**UNITED
                STATES****SECURITIES
                AND EXCHANGE COMMISSION****WASHINGTON,
                D.C. 20549**








**FORM
                10-K**(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, 2005**
              
              **[ 
                 ]****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





**APPALACHIAN
                BANCSHARES, INC.****(Exact
                name of registrant as specified in its
                charter)**





**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**None
            
            None





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




Common
                Stock, $0.01 par value(Title
                of class)




Indicate
                by check mark if the registrant is a well-known seasoned issuer,
                as
                defined in Rule 405 of the Securities Act. Yes  oNo  xIndicate
                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  oNo  xIndicate
                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  xNo  oIndicate
                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.Yeso     No  xIndicate
                by check mark whether the registrant is an accelerated filer (as
                defined
                in Rule 12b-2 of the Exchange Act).
              
              Large
                accelerated filer   o   Accelerated
                filer   o     Non-accelerated
                filer xIndicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange
                Act).     Yeso     No  x













The
                estimated aggregate market value of the Common Stock held by
                non-affiliates of the registrant at June 30, 2005 was $42,074,024.
                This
                calculation is based upon an estimate of the fair market value of
                the
                Common Stock of $16.00 per share, which was the price of the last
                trade of
                which management was aware prior to this date. Although directors
                and
                executive officers of the registrant were assumed to be “affiliates” of
                the registrant for purposes of this calculation, the classification
                is not
                to be interpreted as an admission of such status.
              
              At
                March 14, 2006, there were 5,156,124 shares of the registrant’s common
                stock outstanding.**DOCUMENTS
                INCORPORATED BY REFERENCE**
              
              Part
                III incorporates by reference from the definitive proxy statement
                for the
                Annual Meeting of the Shareholders to be held on May 23,
                2006.














**APPALACHIAN
      BANCSHARES, INC.**





**2005
      Form 10-K Annual Report**





**TABLE
      OF CONTENTS**





**Item
                Number**
              **In
                Form 10-K**
            **Description**
            **Page
                or**
              **Location****Part
                I**Item
                1.
            Business
            1Item
                1A.
            Risk
                Factors
            11Item
                1B.
            Unresolved
                Staff Comments
            15Item
                2.
            Properties
            15Item
                3.
            Legal
                Proceedings
            16Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            16**PART
                II**Item
                5.
            Market
                for the Registrant’s Common Equity, Related Stockholder Mattersand
                Issuer Purchases of Equity Securities
            16Item
                6.
            Selected
                Financial Data
            18Item
                7.
            Management’s
                Discussion and Analysis of Financial Conditionand
                Results of Operation
            20Item
                7A.
            Quantitative
                and Qualitative Disclosures About Market Risk
            39Item
                8.
            Financial
                Statements and Supplementary Data
            39Item
                9.
            Changes
                in and Disagreements with Accountants on Accountingand
                Financial Disclosure
            71Item
                9A.
            Controls
                and Procedures
            71Item
                9B.
            Other
                Information
            71**PART
                III**Item
                10.
            Directors
                and Executive Officers of the Registrant
            71Item
                11.
            Executive
                Compensation
            71Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            71Item
                13.
            Certain
                Relationships and Related Transactions
            71Item
                14.
            Principal
                Accounting Fees and Services
            71**PART
                IV**Item
                15.
            Exhibits,
                Financial Statement Schedules
            72**Signatures**





**PARTI**





**ITEM1.** **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.”





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, 2005, we had total assets of approximately $592.6 million, total
      loans of approximately $457.4 million, total deposits of approximately $473.3
      million and total shareholders’ equity of approximately $59.8 million. Our
      website is located at www.acbanks.net.





During
      the fourth quarter of 2005, we closed the sale of 1,265,000 shares of our common
      stock at $16.00 per share in a firm commitment underwritten offering. We
      received net proceeds of approximately $18.4 million from the offering, after
      deducting underwriting discounts and expenses. Net proceeds from the offering
      are being used for general corporate purposes, including, among other things,
      providing additional capital to our subsidiary, Appalachian Community Bank,
      to
      support asset growth.





**Our
      Market Area**





Our
      market area is located approximately 80 miles north of Atlanta and is primarily
      comprised of Gilmer, Fannin and Union counties. We refer to our market area,
      which borders Tennessee and North Carolina, as “North Georgia”. North Georgia
      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. North Georgia’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.





**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 the
      North Georgia mountains 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 also have plans to expand our market
      presence, either through acquisition or *de
      novo* branching, to other areas of North Georgia and possibly North Carolina and
      Tennessee.


1


**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, 2005, 86.8% of the loans in our loan
      portfolio were secured by real estate. At December 31, 2005, we had total loans
      of $457.4 million, representing 77.2% of our total assets. We have focused
      our
      lending activities primarily on small business owners and residential real
      estate developers. At December 31, 2005, loans to the construction industry
      amounted to $203.5 million, or approximately 44.5% of our total loan portfolio,
      loans to the poultry industry amounted to $21.4 million, or approximately 4.7%
      of our total loan portfolio and loans to the hospitality (hotel/motel) industry
      amounted to $21.4 million, or approximately 4.7% 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. We do not hold any
      of
      these mortgage loans for resale and do not service the mortgages.





*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, 2005, loans secured by real estate
      amounted to $397.2 million, or 86.8%, 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 residential and commercial construction
                loans to builders and developers and to consumers wishing to build
                their
                own homes. The duration of our construction and development loans
                generally is limited to 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:





o
            cost
                overruns;





o
            mismanaged
                construction;





o
            inferior
                or improper construction techniques;





o
            economic
                changes or downturns during construction;


2





o
            a
                downturn in the real estate market;





o
            rising
                interest rates which may prevent sale of the property; and





o
            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, 2005, total
      construction and development loans amounted to $203.5 million, or 44.5% of
      our
      loan portfolio. Of this amount, commercial construction loans represented $37.9
      million, or 8.3% of our loan portfolio, and residential construction loans
      totaled $165.6 million, or 36.2% 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, 2005, commercial real estate loans (other than commercial
                construction loans) amounted to $109.3 million, or approximately
                23.9% of
                our loan portfolio.





·
            *Residential
                Real Estate Loans.*At
                December 31, 2005, 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. At December 31, 2005, total residential real estate loans
                amounted
                to $84.4 million, or 18.5% of our loan portfolio. Of this amount,
                loans
                secured by one-to-four family residences totaled $74.6 million, or
                16.3%
                of our loan portfolio, and loans secured by multi-family residences
                totaled $9.9 million, or 2.2% 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, 2005, commercial business loans
      amounted to $33.8 million, or 7.4% 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 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,
      2005, consumer loans amounted to $21.1 million, or 4.6% 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


3


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, which ranges from
      $5,000 to $500,000, the loan request will be considered by an officer with
      a
      higher lending limit or by the officers’ loan committee. The members of our
      officers’ loan committee can approve loans up to $1.0 million. If a loan 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. The credit administration group also supervises loan and
      processing functions.





*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, 2005, our
      legal lending limits were approximately $7.3 million for secured loans and
      $4.4
      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, 2005, we had participations
      totaling $22.2 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.





**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.


4


As
      of
      June 30, 2005, the most recent date for deposit data complied by the Federal
      Deposit Insurance Corporation (“FDIC”), one locally owned bank and three
      non-locally-owned banks had offices in Gilmer County, two locally-owned banks
      and one non-locally-owned bank had offices in Union County, and five
      non-locally-owned banks had offices in Fannin 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.





**Market
      Share**





As
      of
      June 30, 2005, according to the most recent data compiled by the FDIC, our
      market area had total deposits of approximately $1.79 billion, which represented
      a 5% deposit increase from 2004. As of June 30, 2005, we had over 55% market
      share in Gilmer County, a 15% share in Fannin County and an 8% share in Union
      County.





**Employees**





As
      of
      December 31, 2005, we had 157 full-time employees and 15 part-time
      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. 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**





Both
      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.





5


**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 Federal Reserve and Georgia Department of Banking
      and
      Finance will also regularly examine us and may examine our bank or other
      subsidiaries.





**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%.





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.


6


**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.





**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. A major portion of our revenue
      results from amounts paid as dividends to us 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%.


7


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 range from 0 to 27 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.





**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.


8


**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.





**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.


9


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.





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’


10


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.





**ITEM1A. 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 and
      Fannin counties. 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. Given our heavy reliance on
      real estate lending, this could have a significant adverse affect on our
      business.


11


***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.





***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.


12


***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.





***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. On December 6, 2005, Darren M. Cantlay,
      our
      chief financial officer, resigned from the company and the bank. 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.





***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.


13


***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.





***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.





***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, by December 31,
      2007, we will be required to comply with Section 404 of the Sarbanes-Oxley
      Act
      and 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, or if we are unable to receive a positive
      attestation from our independent registered public accounting firm with respect
      to our internal control over financial reporting, 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.


14


**ITEM
      1B. UNRESOLVED STAFF
      COMMENTS**





Not
      applicable.





**ITEM2.** **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. The office and operations center is
      located on approximately 6.3 acres of land that we purchased in 2004 for
      $752,000. We constructed a 39,000 square foot building on this site, as well
      as
      a maintenance building and a community building to use as a meeting area for
      our
      employees and for our customers. We incurred construction costs of approximately
      $4.8 million as of December 31, 2005 and we expect to incur another $1.5 million
      prior to completion. These costs include furniture, fixtures and equipment,
      and
      were paid out of earnings and from the proceeds of our public stock offering.





The
      bank’s main office, which we own, is located at 829 Industrial Boulevard,
      Ellijay, directly across the street from our headquarters and operations center.
      This office operates under the tradename “Gilmer County Bank.” Adjacent to this
      location, we have constructed a community building on property that we lease
      from the United States Postal Service. We use this building for meeting space
      and allow our customers to use it for various community functions. We pay annual
      rent of $600 for this adjacent property under a lease that is up for renewal
      in
      2006. We plan to renew this lease.





In
      addition to our main bank office, we operate three branches. Our Union County
      branch is located on Highway 515 in Blairsville, Georgia. The building is owned
      by the bank. The second floor of this location is vacant and may be used by
      the
      bank for future expansion. Our branch in East Ellijay, Georgia, which is located
      at 696 First Avenue, operates under the trade name “Gilmer County Bank”. We have
      a long-term lease for this location in which the rent increases 2% annually.
      In
      2005, we paid $32,485 in annual rent. Our Fannin County branch, which we own,
      is
      located at 150 Orvin Lance Connector, in Blue Ridge, Georgia. There is also
      a
      community building at this location that is available for the bank to use as
      a
      meeting area, as well as for our customers to use for various community
      functions. The buildings sit on approximately 2.6 acres that we also
      own.





We
      also
      own a building located at 9 Russell Drive, 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. At this time, we are seeking new
      tenants until the building can be sold. 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
      own
      additional property in East Ellijay that will be used for a new branch office.
      An ATM has been placed at this location. The property consists of approximately
      2 acres located on Highway 515 South in the new Highland Crossing Shopping
      Center, which has a Super Wal-Mart, Lowe’s Home Improvement Warehouse and an
      additional 90,000 square feet of shops and restaurants.





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





15


**ITEM3.** **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.





**ITEM4.** **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.





**PARTII**





**ITEM5.**
            **MARKET
                FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER****MATTERS
                AND ISSUER PURCHASES OF EQUITY
                SECURITIES**





On
      October 6, 2005, our c ommon
      stock commenced trading on the Nasdaq National 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 3, 2006, we had approximately
      1,364 shareholders of record.





The
      following table shows the reported high and low sales prices reported by
      management for 2004 and the first two quarters of 2005, the reported high and
      low bid information reported on the OTC Bulletin Board for the second quarter
      of
      2005, and the high and low sales prices reported by the Nasdaq National Market
      for the third and fourth quarters of 2005. 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 ShareHigh
            
            LowYear
                End 2005:First
                Quarter
            
            $
            16.50
            
            $
            15.00Second
                Quarter
            
            
            16.78
            
            
            15.50Third
                Quarter
            
            
            17.50
            
            
            16.00Fourth
                Quarter
            
            
            18.50
            
            
            16.00Year
                End 2004:First
                Quarter
            
            $
            15.00
            
            $
            14.50Second
                Quarter
            
            
            15.00
            
            
            15.00Third
                Quarter
            
            
            16.00
            
            
            16.00Fourth
                Quarter
            
            
            17.00
            
            
            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.”


16


The
      following table provides information as of December 31, 2005 regarding our
      three
      equity compensation plans: the 1997 Employee Stock Incentive Plan, the 1997
      Directors’ Non-Qualified Stock Option Plan and the 2003 Stock Option Plan, each
      of which has been approved by our shareholders.





**Plan
                category**
            
            **(a)**
              **Number
                of securities**
              **to
                be issued upon**
              **exercise**
              **of
                outstanding**
              **options,
                warrants**
              **and
                rights**
            
            **(b)**
              **Weighted-average**
              **exercise
                price of**
              **outstanding**
              **options,**
              **warrants
                and**
              **rights**
            
            **(c)**
              **Number
                of securities**
              **remaining
                available for**
              **future
                issuance under**
              **equity
                compensation**
              **plans
                (excluding securities**
              **reflected
                in column (a))**Equity
                compensation plans approved by security holders
            
            293,975
            
            $7.55
            
            228,060Equity
                compensation plans not approved by security holders
            
            -
            
            -
            
            -Total
            
            293,975
            
            $7.55
            
            228,060





17


**ITEM6.** **SELECTED
      FINANCIAL DATA** ****





Our
      selected consolidated financial data presented below as of and for the years
      ended December 31, 2001 through 2005 is derived from our audited consolidated
      financial statements. Our audited consolidated financial statements as of
      December 31, 2004 and 2005 and for each of the years in the three year period
      ended December 31, 2005 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 31,2005
            
            2004
            
            2003
            
            2002
            
            2001(In
                thousands, except per share data and ratios)**Selected
                Balance Sheet Data:**Assets
            
            $
            592,606
            
            $
            472,811
            
            $
            409,617
            
            $
            384,024
            
            $
            319,679Investment
                securities
            
            
            71,570
            
            
            64,655
            
            
            55,363
            
            
            40,375
            
            
            49,394Loans
            
            
            457,418
            
            
            377,352
            
            
            332,307
            
            
            298,063
            
            
            250,569Allowance
                for loan losses
            
            
            6,059
            
            
            4,349
            
            
            3,610
            
            
            3,238
            
            
            2,995Deposits
            
            
            473,310
            
            
            381,498
            
            
            332,919
            
            
            316,283
            
            
            264,028Short-term
                borrowings
            
            
            24,892
            
            
            15,470
            
            
            12,086
            
            
            5,929
            
            
            3,665Accrued
                interest
            
            
            728
            
            
            540
            
            
            671
            
            
            976
            
            
            1,267Long-term
                debt
            
            
            24,950
            
            
            31,950
            
            
            25,693
            
            
            34,736
            
            
            29,654Subordinated
                long-term capital notes
            
            
            6,186
            
            
            6,186
            
            
            6,186
            
            
            --
            
            
            --Other
                liabilities
            
            
            2,715
            
            
            1,084
            
            
            981
            
            
            482
            
            
            475Shareholders’
                equity
            
            
            59,825
            
            
            36,083
            
            
            31,082
            
            
            25,619
            
            
            20,591**Selected
                Results of Operations Data:**Interest
                income
            
