan may be impaired. This cash flow shortage may result in the failure to make loan payments. In these cases, we
may be compelled to modify the terms of the loan. As a result, repayment of these loans may, to a greater extent than other types of loans, be subject to adverse conditions in the real estate market or economy.

Many of our borrowers have more than one loan or credit relationship with us.

Many of our borrowers have more than one commercial real estate or commercial business loan outstanding with us. Consequently, an adverse development
with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to, for example, a one- to- four-family residential mortgage loan.



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Our decisions regarding credit risk and reserves for loan losses may materially and adversely affect our business.

Making loans and other extensions of credit is an essential element of our business. Although we seek to mitigate risks inherent
in lending by adhering to specific underwriting practices, our loans and other extensions of credit may not be repaid. The risk of nonpayment is affected by a number of factors, including:



| |  |  | the duration of the credit;
| | - |  | ---------------------------



| |  |  | credit risks of a particular customer;
| | - |  | --------------------------------------



| |  |  | changes in economic and industry conditions; and
| | - |  | ------------------------------------------------



| |  |  | in the case of a collateralized loan, risks resulting from uncertainties about the future value of the collateral.
| | - |  | ------------------------------------------------------------------------------------------------------------------

We attempt to maintain an appropriate allowance for loan losses to provide for potential losses in our loan portfolio. However, there is no precise
method of predicting credit losses, since any estimate of loan losses is necessarily subjective and the accuracy depends on the outcome of future events. Therefore, we face the risk that charge-offs in future periods will exceed our allowance for
loan losses and that additional increases in the allowance for loan losses will be required. Additions to the allowance for loan losses would result in a decrease of our net income, and possibly our capital.

We face strong competition for customers, which could prevent us from obtaining customers and may cause us to pay higher interest rates to attract deposits.

The banking business is highly competitive and we experience competition in each of our markets from many other financial
institutions. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as
super-regional, national and international financial institutions that operate offices in our primary market areas and elsewhere. We compete with these institutions both in attracting deposits and in making loans. In addition, we have to attract our
customer base from other existing financial institutions and from new residents. Many of our competitors are well-established, larger financial institutions. These institutions offer some services, such as extensive and established branch networks
and trust services, that we currently do not provide. There is a risk that we will not be able to compete successfully with other financial institutions in our markets, and that we may have to pay higher interest rates to attract deposits, resulting
in reduced profitability. Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us. In new markets that we may enter, we will also compete against well-established community banks that
have developed relationships within the community.

Changes in interest rates may reduce our profitability.

Our profitability depends in large part on our net interest income, which is the difference between interest earned from interest-earning assets, such as
loans and mortgage-backed securities, and interest paid on interest-bearing liabilities, such as deposits and borrowings. Our net interest income will be adversely affected if market interest rates change such that the interest we pay on deposits
and borrowings increases faster than the interest we earn on loans and investments. Many factors cause changes in interest rates, including governmental monetary policies and domestic and international economic and political conditions. While we
intend to manage the effects of changes in interest rates by adjusting the terms, maturities, and pricing of our assets and liabilities, our efforts may not be effective and our financial condition and results of operations may suffer.

Our recent operating results may not be indicative of our future operating results.

We may not be able to sustain our historical rate of growth and may not even be able to grow our business at all. If we continue to expand, it will be
difficult for us to generate similar earnings growth. Consequently, our historical results of operations are not necessarily indicative of our future operations. Various factors, such as economic conditions, regulatory and legislative considerations
and competition may also impede our ability to expand our market presence. If we experience a significant decrease in our rate of growth, our results of operations and financial condition may be adversely affected because a high percentage of our
operating costs are fixed expenses.



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We could be adversely affected by the loss of one or more key personnel or by an inability to attract and retain
employees.

We believe that our growth and future success will depend in large part on the skills of our executive officers. The
loss of the services of one or more of these officers could impair our ability to continue to implement our business strategy. In particular, Tracy R. Newton, our chief executive officer, has extensive and long-standing ties within our primary
market area and substantial experience with our operations, and has contributed significantly to our growth. If we lose the services of Mr. Newton, he would be difficult to replace and our business and development could be materially and
adversely affected.

Our success also depends, in part, on our continued ability to attract and retain experienced and qualified employees.
The competition for such employees is intense, and our inability to continue to attract, retain and motivate employees could adversely affect our business. Currently, Joseph T. Moss Jr., our president and chief operating officer, is serving as the
interim principal financial officer of the company and the bank until such time as we identify a successor chief financial officer that we feel will fit the culture and values of our company.

The success of our growth strategy depends on our ability to identify and recruit individuals with experience and relationships in the markets in which we intend
to expand.

We intend to expand our banking network over the next several years in the North Georgia mountains and other
surrounding fast-growing communities. We believe that to expand into new markets successfully, we must identify and recruit experienced key management members with local expertise and relationships in these markets. We expect that competition for
qualified management in the markets in which we expand will be intense and that there will be a limited number of qualified persons with knowledge of and experience in the community banking industry in these markets. Even if we identify individuals
that we believe could assist us in establishing a presence in a new market, we may be unable to recruit these individuals away from more established banks. In addition, the process of identifying and recruiting individuals with the combination of
skills and attributes required to carry out our strategy is often lengthy. Our inability to identify, recruit and retain talented personnel to manage new offices effectively and in a timely manner would limit our growth and could materially
adversely affect our business, financial condition and results of operations. We may fail to open any additional offices and, if we open these offices, they may not be profitable.

We will face risks with respect to future expansion and acquisitions or mergers.

We may
expand into new lines of business or offer new products or services. Any expansion plans we undertake may also divert the attention of our management from the operation of our business, which would have an adverse effect on our results of
operations. We may also seek to acquire other financial institutions or parts of those institutions. Any of these activities would involve a number of risks such as the time and expense associated with evaluating new lines of business or new markets
for expansion, hiring or retaining local management and integrating new acquisitions. Even if we identify new lines of business or new products or services, they may not be profitable. Nor can we say with certainty that we will be able to
consummate, or if consummated, successfully integrate, future acquisitions, if any, or that we will not incur disruptions or unexpected expense in integrating such acquisitions. Any given acquisition, if and when consummated, may adversely affect
our results of operations and financial condition.



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Our growth may require us to raise additional capital that may not be available when it is needed or may not be
available on terms acceptable to us.

We are required by regulatory authorities to maintain adequate levels of capital to support
our operations. To support our continued growth, we may need to raise additional capital. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control.
Accordingly, we cannot assure you of our ability to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and
acquisitions could be materially impaired.

We are subject to extensive regulation that could limit or restrict our activities.

We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various regulatory agencies. Our
compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices.
We are also subject to regulatory capital requirements established by our regulators, which require us to maintain adequate capital to support our growth. If we fail to meet these capital and other regulatory requirements, our ability to grow, our
cost of funds and FDIC insurance, our ability to pay dividends on common stock, and our ability to make acquisitions could be materially and adversely affected.

The laws and regulations applicable to the banking industry could change at any time, and we cannot predict the effects of these changes on our business and profitability. Because government regulation greatly affects
the business and financial results of all banks and bank holding companies, our cost of compliance could adversely affect our ability to operate profitably.

There is a limited trading market for our common stock

Our common stock is traded on the Nasdaq Global Market under
the symbol APAB. There is, however, a limited trading market for our common stock, with average trading volumes of approximately 4,000 shares per day. There can be no assurance that a holder of our common stock, particularly a large
block of stock, will have the ability to dispose of such shares.

Efforts to comply with the Sarbanes-Oxley Act will involve significant
expenditures, and non-compliance with the Sarbanes-Oxley Act may adversely affect us.

The Sarbanes-Oxley Act of 2002, and the
related rules and regulations promulgated by the Securities and Exchange Commission that are now applicable to us, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. We have experienced, and we
expect to continue to experience, greater compliance costs, including costs related to internal controls, as a result of the Sarbanes-Oxley Act. For example, for the year ended December 31, 2007, we will be required to comply with
Section 404 of the Sarbanes-Oxley Act and our management will be required to issue a report on our internal controls. We expect these new rules and regulations to continue to increase our accounting, legal and other costs, and to make some
activities more difficult, time consuming and costly. In the event that we are unable to maintain or achieve compliance with the Sarbanes-Oxley Act and related rules, we may be adversely affected.

We are evaluating our internal control systems in order to allow management to report on, and our independent registered public accounting firm to attest
to, our internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. If we identify significant deficiencies or material weaknesses in our internal control over financial reporting that we cannot remediate in
a timely manner, the trading price of our common stock could decline, our ability to obtain any necessary equity or debt financing could suffer and the trading market for our common stock could be materially impaired.



|ITEM 1B. | UNRESOLVED STAFF COMMENTS
|-------- | -------------------------

Not applicable.



15



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##### Table of Contents

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

Our principal headquarters and the
operations center for the company and the bank is located at 822 Industrial Boulevard, Ellijay, Georgia, between the business districts of Ellijay and East Ellijay. We own this property and in March 2006, completed construction of 39,000 square foot
building, as well as a maintenance building and a community building to use as a meeting area for our employees and for our customers. In addition to our principal headquarters and operations center, we operate nine branch offices, including our
banks main office, and two loan production offices, of which 4 are owned and 7 are subject to either building or ground leases.

We
also own a building in Ellijay, Georgia, which previously housed our operations center. This building is approximately 14,200 square feet, including approximately 8,000 square feet of commercial space that we have leased to various third parties in
the past. We have two tenants occupying sections of this building and at this time we are using the remaining space as a storage facility for all of our branches and operations. In addition, we lease a building directly behind the old operations
building, which was previously used to house additional operations staff members. We have a two-year lease for this space and pay annual rent of $16,800. This lease expires in August 2007 and we are currently seeking suitable tenants to sublease
this space.

We believe that all of our properties are adequately covered by insurance.



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------

In the ordinary course of
operations, we are a party to various legal proceedings from time to time. We do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of
operations or financial condition.



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

No matters were submitted to a vote of shareholders during the fourth quarter of the fiscal year covered by this report.



16



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##### Table of Contents

PART II



|ITEM 5. | MARKET FOR THE REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
|------- | ----------------------------------------------------------------------------------------------------------------

On October 6, 2005, our common stock commenced trading on the Nasdaq Global Market under the symbol APAB. Prior to such listing, our
common stock was quoted on the OTC Bulletin Board under the symbol APAB.OB and quoted in the Pink Sheets under the symbol APAB.PK. During such time, trading had been limited and had not created an active public trading market
for our common stock. As of March 21, 2007, we had approximately 1,364 shareholders of record.

The following table shows the reported
high and low sales prices reported by management for the first two quarters of 2005 and the reported high and low bid information reported on the OTC Bulletin Board for the third quarter of 2005, and the high and low sales prices reported by the
Nasdaq National Market for the fourth quarter of 2005 and for all four quarters of 2006. The prices listed by the OTC Bulletin Board are quotations, which reflect inter-dealer prices, without retail mark-up, mark-down, or commission, and may not
represent actual transactions. The prices provided by management are to the best of managements knowledge, and should not be viewed as indicative of the actual or market value of our common stock during the periods indicated.



|               |  |                                |       |     |   |      
|-------------- |  | ------------------------------ | ----- | --- | - | -----
|               |  | Estimated PriceRange Per Share
|               |  | High                           |       | Low
|Year End 2006: |  |                                |       |     |   |      
|First Quarter  |  | $                              | 20.85 |     | $ | 17.70
|Second Quarter |  |                                | 21.73 |     |   | 17.62
|Third Quarter  |  |                                | 24.39 |     |   | 18.50
|Fourth Quarter |  |                                | 24.00 |     |   | 19.25
|               |  |                               
|Year End 2005: |  |                                |       |     |   |      
|First Quarter  |  | $                              | 16.50 |     | $ | 15.00
|Second Quarter |  |                                | 16.78 |     |   | 15.50
|Third Quarter  |  |                                | 17.50 |     |   | 15.00
|Fourth Quarter |  |                                | 18.50 |     |   | 16.00

To date, we have not paid cash dividends on our common stock. For the foreseeable future we do not
intend to declare cash dividends. We intend to retain earnings to grow our business and strengthen our capital base. Our ability to pay cash dividends is dependent upon receiving cash dividends from our bank. In addition, Georgia and federal banking
regulations restrict the amount of cash dividends that can be paid to the company from the bank. See Subsidiary Dividends in the section entitled Supervision and Regulation.



17



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##### Table of Contents

Performance Graph. Set forth below is a line graph comparing the yearly percentage change in the cumulative total
shareholder return of our common stock against the cumulative total return on the Nasdaq Stock Market (U.S. Companies) Index and the index of Nasdaq Bank Stocks for the five-year period commencing December 31, 2001 and ending on
December 31, 2006. Our common stock was not traded on an exchange until October 6, 2005, when it became listed on the Nasdaq Stock Market. The total shareholder return is based on stock trades known to us during the periods prior to
October 6, 2005. This line graph assumes an investment of $100 on December 31, 2001 and reinvestment of dividends and other distributions to shareholders.

Five-Year Cumulative Total Returns

Comparison of Appalachian Bancshares, Inc., Nasdaq Stock Market
Index

and Nasdaq Bank Index, as of December 31

LOGO



|                             |  |                         |        |      |   |        |  |      |        |      |   |        |  |   |        |  |   |       
|---------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------ |  | - | ------
|                             |  | Cumulative Total Return
|Index Value                  |  | 2001                    |        | 2002 |   | 2003   |  | 2004 |        | 2005 |   | 2006  
|Appalachian Bancshares, Inc. |  | $                       | 100.00 |      | $ | 102.49 |  | $    | 122.99 |      | $ | 139.38 |  | $ | 157.77 |  | $ | 167.70
|NASDAQ Composite             |  |                         | 100.00 |      |   | 68.76  |  |      | 103.67 |      |   | 113.16 |  |   | 115.57 |  |   | 127.58
|NASDAQ Bank                  |  |                         | 100.00 |      |   | 106.95 |  |      | 142.29 |      |   | 161.73 |  |   | 158.61 |  |   | 180.53

Source: SNL Financial LC, Charlottesville, VA© 2007



18



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##### Table of Contents

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

Our selected consolidated
financial data presented below as of and for the years ended December 31, 2002 through 2006 is derived from our audited consolidated financial statements. Our audited consolidated financial statements as of December 31, 2006 and 2005 and
for each of the years in the three year period ended December 31, 2006 are included elsewhere in this report. All per share data has been adjusted to reflect a 10% common stock dividend on July 1, 2003.



|                                                    |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|--------------------------------------------------- |  | --------------------------------------- | --------- | ---- | - | --------- |  | ---- | --------- | ---- | - | --------- |  | - | ---------
|                                                    |  | At and for the Years Ended December 31,
|                                                    |  | 2006                                    |           | 2005 |   | 2004      |  | 2003 |           | 2002
|                                                    |  | (In thousands, except per share data)  
|Selected Balance Sheet Data                         |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Assets                                              |  | $                                       | 758,214   |      | $ | 592,606   |  | $    | 472,811   |      | $ | 409,617   |  | $ | 384,024  
|Investment securities                               |  |                                         | 74,725    |      |   | 71,570    |  |      | 64,655    |      |   | 55,363    |  |   | 40,375   
|Loans                                               |  |                                         | 631,786   |      |   | 457,418   |  |      | 377,352   |      |   | 332,307   |  |   | 298,063  
|Allowance for loan losses                           |  |                                         | 7,670     |      |   | 6,059     |  |      | 4,349     |      |   | 3,610     |  |   | 3,238    
|Deposits                                            |  |                                         | 651,134   |      |   | 473,310   |  |      | 381,498   |      |   | 332,919   |  |   | 316,283  
|Short-term borrowings                               |  |                                         | 4,738     |      |   | 24,892    |  |      | 15,470    |      |   | 12,086    |  |   | 5,929    
|Accrued interest payable                            |  |                                         | 1,454     |      |   | 728       |  |      | 540       |      |   | 671       |  |   | 976      
|FHLB advances                                       |  |                                         | 25,050    |      |   | 24,950    |  |      | 31,950    |      |   | 25,693    |  |   | 34,736   
|Subordinated long-term capital notes                |  |                                         | 6,186     |      |   | 6,186     |  |      | 6,186     |      |   | 6,186     |  |   |         
|Other liabilities                                   |  |                                         | 2,889     |      |   | 2,715     |  |      | 1,084     |      |   | 981       |  |   | 482      
|Shareholders equity                                |  |                                         | 66,763    |      |   | 59,825    |  |      | 36,083    |      |   | 31,082    |  |   | 25,619   
|                                                    |  |                                         |           |      |  
|Summary Results of Operations Data                  |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Interest income                                     |  | $                                       | 53,193    |      | $ | 34,750    |  | $    | 25,736    |      | $ | 23,090    |  | $ | 22,892   
|Interest expense                                    |  |                                         | 22,494    |      |   | 11,880    |  |      | 7,558     |      |   | 8,257     |  |   | 11,425   
|                                                    |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Net interest income                                 |  |                                         | 30,699    |      |   | 22,870    |  |      | 18,178    |      |   | 14,833    |  |   | 11,467   
|Provision for loan losses                           |  |                                         | 3,253     |      |   | 2,211     |  |      | 1,235     |      |   | 1,465     |  |   | 1,028    
|                                                    |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Net interest income after provision for loan losses |  |                                         | 27,446    |      |   | 20,659    |  |      | 16,943    |      |   | 13,368    |  |   | 10,439   
|Non-interest income                                 |  |                                         | 3,971     |      |   | 3,303     |  |      | 2,829     |      |   | 2,703     |  |   | 2,937    
|Non-interest expense                                |  |                                         | 22,561    |      |   | 16,338    |  |      | 13,840    |      |   | 11,732    |  |   | 9,702    
|                                                    |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Income before taxes                                 |  |                                         | 8,856     |      |   | 7,624     |  |      | 5,932     |      |   | 4,339     |  |   | 3,674    
|Income tax expense                                  |  |                                         | 2,852     |      |   | 2,502     |  |      | 1,885     |      |   | 1,253     |  |   | 1,006    
|                                                    |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Net income                                          |  | $                                       | 6,004     |      | $ | 5,122     |  | $    | 4,047     |      | $ | 3,086     |  | $ | 2,668    
|                                                    |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Per Share Data                                      |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Net incomebasic                                    |  | $                                       | 1.16      |      | $ | 1.24      |  | $    | 1.09      |      | $ | 0.86      |  | $ | 0.81     
|Net incomediluted                                  |  |                                         | 1.14      |      |   | 1.21      |  |      | 1.04      |      |   | 0.81      |  |   | 0.76     
|Book value                                          |  |                                         | 12.83     |      |   | 11.62     |  |      | 9.58      |      |   | 8.49      |  |   | 7.45     
|Cash dividends declared per common share            |  |                                         | 0.00      |      |   | 0.00      |  |      | 0.00      |      |   | 0.00      |  |   | 0.00     
|Weighted average number shares outstanding:         |  |                                         |           |      |   |           |  |      |           |      |   |           |  |   |          
|Basic                                               |  |                                         | 5,170,687 |      |   | 4,123,403 |  |      | 3,724,095 |      |   | 3,609,728 |  |   | 3,277,787
|Diluted                                             |  |                                         | 5,278,711 |      |   | 4,247,334 |  |      | 3,885,490 |      |   | 3,809,625 |  |   | 3,508,019



19



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|                                                  |  |                                         |   |  |        |   |  |        |   |  |        |   |  |       |  
|------------------------------------------------- |  | --------------------------------------- | - |  | ------ | - |  | ------ | - |  | ------ | - |  | ----- | -
|                                                  |  | At and for the Years Ended December 31, |  
|                                                  |  | 2006                                    |   |  | 2005   |   |  | 2004   |   |  | 2003   |   |  | 2002  |  
|Performance Ratios                                |  |                                         |   |  |        |   |  |        |   |  |        |   |  |       |  
|Return on average assets                          |  | 0.91                                    | % |  | 0.99   | % |  | 0.91   | % |  | 0.78   | % |  | 0.75  | %
|Return on average equity                          |  | 9.57                                    |   |  | 12.18  |   |  | 12.23  |   |  | 10.85  |   |  | 11.88 |  
|Net interest margin (1)                           |  | 5.04                                    |   |  | 4.77   |   |  | 4.43   |   |  | 4.15   |   |  | 3.58  |  
|Efficiency ratio (2)                              |  | 65.07                                   |   |  | 62.42  |   |  | 65.81  |   |  | 66.83  |   |  | 68.72 |  
|Loan to deposit ratio                             |  | 97.03                                   |   |  | 96.64  |   |  | 98.91  |   |  | 99.82  |   |  | 94.24 |  
|                                                  |  |                                         |   |  |       
|Asset Quality Ratios                              |  |                                         |   |  |        |   |  |        |   |  |        |   |  |       |  
|Nonperforming loans to total loans                |  | 0.55                                    | % |  | 0.24   | % |  | 0.41   | % |  | 0.50   | % |  | 1.73  | %
|Nonperforming assets to total assets              |  | 0.62                                    |   |  | 0.21   |   |  | 0.44   |   |  | 0.58   |   |  | 1.60  |  
|Net charge-offs to average total loans            |  | 0.30                                    |   |  | 0.12   |   |  | 0.14   |   |  | 0.35   |   |  | 0.28  |  
|Allowance for loan losses to nonperforming loans  |  | 220.21                                  |   |  | 555.36 |   |  | 279.14 |   |  | 219.05 |   |  | 62.99 |  
|Allowance for loan losses to total loans          |  | 1.21                                    |   |  | 1.32   |   |  | 1.15   |   |  | 1.09   |   |  | 1.09  |  
|                                                  |  |                                         |   |  |       
|Capital Ratios                                    |  |                                         |   |  |        |   |  |        |   |  |        |   |  |       |  
|Average equity to average assets                  |  | 9.49                                    | % |  | 8.11   | % |  | 7.42   | % |  | 7.23   | % |  | 6.34  | %
|Leverage ratio                                    |  | 9.55                                    |   |  | 11.35  |   |  | 8.53   |   |  | 8.58   |   |  | 6.07  |  
|Tier 1 risk-based capital ratio                   |  | 10.69                                   |   |  | 13.27  |   |  | 10.32  |   |  | 10.46  |   |  | 7.54  |  
|Total risk-based capital ratio                    |  | 11.85                                   |   |  | 14.52  |   |  | 11.45  |   |  | 11.55  |   |  | 8.59  |  
|                                                  |  |                                         |   |  |       
|Growth Ratios and Other Data                      |  |                                         |   |  |        |   |  |        |   |  |        |   |  |       |  
|Percentage change in net income                   |  | 17.22                                   | % |  | 26.56  | % |  | 31.14  | % |  | 15.67  | % |  | 5.12  | %
|Percentage change in diluted net income per share |  | (5.79                                   | ) |  | 16.35  |   |  | 28.40  |   |  | 6.58   |   |  | 1.33  |  
|Percentage change in assets                       |  | 27.95                                   |   |  | 25.34  |   |  | 15.43  |   |  | 6.66   |   |  | 20.13 |  
|Percentage change in loans                        |  | 38.12                                   |   |  | 21.22  |   |  | 13.56  |   |  | 11.49  |   |  | 18.95 |  
|Percentage change in deposits                     |  | 37.57                                   |   |  | 24.07  |   |  | 14.59  |   |  | 5.26   |   |  | 19.79 |  
|Percentage change in equity                       |  | 11.60                                   |   |  | 65.80  |   |  | 16.09  |   |  | 21.32  |   |  | 24.42 |  

---

|(1) | Taxable Equivalent.
|--- | -------------------

|(2) | Computed by dividing noninterest expense by the sum of net interest and noninterest income, excluding gains and losses on the sale of assets
|--- | --------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

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

The following discussion reviews our results of operations and assesses our financial condition. You should read the following discussion and analysis
in conjunction with our Selected Consolidated Financial Data and our consolidated financial statements and the related notes included elsewhere in this Report.

Overview

We were incorporated in 1996 to serve as the holding company for Gilmer County Bank (now
Appalachian Community Bank). Since that time, we have experienced consistent growth in net income, total assets, total loans, total deposits and shareholders equity.

The following table sets forth selected measures of our financial performance for the periods indicated.



|                     |  |                          |         |      |   |         |  |   |        
|-------------------- |  | ------------------------ | ------- | ---- | - | ------- |  | - | -------
|                     |  | Years Ended December 31,
|                     |  | 2006                     |         | 2005 |   | 2004   
|                     |  | (In thousands)          
|Net income           |  | $                        | 6,004   |      | $ | 5,122   |  | $ | 4,047  
|Total assets         |  |                          | 758,214 |      |   | 592,606 |  |   | 472,811
|Total loans(1)       |  |                          | 631,786 |      |   | 457,418 |  |   | 377,352
|Total deposits       |  |                          | 651,134 |      |   | 473,310 |  |   | 381,498
|Shareholders equity |  |                          | 66,763  |      |   | 59,825  |  |   | 36,083 

---

|(1) | Loans are net of unearned income
|--- | --------------------------------

Like most community
banks, we derive the majority of our income from interest and fees received on our loans. Our primary sources of funds for making these loans and investments are our deposits and advances from the Federal Home Loan Bank of Atlanta (FHLB).
Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income earned on our interest-earning assets, such as loans and investments, and the interest paid on our interest-bearing
liabilities, such as deposits and advances from the FHLB. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread.

We have included a number of tables to assist in our description of these measures. For example, the Average Balances, Income and
Expense and Rates tables show for the periods indicated the average balance for each category of our assets and liabilities, as well as the yield we earned or the rate we paid with respect to each category. A review of these tables show that
our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we intend to channel a substantial percentage of our earning assets into our loan portfolio. Similarly, the Analysis of Changes in
Net Interest Income table helps demonstrate the impact of changing interest rates and changing volume of assets and liabilities during the periods shown. We also track the sensitivity of our various categories of assets and liabilities to
changes in interest rates, and we have included an Interest Sensitivity Analysis table to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans, our deposits and
other borrowings.

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing
loans that may become uncollectible. We maintain this allowance by charging a provision for loan losses against our operating earnings for each period. We have included a detailed discussion of this process, as well as several tables describing our
allowance for loan losses.

