**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **WASHINGTON,
        DC 20549**
 **FORM
        10-K**
 
 x
              Annual
                  Report Pursuant to Section 13 or 15(d) of the Securities Exchange
                  Act of
                  1934.
 For
                  the fiscal year ended December 31,
                  2005
 
 o
              Transition
                  Report Pursuant to Section 13 or 15(d) of the Securities Exchange
                  Act of
                  1934
 
 Commission
        File Number 000-23129
 
 **NORTHWAY
        FINANCIAL, INC.**
 (Exact
        name of registrant as specified in its charter)
 
 New
                  Hampshire
              
              04-3368579(State
                  or other jurisdiction ofincorporation
                  or organization)
              
              (I.R.S.
                  EmployerIdentification
                  No.)9
                  Main StreetBerlin,
                  New Hampshire
              
              03570Address
                  of principal executive offices
              
              (Zip
                  Code)
 
 
 (603)
        752-1171
 (Registrant’s
        telephone number, including area code)
  Securities
          Registered Pursuant to Section 12(b) of the Act: None
 
 Securities
          Registered Pursuant to Section 12(g) of the Act:
 Common
          Stock, Par Value $1.00
 
 Indicate
          by check mark if the registrant is a well-known seasoned issue, as defined
          in
          Rule 405 of the Securities Act. YES o NO x
 
 Indicate
          by check mark if the registrant is not required to file reports pursuant
          to
          Section 13 or Section 15(d) of the Act. YES o NO x
 
 Indicate
          by check mark whether the registrant (1) has filed all reports required
          to be
          filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
          the
          preceding twelve 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 ninety days.  YES x NO o
 
 Indicate
          by check mark if disclosure of delinquent filers pursuant to Item 405 of
          Regulation S-K is not contained herein, and will not be contained, to the
          best
          of registrant’s knowledge, in definitive proxy or information statements
          incorporated by reference in Part III of this Form 10-K or any amendment
          to this
          Form 10-K. o
 
 Indicate
          by check mark whether the registrant is a large accelerated filer, an
          accelerated filer, or a non-accelerated file. See definition of “accelerated
          filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.. Large
          Accelerated Filer o Accelerated
          Filer o Non-Accelerated
          Filer x
 
 Indicate
          by check mark whether the registrant is a shell company (as defined in
          Rule
          12b-2 of the Act. YES x NO o
 
 The
          number of shares of voting and nonvoting common stock, par value $1.00
          per
          share, held by nonaffiliates of the registrant as of June 30, 2005 was
          1,290,784
          shares with an aggregate market value, computed by reference to the last
          reported sales price on the NASDAQ National Market on such date, of $41,305,088.
          Although directors and executive officers of the registrant were assumed
          to be
“affiliates” of the registrant for purposes of this calculation, this
          classification is not to be interpreted as an admission of such
          status.
 
 At March
          25,
          2006 ,
          there
          were 1,491,174 shares of common stock outstanding, par value $1.00 per
          share.
 
 DOCUMENTS
          INCORPORATED BY REFERENCE
 
 Portions
          of the registrant’s proxy statement for its 2006 Annual Meeting of Stockholders
          are incorporated by reference in Items 10, 11, 12, 13 and 14 of Part
          III.
  
 
  **NORTHWAY
        FINANCIAL, INC.**
 **2005
        FORM 10-K ANNUAL REPORT**
 
 **TABLE
                  OF CONTENTS**PART
                  IITEM
                  1
              
              Business
              1ITEM
                  1A
              
              Risk
                  Factors
              9ITEM
                  2
              
              Properties
              11ITEM
                  3
              
              Legal
                  Proceedings
              11ITEM
                  4
              
              Submission
                  of Matters to a Vote of Security
                  Holders
              12PART
                  IIITEM
                  5
              
              Market
                  for Registrant’s Common Equity, Related Stockholder
                  Matters and Issuer Purchases of Equity Securities
              12ITEM
                  6
              
              Selected
                  Financial Data
              13ITEM
                  7
              
              Management’s
                  Discussion and Analysis of Financial Condition and
                  Results of Operations
              14ITEM
                  7A
              
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              28ITEM
                  8
              
              Financial
                  Statements and Supplementary Data
              29ITEM
                  9
              
              Changes
                  in and Disagreements with Accountants on Accounting and
                  Financial Disclosure
              56ITEM
                  9A
              
              Controls
                  and Procedures
              56PART
                  IIIITEM
                  10
              
              Directors
                  and Executive Officers of the
                  Registrant
              56ITEM
                  11
              
              Executive
                  Compensation
              56ITEM
                  12
              
              Security
                  Ownership of Certain Beneficial Owners and Management
                  and Related Stockholder Matters
              56ITEM
                  13
              
              Certain
                  Relationships and Related
                  Transactions
              56ITEM
                  14
              
              Principal
                  Accountant Fees and Services
              56ITEM
                  15
              
              Exhibits
                  and Financial Statement Schedules
              57Signatures
              58
  *Table
            of Contents*
  **FORWARD-LOOKING
        STATEMENTS**
 
 Certain
        statements in this report are “forward-looking statements” within the meaning of
        the Private Securities Litigation Reform Act of 1995. Such forward-looking
        statements may include, but are not limited to, projections of revenue, income
        or loss, plans for future operations and acquisitions, projections based
        on
        assumptions regarding market and liquidity risk, and plans related to products
        or services of Northway Financial, Inc. (“Northway”) and its subsidiaries (the
“Company”). Such forward-looking statements are subject to known and unknown
        risks, uncertainties and contingencies, many of which are beyond the control
        of
        the Company. To the extent any such risks, uncertainties and contingencies
        are
        realized, the Company’s actual results, performance or achievements could differ
        materially from anticipated results, performance or achievements. Factors
        that
        might affect such forward-looking statements include, among other factors,
        the
        factors described under the caption “Risk Factors” in Item 1A of this report,
        overall economic and business conditions, economic and business conditions
        in
        the Company’s market areas, interest rate fluctuations, the demand for the
        Company’s products and services, competitive factors in the industries in which
        the Company competes, changes in government regulations, and the timing,
        impact
        and other uncertainties of future acquisitions.
 
 In
        addition to the factors described above, the following are some additional
        factors that could cause our financial performance to differ from any
        forward-looking statement contained herein: i) changes in interest rates
        over
        the past year and the relative relationship between the various interest
        rate
        indices that the Company uses; ii) a determination in the financial market
        affecting the valuation of securities held in the Company’s investment
        portfolio; (iii) a change in product mix attributable to changing interest
        rates, customer preferences or competition; iv) a significant portion of
        the
        Company’s loan customers are in the hospitality business and therefore could be
        affected by a slower economy, adverse weather conditions and/or rising gasoline
        prices; and v) the effectiveness of advertising, marketing and promotional
        programs.
 