            $
            34,750
            
            $
            25,736
            
            $
            23,090
            
            $
            22,892
            
            $
            23,890Interest
                expense
            
            
            11,880
            
            
            7,558
            
            
            8,257
            
            
            11,425
            
            
            13,675Net
                interest income
            
            
            22,870
            
            
            18,178
            
            
            14,833
            
            
            11,467
            
            
            10,215Provision
                for loan losses
            
            
            2,211
            
            
            1,235
            
            
            1,465
            
            
            1,028
            
            
            1,294Net
                interest income after provision forprovision
                for loan losses
            
            
            20,659
            
            
            16,943
            
            
            13,368
            
            
            10,439
            
            
            8,921Noninterest
                income
            
            
            3,303
            
            
            2,829
            
            
            2,703
            
            
            2,937
            
            
            2,411Noninterest
                expense
            
            
            16,338
            
            
            13,840
            
            
            11,732
            
            
            9,702
            
            
            7,831Income
                before taxes
            
            
            7,624
            
            
            5,932
            
            
            4,339
            
            
            3,674
            
            
            3,501Income
                tax expense
            
            
            2,502
            
            
            1,885
            
            
            1,253
            
            
            1,006
            
            
            963Net
                income
            
            $
            5,122
            
            $
            4,047
            
            $
            3,086
            
            $
            2,668
            
            $
            2,538**Per
                Share Data**Net
                income - basic
            
            $
            1.24
            
            $
            1.09
            
            $
            0.86
            
            $
            0.81
            
            $
            0.81Net
                income - diluted
            
            
            1.21
            
            
            1.04
            
            
            0.81
            
            
            0.76
            
            
            0.75Book
                value
            
            
            11.62
            
            
            9.58
            
            
            8.49
            
            
            7.45
            
            
            6.50Cash
                dividends declared per common share
            
            
            0.00
            
            
            0.00
            
            
            0.00
            
            
            0.00
            
            
            0.00Weighted
                average number of sharesoutstanding:Basic
            
            
            4,123,403
            
            
            3,724,095
            
            
            3,609,728
            
            
            3,277,787
            
            
            3,145,651Diluted
            
            
            4,247,334
            
            
            3,885,490
            
            
            3,809,625
            
            
            3,508,019
            
            
            3,389,404





18








At
                and for the Years Ended December 31,2005
            
            2004
            
            2003
            
            2002
            
            2001(In
                thousands, except per share data and ratios)**Performance
                Ratios:**Return
                on average assets
            
            
            0.99
            %
            
            0.91
            %
            
            0.78
            %
            
            0.75
            %
            
            0.85
            %Return
                on average equity
            
            
            12.18
            
            
            12.23
            
            
            10.85
            
            
            11.88
            
            
            12.80Net
                interest margin(1)
            
            
            4.77
            
            
            4.43
            
            
            4.15
            
            
            3.58
            
            
            4.07Efficiency
                ratio(2)
            
            
            62.42
            
            
            65.81
            
            
            66.83
            
            
            68.72
            
            
            62.75Loan
                to deposit ratio
            
            
            96.64
            
            
            98.91
            
            
            99.82
            
            
            94.24
            
            
            94.90**Asset
                Quality Ratios:**Nonperforming
                loans to total loans
            
            
            0.24
            %
            
            0.41
            %
            
            0.50
            %
            
            1.73
            %
            
            0.66
            %Nonperforming
                assets to total assets
            
            
            0.21
            
            
            0.44
            
            
            0.58
            
            
            1.60
            
            
            0.56Net
                charge-offs to average total loans
            
            
            0.12
            
            
            0.14
            
            
            0.35
            
            
            0.28
            
            
            0.22Allowance
                for loan losses tononperforming
                loans
            
            
            555.36
            %
            
            279.14
            %
            
            219.05
            %
            
            62.99
            %
            
            181.08
            %Allowance
                for loan losses tototal
                loans
            
            
            1.32
            %
            
            1.15
            %
            
            1.09
            %
            
            1.09
            %
            
            1.20
            %**Capital
                Ratios:**Average
                equity to average assets
            
            
            8.11
            %
            
            7.42
            %
            
            7.23
            %
            
            6.34
            %
            
            6.63
            %Leverage
                ratio
            
            
            11.35
            
            
            8.53
            
            
            8.58
            
            
            6.07
            
            
            5.87Tier
                1 risk-based capital ratio
            
            
            13.27
            
            
            10.32
            
            
            10.46
            
            
            7.54
            
            
            7.16Total
                risk-based capital ratio
            
            
            14.52
            
            
            11.45
            
            
            11.55
            
            
            8.59
            
            
            8.32**Growth
                Ratios and Other Data:**Percentage
                change in net income
            
            
            26.56
            %
            
            31.14
            %
            
            15.67
            %
            
            5.12
            %
            
            55.80
            %Percentage
                change in diluted netincome
                per share
            
            
            16.35
            
            
            28.40
            
            
            6.58
            
            
            1.33
            
            
            50.00Percentage
                change in assets
            
            
            25.34
            
            
            15.43
            
            
            6.66
            
            
            20.13
            
            
            17.99Percentage
                change in loans
            
            
            21.22
            
            
            13.56
            
            
            11.49
            
            
            18.95
            
            
            17.02Percentage
                change in deposits
            
            
            24.07
            
            
            14.59
            
            
            5.26
            
            
            19.79
            
            
            23.28Percentage
                change in equity
            
            
            65.80
            
            
            16.09
            
            
            21.32
            
            
            24.42
            
            
            16.54




(1)
          Taxable Equivalent.
 (2)
          Computed by dividing noninterest expense by the sum
          of net interest income and noninterest income, excluding gains and losses
          on the
          sale of assets.










19


**ITEM7.** **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 31,2005
            
            2004
            
            2003(Dollars
                in thousands)Net
                income
            
            $
            5,122
            
            $
            4,047
            
            $
            3,086Total
                assets
            
            
            592,606
            
            
            472,811
            
            
            409,617Total
                loans(1)
            
            
            457,418
            
            
            377,352
            
            
            332,307Total
                deposits
            
            
            473,310
            
            
            381,498
            
            
            332,919Shareholders’
                equity
            
            
            59,825
            
            
            36,083
            
            
            31,082







(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.





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.


20


**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*





*Years
      Ended December 31, 2005, 2004, and 2003*





For
      the
      year ended December 31, 2005, our net income was $5.1 million, or $1.24 basic
      net income per common share, as compared to $4.0 million, or $1.09 basic net
      income per common share, for the year ended December 31, 2004, and $3.1 million,
      or $0.86 basic net income per common share, for the year ended December 31,
      2003. Per share data for all periods has been adjusted to reflect a 10% stock
      dividend that we paid in 2003. The increase in net income for these periods
      relates to loan growth and although our deposits have increased, the increase
      in
      the cost of deposits has been less than the increase in the yield on our loans.
      Return on average assets was 0.99% in 2005, compared with 0.91% in 2004, and
      0.78% in 2003. Return on average shareholders’ equity for 2005 was 12.18%,
      versus 12.23% in 2004 and 10.85% in 2003. The decline in return on average
      shareholders’ equity from 2004 to 2005 was due primarily to the sale of
      1,265,000 shares of common stock for net proceeds of approximately $18.4 million
      during the fourth quarter of 2005. The additional funds will be used for general
      corporate purposes as well as to provide additional capital to our subsidiary, Appalachian Community Bank, to support
      asset growth. Our
      average equity to average assets ratio was 8.11% in 2005, 7.42% in 2004, and
      7.23% in 2003.





*Net
      Interest Income*





*Years
      Ended December 31, 2005, 2004, and 2003*





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 $4.7 million, or
      25.8%, to $22.9 million for 2005, compared to $18.2 million for 2004. Net
      interest income increased $3.4 million, or 22.5%, for 2004, compared to $14.8
      million for 2003. Generally, the overall increase in net interest income was
      primarily the result of the growth in our loan portfolio. Our average total
      loans increased 14.9% from 2004 to 2005, and 14.2% from 2003 to 2004. 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. The continued strong demand
      for loans also provides us with the opportunity to develop business as the
      communities we serve continue to grow.


21





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
      2005 was 4.77% compared to a net interest margin of 4.43% in 2004 and 4.15%
      in
      2003. Net interest spread, the difference between the average yield on earning
      assets and the average rate paid on interest-bearing sources of funds, was
      4.46%
      in 2005, compared to 4.25% in 2004 and 3.98% in 2003.


22


*Average
      Balances, Income and Expenses, and Rates.* The
      following table shows, for years ended December 31, 2005, 2004 and 2003,
      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 31,2005
            
            2004
            
            2003Average
            
            Income/
            
            Yields/
            
            Average
            
            Income/
            
            Yields/
            
            Average
            
            Income/
            
            Yields/Balance
            
            Expense
            
            Rates
            
            Balance
            
            Expense
            
            Rates
            
            Balance
            
            Expense
            
            Rates(Dollars
                in thousands)Earning
                assets:Loans,
                net of unearnedincome(1)
            
            $
            412,307
            
            $
            32,019
            
            
            7.77
            %
            $
            358,925
            
            $
            23,667
            
            
            6.59
            %
            $
            314,182
            
            $
            21,321
            
            
            6.79
            %Investment
                securities:Taxable
            
            
            52,887
            
            
            1,843
            
            
            3.48
            
            
            42,224
            
            
            1,402
            
            
            3.32
            
            
            34,467
            
            
            1,058
            
            
            3.07Tax
                exempt
            
            
            13,766
            
            
            949
            
            
            6.89
            
            
            14,191
            
            
            952
            
            
            6.71
            
            
            15,013
            
            
            1,073
            
            
            7.15Total
                investment
              securities(2)
            
            
            66,653
            
            
            2,792
            
            
            4.19
            
            
            56,415
            
            
            2,354
            
            
            4.17
            
            
            49,480
            
            
            2,131
            
            
            4.31Interest-bearing
                deposits
            
            
            677
            
            
            20
            
            
            2.95
            
            
            350
            
            
            5
            
            
            1.43
            
            
            784
            
            
            30
            
            
            3.83Federal
                funds sold
            
            
            5,986
            
            
            218
            
            
            3.64
            
            
            1,994
            
            
            26
            
            
            1.30
            
            
            3,314
            
            
            37
            
            
            1.12Total
                interest-earningassets(3)
            
            $
            485,623
            
            $
            35,049
            
            
            7.22
            
            $
            417,684
            
            $
            26,052
            
            
            6.24
            
            $
            367,760
            
            $
            23,519
            
            
            6.40Interest-bearing
                liabilities:Demand
                deposits
            
            $
            75,670
            
            $
            1,057
            
            
            1.40
            %
            $
            82,617
            
            $
            952
            
            
            1.15
            %
            $
            83,040
            
            $
            1,178
            
            
            1.42
            %Savings
                deposits
            
            
            84,653
            
            
            1,745
            
            
            2.06
            
            
            61,281
            
            
            713
            
            
            1.16
            
            
            45,318
            
            
            418
            
            
            0.92Time
                deposits
            
            
            222,561
            
            
            7,330
            
            
            3.29
            
            
            187,578
            
            
            4,544
            
            
            2.42
            
            
            170,419
            
            
            5,363
            
            
            3.15Total
                deposits
            
            
            382,884
            
            
            10,132
            
            
            2.65
            
            
            331,476
            
            
            6,209
            
            
            1.87
            
            
            298,777
            
            
            6,959
            
            
            2.33Other
                short-term borrowings
            
            
            11,658
            
            
            174
            
            
            1.49
            
            
            17,953
            
            
            123
            
            
            0.69
            
            
            9,964
            
            
            83
            
            
            0.83Long-term
                debt
            
            
            35,803
            
            
            1,574
            
            
            4.40
            
            
            30,946
            
            
            1,226
            
            
            3.96
            
            
            32,240
            
            
            1,214
            
            
            3.77Total
                interest-bearingliabilities
            
            $
            430,345
            
            
            11,880
            
            
            2.76
            
            $
            380,375
            
            
            7,558
            
            
            1.99
            
            $
            340,981
            
            
            8,256
            
            
            2.42Net
                interest income/netinterest
                spread
            
            
            
            
            
            23,169
            
            
            4.46
            %
            
            
            
            
            18,494
            
            
            4.25
            %
            
            
            
            
            15,263
            
            
            3.98
            %Net
                yield on earning assets
            
            
            
            
            
            
            
            
            4.77
            %
            
            
            
            
            
            
            
            4.43
            %
            
            
            
            
            
            
            
            4.15
            %Taxable
                equivalent adjustment:Loans
            
            
            
            
            
            5
            
            
            
            
            
            
            
            
            15
            
            
            
            
            
            
            
            
            63Investment
                securities
            
            
            
            
            
            294
            
            
            
            
            
            
            
            
            301
            
            
            
            
            
            
            
            
            367Total
                taxable equivalentadjustment
            
            
            
            
            
            299
            
            
            
            
            
            
            
            
            316
            
            
            
            
            
            
            
            
            430Net
                interest income
            
            
            
            
            $
            22,870
            
            
            
            
            
            
            
            $
            18,178
            
            
            
            
            
            
            
            $
            14,833







(1)
            Average
                loans exclude nonaccrual loans of $1.3, $1.4 and $2.2 million for
                years
                ended December 31, 2005, 2004 and 2003, respectively. All loans and
                deposits are domestic.


(2)
            Average
                securities exclude unrealized gains/(losses) of $(249,000), $567,000,
                and
                $471,000.


(3)
            Tax
                equivalent adjustments have been based on an assumed tax rate of
                34%.**








23





*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.





**Analysis
      of Changes in Net Interest Income**





For
                the Years Ended
              December
                31, 2005 vs. 2004
            
            For
                the Years Ended
              December
                31, 2004 vs. 2003Increase
                (Decrease) Due to:
            
            Increase
                (Decrease) Due to:Volume(1)
            
            Rate(1)
            
            Net
                Change
            
            Volume(1)
            
            Rate(1)
            
            Net
                Change(In
                thousands)Earning
                assets:Loans,
                net of unearnedincome
            
            $
            3,790
            
            $
            4,562
            
            $
            8,352
            
            $
            2,965
            
            $
            (619
            )
            $
            2,346Total
                investment securities
            
            
            427
            
            
            11
            
            
            438
            
            
            195
            
            
            27
            
            
            222Interest-bearing
                deposits
            
            
            7
            
            
            8
            
            
            15
            
            
            (12
            )
            
            (13
            )
            
            (25
            )Federal
                funds sold
            
            
            101
            
            
            91
            
            
            192
            
            
            (16
            )
            
            5
            
            
            (11
            )Total
                earning assets
            
            
            4,325
            
            
            4,672
            
            
            8,997
            
            
            3,132
            
            
            (600
            )
            
            2,532Interest-bearing
                liabilities:Demand
                deposits
            
            
            (85
            )
            
            190
            
            
            105
            
            
            (6
            )
            
            (220
            )
            
            (226
            )Savings
                deposits
            
            
            341
            
            
            691
            
            
            1,032
            
            
            169
            
            
            126
            
            
            295Time
                deposits
            
            
            952
            
            
            1,834
            
            
            2,786
            
            
            502
            
            
            (1,321
            )
            
            (819
            )Total
                deposits
            
            
            1,208
            
            
            2,715
            
            
            3,923
            
            
            665
            
            
            (1,415
            )
            
            (750
            )Other
                short-term borrowings
            
            
            (55
            )
            
            106
            
            
            51
            
            
            57
            
            
            (17
            )
            
            40Long-term
                debt
            
            
            205
            
            
            143
            
            
            348
            
            
            (50
            )
            
            62
            
            
            12Total
                interest-bearingliabilities
            
            
            1,358
            
            
            2,964
            
            
            4,322
            
            
            672
            
            
            (1,370
            )
            
            (698
            )Net
                interest income
            
            $
            2,967
            
            $
            1,708
            
            $
            4,675
            
            $
            2,460
            
            $
            770
            
            $
            3,230







(1)
            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.