In addition to earning interest on our loans and investments, we earn income through fees and other charges to
our customers. We have also included a discussion of the various components of this noninterest income, as well as of our noninterest expense, included in the Noninterest Income and Expense section.



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The following discussion and analysis also identifies significant factors that have affected our
financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information
included in this Report.

Critical Accounting Policies

In the preparation of our consolidated financial statements, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States as well as the
general practices within the banking industry. Our significant accounting policies are described in the footnotes to our audited consolidated financial statements included in this Report.

Certain accounting policies involve significant judgments and assumptions by management that may have a material impact on the carrying value of certain
assets and liabilities. We consider such accounting policies to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which are believed to be reasonable under the circumstances.
Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates. These differences could have a material impact on our carrying values of assets and liabilities and our results of
operations.

We believe the determination of the allowance for loan losses is the critical accounting policy that requires the most
significant judgments and estimates when preparing our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the
estimated value of the underlying collateral, cash flow assumptions, the determination of loss factors for estimating credit losses, the impact of current events and other factors impacting the level of probable inherent losses. Under different
conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from managements estimates provided in our consolidated financial statements. Refer to the section entitled Allowance for Loan
Losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Results of Operations

Income Statement Review

Overview

For the year ended December 31, 2006, our net income was $6.0 million, or $1.16 basic net income per common share, as compared to
$5.1 million, or $1.24 basic net income per common share, for the year ended December 31, 2005, and $4.0 million, or $1.09 basic net income per common share, for the year ended December 31, 2004.

Our earnings during 2006 reflect the continued strong growth in loans and deposits, rising interest rates, and our de novo branch expansions. Our net
interest margin increased 27 basis points from 2005 to 2006, to 5.04%. Operating expenses grew during 2006 to $22.6 million, or 38%, from 2005. This growth in operating expenses relates primarily to our de novo branch expansion and from hiring
additional employees to staff our new banking offices and to support our continued growth. In 2006 and early 2007, we opened 5 new branches and two loan production offices, and expanded our sales and production staff, adding 97 full-time equivalent
new employees in 2006.

Net Interest Income

Years Ended December 31, 2006, 2005, and 2004

Our primary source of revenue is net interest income, which represents
the difference between the income on interest-earning assets and expense on interest-bearing liabilities. Net interest income increased $7.8 million, or 34.2%, to $30.7 million for 2006, compared to $22.9 million for 2005. Net interest income
increased $4.7 million, or 25.8%, for 2005, compared to $18.2 million for 2004. Generally, the overall increase in net interest income was primarily the result of the growth in our loan portfolio. Our average total loans increased 30.5% from 2005 to
2006,



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##### Table of Contents

and 14.9% from 2004 to 2005. Rising interest rates and the continued growth of our loan portfolio, due to growth in our existing markets as well as our move
into new markets, are the primary reasons for the increase in interest income. However, the increase in interest expense is largely the result of the significant growth of our company as well as continued strong competition for deposits. To maintain
the net interest margin, we actively manage loan rates and yields and monitor the cost of funds locally and in other markets. Management has focused on loan yields keeping pace with increases in the prime rate. Although our cost of funds has
increased due to market pressure, we continue to grow our core deposits and monitor our deposit rates and pricing. In addition, we will continue to use brokered deposits as a secondary source to fund loan growth when necessary. These brokered
deposits are often less expensive than our local deposits, due to the strong competition for deposits in our market area. The continued strong demand for loans also provides us with the opportunity to develop business as the communities we serve
continue to grow.

The trend in net interest income is also evaluated in terms of average rates using the net interest margin and the
interest rate spread. The net interest margin, or the net yield on earning assets, is computed by dividing fully taxable equivalent net interest income by average earning assets. This ratio represents the difference between the average yield
returned on average earning assets and the average rate paid for funds used to support those earning assets, including both interest-bearing and noninterest-bearing sources. The net interest margin for 2006 was 5.04% compared to a net interest
margin of 4.77% in 2005 and 4.43% in 2004. Net interest spread, the difference between the average yield on earning assets and the average rate paid on interest-bearing sources of funds, was 4.53% in 2006, compared to 4.46% in 2005 and 4.25% in
2004.



23



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##### Table of Contents

Average Balances, Income and Expenses, and Rates. The following table shows, for years ended
December 31, 2006, 2005 and 2004, the average daily balances outstanding for the major categories of interest-earning assets and interest-bearing liabilities, and the average interest rate earned or paid. Such yields are calculated by dividing
income or expense by the average daily balance of the corresponding assets or liabilities.

Average Balances, Income and Expenses, and
Rates.



|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|--------------------------------------- |  | ------------------------ | ------- | -------------- | ---- | ------------ |  | ---- | -------------- |  | -------------- | ------- | ------------ | - | ------ | -------------- | ---- | -------------- |  | ------------ | ------- |  | - | ------ |  | ---- | -
|                                        |  | Years Ended December 31, |        
|                                        |  | 2006                     |         |                | 2005 |              |  | 2004 |               
|                                        |  | AverageBalance           |         | Income/Expense |      | Yields/Rates |  |      | AverageBalance |  | Income/Expense |         | Yields/Rates |   |        | AverageBalance |      | Income/Expense |  | Yields/Rates |        
|                                        |  | (Dollars in thousands)   |        
|Earning assets:                         |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Loans, net of unearned income(1)        |  | $                        | 537,974 |                | $    | 49,871       |  | 9.27 | %              |  | $              | 412,307 |              | $ | 32,019 |                | 7.77 | %              |  | $            | 358,925 |  | $ | 23,667 |  | 6.59 | %
|Investment securities:                  |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Taxable                                 |  |                          | 58,277  |                |      | 2,301        |  | 3.95 |                |  |                | 52,887  |              |   | 1,843  |                | 3.48 |                |  |              | 42,224  |  |   | 1,402  |  | 3.32 |  
|Tax-exempt                              |  |                          | 14,173  |                |      | 1,037        |  | 7.32 |                |  |                | 13,766  |              |   | 949    |                | 6.89 |                |  |              | 14,191  |  |   | 952    |  | 6.71 |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Total investment securities(2)          |  |                          | 72,450  |                |      | 3,338        |  | 4.61 |                |  |                | 66,653  |              |   | 2,792  |                | 4.19 |                |  |              | 56,415  |  |   | 2,354  |  | 4.17 |  
|Interest-bearing deposits               |  |                          | 632     |                |      | 30           |  | 4.75 |                |  |                | 677     |              |   | 20     |                | 2.95 |                |  |              | 350     |  |   | 5      |  | 1.43 |  
|Federal funds sold                      |  |                          | 6,539   |                |      | 351          |  | 5.37 |                |  |                | 5,986   |              |   | 218    |                | 3.64 |                |  |              | 1,994   |  |   | 26     |  | 1.30 |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Total interest-earning assets(3)        |  | $                        | 617,595 |                |      | 53,590       |  | 8.68 |                |  | $              | 485,623 |              |   | 35,049 |                | 7.22 |                |  | $            | 417,684 |  |   | 26,052 |  | 6.24 |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Interest-bearing liabilities:           |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Demand deposits                         |  | $                        | 74,125  |                |      | 1,610        |  | 2.17 |                |  | $              | 75,670  |              |   | 1,057  |                | 1.40 |                |  | $            | 82,617  |  |   | 952    |  | 1.15 |  
|Savings deposits                        |  |                          | 105,022 |                |      | 3,544        |  | 3.38 |                |  |                | 84,653  |              |   | 1,745  |                | 2.06 |                |  |              | 61,281  |  |   | 713    |  | 1.16 |  
|Time deposits                           |  |                          | 315,429 |                |      | 15,197       |  | 4.82 |                |  |                | 222,561 |              |   | 7,330  |                | 3.29 |                |  |              | 187,578 |  |   | 4,544  |  | 2.42 |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Total deposits                          |  |                          | 494,576 |                |      | 20,351       |  | 4.12 |                |  |                | 382,884 |              |   | 10,132 |                | 2.65 |                |  |              | 331,476 |  |   | 6,209  |  | 1.87 |  
|Other short-term borrowings             |  |                          | 12,178  |                |      | 472          |  | 3.88 |                |  |                | 11,658  |              |   | 174    |                | 1.49 |                |  |              | 17,953  |  |   | 123    |  | 0.69 |  
|Long-term debt                          |  |                          | 34,976  |                |      | 1,671        |  | 4.78 |                |  |                | 35,803  |              |   | 1,574  |                | 4.40 |                |  |              | 30,946  |  |   | 1,226  |  | 3.96 |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Total interest-bearing liabilities      |  | $                        | 541,730 |                |      | 22,494       |  | 4.15 |                |  | $              | 430,345 |              |   | 11,880 |                | 2.76 |                |  | $            | 380,375 |  |   | 7,558  |  | 1.99 |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Net interest income/net interest spread |  |                          |         |                |      | 31,096       |  | 4.53 | %              |  |                |         |              |   | 23,169 |                | 4.46 | %              |  |              |         |  |   | 18,494 |  | 4.25 | %
|Net yield on earning assets             |  |                          |         |                |      |              |  | 5.04 | %              |  |                |         |              |   |        |                | 4.77 | %              |  |              |         |  |   |        |  | 4.43 | %
|Taxable equivalent adjustment:          |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Loans                                   |  |                          |         |                |      | 28           |  |      |                |  |                |         |              |   | 5      |                |      |                |  |              |         |  |   | 15     |  |      |  
|Investment securities                   |  |                          |         |                |      | 369          |  |      |                |  |                |         |              |   | 294    |                |      |                |  |              |         |  |   | 301    |  |      |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Total taxable equivalent adjustment     |  |                          |         |                |      | 397          |  |      |                |  |                |         |              |   | 299    |                |      |                |  |              |         |  |   | 316    |  |      |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  
|Net interest income                     |  |                          |         |                | $    | 30,699       |  |      |                |  |                |         |              | $ | 22,870 |                |      |                |  |              |         |  | $ | 18,178 |  |      |  
|                                        |  |                          |         |                |      |              |  |      |                |  |                |         |              |   |        |                |      |                |  |              |         |  |   |        |  |      |  

---

|(1) | Average loans exclude nonaccrual loans of $1.6, $1.3 and $1.4 million for years ended December 31, 2006, 2005 and 2004, respectively. All loans and deposits are domestic.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Average securities exclude unrealized gains/(losses) of $(839,000), $(249,000) and $567,000 for years ended December 31, 2006, 2005 and 2004, respectively
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Tax equivalent adjustments have been based on an assumed tax rate of 39% for 2006 and 34% for 2005 and 2004.
|--- | ------------------------------------------------------------------------------------------------------------



24



---

##### Table of Contents

Analysis of Changes in Net Interest Income. The following table sets forth a summary of the
changes in interest income and interest expense resulting from changes in interest rates and in changes in the volume of earning assets and interest-bearing liabilities, segregated by category. The change due to volume is calculated by multiplying
the change in volume by the prior years rate. The change due to rate is calculated by multiplying the change in the applicable rate by the prior years volume. Figures are presented on a taxable equivalent basis. The change in interest
due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

Analysis of Changes in Net Interest Income



|                                        |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|--------------------------------------- |  | ---------------------------------------------- | ------ | ---------------------------------------------- | ---- | - | ---------- |  | ------ | ------ |  | ---- | ----- | ---------- |  | - | ----- |  | - | -----
|                                        |  | For the Years Ended December 31, 2006 vs. 2005 |        | For the Years Ended December 31, 2005 vs. 2004
|                                        |  | Volume                                         |        |                                                | Rate |   | Net Change |  | Volume |        |  | Rate |       | Net Change
|                                        |  | (In thousands)                                
|Earning assets:                         |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|Loans, net of unearned income           |  | $                                              | 10,929 |                                                |      | $ | 6,923      |  | $      | 17,852 |  | $    | 3,790 |            |  | $ | 4,562 |  | $ | 8,352
|Investment securities                   |  |                                                | 254    |                                                |      |   | 292        |  |        | 546    |  |      | 427   |            |  |   | 11    |  |   | 438  
|Interest bearing deposits               |  |                                                | (1     | )                                              |      |   | 11         |  |        | 10     |  |      | 7     |            |  |   | 8     |  |   | 15   
|Federal funds sold                      |  |                                                | 22     |                                                |      |   | 111        |  |        | 133    |  |      | 101   |            |  |   | 91    |  |   | 192  
|                                        |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|Total earning assets                    |  |                                                | 11,204 |                                                |      |   | 7,337      |  |        | 18,541 |  |      | 4,325 |            |  |   | 4,672 |  |   | 8,997
|                                        |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|Interest-bearing liabilities:           |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|Demand deposits                         |  |                                                | (22    | )                                              |      |   | 575        |  |        | 553    |  |      | (85   | )          |  |   | 190   |  |   | 105  
|Savings deposits                        |  |                                                | 493    |                                                |      |   | 1,306      |  |        | 1,799  |  |      | 341   |            |  |   | 691   |  |   | 1,032
|Time deposits                           |  |                                                | 3,730  |                                                |      |   | 4,137      |  |        | 7,867  |  |      | 952   |            |  |   | 1,834 |  |   | 2,786
|                                        |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|Total deposits                          |  |                                                | 4,201  |                                                |      |   | 6,018      |  |        | 10,219 |  |      | 1,208 |            |  |   | 2,715 |  |   | 3,923
|Other short-term borrowings             |  |                                                | 8      |                                                |      |   | 290        |  |        | 298    |  |      | (55   | )          |  |   | 106   |  |   | 51   
|Long-term debt                          |  |                                                | (37    | )                                              |      |   | 134        |  |        | 97     |  |      | 205   |            |  |   | 143   |  |   | 348  
|                                        |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|Total interest-bearing liabilities      |  |                                                | 4,172  |                                                |      |   | 6,442      |  |        | 10,614 |  |      | 1,358 |            |  |   | 2,964 |  |   | 4,322
|                                        |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      
|Net interest income/net interest spread |  | $                                              | 7,032  |                                                |      | $ | 895        |  | $      | 7,927  |  | $    | 2,967 |            |  | $ | 1,708 |  | $ | 4,675
|                                        |  |                                                |        |                                                |      |   |            |  |        |        |  |      |       |            |  |   |       |  |   |      

Provision for Loan Losses

Years Ended December 31, 2006, 2005 and 2004

The provision for loan losses is based on the
growth of the loan portfolio, the amount of net loan losses incurred and managements estimation of potential future losses based on an evaluation of the risk in the loan portfolio. The provision for loan losses was $3.3 million for 2006, $2.2
million for 2005 and $1.2 million for 2004. Please see the discussion below under Allowance for Loan Losses for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this
allowance.

Noninterest Income

Years Ended December 31, 2006, 2005 and 2004

Noninterest income for 2006, 2005 and 2004 totaled $4.0 million, $3.3
million and $2.8 million, respectively. These amounts are primarily from customer service fees, mortgage origination commissions, insurance commissions, as well as other fees charged to customers such as safe deposit box rental and ATM fees.
Customer service fees increased from $1.2 million in 2004, to $1.4 million in 2005, and grew to $1.7 in 2006. The increase in customer service fees for all years is primarily related to our continuing efforts to increase the amount of deposit
account charges, non-sufficient funds (NSF), and returned check charges, all of which increased during 2006. Mortgage origination commissions increased to $1.3 million in 2006, and increased to 959,000 in 2005 from 801,000 in 2004. The increase in
mortgage origination commissions from 2005 to 2006 relates primarily to the additional mortgage activity generated from our 2006 expansion efforts. The increase from 2004 to 2005 relates to increasing land and real estate development and the
continued strong loan demand in our market area.



25



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##### Table of Contents

Noninterest Expenses

Years Ended December 31, 2006, 2005 and 2004

Noninterest expenses totaled $22.6 million in
2006, up from $16.3 million in 2005, and $13.8 million in 2004. As a percentage of total assets, our total noninterest expenses decreased from 2.9% in 2004 to 2.8% in 2005, and increased to 3.0% in 2006. Salaries and employee benefits increased $4.6
million or 52.6%, to $13.3 million in 2006, and increased $1.9 million, or 27.0%, to $8.7 million in 2005 from 2004. This increase in salaries and employee benefits was primarily due to the additional staff necessary to support our continued growth
and expansion into new markets, as well as the addition of several management-level employees necessary to provide the infrastructure to support our continued growth. Since December 31, 2005, we have added 97 full-time equivalent employees. In
addition, in the third quarter of 2004, we implemented a new salary continuation plan for our directors and executive officers. This salary continuation plan was subsequently amended in May and August of 2006, which caused an increase to the expense
of approximately $164,000 for 2006.

Occupancy, furniture and equipment expenses totaled $2.7 million in 2006, $2.0 million in 2005, and
$2.0 million in 2004. The 33.3% increase from 2005 to 2006 is primarily due to our expansion efforts and the increase in the number of branches and loan production offices, as well as the new corporate and operations center that opened in March
2006.

Other operating expenses increased from $5.0 million in 2004 to $5.6 million in 2005, and to $6.5 million in 2006. These annual
increases are primarily the result of increased legal fees, marketing expenses, data processing, business license fees, and supplies and postage.Legal fees increased by approximately $208,000 to $446,000 in 2006, compared to $238,000 in 2005
and $186,000 in 2004. The increase in legal expense for 2006 is primarily due to nonrecurring legal costs associated with chartering the new thrift, as well as general corporate matters associated with our growing company. Total marketing expenses
increased $450,000, or 43.1% from 2005 to 2006 due to the increased advertising and promotional activities related to the opening of the new branches and loan production offices. From 2004 to 2005 total marketing increased $263,000, or 33.7%, due to
our increased marketing of our new deposit products. Data processing, business license fees, as well as supplies and postage increases were all primarily due to our expansion efforts in 2006.

Noninterest expenses related to expansionary activities were approximately $2.9 million for the year ended December 31, 2006. These expenses
consisted of $1.7 in salaries and benefits, $275,000 in occupancy costs and $850,000 in other expenses. Included in the $850,000 for other expenses are approximately $351,000 in nonrecurring costs directly related to our expansionary activities,
including legal expenses of $250,000 and application fees of $20,000 in connection with the thrift charter, as well as increased advertising and promotional costs related to the opening of the new branches and loan production offices.

Balance Sheet Review

General

At December 31, 2006, we had total assets of $758.2 million, consisting principally of $624.1 million in net loans (net of allowance of $7.7
million), $74.7 million in investments, $11.6 million in cash and cash equivalents, and $23.4 million in net premises and equipment (net of accumulated depreciation of $5.4 million). Our liabilities at December 31, 2006 totaled $691.5 million,
consisting principally of $651.1 million in deposits, $25.1 million in FHLB advances, $4.7 million of short-term borrowings and $6.2 million of subordinated long-term capital notes. At December 31, 2006, our shareholders equity was $66.8
million.

At December 31, 2005, we had total assets of $592.6 million, consisting principally of $451.4 million in net loans (net of
allowance of $6.1 million), $71.6 million in investments, $35.3 million in cash and cash equivalents, and $16.8 million in net premises and equipment (net of accumulated depreciation of $4.7 million). Our liabilities at December 31, 2005
totaled $532.8 million, consisting principally of $473.3 million in deposits, $25.0 million in FHLB advances, $24.9 million of short-term borrowings and $6.2 million of subordinated long-term capital notes. At December 31, 2005, our
shareholders equity was $59.8 million.



26



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##### Table of Contents

Federal Funds Sold

Management maintains federal funds sold as a tool in managing daily cash needs. Federal funds sold at December 31, 2006 and December 31, 2005 were $3.1 million and $799,000 respectively. The increase in
year-end federal funds sold resulted from the timing of funding loan demand. Average federal funds sold for the twelve months ended December 31, 2006 and 2005 were approximately $6.5 million, or 1.1% of average earning assets, and approximately
$6.0 million, or 1.2% of average earning assets, respectively. Although we use federal funds as a source of liquidity, we continue to try to minimize federal funds sold to maximize our use of earning assets.

Securities Portfolio

The primary objectives of our
investment strategy are to maintain an appropriate level of liquidity, and to provide a tool with which to control our interest rate position while, at the same time, producing adequate levels of interest income.

The following table presents the carrying amounts of the securities portfolio at December 31 in each of the last three years.



|                               |  |                |        |      |   |        |  |   |       
|------------------------------ |  | -------------- | ------ | ---- | - | ------ |  | - | ------
|                               |  | December 31,  
|                               |  | 2006           |        | 2005 |   | 2004  
|                               |  | (In thousands)
|Securities Available-for-Sale: |  |                |        |      |   |        |  |   |       
|Government sponsored agencies  |  | $              | 43,396 |      | $ | 37,357 |  | $ | 31,744
|State and municipal securities |  |                | 13,148 |      |   | 14,806 |  |   | 14,277
|Mortgage-backed securities     |  |                | 14,833 |      |   | 15,803 |  |   | 14,927
|Equity securities              |  |                | 3,348  |      |   | 3,604  |  |   | 3,707 
|                               |  |                |        |      |   |        |  |   |       
|Total                          |  | $              | 74,725 |      | $ | 71,570 |  | $ | 64,655
|                               |  |                |        |      |   |        |  |   |       

Gross unrealized gains in the portfolio amounted to $502,000 at year-end 2006 and unrealized
losses amounted to $837,000. Gross unrealized gains in the portfolio amounted to $574,000 at year-end 2005 and unrealized losses amounted to $1,284,000. For 2004, gross unrealized gains in the portfolio amounted to $909,000 and unrealized losses,
which we consider to be temporary, amounted to $337,000.

At December 31, 2006, 2005 and 2004 the percentage of the total carrying
value of the securities portfolio to total assets was 9.9%, 12.1% and 13.7%, respectively.

The maturities and weighted average yields of
our investments in securities (all available for sale) at December 31, 2006 are presented below. Taxable equivalent adjustments (using a 34% tax rate) have been made in calculating yields on tax-exempt obligations.



|                               |  |                        |        |         |                                |   |        |                                |         |  |                 |        |  |         |       |  |        |   |         |   |        |  |      |  
|------------------------------ |  | ---------------------- | ------ | ------- | ------------------------------ | - | ------ | ------------------------------ | ------- |  | --------------- | ------ |  | ------- | ----- |  | ------ | - | ------- | - | ------ |  | ---- | -
|                               |  | Maturing               |       
|                               |  | Within One Year        |        |         | After One ButWithin Five Years |   |        | After Five ButWithin Ten Years |         |  | After Ten Years |       
|                               |  | Amount                 |        | % Yield |                                |   | Amount |                                | % Yield |  |                 | Amount |  | % Yield |       |  | Amount |   | % Yield |  
|                               |  | (Dollars in thousands) |       
|Securities Available-for-Sale: |  |                        |        |         |                                |   |        |                                |         |  |                 |        |  |         |       |  |        |   |         |   |        |  |      |  
|Government sponsored agencies  |  | $                      | 11,638 |         | 3.88                           | % |        | $                              | 31,758  |  | 4.09            | %      |  | $       |      |  | 0.00   | % |         | $ |       |  | 0.00 | %
|State and municipal            |  |                        |       |         | 0.00                           |   |        |                                | 205     |  | 4.45            |        |  |         | 2,360 |  | 5.04   |   |         |   | 10,583 |  | 4.93 |  
|Mortgage-backed                |  |                        |       |         | 0.00                           |   |        |                                | 574     |  | 4.56            |        |  |         | 798   |  | 4.50   |   |         |   | 13,461 |  | 4.55 |  
|Equity securities              |  |                        |       |         | 0.00                           |   |        |                                |        |  | 0.00            |        |  |         |      |  | 0.00   |   |         |   | 3,348  |  | 5.24 |  
|                               |  |                        |        |         |                                |   |        |                                |         |  |                 |        |  |         |       |  |        |   |         |   |        |  |      |  
|Total Securities               |  | $                      | 11,638 |         | 3.88                           |   |        | $                              | 32,537  |  | 4.10            |        |  | $       | 3,158 |  | 4.87   |   |         | $ | 27,392 |  | 4.78 |  
|                               |  |                        |        |         |                                |   |        |                                |         |  |                 |        |  |         |       |  |        |   |         |   |        |  |      |  

There were no securities held by us of which the aggregate value by issuer on December 31,
2006 exceeded 10% of shareholders equity at that date. Securities which are payable from and secured by the same source of revenue or taxing authority are considered to be securities of a single issuer. Securities of Government agencies and
corporations are not included.



27



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##### Table of Contents

Loan Portfolio

Loans make up the largest component of our earning assets. In 2006, average loans (excluding nonaccrual loans of $1.6 million) represented 87.1% of average earning assets, while in 2005 average loans (excluding
nonaccrual loans of $1.3 million) represented 84.9% of average earning assets. Average loans increased from $412.3 million (excluding nonaccrual loans of $1.3 million) with a yield of 7.8% in 2005, to $538.0 million (excluding nonaccrual loans of
$1.3 million) with a yield of 9.3% in 2006. Loan demand in our market area remains strong due to the current interest rate environment as well as the amount of development occurring in our both our existing and new markets and the strong customer
relationships that our employees have developed. The ratio of total loans to total deposits was 97.0% in 2006 and 96.6% in 2005.