 The
        words
“believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” or the
        negative of such terms and other similar expressions which are predications
        of
        or indicate future events and trends and which do not relate to historical
        matters identify forward-looking statements. Reliance should not be placed
        on
        forward-looking statements because they involve known or unknown risks,
        uncertainties or other factors, which may cause the actual results, performance
        or achievements of the Company to differ materially from anticipated future
        results, performance or achievements expressed or implied by such
        forward-looking statements. The Company expressly disclaims any obligation
        to
        publicly update or revise any forward-looking statement, whether as a result
        of
        new information, future events or otherwise.
 
 Though
        the Company has attempted to list comprehensively the factors which might
        affect
        forward-looking statements, the Company wishes to caution you that other
        factors
        may in the future prove to be important in affecting the Company’s results of
        operations. New factors emerge from time to time and it is not possible for
        management to anticipate all of such factors, nor can it assess the impact
        of
        each such factor, or combination of factors, which may cause actual results
        to
        differ materially from forward-looking statements.
 
 **PART
        1**
 
 ITEM
        1. BUSINESS
 
 **Description
        of Business**
 
 Northway
        Financial, Inc. was incorporated on March 7, 1997, under the laws of the
        State
        of New Hampshire, for the purpose of becoming the holding company of The
        Berlin
        City Bank, a New Hampshire-chartered bank headquartered in Berlin, New Hampshire
        (“BCB”), pursuant to a reorganization transaction (the “BCB Reorganization”) by
        and among the Company, BCB, and a subsidiary of BCB, and, thereafter, the
        merger
        (the “Merger”) by and among the Company, BCB, Pemi Bancorp, Inc. (“PEMI”), and
        PEMI’s wholly owned subsidiary, The Pemigewasset National Bank of Plymouth, New
        Hampshire, a national bank headquartered in Plymouth, New Hampshire (“PNB”). The
        BCB Reorganization and the Merger became effective on September 30, 1997.
        As of
        such date, BCB and PNB became wholly owned subsidiaries of the Company. On
        October 1, 2005, BCB was renamed Northway Bank and PNB was merged into Northway
        Bank (“Bank”). Unless the context otherwise requires, references herein to the
“Company" include Northway Financial, Inc. and its consolidated
        subsidiary.
 
 The
        Company derives substantially all of its revenue and income from the furnishing
        of bank and bank-related services, principally to individuals and small and
        medium-sized companies in New Hampshire. The Bank operates as a typical
        community banking institution and does not engage in any specialized finance
        or
        capital market activities. The Company functions primarily as the holder
        of
        stock of its subsidiaries and assists the management of its subsidiaries
        as
        appropriate.
 
 The
        Company is subject to regulation by the New Hampshire Bank Commissioner (the
        “Commissioner”), the Federal Deposit Insurance Corporation (the “FDIC”), and the
        Board of Governors of the Federal Reserve System. See "Supervision and
        Regulation."
  1
 *Table
            of Contents*
  The
        Bank
        is engaged in a general commercial banking business and offers commercial
        and
        construction loans, real estate mortgages, consumer loans, including personal
        secured and unsecured loans, and lines of credit.
 
 During
        1998 the Bank established an indirect lending business unit in Concord, New
        Hampshire. On August 25, 2004, the Company announced its exit from the indirect
        automobile lending line of business. Effective August 31, 2004, the Company
        ceased accepting applications from its dealer network. As of December 31,
        2005
        this line of business accounted for approximately 14% of the Company’s loan
        portfolio. The Bank will continue to service the existing portfolio of
        approximately 7,000 loans. The decision to exit this line of business was
        predicated on the low interest rate environment and competitive pressures.
        Over
        the next twelve months, cash flows from the existing portfolio are expected
        to
        be redeployed into commercial loans, residential mortgage loans, consumer
        loans,
        such as home equity loans and automobile loans, and the Company’s investment
        portfolio.
 
 The
        Bank
        accepts savings, time, demand, NOW and money market deposit accounts, and
        offers
        a variety of banking services including safe deposit boxes, credit card
        accounts, official checks and money orders, overdraft lines of credit and
        wire
        transfer services.
 
 Northway
        is a legal entity separate and distinct from its subsidiary. The right of
        Northway to participate in any distribution of assets or earnings of the
        subsidiary is subject to the prior claims of creditors of the subsidiary,
        except
        to the extent that claims, if any, of Northway itself as a creditor may be
        recognized. See “Supervision and Regulation.”
 
 The
        following information concerning the Company’s investment activities, lending
        activities, asset quality and allowance for loan losses should be read in
        conjunction with “Management’s Discussion and Analysis of Financial Condition
        and Results of Operations,” appearing under Item 7 of this report and the
        Company’s Consolidated Financial Statements and Notes thereto.
 
 **Investment
        Activities**
 
 The
        following table presents the carrying amount of the Company’s securities
        available-for-sale as of December 31, 2005, 2004 and 2003 (dollars in
        thousands):
 
 2005
              
              2004
              
              2003U.S.
                  Treasury and otherU.S.
                  government agency securities
              
              $
              47,751
              
              $
              54,563
              
              $
              37,840Mortgage-backed
                  securities(1)
              
              
              23,939
              
              
              29,301
              
              
              2,903Marketable
                  equity securities
              
              
              2,809
              
              
              1,931
              
              
              2,766Corporate
                  bonds
              
              
              5,569
              
              
              12,287
              
              
              21,983State
                  and political subdivision bonds and notes
              
              
              23,176
              
              
              3,051
              
              
              2,590Total
                  securities
              
              $
              103,244
              
              $
              101,133
              
              $
              68,082
 
 (1)
              Includes
                  collateralized mortgage obligations of
                  $8
 
 The
        following table sets forth the amortized cost of the Company’s investment in
        debt securities maturing within stated periods and their related weighted
        average yields, reported on a tax equivalent basis, as of December 31, 2005
        (dollars in thousands):
 MaturitiesWithin
                  one
                    year
                
                One
                    to
                  five
                  years
                
                Five
                    to
                  ten
                  years
                
                Over
                  ten
                  years
                
                Total
                  amortized
                  costAvailable-for-sale:U.S.
                    Treasury and otherU.S.
                    government agency securities
                
                $
                5,998
                
                $
                37,730
                
                $
                5,000
                
                $
                -
                
                $
                48,728Mortgage-backed
                    securities(1)
                
                
                -
                
                
                29
                
                
                -
                
                
                24,683
                
                
                24,712Corporate
                    bonds
                
                
                2,003
                
                
                3,538
                
                
                -
                
                
                -
                
                
                5,541State
                    and political subdivision bonds and notes
                
                
                1,101
                
                
                425
                
                
                562
                
                
                21,308
                
                
                23,396Total
                    amortized cost
                
                $
                9,102
                
                $
                41,722
                
                $
                5,562
                
                $
                45,991
                
                $
                102,377Market
                    value
                
                $
                9,052
                
                $
                40,916
                
                $
                5,485
                
                $
                44,982
                
                $
                100,435Weighted
                    average yield
                
                
                3.69
                %
                
                3.97
                %
                
                5.29
                %
                
                5.32
                %
                
                4.63
                %
 
 (1)
              Includes
                  collateralized mortgage obligations of
                  $8
  2
 *Table
            of Contents*
  **Lending
        Activities**
 