*Provision
      for Loan Losses*





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 $2.2 million for 2005, $1.2 million for 2004
      and
      $1.5 million for 2003. 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, including
      our provision for a loan asset, which we concluded, in the fourth quarter,
      had
      become impaired.





*Noninterest
      Income*





*Years
      Ended December 31, 2005, 2004 and 2003*





Noninterest
      income for 2005, 2004 and 2003 totaled $3.3 million, $2.8 million and $2.7
      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 rental and ATM fees. Customer service
      fees increased from $845,000 in 2003 to $1.2 million in 2004, and grew to $1.4
      million in 2005. The increase in customer service fees from 2004 to 2005 is
      primarily related to our increased efforts to collect deposit account charges,
      non-sufficient funds (NSF), and returned check charges during the second half
      of
      2005. Demand deposits (not including money market accounts) also increased
      by
      approximately 18.4% from December 31, 2004 to


24


December
      31, 2005. The increase in customer service fees during 2004 was partially
      related to some of the new products introduced during the year, such as our
      consumer overdraft protection service. Mortgage origination commissions
      increased to $959,000 in 2005, after decreasing from $1.3 million in 2003 to
      $801,000 in 2004. The increase from 2004 to 2005 relates to increasing land
      and
      real estate development and the continued strong loan demand in our market
      area.
      The fluctuations in mortgage origination commissions from 2003 to 2004 were
      primarily due to a high volume of mortgage refinancing in 2003 due to the
      historically low interest rates. The subsequent rise in rates during 2004
      contributed to a decrease in mortgage refinancing during that year **.** ****




*Noninterest
      Expenses*





*Years
      Ended December 31, 2005, 2004 and 2003*





Noninterest
      expenses totaled $16.3 million in 2005, up from $13.8 million in 2004, and
      $11.7
      million in 2003. As a percentage of total assets, our total noninterest expenses
      decreased from 2.9% in both 2003 and 2004, to 2.8% in 2005. Salaries and
      employee benefits increased $1.9 million, or 27.0%, to $8.7 million in 2005,
      and
      $1.2 million, or 21.9%, to $6.9 million from 2003 to 2004. This increase in
      salaries and employee benefits was due to the addition of several
      management-level employees necessary to provide the infrastructure to support
      our continued growth. Since December 31, 2004, we have added 30 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.





Occupancy,
      furniture and equipment expenses totaled $2.0 million in 2005, $2.0 million
      in
      2004, and $1.6 million in 2003. The 21.3% increase from 2003 to 2004 was due
      to
      the completion of construction of the new Blue Ridge branch. Other operating
      expenses increased from $4.5 million in 2003 to $5.0 million in 2004, and to
      $5.6 million in 2005. These annual increases are primarily the result of
      increased professional fees, marketing expenses, and funding obligations for
      our
      director retirement plan, which was implemented in the third quarter of 2004,
      as
      well as increases in data processing expenses. **** Professional
      fees increased $287,000 to $1.3 million for 2005, compared to $987,000 in 2004
      and $948,000 in 2003. This increase is due to the increasing cost of accounting,
      auditing and legal services associated with the requirements of the
      Sarbanes-Oxley Act of 2002, as well as consulting fees incurred in 2005 related
      to our revenue enhancement initiatives.





Total
      marketing expenses increased $263,000, or 33.7%, from 2004 to 2005 due to our
      increased marketing of our new deposits products. Marketing expenses increased
      $266,000, or 51.6%, to $782,000 from 2003 to 2004. The marketing expense
      increase for 2004 is related to the marketing of the new Blue Ridge location
      as
      well as new products that were rolled out during 2004. Noninterest expenses
      also
      increased by $354,000 from 2003 to 2004 due to losses on disposal of repossessed
      property. These increases were partially offset by some decreases in other
      expenses, such as decrease in loss on sale of other real estate. The expenses
      related to the director retirement plan are offset by earnings on the cash
      surrender value of life insurance.





**Balance
      Sheet Review**





*General*





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.





At
      December 31, 2004, we had total assets of $472.8 million, consisting principally
      of $373.0 million in net loans (net of allowance of $4.3 million), $64.7 million
      in investments, $7.5 million in cash and cash equivalents, and $13.0 million
      in
      net premises and equipment (net of accumulated depreciation of $3.9 million).
      Our liabilities at December 31, 2004 totaled $436.7 million, consisting
      principally of $381.5 million in deposits, $32.0 million in FHLB advances,
      $15.5
      million of short-term borrowings and $6.2 million of subordinated long-term
      capital notes. At December 31, 2004, our shareholders’ equity was $36.1 million.


25


*Federal
      Funds Sold*





Management
      maintains federal funds sold as a tool in managing daily cash needs. Federal
      funds sold at December 31, 2005 and December 31, 2004 were $799,000 and $2.2
      million respectively. The 63.0% decrease 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, 2005 and 2004 were approximately $6.0 million,
      or 1.23% of average earning assets, and approximately $2.0 million, or 0.48%
      of
      average earning assets, respectively. We continue to try to minimize federal
      funds sold in this low rate environment 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
                31,2005
            
            2004
            
            2003**Securities
                Available-for-Sale:**U.S.
                government and agency securities
            
            $
            37,357
            
            $
            31,744
            
            $
            20,074State
                and municipal securities
            
            
            14,806
            
            
            14,277
            
            
            19,205Mortgage-backed
                securities
            
            
            15,803
            
            
            14,927
            
            
            14,355Equity
                securities
            
            
            3,604
            
            
            3,707
            
            
            1,729Total
            
            $
            71,570
            
            $
            64,655
            
            $
            55,363





Gross
      unrealized gains in the portfolio amounted to $574,000 at year-end 2005 and
      unrealized losses amounted to $1,284,000. Gross unrealized gains in the
      portfolio amounted to $909,000 at year-end 2004 and unrealized losses amounted
      to $337,000. For 2003, gross unrealized gains in the portfolio amounted to
      $967,000 and unrealized losses amounted to $316,000.





At
      December 31, 2005, 2004 and 2003 the percentage of the total carrying value
      of
      the securities portfolio to total assets was 12.1%, 13.7% and 13.5%,
      respectively.





The
      maturities and weighted average yields of our investments in securities (all
      available for sale) at December 31, 2005 are presented below. Taxable equivalent
      adjustments (using a 34% tax rate) have been made in calculating yields on
      tax-exempt obligations.





MaturingWithin
            
            After
                One But
            
            After
                Five But
            
            AfterOne
                Year
            
            Within
                Five Years
            
            Within
                Ten Years
            
            Ten
                YearsAmount
            
            Yield
            
            Amount
            
            Yield
            
            Amount
            
            Yield
            
            Amount
            
            Yield(Dollars
                in thousands)**Securities
                Available-for-Sale**U.S.
                Government and agencysecurities
            
            $
            6,441
            
            
            3.42
            %
            $
            30,916
            
            
            3.42
            %
            $
            --
            
            
            0.00
            %
            $
            --
            
            
            0.00
            %State
                and municipal securities
            
            
            105
            
            
            4.00
            
            
            334
            
            
            4.82
            
            
            3,185
            
            
            4.97
            
            
            11,182
            
            
            4.71Mortgage-backed
                securities
            
            
            --
            
            
            0.00
            
            
            111
            
            
            4.91
            
            
            1,997
            
            
            4.13
            
            
            13,695
            
            
            4.19Equity
                securities
            
            
            --
            
            
            0.00
            
            
            --
            
            
            0.00
            
            
            --
            
            
            0.00
            
            
            3,604
            
            
            5.30**Total
                Securities**
            
            $
            6,546
            
            
            3.42
            %
            $
            31,361
            
            
            3.44
            %
            $
            5,182
            
            
            4.64
            %
            $
            28,481
            
            
            4.53
            %





There
      were no securities held by us of which the aggregate value by issuer on December
      31, 2005 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 the U.S.
      Government and U.S. Government agencies and corporations are not
      included.


26


*Loan
      Portfolio*





Loans
      make up the largest component of our earning assets. In 2005, average loans
      (excluding nonaccrual loans of $1.3 million) represented 84.9% of average
      earning assets, while in 2004 average loans (excluding nonaccrual loans of
      $1.4
      million) represented 85.9% of average earning assets. Average loans increased
      from $358.9 million (excluding nonaccrual loans of $1.4 million) with a yield
      of
      6.6% in 2004, to $412.3 million (excluding nonaccrual loans of $1.3 million)
      with a yield of 7.8% in 2005. Loan demand in our market area remains strong
      due
      to the current interest rate environment, the amount of development occurring
      in
      our market, and the strong customer relationships that our employees have
      developed. The ratio of total loans to total deposits was 96.6% in 2005 and
      98.9% in 2004.





The
      following table shows the classification of loans by major category at December
      31, 2005, and for each of the preceding four years.





December
                31,2005
            
            2004
            
            2003
            
            2002
            
            2001Percent
            
            
            
            Percent
            
            
            
            Percent
            
            
            
            Percent
            
            
            
            PercentAmount
            
            of
                Total
            
            Amount
            
            of
                Total
            
            Amount
            
            of
                Total
            
            Amount
            
            of
                Total
            
            Amount
            
            of
                Total(Dollars
                in thousands)Commercial,financial
                andagricultural
            
            $
            33,778
            
            
            7.4
            %
            $
            31,920
            
            
            8.5
            %
            $
            34,613
            
            
            10.4
            %
            $
            33,449
            
            
            11.2
            %
            $
            29,092
            
            
            11.6
            %Real
                estate --Construction(1)
            
            
            203,538
            
            
            44.5
            
            
            145,588
            
            
            38.6
            
            
            104,619
            
            
            31.5
            
            
            73,242
            
            
            24.6
            
            
            54,255
            
            
            21.7Real
                estate - other(2)
            
            
            193,704
            
            
            42.3
            
            
            173,955
            
            
            46.1
            
            
            166,598
            
            
            50.1
            
            
            165,526
            
            
            55.5
            
            
            147,852
            
            
            59.0Consumer
            
            
            21,051
            
            
            4.6
            
            
            20,957
            
            
            5.6
            
            
            20,535
            
            
            6.2
            
            
            20,296
            
            
            6.8
            
            
            19,370
            
            
            7.7Other
                loans
            
            
            5,347
            
            
            1.2
            
            
            4,932
            
            
            1.2
            
            
            5,942
            
            
            1.8
            
            
            5,550
            
            
            1.9
            
            
            --
            
            
            0.0457,418
            
            
            100.0
            %
            
            377,352
            
            
            100.0
            %
            
            332,307
            
            
            100.0
            %
            
            298,063
            
            
            100.0
            %
            
            250,569
            
            
            100.0
            %Allowance
                for loanlosses
            
            
            (6,059
            )
            
            
            
            
            (4,349
            )
            
            
            
            
            (3,610
            )
            
            
            
            
            (3,238
            )
            
            
            
            
            (2,995
            )Net
                loans
            
            $
            451,359
            
            
            
            
            $
            373,003
            
            
            
            
            $
            328,697
            
            
            
            
            $
            294,825
            
            
            
            
            $
            247,574







(1)
            The
                “real estate - construction” category includes residential construction
                loans and commercial construction
                loans.


(2)
            The
                “real estate - other” category includes one- to- four family residential,
                home equity, multi-family (more than five) residential, commercial
                real
                estate and undeveloped agricultural real estate
                loans.





The
      following table shows the maturity distribution of selected loan classifications
      at December 31, 2005, and an analysis of these loan maturities. For the purposes
      of this schedule, loans that have reached the contractual floor rate are treated
      as having a pre-determined interest rate.





Rate
                Structure for LoansMaturity
            
            Maturing
                Over One YearOver
                OneOne
            
            Year
            
            Over
            
            
            
            Predetermined
            
            Floating
                orYear
                or
            
            Through
            
            Five
            
            
            
            Interest
            
            AdjustableLess
            
            Five
                Years
            
            Years
            
            Total
            
            Rate
            
            Rate(Dollars
                in thousands)Commercial,
                financialand
                agricultural
            
            $
            21,464
            
            $
            11,483
            
            $
            831
            
            $
            33,778
            
            $
            5,409
            
            $
            6,905Real
                estate - construction
            
            
            169,701
            
            
            32,291
            
            
            1,546
            
            
            203,538
            
            
            22,580
            
            
            11,257Real
                estate - other
            
            
            99,336
            
            
            82,427
            
            
            11,941
            
            
            193,704
            
            
            59,104
            
            
            35,264Total
            
            $
            290,501
            
            $
            126,201
            
            $
            14,318
            
            $
            431,020
            
            $
            87,093
            
            $
            53,426











27


*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, 2005, our allowance for loan losses was $6.1 million, or 1.32%
      of
      total outstanding loans, compared to an allowance for loan losses of $4.3
      million, or 1.15% of outstanding loans, at December 31, 2004, and $3.6 million,
      or 1.09% of outstanding loans, at December 31, 2003. Further,
      during the fourth quarter, in connection with our preparation of the year-end
      financial statements to be included in this Report, we concluded that one of
      our
      loan assets, which we had previously identified as a possible problem asset,
      had
      become impaired under generally accepted accounting principles. The amount
      of
      this loan asset is $2,524,000.





Our
      allowance for loan losses at December 31, 2005, reflects a specific allocation
      for the impairment of this loan asset, in the amount of **$** 850,000.
      Without this specific allocation, our loan loss reserves at December 31, 2005,
      are $5.2 million, or 1.14%, of our outstanding loans. We anticipate that the
      amount of this loan specifically reserved for will be charged off in the first
      quarter of 2006.








28


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, 2001 to 2005.





Years
                ended December 31,2005
            
            2004
            
            2003
            
            2002
            
            2001(Dollars
                in thousands)Allowance
                for loan losses at beginning of year
            
            $
            4,349
            
            $
            3,610
            
            $
            3,238
            
            $
            2,995
            
            $
            2,211Loans
                charged off:Commercial,
                financial, and agricultural
            
            
            359
            
            
            30
            
            
            277
            
            
            89
            
            
            240Real
                estate - construction
            
            
            10
            
            
            240
            
            
            28
            
            
            50
            
            
            --Real
                estate - other
            
            
            41
            
            
            158
            
            
            638
            
            
            427
            
            
            134Consumer
            
            
            150
            
            
            127
            
            
            265
            
            
            250
            
            
            170Total
                loans charged off
            
            
            560
            
            
            555
            
            
            1,208
            
            
            816
            
            
            544Recoveries
                on loans previously charged off:Commercial,
                financial, and agricultural
            
            
            24
            
            
            35
            
            
            25
            
            
            5
            
            
            8Real
                estate - construction
            
            
            --
            
            
            --
            
            
            3
            
            
            --
            
            
            --Real
                estate - other
            
            
            --
            
            
            2
            
            
            50
            
            
            --
            
            
            6Consumer
            
            
            35
            
            
            22
            
            
            37
            
            
            26
            
            
            20Total
                recoveries on loans previouslycharged
                off
            
            
            59
            
            
            59
            
            
            115
            
            
            31
            
            
            34Net
                loans charged off
            
            
            501
            
            
            496
            
            
            1,093
            
            
            785
            
            
            510Provision
                for loan losses
            
            
            2,211
            
            
            1,235
            
            
            1,465
            
            
            1,028
            
            
            1,294Allowance
                for loan losses, at end of period
            
            $
            6,059
            
            $
            4,349
            
            $
            3,610
            
            $
            3,238
            
            $
            2,995Loans,
                net of unearned income, at end of period
            
            $
            457,418
            
            $
            377,352
            
            $
            332,307
            
            $
            298,063
            
            $
            250,569Average
                loans, net of unearned income,outstanding
                at the end of the period
            
            $
            413,561
            
            $
            360,261
            
            $
            316,605
            
            $
            276,733
            
            $
            234,031Ratios:Allowance
                at end of period to loans, net ofunearned
                income
            
            
            1.32
            %
            
            1.15
            %
            
            1.09
            %
            
            1.09
            %
            
            1.20
            %Allowance
                at end of period to average loans,net
                of unearned income
            
            
            1.47
            
            
            1.21
            
            
            1.14
            
            
            1.17
            
            
            1.28Net
                charge-offs to average loans, net ofunearned
                income
            
            
            0.12
            
            
            0.14
            
            
            0.35
            
            
            0.28
            
            
            0.22Net
                charge-offs to allowance at end of period
            
            
            8.27
            
            
            11.40
            
            
            30.28
            
            
            24.24
            
            
            17.03Recoveries
                to prior year charge-offs
            
            
            10.63
            
            
            4.88
            
            
            14.09
            
            
            5.70
            
            
            5.75





29


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, 2001 to 2005.