The
following table shows the classification of loans by major category at December 31, 2006, and for each of the preceding four years.



|                                       |  |                        |         |   |                |       |   |        |   |         |                |  |       |        |  |   |                |   |  |        |   |  |                |         |   |        |       |   |                 |   |         |   |  |       |  
|-------------------------------------- |  | ---------------------- | ------- | - | -------------- | ----- | - | ------ | - | ------- | -------------- |  | ----- | ------ |  | - | -------------- | - |  | ------ | - |  | -------------- | ------- | - | ------ | ----- | - | --------------- | - | ------- | - |  | ----- | -
|                                       |  | December 31,           |        
|                                       |  | 2006                   |         |   | 2005           |       |   | 2004   |   |         | 2003           |  |       | 2002   | 
|                                       |  | Amount                 |         |   | PercentofTotal |       |   | Amount |   |         | PercentofTotal |  |       | Amount |  |   | PercentofTotal |   |  | Amount |   |  | PercentofTotal |         |   | Amount |       |   | Percentof Total |  
|                                       |  | (Dollars in thousands) |        
|Commercial, financial and agricultural |  | $                      | 40,491  |   |                | 6.4   | % |        | $ | 33,778  |                |  | 7.4   | %      |  | $ | 31,920         |   |  | 8.5    | % |  | $              | 34,613  |   |        | 10.4  | % |                 | $ | 33,449  |   |  | 11.2  | %
|Real estate  construction(1)          |  |                        | 320,406 |   |                | 50.7  |   |        |   | 203,538 |                |  | 44.5  |        |  |   | 145,588        |   |  | 38.6   |   |  |                | 104,619 |   |        | 31.5  |   |                 |   | 73,242  |   |  | 24.6  |  
|Real estate  other(2)                 |  |                        | 241,569 |   |                | 38.2  |   |        |   | 193,704 |                |  | 42.3  |        |  |   | 173,955        |   |  | 46.1   |   |  |                | 166,598 |   |        | 50.1  |   |                 |   | 165,526 |   |  | 55.5  |  
|Consumer                               |  |                        | 25,386  |   |                | 4.0   |   |        |   | 21,051  |                |  | 4.6   |        |  |   | 20,957         |   |  | 5.6    |   |  |                | 20,535  |   |        | 6.2   |   |                 |   | 20,296  |   |  | 6.8   |  
|Other loans                            |  |                        | 3,934   |   |                | 0.7   |   |        |   | 5,347   |                |  | 1.2   |        |  |   | 4,932          |   |  | 1.2    |   |  |                | 5,942   |   |        | 1.8   |   |                 |   | 5,550   |   |  | 1.9   |  
|                                       |  |                        |         |   |                |       |   |        |   |         |                |  |       |        |  |   |                |   |  |        |   |  |                |         |   |        |       |   |                 |   |         |   |  |       |  
|                                       |  |                        | 631,786 |   |                | 100.0 | % |        |   | 457,418 |                |  | 100.0 | %      |  |   | 377,352        |   |  | 100.0  | % |  |                | 332,307 |   |        | 100.0 | % |                 |   | 298,063 |   |  | 100.0 | %
|                                       |  |                        |         |   |                |       |   |        |   |         |                |  |       |        |  |   |                |   |  |        |   |  |                |         |   |        |       |   |                 |   |         |   |  |       |  
|Allowance for loan losses              |  |                        | (7,670  | ) |                |       |   |        |   | (6,059  | )              |  |       |        |  |   | (4,349         | ) |  |        |   |  |                | (3,610  | ) |        |       |   |                 |   | (3,238  | ) |  |       |  
|                                       |  |                        |         |   |                |       |   |        |   |         |                |  |       |        |  |   |                |   |  |        |   |  |                |         |   |        |       |   |                 |   |         |   |  |       |  
|Net loans                              |  | $                      | 624,116 |   |                |       |   |        | $ | 451,359 |                |  |       |        |  | $ | 373,003        |   |  |        |   |  | $              | 328,697 |   |        |       |   |                 | $ | 294,825 |   |  |       |  
|                                       |  |                        |         |   |                |       |   |        |   |         |                |  |       |        |  |   |                |   |  |        |   |  |                |         |   |        |       |   |                 |   |         |   |  |       |  

---

|(1) | The real estate  construction category includes residential construction and development loans and commercial construction loans.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(2) | The real estate  other category includes one-to-four family residential, home equity, multi-family (five or more) residential, commercial real estate and
undeveloped agricultural real estate loans.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The following table shows the maturity distribution of selected loan
classifications at December 31, 2006, and an analysis of these loan maturities.



|                                       |  |                 |         |                               |   |                                                 |  |   |                            |  |                           |         |  |   |         |  |   |       
|-------------------------------------- |  | --------------- | ------- | ----------------------------- | - | ----------------------------------------------- |  | - | -------------------------- |  | ------------------------- | ------- |  | - | ------- |  | - | ------
|                                       |  | Maturity        |         | Total                         |   | Rate Structure for Loans Maturing Over One Year
|                                       |  | One Year orLess |         | Over OneYearThroughFive Years |   | OverFiveYears                                   |  |   | PredeterminedInterest Rate |  | Floating orAdjustableRate
|                                       |  | (In thousands) 
|Commercial, financial and agricultural |  | $               | 24,653  |                               | $ | 12,886                                          |  | $ | 2,952                      |  | $                         | 40,491  |  | $ | 9,774   |  | $ | 6,063 
|Real estate  construction             |  |                 | 280,116 |                               |   | 39,067                                          |  |   | 1,223                      |  |                           | 320,406 |  |   | 26,078  |  |   | 14,212
|Real estate  other                    |  |                 | 130,369 |                               |   | 97,527                                          |  |   | 13,673                     |  |                           | 241,569 |  |   | 68,246  |  |   | 42,955
|                                       |  |                 |         |                               |   |                                                 |  |   |                            |  |                           |         |  |   |         |  |   |       
|Total                                  |  | $               | 435,138 |                               | $ | 149,480                                         |  | $ | 17,848                     |  | $                         | 602,466 |  | $ | 104,098 |  | $ | 63,230
|                                       |  |                 |         |                               |   |                                                 |  |   |                            |  |                           |         |  |   |         |  |   |       



28



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##### Table of Contents

Allowance for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged as an expense on our income statement. The allowance for loan
losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions about
future events, which we believe to be reasonable, but which may or may not prove to be accurate. In assessing adequacy, management relies predominantly on its ongoing review of the loan portfolio, which is undertaken both to determine whether there
are probable losses that must be charged off and to assess the risk characteristics of the aggregate portfolio. This review takes into consideration the judgments of the responsible lending officers and senior management, and also those of bank
regulatory agencies that review the loan portfolio as part of the regular bank examination process. In evaluating the allowance, management also considers our loan loss experience, the amount of past due and nonperforming loans, current and
anticipated economic conditions, lender requirements and other appropriate information. Certain nonperforming loans are individually assessed for impairment under Statement of Accounting Financial Accounting Standards (SFAS) No. 114
and assigned specific allocations. Other identified high-risk loans or credit relationships based on internal risk ratings are also individually assessed and assigned specific allocations.

Periodically, we adjust the amount of the allowance based on changing circumstances, including changes in general economic conditions, changes in the
interest-rate environment, changes in loan concentrations in various areas of our banking activities, changes in identified troubled credits, and economic changes in our market area. We charge recognized losses to the allowance and add subsequent
recoveries back to the allowance for loan losses. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be
significant to a particular accounting period.

The allocation of the allowance to the respective loan segments is an approximation and not
necessarily indicative of future losses or future allocations. The entire allowance is available to absorb losses occurring in the overall loan portfolio. In addition, the allowance is subject to examination and adequacy testing by regulatory
agencies, which may consider such factors as the methodology used to determine adequacy and the size of the allowance relative to that of peer institutions, and other adequacy tests. Such regulatory agencies could require us to adjust the allowance
based on information available to them at the time of their examination.

At December 31, 2006, our allowance for loan losses was $7.7
million, or 1.21% of total outstanding loans, compared to an allowance for loan losses of $6.1 million, or 1.32% of outstanding loans, at December 31, 2005, and $4.3 million, or 1.15% of outstanding loans, at December 31, 2004. Our
allowance for loan losses at December 31, 2005, included a specific allocation for an identified loan relationship, in the amount of $850,000. In the first quarter of 2006 we charged off approximately $751,000 of this specific reserve.



29



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##### Table of Contents

The following table sets forth certain information with respect to our loans, net of unearned income, and
the allowance for loan losses for the years ended December 31, 2002 to 2006.



|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|------------------------------------------------------------------- |  | ----------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                                                    |  | Years ended December 31,      |        
|                                                                    |  | 2006                          |         |   | 2005 |   |         | 2004 |  |   | 2003    |   |  | 2002 |        
|                                                                    |  | (In thousands, except ratios) |        
|Allowance for loan losses, at beginning of period                   |  | $                             | 6,059   |   |      | $ | 4,349   |      |  | $ | 3,610   |   |  | $    | 3,238   |   |  | $ | 2,995   |  
|Loans charged off:                                                  |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Commercial, financial, and agricultural                             |  |                               | 859     |   |      |   | 359     |      |  |   | 30      |   |  |      | 277     |   |  |   | 89      |  
|Real estate  construction                                          |  |                               | 387     |   |      |   | 10      |      |  |   | 240     |   |  |      | 28      |   |  |   | 50      |  
|Real estate  other                                                 |  |                               | 317     |   |      |   | 41      |      |  |   | 158     |   |  |      | 638     |   |  |   | 427     |  
|Consumer                                                            |  |                               | 263     |   |      |   | 150     |      |  |   | 127     |   |  |      | 265     |   |  |   | 250     |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Total loans charged off                                             |  |                               | 1,826   |   |      |   | 560     |      |  |   | 555     |   |  |      | 1,208   |   |  |   | 816     |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Recoveries on loans previously charged off:                         |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Commercial, financial, and agricultural                             |  |                               | 75      |   |      |   | 24      |      |  |   | 35      |   |  |      | 25      |   |  |   | 5       |  
|Real estate  construction                                          |  |                               | 1       |   |      |   |        |      |  |   |        |   |  |      | 3       |   |  |   |        |  
|Real estate  other                                                 |  |                               | 1       |   |      |   |        |      |  |   | 2       |   |  |      | 50      |   |  |   |        |  
|Consumer                                                            |  |                               | 107     |   |      |   | 35      |      |  |   | 22      |   |  |      | 37      |   |  |   | 26      |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  |                               |         |   |     
|Total recoveries on loans previously charged off                    |  |                               | 184     |   |      |   | 59      |      |  |   | 59      |   |  |      | 115     |   |  |   | 31      |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  |                               |         |   |     
|Net loans charged off                                               |  |                               | 1,642   |   |      |   | 501     |      |  |   | 496     |   |  |      | 1,093   |   |  |   | 785     |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  |                               |         |   |     
|Provision for loan losses                                           |  |                               | 3,253   |   |      |   | 2,211   |      |  |   | 1,235   |   |  |      | 1,465   |   |  |   | 1,028   |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  |                               |         |   |     
|Allowance for loan losses, at end of period                         |  | $                             | 7,670   |   |      | $ | 6,059   |      |  | $ | 4,349   |   |  | $    | 3,610   |   |  | $ | 3,238   |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  |                               |         |   |     
|Loans, net of unearned income, at end of period                     |  | $                             | 631,786 |   |      | $ | 457,418 |      |  | $ | 377,352 |   |  | $    | 332,307 |   |  | $ | 298,063 |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|                                                                    |  |                               |         |   |     
|Average loans, net of unearned income, outstanding for the period   |  | $                             | 539,577 |   |      | $ | 413,561 |      |  | $ | 360,261 |   |  | $    | 316,605 |   |  | $ | 276,733 |  
|                                                                    |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Ratios:                                                             |  |                               |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |         |  
|Allowance at end of period to loans, net of unearned income         |  |                               | 1.21    | % |      |   | 1.32    | %    |  |   | 1.15    | % |  |      | 1.09    | % |  |   | 1.09    | %
|Allowance at end of period to average loans, net of unearned income |  |                               | 1.42    |   |      |   | 1.47    |      |  |   | 1.21    |   |  |      | 1.14    |   |  |   | 1.17    |  
|Net charge-offs to average loans, net of unearned income            |  |                               | 0.30    |   |      |   | 0.12    |      |  |   | 0.14    |   |  |      | 0.35    |   |  |   | 0.28    |  
|Net charge-offs to allowance at end of period                       |  |                               | 21.41   |   |      |   | 8.27    |      |  |   | 11.40   |   |  |      | 30.28   |   |  |   | 24.24   |  
|Recoveries to prior year charge-offs                                |  |                               | 32.86   |   |      |   | 10.63   |      |  |   | 4.88    |   |  |      | 14.09   |   |  |   | 5.70    |  



30



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##### Table of Contents

The following table sets forth the breakdown of the allowance for loan losses by loan category and the
percentage of loans in each category to total loans for the years ended December 31, 2002 to 2006.

Allocation of Allowance for Loan
Losses



|                                       |  |                        |       |  |      |   |  |      |       |  |      |   |  |      |       |  |     |   |  |   |       |  |     |   |  |   |       |  |     |  
|-------------------------------------- |  | ---------------------- | ----- |  | ---- | - |  | ---- | ----- |  | ---- | - |  | ---- | ----- |  | --- | - |  | - | ----- |  | --- | - |  | - | ----- |  | --- | -
|                                       |  | At December 31,        |      
|                                       |  | 2006                   |       |  | 2005 |   |  | 2004 |       |  | 2003 |   |  | 2002 |      
|                                       |  | (Dollars in thousands) |      
|Domestic Loans (1)                     |  |                        |       |  |      |   |  |      |       |  |      |   |  |      |       |  |     |   |  |   |       |  |     |   |  |   |       |  |     |  
|Commercial, financial and agricultural |  | $                      | 2,266 |  | 6    | % |  | $    | 3,209 |  | 7    | % |  | $    | 548   |  | 8   | % |  | $ | 1,257 |  | 10  | % |  | $ | 1,615 |  | 11  | %
|Real estate  construction             |  |                        | 1,399 |  | 51   |   |  |      | 271   |  | 45   |   |  |      | 421   |  | 39  |   |  |   | 184   |  | 32  |   |  |   | 85    |  | 25  |  
|Real estate  other                    |  |                        | 3,265 |  | 38   |   |  |      | 1,962 |  | 42   |   |  |      | 2,138 |  | 46  |   |  |   | 1,277 |  | 50  |   |  |   | 1,044 |  | 55  |  
|Consumer                               |  |                        | 199   |  | 4    |   |  |      | 202   |  | 5    |   |  |      | 425   |  | 6   |   |  |   | 267   |  | 6   |   |  |   | 168   |  | 7   |  
|Other                                  |  |                        | 541   |  | 1    |   |  |      | 415   |  | 1    |   |  |      | 817   |  | 1   |   |  |   | 625   |  | 2   |   |  |   | 326   |  | 2   |  
|                                       |  |                        |       |  |      |   |  |      |       |  |      |   |  |      |       |  |     |   |  |   |       |  |     |   |  |   |       |  |     |  
|Total                                  |  | $                      | 7,670 |  | 100  | % |  | $    | 6,059 |  | 100  | % |  | $    | 4,349 |  | 100 | % |  | $ | 3,610 |  | 100 | % |  | $ | 3,238 |  | 100 | %
|                                       |  |                        |       |  |      |   |  |      |       |  |      |   |  |      |       |  |     |   |  |   |       |  |     |   |  |   |       |  |     |  

---

|(1) | There are no foreign loans.
|--- | ---------------------------

Nonperforming Assets

Nonperforming assets include nonperforming loans and foreclosed assets held for sale. Nonperforming loans include loans classified
as nonaccrual or renegotiated and loans past due 90 days or more. Our general practice is to place a loan on nonaccrual status when it is contractually past due 90 days or more as to payment of principal or interest, unless the collateral value is
greater than both the principal due and the accrued interest. At the time a loan is placed on nonaccrual status, interest previously accrued but not collected is reversed and charged against current earnings. Recognition of any interest after a loan
has been placed on nonaccrual status is accounted for on a cash basis. Nonperforming loans were .55% of total loans at December 31, 2006 and 0.24% of total loans at December 31, 2005, compared to 0.41% at December 31, 2004.

It is our general practice to stop accruing interest income and place the recognition of interest on a cash basis when any commercial,
industrial or real estate loan is past due as to principal or interest and the ultimate collection of either is in doubt. Accrual of interest income on consumer installment loans is suspended when any payment of principal or interest, or both, is
more than 90 days delinquent. When a loan is placed on a nonaccrual basis, any interest previously accrued but not collected is reversed against current income unless the collateral for the loan is sufficient to cover the accrued interest or a
guarantor assures payment of interest. For each of the five years in the period ended December 31, 2006, the difference between gross interest income that would have been recorded in such period, if the nonaccruing loans had been current in
accordance with their original terms, and the amount of interest income on those loans, that was included in such periods net income, was immaterial.



31



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##### Table of Contents

The following table shows our nonperforming assets as well as the ratio of the allowance for loan losses
to total nonperforming assets, the total nonperforming loans to total loans, and the total nonperforming assets to total assets, for the years ended December 31, 2002 to 2006.



|                                                                    |  |                               |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       |  
|------------------------------------------------------------------- |  | ----------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | - |  | ---- | ------ | - |  | - | ----- | -
|                                                                    |  | At December 31,               |       
|                                                                    |  | 2006                          |        |   | 2005 |   |        | 2004 |  |   | 2003   |   |  | 2002 |       
|                                                                    |  | (In thousands, except ratios) |       
|Nonaccruing loans                                                   |  | $                             | 2,611  |   |      | $ | 1,020  |      |  | $ | 1,524  |   |  | $    | 1,127  |   |  | $ | 4,823 |  
|Loans past due 90 days or more                                      |  |                               | 871    |   |      |   | 71     |      |  |   | 34     |   |  |      | 521    |   |  |   | 334   |  
|Restructured loans                                                  |  |                               |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |      |  
|                                                                    |  |                               |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       |  
|Total nonperforming loans                                           |  |                               | 3,482  |   |      |   | 1,091  |      |  |   | 1,558  |   |  |      | 1,648  |   |  |   | 5,157 |  
|Nonaccruing securities                                              |  |                               |       |   |      |   |       |      |  |   |       |   |  |      |       |   |  |   |      |  
|Other real estate                                                   |  |                               | 1,218  |   |      |   | 147    |      |  |   | 516    |   |  |      | 737    |   |  |   | 986   |  
|                                                                    |  |                               |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       |  
|Total nonperforming assets                                          |  | $                             | 4,700  |   |      | $ | 1,238  |      |  | $ | 2,074  |   |  | $    | 2,385  |   |  | $ | 6,143 |  
|                                                                    |  |                               |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       |  
|Ratios:                                                             |  |                               |        |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       |  
|Allowance to total nonperforming assets                             |  |                               | 163.19 | % |      |   | 489.42 | %    |  |   | 209.69 | % |  |      | 151.36 | % |  |   | 52.71 | %
|                                                                    |  |                               |        |   |     
|Total nonperforming loans to total loans (net of unearned interest) |  |                               | 0.55   | % |      |   | 0.24   | %    |  |   | 0.41   | % |  |      | 0.50   | % |  |   | 1.73  | %
|                                                                    |  |                               |        |   |     
|Total nonperforming assets to total assets                          |  |                               | 0.62   | % |      |   | 0.21   | %    |  |   | 0.44   | % |  |      | 0.58   | % |  |   | 1.60  | %

The 2.6 million in nonaccruing loans consist of 55 loans broken down as follows: two loans
totaling $521,000 in real estate  construction loans, 15 loans totaling $1.4 million in real estate  mortgage loans, 10 loans totaling $524,000 in the commercial/financial/agricultural industry and 28 loans totaling $207,000 in consumer
loans. Loans past due 90 days or more and still accruing consists of $622,000 in real estate  mortgage loans, $195,000 in commercial/financial/agricultural loans and $54,000 in consumer loans. We have in reserve for the nonaccrual loans
approximately $723,000. The majority of the nonperforming assets are secured by real estate with adequate loan to value ratios, therefore we do not expect significant losses related to these assets.

Deposits and Other Interest-Bearing Liabilities

Deposits are the primary source of funds to support our earning assets. Average deposits increased 28.1%, from $426.8 million in 2005 to $546.9 million in 2006. Average deposits increased 17.8%, from $362.3 million in
2004 to 2005. At December 31, 2006, total deposits were $651.1 million, of which $597.7 million or 91.8%, were interest bearing. At December 31, 2005, total deposits were $473.3 million, of which $426.7 million or 90.2%, were interest
bearing. Alternative funding sources such as national CDs and brokered deposits were used to supplement funding sources. Brokered deposits were $124.0 million at December 31, 2006. At December 31, 2005, brokered deposits were $52.6
million. The increase in our brokered deposits was necessary to fund our growth in loans during the year ended December 31, 2006 at reasonable spreads. Brokered deposits are a secondary source of deposits utilized to fund loan growth. The cost
of these brokered deposits can be less expensive than our local deposits.



32



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##### Table of Contents

The average amounts of, and the average rate paid on, each of the following categories of deposits, for
the years ended December 31, 2006, 2005, and 2004, are as follows:



|                                    |  |                        |         |      |      |   |        |      |         |  |      |        |  |      |         |  |      |  
|----------------------------------- |  | ---------------------- | ------- | ---- | ---- | - | ------ | ---- | ------- |  | ---- | ------ |  | ---- | ------- |  | ---- | -
|                                    |  | At December 31,        |        
|                                    |  | 2006                   |         |      | 2005 |   |        | 2004 |        
|                                    |  | Amount                 |         | Rate |      |   | Amount |      | Rate    |  |      | Amount |  | Rate |        
|                                    |  | (Dollars in thousands) |        
|Noninterest-bearing demand deposits |  | $                      | 52,298  |      | 0.00 | % |        | $    | 43,878  |  | 0.00 | %      |  | $    | 30,840  |  | 0.00 | %
|                                    |  |                        |         |      |      |   |        |      |         |  |      |        |  |      |         |  |      |  
|                                    |  |                        |         |      |      |  
|Interest-bearing demand deposits    |  |                        | 74,125  |      | 2.17 |   |        |      | 75,670  |  | 1.40 |        |  |      | 82,617  |  | 1.15 |  
|Savings                             |  |                        | 105,022 |      | 3.37 |   |        |      | 84,653  |  | 2.06 |        |  |      | 61,281  |  | 1.16 |  
|Time deposits                       |  |                        | 315,429 |      | 4.82 |   |        |      | 222,561 |  | 3.29 |        |  |      | 187,578 |  | 2.42 |  
|                                    |  |                        |         |      |      |   |        |      |         |  |      |        |  |      |         |  |      |  
|Total interest-bearing deposits     |  | $                      | 494,576 |      | 4.11 |   |        | $    | 382,884 |  | 2.65 |        |  | $    | 331,476 |  | 1.87 |  
|                                    |  |                        |         |      |      |   |        |      |         |  |      |        |  |      |         |  |      |  
|Total average deposits              |  | $                      | 546,874 |      | 3.72 |   |        | $    | 426,762 |  | 2.37 |        |  | $    | 362,316 |  | 1.71 |  
|                                    |  |                        |         |      |      |   |        |      |         |  |      |        |  |      |         |  |      |  

Our core deposits, which exclude brokered and national certificates of deposits, were $478.1
million at December 31, 2006, an increase of 20.3% compared to $397.3 million at December 31, 2005. Core deposits as a percentage of total deposits were approximately 73.4% and 83.9% at December 31, 2006 and 2005, respectively.In 2005, we began using the Certificate of Deposit Account Registry Service (CDARS) in order to obtain FDIC insurance on some of our larger customers. Although CDARS are required to be categorized as brokered deposits, these deposits represent
deposits greater than $100,000 originated in our local markets that are placed with other institutions that are members in the CDARS network. By placing these deposits in these other institutions, the deposits of our customers are fully insured by
the FDIC. In return for the deposits that we place with network institutions, we receive from network institutions, deposits that are approximately equal in amount of what was originated from our customers. In addition, the CDARS are priced at local
rates, which generally have lower rates than rates being offered for brokered deposits. At December 31, 2006, CDARS represented $22.7 million of our deposits, or 3.5% and at December 31, 2005, CDARS represented $19.7 million of our
deposits, or 4.2%. We continue to focus on increasing our core deposit base. The two categories of lowest cost deposits comprised the following percentages of average total deposits during 2006: average noninterest-bearing demand deposits, 9.6%; and
average savings deposits, 19.2%. Of average time deposits, approximately 56.9% were large denomination certificates of deposit.

Noninterest-bearing deposits increased $6.9 million, or 14.7%, from year-end 2005 to $53.4 million at December 31, 2006, and interest-bearing deposits increased $171.0 million, or 40.1%, during the same period to $597.7 million. The
increase in noninterest-bearing deposits has been the result of our focus on providing excellent customer service to our small business customers and also by the development of relationships with new businesses that have moved into our communities.
The increase in our interest-bearing deposits has been the result of offering competitive products to serve our customers as well as the development of relationships with individuals who have relocated to our communities.



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The following table sets forth the maturities of our time deposits of $100,000 or more by category at
December 31, 2006.



|                               |  |                |        
|------------------------------ |  | -------------- | -------
|                               |  | (In thousands)
|Three months or less           |  | $              | 57,147 
|Over three through six months  |  |                | 67,255 
|Over six through twelve months |  |                | 94,364 
|Over twelve months             |  |                | 17,862 
|                               |  |                |        
|Total                          |  | $              | 236,628
|                               |  |                |        

Borrowings

Short-Term Borrowings

Securities sold under agreements to repurchase amounted to $4.7 million at
December 31, 2006, compared to $3.7 million at December 31, 2005, and $6.3 million at December 31, 2004. The weighted average rates were 1.62%, 1.24%, and 1.36% for 2006, 2005 and 2004, respectively. The total amount of securities
sold under agreements to repurchase are associated with the cash flow needs of our corporate customers who participate in repurchase agreements. We also had a short-term line of credit with the Federal Home Loan Bank with balances of $-0-, $14.0
million, and $9.2 million at December 31, 2006, 2005 and 2004, respectively. The short-term line of credit with the Federal Home Loan Bank is in the form of a daily rate credit. It floats daily based on the overnight funds market. The line of
credit has a one year term and matures in May of each year. We have available $36.0 million in lines of credit to purchase federal funds, on an unsecured basis, from commercial banks, of which all was available at December 31, 2006. We had
federal funds purchased that amounted to $-0- at year-end 2006, and $7.2 million at year-end 2005, compared to $-0- at year-end 2004.

Short-term borrowings at December 31, 2006, 2005 and 2004 consisted of the following:



|                                               |  |                    |       |      |   |        |  |   |       
|---------------------------------------------- |  | ------------------ | ----- | ---- | - | ------ |  | - | ------
|                                               |  | As of December 31,
|                                               |  | 2006               |       | 2005 |   | 2004  
|                                               |  | (In thousands)    
|Federal funds purchased                        |  | $                  |      |      | $ | 7,217  |  | $ |      
|Securities sold under agreements to repurchase |  |                    | 4,738 |      |   | 3,675  |  |   | 6,264 
|FHLB line of credit                            |  |                    |      |      |   | 14,000 |  |   | 9,206 
|                                               |  |                    |       |      |   |        |  |   |       
|                                               |  | $                  | 4,738 |      | $ | 24,892 |  | $ | 15,470
|                                               |  |                    |       |      |   |        |  |   |       

FHLB Advances

Our total borrowed funds consist primarily of long-term debt with maturities from one to ten years. At December 31, 2006 we were approved to borrow up to approximately $111.3 million under various short-term and
long-term programs offered by the Federal Home Loan Bank of Atlanta. These borrowings are secured under a blanket lien agreement on certain qualifying mortgage instruments in the loan and securities portfolios. At December 31, 2006, the
outstanding balance of our credit line was $25.1 million, all of which was accounted for as long-term debt.