 The
        following table sets forth information with respect to the composition of
        the
        Company’s loan portfolio, excluding loans held for sale, as of December 31,
        2005, 2004, 2003, 2002 and 2001 (dollars in thousands):
 
 December
                  31,2005
              
              2004
              
              2003
              
              2002
              
              2001Real
                  estate:Residential
              
              $
              158,729
              
              $
              147,333
              
              $
              129,493
              
              $
              114,526
              
              $
              109,261Commercial
              
              
              143,456
              
              
              130,334
              
              
              120,366
              
              
              111,941
              
              
              111,642Construction
              
              
              13,241
              
              
              5,366
              
              
              3,851
              
              
              6,330
              
              
              1,581Commercial
              
              
              27,349
              
              
              27,013
              
              
              24,528
              
              
              23,885
              
              
              22,727Installment
              
              
              35,786
              
              
              29,345
              
              
              30,291
              
              
              40,169
              
              
              28,210Indirect
                  installment
              
              
              62,221
              
              
              116,520
              
              
              150,807
              
              
              139,477
              
              
              120,761Other
              
              
              19,507
              
              
              18,901
              
              
              14,530
              
              
              9,652
              
              
              6,303Total
                  loans
              
              
              460,289
              
              
              474,812
              
              
              473,866
              
              
              445,980
              
              
              400,485Less:(Unamortized
                  cost)/unearned income
              
              
              (84
              )
              
              106
              
              
              247
              
              
              207
              
              
              169Allowance
                  for loan losses
              
              
              5,150
              
              
              5,204
              
              
              5,036
              
              
              4,920
              
              
              4,642Total
                  unearned income and allowance for loan losses
              
              
              5,066
              
              
              5,310
              
              
              5,283
              
              
              5,127
              
              
              4,811Net
                  loans
              
              $
              455,223
              
              $
              469,502
              
              $
              468,583
              
              $
              440,853
              
              $
              395,674
 
 
 The
        following table presents the maturity distribution of the Company’s real estate
        construction and commercial loans at December 31, 2005 (dollars in
        thousands):
 
 Amount
              
              Percent
                  of
                TotalWithin
                  one year
              
              $
              13,532
              
              
              33.34
              %One
                  to five years
              
              
              12,324
              
              
              30.36Over
                  five years
              
              
              14,734
              
              
              36.30$
              40,590
              
              
              100.00
              %
  The
        Company’s real estate construction and commercial loans due after one year at
        December 31, 2005 were comprised of the following (dollars in
        thousands):
 
 AmountFixed
                  interest rate
              
              $
              10,004Adjustable
                  interest rate
              
              
              17,054$
              27,058
  3
 *Table
            of Contents*
  **Analysis
        of the Allowance for Loan Losses**
  The
        following table reflects activity in the Company’s allowance for loan losses for
        the years ended December 31, 2005, 2004, 2003, 2002 and 2001 (dollars in
        thousands):
 
 Years
                  ended December 31,2005
              
              2004
              
              2003
              
              2002
              
              2001Balance
                  at the beginning of period
              
              $
              5,204
              
              $
              5,036
              
              $
              4,920
              
              $
              4,642
              
              $
              4,354Charge-offs:Real
                  estate
              
              
              8
              
              
              56
              
              
              -
              
              
              83
              
              
              110Commercial
              
              
              10
              
              
              28
              
              
              120
              
              
              12
              
              
              95Installment
                  loans to individuals
              
              
              397
              
              
              581
              
              
              750
              
              
              729
              
              
              529Total
              
              
              415
              
              
              665
              
              
              870
              
              
              824
              
              
              734Recoveries:Real
                  estate
              
              
              44
              
              
              162
              
              
              25
              
              
              64
              
              
              35Commercial
              
              
              85
              
              
              16
              
              
              11
              
              
              4
              
              
              -Installment
                  loans to individuals
              
              
              157
              
              
              160
              
              
              145
              
              
              134
              
              
              87Total
              
              
              286
              
              
              338
              
              
              181
              
              
              202
              
              
              122Net
                  charge-offs
              
              
              129
              
              
              327
              
              
              689
              
              
              622
              
              
              612Provision
                  charged to expense
              
              
              75
              
              
              495
              
              
              805
              
              
              900
              
              
              900Balance
                  at the end of period
              
              $
              5,150
              
              $
              5,204
              
              $
              5,036
              
              $
              4,920
              
              $
              4,642Ratio
                  of net charge-offs to average loans
              
              
              0.03
              %
              
              0.07
              %
              
              0.15
              %
              
              0.15
              %
              
              0.15
              %
 
 
 **Allocation
        of the Allowance for Loan Losses**
 
 The
        following table sets forth the breakdown of the Company’s allowance for loan
        losses in the Company’s portfolio by category of loan and the percentage of
        loans in each category to total loans in the respective portfolios at the
        dates
        indicated (dollars in thousands):
 December
                    31,2005
                
                2004
                
                2003
                
                2002
                
                2001Amount
                
                Percent
                    ofloans
                    in each
                  category
                    to
                  total
                    loans
                
                Amount
                
                Percent
                    of
                  loans
                    in each
                  category
                    to
                  total
                    loans
                
                Amount
                
                Percent
                    of
                  loans
                    in each
                  category
                    to
                  total
                    loans
                
                Amount
                
                Percent
                    of
                  loans
                    in each
                  category
                    to
                  total
                    loans
                
                Amount
                
                Percent
                    of
                  loans
                    in each
                  category
                    to
                  total
                    loansReal
                    estate:Residential
                
                $
                784
                
                
                34.5
                %
                $
                644
                
                
                31.0
                %
                $
                624
                
                
                27.3
                %
                $
                598
                
                
                25.9
                %
                $
                585
                
                
                27.2
                %Commercial
                    & construction
                
                
                3,032
                
                
                34.0
                
                
                1,892
                
                
                28.6
                
                
                1,724
                
                
                26.2
                
                
                2,008
                
                
                26.7
                
                
                1,621
                
                
                28.3Commercial
                
                
                278
                
                
                6.0
                
                
                174
                
                
                5.7
                
                
                155
                
                
                5.2
                
                
                216
                
                
                5.4
                
                
                208
                
                
                5.7Installment
                
                
                985
                
                
                21.3
                
                
                2,398
                
                
                30.7
                
                
                2,505
                
                
                38.2
                
                
                2,084
                
                
                40.6
                
                
                1,719
                
                
                37.2Other
                
                
                71
                
                
                4.2
                
                
                96
                
                
                4.0
                
                
                28
                
                
                3.1
                
                
                14
                
                
                1.4
                
                
                17
                
                
                1.6Unallocated
                
                
                -
                
                
                N/A
                
                
                -
                
                
                N/A
                
                
                -
                
                
                N/A
                
                
                -
                
                
                N/A
                
                
                492
                
                
                N/A$
                5,150
                
                
                100.0
                %
                $
                5,204
                
                
                100.0
                %
                $
                5,036
                
                
                100.0
                %
                $
                4,920
                
                
                100.0
                %
                $
                4,642
                
                
                100.0
                %
   **Deposits**
  See
        “Financial Statements and Supplementary Data” in Item 8 of this
        report.
 