**Allocation
      of Allowance for Loan Losses**





At
                December 31,2005
            
            2004
            
            2003
            
            2002
            
            2001(Dollars
                in thousands)**Domestic
                Loans****(1)**Commercial,financial,
                andagricultural
            
            $
            3,209
            
            
            7
            %
            $
            548
            
            
            8
            %
            $
            1,257
            
            
            10
            %
            $
            1,615
            
            
            11
            %
            $
            807
            
            
            12
            %Real
                estate -construction
            
            
            271
            
            
            45
            
            
            421
            
            
            39
            
            
            184
            
            
            32
            
            
            85
            
            
            25
            
            
            193
            
            
            22Real
                estate -other(1)
            
            
            1,962
            
            
            42
            
            
            2,138
            
            
            46
            
            
            1,277
            
            
            50
            
            
            1,044
            
            
            55
            
            
            1,760
            
            
            59Consumer
            
            
            202
            
            
            5
            
            
            425
            
            
            6
            
            
            267
            
            
            6
            
            
            168
            
            
            7
            
            
            235
            
            
            7Other
                loans
            
            
            415
            
            
            1
            
            
            817
            
            
            1
            
            
            625
            
            
            2
            
            
            326
            
            
            2
            
            
            --
            
            
            --Total
            
            $
            6,059
            
            
            100
            %
            $
            4,349
            
            
            100
            %
            $
            3,610
            
            
            100
            %
            $
            3,238
            
            
            100
            %
            $
            2,995
            
            
            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 policy 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 .24% of total loans at December 31, 2005 and 0.41% of total loans
      at
      December 31, 2004, compared to 0.50% at December 31, 2003.





It
      is our
      general policy 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, 2005, 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.


30


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, 2001 to 2005.





December
                31,2005
            
            2004
            
            2003
            
            2002
            
            2001(Dollars
                in thousands)Nonaccruing
                loans
            
            $
            1,020
            
            $
            1,524
            
            $
            1,127
            
            $
            4,823
            
            $
            1,642Loans
                past due 90 days or more
            
            
            71
            
            
            34
            
            
            521
            
            
            334
            
            
            12Restructured
                loans
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --Total
                nonperforming loans
            
            
            1,091
            
            
            1,558
            
            
            1,648
            
            
            5,157
            
            
            1,654Nonaccruing
                securities
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --Other
                real estate
            
            
            147
            
            
            516
            
            
            737
            
            
            986
            
            
            133Total
                nonperforming assets
            
            $
            1,238
            
            $
            2,074
            
            $
            2,385
            
            $
            6,143
            
            $
            1,787Ratios:Loan
                loss allowance to totalnonperforming
                assets
            
            
            489.42
            %
            
            209.69
            %
            
            151.36
            %
            
            52.71
            %
            
            167.60
            %Total
                nonperforming loans to total loans(net
                of unearned interest)
            
            
            0.24
            %
            
            0.41
            %
            
            0.50
            %
            
            1.73
            %
            
            0.66
            %Total
                nonperforming assets to total assets
            
            
            0.21
            %
            
            0.44
            %
            
            0.58
            %
            
            1.60
            %
            
            0.56
            %





***Deposits
      and Other Interest-Bearing Liabilities***




Deposits
      are the primary source of funds to support our earning assets. Average deposits
      increased 17.8%, from approximately $362.3 million in 2004 to approximately
      $426.8 million in 2005. Average deposits increased 12.9%, from approximately
      $320.8 million in 2003 to approximately $362.3 million in 2004. At December
      31,
      2005, total deposits were $473.3 million, of which $426.7 million or 90.2%,
      were
      interest bearing, at December 31, 2004, total deposits were $381.5 million,
      of
      which $348.6 million, or 91.4%, were interest bearing, and at December 31,
      2003,
      total deposits were $332.9 million, of which $309.1 million, or 92.9%, were
      interest bearing. Alternative funding sources such as national CDs and brokered
      deposits were used to supplement funding sources. Brokered deposits were $52.6
      at December 31, 2005. At December 31, 2004, brokered deposits were $23.4
      million. The increase in our brokered deposits is due to the fact that in 2005
      we began using the Certificate of Deposit Account Registry Service, which
      accounted for 19.7 of total brokered deposits at December 31, 2005. Brokered
      deposits are a secondary source of deposits utilized to fund loan growth. In
      many instances, the cost of these deposits is comparable to our local
      deposits.


31


The
      average amounts of, and the average rate paid on, each of the following
      categories of deposits, for the years ended December 31, 2005, 2004 and 2003,
      are as follows:





Years
                ended December 31,2005
            
            2004
            
            2003Amount
            
            Rate
            
            Amount
            
            Rate
            
            Amount
            
            Rate(Dollars
                in thousands)Noninterest-bearing
                  demanddeposits
            
            $
            43,878
            
            
            0.00
            %
            $
            30,840
            
            
            0.00
            %
            $
            22,056
            
            
            0.00
            %Interest-bearing
                demand deposits
            
            
            75,670
            
            
            1.40
            
            
            82,617
            
            
            1.15
            
            
            83,040
            
            
            1.42Savings
                deposits
            
            
            84,653
            
            
            2.06
            
            
            61,281
            
            
            1.16
            
            
            45,318
            
            
            0.92Time
                deposits
            
            
            222,561
            
            
            3.29
            
            
            187,578
            
            
            2.42
            
            
            170,419
            
            
            3.15Total
                interest-bearing deposits
            
            
            382,884
            
            
            2.65
            
            
            331,476
            
            
            1.87
            
            
            298,777
            
            
            2.33Total
                average deposits
            
            $
            426,762
            
            
            2.37
            
            $
            362,316
            
            
            1.71
            
            $
            320,833
            
            
            2.17





Our
      core
      deposits, which exclude brokered and national certificates of deposits, were
      $397.3 million at December 31, 2005, an increase of 19.2% compared to $333.4
      million at December 31, 2004. Core deposits as a percentage of total deposits
      were approximately 83.9% and 87.4% at December 31, 2005 and 2004,
      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, 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 2005:
      average noninterest-bearing demand deposits, 10.3%; and average savings
      deposits, 19.8%. Of average time deposits, approximately 55.6% were large
      denomination certificates of deposit.





Noninterest-bearing
      deposits increased $13.7 million, or 41.5%, from year-end 2004 to $46.6 million
      at December 31, 2005, and interest-bearing deposits increased $78.1 million,
      or
      22.4%, during the same period to $426.7 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.





The
      following table sets forth the maturities of our time deposits of $100,000
      or
      more by category at December 31, 2005.





(Dollars
                inthousands)Three
                months or less
            
            $
            28,618Over
                three through six months
            
            
            24,386Over
                six through twelve months
            
            
            44,484Over
                twelve months
            
            
            27,534Total
            
            $
            125,022





32


**Borrowings**





*Short-Term
      Borrowings*





Securities
      sold under agreements to repurchase amounted to $3.7 million at December 31,
      2005, compared to $6.3 million at December 31, 2004, and $4.1 million at
      December 31, 2003. The weighted average rates were 1.24%, 1.36%, and 1.23%
      for
      2005, 2004 and 2003, 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
      $14.0
      million, $9.2 million, and $5.0 million at December 31, 2005, 2004 and 2003,
      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 a $30.0 million in lines of credit to purchase Federal Funds,
      on an unsecured basis, from commercial banks, of which $22.8 million was
      available at December 31, 2005. We had federal funds purchased that amounted
      to
      $7.2 million at year-end 2005, and $-0- at year-end 2004, compared to $3,000,000
      at year-end 2003.





Short-term
      borrowings at December 31, 2005, 2004 and 2003 consisted of the
      following:





As
                of December 31,2005
            
            2004
            
            2003(Dollars
                in thousands)Federal
                funds purchased
            
            $
            7,217
            
            $
            --
            
            $
            3,000Securities
                sold under agreements to repurchase
            
            
            3,675
            
            
            6,264
            
            
            4,086FHLB
                line of credit
            
            
            14,000
            
            
            9,206
            
            
            5,000$
            24,892
            
            $
            15,470
            
            $
            12,086





*FHLB
      Advances*





Our
      total
      borrowed funds consist primarily of long-term debt with maturities from one
      to
      ten years. At December 31, 2005 we were approved to borrow up to approximately
      $81.9 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, 2005, the outstanding balance of our
      credit line was $38.9 million, of which $14 million was accounted for as a
      short-term line of credit.





*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 a minority interest of $186,000 and as a 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 interest rate on
      the
      Trust Preferred liability at December 31, 2005 and 2004 was 7.25% and 5.16%,
      respectively. 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.





33


**Capital
      Resources**





Total
      shareholders’ equity was $59.8 million at December 31, 2005, an increase of
      $23.7 million from $36.1 million at December 31, 2004. This increase resulted
      primarily from net proceeds of $18.4 million stemming from the sale of
      approximately 1.3 million shares of our common stock in the fourth quarter
      of
      2005. The increase was also due in part to net earnings of $5.1 million during
      2005. We issued 33,000 shares of stock to our 401(k) Plan during 2005 for
      proceeds of $495,000. We had an additional $847,000 increase 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
      86,525 options during 2005 increased equity by $602,000, 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 $64.3 million at
      December 31, 2005. 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 $70.4 million
      at
      year-end 2005. The percentage ratios as calculated under regulatory guidelines
      were 13.3% and 14.5% for Tier 1 and Total Capital, respectively, at year-end
      2005. Our Tier 1 Capital and Total Capital exceeded the minimum ratios of 4.0%
      and 8.0%, respectively.





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,
      2005, our leverage ratio was 11.35%, exceeding the regulatory minimum
      requirement of 4.0%.





The
      table
      following illustrates our regulatory capital ratios under federal guidelines
      at
      December 31, 2005, 2004 and 2003:





Statutory
            
            Years
                ended December 31,Minimum
            
            2005
            
            2004
            
            2003(Dollars
                in thousands)Tier
                1 Capital
            
            
            
            
            $
            64,301
            
            $
            39,713
            
            
            34,681Tier
                2 Capital
            
            
            
            
            
            6,057
            
            
            4,349
            
            
            3,610Total
                Qualifying Capital
            
            
            
            
            $
            70,358
            
            $
            44,062
            
            $
            38,291Risk
                Adjusted Total Assets (includingoff-balance
                sheet exposures)
            
            
            
            
            $
            484,577
            
            $
            384,847
            
            $
            331,638Tier
                1 Risk-Based Capital Ratio
            
            
            4.0
            %
            
            13.27
            %
            
            10.32
            %
            
            10.46
            %Total
                Risk-Based Capital Ratio
            
            
            8.0
            
            
            14.52
            
            
            11.45
            
            
            11.55Leverage
                Ratio
            
            
            4.0
            
            
            11.35
            
            
            8.53
            
            
            8.58





34


**Return
      on Equity and Assets**





The
      following table summarizes certain of our financial ratios for the years ended
      December 31, 2005, 2004 and 2003.





2005
            
            2004
            
            2003Return
                on average assets
            
            
            0.99
            %
            
            0.91
            %
            
            0.78
            %Return
                on average equity
            
            
            12.18
            
            
            12.23
            
            
            10.85Dividend
                payout ratio
            
            
            --
            
            
            --
            
            
            --Average
                equity to average assets ratio
            
            
            8.11
            
            
            7.42
            
            
            7.23





**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.





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. 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
      $490,000. For the first 365 days, interest-bearing liabilities exceed earning
      assets by approximately $59.9 million. During this one-year time frame, 86.1%
      of
      all interest-bearing liabilities will reprice compared to 65.5% 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.


35


The
      following table sets forth information regarding our rate sensitivity as of
      December 31, 2005 for each of the intervals indicated.





0-30
            
            31-90
            
            90-365
            
            1-5
            
            Over
                5Days
            
            Days
            
            Days
            
            Years
            
            Years
            
            Total(Dollars
                in thousands)Interest-earning
                assets(1)Loans
            
            $
            222,850
            
            $
            23,191
            
            $
            88,501
            
            $
            117,267
            
            $
            4,589
            
            $
            456,398SecuritiesTaxable
            
            
            --
            
            
            49
            
            
            6,496
            
            
            35,886
            
            
            15,598
            
            
            58,029Tax-exempt
            
            
            105
            
            
            --
            
            
            --
            
            
            330
            
            
            13,816
            
            
            14,251Time
                deposits in other banks
            
            
            13,765
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            13,765Federal
                funds sold
            
            
            799
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            799237,519
            
            
            23,240
            
            
            94,997
            
            
            153,483
            
            
            34,003
            
            
            543,242Interest-bearing
                liabilities(2)Demand
                deposits(3)
            
            
            88,071
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            88,071Savings
                deposits(3)
            
            
            95,022
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            95,022Time
                deposits
            
            
            28,944
            
            
            54,621
            
            
            115,002
            
            
            45,089
            
            
            --
            
            
            243,656Other
                short-term borrowings
            
            
            24,892
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            24,892Long-term
                debt
            
            
            100
            
            
            150
            
            
            2,650
            
            
            10,050
            
            
            12,000
            
            
            24,950Subordinated
                long-term capital notes
            
            
            --
            
            
            6,186
            
            
            --
            
            
            --
            
            
            --
            
            
            6,186237,029
            
            
            60,957
            
            
            117,652
            
            
            55,139
            
            
            12,000
            
            
            482,777Interest
                sensitivity gap
            
            $
            490
            
            $
            (37,717
            )
            $
            (22,655
            )
            $
            98,344
            
            $
            22,003
            
            $
            60,465Cumulative
                interestsensitivity
                gap
            
            $
            490
            
            $
            (37,227
            )
            $
            (59,882
            )
            $
            38,462
            
            $
            60,465Ratio
                of interest-earning assetsto
                interest-bearing liabilities
            
            
            1.00
            
            
            0.38
            
            
            0.81
            
            
            2.78
            
            
            2.83Cumulative
                ratio
            
            
            1.00
            
            
            0.88
            
            
            0.86
            
            
            1.08
            
            
            1.13Ratio
                of cumulative gap to totalinterest-earning
                assets
            
            
            0.00
            
            
            (0.07
            )
            
            (0.11
            )
            
            0.07
            
            
            0.11


__________________________





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


(2)
            Excludes
                matured certificates which have not been redeemed by the customer
                and on
                which no interest is accruing.


(3)
            Demand
                and savings deposits are assumed to be core deposits and not likely
                to be
                affected by changing interest rates. These deposits typically reprice
                simultaneously with market changes.





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.