Subordinated Long-term
Capital Notes

On August 28, 2003, Appalachian Capital Trust I (the Trust), a Delaware statutory trust established by
us, received $6.0 million principal amount of the Trusts floating rate cumulative trust preferred securities in a trust preferred private placement. The proceeds of that transaction were used by the Trust to purchase an equal amount of our
floating rate-subordinated debentures. We have fully and unconditionally guaranteed all obligations of the Trust on a subordinated basis with respect to the trust preferred securities. We account for the trust preferred securities as long-term debt
liability in the amount of $6.2 million. Interest only is payable quarterly at a variable per annum rate of interest, reset quarterly, equal to LIBOR plus 3.00 % percent until the debt becomes due on August 8, 2033. The



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interest rate on the Trust Preferred liability at December 31, 2006 and 2005 was 8.37% and 7.25%, respectively. The debt is callable by Appalachian
Bancshares, Inc. on August 28, 2008 and every quarter thereafter. Subject to certain limitations, the trust preferred securities qualify as Tier 1 capital and are presented in the consolidated financial statements included elsewhere in this
Form 10-K as subordinated long-term capital notes.

The sole assets of the Trust are the subordinated debentures issued by us.
Both the trust preferred securities and the subordinated debentures have approximately 30-year lives. However, both we and the Trust have options to call our respective securities after five years, subject to regulatory capital requirements.

Capital Resources

Total
shareholders equity was $66.8 million at December 31, 2006, an increase of $6.9 million from $59.8 million at December 31, 2005. This increase resulted primarily from net earnings of $6.0 million during 2006. We issued 2,800 shares
of stock to our 401(k) Plan during 2006 for proceeds of $50,000. We had a $247,000 decrease in the accumulated other comprehensive loss on our available-for-sale securities. In addition, the effects of the stock-based compensation expense as well as
the exercise of 52,600 options during 2006 increased equity by $649,000, including the tax benefit.

The Federal Deposit Insurance
Corporation Improvement Act establishes risk-based capital guidelines that take into consideration risk factors, as defined by regulators, associated with various categories of assets, both on and off the balance sheet. Under the guidelines, capital
strength is measured in two tiers, which are used in conjunction with risk-adjusted assets to determine the risk-based capital ratios. Our Tier 1 capital, which consists of common equity, paid-in capital, retained earnings and qualifying trust
preferred securities (less intangible assets and treasury stock), amounted to $70.7 million at December 31, 2006. Tier 2 capital components include supplemental capital components such as qualifying allowance for loan losses and trust preferred
securities not qualified for Tier 1 capital. Tier 1 capital, plus the Tier 2 capital components, are referred to as Total Capital and was $78.4 million at year-end 2006. The percentage ratios as calculated under regulatory guidelines were 10.69% and
11.85% for Tier 1 and Total Capital, respectively, at year-end 2006. Our Tier 1 Capital and Total Capital exceeded the minimum ratios of 4.0% and 8.0%, respectively. Upon final approval of the thrift charter, we anticipate injecting approximately
$8.0 million in capital into the newly established thrift.

Another important indicator of capital adequacy in the banking industry is the
leverage ratio. The leverage ratio is defined as the ratio which shareholders equity, minus intangibles, bears to total assets minus intangibles. At December 31, 2006, our leverage ratio was 9.55%, exceeding the regulatory minimum
requirement of 4.0%.



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The table following illustrates our regulatory capital ratios under federal guidelines at
December 31, 2006, 2005 and 2004:



|                                                                   |  |                               |   |  |                          |         |   |      |   |         |   |  |   |         |  
|------------------------------------------------------------------ |  | ----------------------------- | - |  | ------------------------ | ------- | - | ---- | - | ------- | - |  | - | ------- | -
|                                                                   |  | StatutoryMinimum              |   |  | Years ended December 31, |        
|                                                                   |  | 2006                          |   |  | 2005                     |         |   | 2004 |  
|                                                                   |  | (In thousands, except ratios) |  
|Tier 1 Capital                                                     |  |                               |   |  | $                        | 70,730  |   |      | $ | 64,301  |   |  | $ | 39,713  |  
|                                                                   |  |                               |   | 
|Tier 2 Capital                                                     |  |                               |   |  |                          | 7,670   |   |      |   | 6,057   |   |  |   | 4,349   |  
|                                                                   |  |                               |   |  |                          |         |   |      |   |         |   |  |   |         |  
|                                                                   |  |                               |   | 
|Total Qualifying Capital                                           |  |                               |   |  | $                        | 78,400  |   |      | $ | 70,358  |   |  | $ | 44,062  |  
|                                                                   |  |                               |   |  |                          |         |   |      |   |         |   |  |   |         |  
|                                                                   |  |                               |   | 
|Risk Adjusted Total Assets (including off-balance sheet exposures) |  |                               |   |  | $                        | 661,431 |   |      | $ | 484,577 |   |  | $ | 384,847 |  
|                                                                   |  |                               |   |  |                          |         |   |      |   |         |   |  |   |         |  
|                                                                   |  |                               |   | 
|Tier 1 Risk-Based Capital Ratio                                    |  | 4.00                          | % |  |                          | 10.69   | % |      |   | 13.27   | % |  |   | 10.32   | %
|                                                                   |  |                               |   | 
|Total Risk-Based Capital Ratio                                     |  | 8.00                          |   |  |                          | 11.85   |   |      |   | 14.52   |   |  |   | 11.45   |  
|                                                                   |  |                               |   | 
|Leverage Ratio                                                     |  | 4.00                          |   |  |                          | 9.55    |   |      |   | 11.35   |   |  |   | 8.53    |  

Return on Equity and Assets

The following table summarizes certain of our financial ratios for the years ended December 31, 2006, 2005 and 2004.



|                                       |  |      |   |  |       |   |  |       |  
|-------------------------------------- |  | ---- | - |  | ----- | - |  | ----- | -
|                                       |  | 2006 |   |  | 2005  |   |  | 2004  |  
|Return on average assets               |  | 0.91 | % |  | 0.99  | % |  | 0.91  | %
|Return on average equity               |  | 9.57 |   |  | 12.18 |   |  | 12.23 |  
|Dividend payout ratio                  |  | 0.00 |   |  | 0.00  |   |  | 0.00  |  
|Average equity to average assets ratio |  | 9.49 |   |  | 8.11  |   |  | 7.42  |  

The decline in return on average equity from 2005 to 2006 is primarily due to the investment that
we have made in our expansionary activities during 2006, which has generated significant growth in assets and deposits, but has operated at a net loss during the year. Additionally, our average stockholders equity was much higher in 2006. We
sold 1.3 million shares of common stock during the fourth quarter of 2005 for net proceeds of approximately $18.4 million. Our return on average equity for 2005 was lower than 2004 which was also due to the common stock sale during the fourth
quarter of 2005. Average shareholders equity increased to $62.7 million in 2006 from $42.1 million in 2005, and from $33.1 million in 2004. Our average equity to average assets ratio was 9.49% in 2006, 8.11% in 2005, and 7.42% in 2004.

Interest Rate Sensitivity Management

Interest rate sensitivity is a function of the repricing characteristics of our portfolios of assets and liabilities. These repricing characteristics are the time frames within which the interest-bearing assets and liabilities are subject
to changes in interest rates, either at replacement or maturity during the life of the instruments. Sensitivity is measured as the difference between the volume of assets and liabilities in our current portfolio that is subject to repricing in
future time periods. The differences are known as interest rate sensitivity gaps and are usually calculated separately for segments of time, ranging from zero to 30 days, 31 to 90 days, 91 days to one year, one to five years, over five years and on
a cumulative basis.



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The following table indicates that, in a rising interest rate environment, our earnings may be adversely
affected in the 0-365 day periods where liabilities will reprice faster than assets, if rates move simultaneously. For purposes of this table, all demand and savings deposits are included in the 0  30 day period, but because these deposits are
not as sensitive to rate change, we do not anticipate these deposits to mature in this time period. We anticipate that these deposits will mature over all time periods. As seen in the following table, for the first 30 days of repricing opportunity,
there is an excess of earning assets over interest-bearing liabilities of approximately $70.7 million. For the first 365 days, interest-bearing liabilities exceed earning assets by approximately $89.5 million. During this one-year time frame, 93.8%
of all interest-bearing liabilities will reprice compared to 71.3% of all interest-earning assets. Changes in the mix of earning assets or supporting liabilities can either increase or decrease the net interest margin without affecting interest rate
sensitivity. In addition, the interest rate spread between an asset and its supporting liability can vary significantly while the timing of repricing for both the asset and the liability remain the same, thus impacting net interest income. It should
be noted, therefore, that a matched interest-sensitive position by itself would not ensure maximum net interest income.



37



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The following table sets forth information regarding our rate sensitivity as of December 31, 2006
for each of the intervals indicated.



|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|---------------------------------------------------------------- |  | ----------------------------- | ------- | --------- | - | ------- | ---------- |  | - | --------- | - | ----------- | - | ------- |  | - | ------ |  | - | -------
|                                                                 |  | 0-30 Days                     |         | 31-90Days |   |         | 91-365Days |  |   | 1-5 Years |   | Over 5Years |   | Total  
|                                                                 |  | (In thousands, except ratios)
|Interest-earning assets(1)                                       |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|Loans                                                            |  | $                             | 327,777 |           | $ | 27,594  |            |  | $ | 132,658   |   |             | $ | 134,678 |  | $ | 6,468  |  | $ | 629,175
|Securities:(2)                                                   |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|Taxable                                                          |  |                               | 3,450   |           |   | 2,021   |            |  |   | 7,567     |   |             |   | 33,870  |  |   | 15,471 |  |   | 62,379 
|Tax-exempt                                                       |  |                               |        |           |   |        |            |  |   |          |   |             |   | 200     |  |   | 12,481 |  |   | 12,681 
|Interest-bearing deposits in other banks                         |  |                               | 541     |           |   |        |            |  |   |          |   |             |   |        |  |   |       |  |   | 541    
|Federal funds sold                                               |  |                               | 3,107   |           |   |        |            |  |   |          |   |             |   |        |  |   |       |  |   | 3,107  
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|                                                                 |  | $                             | 334,875 |           | $ | 29,615  |            |  | $ | 140,225   |   |             | $ | 168,748 |  | $ | 34,420 |  | $ | 707,883
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|Interest-bearing liabilities:(3)                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|Demand deposits(4)                                               |  |                               | 66,914  |           |   |        |            |  |   |          |   |             |   |        |  |   |       |  |   | 66,914 
|Savings deposits(4)                                              |  |                               | 129,450 |           |   |        |            |  |   |          |   |             |   |        |  |   |       |  |   | 129,450
|Time deposits                                                    |  |                               | 63,056  |           |   | 66,074  |            |  |   | 240,502   |   |             |   | 31,716  |  |   |       |  |   | 401,348
|Other short-term borrowings                                      |  |                               | 4,738   |           |   |        |            |  |   |          |   |             |   |        |  |   |       |  |   | 4,738  
|Long-term debt                                                   |  |                               |        |           |   | 5,100   |            |  |   | 12,200    |   |             |   | 7,750   |  |   |       |  |   | 25,050 
|Subordinated long-term capital notes                             |  |                               |        |           |   | 6,186   |            |  |   |          |   |             |   |        |  |   |       |  |   | 6,186  
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|                                                                 |  | $                             | 264,158 |           | $ | 77,360  |            |  | $ | 252,702   |   |             | $ | 39,466  |  | $ |       |  | $ | 633,686
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|                                                                 |  |                               |         |           |   |        
|Interest sensitivity gap                                         |  | $                             | 70,717  |           | $ | (47,745 | )          |  | $ | (112,477  | ) |             | $ | 129,283 |  | $ | 34,420 |  | $ | 74,198 
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|                                                                 |  |                               |         |           |   |        
|Cumulative interest sensitivity gap                              |  | $                             | 70,717  |           | $ | 22,972  |            |  | $ | (89,505   | ) |             | $ | 39,778  |  | $ | 74,198 |  |   |        
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|                                                                 |  |                               |         |           |   |        
|Ratio of interest-earning assets to interest-bearing liabilities |  |                               | 1.27    |           |   | 0.38    |            |  |   | 0.55      |   |             |   | 4.28    |  |   | 0.00   |  |   |        
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|                                                                 |  |                               |         |           |   |        
|Cumulative ratio                                                 |  |                               | 1.27    |           |   | 1.07    |            |  |   | 0.85      |   |             |   | 1.06    |  |   | 1.12   |  |   |        
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        
|                                                                 |  |                               |         |           |   |        
|Ratio of cumulative gap to total interest-earning assets         |  |                               | 0.10    |           |   | 0.03    |            |  |   | (0.13     | ) |             |   | 0.06    |  |   | 0.10   |  |   |        
|                                                                 |  |                               |         |           |   |         |            |  |   |           |   |             |   |         |  |   |        |  |   |        

---

|(1) | Excludes nonaccrual loans. Excludes unrealized gains/losses on securities.
|--- | --------------------------------------------------------------------------

|(2) | Securities are at book value.
|--- | -----------------------------

|(3) | Excludes matured certificates which have not been redeemed by the customer and on which no interest is accruing.
|--- | ----------------------------------------------------------------------------------------------------------------

|(4) | Demand and savings deposits typically reprice simultaneously with market changes.
|--- | ---------------------------------------------------------------------------------



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Management continually evaluates the condition of the economy, the pattern of market interest rates and
other economic data to determine the types of investments that should be made and at what maturities. Using this analysis, management from time to time assumes calculated interest rate sensitivity gap positions to maximize net interest income based
upon anticipated movements in the general level of interest rates.

We also use simulation analysis to monitor and manage our interest rate
sensitivity. Simulation analysis is the primary method of estimating earnings at risk and capital at risk under varying interest rate conditions. Simulation analysis is used to test the sensitivity of our net interest income and shareholders
equity to both the level of interest rates and the slope of the yield curve. Simulation analysis accounts for the expected timing and magnitude of assets and liability cash flows, as well as the expected timing and magnitude of deposits that do not
reprice on a contractual basis. In addition, simulation analysis includes adjustments for the lag between movements in market interest rates on loans and interest-bearing deposits. These adjustments are made to reflect more accurately possible
future cash flows, repricing behavior and ultimately net interest income.

The estimated impact on our net interest income before provision
for loan loss sensitivity over a one-year time horizon is shown below. Such analysis assumes a sustained parallel shift in interest rates and our estimate of how interest-bearing transaction accounts will reprice in each scenario. Actual results
will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and managements strategies, among other factors.



|                                              |  |                                                                                   |    |  |                    |  
|--------------------------------------------- |  | --------------------------------------------------------------------------------- | -- |  | ------------------ | -
|                                              |  | Percentage Increase(Decrease) in InterestIncome/Expense GivenInterest Rate Shifts |   
|                                              |  | Down 200Basis Points                                                              |    |  | Up 200Basis Points |  
|For the Twelve Months After December 31, 2006 |  |                                                                                   |    |  |                    |  
|                                              |  |                                                                                  
|Projected change in:                          |  |                                                                                   |    |  |                    |  
|Interest income                               |  | (15.41                                                                            | )% |  | 13.43              | %
|Interest expense                              |  | (26.34                                                                            | )  |  | 25.60              |  
|Net interest income                           |  | (3.38                                                                             | )  |  | 0.03               |  

Market Risk

Market risk is the risk arising from adverse changes in the fair value of financial instruments due to a change in interest rates, exchange rates and equity prices. Our primary market risk is interest rate risk.

The primary objective of asset/liability management is to manage interest rate risk and achieve reasonable stability in net interest
income throughout interest rate cycles. This is achieved by maintaining the proper balance of rate sensitive earning assets and rate sensitive liabilities. The relationship of rate sensitive earning assets to rate sensitive liabilities is the
principal factor in projecting the effect that fluctuating interest rates will have on future net interest income. Rate sensitive earning assets and interest-bearing liabilities are those that can be repriced to current market rates within a
relatively short time period. Management monitors the rate sensitivity of earning assets and interest-bearing liabilities over the entire life of these instruments, but places particular emphasis on the first year and through three years.

We have not experienced a high level of volatility in net interest income primarily because of our asset/liability management. Management
continues to monitor the proper matching of asset/liability repricing to keep our volatility at a low level.

Off-Balance Sheet Arrangements

In the normal course of business, we offer a variety of financial products to our customers to aid them in meeting their requirements
for liquidity, credit enhancement and interest rate protection. Generally accepted accounting principles recognize these transactions as contingent liabilities and, accordingly, they are not reflected in the consolidated financial statements.
Commitments to extend credit, credit card arrangements, commercial letters of



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credit and standby letters of credit all include exposure to some credit loss in the event of nonperformance of the customer. We use the same credit policies
and underwriting procedures for making off-balance sheet credit commitments and financial guarantees as it does for on-balance sheet extensions of credit. Because these instruments have fixed maturity dates, and because many of them expire without
being drawn upon, they do not generally present any significant liquidity risk to us. Management conducts regular reviews of these instruments on an individual customer basis, and the results are considered in assessing the adequacy of our allowance
for loan losses. Management does not anticipate any material losses as a result of these commitments. The following is a discussion of these commitments:

Standby Letters of Credit. These agreements are used by our customers as a means of improving their credit standings in their dealings with others. Under these agreements, we agree to honor certain financial
commitments in the event that its customers are unable to do so. The amount of credit risk involved in issuing letters of credit in the event of nonperformance by the other party is the contract amount. As of December 31, 2006 and 2005, we had
issued standby letters of credit of approximately $10.7 million and $3.5 million, respectively. When significant, we record a liability for the estimated fair value of standby letters of credit based on the fees charged.

Loan Commitments. As of December 31, 2006 and 2005, the bank had commitments outstanding to extend credit totaling approximately $107.7
million and $73.4 million, respectively.

Contractual Obligations

We have various contractual obligations that we must fund as part of our normal operations. The following table shows aggregate information about our contractual obligations,and the periods in which payments are due.
The amounts and time periods are measured from December 31, 2006.

Payments due by period (in thousands)



|                            |  |       |         |                 |   |           |  |           |        |                  |   |       |  |   |       
|--------------------------- |  | ----- | ------- | --------------- | - | --------- |  | --------- | ------ | ---------------- | - | ----- |  | - | ------
|                            |  | Total |         | Less than1 year |   | 1-3 years |  | 3-5 years |        | More than5 years
|Long-term debt              |  | $     | 24,136  |                 | $ | 4,600     |  | $         | 750    |                  | $ |      |  | $ | 18,786
|Operating lease obligations |  |       | 1,063   |                 |   | 124       |  |           | 119    |                  |   | 74    |  |   | 746   
|Time deposits               |  |       | 401,348 |                 |   | 369,596   |  |           | 29,067 |                  |   | 2,685 |  |   |      
|                            |  |       |         |                 |   |           |  |           |        |                  |   |       |  |   |       
|Total                       |  | $     | 426,547 |                 | $ | 374,320   |  | $         | 29,936 |                  | $ | 2,759 |  | $ | 19,532
|                            |  |       |         |                 |   |           |  |           |        |                  |   |       |  |   |       

Impact of Inflation

The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our financial statements have been prepared on an historical cost
basis in accordance with generally accepted accounting principles.

Unlike most industrial companies, our assets and liabilities are
primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally
increase as the rate of inflation increases, although not necessarily in the same magnitude. As discussed previously, we seek to manage the relationships between interest sensitive assets and liabilities in order to protect against wide rate
fluctuations, including those resulting from inflation.

Recent Developments

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets. SFAS No. 156 amends
SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities.
SFAS No. 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations and requires that all
separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. The provisions of this statement are effective as of the beginning of the first fiscal year that begins after September 15,
2006. Since the Company does not service any assets, the Company does not expect the impact of SFAS No. 156 on its financial position, results of operations or cash flows to be material.



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In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), Accounting for
Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a companys financial statements in accordance with FASB Statement
No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.
FIN 48 provides a two-step process in the evaluation of a tax position. The first step is recognition. A company determines whether it is more-likely-than-not that a tax position will be sustained upon examination, including a resolution of any
related appeals or litigation processes, based upon the technical merits of the position. The second step is measurement. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is
greater than 50 percent likely of being realized upon ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company expects the impact of adopting FIN 48 will not be material to its
financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This statement does not
require any new fair value measurements, but applies under other accounting pronouncements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. The provisions of this
statement are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not expect the impact of SFAS No. 157 on its financial
position, results of operations or cash flows to be material.

In September 2006, the EITF reached a consensus on EITF Issue No. 06-4
(EITF 06-4), Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. EITF 06-4 requires an employer to recognize a liability for future benefits based on the
substantive agreement with the employee. EITF 06-4 requires a company to use the guidance prescribed in FASB Statement No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions and Accounting
Principles Board Opinion No. 12, Omnibus Opinion, when entering into an endorsement split-dollar life insurance agreement and recognizing the liability. EITF 06-4 is effective for fiscal periods beginning after December 15,
2007. The Company is currently evaluating the impact of adopting EITF 06-4 on its financial position, results of operations and cash flows, but has yet to complete its assessment.

In September 2006, the EITF reached a consensus on EITF Issue No. 06-5 (EITF 06-5), Accounting for Purchases of Life Insurance 
Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4. EITF 06-5 requires that a determination of the amount that could be realized under an insurance contract should (1) consider any
additional amounts beyond cash surrender value included in the contractual terms of the policy and (2) be based on an assumed surrender at the individual policy or certificate level, unless all policies or certificates are required to be
surrendered as a group. EITF 06-5 is effective for fiscal periods beginning after December 15, 2006. The Company is currently evaluating the impact of adopting EITF 06-5 on its financial position, results of operations and cash flows, but has
yet to complete its assessment.

In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year
Misstatements When Quantifying Misstatements in Current Year Financial Statements. In December 2006, the Company adopted the provisions of SAB No. 108, which clarifies the way that a company should evaluate an identified unadjusted
error for materiality. SAB No. 108 requires that the effect of misstatements that were not corrected at the end of the prior year be considered in quantifying misstatements in the current year financial statements. Two techniques were
identified as being used by companies in practice to accumulate and quantify misstatements  the rollover approach and the iron curtain approach. The rollover approach, which is the approach that the Company
previously used, quantifies a misstatement based on the amount of the error originating in the current year income statement. Thus, this approach ignores the effects of correcting the portion of the current year balance sheet misstatement that
originated in prior years. The iron curtain approach quantifies a misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, irrespective of the misstatements year(s) of
origination. The primary weakness of the iron curtain approach is that it does not consider the correction of prior year misstatements in the current year to be errors. The adoption of SAB No. 108 did not have a material impact to the
Companys financial position, results of operations or cash flows.



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In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities. SFAS No. 159 permits entities to make an irrevocable election, at specified election dates, to measure eligible financial instruments and certain other items at fair value. This statement also
establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. The provisions of this statement are effective as of
the beginning of the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the impact of adopting SFAS No. 159, but has yet to complete its assessment.



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

Information in response to this Item 7A is incorporated by reference from the following sections of Item 7 of this report: Interest Rate Sensitivity Management and Market Risk.



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

The
consolidated financial statements and supplementary data required by Regulation S-X and by Item 302 of Regulation S-K are set forth in the pages below.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Financial Statements



|                                                                                                     |  |        
|---------------------------------------------------------------------------------------------------- |  | -------
|                                                                                                     |  | Page(s)
|Report of Independent Registered Public Accounting Firm                                              |  | 44     
|                                                                                                     | 
|Report of Independent Registered Public Accounting Firm                                              |  | 45     
|                                                                                                     | 
|Consolidated Statements of Financial Condition as of December 31, 2006 and 2005                      |  | 46     
|                                                                                                     | 
|Consolidated Statements of Income for the Years Ended December 31, 2006, 2005 and 2004               |  | 47     
|                                                                                                     | 
|Consolidated Statements of Shareholders Equity for the Years Ended December 31, 2006, 2005 and 2004 |  | 48     
|                                                                                                     | 
|Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005, and 2004          |  | 49     
|                                                                                                     | 
|Notes to Consolidated Financial Statements                                                           |  | 50     
|                                                                                                     | 
|Quarterly Results (Unaudited)                                                                        |  | 76     



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

Appalachian Bancshares, Inc. and Subsidiaries

Ellijay, Georgia

We have audited the consolidated statements of financial condition of Appalachian Bancshares, Inc. and subsidiaries as of December 31, 2006 and 2005, and the
related consolidated statements of income, shareholders equity and cash flows for the years then ended. 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. The consolidated financial statements of Appalachian Bancshares, Inc. and subsidiaries for the year ended December 31, 2004 were audited by other auditors whose report, dated March 17, 2005,
expressed an unqualified opinion on those statements.

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

In our opinion, the 2006 and 2005 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Appalachian Bancshares, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for the years then ended, in conformity
with U.S. generally accepted accounting principles.

/s/ Mauldin & Jenkins, LLC

Atlanta, Georgia

March 26, 2007



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|     |                                              |                                       
|---- | -------------------------------------------- | --------------------------------------
|LOGO |                                              | Schauer Taylor Cox Vise & Morgan, P.C.
|     | Certified Public Accountants and Consultants

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

Appalachian Bancshares, Inc. and Subsidiaries

Ellijay, Georgia

We have audited the accompanying consolidated statements of financial condition of Appalachian Bancshares, Inc. (a Georgia corporation) and subsidiaries (the Company)
as of December 31, 2004 and 2003, and the related consolidated statements of income, shareholders equity and cash flows for each of the three years in the period ended December 31, 2004. These consolidated financial statements are
the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Appalachian
Bancshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with United States
generally accepted accounting principles.