 **Supervision
        and Regulation**
 
 The
        business in which the Company is engaged is subject to extensive supervision,
        regulation and examination by various bank regulatory authorities and other
        governmental agencies. State and federal banking laws have as their principal
        objective either the maintenance of the safety and soundness of financial
        institutions and the federal deposit insurance system or the protection of
        consumers or classes of consumers, and depositors in particular, rather than
        the
        specific protection of stockholders of a bank or its parent company.
 
 Set
        forth
        below is a brief description of certain laws and regulations that relate
        to the
        regulation of the Company. To the extent the following material describes
        statutory or regulatory provisions, it is qualified in its entirety by reference
        to the particular statute or regulation.
  4
 *Table
            of Contents*
  Regulation
        of the Company
 
 *General.* As
        a
        registered bank holding company, the Company is subject to regulation under
        the
        Bank Holding Company Act of 1956, as amended (“BHCA”) and to inspection,
        examination and supervision by the Board of Governors of the Federal Reserve
        System (“FRB”). The Company is also subject to the laws of the State of New
        Hampshire.
  The
        FRB
        has the authority to issue orders to bank holding companies to cease and
        desist
        from unsound banking practices and violations of conditions imposed by, or
        violations of agreements with, the FRB. The FRB is also empowered to assess
        civil money penalties against companies or individuals who violate the BHCA
        or
        orders or regulations thereunder, to order termination of non-banking activities
        of non-banking subsidiaries of bank holding companies, and to order termination
        of ownership and control of a non-banking subsidiary by a bank holding company.
        Under the BHCA, the Company may not generally engage in activities or acquire
        more than 5% of any class of voting securities of any company engaged in
        activities other than banking or activities that are closely related to banking. However,
        a bank holding company that has elected to be treated as a “financial holding
        company” may engage in activities that are financial in nature or incidental or
        complementary to such financial activities, as determined by the FRB alone,
        or
        together with the Secretary of the Department of the Treasury. The Company
        has
        not elected financial holding company status. Under certain circumstances,
        the
        Company may be required to give notice to or seek approval of the FRB before
        engaging in activities other than banking.
  *Riegle-Neal
        Interstate Banking and Branching Efficiency Act of 1994* (“Riegle-Neal”). Riegle-Neal permits adequately- or well-capitalized and
        adequately- or well-managed bank holding companies, as determined by the
        FRB, to
        acquire banks in any state subject to certain concentration limits and other
        conditions. Riegle-Neal also generally authorizes the interstate merger of
        banks. In addition, among other things, Riegle-Neal permits banks to establish
        new branches on an interstate basis provided that the law of the host state
        specifically authorizes such action. However, as a bank holding company,
        the
        Company is required to obtain prior FRB approval before acquiring more than
        5%
        of a class of voting securities, or substantially all of the assets of a
        bank
        holding company, bank or savings association.
 
 *Control
        Acquisitions* .
        The
        Change in Bank Control Act prohibits a person or group of persons from acquiring
        “control” of a bank holding company, such as the Company, unless the FRB has
        been notified and has not objected to the transaction. Under a rebuttable
        presumption established by the FRB, the acquisition of 10% or more of a class
        of
        voting securities of a bank holding company with a class of securities
        registered under Section 12 of the Securities Exchange Act of 1934, as amended,
        would, under the circumstances set forth in the presumption, constitute
        acquisition of control of the bank holding company. In addition, a company
        is
        required to obtain the approval of the FRB under the BHCA before acquiring
        25%
        (5% in the case of an acquirer that is a bank holding company) or more of
        any
        class of outstanding voting securities of a bank holding company, or otherwise
        obtaining control or a “controlling influence” over that bank holding
        company .
 
 *Bank
        Holding Company Dividends* .
        The FRB
        has authority to prohibit bank holding companies from paying dividends if
        such
        payment is deemed to be unsafe or unsound. The FRB has indicated generally
        that
        it may be an unsafe or unsound practice for bank holding companies to pay
        dividends unless the bank holding company’s net income over the preceding year
        is sufficient to fund the dividends and the expected rate of earnings retention
        is consistent with the organization’s capital needs, asset quality and overall
        financial condition. The Company depends in part upon dividends received
        from
        its subsidiary bank to fund its activities, including the payment of dividends. As
        described below, the Federal Deposit Insurance Corporation (“FDIC”) and the
        Banks’ regulatory agencies may regulate the amount of dividends payable by the
        subsidiary banks. The inability of the Bank to pay a dividend may have an
        adverse effect on the Company.
 
 Regulation
        of the Bank
 
 The
        Bank
        is organized under New Hampshire law and is subject to the regulations of
        the
        Commissioner and the FDIC, including requirements and restrictions related
        to
        the maintenance of adequate levels of capital, the payment of dividends,
        investments, the nature and amount of loans which can be originated and the
        rate
        of interest that can be charged thereon, and other activities. Capital
        requirements applicable to the Bank are substantially similar to those adopted
        by the FRB regarding bank holding companies as described above.
 
 *Insurance
        of Accounts and FDIC Regulation* .
        The
        Bank pays deposit insurance premiums to the FDIC based on an assessment rate
        established by the FDIC for Bank Insurance Fund-member institutions. The
        FDIC
        has established a risk-based premium system under which the FDIC classifies
        institutions based on their capital ratios and on other relevant factors
        and
        generally assesses higher rates on those institutions that tend to pose greater
        risks to the federal deposit insurance funds. The Federal Deposit Insurance
        Act
        (“FDIA”) does not require the FDIC to charge all banks deposit insurance
        premiums when the ratio of deposit insurance reserves to insured deposits
        is
        maintained above specified levels. During 2005, the Bank risk classification
        was
        A1, the most favorable rating, resulting in premiums totaling $63,000. As
        a
        result of general economic conditions, and a decline in the health of the
        banking industry, it is possible that the ratio of deposit insurance reserves
        to
        insured deposits could fall below the minimum ratio that FDIA requires, which
        would result in the FDIC setting deposit insurance assessment rates sufficient
        to increase deposit insurance reserves to the required ratio. We cannot predict
        whether the FDIC will be required to increase deposit insurance assessments
        on
        the Banks above their current levels.
  5
 *Table
            of Contents*
  In
        February 2006, Congress enacted the Federal Deposit Insurance Reform Act
        of 2005
        (the “FDIR Act”). As a result of the passage of the FDIR Act, over the course of
        the next year, among other things: (i) the BIF will be merged with the FDIC’s
        Savings Association Insurance Fund creating the Deposit Insurance Fund (the
        “DIF”); (ii) the $100,000 per account insurance level will be indexed to reflect
        inflation; (iii) deposit insurance coverage for certain retirement accounts
        will
        be increased to $250,000; and (iv) a cap will be placed on the level of the
        DIF
        and dividends will be paid to banks once the level of the DIF exceeds the
        specified threshold.
 