36


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 Interest**
              **Income/Expense
                Given**
              **Interest
                Rate Shifts****Down
                200**
            
            **Up
                200****Basis
                Points**
            
            **Basis
                Points**For
                the Twelve Months After December 31, 2005Projected
                change in:Interest
                income
            
            
            (16.72
            )%
            
            14.09
            %Interest
                expense
            
            
            (34.43
            )
            
            32.95Net
                interest income
            
            
            (2.56
            )
            
            14.51





**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
      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, 2005 and 2004, we had issued standby letters of credit of
      approximately $3.5 million and $1.4 million, respectively. When significant,
      we
      record a liability for the estimated fair value of standby letters of credit
      based on the fees charged.


37


*Loan
      Commitments.* As
      of
      December 31, 2005 and 2004, the bank had commitments outstanding to extend
      credit totaling approximately $73.4 million and $59.0 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, including interest, and the periods in which payments
      are due. The amounts and time periods are measured from December 31, 2005.





**Payments
      due by period (in thousands)**





Less
                than
            
            
            
            
            
            More
                thanTotal
            
            1
                year
            
            1-3
                years
            
            3-5
                years
            
            5
                yearsLong-Term
                Debt
            
            $
            31,136
            
            $
            1,900
            
            $
            4,050
            
            $
            7,000
            
            $
            18,186Operating
                Lease Obligations
            
            
            962
            
            
            36
            
            
            71
            
            
            72
            
            
            783Time
                Deposits
            
            
            243,656
            
            
            198,558
            
            
            38,557
            
            
            6,540
            
            
            1Construction
                commitments
            
            
            901
            
            
            901
            
            
            --
            
            
            --
            
            
            --$
            276,655
            
            $
            201,395
            
            $
            42,678
            
            $
            13,612
            
            $
            18,970





**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.





**Recently
      Issued Accounting Standards**





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), entitled Share-Based
      Payment (“SFAS No. 123(R)”) that will require compensation costs related to
      share-based payment transactions to be recognized in the financial statements.
      SFAS No. 123(R) eliminates the alternative to use Accounting Principles Board
      (“APB”) Opinion No. 25’s Accounting for Stock Issued to Employees intrinsic
      value method of accounting that was provided in Statement 123 as originally
      issued. Under APB Opinion No. 25, issuing stock options to employees generally
      resulted in recognition of no compensation cost. SFAS No. 123(R) requires
      entities to recognize the cost of employee services received in exchange for
      awards of equity instruments based on the grant-date fair value of those awards
      (with limited exceptions). Recognition of that compensation cost helps users
      of
      financial statements to better understand the economic transactions affecting
      an
      entity and to make better resource allocation decisions. 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 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. On April 21, 2005, the SEC amended Rule 4-01(a) of Regulation S-X
      regarding the compliance date for SFAS No. 123(R) so the effective date is
      delayed to January 1, 2006. The Company is currently evaluating the provisions
      of SFAS No. 123(R) and will adopt it on January 1, 2006.


38





**ITEM7A. 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.”








**ITEM8.** **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.


39


**APPALACHIAN
      BANCSHARES, INC. AND SUBSIDIARIES**





**Consolidated
      Financial Statements**





Page(s)Report
                of Independent Registered Public Accounting Firm
            41Report
                of Independent Registered Public Accounting Firm
            42Consolidated
                Statements of Financial Condition as of December 31, 2005 and
                2004
            43Consolidated
                Statements of Income for the Years EndedDecember
                31, 2005, 2004 and 2003
            44Consolidated
                Statements of Shareholders’ Equity for the Years EndedDecember
                31, 2005, 2004 and 2003
            45Consolidated
                Statements of Cash Flows for the Years EndedDecember
                31, 2005, 2004, and 2003
            46Notes
                to Consolidated Financial Statements
            47Quarterly
                Results (Unaudited)
            70


40




















**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 statement of financial condition of Appalachian
      Bancshares, Inc. and subsidiaries as of December 31, 2005, and the related
      consolidated statements of income, shareholders’ equity and cash flows for the
      year 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 audit. The consolidated financial statements
      of Appalachian Bancshares, Inc. and subsidiaries for the years ended December
      31, 2004 and 2003 were audited by other auditors whose report, dated March
      17,
      2005, expressed an unqualified opinion on those statements.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether 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 audit provides a
      reasonable basis for our opinion.





In
      our
      opinion, the 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, 2005, and the results
      of
      their operations and their cash flows for the year then ended, in conformity
      with U.S. generally accepted accounting principles.











Atlanta,
      Georgia


February
      10, 2006


41







**S****chauer****T****aylor****C****ox****V****ise****&
                M****organ,****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.**


42


**APPALACHIAN
      BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF FINANCIAL CONDITION**




**December
      31, 2005 and 2004**





**2005**
            
            2004**Assets**Cash
                and due from banks
            
            **$**
            **20,771,833**
            
            $
            4,953,563Interest-bearing
                deposits with other banks
            
            
            **13,765,151**
            
            
            403,532Federal
                funds sold
            
            
            **798,541**
            
            
            2,156,000**Cash
                and Cash Equivalents**
            
            
            **35,335,525**
            
            
            7,513,095Securities
                available-for-sale
            
            
            **71,570,323**
            
            
            64,654,722Loans,
                net of unearned income
            
            
            **457,418,160**
            
            
            377,351,501Allowance
                for loan losses
            
            
            **(6,059,238**
            **)**
            
            (4,348,618
            )**Net
                Loans**
            
            
            **451,358,922**
            
            
            373,002,883Premises
                and equipment, net
            
            
            **16,797,386**
            
            
            12,988,640Accrued
                interest
            
            
            **4,750,975**
            
            
            2,901,737Cash
                surrender value on life insurance
            
            
            **8,142,533**
            
            
            7,833,450Intangibles,
                net
            
            
            **1,991,891**
            
            
            1,991,891Other
                assets
            
            
            **2,658,180**
            
            
            1,924,710**Total
                Assets**
            
            **$**
            **592,605,735**
            
            $
            472,811,128**Liabilities
                and Shareholders’ Equity****Liabilities**Noninterest-bearing
                deposits
            
            **$**
            **46,560,796**
            
            $
            32,896,346Interest-bearing
                deposits
            
            
            **426,748,963**
            
            
            348,601,825**Total
                Deposits**
            
            
            **473,309,759**
            
            
            381,498,171Short-term
                borrowings
            
            
            **24,891,739**
            
            
            15,469,540Accrued
                interest
            
            
            **728,217**
            
            
            540,217FHLB
                Advances
            
            
            **24,950,000**
            
            
            31,950,000Subordinated
                long-term capital notes
            
            
            **6,186,000**
            
            
            6,186,000Other
                liabilities
            
            
            **2,715,421**
            
            
            1,083,878**Total
                Liabilities**
            
            
            **532,781,136**
            
            
            436,727,806**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,5,225,097
                and 3,840,572 shares issued at December 31, 2005 and
            
            
            **52,251**
            
            
            38,4062004,
                respectivelyPaid-in
                capital
            
            
            **43,184,053**
            
            
            23,731,549Retained
                earnings
            
            
            **17,756,750**
            
            
            12,635,174Accumulated
                other comprehensive income (loss): net unrealizedholding
                gains on securities available-for-sale, net of deferredincome
                tax
            
            
            **(468,659**
            **)**
            
            377,989Less
                cost of treasury stock, 75,973 shares at 2005 and 2004
            
            
            **(699,796**
            **)**
            
            (699,796
            )**Total
                Shareholders’ Equity**
            
            
            **59,824,599**
            
            
            36,083,322**Total
                Liabilities and Shareholders’ Equity**
            
            **$**
            **592,605,735**
            
            $
            472,811,128





See
      notes
      to consolidated financial statements


43


**APPALACHIAN
      BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF INCOME**




**Years
      Ended December 31, 2005, 2004 and 2003**





**2005**
            
            2004
            
            2003**Interest
                Income**Interest
                and fees on loans
            
            **$**
            **32,013,553**
            
            $
            23,652,087
            
            $
            21,257,660Interest
                on securities:Taxable
                securities
            
            
            **1,842,975**
            
            
            1,401,522
            
            
            1,058,688Nontaxable
                securities
            
            
            **655,170**
            
            
            650,486
            
            
            706,115Interest
                on deposits with other banks
            
            
            **20,017**
            
            
            5,488
            
            
            30,224Interest
                on federal funds sold
            
            
            **218,469**
            
            
            26,369
            
            
            37,362**Total
                Interest Income**
            
            
            **34,750,184**
            
            
            25,735,952
            
            
            23,090,049**Interest
                Expense**Interest
                on deposits
            
            
            **10,131,669**
            
            
            6,209,262
            
            
            6,959,433Interest
                on federal funds purchased and securities soldunder
                agreements to repurchase
            
            
            **173,861**
            
            
            123,282
            
            
            82,722Interest
                FHLB advances
            
            
            **1,169,518**
            
            
            941,835
            
            
            1,129,209Interest
                on subordinated long-term capital notes
            
            
            **404,450**
            
            
            283,600
            
            
            85,200**Total
                Interest Expense**
            
            
            **11,879,498**
            
            
            7,557,979
            
            
            8,256,564**Net
                Interest Income**
            
            
            **22,870,686**
            
            
            18,177,973
            
            
            14,833,485Provision
                for loan losses
            
            
            **2,210,900**
            
            
            1,235,107
            
            
            1,465,000**Net
                Interest Income After Provision For Loan Losses**
            
            
            **20,659,786**
            
            
            16,942,866
            
            
            13,368,485**Noninterest
                Income**Customer
                service fees
            
            
            **1,433,835**
            
            
            1,233,655
            
            
            844,669Mortgage
                origination commissions
            
            
            **959,289**
            
            
            800,981
            
            
            1,276,787Securities
                losses
            
            
            **--**
            
            
            (22,633
            )
            
            (16,978
            )Other
                operating income
            
            
            **908,502**
            
            
            817,485
            
            
            598,917**Total
                Noninterest Income**
            
            
            **3,301,626**
            
            
            2,829,488
            
            
            2,703,395**Noninterest
                Expenses**Salaries
                and employee benefits
            
            
            **8,740,788**
            
            
            6,884,579
            
            
            5,645,790Occupancy,
                furniture and equipment expense
            
            
            **2,014,372**
            
            
            1,955,683
            
            
            1,611,939Other
                operating expenses
            
            
            **5,582,503**
            
            
            4,999,746
            
            
            4,474,256**Total
                Noninterest Expenses**
            
            
            **16,337,663**
            
            
            13,840,008
            
            
            11,731,985Income
                before income taxes
            
            
            **7,623,749**
            
            
            5,932,346
            
            
            4,339,895Income
                tax expense
            
            
            **2,502,173**
            
            
            1,885,332
            
            
            1,253,315**Net
                Income**
            
            **$**
            **5,121,576**
            
            $
            4,047,014
            
            $
            3,086,580**Earnings
                Per Common Share**Basic
            
            **$**
            **1.24**
            
            
            1.09
            
            
            0.86Diluted
            
            
            **1.21**
            
            
            1.04
            
            
            0.81**Cash
                Dividends Declared Per Common Share**
            
            
            **0.00**
            
            
            0.00
            
            
            0.00**Weighted
                Average Shares Outstanding**Basic
            
            
            **4,123,403**
            
            
            3,724,095
            
            
            3,609,728Diluted
            
            
            **4,247,334**
            
            
            3,885,490
            
            
            3,809,625





See
        notes
        to consolidated financial statements


44


**APPALACHIAN
      BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED**  **STATEMENTS
      OF SHAREHOLDERS’ EQUITY**




**Years
      Ended December 31, 2005, 2004 and 2003**





AccumulatedOtherCompre-hensiveCommon
            
            Paid-in
            
            Retained
            
            Income
            
            TreasuryStock
            
            Capital
            
            Earnings
            
            (Loss)
            
            Stock
            
            TotalBalance
                at December 31, 2002
            
            $
            36,398
            
            $
            21,115,556
            
            $
            5,805,986
            
            $
            449,050
            
            $
            (1,787,701
            )
            $
            25,619,289Retroactive
                effect of 10%stock
                dividend
            
            
            202
            
            
            302,273
            
            
            (304,406
            )
            
            --
            
            
            --
            
            
            (1,931
            )Net
                income 2003
            
            
            --
            
            
            --
            
            
            3,086,580
            
            
            --
            
            
            --
            
            
            3,086,580Unrealized
                losses on available-for-sale
                securities, net ofreclassification
                adjustment,net
                of tax of $(10,107)
            
            
            --
            
            
            --
            
            
            --
            
            
            (19,616
            )
            
            --
            
            
            (19,616
            )Comprehensive
                income
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            3,066,964Effect
                of exercise and issuance ofstock
                options
            
            
            747
            
            
            528,583
            
            
            --
            
            
            --
            
            
            --
            
            
            529,330Proceeds
                from issuance oftreasury
                stock
            
            
            --
            
            
            780,796
            
            
            --
            
            
            --
            
            
            1,142,805
            
            
            1,923,601Acquisition
                of treasury stock
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            (54,900
            )
            
            (54,900
            )Balance
                at December 31, 2003
            
            
            37,347
            
            
            22,727,208
            
            
            8,588,160
            
            
            429,434
            
            
            (699,796
            )
            
            31,082,353Net
                income 2004
            
            
            --
            
            
            --
            
            
            4,047,014
            
            
            --
            
            
            --
            
            
            4,047,014Unrealized
                losses on available-for-sale
                securities, net ofreclassification
                adjustment,net
                of tax of $(26,501)
            
            
            --
            
            
            --
            
            
            --
            
            
            (51,445
            )
            
            --
            
            
            (51,445
            )Comprehensive
                income
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            3,995,569Proceeds
                from sale of commonstock
                to 401(k) plan
            
            
            336
            
            
            502,855
            
            
            --
            
            
            --
            
            
            --
            
            
            503,191Effect
                of exercise and issuance ofstock
                options
            
            
            723
            
            
            501,486
            
            
            --
            
            
            --
            
            
            --
            
            
            502,209Balance
                at December 31, 2004
            
            
            38,406
            
            
            23,731,549
            
            
            12,635,174
            
            
            377,989
            
            
            (699,796
            )
            
            36,083,322**Net
                income 2005**
            
            
            **--**
            
            
            **--**
            
            
            **5,121,576**
            
            
            **--**
            
            
            **--**
            
            
            **5,121,576****Unrealized
                losses on available-****for-sale
                securities, net of****tax
                of $436,151**
            
            
            **--**
            
            
            **--**
            
            
            **--**
            
            
            **(846,648**
            **)**
            
            **--**
            
            
            **(846,648**
            **)****Comprehensive
                income**
            
            
            **--**
            
            
            **--**
            
            
            **--**
            
            
            **--**
            
            
            **--**
            
            
            **4,274,928****Proceeds
                from sale of common****stock
                to 401(k) plan**
            
            
            **330**
            
            
            **494,670**
            
            
            **--**
            
            
            **--**
            
            
            **--**
            
            
            **495,000****Effect
                of exercise and issuance of****stock
                options**
            
            
            **865**
            
            
            **600,843**
            
            
            **--**
            
            
            **--**
            
            
            **--**
            
            
            **601,708****Proceeds
                from sale of common****stock
                through stock offering**
            
            
            **12,650**
            
            
            **18,356,991**
            
            
            **--**
            
            
            **--**
            
            
            **--**
            
            
            **18,369,641****Balance
                at December 31, 2005**
            
            **$**
            **52,251**
            
            **$**
            **43,184,053**
            
            **$**
            **17,756,750**
            
            **$**
            **(468,659**
            **)**
            **$**
            **(699,796**
            **)**
            **$**
            **59,824,599**