Birmingham, Alabama

March 17, 2005

/s/ Schauer Taylor Cox Vise & Morgan, P.C.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

December 31, 2006 and 2005

(In thousands)



|                                                                                                                                                         |  |      |         |   |      |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                                                                                                                         |  | 2006 |         |   | 2005 |  
|Assets                                                                                                                                                   |  |      |         |   |      |   |         |  
|                                                                                                                                                         |  |     
|Cash and due from banks                                                                                                                                  |  | $    | 7,940   |   |      | $ | 20,772  |  
|Interest-bearing deposits with other banks                                                                                                               |  |      | 541     |   |      |   | 13,765  |  
|Federal funds sold                                                                                                                                       |  |      | 3,107   |   |      |   | 799     |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|Cash and Cash Equivalents                                                                                                                                |  |      | 11,588  |   |      |   | 35,336  |  
|                                                                                                                                                         |  |     
|Securities available-for-sale                                                                                                                            |  |      | 74,725  |   |      |   | 71,570  |  
|                                                                                                                                                         |  |     
|Loans, net of unearned income                                                                                                                            |  |      | 631,786 |   |      |   | 457,418 |  
|Allowance for loan losses                                                                                                                                |  |      | (7,670  | ) |      |   | (6,059  | )
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|Net Loans                                                                                                                                                |  |      | 624,116 |   |      |   | 451,359 |  
|                                                                                                                                                         |  |     
|Premises and equipment, net                                                                                                                              |  |      | 23,412  |   |      |   | 16,797  |  
|Accrued interest                                                                                                                                         |  |      | 8,157   |   |      |   | 4,751   |  
|Cash surrender value on life insurance                                                                                                                   |  |      | 8,438   |   |      |   | 8,143   |  
|Intangibles, net                                                                                                                                         |  |      | 2,197   |   |      |   | 1,992   |  
|Other assets                                                                                                                                             |  |      | 5,581   |   |      |   | 2,658   |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|Total Assets                                                                                                                                             |  | $    | 758,214 |   |      | $ | 592,606 |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|                                                                                                                                                         |  |     
|Liabilities and Shareholders Equity                                                                                                                     |  |      |         |   |      |   |         |  
|                                                                                                                                                         |  |     
|Liabilities                                                                                                                                              |  |      |         |   |      |   |         |  
|Noninterest-bearing deposits                                                                                                                             |  | $    | 53,422  |   |      | $ | 46,561  |  
|Interest-bearing deposits                                                                                                                                |  |      | 597,712 |   |      |   | 426,749 |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|Total Deposits                                                                                                                                           |  |      | 651,134 |   |      |   | 473,310 |  
|                                                                                                                                                         |  |     
|Short-term borrowings                                                                                                                                    |  |      | 4,738   |   |      |   | 24,892  |  
|Accrued interest                                                                                                                                         |  |      | 1,454   |   |      |   | 728     |  
|FHLB Advances                                                                                                                                            |  |      | 25,050  |   |      |   | 24,950  |  
|Subordinated long-term capital notes                                                                                                                     |  |      | 6,186   |   |      |   | 6,186   |  
|Other liabilities                                                                                                                                        |  |      | 2,889   |   |      |   | 2,715   |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|Total Liabilities                                                                                                                                        |  |      | 691,451 |   |      |   | 532,781 |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|                                                                                                                                                         |  |     
|Commitments and Contingencies                                                                                                                            |  |      |         |   |      |   |         |  
|                                                                                                                                                         |  |     
|Shareholders Equity                                                                                                                                     |  |      |         |   |      |   |         |  
|Preferred stock, 20,000,000 shares authorized, none issued                                                                                               |  |      |        |   |      |   |        |  
|Common stock, par value $0.01 per share, 20,000,000 shares authorized, 5,280,497 and 5,225,097 shares issued at December 31, 2006 and
2005, respectively |  |      | 53      |   |      |   | 52      |  
|Paid-in capital                                                                                                                                          |  |      | 43,870  |   |      |   | 43,184  |  
|Retained earnings                                                                                                                                        |  |      | 23,761  |   |      |   | 17,757  |  
|Accumulated other comprehensive loss                                                                                                                     |  |      | (221    | ) |      |   | (468    | )
|Less cost of treasury stock, 75,973 shares                                                                                                               |  |      | (700    | ) |      |   | (700    | )
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|Total Shareholders Equity                                                                                                                               |  |      | 66,763  |   |      |   | 59,825  |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  
|Total Liabilities and Shareholders Equity                                                                                                               |  | $    | 758,214 |   |      | $ | 592,606 |  
|                                                                                                                                                         |  |      |         |   |      |   |         |  

See notes to consolidated financial statements



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2006, 2005 and 2004

(In thousands, except per share data)



|                                                                                       |  |      |        |      |   |        |  |   |        |  
|-------------------------------------------------------------------------------------- |  | ---- | ------ | ---- | - | ------ |  | - | ------ | -
|                                                                                       |  | 2006 |        | 2005 |   | 2004   | 
|Interest Income                                                                        |  |      |        |      |   |        |  |   |        |  
|Interest and fees on loans                                                             |  | $    | 49,843 |      | $ | 32,014 |  | $ | 23,652 |  
|Interest on securities:                                                                |  |      |        |      |   |        |  |   |        |  
|Taxable securities                                                                     |  |      | 2,301  |      |   | 1,843  |  |   | 1,402  |  
|Nontaxable securities                                                                  |  |      | 668    |      |   | 655    |  |   | 650    |  
|Interest on deposits with other banks                                                  |  |      | 30     |      |   | 20     |  |   | 6      |  
|Interest on federal funds sold                                                         |  |      | 351    |      |   | 218    |  |   | 26     |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|Total Interest Income                                                                  |  |      | 53,193 |      |   | 34,750 |  |   | 25,736 |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|                                                                                       |  |      |       
|Interest Expense                                                                       |  |      |        |      |   |        |  |   |        |  
|Interest on deposits                                                                   |  |      | 20,351 |      |   | 10,132 |  |   | 6,209  |  
|Interest on federal funds purchased and securities sold under agreements to repurchase |  |      | 472    |      |   | 174    |  |   | 123    |  
|Interest FHLB advances                                                                 |  |      | 1,180  |      |   | 1,170  |  |   | 942    |  
|Interest on subordinated long-term capital notes                                       |  |      | 491    |      |   | 404    |  |   | 284    |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|Total Interest Expense                                                                 |  |      | 22,494 |      |   | 11,880 |  |   | 7,558  |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|                                                                                       |  |      |       
|Net Interest Income                                                                    |  |      | 30,699 |      |   | 22,870 |  |   | 18,178 |  
|Provision for loan losses                                                              |  |      | 3,253  |      |   | 2,211  |  |   | 1,235  |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|Net Interest Income After Provision For Loan Losses                                    |  |      | 27,446 |      |   | 20,659 |  |   | 16,943 |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|                                                                                       |  |      |       
|Noninterest Income                                                                     |  |      |        |      |   |        |  |   |        |  
|Customer service fees                                                                  |  |      | 1,650  |      |   | 1,434  |  |   | 1,234  |  
|Mortgage origination commissions                                                       |  |      | 1,348  |      |   | 959    |  |   | 801    |  
|Securities losses                                                                      |  |      |      |      |   |      |  |   | (23    | )
|Other operating income                                                                 |  |      | 973    |      |   | 910    |  |   | 817    |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|Total Noninterest Income                                                               |  |      | 3,971  |      |   | 3,303  |  |   | 2,829  |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|                                                                                       |  |      |       
|Noninterest Expenses                                                                   |  |      |        |      |   |        |  |   |        |  
|Salaries and employee benefits                                                         |  |      | 13,341 |      |   | 8,741  |  |   | 6,885  |  
|Occupancy, furniture and equipment expense                                             |  |      | 2,685  |      |   | 2,014  |  |   | 1,956  |  
|Other operating expenses                                                               |  |      | 6,535  |      |   | 5,583  |  |   | 4,999  |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|Total Noninterest Expenses                                                             |  |      | 22,561 |      |   | 16,338 |  |   | 13,840 |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|Income before income taxes                                                             |  |      | 8,856  |      |   | 7,624  |  |   | 5,932  |  
|Income tax expense                                                                     |  |      | 2,852  |      |   | 2,502  |  |   | 1,885  |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|Net Income                                                                             |  | $    | 6,004  |      | $ | 5,122  |  | $ | 4,047  |  
|                                                                                       |  |      |        |      |   |        |  |   |        |  
|                                                                                       |  |      |       
|Earnings Per Common Share                                                              |  |      |        |      |   |        |  |   |        |  
|Basic                                                                                  |  | $    | 1.16   |      | $ | 1.24   |  | $ | 1.09   |  
|Diluted                                                                                |  |      | 1.14   |      |   | 1.21   |  |   | 1.04   |  
|                                                                                       |  |      |       
|Cash Dividends Declared Per Common Share                                               |  |      | 0.00   |      |   | 0.00   |  |   | 0.00   |  
|                                                                                       |  |      |       
|Weighted Average Shares Outstanding                                                    |  |      |        |      |   |        |  |   |        |  
|Basic                                                                                  |  |      | 5,171  |      |   | 4,123  |  |   | 3,724  |  
|Diluted                                                                                |  |      | 5,279  |      |   | 4,247  |  |   | 3,885  |  

See notes to consolidated financial statements



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY

Years Ended December 31, 2006, 2005 and 2004

(In thousands)



|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|----------------------------------------------------------------------------------------------------------- |  | ----------- | -- | -------------- | - | ------ | ---------------- |  | ------------------------------------------ | ------ |  | ------------- | ---- | - | ----- | - | ---- | - |  | - | ------ | -
|                                                                                                            |  | CommonStock |    | Paid-inCapital |   |        | RetainedEarnings |  | AccumulatedOtherCompre-hensiveIncome(Loss) |        |  | TreasuryStock |      |   | Total |  
|Balance at December 31, 2003                                                                                |  | $           | 37 |                | $ | 22,727 |                  |  | $                                          | 8,588  |  | $             | 429  |   |       | $ | (700 | ) |  | $ | 31,081 |  
|                                                                                                            |  |             |    |                |   |       
|Net income 2004                                                                                             |  |             |   |                |   |       |                  |  |                                            | 4,047  |  |               |     |   |       |   |     |   |  |   | 4,047  |  
|Unrealized losses on available-for-sale securities, net of reclassification adjustment, net of tax of $(27) |  |             |   |                |   |       |                  |  |                                            |       |  |               | (51  | ) |       |   |     |   |  |   | (51    | )
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Comprehensive income                                                                                        |  |             |   |                |   |       |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 3,996  |  
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Proceeds from sale of common stock to 401(k) plan                                                           |  |             |   |                |   | 503    |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 503    |  
|Effect of exercise and issuance of stock options                                                            |  |             | 1  |                |   | 460    |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 461    |  
|Stock-based compensation cost                                                                               |  |             |   |                |   | 42     |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 42     |  
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Balance at December 31, 2004                                                                                |  |             | 38 |                |   | 23,732 |                  |  |                                            | 12,635 |  |               | 378  |   |       |   | (700 | ) |  |   | 36,083 |  
|                                                                                                            |  |             |    |                |   |       
|Net income 2005                                                                                             |  |             |   |                |   |       |                  |  |                                            | 5,122  |  |               |     |   |       |   |     |   |  |   | 5,122  |  
|Unrealized losses on available-for-sale securities, net of tax of $(436)                                    |  |             |   |                |   |       |                  |  |                                            |       |  |               | (846 | ) |       |   |     |   |  |   | (846   | )
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Comprehensive income                                                                                        |  |             |   |                |   |       |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 4,276  |  
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Proceeds from sale of common stock to 401(k) plan                                                           |  |             |   |                |   | 494    |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 494    |  
|Effect of exercise and issuance of stock options                                                            |  |             | 1  |                |   | 582    |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 583    |  
|Stock-based compensation cost                                                                               |  |             |   |                |   | 19     |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 19     |  
|Proceeds from sale of common stock through stock offering                                                   |  |             | 13 |                |   | 18,357 |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 18,370 |  
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Balance at December 31, 2005                                                                                |  |             | 52 |                |   | 43,184 |                  |  |                                            | 17,757 |  |               | (468 | ) |       |   | (700 | ) |  |   | 59,825 |  
|                                                                                                            |  |             |    |                |   |       
|Net income 2006                                                                                             |  |             |   |                |   |       |                  |  |                                            | 6,004  |  |               |     |   |       |   |     |   |  |   | 6,004  |  
|Unrealized gains on available-for-sale securities, net of tax of $128                                       |  |             |   |                |   |       |                  |  |                                            |       |  |               | 247  |   |       |   |     |   |  |   | 247    |  
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Comprehensive income                                                                                        |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   | 6,251  |  
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Proceeds from sale of common stock to 401(k) plan                                                           |  |             |   |                |   | 50     |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 50     |  
|Effect of exercise and issuance of stock options                                                            |  |             | 1  |                |   | 444    |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 445    |  
|Stock-based compensation cost                                                                               |  |             |   |                |   | 204    |                  |  |                                            |       |  |               |     |   |       |   |     |   |  |   | 204    |  
|Expense incurred from sale of common stock through stock offering                                           |  |             |   |                |   | (12    | )                |  |                                            |       |  |               |     |   |       |   |     |   |  |   | (12    | )
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  
|Balance at December 31, 2006                                                                                |  | $           | 53 |                | $ | 43,870 |                  |  | $                                          | 23,761 |  | $             | (221 | ) |       | $ | (700 | ) |  | $ | 66,763 |  
|                                                                                                            |  |             |    |                |   |        |                  |  |                                            |        |  |               |      |   |       |   |      |   |  |   |        |  

See notes to consolidated financial statements



48



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##### Table of Contents

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2006, 2005 and 2004

(In thousands)



|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|--------------------------------------------------------------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                            |  | 2006 |          |   | 2005 |   |         | 2004 | 
|Operating Activities                                                                                                        |  |      |          |   |      |   |         |      |  |   |         |  
|Net income                                                                                                                  |  | $    | 6,004    |   |      | $ | 5,122   |      |  | $ | 4,047   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                                           |  |      |          |   |      |   |         |      |  |   |         |  
|Depreciation, amortization, and accretion, net                                                                              |  |      | 968      |   |      |   | 926     |      |  |   | 1,039   |  
|Provision for loan losses                                                                                                   |  |      | 3,253    |   |      |   | 2,211   |      |  |   | 1,235   |  
|Deferred tax benefit                                                                                                        |  |      | (1,363   | ) |      |   | (71     | )    |  |   | (22     | )
|Realized security losses, net                                                                                               |  |      |         |   |      |   |        |      |  |   | 23      |  
|Loss on disposal of premises and equipment                                                                                  |  |      | 15       |   |      |   | 59      |      |  |   | 24      |  
|Loss on disposition of other real estate                                                                                    |  |      | 32       |   |      |   | 80      |      |  |   | 195     |  
|Increase in cash surrender value on life insurance                                                                          |  |      | (295     | ) |      |   | (309    | )    |  |   | (241    | )
|Increase in accrued interest receivable                                                                                     |  |      | (3,406   | ) |      |   | (1,849  | )    |  |   | (612    | )
|Increase (decrease) in accrued interest payable                                                                             |  |      | 726      |   |      |   | 188     |      |  |   | (130    | )
|Stock-based compensation cost                                                                                               |  |      | 204      |   |      |   | 19      |      |  |   | 42      |  
|Excess tax benefits from exercise of stock options                                                                          |  |      | (88      | ) |      |   | (254    | )    |  |   | (193    | )
|Other, net                                                                                                                  |  |      | (600     | ) |      |   | 1,544   |      |  |   | 473     |  
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|Net Cash Provided By Operating Activities                                                                                   |  |      | 5,450    |   |      |   | 7,666   |      |  |   | 5,880   |  
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|                                                                                                                            |  |      |         
|Investing Activities                                                                                                        |  |      |          |   |      |   |         |      |  |   |         |  
|Proceeds from sales of securities available-for-sale                                                                        |  |      | 2,619    |   |      |   | 1,427   |      |  |   | 4,261   |  
|Proceeds from maturity, calls and paydown of securities available-for-sale                                                  |  |      | 11,994   |   |      |   | 6,009   |      |  |   | 12,473  |  
|Purchase of securities available-for-sale                                                                                   |  |      | (17,314  | ) |      |   | (15,690 | )    |  |   | (26,261 | )
|Net increase in loans                                                                                                       |  |      | (178,735 | ) |      |   | (80,819 | )    |  |   | (46,311 | )
|Capital expenditures, net                                                                                                   |  |      | (7,648   | ) |      |   | (4,899  | )    |  |   | (4,959  | )
|Proceeds from sales of premises and equipment                                                                               |  |      | 12       |   |      |   | 161     |      |  |   | 242     |  
|Purchase of insurance contracts                                                                                             |  |      |         |   |      |   |        |      |  |   | (5,000  | )
|Proceeds from disposition of foreclosed real estate                                                                         |  |      | 1,622    |   |      |   | 541     |      |  |   | 807     |  
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|Net Cash Used In Investing Activities                                                                                       |  |      | (187,450 | ) |      |   | (93,270 | )    |  |   | (64,748 | )
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|                                                                                                                            |  |      |         
|Financing Activities                                                                                                        |  |      |          |   |      |   |         |      |  |   |         |  
|Net increase in demand deposits, NOW accounts, and savings accounts                                                         |  |      | 20,132   |   |      |   | 49,184  |      |  |   | 32,358  |  
|Net increase in certificates of deposit                                                                                     |  |      | 157,692  |   |      |   | 42,628  |      |  |   | 16,221  |  
|Net increase (decrease) in federal funds purchased, securities sold under agreements to repurchase, and FHLB line of credit |  |      | (20,154  | ) |      |   | 9,422   |      |  |   | 3,384   |  
|Issuance of FHLB advances                                                                                                   |  |      | 20,000   |   |      |   | 4,000   |      |  |   | 13,500  |  
|Repayment of FHLB advances                                                                                                  |  |      | (19,900  | ) |      |   | (11,000 | )    |  |   | (7,243  | )
|Issuance of common stock                                                                                                    |  |      | 394      |   |      |   | 18,939  |      |  |   | 577     |  
|Excess tax benefits from exercise of stock options                                                                          |  |      | 88       |   |      |   | 254     |      |  |   | 193     |  
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|Net Cash Provided By Financing Activities                                                                                   |  |      | 158,252  |   |      |   | 113,427 |      |  |   | 58,990  |  
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|                                                                                                                            |  |      |         
|Net Increase (Decrease) in Cash and Cash Equivalents                                                                        |  |      | (23,748  | ) |      |   | 27,823  |      |  |   | 122     |  
|                                                                                                                            |  |      |         
|Cash and Cash Equivalents at Beginning of Year                                                                              |  |      | 35,336   |   |      |   | 7,513   |      |  |   | 7,391   |  
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  
|Cash and Cash Equivalents at End of Year                                                                                    |  | $    | 11,588   |   |      | $ | 35,336  |      |  | $ | 7,513   |  
|                                                                                                                            |  |      |          |   |      |   |         |      |  |   |         |  

See notes to consolidated financial statements



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##### Table of Contents

APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1  Summary of Significant Accounting Policies

The accompanying consolidated financial statements include the accounts of Appalachian Bancshares, Inc. (the Company) (a Georgia corporation) and its wholly-owned subsidiary: Appalachian Community Bank (the Bank).
All significant intercompany transactions and balances have been eliminated in consolidation. Unless otherwise indicated herein, the financial results of the Company refer to the Company and the Bank on a consolidated basis. The Bank provides a full
range of banking services to individual and corporate customers in North Georgia and the surrounding areas.

The Company operates
predominantly in the domestic commercial banking industry. The accounting and reporting policies of the Company conform to generally accepted accounting principles in the United States and to general practice within the banking industry. The
following summarizes the most significant of these policies.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles 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.

The determination of the adequacy of the allowance for loan losses is
based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for
significant collateral. While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies,
as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may require the Bank to recognize additional losses based on their judgments about information available to them at the time of their
examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

Securities

Securities are classified as either
held-to-maturity, available-for-sale or trading.

Held-to-maturity securities are securities for which management has the ability and
intent to hold until maturity. These securities are carried at amortized cost, adjusted for amortization of premiums and accretion of discount, to the earlier of the maturity or call date.

Securities available-for-sale represent those securities intended to be held for an indefinite period of time, including securities that management
intends to use as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, the need to increase regulatory capital, or other similar factors. Securities available-for-sale are
recorded at market value with unrealized gains and losses net of any tax effect, added or deducted directly from shareholders equity.

Securities carried in trading accounts are carried at market value with unrealized gains and losses reflected in income.

Realized
and unrealized gains and losses are based on the specific identification method.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



The amortization of premiums and accretion of discounts are recognized in interest income using the
interest method over the life of the securities.

Declines in the fair value of individual held-to maturity and available-for-sale
securities below their cost that are other than temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in earnings as realized losses.

The Company had no trading or held-to-maturity securities as of December 31, 2006 and 2005.

Loans

Loans are stated at unpaid principal balances, less the
allowance for loan losses.

Loan origination and commitment fees, net of certain origination costs, are deferred and amortized as a yield adjustment over
the lives of the related loans using the interest method.

Allowance for Loan Losses

A loan is generally classified as 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. Smaller balance homogeneous loans, which consist of residential mortgages and consumer loans, are evaluated
collectively and reserves are established based on historical loss experience.

The allowance for loan losses is established through
charges to earnings in the form of a provision for loan losses. Increases and decreases in the allowance due to changes in the measurement of the impaired loans are included in the provision for loan losses. Loans continue to be classified as
impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable. When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the
allowance and subsequent recoveries, if any, are credited to the allowance.

Management determines the Banks loan loss allowance by
first dividing the loan portfolio into two major categories: (1)satisfactory and past due loans and (2)problem loans. Loan loss reserves are calculated primarily based upon the historical loss experience by segment for the satisfactory and past due
portion of the portfolio. The Bank uses the prior three year net loan charge off/recovery experience rate (net charge off percentage of total loans) to calculate the various segments in the loan portfolio. This experience rate is applied to the
satisfactory and past due loans by segment, in order to determine the reserve amount for satisfactory and past due loans. Problem loans are considered individually for loans over $100,000. For problem loans $100,000 and under, a specific reserve
will be calculated based on classification on the Banks watch list as follows: Grade 5  Special Mention, 5% reserve; Grade 6  Substandard, 15% reserve; Grade 7  Doubtful, 50% reserve; and Grade 8  Loss, 100% reserve. In
managements opinion, the Banks loan loss allowance is considered adequate at December 31, 2006 and 2005.

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 borrowers ability to
repay, estimated value of any underlying collateral, and an analysis of current economic conditions. While management believes that it has established the allowance in accordance with generally accepted accounting principles 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 its economic environment will not require further increases in the allowance.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



Income Recognition on Impaired and Nonaccrual Loans

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a
period of more than 90 days, unless such loans are well collateralized 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 are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment
performance 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 amortizations 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. In the case where a nonaccrual loan has been partially charged off,
recognition of interest on a cash basis is 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. Interest income recognized on a cash basis was immaterial for the years ended December 31, 2006, 2005 and 2004.

Premises and Equipment

Land is carried at cost. Other premises and equipment are carried at cost,
net of accumulated depreciation. Depreciation is provided generally by the straight-line method based principally on the estimated useful lives of the respective assets. Maintenance and repairs are expensed as incurred, while major additions and
improvements are capitalized. Gains and losses on dispositions are included in current operations.

Foreclosed Assets

Foreclosed assets includes both formally foreclosed property and in-substance foreclosed property. In-substance foreclosed properties are those properties
for which the Bank has taken physical possession, regardless of whether formal foreclosure proceedings have taken place.

At the time of
foreclosure, foreclosed assets are recorded at the lower of the carrying amount or fair value less cost to sell, which becomes the propertys new basis. Any write-downs based on the assets fair value at date of acquisition are charged to
the allowance for loan losses. After foreclosure, these assets are carried at the lower of their new cost basis or fair value less cost to sell.

Costs incurred in maintaining foreclosed assets and subsequent adjustments to the carrying amount of the property are included in income (loss) on foreclosed assets. The carrying amount of foreclosed assets of December 31, 2006 and
2005 was $1,217,942 and $147,019, respectively.

Advertising Costs

The Companys policy is to expense advertising costs as incurred. Advertising expense for the years ended December 31, 2006, 2005 and 2004 amounted to approximately $882,000, $510,000, and $355,000,
respectively.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



Income Taxes

Income taxes are provided for the tax effects of the transactions reported in the consolidated financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the
basis of available-for-sale securities, allowance for loan losses, estimated losses on foreclosed real estate, and accumulated depreciation for financial and income tax reporting. The deferred tax assets and liabilities represent the future tax
return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which
the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. The Company files consolidated
income tax returns with its subsidiaries.

Stock-Based Compensation

At December 31, 2006, the Company had two stock-based employee compensation plans, which are more fully described in Note 15. Prior to 2003, the Company accounted for these plans under the recognition and
measurement provisions of APB No. 25, Accounting for Stock Issued to Employees, and the related Interpretations. Accordingly, no stock-based compensation cost was included in net income, as all options granted under the plans had an exercise
price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as
provided by SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure. SFAS No. 148 allows for a modified prospective method of adoption of SFAS No. 123, whereby the Company can prospectively account
for the current expense of options granted during 2003 and thereafter. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), entitled Share-Based Payment (SFAS
No. 123R) using the modified-prospective-transition method. Under that transition method, compensation cost recognized in 2006 includes compensation cost for all share-based payments granted prior to but not vested as of January 1,
2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value
estimated in accordance with the provisions of SFAS No. 123R. Results for prior periods have not been restated.

As a result of
adopting SFAS 123R on January 1, 2006, the Companys income before income taxes and net income for the year ended December 31, 2006 are $10,239 lower, than if it had continued to account for share-based compensation under the
provisions of SFAS No. 123, as provided by SFAS No. 148. Basic and diluted earnings per share for the year ended December 31, 2006 would not have changed.