 *Bank
        Holding Company Support of Subsidiary Banks* .
        Under
        FRB policy, a bank holding company is expected to act as a source of financial
        and managerial strength to each of its subsidiary banks and to commit resources
        to their support. This support may be required at times when the bank holding
        company may not have the resources to provide it. Similarly, under the
        cross-guarantee provisions of FDIA, the FDIC can hold any FDIC-insured
        depository institution liable for any loss suffered or anticipated by the
        FDIC
        in connection with (1) the “default” of a commonly controlled FDIC-insured
        depository institution; or (2) any assistance provided by the FDIC to a commonly
        controlled FDIC-insured depository institution “in danger of default.” The Bank
        is an FDIC-insured depository institution.
 
 *Regulatory
        Capital Requirements.* The FRB
        and the FDIC have issued substantially similar risk-based and leverage capital
        guidelines applicable to United States banking organizations. In addition,
        these
        regulatory agencies may from time to time require that a banking organization
        maintain capital above the minimum levels, whether because of its financial
        condition or actual or anticipated growth.
 
 The
        FRB
        risk-based guidelines define a three-tier capital framework. Tier 1 capital
        includes common stockholders’ equity and qualifying preferred stock, less
        goodwill and other adjustments. Tier 2 capital consists of preferred stock
        not
        qualifying as Tier 1 capital, mandatory convertible debt, limited amounts
        of
        subordinated debt, other qualifying term debt and the allowance for loan
        losses
        up to 1.25 percent of risk-weighted assets. Tier 3 capital includes subordinated
        debt that is unsecured, fully paid, has an original maturity of at least
        two
        years, is not redeemable before maturity without prior approval by the FRB
        and
        includes a lock-in clause precluding payment of either interest or principal
        if
        the payment would cause the issuing bank’s risk-based capital ratio to fall or
        remain below the required minimum. The sum of Tier 1 and Tier 2 capital less
        investments in unconsolidated subsidiaries represents qualifying total capital.
        Risk-based capital ratios are calculated by dividing Tier 1 and total capital
        by
        risk-weighted assets. Assets and off-balance sheet exposures are assigned
        to one
        of four categories of risk-weights, based primarily on relative credit risk.
        The
        minimum Tier 1 capital ratio is four percent and the minimum total capital
        ratio
        is eight percent. The Company’s tier 1 calculation as of December 31, 2005
        equaled 13.07% and its total capital ratio as of December 31, 2005 was 15.24%.
 
 The
        leverage ratio is determined by dividing Tier 1 capital by adjusted average
        total assets for the quarter. Although the stated minimum ratio is 100 to
        200
        basis points above three percent, banking organizations are required to maintain
        a ratio of at least five percent to be classified as “well capitalized”. The
        Company’s leverage ratio as of December 31, 2005 was 8.96%.
 
 The
        Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among
        other things, identifies five capital categories for insured depository
        institutions (well capitalized, adequately capitalized, undercapitalized,
        significantly undercapitalized and critically undercapitalized) and requires
        the
        federal bank regulatory agencies to implement systems for “prompt corrective
        action” for insured depository institutions that do not meet minimum capital
        requirements within such categories. FDICIA imposes progressively more
        restrictive constraints on operations, management and capital distributions,
        depending on the category in which an institution is classified. Failure
        to meet
        the capital guidelines could also subject a banking institution to capital
        raising requirements. An “undercapitalized” bank must develop a capital
        restoration plan and its parent holding company must guarantee that bank’s
        compliance with the plan. The liability of the parent holding company under
        any
        such guarantee is limited to the lesser of five percent of the bank’s assets at
        the time it became “undercapitalized” or the amount needed to comply with the
        plan. Furthermore, in the event of the bankruptcy of the parent holding company,
        such guarantee would take priority over the parent’s general unsecured
        creditors. In addition, FDICIA requires the various regulatory agencies to
        prescribe certain non-capital standards for safety and soundness relating
        generally to operations and management, asset quality and executive compensation
        and permits regulatory action against a financial institution that does not
        meet
        such standards.
 
 The
        various regulatory agencies have adopted substantially similar regulations
        that
        define the five capital categories identified by FDICIA, using the total
        risk-based capital, Tier 1 risk-based capital and leverage capital ratios
        as the
        relevant capital measures. Such regulations establish various degrees of
        corrective action to be taken when an institution is considered
        undercapitalized. Under the regulations, a “well capitalized” institution must
        have a Tier 1 risk-based capital ratio of at least six percent, a total
        risk-based capital ratio of at least ten percent and a leverage ratio of
        at
        least five percent and not be subject to a capital directive order.
  6
 *Table
            of Contents*
  Regulators
        also must take into consideration (a) concentrations of credit risk; (b)
        interest rate risk (when the interest rate sensitivity of an institution’s
        assets does not match the sensitivity of its liabilities or its
        off-balance-sheet position); and (c) risks from non-traditional activities,
        as
        well as an institution’s ability to manage those risks, when determining the
        adequacy of an institution’s capital. This evaluation will be made as a part of
        the institution’s regular safety and soundness examination. In addition, the
        Company, and any bank with significant trading activity, must incorporate
        a
        measure for market risk in their regulatory capital calculations. As of December
        31, 2005, the most recent notification from the FDIC categorized the Bank
        as
“well capitalized”.
  In
        October 2005, the federal banking agencies issued an advance notice of proposed
        rulemaking (“ANPR”) concerning potential changes in the risk-based capital rules
        (“Basel IA”) that are designed to apply to, and potentially reduce the risk
        capital requirements of bank holding companies, such as the Company, that
        are
        not among the 20 or so larges US bank holding companies. It remains uncertain
        whether the Basel IA rules will be adopted and, even if adopted, how closely
        the
        final Basel IA rules will resemble the rules described in the ANPR and what
        the
        effective date of such rules will be. Accordingly, the Company is not yet
        in a
        position to determine the effect of such rules on its risk capital requirements.
 
 *Transactions
        with Affiliates.* Under
        Sections 23A and 23B of the Federal Reserve Act and Regulation W thereunder,
        there are various legal restrictions on the extent to which a bank holding
        company and its non-bank subsidiaries may borrow, obtain credit from or
        otherwise engage in "covered transactions" with its FDIC insured depository
        institution subsidiaries. Such borrowings and other covered transactions
        by an
        insured depository institution subsidiary (and its subsidiaries) with its
        non-depository institution affiliates are limited to the following amounts:
        (a)
        in the case of one such affiliate, the aggregate amount of covered transactions
        of the insured depository institution and its subsidiaries cannot exceed
        ten
        percent (10%) of the capital stock and surplus of the insured depository
        institution; and (b) in the case of all affiliates, the aggregate amount
        of
        covered transactions of the insured depository institution and its subsidiaries
        cannot exceed twenty percent (20%) of the capital stock and surplus of the
        insured depository institution.
 