See
        notes
        to consolidated financial statements


45


**APPALACHIAN
      BANCSHARES, INC. AND SUBSIDIARIES**




**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




**Years
      Ended December 31, 2005, 2004 and 2003**








**2005**
            
            2004
            
            2003**Operating
                Activities**Net
                income
            
            **$**
            **5,121,576**
            
            $
            4,047,014
            
            $
            3,086,580Adjustments
                to reconcile net income to net cashprovided
                by operating activities:Depreciation,
                amortization, and accretion, net
            
            
            **926,159**
            
            
            1,039,402
            
            
            1,312,067Provision
                for loan losses
            
            
            **2,210,900**
            
            
            1,235,107
            
            
            1,465,000Deferred
                tax benefit
            
            
            **(70,827**
            **)**
            
            (22,000
            )
            
            (20,000
            )Realized
                security losses, net
            
            
            **--**
            
            
            22,633
            
            
            16,978Loss
                on disposal of premises and equipment
            
            
            **59,158**
            
            
            24,205
            
            
            8,630Loss
                on disposition of other real estate
            
            
            **80,191**
            
            
            195,181
            
            
            42,143Increase
                in cash surrender value on life insurance
            
            
            **(309,083**
            **)**
            
            (241,034
            )
            
            (109,173
            )Increase
                in accrued interest receivable
            
            
            **(1,849,238**
            **)**
            
            (611,743
            )
            
            (49,074
            )(Increase)
                decrease in accrued interest payable
            
            
            **188,000**
            
            
            (130,397
            )
            
            (305,542
            )Other,
                net
            
            
            **1,290,228**
            
            
            280,116
            
            
            685,954**Net
                Cash Provided By Operating Activities**
            
            
            **7,647,064**
            
            
            5,838,484
            
            
            6,133,563**Investing
                Activities**Proceeds
                from sales of securities available-for-sale
            
            
            **1,427,235**
            
            
            4,261,201
            
            
            5,368,830Proceeds
                from maturity, calls and paydown ofsecurities
                available-for-sale
            
            
            **6,008,703**
            
            
            12,472,586
            
            
            23,121,518Purchase
                of securities available-for-sale
            
            
            **(15,690,130**
            **)**
            
            (26,260,504
            )
            
            (43,960,542
            )Net
                increase in loans
            
            
            **(80,818,958**
            **)**
            
            (46,311,074
            )
            
            (36,321,605
            )Capital
                expenditures, net
            
            
            **(4,899,152**
            **)**
            
            (4,959,258
            )
            
            (1,211,594
            )Proceeds
                from sales of premises and equipment
            
            
            **160,909**
            
            
            241,917
            
            
            27,746Purchase
                of insurance contracts
            
            
            **--**
            
            
            (5,000,000
            )
            
            --Proceeds
                from disposition of foreclosed real estate
            
            
            **540,949**
            
            
            806,763
            
            
            1,248,201**Net
                Cash Used In Investing Activities**
            
            
            **(93,270,444**
            **)**
            
            (64,748,369
            )
            
            (51,727,446
            )**Financing
                Activities**Net
                increase in demand deposits, NOW accounts,and
                savings accounts
            
            
            **49,183,313**
            
            
            32,357,873
            
            
            2,458,008Net
                increase in certificates of deposit
            
            
            **42,628,275**
            
            
            16,221,350
            
            
            14,178,184Net
                increase in federal funds purchased, securities soldunder
                agreements to repurchase, and FHLB line ofcredit
            
            
            **9,422,199**
            
            
            3,383,548
            
            
            1,157,368Issuance
                of FHLB advances
            
            
            **4,000,000**
            
            
            13,500,000
            
            
            33,736,000Repayment
                of FHLB advances
            
            
            **(11,000,000**
            **)**
            
            (7,242,858
            )
            
            (31,592,858
            )Compensation
                associated with issuance of stock options
            
            
            **18,746**
            
            
            42,301
            
            
            21,739Issuance
                of common stock
            
            
            **19,193,277**
            
            
            769,941
            
            
            302,800Sale
                of treasury stock
            
            
            **--**
            
            
            --
            
            
            1,923,601Purchase
                of treasury stock
            
            
            **--**
            
            
            --
            
            
            (54,900
            )Cash
                in lieu of fractional shares on stock dividend
            
            
            **--**
            
            
            --
            
            
            (1,931
            )**Net
                Cash Provided By Financing Activities**
            
            
            **113,445,810**
            
            
            59,032,155
            
            
            22,128,011**Net
                Increase (Decrease) in Cash and Cash Equivalents**
            
            
            **27,822,430**
            
            
            122,270
            
            
            (23,465,872
            )Cash
                and Cash Equivalents at Beginning of Year
            
            
            **7,513,095**
            
            
            7,390,825
            
            
            30,856,697**Cash
                and Cash Equivalents at End of Year**
            
            **$**
            **35,335,525**
            
            $
            7,513,095
            
            $
            7,390,825




See
        notes
        to consolidated financial statements


46
 **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”). Another
      corporation still in existence, Appalachian Information Management, Inc. (“AIM”)
      was formed as a wholly-owned subsidiary of the Bank, but ceased operations
      in
      August, 2002. These consolidated financial statements do not include any
      activities of AIM. The Company continues to keep AIM in existence, however,
      in
      order to retain the name for potential future use. 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.


47
 **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, 2005
      and 2004.





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
      considered insignificant and are recognized immediately. Any significant net
      fees would be 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
      considered impaired, based on current information and events, if it is probable
      that the Bank will be unable to collect the scheduled payments of principal
      or
      interest when due according to the contractual terms of the loan agreement.
      Uncollateralized loans are measured for impairment based on the present value
      of
      expected future cash flows discounted at the historical effective interest
      rate,
      while all collateral-dependent loans are measured for impairment based on the
      fair value of the collateral. 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, 2005 and 2004.





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.


48
 **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, 2005, 2004 and
      2003.





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 straight-line
      methods 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, 2005 and 2004
      was $147,019 and $516,140, respectively.





Advertising
      Costs





The
      Company’s policy is to expense advertising costs as incurred. Advertising
      expense for the years ended December 31, 2005, 2004 and 2003 amounted to
      approximately $1,045,396, $782,000, and $516,000, respectively.


49
 **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, 2005, 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 earnings, 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 Statement of Financial Accounting Standards (“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 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. The following table illustrates the effects on
      net
      income and earnings per share if the fair value based method had been applied
      to
      all outstanding awards in each period.





Years
                Ended December 31,**2005**
            
            2004
            
            2003Net
                Income, As Reported
            
            **$**
            **5,121,576**
            
            $
            4,047,014
            
            $
            3,086,580Add:
                Stock-based compensation expense includedin
                net income, net of related taxes
            
            
            **18,745**
            
            
            42,301
            
            
            21,739Deduct:
                Total stock-based employee compensationexpense
                determined under the fair value methodfor
                all awards, net of related taxes
            
            
            **(52,714**
            **)**
            
            (60,293
            )
            
            (63,350
            )Pro
                Forma Net Income
            
            **$**
            **5,087,607**
            
            $
            4,029,022
            
            $
            3,044,969








50
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
        1 - Summary of Significant Accounting Policies -
        Continued**





Years
                Ended December 31,**2005**
            
            2004
            
            2003Basic
                Earnings per Common ShareAs
                reported
            
            $
            1.24
            
            $
            1.09
            
            $
            0.86Pro
                Forma
            
            
            1.23
            
            
            1.08
            
            
            0.84Diluted
                Earnings per Common ShareAs
                reported
            
            
            1.21
            
            
            1.04
            
            
            0.81Pro
                Forma
            
            
            1.20
            
            
            1.04
            
            
            0.80Weighted
                average fair value of options grantedduring
                the year
            
            
            4.89
            
            
            3.79
            
            
            4.20Assumptions:Average
                risk free interest rate
            
            
            4.15
            %
            
            4.07
            %
            
            4.95
            %Average
                expected volatility
            
            
            15.80
            
            
            21.30
            
            
            22.53Expected
                dividend yield
            
            
            0.00
            
            
            1.90
            
            
            1.90Expected
                life
            
            
            7.5
                years
            
            
            7.5
                years
            
            
            7.5
                years





The
      effects of applying SFAS No. 123 as amended by SFAS No. 148 for providing pro
      forma disclosures are not likely to be representative of the effects on reported
      earnings for future years, nor are the dividend estimates representative of
      commitments on the part of the Company’s Board.





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. The goodwill represents a premium paid on the purchase
      of
      assets and deposit liabilities. The asset 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, 2005 and 2004 is
      $1,991,891.





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 an 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 December 31, 2005 and determined that there was no
      impairment of the carrying value.





51
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**




**Note
        1 - Summary of Significant Accounting Policies -
        Continued**
  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 19 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 $30
      million, of which $22.8 million was available. In addition, the Company has
      a
      line of credit with the Federal Home Loan Bank (the “FHLB”), of up to
      approximately $81,870,000, of which approximately $43,000,000 is available
      and
      unused, subject to proper collateralization.





Recently
      Issued Accounting Standards





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), entitled Share-Based
      Payment (“SFAS No. 123R”) that will require compensation costs related to
      share-based payment transactions to be recognized in the financial statements.
      This Statement eliminates the alternative to use Accounting Principles Board
      (“APB”) Opinion No. 25’s Accounting for Stock Issued to Employees intrinsic
      value method of accounting that was provided in Statement 123 as originally
      issued. Under APB Opinion No. 25, issuing stock options to employees generally
      resulted in recognition of no compensation cost. This statement requires
      entities to recognize the cost of employee services received in exchange for
      awards of equity instruments based on the grant-date fair value of those awards
      (with limited exceptions). Recognition of that compensation cost helps users
      of
      financial statements to better understand the economic transactions affecting
      an
      entity and to make better resource allocation decisions. 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 will be required to expense any unvested option. On April
      21, 2005 the SEC amended Rule 4-01(a) of Regulation S-X regarding the compliance
      date for SFAS 123(R) so the effective date is delayed to January 1, 2006. The
      Company is currently evaluating the provisions of SFAS No. 123(R) and will
      adopt
      it on January 1, 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,**2005**
            
            2004
            
            2003Weighted
                average of common shares outstanding
            
            
            **4,123,403**
            
            
            3,724,095
            
            
            3,609,728Effect
                of dilutive options
            
            
            **123,931**
            
            
            161,395
            
            
            199,897Weighted
                average of common shares outstandingeffected
                for dilution
            
            
            **4,247,334**
            
            
            3,885,490
            
            
            3,809,625





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.


52
 **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,**2005**
            
            2004
            
            2003Unrealized
                gains (losses) on securitiesUnrealized
                holding losses arising during period
            
            **$**
            **(1,282,799**
            **)**
            $
            (100,579
            )
            $
            (46,701
            )Reclassification
                adjustments for lossesincluded
                in net income
            
            
            **--**
            
            
            22,633
            
            
            16,978Net
                unrealized losses
            
            
            **(1,282,799**
            **)**
            
            (77,946
            )
            
            (29,723
            )Income
                tax related to items of othercomprehensive
                income
            
            
            **436,151**
            
            
            26,501
            
            
            10,107Other
                comprehensive loss
            
            **$**
            **(846,648**
            **)**
            $
            (51,445
            )
            $
            (19,616
            )





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, 2005.





Years
                Ended December 31,**2005**
            
            2004
            
            2003Cash
                paid during the year for interest
            
            **$**
            **10,030,260**
            
            $
            7,688,376
            
            $
            8,562,106Cash
                paid during the year for income taxes
            
            
            **2,291,528**
            
            
            1,690,000
            
            
            836,039Non-cash
                Disclosures:Loans
                transferred to foreclosed assets
            
            
            **252,019**
            
            
            1,563,178
            
            
            1,517,302Net
                decrease in unrealized gains andlosses
                on securities available-for-sale
            
            
            **(1,282,799**
            **)**
            
            (77,946
            )
            
            (29,723
            )Proceeds
                from sales of foreclosed assetsfinanced
                through loans
            
            
            **--**
            
            
            793,442
            
            
            532,192Tax
                benefit of the exercise of non-qualified options
            
            
            **254,326**
            
            
            193,158
            
            
            204,791Increase
                in cash surrender value on life insurance
            
            
            **309,083**
            
            
            241,034
            
            
            109,173





53
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**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, 2005 and 2004, the
      average amount of the required reserves was $626,000 and $623,000, respectively.








**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, 2005 and 2004 are presented below.





**December
                31, 2005**
            
            
            
            Gross
            
            Gross
            
            EstimatedAmortized
            
            Unrealized
            
            Unrealized
            
            FairCost
            
            Gains
            
            Losses
            
            Value**Securities
                Available-for-Sale****December
                31, 2005****:****U.S.
                Government and agency securities**
            
            **$**
            **38,175,337**
            
            **$**
            **--**
            
            **$**
            **817,790**
            
            **$**
            **37,357,547****State
                and municipal securities**
            
            
            **14,250,685**
            
            
            **572,319**
            
            
            **16,758**
            
            
            **14,806,246****Mortgage-backed
                securities**
            
            
            **16,120,789**
            
            
            **1,656**
            
            
            **319,515**
            
            
            **15,802,930****Equity
                securities**
            
            
            **3,733,600**
            
            
            **--**
            
            
            **130,000**
            
            
            **3,603,600****$**
            **72,280,411**
            
            **$**
            **573,975**
            
            **$**
            **1,284,063**
            
            **$**
            **71,570,323**December
                31, 2004:U.S.
                Government and agency securities
            
            $
            31,982,618
            
            $
            45,348
            
            $
            283,784
            
            $
            31,744,182State
                and municipal securities
            
            
            13,458,279
            
            
            819,037
            
            
            --
            
            
            14,277,316Mortgage-backed
                securities
            
            
            14,934,714
            
            
            45,047
            
            
            52,937
            
            
            14,926,824Equity
                securities
            
            
            3,706,400
            
            
            --
            
            
            --
            
            
            3,706,400$
            64,082,011
            
            $
            909,432
            
            $
            336,721
            
            $
            64,654,722





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. At December 31, 2004, the Company’s
      available-for-sale securities reflected net unrealized gains of $572,711, which
      resulted in an increase in stockholders’ equity of $377,989, net of deferred
      taxes.


54
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**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, 2005 and 2004.





**December
                31, 2005****Less
                Than 12 Months**
            
            **12
                Months or More**
            
            **Total****Gross**
            
            
            
            **Gross**
            
            
            
            **Gross****Fair**
            
            **Unrealized**
            
            **Fair**
            
            **Unrealized**
            
            **Fair**
            
            **Unrealized****Value**
            
            **Losses**
            
            **Value**
            
            **Losses**
            
            **Value**
            
            **Losses****Securities
                Available-for-Sale****U.S.
                Government and****agency
                securities**
            
            **$**
            **16,620,277**
            
            **$**
            **260,453**
            
            **$**
            **20,737,270**
            
            **$**
            **557,337**
            
            **$**
            **37,357,547**
            
            **$**
            **817,790****State
                and municipal****securities**
            
            
            **1,143,100**
            
            
            **16,758**
            
            
            **--**
            
            
            **--**
            
            
            **1,143,100**
            
            
            **16,758****Mortgage-backed****securities**
            
            
            **10,095,729**
            
            
            **121,178**
            
            
            **5,519,968**
            
            
            **198,337**
            
            
            **15,615,697**
            
            
            **319,515****Equity
                securities**
            
            
            **720,000**
            
            
            **130,000**
            
            
            **--**
            
            
            **--**
            
            
            **720,000**
            
            
            **130,000****$**
            **28,579,106**
            
            **$**
            **528,389**
            
            **$**
            **26,257,238**
            
            **$**
            **755,674**
            
            **$**
            **54,836,344**
            
            **$**
            **1,284,063**





**December
                31, 2004**Less
                Than 12 Months
            
            12
                Months or More
            
            TotalGross
            
            
            
            Gross
            
            
            
            GrossFair
            
            Unrealized
            
            Fair
            
            Unrealized
            
            Fair
            
            UnrealizedValue
            
            Losses
            
            Value
            
            Losses
            
            Value
            
            Losses**Securities
                Available-for-Sale**U.S.
                Government andagency
                securities
            
            $
            15,217,628
            
            $
            133,822
            
            $
            5,797,158
            
            $
            149,962
            
            $
            21,014,786
            
            $
            283,784Mortgage-backedsecurities
            
            
            10,496,622
            
            
            52,937
            
            
            --
            
            
            --
            
            
            10,496,622
            
            
            52,937$
            25,714,250
            
            $
            186,759
            
            $
            5,797,158
            
            $
            149,962
            
            $
            31,511,408
            
            $
            336,721





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, 2005 and 2004 are in 20 and four securities,
      respectively, that are insured agencies of the United States Government and
      the
      losses can be attributable to changes in interest rates. 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.