SFAS 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing
cash flows. For the years ended December 31, 2006, 2005 and 2004, there were $88,459, $254,326 and 193,158, respectively, in tax benefits realized from the exercise of stock options.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



The following table illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of SFAS 123R to options granted under the Companys stock option plans in all periods presented. For purposes of this pro forma disclosure, the value of the options is estimated using a
Black-Scholes option valuation model and amortized to expense over the options vesting periods.



|                                                                                                                                    |  |                                       |           |   |      |   |           |  
|----------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------- | --------- | - | ---- | - | --------- | -
|                                                                                                                                    |  | Years Ended December 31,              |          
|                                                                                                                                    |  | 2005                                  |           |   | 2004 |  
|                                                                                                                                    |  | (In thousands, except per share data) |          
|Net income as reported                                                                                                              |  | $                                     | 5,122     |   |      | $ | 4,047     |  
|Add: Stock based compensation expense included in net income, net of related taxes                                                  |  |                                       | 19        |   |      |   | 42        |  
|Deduct: Total stock-based employee compensation expense determined under the fair value method for all awards, net of related
taxes |  |                                       | (53       | ) |      |   | (60       | )
|                                                                                                                                    |  |                                       |           |   |      |   |           |  
|Pro Forma Net income                                                                                                                |  | $                                     | 5,088     |   |      | $ | 4,029     |  
|                                                                                                                                    |  |                                       |           |   |      |   |           |  
|                                                                                                                                    |  |                                      
|Basic Earnings per Common Share                                                                                                     |  |                                       |           |   |      |   |           |  
|As reported                                                                                                                         |  | $                                     | 1.24      |   |      | $ | 1.09      |  
|Pro Forma                                                                                                                           |  |                                       | 1.23      |   |      |   | 1.08      |  
|                                                                                                                                    |  |                                      
|Diluted Earnings per Common Share                                                                                                   |  |                                       |           |   |      |   |           |  
|As reported                                                                                                                         |  |                                       | 1.21      |   |      |   | 1.04      |  
|Pro Forma                                                                                                                           |  |                                       | 1.20      |   |      |   | 1.04      |  
|                                                                                                                                    |  |                                      
|Weighted average fair value of options granted during the year                                                                      |  |                                       | 4.89      |   |      |   | 3.79      |  
|                                                                                                                                    |  |                                      
|Assumptions:                                                                                                                        |  |                                       |           |   |      |   |           |  
|Average risk free interest rate                                                                                                     |  |                                       | 4.15      | % |      |   | 4.07      | %
|Average expected volatility                                                                                                         |  |                                       | 15.80     |   |      |   | 21.30     |  
|Expected dividend yield                                                                                                             |  |                                       | 0.00      |   |      |   | 0.00      |  
|Expected life                                                                                                                       |  |                                       | 7.5 years |   |      |   | 7.5 years |  

Employee Benefit Plan

The Company has a 401(k) profit-sharing plan covering substantially all of its employees. Eligible participating employees may elect to contribute tax-deferred contributions. Company contributions to the plan are
determined by the board of directors, not to exceed the amount that can be deducted for federal income tax purposes. The Company is presently matching up to 3% of the employees salary if the employee contributes at least 10%. The match is
prorated if the employee contributes less than 10%.

Intangibles

Intangibles consist of goodwill and a non-compete agreement with a former employee of the Bank. The goodwill represents a premium paid on the purchase of assets and deposit liabilities. Goodwill is stated at cost, net
of accumulated amortization, which was provided using the straight-line method over the estimated useful life of 20 years, until the Financial Accounting Standards Board (the FASB) issued SFAS No. 142, Goodwill and Other
Intangible Assets, in June 2001. The carrying amount of goodwill at December 31, 2006 and 2005 is $1,991,891.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



Goodwill is required to be tested annually for impairment, or whenever events occur that may indicate
that the recoverability of the carrying amount is not probable. In the event of impairment, the amount by which the carrying amount exceeds the fair value would be charged to earnings. The Company performed its annual test of impairment as of
November 30, 2006 and determined that there was no impairment of the carrying value.

The noncompete intangible represents an amount
paid during 2006 to a former employee who agreed to certain stipulations concerning future employment spelled out in a noncompete agreement. The asset is stated at cost, net of accumulated amortization, which is provided using the straight-line
method over the contract period of 2 years. The carrying amount of the noncompete agreement at December 31, 2006 is $205,000, which consists of the original amount of $246,000, net of accumulated amortization of $41,000. Amortization expense
for the year ended December 31, 2006 amounted to $41,000 for this noncompete agreement.

Off-Balance Sheet Financial Instruments

In the ordinary course of business the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit,
commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded in the consolidated financial statements when they are funded. See Note 13 for a further discussion of
these financial instruments.

The Company also has available as a source of short-term financing the purchase of federal funds from other
commercial banks from an available line of up to $36 million, of which all funds were available at December 31, 2006. In addition, the Company has a line of credit with the Federal Home Loan Bank (the FHLB), of up to approximately
$111,310,000, of which approximately $86,260,000 was available and unused, subject to proper collateralization at December 31, 2006.

Earnings per
Common Share

Basic earnings per common share are computed by dividing earnings available to shareholders by the weighted average number
of common shares outstanding during the period. Diluted earnings per share reflect per share amounts that would have resulted if dilutive potential common stock had been converted to common stock, as prescribed by SFAS No. 128, Earnings per
Share.



|                                                                    |  |                          |  |       |  |      
|------------------------------------------------------------------- |  | ------------------------ |  | ----- |  | -----
|                                                                    |  | Years ended December 31,
|                                                                    |  | 2006                     |  | 2005  |  | 2004 
|                                                                    |  | (In thousands)          
|Weighted average of common shares outstanding                       |  | 5,171                    |  | 4,123 |  | 3,724
|Effect of dilutive options                                          |  | 108                      |  | 124   |  | 161  
|                                                                    |  |                          |  |       |  |      
|Weighted average of common shares outstanding effected for dilution |  | 5,279                    |  | 4,247 |  | 3,885
|                                                                    |  |                          |  |       |  |      

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on
available-for-sale securities, are reported as a separate component of the equity sections of the statement of financial condition, such items, along with net income, are components of comprehensive income.



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



In the calculation of comprehensive income, certain reclassification adjustments are made to avoid
double counting items that are displayed as part of net income for a period that also had been displayed as part of other comprehensive income in that period or earlier periods. The disclosure of the reclassification amounts and other details of
other comprehensive income (loss) are as follows:



|                                                                      |  |                          |      |   |      |   |        |      |  |   |      |  
|--------------------------------------------------------------------- |  | ------------------------ | ---- | - | ---- | - | ------ | ---- |  | - | ---- | -
|                                                                      |  | Years ended December 31, |     
|                                                                      |  | 2006                     |      |   | 2005 |   |        | 2004 | 
|                                                                      |  | (In thousands)           |     
|Unrealized gains (losses) on securities                               |  |                          |      |   |      |   |        |      |  |   |      |  
|                                                                      |  |                          |     
|Unrealized holding gains arising during period                        |  | $                        | 375  |   |      | $ | (1,283 | )    |  | $ | (101 | )
|Reclassification adjustment for (gains) losses included in net income |  |                          |     |   |      |   |       |      |  |   | 23   |  
|                                                                      |  |                          |      |   |      |   |        |      |  |   |      |  
|Net unrealized losses                                                 |  |                          | 375  |   |      |   | (1,283 | )    |  |   | (78  | )
|Income tax related to items of other comprehensive income             |  |                          | (128 | ) |      |   | 436    |      |  |   | 27   |  
|                                                                      |  |                          |      |   |      |   |        |      |  |   |      |  
|Other comprehensive income (loss)                                     |  | $                        | 247  |   |      | $ | (847   | )    |  | $ | (51  | )
|                                                                      |  |                          |      |   |      |   |        |      |  |   |      |  

Statements of Cash Flows

The Company includes cash, due from banks, and short-term investments as cash equivalents in preparing the consolidated statements of cash flows. The following is supplemental disclosure to the statements of cash
flows for the three years ended December 31, 2006.



|                                                                                        |  |                |        |      |   |        |      |  |   |       |  
|--------------------------------------------------------------------------------------- |  | -------------- | ------ | ---- | - | ------ | ---- |  | - | ----- | -
|                                                                                        |  | 2006           |        | 2005 |   |        | 2004 | 
|                                                                                        |  | (In thousands) |       
|Cash paid during the year for interest                                                  |  | $              | 21,768 |      | $ | 10,030 |      |  | $ | 7,688 |  
|                                                                                        |  |                |       
|Cash paid during the year for income taxes                                              |  |                | 3,358  |      |   | 2,292  |      |  |   | 1,690 |  
|                                                                                        |  |                |       
|Non-cash Disclosures:                                                                   |  |                |        |      |   |        |      |  |   |       |  
|                                                                                        |  |                |       
|Loans transferred to foreclosed assets                                                  |  |                | 2,824  |      |   | 252    |      |  |   | 1,563 |  
|                                                                                        |  |                |       
|Net increase (decrease) in unrealized gains and losses on securities available-for-sale |  |                | 375    |      |   | (1,282 | )    |  |   | (78   | )
|                                                                                        |  |                |       
|Sales of foreclosed assets financed through loans                                       |  |                | 99     |      |   |       |      |  |   | 793   |  
|                                                                                        |  |                |       
|Increase in cash surrender value on life insurance                                      |  |                | 295    |      |   | 309    |      |  |   | 241   |  

Recent Developments

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets. SFAS No. 156 amends SFAS No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 requires an entity to recognize a servicing asset or servicing
liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations and



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. The provisions of
this statement are effective as of the beginning of the first fiscal year that begins after September 15, 2006. Since the Company does not service any assets, the Company does not expect the impact of SFAS No. 156 on its financial
position, results of operations or cash flows to be material.

In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48),
Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a companys financial statements in accordance with
FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in
a tax return. FIN 48 provides a two-step process in the evaluation of a tax position. The first step is recognition. A company determines whether it is more-likely-than-not that a tax position will be sustained upon examination, including a
resolution of any related appeals or litigation processes, based upon the technical merits of the position. The second step is measurement. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of
benefit that is greater than 50 percent likely of being realized upon ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company expects the impact of adopting FIN 48 will not be
material to its financial position, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157,
Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This
statement does not require any new fair value measurements, but applies under other accounting pronouncements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. The
provisions of this statement are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not expect the impact of SFAS No. 157 on
its financial position, results of operations or cash flows to be material.

In September 2006, the EITF reached a consensus on EITF Issue
No. 06-4 (EITF 06-4), Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. EITF 06-4 requires an employer to recognize a liability for future benefits based
on the substantive agreement with the employee. EITF 06-4 requires a company to use the guidance prescribed in FASB Statement No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions and Accounting
Principles Board Opinion No. 12, Omnibus Opinion, when entering into an endorsement split-dollar life insurance agreement and recognizing the liability. EITF 06-4 is effective for fiscal periods beginning after December 15,
2007. The Company is currently evaluating the impact of adopting EITF 06-4 on its financial position, results of operations and cash flows, but has yet to complete its assessment.

In September 2006, the EITF reached a consensus on EITF Issue No. 06-5 (EITF 06-5), Accounting for Purchases of Life Insurance 
Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4. EITF 06-5 requires that a determination of the amount that could be realized under an insurance contract should (1) consider any
additional amounts beyond cash surrender value included in the contractual terms of the policy and (2) be based on an assumed surrender at the individual policy or certificate level, unless all policies or certificates are required to be
surrendered as a group. EITF 06-5 is effective for fiscal periods beginning after December 15, 2006. The Company is currently evaluating the impact of adopting EITF 06-5 on its financial position, results of operations and cash flows, but has
yet to complete its assessment.

In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year
Misstatements When Quantifying Misstatements in Current Year Financial Statements. In December 2006, the Company adopted the provisions of SAB No. 108, which clarifies the way that a company should evaluate an identified unadjusted
error for materiality. SAB No. 108 requires that the effect of misstatements that were not corrected at the end of the prior year be considered in quantifying misstatements in the current year financial statements. Two techniques were
identified as being used by companies in practice to accumulate and quantify misstatements  the rollover approach and the iron curtain approach. The rollover approach, which is the



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APPALACHIAN BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1
 Summary of Significant Accounting Policies  Continued



approach that the Company previously used, quantifies a misstatement based on the amount of the error originating in the current year income statement. Thus,
this approach ignores the effects of correcting the portion of the current year balance sheet misstatement that originated in prior years. The iron curtain approach quantifies a misstatement based on the effects of correcting the misstatement
existing in the balance sheet at the end of the current year, irrespective of the misstatements year(s) of origination. The primary weakness of the iron curtain approach is that it does not consider the correction of prior year misstatements
in the current year to be errors. The adoption of SAB No. 108 did not have a material impact to the Companys financial position, results of operations or cash flows.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities.
SFAS No. 159 permits entities to make an irrevocable election, at specified election dates, to measure eligible financial instruments and certain other items at fair value. This statement also establishes presentation and disclosure
requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. The provisions of this statement are effective as of the beginning of the first fiscal year
that begins after November 15, 2007. The Company is currently evaluating the impact of adopting SFAS No. 159, but has yet to complete its assessment.

Note 2 - Restrictions On Cash and Due From Bank Accounts

The Company is required to maintain average
reserve balances either in vault cash or on deposit with the Federal Reserve Bank. At December 31, 2006 and 2005, the average amount of the required reserves was $569,000 and $626,000, respectively.



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##### Table of Contents

Note 3  Securities

The carrying amounts of securities as shown in the consolidated statements of financial condition of the Company and their approximate fair values at December 31, 2006 and 2005 are presented below.



|                                       |  |                |        |                      |   |                       |  |                    |       |  |   |       
|-------------------------------------- |  | -------------- | ------ | -------------------- | - | --------------------- |  | ------------------ | ----- |  | - | ------
|                                       |  | AmortizedCost  |        | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | EstimatedFairValue
|                                       |  | (In thousands)
|Securities Available-For-Sale          |  |                |       
|                                       |  |                |        |                     
|December 31, 2006:                     |  |                |        |                      |   |                       |  |                    |       |  |   |       
|Government sponsored agency securities |  | $              | 43,933 |                      | $ | 10                    |  | $                  | 547   |  | $ | 43,396
|State and municipal securities         |  |                | 12,681 |                      |   | 479                   |  |                    | 12    |  |   | 13,148
|Mortgage-backed securities             |  |                | 15,098 |                      |   | 13                    |  |                    | 278   |  |   | 14,833
|Equity securities                      |  |                | 3,348  |                      |   |                      |  |                    |      |  |   | 3,348 
|                                       |  |                |        |                      |   |                       |  |                    |       |  |   |       
|                                       |  | $              | 75,060 |                      | $ | 502                   |  | $                  | 837   |  | $ | 74,725
|                                       |  |                |        |                      |   |                       |  |                    |       |  |   |       
|                                       |  |                |        |                     
|December 31, 2005:                     |  |                |        |                      |   |                       |  |                    |       |  |   |       
|Government sponsored agency securities |  | $              | 38,175 |                      | $ |                      |  | $                  | 817   |  | $ | 37,358
|State and municipal securities         |  |                | 14,250 |                      |   | 572                   |  |                    | 17    |  |   | 14,805
|Mortgage-backed securities             |  |                | 16,121 |                      |   | 2                     |  |                    | 320   |  |   | 15,803
|Equity securities                      |  |                | 3,734  |                      |   |                      |  |                    | 130   |  |   | 3,604 
|                                       |  |                |        |                      |   |                       |  |                    |       |  |   |       
|                                       |  | $              | 72,280 |                      | $ | 574                   |  | $                  | 1,284 |  | $ | 71,570
|                                       |  |                |        |                      |   |                       |  |                    |       |  |   |       

At December 31, 2006, the Companys available-for-sale securities reflected net
unrealized losses of $334,786 that resulted in a decrease in stockholders equity of $220,959 net of deferred taxes. At December 31, 2005, the Companys available-for-sale securities reflected net unrealized losses of $710,088 that
resulted in a decrease in stockholders equity of $468,659 net of deferred taxes.



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Note 3  Securities  Continued

The following tables show the Companys securities gross unrealized losses and fair value, aggregated by security category and length of time
that individual securities have been in a continuous unrealized loss position, at December 31, 2006 and 2005.



|                                       |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      
|-------------------------------------- |  | ------------------- | ------ | --------------------- | - | --------- |  | --------------------- | ------ | --------- | - | --------------------- |  | - | ------ |  | - | -----
|                                       |  | Less Than 12 Months |        | 12 Months or More     |   | Total    
|                                       |  | FairValue           |        | GrossUnrealizedLosses |   | FairValue |  | GrossUnrealizedLosses |        | FairValue |   | GrossUnrealizedLosses
|                                       |  | (In thousands)     
|Securities Available-for-sale          |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      
|                                       |  |                     |        |                       |   |          
|December 31, 2006:                     |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      
|Government sponsored agency securities |  | $                   | 6,733  |                       |   | 7         |  |                       | 29,176 |           |   | 540                   |  |   | 35,909 |  |   | 547  
|State and municipal securities         |  |                     | 574    |                       |   | 12        |  |                       |       |           |   |                      |  |   | 574    |  |   | 12   
|Mortgage-backed securities             |  |                     | 1,535  |                       |   |          |  |                       | 11,821 |           |   | 278                   |  |   | 13,356 |  |   | 278  
|                                       |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      
|                                       |  | $                   | 8,842  |                       | $ | 19        |  | $                     | 40,997 |           | $ | 818                   |  | $ | 49,839 |  | $ | 837  
|                                       |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      
|                                       |  |                     |        |                       |   |          
|December 31, 2005:                     |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      
|Government sponsored agency securities |  | $                   | 16,620 |                       | $ | 261       |  | $                     | 20,737 |           | $ | 557                   |  | $ | 37,357 |  | $ | 818  
|State and municipal securities         |  |                     | 1,143  |                       |   | 17        |  |                       |       |           |   |                      |  |   | 1,143  |  |   | 17   
|Mortgage-backed securities             |  |                     | 10,096 |                       |   | 121       |  |                       | 5,520  |           |   | 198                   |  |   | 15,616 |  |   | 319  
|Equity securities                      |  |                     | 720    |                       |   | 130       |  |                       |       |           |   |                      |  |   | 720    |  |   | 130  
|                                       |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      
|                                       |  | $                   | 28,579 |                       | $ | 529       |  | $                     | 26,257 |           | $ | 755                   |  | $ | 54,836 |  | $ | 1,284
|                                       |  |                     |        |                       |   |           |  |                       |        |           |   |                       |  |   |        |  |   |      

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis,
and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term
prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The securities at a loss for 12 months or more at
December 31, 2006 are in 37 securities, that are insured agencies of the United States Government and the losses can be attributable to changes in interest rates. In addition, there were 2 securities in 2006 that are not insured agencies, but
have either an Aaa or AAA rating with short modified durations. Because the declines in value are not attributed to credit quality and the Company has the ability and intent to hold the securities until a market price recovery or maturity, these
investments are not considered other-than-temporarily impaired.



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Note 3  Securities  Continued

The contractual maturities of securities available-for-sale at December 31, 2006 are shown as follows. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.



|                                       |  |                |        |                    |   |       
|-------------------------------------- |  | -------------- | ------ | ------------------ | - | ------
|                                       |  | AmortizedCost  |        | EstimatedFairValue
|                                       |  | (In thousands)
|Due in one year or less                |  | $              | 11,676 |                    | $ | 11,638
|Due after one year through five years  |  |                | 33,050 |                    |   | 32,537
|Due after five years through ten years |  |                | 3,146  |                    |   | 3,158 
|Due after ten years                    |  |                | 23,840 |                    |   | 24,044
|Equity securities                      |  |                | 3,348  |                    |   | 3,348 
|                                       |  |                |        |                    |   |       
|                                       |  | $              | 75,060 |                    | $ | 74,725
|                                       |  |                |        |                    |   |       

Mortgage-backed securities have been included in the maturity table based upon the guaranteed
payoff date of each security.

Gross realized gains and losses on the sale of securities available-for-sale for each of the three years in
the period ended December 31, 2006, were as follows:



|                      |  |                |   |      |   |      |  |   |   
|--------------------- |  | -------------- | - | ---- | - | ---- |  | - | --
|                      |  | 2006           |   | 2005 |   | 2004
|                      |  | (In thousands)
|Gross realized gains  |  | $              |  |      | $ |     |  | $ |  
|Gross realized losses |  |                |  |      |   |     |  |   | 23

Equity securities include a restricted investment in Federal Home Loan Bank stock, which must be
maintained to secure the available line of credit. The amount of investment in this stock amounted to $2,312,000 and $2,697,600 at December 31, 2006 and 2005, respectively. In addition to the restricted investment in Federal Home Loan Bank, the
Company also had an investment in Federal Home Loan Bank preferred stock with a carrying value of $850,000 and $720,000 at December 31, 2006 and 2005, respectively. Equity securities also include an investment in Appalachian Capital Trust I.
The amount of investment in the trust amounted to $186,000 at December 31, 2006 and 2005.

The carrying value of investment securities
pledged to secure public funds on deposit, securities sold under agreements to repurchase, and for other purposes as required by law amounted to $42,134,460 and $50,687,921 at December 31, 2006 and 2005, respectively.



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Note 4  Loans

The Company grants loans to customers primarily in the North Georgia area. The major classifications of loans as of December 31, 2006 and 2005 were as follows:



|                                       |  |                |         |   |      |   |         |  
|-------------------------------------- |  | -------------- | ------- | - | ---- | - | ------- | -
|                                       |  | 2006           |         |   | 2005 |  
|                                       |  | (In thousands) |        
|Commercial, financial and agricultural |  | $              | 40,491  |   |      | $ | 33,778  |  
|Real estate - construction             |  |                | 320,406 |   |      |   | 203,538 |  
|Real estate - mortgage(1)              |  |                | 241,569 |   |      |   | 193,704 |  
|Consumer                               |  |                | 25,386  |   |      |   | 21,051  |  
|Other loans                            |  |                | 3,934   |   |      |   | 5,347   |  
|                                       |  |                |         |   |      |   |         |  
|                                       |  |                | 631,786 |   |      |   | 457,418 |  
|Allowance for loan losses              |  |                | (7,670  | ) |      |   | (6,059  | )
|                                       |  |                |         |   |      |   |         |  
|Net loans                              |  | $              | 624,116 |   |      | $ | 451,359 |  
|                                       |  |                |         |   |      |   |         |  

---

|(1) | includes loans held for sale in the amounts of $733 and $-0- for the years ended December 31, 2006
and 2005, respectively.
|--- | --------------------------------------------------------------------------------------------------------------------------

Total loans which the Company considered to be impaired at December 31, 2006 and 2005 were
$4,645,796 and $3,543,578, respectively. Of these loans, $2,611,282 and $1,020,030 were on nonaccrual status at December 31, 2006 and 2005, respectively. Allowances on the impaired loans at December 31, 2006 and 2005 were $1,222,904 and
$1,422,509, respectively. Impaired loans consisted primarily of commercial loans and real estatemortgage loans as of December 31, 2006 and 2005. The average recorded investment in impaired loans for the years ended December 31, 2006,
2005 and 2004 was approximately $3,906,000, $3,811,000 and $1,353,000, respectively. No material amount of interest income was recognized on nonaccrual loans for the years ended December 31, 2006, 2005 and 2004. For other impaired loans we
collected approximately $184,000 in interest during each of the years ended December 31, 2006 and 2005, respectively, and $-0- for the year ended December 31, 2004. For the year ended December 31, 2006, the difference between gross
interest income that would have been recorded in such period if the nonaccruing loans had been current in accordance with their original terms and the amount of interest income on those loans that was included in such periods net income was
approximately $115,480. In the year ended December 31, 2005, the amount was approximately $70,000.

The Company has no commitments to
loan additional funds to the borrowers of nonaccrual loans.

At December 31, 2006 and 2005, the Company had loans past due 90 days or
more and still accruing interest of $871,744 and $70,974, respectively.

Commercial and residential real estate loans pledged to secure
Federal Home Loan Bank advances and letters of credit amounted to $72,441,162 and $56,989,366 at December 31, 2006 and 2005, respectively.



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Note 5  Allowance for Loan Losses

Changes in the allowance for loan losses for each of the three years ended December 31, 2006, 2005 and 2004 are as follows:



|                             |  |                |        |   |      |   |       |      |  |   |       |  
|---------------------------- |  | -------------- | ------ | - | ---- | - | ----- | ---- |  | - | ----- | -
|                             |  | 2006           |        |   | 2005 |   |       | 2004 | 
|                             |  | (In thousands) |       
|Balance at beginning of year |  | $              | 6,059  |   |      | $ | 4,349 |      |  | $ | 3,610 |  
|                             |  |                |       
|Charge-offs                  |  |                | (1,826 | ) |      |   | (560  | )    |  |   | (555  | )
|Recoveries                   |  |                | 184    |   |      |   | 59    |      |  |   | 59    |  
|                             |  |                |        |   |      |   |       |      |  |   |       |  
|Net charge-offs              |  |                | (1,642 | ) |      |   | (501  | )    |  |   | (496  | )
|                             |  |                |       
|Provision for loan losses    |  |                | 3,253  |   |      |   | 2,211 |      |  |   | 1,235 |  
|                             |  |                |        |   |      |   |       |      |  |   |       |  
|Balance at end of year       |  | $              | 7,670  |   |      | $ | 6,059 |      |  | $ | 4,349 |  
|                             |  |                |        |   |      |   |       |      |  |   |       |  

Note 6  Premises and Equipment

Premises and Equipment

Premises and equipment were as follows:



|                                                                   |  |                |        |   |      |   |        |  
|------------------------------------------------------------------ |  | -------------- | ------ | - | ---- | - | ------ | -
|                                                                   |  | December 31,   |       
|                                                                   |  | 2006           |        |   | 2005 |  
|                                                                   |  | (In thousands) |       
|Land                                                               |  | $              | 5,129  |   |      | $ | 3,873  |  
|Buildings and improvements                                         |  |                | 13,841 |   |      |   | 6,878  |  
|Furniture and equipment                                            |  |                | 5,710  |   |      |   | 4,130  |  
|Computer equipment and software                                    |  |                | 2,159  |   |      |   | 1,612  |  
|Automobiles                                                        |  |                | 400    |   |      |   | 247    |  
|Construction in progress (estimated cost to complete $7.7 million) |  |                | 1,618  |   |      |   | 4,773  |  
|                                                                   |  |                |        |   |      |   |        |  
|                                                                   |  |                | 28,857 |   |      |   | 21,513 |  
|Allowance for depreciation                                         |  |                | (5,445 | ) |      |   | (4,716 | )
|                                                                   |  |                |        |   |      |   |        |  
|                                                                   |  | $              | 23,412 |   |      | $ | 16,797 |  
|                                                                   |  |                |        |   |      |   |        |  

The provision for depreciation charged to occupancy and furniture and equipment expense for the
years ended December 31, 2006, 2005 and 2004 was $1,006,378, $870,339 and $866,108, respectively.