 "Covered
        transactions" are defined by statute for these purposes to include a loan
        or
        extension of credit to an affiliate, a purchase of or investment in securities
        issued by an affiliate, a purchase of assets from an affiliate unless exempted
        by the Federal Reserve Board, the acceptance of securities issued by an
        affiliate as collateral for a loan or extension of credit to any person or
        company, or the issuance of a guarantee, acceptance, or letter of credit
        on
        behalf of an affiliate. Covered transactions are also subject to certain
        collateral security requirements. Further, a bank holding company and its
        subsidiaries are prohibited from engaging in certain tying arrangements in
        connection with any extension of credit, lease or sale of property of any
        kind,
        or furnishing of any service.
 
 *Limitations
        on Bank Dividends* .
        The
        FDIC has the authority to use its enforcement powers to prohibit a bank from
        paying dividends if, in its opinion, the payment of dividends would constitute
        an unsafe or unsound practice. Federal law also prohibits the payment of
        dividends by a bank that will result in the bank failing to meet its applicable
        capital requirements on a pro forma basis.
  *Customer
        Information Security.* The
        FDIC
        and other bank regulatory agencies have adopted final guidelines for
        establishing standards for safeguarding nonpublic personal information about
        customers that implement provisions of the Gramm-Leach-Bliley Act of 1999
        or
“GLBA,” which establishes a comprehensive framework to permit affiliations among
        commercial banks, insurance companies, securities firms, and other financial
        service providers by revising and expanding the BHCA framework. Specifically,
        the Information Security Guidelines established by the GLBA require each
        financial institution, under the supervision and ongoing oversight of its
        Board
        of Directors or an appropriate committee thereof, to develop, implement and
        maintain a comprehensive written information security program designed to
        ensure
        the security and confidentiality of customer information, to protect against
        anticipated threats or hazards to the security or integrity of such information;
        and to protect against unauthorized access to or use of such information
        that
        could result in substantial harm or inconvenience to any customer. The federal
        banking regulators have issued guidance for banks on response programs for
        unauthorized access to customer information. This guidance, among other things,
        requires notice to be sent to customers whose “sensitive information” has been
        compromised if unauthorized use of this information is “reasonably possible.”
Various states have enacted legislation concerning breaches of data security
        and
        various bills requiring consumer notice of data security breaches are being
        considered by Congress.
 
 *Privacy.* The
        GLBA
        requires financial institutions to implement policies and procedures regarding
        the disclosure of nonpublic personal information about consumers to
        nonaffiliated third parties. In general, the statute requires financial
        institutions to explain to consumers their policies and procedures regarding
        the
        disclosure of such nonpublic personal information, and, unless otherwise
        required or permitted by law, financial institutions are prohibited from
        disclosing such information except as provided in their policies and procedures.
 
 *USA
        Patriot Act.* The
        USA
        Patriot Act of 2001, designed to deny terrorists and others the ability to
        obtain anonymous access to the U.S. financial system, has significant
        implications for depository institutions, broker-dealers, mutual funds,
        insurance companies and businesses of other types involved in the transfer
        of
        money. The USA Patriot Act, together with the implementing regulations of
        various federal regulatory agencies, have caused financial institutions,
        including banks, to adopt and implement additional, or amend existing, policies
        and procedures with respect to, among other things, anti-money laundering
        compliance, suspicious activity and currency transaction reporting, customer
        identity verification and customer risk analysis. The statute and its underlying
        regulations also permit information sharing for counter-terrorist purposes
        between federal law enforcement agencies and financial institutions, as well
        as
        among financial institutions, subject to certain conditions, and require
        the FRB
        (and other federal banking agencies) to evaluate the effectiveness of an
        applicant and a target institution in combating money laundering activities
        when
        considering applications filed under Section 3 of the BHCA or under the Bank
        Merger Act. Management believes that the Company is in compliance with all
        the
        requirements prescribed by the USA Patriot Act and all applicable final
        implementing regulations.
  7
 *Table
            of Contents*
  *The
        Community Reinvestment Act* .
        The
        Community Reinvestment Act ("CRA") requires lenders to identify the communities
        served by the institution's offices and other deposit taking facilities and
        to
        make loans and investments and provide services that meet the credit needs
        of
        these communities. Regulatory agencies examine each of the banks and rate
        such
        institutions’ compliance with CRA as "Outstanding", "Satisfactory", "Needs to
        Improve," or "Substantial Noncompliance". Failure of an institution to receive
        at least a "Satisfactory" rating could inhibit such institution or its holding
        company from undertaking certain activities, including engaging in activities
        newly permitted as a financial holding company under the GLBA and acquisitions
        of other financial institutions. The FRB must take into account the record
        of
        performance of banks in meeting the credit needs of the entire community
        served,
        including low-and moderate-income neighborhoods. The Bank has achieved a
        rating
        of Satisfactory on their respective most recent examination. New Hampshire
        also
        has enacted substantially similar community reinvestment requirements. In
        2005,
        the federal banking agencies adopted less burdensome CRA requirements for
        “intermediate - small banks,” which are banks with $250 million or more, but
        less than $1 billion in total assets, under which such banks, including Northway
        Bank, will be examined using only two tests, a Lending Test and a new Community
        Development Test, and will be relieved of certain data collection and reporting
        requirements.
 
 **Competition**
 
 The
        banking industry in the United States, which includes commercial banks, savings
        and loan associations, mutual savings banks, capital stock savings banks,
        credit
        unions, and bank and savings and loan holding companies, is part of the broader
        financial services industry which includes insurance companies, mutual funds,
        and the brokerage industry, among others. In recent years, intense market
        demands and economic pressures have eroded once clearly defined industry
        classifications and have forced financial services institutions to diversify
        their services, increase returns on deposits, and become more cost-effective
        as
        a result of competition with one another and with new types of financial
        services companies, including non-bank competitors.
 
 The
        Company’s banking subsidiary faces significant competition in its markets from
        commercial banks, savings banks, credit unions, consumer finance companies,
        insurance companies, "non-bank banks," mutual funds, government agencies,
        investment management companies, investment advisors, brokers and investment
        bankers. In addition, increasing consolidation within the banking and financial
        services industry, as well as increased competition from larger regional
        and
        out-of-state banking organizations and non-bank providers of various financial
        services, may adversely affect the Company’s ability to achieve its financial
        goals. Federal banking laws permit adequately capitalized bank holding companies
        to venture across state lines to offer banking services through bank
        subsidiaries to a wider geographic market. Consequently, it is possible for
        large organizations to enter many new markets including the markets served
        by
        the Company. Certain of these competitors, by virtue of their size and
        resources, may enjoy certain efficiencies and competitive advantages over
        the
        Company in pricing, delivery, and marketing of their products and services.
        The
        Company’s long-term success depends on the ability of the Company’s banking
        subsidiaries to compete successfully with other financial institutions in
        their
        service areas. It is not possible to assess what impact these changes in
        the
        regulatory environment will have on the Company. Many of these large competitors
        have significantly more financial resources, larger market share and greater
        name recognition in the market areas served by the Company and its banking
        subsidiaries.
 