55
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      3 - Securities - Continued**





The
      contractual maturities of securities available-for-sale at December 31, 2005
      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.





Amortized
            
            EstimatedCost
            
            Fair
                Value**Securities
                Available-for-Sale**Due
                in one year or less
            
            $
            6,600,645
            
            $
            6,546,175Due
                after one year through five years
            
            
            32,120,691
            
            
            31,361,598Due
                after five years through ten years
            
            
            5,161,369
            
            
            5,182,397Due
                after ten years
            
            
            24,664,106
            
            
            24,876,553Equity
                securities
            
            
            3,733,600
            
            
            3,603,600$
            72,280,411
            
            $
            71,570,323





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, 2005, were as
      follows:





**2005**
            
            2004
            
            2003Gross
                realized gains
            
            **$**
            **--**
            
            $
            --
            
            $
            24,243Gross
                realized losses
            
            
            **--**
            
            
            22,633
            
            
            41,221





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 $2,697,600 and $2,670,400 at
      December 31, 2005 and 2004, 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 $720,000 and
      $850,000 at December 31, 2005 and 2004, 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, 2005 and 2004.





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 $50,687,921 and $44,354,611 at December 31,
      2005
      and 2004, respectively.





56
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      4 - Loans**





The
      Company grants loans to customers primarily in the North Georgia area. The
      major
      classifications of loans as of December 31, 2005 and 2004 were as
      follows:





December
                31,**2005**
            
            2004Commercial,
                financial and agricultural
            
            **$**
            **33,778,091**
            
            $
            31,919,880Real
                estate - construction
            
            
            **203,538,127**
            
            
            145,587,858Real
                estate - mortgage
            
            
            **193,704,321**
            
            
            173,954,978Consumer
            
            
            **21,051,214**
            
            
            20,956,568Other
                loans
            
            
            **5,346,407**
            
            
            4,932,217**457,418,160**
            
            
            377,351,501Allowance
                for loan losses
            
            
            **(6,059,238**
            **)**
            
            (4,348,618
            )Net
                loans
            
            **$**
            **451,358,922**
            
            $
            373,002,883





Total
      loans which the Company considered to be impaired at December 31, 2005 and
      2004
      were $3,543,578 and $1,524,541, respectively. Of these loans, $1,020,030 and
      $1,524,541 were on nonaccrual status at December 31, 2005 and 2004,
      respectively. Allowances on the impaired loans at December 31, 2005 and 2004
      were $1,422,509 and $546,016, respectively. Impaired loans consisted primarily
      of commercial loans and real estate - mortgage loans as of December 31, 2005
      and
      real estate - mortgage loans as of December 31, 2004. The average recorded
      investment in impaired loans for the years ended December 31, 2005 and 2004
      was
      approximately $3,811,169 and $1,353,000, respectively. No material amount of
      interest income was recognized on nonaccrual loans for the years ended December
      31, 2005 and 2004. For other impaired loans we collected approximately $184,000
      in interest. For the year ended December 31, 2005, 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 $70,000. In the year ended December 31, 2004, the amount was
      approximately $89,000.





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





At
      December 31, 2005 and 2004, the Company had loans past due 90 days or more
      and
      still accruing interest of $70,974 and $34,263, respectively.





Commercial
      and residential real estate loans pledged to secure Federal Home Loan Bank
      advances and letters of credit amounted to $56,989,366 and $64,349,607 at
      December 31, 2005 and 2004, respectively.








57
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      5 - Allowance for Loan Losses**





Changes
      in the allowance for loan losses for each of the three years ended December
      31,
      2005, 2004 and 2003 are as follows:





**2005**
            
            2004
            
            2003Balance
                at beginning of year
            
            **$**
            **4,348,618**
            
            $
            3,609,794
            
            $
            3,237,898Charge-offs
            
            
            **(559,795**
            **)**
            
            (555,779
            )
            
            (1,207,788
            )Recoveries
            
            
            **59,515**
            
            
            59,496
            
            
            114,684Net
                charge-offs
            
            
            **(500,280**
            **)**
            
            (496,283
            )
            
            (1,093,104
            )Provision
                for loan losses
            
            
            **2,210,900**
            
            
            1,235,107
            
            
            1,465,000Balance
                at end of year
            
            **$**
            **6,059,238**
            
            $
            4,348,618
            
            $
            3,609,794








**Note
      6 - Premises and Equipment**





Premises
      and Equipment


Premises
      and equipment were as follows:





December
                31,**2005**
            
            2004Land
            
            **$**
            **3,873,396**
            
            $
            3,853,534Buildings
                and improvements
            
            
            **6,877,816**
            
            
            7,060,222Furniture
                and equipment
            
            
            **4,130,007**
            
            
            4,083,395Computer
                equipment and software
            
            
            **1,612,414**
            
            
            1,429,038Automobiles
            
            
            **247,167**
            
            
            175,971Construction
                in progress
            
            
            **4,772,531**
            
            
            272,637**21,513,331**
            
            
            16,874,797Allowance
                for depreciation
            
            
            **(4,715,945**
            **)**
            
            (3,886,157
            )**$**
            **16,797,386**
            
            $
            12,988,640





The
      provision for depreciation charged to occupancy and furniture and equipment
      expense for the years ended December 31, 2005, 2004 and 2003 was $870,339,
      $866,108 and $784,918, respectively.





In
      2004,
      we purchased approximately 6.3 acres of land in Ellijay directly across the
      street from the main office upon which we are constructing a 39,000 square
      foot
      operations center. We have also constructed a maintenance building and a
      community building at this location to use as a meeting area, as well as for
      our
      customers to use for various community functions. The entire project is expected
      to cost approximately $6.3 million. Completion of this building is expected
      in
      March 2006.





*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, 2005, 2004 and 2003, rental expense for operating
      leases was approximately $69,684, $90,248 and $81,500, respectively.


58
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      6 - Premises and Equipment - Continued**





Future
      minimum lease payments under noncancellable operating leases at December 31,
      2005, are as follows:





Years
                Ending December 31,2006
            
            $
            36,3852007
            
            
            35,9982008
            
            
            35,0742009
            
            
            35,7632010
            
            
            35,917Thereafter
            
            $
            783,346Total
                minimum lease payments
            
            $
            962,483





**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, 2005 and 2004 were $125,022,322
      and $108,687,921, respectively. The Company had brokered time deposits at
      December 31, 2005 and 2004 of $52,587,602 and $23,371,264, respectively. Demand
      deposits reclassified as loan balances as of December 31, 2005 and 2004 amounted
      to $172,599 and $143,076, respectively.




The
      maturities of time certificates of deposit and other time deposits issued by
      the
      Company at December 31, 2005, are as follows:





Years
                ending December 31,2006
            
            $
            198,557,5612007
            
            
            36,202,6472008
            
            
            2,353,7902009
            
            
            4,937,4762010
            
            
            1,603,756After
                2010
            
            
            969$
            243,656,199








**Note
      8 - Short-term Borrowings**





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





**2005**
            
            2004Federal
                funds purchased
            
            **$**
            **7,217,000**
            
            $
            --Securities
                sold under repurchase agreements
            
            
            **3,674,739**
            
            
            6,263,790FHLB
                line of credit
            
            
            **14,000,000**
            
            
            9,205,750**$**
            **24,891,739**
            
            $
            15,469,540





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.


59
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**





**Note
      9 - Federal Home Loan Bank Advances**





At
      December 31, 2005 and 2004, the Company had advances from the Federal Home
      Loan
      Bank (FHLB) totaling $24,950,000 and $31,950,000, respectively. These advances
      do not include the FHLB Daily Rate Credit included in short-term borrowings
      in
      the previous note.





FHLB
      advances consist of the following at December 31:


**2005**
            
            2004Notes
                payable on line of credit at FHLB, with varying maturities
                fromSeptember
                2006 through December 2015, interest rate vary from3.26
                % to 6.77%, secured by residential mortgages
            
            **$**
            **24,950,000**
            
            $
            31,950,000





Fixed
            
            VariableYears
                ending December 31,2006
            
            $
            400,000
            
            $
            1,500,0002007
            
            
            2,900,000
            
            
            --2008
            
            
            1,150,000
            
            
            --2009
            
            
            --
            
            
            5,000,0002010
            
            
            --
            
            
            2,000,000Thereafter
            
            
            --
            
            
            12,000,000$
            4,450,000
            
            $
            20,500,000








**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, 2005 and 2004 was 7.25% and 5.16%,
      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
      approximately 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.




















60
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      11 - Other Operating Expenses**





Other
      operating expenses consist of the following:





**2005**
            
            2004
            
            2003Professional
                fees
            
            **$**
            **1,274,662**
            
            $
            987,499
            
            $
            948,335Advertising
                and marketing
            
            
            **1,045,396**
            
            
            782,072
            
            
            516,036Data
                processing
            
            
            **653,283**
            
            
            536,713
            
            
            569,915Director
                and committee fees
            
            
            **531,686**
            
            
            426,505
            
            
            314,500Stationery
                and supplies
            
            
            **321,283**
            
            
            367,507
            
            
            337,712Other
            
            
            **1,756,193**
            
            
            1,899,450
            
            
            1,787,758Total
                other operating expenses
            
            **$**
            **5,582,503**
            
            $
            4,999,746
            
            $
            4,474,256








**Note
      12 - Income Taxes**





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





**2005**
            
            2004
            
            2003CurrentFederal
            
            **$**
            **2,906,000**
            
            $
            1,717,676
            
            $
            1,150,739State
            
            
            **401,000**
            
            
            189,656
            
            
            122,576DeferredFederal
            
            
            **(737,827**
            **)**
            
            (18,000
            )
            
            (19,000
            )State
            
            
            **(67,000**
            **)**
            
            (4,000
            )
            
            (1,000
            )**$**
            **2,502,173**
            
            $
            1,885,332
            
            $
            1,253,315








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, 2005, 2004 and
      2003.





**2005**
            
            2004
            
            2003Statutory
                federal income tax rate
            
            
            **34.0**
            **%**
            
            34.0
            %
            
            34.0
            %Effect
                on rate of:Tax-exempt
                securities
            
            
            **(2.9**
            **)**
            
            (3.7
            )
            
            (5.4
            )Tax-exempt
                loans
            
            
            **(0.1**
            **)**
            
            (0.2
            )
            
            (1.0
            )Interest
                expense disallowance
            
            
            **0.3**
            
            
            0.3
            
            
            0.5State
                income tax, net of federal tax
            
            
            **2.9**
            
            
            2.1
            
            
            1.9Other
            
            
            **(1.4**
            **)**
            
            (0.7
            )
            
            (1.1
            )Effective
                income tax rate
            
            
            **32.8**
            **%**
            
            31.8
            %
            
            28.9
            %





61
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      12 - Income Taxes - Continued**





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





**2005**
            
            2004Net
                unrealized (gains) losses on securities available-for-sale
            
            **$**
            **241,430**
            
            $
            (194,722
            )Depreciation
            
            
            **(520,566**
            **)**
            
            (595,580
            )Allowance
                for loan losses
            
            
            **1,846,613**
            
            
            1,223,341Deferred
                compensation
            
            
            **207,276**
            
            
            103,947Other
            
            
            **504**
            
            
            (2,708
            )Net
                deferred tax assets
            
            **$**
            **1,775,257**
            
            $
            534,278





**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 conducts regular reviews
      of
      these instruments on an individual customer basis, and the results are
      considered in assessing the adequacy of the Bank’s allowance for loan losses.
      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, 2005 and 2004, the Bank has issued standby letters of credit of
      approximately $3,491,000 and $1,403,000. 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, 2005 and 2004, the Bank had commitments outstanding to extend
      credit totaling approximately $73,363,000 and $59,005,000, 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
      Bank 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.


62
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      15 - Stock Option Plans**





The
      Company has adopted a 1997 Employee Stock Incentive Plan and a 1997 Directors’
Non-qualified 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
      following sets forth certain information regarding stock options for the years
      ended December 31, 2005, 2004 and 2003.





2005
            
            2004
            
            2003Weighted
            
            
            
            Weighted
            
            
            
            WeightedAverage
            
            
            
            Average
            
            
            
            AverageExercise
            
            
            
            Exercise
            
            
            
            ExerciseShares
            
            Price
            
            Shares
            
            Price
            
            Shares
            
            PriceOutstanding
                at beginning of year
            
            
            360,300
            
            $
            6.07
            
            
            433,140
            
            $
            5.65
            
            
            502,810
            
            $
            5.11Granted
            
            
            52,000
            
            
            16.16
            
            
            5,000
            
            
            15.00
            
            
            18,000
            
            
            13.92Exercised
            
            
            (86,525
            )
            
            3.80
            
            
            (72,340
            )
            
            3.68
            
            
            (82,170
            )
            
            3.69Forfeited
            
            
            (31,800
            )
            
            15.10
            
            
            (5,500
            )
            
            12.73
            
            
            (5,500
            )
            
            13.64Outstanding
                at end of year
            
            
            293,975
            
            
            7.55
            
            
            360,300
            
            
            6.07
            
            
            433,140
            
            
            5.65Exercisable
                at end of year
            
            
            243,675
            
            
            5.94
            
            
            325,660
            
            
            5.29
            
            
            362,780
            
            
            4.57Weighted
                average fair valueof
                options granted
            
            $
            4.89
            
            
            
            
            $
            3.79
            
            
            
            
            $
            4.20





Information
      pertaining to options outstanding at December 31, 2005 is as
      follows:





Options
                Outstanding
            
            Options
                ExercisableWeighted
            
            Weighted
            
            
            
            WeightedNumber
                of
            
            Average
            
            Average
            
            Number
                of
            
            AverageOptions
            
            Remaining
            
            Exercise
            
            Options
            
            ExerciseOutstanding
            
            Life
            
            Price
            
            Exercisable
            
            PriceOptions
                with an Exercise Price Rangeof
                $3.64 to $5.45
            
            
            199,075
            
            
            2.22
            
            $
            4.35
            
            
            199,075
            
            $
            4.35Options
                with an Exercise Priceof
                $12.73 to $16.55
            
            
            94,900
            
            
            7.30
            
            
            14.25
            
            
            44,600
            
            
            13.03Total
                Options Outstanding
            
            
            293,975
            
            
            3.86
            
            
            7.55
            
            
            243,675
            
            
            5.94








63
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**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, 2005, the Bank could declare dividends of approximately $3,013,000
      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.