Leases

The Company has a number of operating lease agreements, involving land, buildings and equipment. These leases are noncancellable and expire on various
dates through the year 2028. The leases provide for renewal options and generally require the Company to pay maintenance, insurance and property taxes. For the years ended December 31, 2006, 2005 and 2004, rental expense for operating leases
was approximately $175,715, $69,684 and $90,248, respectively.



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Note 6  Premises and Equipment  Continued

Future minimum lease payments under noncancellable operating leases at December 31, 2006, are as follows:



|                             |  |  |  |  |  |   |       |                |    
|---------------------------- |  |  |  |  |  | - | ----- | -------------- | ---
|Years Ending December 31,    |  |  |  |  |  |   |       | (In thousands)
|2007                         |  |  |  |  |  |   |       | $              | 124
|2008                         |  |  |  |  |  |   |       |                | 80 
|2009                         |  |  |  |  |  |   |       |                | 39 
|2010                         |  |  |  |  |  |   |       |                | 37 
|2011                         |  |  |  |  |  |   |       |                | 37 
|Thereafter                   |  |  |  |  |  |   |       |                | 746
|                             |  |  |  |  |  |   |       |                |    
|Total minimum lease payments |  |  |  |  |  | $ | 1,063
|                             |  |  |  |  |  |   |       |                |    

Note 7  Deposits

The aggregate amounts of time deposits of $100,000 or more, including certificates of deposit of $100,000 or more at December 31, 2006 and 2005 were $236,627,667 and $125,022,322, respectively. The Company had
brokered time deposits at December 31, 2006 and 2005 of $123,982,411 and $52,587,602, respectively. Demand deposits reclassified as loan balances as of December 31, 2006 and 2005 amounted to $245,601 and $172,599, respectively.

The maturities of time certificates of deposit and other time deposits issued by the Company at December 31, 2006, are as follows:



|                          |  |  |  |  |  |  |  |                |        
|------------------------- |  |  |  |  |  |  |  | -------------- | -------
|Years ending December 31, |  |  |  |  |  |  |  | (In thousands)
|2007                      |  |  |  |  |  |  |  | $              | 369,596
|2008                      |  |  |  |  |  |  |  |                | 21,536 
|2009                      |  |  |  |  |  |  |  |                | 7,531  
|2010                      |  |  |  |  |  |  |  |                | 1,772  
|2011                      |  |  |  |  |  |  |  |                | 913    
|                          |  |  |  |  |  |  |  |                |        
|                          |  |  |  |  |  |  |  | $              | 401,348
|                          |  |  |  |  |  |  |  |                |        

Note 8  Short-term Borrowings

Short-term borrowings at December 31, 2006 and 2005 consist of the following:



|                                               |  |                |       |      |   |       
|---------------------------------------------- |  | -------------- | ----- | ---- | - | ------
|                                               |  | 2006           |       | 2005
|                                               |  | (In thousands)
|Federal funds purchased                        |  | $              |      |      | $ | 7,217 
|Securities sold under agreements to repurchase |  |                | 4,738 |      |   | 3,675 
|FHLB line of credit                            |  |                |      |      |   | 14,000
|                                               |  |                |       |      |   |       
|                                               |  | $              | 4,738 |      | $ | 24,892
|                                               |  |                |       |      |   |       



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Note 8  Short-term Borrowings  Continued

Securities sold under repurchase agreements, which are secured borrowings, generally mature within one to ninety days from the transaction date.
Securities sold under repurchase agreements are reflected at the amount of cash received in connection with the transaction. The Company may be required to provide additional collateral based on the fair value of the underlying securities. The
Company monitors the fair value of the underlying securities on a daily basis.

Note 9  Federal Home Loan Bank Advances

At December 31, 2006 and 2005, the Company had advances from the Federal Home Loan Bank (FHLB) totaling $25,050,000 and $24,950,000, respectively.
These advances do not include the FHLB line of credit balances included in short-term borrowings in the previous note.

FHLB advances consist of the
following at December 31:



|                                                                                                                                                                                        |  |                |        |      |   |       
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------ | ---- | - | ------
|                                                                                                                                                                                        |  | 2006           |        | 2005
|                                                                                                                                                                                        |  | (In thousands)
|Notes payable on line of credit at FHLB, with varying maturities from March 2007 through January 2016, interest rates varying from 3.26% to
6.77%, and secured by residential mortgages |  | $              | 25,050 |      | $ | 24,950
|                                                                                                                                                                                        |  |                |        |      |   |       

The maturities of FHLB advances at December 31, 2006, are as follows:



|                          |  |  |  |  |  |  |  |                |       |             |   |       
|------------------------- |  |  |  |  |  |  |  | -------------- | ----- | ----------- | - | ------
|Years ending December 31, |  |  |  |  |  |  |  | Fixed          |       | Convertible
|                          |  |  |  |  |  |  |  | (In thousands)
|2007                      |  |  |  |  |  |  |  | $              | 7,300 |             | $ |      
|2008                      |  |  |  |  |  |  |  |                | 750   |             |   |      
|2009                      |  |  |  |  |  |  |  |                |      |             |   |      
|2010                      |  |  |  |  |  |  |  |                |      |             |   |      
|2011                      |  |  |  |  |  |  |  |                |      |             |   |      
|Thereafter                |  |  |  |  |  |  |  |                |      |             |   | 17,000
|                          |  |  |  |  |  |  |  |                |       |             |   |       
|                          |  |  |  |  |  |  |  | $              | 8,050 |             | $ | 17,000
|                          |  |  |  |  |  |  |  |                |       |             |   |       

Note 10  Subordinated Long-term Capital Notes

On August 28, 2003, Appalachian Capital Trust I (the Trust), a Delaware statutory trust established by the Company, received $6,000,000
principal amount of the Trusts floating rate cumulative trust preferred securities (the Trust Preferred Securities) in a trust preferred private placement. The proceeds of that transaction were then used by the Trust to purchase an
equal amount of floating rate-subordinated debentures (the Subordinated Debentures) of the Company. The Company has fully and unconditionally guaranteed all obligations of the Trust on a subordinated basis with respect to the Trust
Preferred Securities. The Company accounts for the Trust Preferred Securities as a long-term debt liability to the Trust in the amount of $6,186,000. Interest only is payable quarterly at a variable per annum rate of interest, reset quarterly, equal
to LIBOR plus 3.00% until the debt becomes due on August 8, 2033. The interest rate on the Trust Preferred liability at December 31, 2006 and 2005 was 8.37% and 7.25%, respectively. Subject to certain limitations, the Trust Preferred
Securities qualify as Tier 1 capital.

The sole asset of the Trust is the Subordinated Debentures issued by the Company. Both the Trust
Preferred Securities and the Subordinated Debentures have stated 30-year lives. However, both the Company and the Trust have options to call their respective securities after five years, subject to regulatory capital requirements.



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Note 11  Other Operating Expenses

Other operating expenses consist of the following:



|                          |  |                          |       |      |   |       |  |   |      
|------------------------- |  | ------------------------ | ----- | ---- | - | ----- |  | - | -----
|                          |  | Years ended December 31,
|                          |  | 2006                     |       | 2005 |   | 2004 
|                          |  | (In thousands)          
|Advertising               |  | $                        | 882   |      | $ | 510   |  | $ | 355  
|Data processing           |  |                          | 776   |      |   | 653   |  |   | 537  
|Professional fees         |  |                          | 665   |      |   | 1,275 |  |   | 987  
|Marketing and promotional |  |                          | 614   |      |   | 535   |  |   | 427  
|Director & committee fees |  |                          | 608   |      |   | 532   |  |   | 427  
|Stationary and supplies   |  |                          | 531   |      |   | 321   |  |   | 368  
|Other                     |  |                          | 2,459 |      |   | 1,757 |  |   | 1,898
|                          |  |                          |       |      |   |       |  |   |      
|                          |  | $                        | 6,535 |      | $ | 5,583 |  | $ | 4,999
|                          |  |                          |       |      |   |       |  |   |      

Note 12  Income Taxes

The components of income tax expense for the years ended December 31, 2006, 2005 and 2004 are as follows:



|         |  |                |       |   |      |   |       |      |  |   |       |  
|-------- |  | -------------- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | -
|         |  | 2006           |       |   | 2005 |   |       | 2004 | 
|         |  | (In thousands) |      
|Current  |  |                |       |   |      |   |       |      |  |   |       |  
|Federal  |  | $              | 2,886 |   |      | $ | 2,906 |      |  | $ | 1,718 |  
|State    |  |                | 468   |   |      |   | 401   |      |  |   | 189   |  
|         |  |                |      
|Deferred |  |                |       |   |      |   |       |      |  |   |       |  
|Federal  |  |                | (343  | ) |      |   | (738  | )    |  |   | (18   | )
|State    |  |                | (159  | ) |      |   | (67   | )    |  |   | (4    | )
|         |  |                |       |   |      |   |       |      |  |   |       |  
|         |  | $              | 2,852 |   |      | $ | 2,502 |      |  | $ | 1,885 |  
|         |  |                |       |   |      |   |       |      |  |   |       |  

The principal reasons for the difference in the effective tax rate and the federal statutory rate
are as follows for the years ended December 31, 2006, 2005 and 2004.



|                                     |  |      |   |  |      |   |  |      |  
|------------------------------------ |  | ---- | - |  | ---- | - |  | ---- | -
|                                     |  | 2006 |   |  | 2005 |   |  | 2004 |  
|Statutory federal income tax rate    |  | 34.0 | % |  | 34.0 | % |  | 34.0 | %
|                                     |  |      |  
|Effect on rate of:                   |  |      |   |  |      |   |  |      |  
|Tax-exempt securities                |  | (2.6 | ) |  | (2.9 | ) |  | (3.7 | )
|Tax-exempt loans                     |  | (0.2 | ) |  | (0.1 | ) |  | (0.2 | )
|Interest expense disallowance        |  | 0.4  |   |  | 0.3  |   |  | 0.3  |  
|State income tax, net of federal tax |  | 2.3  |   |  | 2.9  |   |  | 2.1  |  
|Other                                |  | (1.7 | ) |  | (1.4 | ) |  | (0.7 | )
|                                     |  |      |   |  |      |   |  |      |  
|Effective income tax rate            |  | 32.2 | % |  | 32.8 | % |  | 31.8 | %
|                                     |  |      |   |  |      |   |  |      |  



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Note 12  Income Taxes  Continued

The tax effects of each type of income and expense item that gave rise to deferred taxes are:



|                                                      |  |                |       |   |      |   |       |  
|----------------------------------------------------- |  | -------------- | ----- | - | ---- | - | ----- | -
|                                                      |  | 2006           |       |   | 2005 |  
|                                                      |  | (In thousands) |      
|Net unrealized gains on securities available-for-sale |  | $              | 114   |   |      | $ | 241   |  
|Depreciation                                          |  |                | (737  | ) |      |   | (521  | )
|Allowance for loan losses                             |  |                | 2,450 |   |      |   | 1,847 |  
|Deferred compensation                                 |  |                | 338   |   |      |   | 207   |  
|Other                                                 |  |                | 112   |   |      |   | 1     |  
|                                                      |  |                |       |   |      |   |       |  
|                                                      |  | $              | 2,277 |   |      | $ | 1,775 |  
|                                                      |  |                |       |   |      |   |       |  

Note 13  Commitments and Contingencies

In the normal course of business, the Bank offers a variety of financial products to its customers to aid them in meeting their requirements for
liquidity, credit enhancement, and interest rate protection. Generally accepted accounting principles recognize these transactions as contingent liabilities and, accordingly, they are not reflected in the consolidated financial statements.
Commitments to extend credit, credit card arrangements, commercial letters of credit, and standby letters of credit all include exposure to some credit loss in the event of nonperformance of the customer. The Bank uses the same credit policies and
underwriting procedures for making off-balance sheet credit commitments and financial guarantees as it does for on-balance sheet extensions of credit. Because these instruments have fixed maturity dates, and because many of them expire without being
drawn upon, they do not generally present any significant liquidity risk to the Bank. Management does not anticipate any material losses as a result of these commitments.

Following is a discussion of these commitments:

Standby Letters of Credit: These agreements are used
by the Banks customers as a means of improving their credit standings in their dealings with others. Under these agreements, the Bank agrees to honor certain financial commitments in the event that its customers are unable to do so. The amount
of credit risk involved in issuing letters of credit in the event of nonperformance by the other party is the contract amount. As of December 31, 2006 and 2005, the Bank has issued standby letters of credit of approximately $10,723,000 and
$3,491,000. When significant, we record a liability for the estimated fair value of standby letters of credit based on the fees charged.

Loan Commitments: As of December 31, 2006 and 2005, the Bank had commitments outstanding to extend credit totaling approximately $107,671,000 and $73,363,000, respectively. These commitments generally require the customers to
maintain certain credit standards. Management does not anticipate any material losses as a result of these commitments.

Litigation:
The Company is party to litigation and claims arising in the normal course of business. Management believes that the liabilities, if any, arising from such litigation and claims are not material to the consolidated financial statements.

Note 14  Concentrations of Credit

Substantially all of the Banks loans, commitments and standby letters of credit have been granted to customers in the Banks market area. The concentrations of credit by type of loan are set forth in Note 4 and includes a
concentration on loans secured by real estate. The commitments to extend credit relate primarily to unused real estate draw lines. Commercial and standby letters of credit were granted primarily to commercial borrowers.



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Note 15  Stock Based Compensation

The Company has a 1997 Employee Stock Incentive Plan, a 1997 Directors Nonqualified Stock Option Plan and a 2003 Stock Option Plan under which it
has granted statutory and nonstatutory stock options to certain directors and employees. The options granted provide for these directors and employees the opportunity to purchase shares of the Companys $0.01 par value common stock at the
market value at the dates of grant. The options granted may be exercised within ten years from the date of grant subject to vesting requirements.

The Companys 1997 Employee Stock Incentive Plan and the 1997 Directors Nonqualified Stock Option Plan (the 1997 Plan), which are shareholder approved, permits the grant of stock options to its employees and directors
for up to 440,000 shares of common stock from each of these plans. Option awards are generally granted with an exercise price equal to the market price of the Companys stock at the date of grant; those option awards generally vest based on
five years of continuous service and have ten-year contractual terms. At its discretion, the Board may provide in any stock option agreement under the 1997 Plan (or in an amendment thereto) that in the event of a change in control, any outstanding
options covered by such an agreement shall be fully vested, nonforfeitable and become exercisable as of the date of the change in control. There were no shares available under the 1997 Plan for future stock option grants at December 31, 2006.

The Companys 2003 Stock Option Plan (the 2003 Plan), which is shareholder approved, permits the grant of stock options
to its employees and directors for up to 165,000 shares of common stock. Option awards are generally granted with an exercise price equal to the average of the high and low market price of the Companys stock at the date of grant; those option
awards generally vest based on five years of continuous service and have ten-year contractual terms. All options under the 2003 Plan, in the event of a change in control, shall become immediately exercisable and fully vested for a period of 60 days
beginning on the date of the change in control. Shares available for future stock options grants to employees and directors under the 2003 Plan were 12,760 at December 31, 2006.

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option valuation model that uses the assumptions
noted in the following table. Expected volatilities are based on historical volatility of the Companys stock. The Company uses historical data to estimate option exercises, employee terminations and forfeitures within the valuation model;
separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The expected term of options granted is estimated based on the short-cut method. The risk-free rate for periods within the
estimated life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

The following assumptions were used
for the years ended December 31, 2006, 2005, and 2004.



|                                       |  |      |               |   |      |   |               |      |  |   |            |  
|-------------------------------------- |  | ---- | ------------- | - | ---- | - | ------------- | ---- |  | - | ---------- | -
|                                       |  | 2006 |               |   | 2005 |   |               | 2004 | 
|Dividend Yield                         |  |      | 0.00          | % |      |   | 0.00          | %    |  |   | 0.00       | %
|Expected volatility                    |  |      | 15.52  19.21 | % |      |   | 15.84  16.40 | %    |  |   | 21.30      | %
|Risk-free interest rate                |  |      | 4.11  5.03   | % |      |   | 3.96  4.36   | %    |  |   | 4.07       | %
|Forfeiture rate                        |  |      | 10.90         | % |      |   | 10.90         | %    |  |   | 10.90      | %
|Expected life of options (in years)    |  |      | 7.50 years    |   |      |   | 7.50 years    |      |  |   | 7.50 years |  
|Weighted-average grant-date fair value |  | $    | 6.81          |   |      | $ | 4.89          |      |  | $ | 3.79       |  



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Note 15  Stock Based Compensation  Continued

The following table represents stock option activity for the year ended December 31, 2006.



|                                 |  |         |   |  |                               |       |                                             |      |                               |   |      
|-------------------------------- |  | ------- | - |  | ----------------------------- | ----- | ------------------------------------------- | ---- | ----------------------------- | - | -----
|                                 |  | Shares  |   |  | WeightedAverageExercise Price |       | WeightedAverageRemainingContractLife(Years) |      | AggregateIntrinsicValue($000)
|Outstanding at January 1, 2006   |  | 293,975 |   |  | $                             | 7.55  |                                             |      |                               |   |      
|Granted                          |  | 215,300 |   |  |                               | 19.67 |                                             |      |                               |   |      
|Exercised                        |  | (52,600 | ) |  |                               | 6.78  |                                             |      |                               |   |      
|Forfeited                        |  |        |   |  |                               | 0.00  |                                             |      |                               |   |      
|                                 |  |         |   |  |                               |       |                                             |      |                               |   |      
|Outstanding at December 31, 2006 |  | 456,675 |   |  | $                             | 13.35 |                                             | 5.80 |                               | $ | 2,695
|                                 |  |         |   |  |                               |       |                                             |      |                               |   |      
|Exercisable at December 31, 2006 |  | 209,525 |   |  | $                             | 6.47  |                                             | 2.19 |                               | $ | 2,678
|                                 |  |         |   |  |                               |       |                                             |      |                               |   |      

Total intrinsic value of options exercised was $788,574, $1,027,164 and $818,591 for the years
ended December 31, 2006, 2005 and 2004, respectively. The total fair value of options vested during the years ended December 31, 2006, 2005 and 2004 was $79,005, $50,566 and $84,754, respectively.

The compensation cost charged against income for the years ended December 31, 2006, 2005, and 2004 was $204,392, $18,745 and $42,301, respectively.
Income tax benefits recognized for the respective years were $27,557, $-0- and $5,166.

Cash received from the exercise of options was
$356,545 for the year ended December 31, 2006. The tax benefit realized for the tax deductions from the option exercise of the share-based payment arrangements totaled $88,459 for the year ended December 31, 2006.

As of December 31, 2006, there was $1,338,334 of total unrecognized compensation cost related to the nonvested share-based compensation arrangements
granted under the option plan. That cost is expected to be recognized over a weighted-average period of 4.22 years.

Note 16  Regulatory Matters

The board of directors of any state-chartered bank in Georgia may declare and pay cash dividends on its outstanding capital stock without any request
for approval of the Banks regulatory agency if the following conditions are met:



|1. | Total classified assets at the most recent examination of the Bank do not exceed 80% of equity capital.
|-- | -------------------------------------------------------------------------------------------------------



|2. | The aggregate amount of dividends declared in the calendar year does not exceed 50% of the prior years net income.
|-- | -------------------------------------------------------------------------------------------------------------------



|3. | The ratio of equity capital to adjusted assets shall not be less than 6%.
|-- | -------------------------------------------------------------------------

As of December 31, 2006, the Bank could declare dividends of approximately $3,567,000 without regulatory consent, subject to the Banks compliance with regulatory capital restrictions. It is anticipated that any such dividends
would be used for the payment of long-term debt service.



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Note 16  Regulatory Matters  Continued

The Company and the Bank are subject to various regulatory capital requirements administered by the federal 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 Company and the Bank and the consolidated financial statements. Under capital adequacy guidelines and the regulatory framework from
prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The
Banks capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

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

As of December 31, 2006, the most recent notification from the applicable regulatory agencies categorized the Bank as well capitalized under the
regulatory framework for prompt corrective action. To become well capitalized the Bank must maintain minimum Total Capital, Tier 1 Capital and Tier 1 Leverage ratios as set forth in the following table. Prompt corrective action provisions are not
applicable to bank holding companies.

The Companys and Banks actual capital amounts and ratios are also presented in the table.



|                           |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|-------------------------- |  | ---------------------- | ------ | ----- | ---------------------------- | - | ------ | ------------------------------------------------------------- | ------ |  | ---- | ------ |  | ----- | ------ |  | ----- | -
|                           |  | Actual                 |        |       | For CapitalAdequacy Purposes |   |        | To be WellCapitalized UnderPrompt CorrectiveAction Provisions |       
|                           |  | Amount                 |        | Ratio |                              |   | Amount |                                                               | Ratio  |  |      | Amount |  | Ratio |       
|                           |  | (Dollars in thousands) |       
|As of December 31, 2006:   |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Total Capital              |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Consolidated               |  | $                      | 78,400 |       | 11.85                        | % |        | $                                                             | 52,914 |  | 8.00 | %      |  | $     | N/A    |  | N/A   | %
|Appalachian Community Bank |  |                        | 67,270 |       | 10.18                        |   |        |                                                               | 52,874 |  | 8.00 |        |  |       | 66,093 |  | 10.00 |  
|Tier 1 Capital             |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Consolidated               |  |                        | 70,730 |       | 10.69                        |   |        |                                                               | 26,457 |  | 4.00 |        |  |       | N/A    |  | N/A   |  
|Appalachian Community Bank |  |                        | 59,600 |       | 9.02                         |   |        |                                                               | 26,437 |  | 4.00 |        |  |       | 39,656 |  | 6.00  |  
|Tier 1 Leverage            |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Consolidated               |  |                        | 70,730 |       | 9.55                         |   |        |                                                               | 29,618 |  | 4.00 |        |  |       | N/A    |  | N/A   |  
|Appalachian Community Bank |  |                        | 59,600 |       | 8.06                         |   |        |                                                               | 29,593 |  | 4.00 |        |  |       | 36,992 |  | 5.00  |  
|                           |  |                        |        |       |                              |  
|As of December 31, 2005:   |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Total Capital              |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Consolidated               |  | $                      | 70,358 |       | 14.52                        | % |        | $                                                             | 38,766 |  | 8.00 | %      |  | $     | N/A    |  | N/A   |  
|Appalachian Community Bank |  |                        | 52,819 |       | 10.91                        |   |        |                                                               | 38,744 |  | 8.00 |        |  |       | 48,430 |  | 10.00 | %
|Tier 1 Capital             |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Consolidated               |  |                        | 64,301 |       | 13.27                        |   |        |                                                               | 19,383 |  | 4.00 |        |  |       | N/A    |  | N/A   |  
|Appalachian Community Bank |  |                        | 46,765 |       | 9.66                         |   |        |                                                               | 19,372 |  | 4.00 |        |  |       | 29,058 |  | 6.00  |  
|Tier 1 Leverage            |  |                        |        |       |                              |   |        |                                                               |        |  |      |        |  |       |        |  |       |  
|Consolidated               |  |                        | 64,301 |       | 11.35                        |   |        |                                                               | 22,652 |  | 4.00 |        |  |       | N/A    |  | N/A   |  
|Appalachian Community Bank |  |                        | 46,765 |       | 8.26                         |   |        |                                                               | 22,637 |  | 4.00 |        |  |       | 28,296 |  | 5.00  |  



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Note 17  Employee Benefit Plan

The Company adopted a defined contribution plan covering substantially all employees; that is qualified under Section 401(k) of the Internal Revenue Code. Under the provisions of the plan, eligible participating
employees may elect to contribute up to the maximum amount of tax deferred contribution allowed by the Internal Revenue Code. Employer and employee contributions may be made in the form of cash or Company stock. The Companys contribution to
the plan is determined by its board of directors. The Company made discretionary cash contributions to the plan of approximately $563,518 in 2006, $472,200 in 2005 and $313,200 in 2004.

The Company has various deferred compensation plans providing for death and retirement benefits for certain officers and directors. Expenses recognized for the years ended December 31, 2006, 2005, and 2004
related to these plans were $336,946, $277,426 and $97,653, respectively. The estimated amounts to be paid under the compensation plan have been partially provided for through the purchase of life insurance policies on certain officers and
directors. Accrued deferred compensation of $900,848, and $575,667 is included in other liabilities as of December 31, 2006 and 2005, respectively. Cash surrender values of $8,438,378 and $8,142,533 on the insurance policies is included in
other assets at December 31, 2006 and 2005, respectively.

Note 18  Related Party Transactions

Loans: Certain directors, executive officers and principal shareholders, including their immediate families and associates were loan customers of the Bank during
2006 and 2005. Such loans are made in the ordinary course of business at normal credit terms, including interest rates and collateral and do not represent more than a normal risk of collection. A summary of activity and amounts outstanding are as
follows:



|                             |  |                |        |   |      |   |        |  
|---------------------------- |  | -------------- | ------ | - | ---- | - | ------ | -
|                             |  | 2006           |        |   | 2005 |  
|                             |  | (In thousands) |       
|Balance at Beginning of Year |  | $              | 11,216 |   |      | $ | 15,025 |  
|New loans                    |  |                | 15,007 |   |      |   | 8,396  |  
|Repayments                   |  |                | (8,369 | ) |      |   | (7,938 | )
|Change in related parties    |  |                | (345   | ) |      |   | (4,267 | )
|                             |  |                |        |   |      |   |        |  
|Balance at End of Year       |  | $              | 17,509 |   |      | $ | 11,216 |  
|                             |  |                |        |   |      |   |        |  

Deposits: Deposits held from related parties were $2,667,125 and $2,075,324 at December 31, 2006 and
2005, respectively.