 The
        Bank
        competes in this environment by providing a broad range of financial services,
        competitive interest rates and a personal level of service that, combined,
        tend
        to retain the loyalty of its customers in its market areas against competitors
        with far larger resources. To a lesser extent, convenience of branch locations
        and hours of operations are also considered competitive advantages of the
        Bank.
 
 **Employees**
 
 As
        of
        December 31, 2005 the Company has 234 full-time equivalent employees. The
        Company considers its employee relations to be good.
  8
 *Table
            of Contents*
  **Website
        Access to Company Reports**
 
 The
        Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current
        reports on Form 8-K, and all amendments to those reports are available free
        of
        charge on the Company’s website at www.northwaybank.com as soon
        as reasonably practicable after such material is electronically filed with
        or
        furnished to the Securities and Exchange Commission. Also, copies of the
        Company’s annual report will be made available, free of charge, upon written
        request.
 
 ITEM
        1A. RISK FACTORS
 
 *Recent
        accounting changes could give rise to adverse changes in the regulatory capital
        treatment of our outstanding junior subordinated debenture, which, in turn,
        could adversely affect our regulatory capital position.* In
        January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB
        Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”)
        that addresses the consolidation rules to be applied to “variable interest
        entities” as defined in FIN 46. FIN 46, which applies to certain variable
        interest entities as of February 1, 2003 and to all variable interest entities
        as of December 14, 2003, provides that certain variable interest entities
        should
        not be treated as consolidated subsidiaries. Northway Capital Trust I and
        Northway Capital Trust II, our Delaware statutory business trusts, may
        constitute variable interest entities. Historically, issuer trusts, such
        as
        Northway Capital Trust I and Northway Capital Trust II that issued junior
        subordinated debentures have been consolidated by their parent companies.
        In
        addition, junior subordinated debentures have been treated as eligible for
        Tier
        1 capital treatment by bank holding companies under the FRB’s rules and
        regulations relating to minority interests in equity accounts of consolidated
        subsidiaries. Accordingly, we have consolidated our existing issuer trusts
        in
        preparing our consolidated financial statements in the past, and our outstanding
        junior subordinated debentures have been treated as Tier 1 capital.
 
 On
        December 24, 2003, FASB issued a revision to FIN 46 (“FIN46R”), to clarify some
        of the provisions of FIN 46. Based on FIN46R, we deconsolidated our existing
        issuer trusts as of December 31, 2003, and restated our historical financial
        statements. The adoption of FIN46R results in the reclassification of the
        redeemable junior subordinated debentures from mezzanine capital to other
        liabilities as well as the reclassification of interest cost from minority
        interest to interest expense.
 
 This
        deconsolidation could result in a change to the regulatory capital treatment
        of
        junior subordinated debentures issued by us and other U.S. bank holding
        companies. Specifically, it is possible that since the issuer trusts would
        no
        longer be consolidated by us the junior subordinated debentures issued by
        each
        such issuer trust would not be considered a minority interest in equity accounts
        of a consolidated subsidiary and therefore not be accorded Tier 1 capital
        treatment by the FRB. Trust preferred securities have historically been eligible
        for Tier 1 capital treatment by bank holding companies under FRB rules and
        regulations relating to minority interests in equity accounts of consolidated
        subsidiaries. Following the issuance of FIN 46, including the consolidation
        rules with respect to variable interest entities, the FRB requested public
        comment on a proposed rule that would limit trust preferred securities in
        the
        Tier 1 capital of bank holding companies, but with stricter limits and clearer
        qualitative standards. After considering the public comments, the FRB issued
        a
        final rule on March 1, 2005, which provides that after a five-year transition
        period ending on March 31, 2009, the aggregate amount of the trust preferred
        securities and certain other capital elements would be limited to 25% of
        Tier 1
        capital elements, net of goodwill and intangibles. As
        of
        December 31, 2005, assuming the aggregate amount of the trust preferred
        securities is limited to 25% of Tier 1 capital, we would still exceed the
        regulatory required minimums for capital adequacy purposes.
 
 *We
        could be adversely impacted by changes in applicable
        regulations* .
        We are
        subject to extensive federal and state laws and regulations and are subject
        to
        supervision, regulation and examination by various federal and state bank
        regulatory agencies. The restrictions imposed by such laws and regulations
        limit
        the manner in which we and our bank subsidiary may conduct business and obtain
        financing. There can be no assurance that any modification of these laws
        and
        regulations, or new legislation that may be enacted, in the future will not
        make
        compliance more difficult or expensive, restrict our ability to originate,
        broker or sell loans or otherwise adversely affect our operations. See
“Supervision and Regulation” on page 4 of this report.
 
 *Our
        business is largely dependent upon the hospitality industry* .
        A
        number of our loan customers are in the hospitality industry. The hospitality
        industry is dependent on personal discretionary spending levels. As a result,
        the hospitality industry may be adversely impacted by economic trends, including
        recession and increased unemployment. Additionally, unforeseen events including
        acts of terrorism, war, increases in fuel prices, travel-related accidents
        and
        unusual weather patterns also may adversely affect the hospitality industry.
        As
        a result, our business also is likely to be adversely affected by those events.
 
 *Interest
        rate volatility may adversely impact our results of operations* .
        The
        principal component of our income stream is net interest and dividend income.
        Net interest and dividend income is the difference between interest and fee
        income on earning assets, such as loans and investments, and the interest
        expense paid on interest bearing liabilities, such as deposits and borrowed
        funds. Our net interest and dividend income may be significantly affected
        by
        changes in market interest rates. A decrease in interest rates could reduce
        our
        net interest and dividend income as the difference between interest and fee
        income and interest expense decreases. An increase in interest rates could
        also
        negatively impact our results of operations by reducing borrowers’ ability to
        repay their current loan obligations, resulting in increased loan defaults,
        foreclosures and write-offs and could necessitate increases to our allowance
        for
        loan losses.
  9
 *Table
            of Contents*
  *Our
        allowance for loan losses may not be adequate to cover actual
        losses* .
        We make
        various assumptions and judgments about the collectibility of our loan portfolio
        and provide an allowance for potential loan losses based on several factors.
        If
        our assumptions are incorrect, our allowance for loan losses may be insufficient
        to cover our actual losses, which would have an adverse effect on our results
        of
        operations, and may cause us to increase the allowance in the future.
 
 *Changes
        in the securities market may adversely impact our results of
        operations.* In
        recent years the securities market has experienced a significant downturn
        and
        will likely continue to experience volatility as a result of, among other
        things, global economic and political conditions. Continued declines in equity
        prices, as well as declines in the performance of certain sectors or specific
        companies, may result in a corresponding decline in the value of Company-held
        securities. The decline in the value of Company-held securities may decrease
        our
        earnings.
 