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, 2005, that the
      Company and the Bank met all capital adequacy requirements to which they are
      subject.





As
      of
      December 31, 2005, 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 Company the Bank
      must maintain minimum Total Capital, Tier 1 Capital and Tier 1 Leverage ratios
      as set forth in the table following table.


64
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      16 - Regulatory Matters - Continued**





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





To
                Be Well CapitalizedUnder
                PromptCorrective
                ActionActual
            
            Adequacy
                Purposes
            
            ProvisionsAmount
            
            Ratio
            
            Amount
            
            Ratio
            
            Amount
            
            Ratio(Dollars
                in thousands)**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
            
            
            5.00As
                of December 31, 2004:Total
                CapitalConsolidated
            
            $
            44,062
            
            
            11.45
            %
            $
            30,788
            
            
            8.00
            %
            $
            N/A
            
            
            N/AAppalachian
                Community Bank
            
            
            41,586
            
            
            10.82
            
            
            30,752
            
            
            8.00
            
            
            38,440
            
            
            10.00
            %Tier
                1 CapitalConsolidated
            
            
            39,713
            
            
            10.32
            
            
            15,394
            
            
            4.00
            
            
            N/A
            
            
            N/AAppalachian
                Community Bank
            
            
            37,237
            
            
            9.69
            
            
            15,376
            
            
            4.00
            
            
            23,064
            
            
            6.00Tier
                1 LeverageConsolidated
            
            
            39,713
            
            
            8.53
            
            
            18,618
            
            
            4.00
            
            
            N/A
            
            
            N/AAppalachian
                Community Bank
            
            
            37,237
            
            
            8.01
            
            
            18,597
            
            
            4.00
            
            
            23,246
            
            
            5.00





**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 $472,200 in 2005, $313,200 in 2004
      and $300,200 in 2003.





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, 2005, 2004, and 2003 related to these plans were
      $277,426, $97,653 and $33,331, 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 $575,667, and $288,741 is included in other liabilities
      as of December 31, 2005 and 2004, respectively. Cash surrender values of
      $8,142,533 and $7,833,450 on the insurance policies is included in other assets
      at December 31, 2005 and 2004, respectively.


65
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**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 2005
      and 2004. 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:





**2005**
            
            2004Balance
                at beginning of year
            
            **$**
            **11,237,734**
            
            $
            7,988,488New
                loans
            
            
            **9,738,361**
            
            
            11,237,794Repayments
            
            
            **(6,595,460**
            **)**
            
            (5,754,205
            )Participations
                sold
            
            
            **1,103,176**
            
            
            (2,234,343
            )Change
                in related parties
            
            
            **(4,267,156**
            **)**
            
            --Balance
                at end of year
            
            **$**
            **11,216,655**
            
            $
            11,237,734





Deposits :
      Deposits held from related parties were $2,075,324 and $3,117,444 at December
      31, 2005 and 2004, respectively.





Construction
      contracts :
      During
      2005 and 2004, 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 2005 amounted to $469,780, and amounts paid in 2004 amounted
      to
      $309,791.





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 Company in 2005 and 2004
      amounted to $231,728 and $196,000, respectively.








**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.





Securities :
      For
      securities and marketable equity securities held for investment purposes, 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.





66
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      19 - Fair Value of Financial Instruments - Continued**





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.





The
      estimated fair values of the Company’s financial instruments as of December 31,
      2005 and 2004 are as follows:





**2005**
            
            2004**Carrying**
            
            **Fair**
            
            Carrying
            
            Fair**Amount**
            
            **Value**
            
            Amount
            
            Value(In
                thousands)**Financial
                Assets**Cash
                and short-term investments
            
            **$**
            **35,336**
            
            **$**
            **35,336**
            
            $
            7,513
            
            $
            7,513Securities
            
            
            **71,570**
            
            
            **71,570**
            
            
            64,655
            
            
            64,655Loans
            
            
            **451,359**
            
            
            **449,416**
            
            
            373,003
            
            
            372,767Accrued
                interest receivable
            
            
            **4,751**
            
            
            **4,751**
            
            
            2,902
            
            
            2,902**Total
                Financial Assets**
            
            **$**
            **563,016**
            
            **$**
            **561,073**
            
            $
            448,073
            
            $
            447,837**Financial
                Liabilities**Deposits
            
            **$**
            **473,310**
            
            **$**
            **473,276**
            
            $
            381,498
            
            $
            367,583Short-term
                borrowings
            
            
            **24,892**
            
            
            **24,892**
            
            
            15,470
            
            
            15,470Accrued
                interest payable
            
            
            **728**
            
            
            **728**
            
            
            540
            
            
            540FHLB
                advances
            
            
            **31,136**
            
            
            **31,157**
            
            
            38,136
            
            
            38,048**Total
                Financial Liabilities**
            
            **$**
            **530,066**
            
            **$**
            **530,053**
            
            $
            435,644
            
            $
            421,641**Unrecognized
                financial instruments**Commitments
                to extend credit
            
            **$**
            **73,363**
            
            **$**
            **448**
            
            $
            59,005
            
            $
            236Standby
                letters of credit
            
            
            **3,491**
            
            
            **21**
            
            
            1,403
            
            
            6**Total
                Unrecognized Financial****Instruments**
            
            **$**
            **76,854**
            
            **$**
            **469**
            
            $
            60,408
            
            $
            242








**Note
      20 - Stock Offering**





On
      September 23, 2005, the Company filed a Registration Statement on Form S-2
      to
      register up to 1,265,000 shares of its common stock for sale in a public
      offering. In November 2005, the Company completed the sale of 1,265,000 shares
      of its common stock receiving net proceeds of approximately $18.4 million.
      The
      Company intends to use the proceeds of the offering for general corporate
      purposes.





67
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      21 - Condensed Parent Information**





**Statements
                of Financial Condition****December
                31,****2005**
            
            2004**Assets**Cash
                and due from banks
            
            **$**
            **17,291,201**
            
            $
            2,150,693Investment
                in subsidiaries
            
            
            **48,287,718**
            
            
            39,607,384Securities
                available-for-sale
            
            
            **186,000**
            
            
            186,000Other
                assets
            
            
            **623,641**
            
            
            498,721**Total
                Assets**
            
            **$**
            **66,388,560**
            
            $
            42,442,798**Liabilities
                and Shareholders’ Equity**Subordinated
                long-term capital notes
            
            **$**
            **6,186,000**
            
            $
            6,186,000Other
                liabilities
            
            
            **377,961**
            
            
            173,476**Total
                Liabilities**
            
            
            **6,563,961**
            
            
            6,359,476**Total
                Shareholders’ Equity**
            
            
            **59,824,599**
            
            
            36,083,322**Total
                Liabilities and Shareholders’ Equity**
            
            **$**
            **66,388,560**
            
            $
            42,442,798





**Statements
                of Income****Years
                ended December 31,****2005**
            
            2004
            
            2003**Income**Interest
            
            $
            —
            
            $
            —
            
            $
            —Dividends
                from subsidiaries
            
            
            —
            
            
            —
            
            
            —Other
                income
            
            
            **11,227**
            
            
            9,638
            
            
            —**11,227**
            
            
            9,638
            
            
            —**Expenses**Interest
            
            
            **404,450**
            
            
            283,600
            
            
            201,454Other
                expenses
            
            
            **1,016,182**
            
            
            755,571
            
            
            729,245**1,420,632**
            
            
            1,039,171
            
            
            930,699Loss
                before income taxes and equity in undistributedearnings
                of subsidiaries
            
            
            **(1,409,405**
            **)**
            
            (1,029,533
            )
            
            (930,699
            )Income
                tax benefits
            
            
            **504,000**
            
            
            365,835
            
            
            378,685Loss
                before equity in undistributed earningsof
                subsidiaries
            
            
            **(905,405**
            **)**
            
            (663,698
            )
            
            (552,014
            )Equity
                in undistributed earnings of subsidiaries
            
            
            **6,026,981**
            
            
            4,710,712
            
            
            3,638,594**Net
                Income**
            
            **$**
            **5,121,576**
            
            $
            4,047,014
            
            $
            3,086,580





68
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      22 - Condensed Parent Information - Continued**





**Statements
      of Cash Flow**




**Years
                ended December
                31,****2005**
            
            2004
            
            2003**Operating
                Activities**Net
                Income
            
            **$**
            **5,121,576**
            
            $
            4,047,014
            
            $
            3,086,580Adjustments
                to reconcile net income to net cashprovided
                by (used in) operating activitiesEquity
                in undistributed income of subsidiaries
            
            
            **(6,026,981**
            **)**
            
            (4,710,712
            )
            
            (3,638,594
            )Increase
                (decrease) in accrued interest payable
            
            
            **31,075**
            
            
            (36,938
            )
            
            85,200Other
            
            
            **302,815**
            
            
            892,869
            
            
            (483,620
            )**Net
                Cash Used In Operating Activities**
            
            
            **(571,515**
            **)**
            
            192,233
            
            
            (950,434
            )**Investing
                Activities**Investment
                in preferred securities trust
            
            
            —
            
            
            —
            
            
            (186,000
            )Capital
                injection in subsidiaries
            
            
            **(3,500,000**
            **)**
            
            —
            
            
            (1,500,000
            )**Net
                Cash Used In Investing Activities**
            
            
            **(3,500,000**
            **)**
            
            —
            
            
            (1,686,000
            )**Financing
                Activities**Proceeds
                from issuance of subordinated long-termcapital
                notes
            
            
            —
            
            
            —
            
            
            6,186,000Repayment
                of long-term debt
            
            
            —
            
            
            —
            
            
            (4,600,000
            )Proceeds
                from issuance of common stock
            
            
            **19,193,277**
            
            
            769,941
            
            
            302,800Purchases
                of treasury stock
            
            
            —
            
            
            —
            
            
            (54,900
            )Compensation
                associated with issuance of options
            
            
            **18,746**
            
            
            42,301
            
            
            21,739Proceeds
                from issuance of treasury stock
            
            
            —
            
            
            —
            
            
            1,923,601Cash
                paid in lieu of fractional shares on stock dividend
            
            
            —
            
            
            —
            
            
            (1,931
            )**Net
                Cash Provided By Financing Activities**
            
            
            **19,212,023**
            
            
            812,242
            
            
            3,777,309**Net
                Increase (Decrease) in Cash and Cash Equivalents**
            
            
            **15,140,508**
            
            
            1,004,475
            
            
            1,140,875**Cash
                and Cash Equivalents at Beginning of Year**
            
            
            **2,150,693**
            
            
            1,146,218
            
            
            5,343**Cash
                and Cash Equivalents at End of Year**
            
            **$**
            **17,291,201**
            
            $
            2,150,693
            
            $
            1,146,218Cash
                paid during the year for:Interest
            
            **$**
            **373,375**
            
            $
            320,538
            
            $
            116,254











69
 **APPALACHIAN
            BANCSHARES, INC. AND SUBSIDIARIES**
 **NOTES
          TO CONSOLIDATED FINANCIAL STATEMENTS**


**Note
      23 - Quarterly Results of Operations (Unaudited)**





Selected
      quarterly results of operations for the four quarters of each of the years
      ended
      December 31, 2005 and 2004 are as follows:




First
            
            Second
            
            Third
            
            FourthQuarter
            
            Quarter
            
            Quarter
            
            Quarter**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**2004:Total
                interest income
            
            $
            6,026
            
            $
            6,260
            
            $
            6,536
            
            $
            6,914Total
                interest expense
            
            
            1,739
            
            
            1,793
            
            
            1,927
            
            
            2,099Provision
                for loan losses
            
            
            360
            
            
            291
            
            
            274
            
            
            310Net
                interest income afterprovision
                for loan losses
            
            
            3,927
            
            
            4,176
            
            
            4,335
            
            
            4,505Securities
                gains (losses)
            
            
            --
            
            
            (23
            )
            
            —
            
            
            —Total
                noninterest income
            
            
            675
            
            
            706
            
            
            726
            
            
            745Total
                noninterest expense
            
            
            3,279
            
            
            3,437
            
            
            3,508
            
            
            3,616Income
                tax expense
            
            
            427
            
            
            442
            
            
            485
            
            
            531Net
                income
            
            $
            896
            
            $
            980
            
            $
            1,068
            
            $
            1,103Per
                Common Share:Basic
                earnings
            
            $
            0.24
            
            $
            0.26
            
            $
            0.29
            
            $
            0.30Diluted
                earnings
            
            
            0.23
            
            
            0.25
            
            
            0.27
            
            
            0.29














70


**ITEM9.**
            **CHANGES
                IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                DISCLOSURE**




None.





**ITEM9A.**
            **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 2005, 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.





**ITEM9B.**
            **OTHER
                INFORMATION**





None.








**PARTIII**





**ITEM10.**
            **DIRECTORS
                AND EXECUTIVE OFFICERS OF THE
                REGISTRANT**





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 “2006 Proxy
      Statement”) relating to our 2006 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.








**ITEM11.**
            **EXECUTIVE
                COMPENSATION**





The
      information appearing under the heading “Compensation of Executive Officers and
      Directors” in the 2006 Proxy Statement is incorporated herein by
      reference.





**ITEM12.**
            **SECURITY
                OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT****AND RELATED STOCKHOLDER
                MATTERS**





The
      information appearing under the heading “Ownership of Common Stock” in the 2006
      Proxy Statement is incorporated herein by reference.








**ITEM13.**
            **CERTAIN
                RELATIONSHIPS AND RELATED
                TRANSACTIONS**





The
      information appearing under the caption “Related Party Transactions” in the 2006
      Proxy Statement is incorporated herein by reference.








**ITEM14.**
            **PRINCIPAL
                ACCOUNTANT FEES AND
                SERVICES**





The
      information appearing under the caption “Independent Public Accountants” in the
      2006 Proxy Statement is incorporated herein by reference.


71


**PARTIV**





**ITEM15.**
            **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, 2005 and 2004


Consolidated
      Statements of Income for the Years Ended December 31, 2005, 2004 and
      2003


Consolidated
      Statements of Shareholders’ Equity for the Years Ended December 31, 2005, 2004
      and 2003


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


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:





**Exhibit
                  Number**
              **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).*





72





**Exhibit
                Number**
            **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).*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





73





**Exhibit
                Number**
            **Description
                of Exhibit**23.1
            Consent
                of Mauldin & Jenkins, LLC23.2
            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.
































74


**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
      2006.








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, 2006Tracy
                R. Newton, Chief ExecutiveOfficer
                and Director (principal executive officer)/s/
                Joseph T. Moss, Jr.
            
            Date:
                March 30, 2006Joseph
                T. Moss, Jr., President and Chief
              Operating
                Officer (principal accounting and
              financial
                officer)/s/
                Alan S. Dover
            
            Date:
                March 30, 2006Alan
                S. Dover, Director/s/
                Charles A. Edmondson
            
            Date:
                March 30, 2006Charles
                A. Edmondson, Director/s/
                Roger E. Futch
            
            Date:
                March 30, 2006Roger
                E. Futch, Director/s/
                Joseph C. Hensley
            
            Date:
                March 30, 2006Joseph
                C. Hensley, Director/s/
                Frank E. Jones
            
            Date:
                March 30, 2006Frank
                E. Jones, Director/s/
                J. Ronald Knight
            
            Date:
                March 30, 2006J.
                Ronald Knight, Chairman and Director/s/
                Kenneth D. Warren
            
            Date:
                March 30, 2006Kenneth
                D. Warren, Director





75


**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):








**Exhibit
                Number**
            **Description
                of Exhibit**21
            Subsidiaries
                of the Registrant23.1
            Consent
                of Mauldin & Jenkins, LLC23.2
            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.












76