Construction contracts: During 2006 and 2005, the Bank used as a construction contractor, a company owned by one of the
directors of the Company. Amounts paid to this construction contractor in 2006 amounted to $191,158, and amounts paid in 2005 amounted to $469,780, which represented the fair market price for the services provided.

Purchases: The Bank purchases telecommunication, internet, cable and advertising services from a local telecommunications company. One of the directors of the
Company and the Bank, serves as executive vice president and chief operations officer of this telecommunications company. Amounts paid to the telecommunication company in 2006 and 2005 amounted to $458,587 and $231,728, respectively, which
represented the fair market price for the services provided.

Note 19  Fair Value of Financial Instruments

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Short-term Investments: For those short-term instruments, the carrying amount is a reasonable estimate of fair value.



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Note 19  Fair Value of Financial Instruments  Continued

Securities: For securities and marketable equity securities, fair values are based on quoted market prices or dealer quotes. If a quoted market price is not
available, fair value is estimated using quoted market prices for similar securities.

Loans: For certain homogeneous categories of loans, such as
some residential mortgages, credit card receivables, and other consumer loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other
types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Accrued Interest Receivable: The carrying amount of accrued interest receivable approximates its fair value.

Deposits: The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair
value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Accrued
Interest Payable: The carrying amount of accrued interest payable approximates its fair value.

Short-term Borrowings: The fair value of
short-term borrowings, including securities sold under agreements to repurchase, is estimated to be approximately the same as the carrying amount.

FHLB
Advances and Subordinated Debt: Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.

Commitments to Extend Credit, Letters of Credit, and Financial Guarantees Written: The fair value of commitments and letters of credit is estimated to be approximately the fees charged for these arrangements.



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Note 19  Fair Value of Financial Instruments  Continued

The estimated fair values of the Companys financial instruments as of December 31, 2006 and 2005 are as follows:



|                                         |  |                |         |            |   |                |  |            |         |  |   |        
|---------------------------------------- |  | -------------- | ------- | ---------- | - | -------------- |  | ---------- | ------- |  | - | -------
|                                         |  | 2006           |         | 2005      
|                                         |  | CarryingAmount |         | Fair Value |   | CarryingAmount |  | Fair Value
|                                         |  | (In thousands)
|Financial assets                         |  |                |         |            |   |                |  |            |         |  |   |        
|Cash and short-term investments          |  | $              | 11,588  |            | $ | 11,588         |  | $          | 35,336  |  | $ | 35,336 
|Securities                               |  |                | 74,725  |            |   | 74,725         |  |            | 71,570  |  |   | 71,570 
|Loans                                    |  |                | 624,116 |            |   | 622,148        |  |            | 451,359 |  |   | 449,416
|Accrued interest receivable              |  |                | 8,157   |            |   | 8,157          |  |            | 4,751   |  |   | 4,751  
|                                         |  |                |         |            |   |                |  |            |         |  |   |        
|Total Financial Assets                   |  | $              | 718,586 |            | $ | 716,618        |  | $          | 563,016 |  | $ | 561,073
|                                         |  |                |         |            |   |                |  |            |         |  |   |        
|                                         |  |                |         |           
|Financial Liabilities                    |  |                |         |            |   |                |  |            |         |  |   |        
|                                         |  |                |         |           
|Deposits                                 |  | $              | 651,134 |            | $ | 650,745        |  | $          | 473,310 |  | $ | 473,276
|Short-term borrowings                    |  |                | 4,738   |            |   | 4,738          |  |            | 24,892  |  |   | 24,892 
|Accrued interest payable                 |  |                | 1,454   |            |   | 1,454          |  |            | 728     |  |   | 728    
|Long-term debt                           |  |                | 31,236  |            |   | 31,365         |  |            | 31,136  |  |   | 31,157 
|                                         |  |                |         |            |   |                |  |            |         |  |   |        
|Total Financial Liabilities              |  | $              | 688,562 |            | $ | 688,302        |  | $          | 530,066 |  | $ | 530,053
|                                         |  |                |         |            |   |                |  |            |         |  |   |        
|                                         |  |                |         |           
|Unrecognized financial instruments       |  |                |         |            |   |                |  |            |         |  |   |        
|                                         |  |                |         |           
|Commitments to extend credit             |  | $              | 107,671 |            | $ | 624            |  | $          | 73,363  |  | $ | 448    
|Standby letters of credit                |  |                | 10,723  |            |   | 62             |  |            | 3,491   |  |   | 21     
|                                         |  |                |         |            |   |                |  |            |         |  |   |        
|Total Unrecognized Financial Instruments |  | $              | 118,394 |            | $ | 686            |  | $          | 76,854  |  | $ | 469    
|                                         |  |                |         |            |   |                |  |            |         |  |   |        



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Note 20  Condensed Parent Information

Statements of Financial Condition



|                                                                                  |  |                |        |      |   |       
|--------------------------------------------------------------------------------- |  | -------------- | ------ | ---- | - | ------
|                                                                                  |  | December 31,  
|                                                                                  |  | 2006           |        | 2005
|                                                                                  |  | (In thousands)
|Assets                                                                            |  |                |       
|Cash and due from banks                                                           |  | $              | 10,498 |      | $ | 17,291
|Investment in subsidiaries                                                        |  |                | 61,576 |      |   | 48,288
|Securities available for sale                                                     |  |                | 186    |      |   | 186   
|Income taxes receivable                                                           |  |                | 814    |      |   | 533   
|Other assets                                                                      |  |                | 56     |      |   | 91    
|                                                                                  |  |                |        |      |   |       
|Total Assets                                                                      |  | $              | 73,130 |      | $ | 66,389
|                                                                                  |  |                |        |      |   |       
|                                                                                  |  |               
|Liabilities and Shareholders Equity                                              |  |                |        |      |   |       
|Guaranteed preferred beneficial interest in the Companys subordinated debentures |  | $              | 6,186  |      | $ | 6,186 
|Accrued interest payable                                                          |  |                | 75     |      |   | 79    
|Other liabilities                                                                 |  |                | 106    |      |   | 299   
|                                                                                  |  |                |        |      |   |       
|Total Liabilities                                                                 |  |                | 6,367  |      |   | 6,564 
|                                                                                  |  |                |        |      |   |       
|Total Shareholders Equity                                                        |  |                | 66,763 |      |   | 59,825
|                                                                                  |  |                |        |      |   |       
|Total Liabilities and Shareholders Equity                                        |  | $              | 73,130 |      | $ | 66,389
|                                                                                  |  |                |        |      |   |       

Statements of Income



|                                                                                     |  |                          |        |   |      |   |        |      |  |   |        |  
|------------------------------------------------------------------------------------ |  | ------------------------ | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                     |  | Years ended December 31, |       
|                                                                                     |  | 2006                     |        |   | 2005 |   |        | 2004 | 
|                                                                                     |  | (In thousands)           |       
|Income                                                                               |  |                          |        |   |      |   |        |      |  |   |        |  
|Other income                                                                         |  | $                        | 15     |   |      | $ | 11     |      |  | $ | 10     |  
|                                                                                     |  |                          |        |   |      |   |        |      |  |   |        |  
|                                                                                     |  |                          |       
|Expenses                                                                             |  |                          |        |   |      |   |        |      |  |   |        |  
|Interest                                                                             |  |                          | 491    |   |      |   | 404    |      |  |   | 284    |  
|Other expenses                                                                       |  |                          | 1,250  |   |      |   | 1,016  |      |  |   | 756    |  
|                                                                                     |  |                          |        |   |      |   |        |      |  |   |        |  
|                                                                                     |  |                          | 1,741  |   |      |   | 1,420  |      |  |   | 1,040  |  
|                                                                                     |  |                          |        |   |      |   |        |      |  |   |        |  
|Loss before income tax benefits and equity in undistributed earnings of subsidiaries |  |                          | (1,726 | ) |      |   | (1,409 | )    |  |   | (1,030 | )
|Income tax benefits                                                                  |  |                          | 596    |   |      |   | 504    |      |  |   | 366    |  
|                                                                                     |  |                          |        |   |      |   |        |      |  |   |        |  
|Loss before equity in undistributed earnings of subsidiaries                         |  |                          | (1,130 | ) |      |   | (905   | )    |  |   | (664   | )
|                                                                                     |  |                          |       
|Equity in undistributed earnings of subsidiaries                                     |  |                          | 7,134  |   |      |   | 6,027  |      |  |   | 4,711  |  
|                                                                                     |  |                          |        |   |      |   |        |      |  |   |        |  
|Net Income                                                                           |  | $                        | 6,004  |   |      | $ | 5,122  |      |  | $ | 4,047  |  
|                                                                                     |  |                          |        |   |      |   |        |      |  |   |        |  



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Note 20  Condensed Parent Information  Continued

Statements of Cash Flow



|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|------------------------------------------------------------------------------------------ |  | ------------------------ | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                           |  | Years ended December 31, |       
|                                                                                           |  | 2006                     |        |   | 2005 |   |        | 2004 | 
|                                                                                           |  | (In thousands)           |       
|Operating Activities                                                                       |  |                          |        |   |      |   |        |      |  |   |        |  
|Net Income                                                                                 |  | $                        | 6,004  |   |      | $ | 5,122  |      |  | $ | 4,047  |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities |  |                          |        |   |      |   |        |      |  |   |        |  
|Equity in undistributed income of subsidiaries                                             |  |                          | (7,134 | ) |      |   | (6,027 | )    |  |   | (4,710 | )
|Increase (decrease) in accrued interest payable                                            |  |                          | (4     | ) |      |   | 31     |      |  |   | (37    | )
|Compensation associated with issuance of options                                           |  |                          | 48     |   |      |   | 19     |      |  |   | 42     |  
|Excess tax benefits from exercise of stock options                                         |  |                          | (88    | ) |      |   | (254   | )    |  |   | (193   | )
|Other                                                                                      |  |                          | (195   | ) |      |   | 302    |      |  |   | 893    |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Net Cash Provided By (Used In) Operating Activities                                        |  |                          | (1,369 | ) |      |   | (807   | )    |  |   | 42     |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|                                                                                           |  |                          |       
|Investing Activities                                                                       |  |                          |        |   |      |   |        |      |  |   |        |  
|Capital injection in subsidiaries                                                          |  |                          | (5,750 | ) |      |   | (3,500 | )    |  |   |       |  
|Other adjustments to equity capital                                                        |  |                          | (156   | ) |      |   |       |      |  |   |       |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Net Cash Used In Investing Activities                                                      |  |                          | (5,906 | ) |      |   | (3,500 | )    |  |   |       |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|                                                                                           |  |                          |       
|Financing Activities                                                                       |  |                          |        |   |      |   |        |      |  |   |        |  
|Proceeds from issuance of common stock                                                     |  |                          | 394    |   |      |   | 19,193 |      |  |   | 770    |  
|Excess tax benefits from exercise of stock options                                         |  |                          | 88     |   |      |   | 254    |      |  |   | 193    |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Net Cash Provided By Financing Activities                                                  |  |                          | 482    |   |      |   | 19,447 |      |  |   | 963    |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|                                                                                           |  |                          |       
|Net Increase (Decrease) in Cash and Cash Equivalents                                       |  |                          | (6,793 | ) |      |   | 15,140 |      |  |   | 1,005  |  
|                                                                                           |  |                          |       
|Cash & Cash Equivalents at Beginning of Year                                               |  |                          | 17,291 |   |      |   | 2,151  |      |  |   | 1,146  |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Cash and Cash Equivalents at End of Year                                                   |  | $                        | 10,498 |   |      | $ | 17,291 |      |  | $ | 2,151  |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|                                                                                           |  |                          |       
|Cash paid during the year for interest                                                     |  | $                        | 495    |   |      | $ | 374    |      |  | $ | 321    |  
|                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  



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Note 23  Quarterly Results of Operations (Unaudited)

Selected quarterly results of operations for the
four quarters of each of the years ended December 31, 2006 and 2005 are as follows:



|                                                    |  |                                       |        |               |   |              |  |               |        |  |   |       
|--------------------------------------------------- |  | ------------------------------------- | ------ | ------------- | - | ------------ |  | ------------- | ------ |  | - | ------
|                                                    |  | FirstQuarter                          |        | SecondQuarter |   | ThirdQuarter |  | FourthQuarter
|                                                    |  | (In thousands, except per share data)
|2006:                                               |  |                                       |        |               |   |              |  |               |        |  |   |       
|Total interest income                               |  | $                                     | 11,063 |               | $ | 12,513       |  | $             | 14,124 |  | $ | 15,494
|Total interest expense                              |  |                                       | 4,075  |               |   | 5,087        |  |               | 6,188  |  |   | 7,144 
|Provision for loan losses                           |  |                                       | 885    |               |   | 823          |  |               | 751    |  |   | 794   
|Net interest income after provision for loan losses |  |                                       | 6,103  |               |   | 6,603        |  |               | 7,185  |  |   | 7,556 
|Total noninterest income                            |  |                                       | 859    |               |   | 937          |  |               | 1,049  |  |   | 1,125 
|Total noninterest expense                           |  |                                       | 4,586  |               |   | 5,326        |  |               | 6,355  |  |   | 6,294 
|Income tax expense                                  |  |                                       | 841    |               |   | 776          |  |               | 491    |  |   | 744   
|Net income                                          |  | $                                     | 1,535  |               | $ | 1,438        |  | $             | 1,388  |  | $ | 1,643 
|                                                    |  |                                       |        |              
|Per Common Share:                                   |  |                                       |        |               |   |              |  |               |        |  |   |       
|Basic earnings                                      |  | $                                     | 0.30   |               | $ | 0.28         |  | $             | 0.27   |  | $ | 0.32  
|Diluted earnings                                    |  |                                       | 0.29   |               |   | 0.27         |  |               | 0.26   |  |   | 0.31  
|                                                    |  |                                       |        |              
|2005:                                               |  |                                       |        |               |   |              |  |               |        |  |   |       
|Total interest income                               |  | $                                     | 7,233  |               | $ | 8,114        |  | $             | 9,267  |  | $ | 10,135
|Total interest expense                              |  |                                       | 2,332  |               |   | 2,684        |  |               | 3,209  |  |   | 3,653 
|Provision for loan losses                           |  |                                       | 437    |               |   | 492          |  |               | 617    |  |   | 665   
|Net interest income after provision for loan losses |  |                                       | 4,464  |               |   | 4,938        |  |               | 5,441  |  |   | 5,817 
|Total noninterest income                            |  |                                       | 746    |               |   | 783          |  |               | 834    |  |   | 937   
|Total noninterest expense                           |  |                                       | 3,833  |               |   | 3,870        |  |               | 4,191  |  |   | 4,442 
|Income tax expense                                  |  |                                       | 412    |               |   | 591          |  |               | 694    |  |   | 806   
|Net income                                          |  | $                                     | 965    |               | $ | 1,260        |  | $             | 1,390  |  | $ | 1,506 
|                                                    |  |                                       |        |              
|Per Common Share:                                   |  |                                       |        |               |   |              |  |               |        |  |   |       
|Basic earnings                                      |  | $                                     | 0.26   |               | $ | 0.33         |  | $             | 0.36   |  | $ | 0.30  
|Diluted earnings                                    |  |                                       | 0.25   |               |   | 0.32         |  |               | 0.35   |  |   | 0.30  



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

None.



|ITEM 9A. | CONTROLS AND PROCEDURES
|-------- | -----------------------

Our Chief Executive
Officer and Principal Financial Officer have evaluated our disclosure controls and procedures as of the end of the fiscal year covered by this Report and have concluded that our disclosure controls and procedures are effective. During the fourth
quarter of 2006, there were no changes in our internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, the our internal control over financial reporting.



|ITEM 9B. | OTHER INFORMATION
|-------- | -----------------

None.

PART III



|ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
|-------- | ------------------------------------------------------

The information appearing under the headings Election of Directors, Executive Officers, Section 16(a) Beneficial Ownership Reporting Compliance and Corporate Governance and Board Matters in
the Proxy Statement (the 2007 Proxy Statement) relating to our 2007 Annual Meeting of Shareholders is incorporated herein by reference. We have adopted a code of ethics that applies to our Chief Executive Officer and senior financial
officers, a copy of which is filed as Exhibit 14 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2003.



|ITEM 11. | EXECUTIVE COMPENSATION
|-------- | ----------------------

The information appearing
under the heading Compensation of Executive Officers and Directors in the 2007 Proxy Statement is incorporated herein by reference.



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

The information appearing under the heading Ownership of Common Stock in the 2007 Proxy Statement is incorporated herein by reference.



|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
|-------- | -------------------------------------------------------------------------

The information appearing under the caption Certain Relationships and Related Party Transactions in the 2007 Proxy Statement is incorporated herein by reference.



|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------

The
information appearing under the caption Independent Public Accountants in the 2007 Proxy Statement is incorporated herein by reference.



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PART IV



|ITEM 15. | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
|-------- | ------------------------------------------



|    |  |    |  |                                                                                                               
|--- |  | -- |  | --------------------------------------------------------------------------------------------------------------
|(a) |  | 1. |  | Financial Statements.                                                                                         
|    |  |   
|    |  |    |  | The following consolidated financial statements are located in Item 8 of this Report:                         
|    |  |   
|    |  |    |  | Report of Independent Registered Public Accounting Firm                                                       
|    |  |    |  | Report of Independent Registered Public Accounting Firm                                                       
|    |  |    |  | Consolidated Statements of Financial Condition as of December 31, 2006 and 2005                               
|    |  |    |  | Consolidated Statements of Income for the Years Ended December 31, 2006, 2005 and 2004                        
|    |  |    |  | Consolidated Statements of Shareholders Equity for the Years Ended December 31, 2006, 2005 and 2004          
|    |  |    |  | Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004                    
|    |  |    |  | Notes to Consolidated Financial Statements                                                                    
|    |  |    |  | Quarterly Results (Unaudited)                                                                                 
|    |  |   
|    |  | 2. |  | Financial Statement Schedules.                                                                                
|    |  |   
|    |  |    |  | Schedules to the consolidated financial statements are omitted, as the required information is not applicable.
|    |  |   
|    |  | 3. |  | Exhibits.                                                                                                     
|    |  |   
|    |  |    |  | The following exhibits are filed or incorporated by reference as part of this Report:                         



|              |  |                                                                                                                                                                                                            
|------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description of Exhibit                                                                                                                                                                                     
|3.1           |  | Articles of Incorporation of the Company, as Restated (included as Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q, dated August 15, 2003 and incorporated herein by
reference).                
|              | 
|3.2           |  | Bylaws of the Company, as Restated (included as Exhibit 3.2 to the Companys Quarterly Report on Form 10-Q, dated August 15, 2003 and incorporated herein by reference).                                   
|              | 
|4.1           |  | See Exhibits 3.1 and 3.2 for provisions in the Companys Articles of Incorporation and Bylaws defining the rights of holders of the common stock.                                                          
|              | 
|4.2           |  | Form of Certificate of Common Stock (incorporated by reference to Exhibit 4.1 of the Companys Registration Statement on Form S-2, File No. 333-127898).                                                   
|              | 
|10.1          |  | 1997 Directors Non-Qualified Stock Option Plan (included as Exhibit 10.1 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996 and incorporated
herein by reference).*
|              | 
|10.2          |  | 1997 Employee Incentive Stock Incentive Plan (included as Exhibit 10.2 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996 and incorporated herein by
reference).*   



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|              |  |                                                                                                                                                                                                                                                                                                   
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description of Exhibit                                                                                                                                                                                                                                                                            
|10.3          |  | Adoption Agreement for the Appalachian Bancshares, Inc. Employees Savings & Profit Sharing Plan Basic Plan Document and related documents (filed as Exhibit 10.2 to the Plans
Annual Report on Form 11-K for the fiscal year ended December 31, 2001 and incorporated herein by reference).     
|              | 
|10.4          |  | Pentegra Services, Inc. Employees Savings & Profit Sharing Plan Basic Plan Document and related documents (filed as Exhibit 10.2 to the Plans Annual Report on Form 11-K for the
fiscal year ended December 31, 2001 and incorporated herein by reference).                                     
|              | 
|10.5          |  | Form of Deferred Fee Agreement between Gilmer County Bank and certain directors and executive officers, with addendum (filed as Exhibit 10.6 to the Companys Quarterly Report on Form 10-QSB
for the period ended June 30, 1997 and incorporated herein by reference).                           
|              | 
|10.6          |  | Form of Data Processing Agreement by and between Appalachian Community Bank and Fiserv Solutions, Inc., effective as of July 26, 2002 (filed as Exhibit 10.3 to the Companys Quarterly
Report on Form 10-Q for the period ended September 30, 2003 and incorporated herein by reference).        
|              | 
|10.7          |  | 2003 Stock Option Plan (included as Exhibit 10.1 to the Companys Quarterly Report on Form 10-Q for the period ended June 30, 2003 and incorporated herein by reference).*                                                                                                                        
|              | 
|10.8          |  | Form of Stock Option Agreement (included as Exhibit 10.2 to the Companys Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 and incorporated herein by
reference).*                                                                                                               
|              | 
|10.9          |  | Form of Change in Control Agreement for Named Executive Officers (and description of benefits for each Named Executive Officer) (included as Exhibit 10.1 to the Companys Quarterly Report
on Form 10-Q for the quarter ended June 30, 2004 and incorporated herein by reference).*              
|              | 
|10.10         |  | Form of Salary Continuation Agreement for Named Executive Officers (and description of benefits for each Named Executive Officer) (included as Exhibit 10.2 to the Companys Quarterly Report
on Form 10-Q for the quarter ended June 30, 2004 and incorporated herein by reference).*            
|              | 
|10.11         |  | Form of Salary Continuation Agreement for the Directors of Appalachian Community Bank (and description of benefits for each of the Directors) (included as Exhibit 10.3 to the Companys
Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 and incorporated herein by reference).*
|              | 
|10.12         |  | Amended Salary Continuation Agreement dated August 11, 2006 by and among Appalachian Community Bank, Appalachian Bancshares, Inc. and Joseph T. Moss, Jr. (included as Exhibit 10.2 to the
Companys Quarterly Report on Form 10-Q, dated August 11, 2006 and incorporated herein by reference).  



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|              |  |                                                                                                                                                                                                                                                                                             
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description of Exhibit                                                                                                                                                                                                                                                                      
|10.13         |  | Amended Salary Continuation Agreement dated August 11, 2006 by and among Appalachian Community Bank, Appalachian Bancshares, Inc. and Tracy R. Newton (included as Exhibit 10.2 to the
Companys Quarterly Report on Form 10-Q, dated August 11, 2006 and incorporated herein by reference).
|              | 
|14            |  | Code of Ethics for CEO and Senior Financial Officers (included as Exhibit 14 to the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2003 and incorporated herein
by reference).                                                                                 
|              | 
|21            |  | Subsidiaries of the Registrant                                                                                                                                                                                                                                                              
|              | 
|23.1          |  | Consent of Mauldin & Jenkins, LLC                                                                                                                                                                                                                                                           
|              | 
|23.2          |  | Consent of Schauer, Taylor, Cox, Vise & Morgan, P.C.                                                                                                                                                                                                                                        
|              | 
|31.1          |  | Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                                                                             
|              | 
|31.2          |  | Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                                                                         
|              | 
|32            |  | Certifications Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                       

---

|* | The referenced exhibit is a compensatory contract, plan or arrangement.
|- | -----------------------------------------------------------------------



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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, on the 30th day of March 2007.



APPALACHIAN BANCSHARES, INC.By:

/s/ Tracy R. NewtonTracy R. NewtonChief Executive Officer


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



|                                                                                                        |  |  |  |                     
|------------------------------------------------------------------------------------------------------- |  |  |  | --------------------
|/s/ Tracy R. Newton                                                                                     |  |  |  | Date: March 30, 2007
|Tracy R. Newton, Chief Executive                                                                        |  |  |  |                     
|Officer and Director (principal executive officer)                                                      |  |  |  |                     
|                                                                                                        |  | 
|/s/ Joseph T. Moss, Jr.                                                                                 |  |  |  | Date: March 30, 2007
|Joseph T. Moss, Jr., President and Chief Operating Officer (principal accounting and financial officer) |  |  |  |                     
|                                                                                                        |  | 
|/s/ Alan S. Dover                                                                                       |  |  |  | Date: March 30, 2007
|Alan S. Dover, Director                                                                                 |  |  |  |                     
|                                                                                                        |  | 
|/s/ Charles A. Edmondson                                                                                |  |  |  | Date: March 30, 2007
|Charles A. Edmondson, Director                                                                          |  |  |  |                     
|                                                                                                        |  | 
|/s/ Roger E. Futch                                                                                      |  |  |  | Date: March 30, 2007
|Roger E. Futch, Director                                                                                |  |  |  |                     
|                                                                                                        |  | 
|/s/ Joseph C. Hensley                                                                                   |  |  |  | Date: March 30, 2007
|Joseph C. Hensley, Director                                                                             |  |  |  |                     
|                                                                                                        |  | 
|/s/ Frank E. Jones                                                                                      |  |  |  | Date: March 30, 2007
|Frank E. Jones, Director                                                                                |  |  |  |                     
|                                                                                                        |  | 
|/s/ J. Ronald Knight                                                                                    |  |  |  | Date: March 30, 2007
|J. Ronald Knight, Chairman and Director                                                                 |  |  |  |                     
|                                                                                                        |  | 
|/s/ Kenneth D. Warren                                                                                   |  |  |  | Date: March 30, 2007
|Kenneth D. Warren, Director                                                                             |  |  |  |                     



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EXHIBIT INDEX

The following exhibits are filed as part of this report (in addition to those exhibits listed in Item 15 which are filed as a part of this report and incorporated by reference):



|              |  |                                                                                                    
|------------- |  | ---------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description of Exhibit                                                                             
|21            |  | Subsidiaries of the Registrant                                                                     
|              | 
|23.1          |  | Consent of Mauldin & Jenkins, LLC                                                                  
|              | 
|23.2          |  | Consent of Schauer, Taylor, Cox, Vise & Morgan, P.C.                                               
|              | 
|31.1          |  | Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.    
|              | 
|31.2          |  | Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act of 2002.
|              | 
|32            |  | Certifications Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                              



82