 *Our
        loans are concentrated in certain areas of New Hampshire and adverse conditions
        in those markets could adversely affect our operations.* We
        are
        exposed to real estate and economic factors in the northern and central areas
        of
        New Hampshire, as virtually the entire loan portfolio is concentrated among
        borrowers in these markets. Further, because a substantial portion of the
        loan
        portfolio is secured by real estate in this area, the value of the associated
        collateral is also subject to regional real estate market conditions. Adverse
        economic, political or business developments or natural hazards may affect
        these
        areas and the ability of property owners in these areas to make payments
        of
        principal and interest on the underlying mortgages. If these regions experience
        adverse economic, political or business conditions, we would likely experience
        higher rates of loss and delinquency on these mortgage loans than if the
        loans
        were more geographically diverse.
 
 *If
        we
        do not maintain net income growth, the market price of our common stock could
        be
        adversely affected.* Our
        return on shareholders’ equity and other measures of profitability, which affect
        the market price of our common stock, depend in part on our continued growth
        and
        expansion. Our growth strategy has two principal components—internal growth and
        external growth. Our ability to generate internal growth is affected by the
        competitive factors described below as well as by the primarily rural
        characteristics and related demographic features of the markets we serve.
        Our
        ability to continue to identify and invest in suitable acquisition candidates
        on
        acceptable terms is crucial to our external growth. In pursuing acquisition
        opportunities, we may be in competition with other companies having similar
        growth strategies. As a result, we may not be able to identify or acquire
        promising acquisition candidates on acceptable terms. Competition for these
        acquisitions could result in increased acquisition prices and a diminished
        pool
        of acquisition opportunities. An inability to find suitable acquisition
        candidates at reasonable prices could slow our growth rate and have a negative
        effect on the market price of our common stock.
 
 *We
        experience strong competition within our markets, which may impact our
        profitability.* Competition
        in the banking and financial services industry is strong. In our market areas,
        we compete for loans and deposits with local independent banks, thrift
        institutions, savings institutions, mortgage brokerage firms, credit unions,
        finance companies, mutual funds, insurance companies and brokerage and
        investment banking firms operating locally as well as nationally. Many of
        these
        competitors have substantially greater resources and lending limits than
        those
        of our subsidiaries and may offer services that our subsidiaries do not or
        cannot provide. Our long-term success depends on the ability of our subsidiaries
        to compete successfully with other financial institutions in their service
        areas. Because we maintain a smaller staff and have fewer financial and other
        resources than larger institutions with which we compete, we may be limited
        in
        our ability to attract customers. If we are unable to attract and retain
        customers, we may be unable to sustain growth in the loan portfolio and our
        results of operations and financial condition may otherwise be negatively
        impacted.
 
 *Our
        cost of funds for banking operations may increase as a result of general
        economic conditions, interest rates and competitive pressures.* Our
        banking subsidiary has traditionally obtained funds principally through deposits
        and borrowings. As a general matter, deposits are a less costly source of
        funds
        than borrowings because interest rates paid for deposits are typically less
        than
        interest rates charged for borrowings. If, as a result of general economic
        conditions, market interest rates, competitive pressures or otherwise, the
        value
        of deposits at our banking subsidiary decreases relative to our overall banking
        operations, we may have to rely more heavily on borrowings as a source of
        funds
        in the future.
 
 *Our
        banking business is highly regulated.* Bank
        holding companies, national banking associations and state-chartered banks
        operate in a highly regulated environment and are subject to supervision,
        regulation and examination by various federal and state bank regulatory
        agencies, as well as other governmental agencies in the states in which they
        operate. Federal and state laws and regulations govern numerous matters
        including changes in the ownership or control of banks and BHCs, maintenance
        of
        adequate capital and the financial condition of a financial institution,
        permissible types, amounts and terms of extensions of credit and investments,
        permissible non-banking activities, the level of reserves against deposits
        and
        restrictions on dividend payments. The FDIC possesses cease and desist powers
        to
        prevent or remedy unsafe or unsound practices or violations of law by banks
        subject to their regulation, and the FRB possesses similar powers with respect
        to BHCs. These and other restrictions limit the manner in which we may conduct
        business and obtain financing.
  10
 *Table
            of Contents*
  Furthermore,
        our business is affected not only by general economic conditions, but also
        by
        the economic, fiscal and monetary policies of the United States and its agencies
        and regulatory authorities, particularly the FRB. The economic and fiscal
        policies of various governmental entities and the monetary policies of the
        FRB
        may affect the interest rates our bank subsidiaries must offer to attract
        deposits and the interest rates they must charge on loans, as well as the
        manner
        in which they offer deposits and make loans. These economic, fiscal and monetary
        policies have had, and are expected to continue to have, significant effects
        on
        the operating results of depository institutions generally, including our
        bank
        subsidiaries.
 
 *We
        could be held responsible for environmental liabilities of properties we
        acquire
        through foreclosure.* If
        we are
        forced to foreclose on a defaulted mortgage loan to recover our investment,
        we
        may be subject to environmental liabilities related to the underlying real
        property. Hazardous substances or wastes, contaminants, pollutants or sources
        thereof may be discovered on properties during our ownership or after a sale
        to
        a third party. The amount of environmental liability could exceed the value
        of
        the real property. There can be no assurance that we would not be fully liable
        for the entire cost of any removal and clean-up on an acquired property,
        that
        the cost of removal and clean-up would not exceed the value of the property,
        or
        that we could recoup any of the costs from any third party.
 
 *To
        the extent that we acquire other companies in the future, our business may
        be
        negatively impacted by certain risks inherent with such acquisitions.* Although
        we do not have an aggressive acquisition strategy, we have acquired, and
        in the
        future, will continue to consider the acquisition of, other financial services
        companies. To the extent that we acquire other companies in the future, our
        business may be negatively impacted by certain risks inherent with such
        acquisitions. These risks include the following:
 
 ·
              The
                  risk that the acquired business will not perform in accordance
                  with
                  management’s expectations;
 ·
              The
                  risk that difficulties will arise in connection with the integration
                  of
                  the operations of the acquired business with the operation of our
                  businesses;
 ·
              The
                  risk that management will divert its attention from other aspects
                  of our
                  business;
 ·
              The
                  risk that we may lose key employees of the acquired business;
                  and
 ·
              The
                  risks associated with entering into geographic and product markets
                  in
                  which we have limited or no direct prior
                  experience.
 
  *Due
        to the nature of our business, we may be subject to litigation from time
        to
        time, some of which may not be covered by insurance.* Through
        our bank subsidiary, we operate in a highly regulated industry, and as a
        result,
        are subject to various regulations related to disclosures to our customers,
        our
        lending practices, and other fiduciary responsibilities. From time to time,
        we
        have been, and may become, subject to legal actions relating to our operations
        that have had, or could, involve claims for substantial monetary damages.
        Although we maintain insurance, the scope of this coverage may not provide
        us
        with full, or even partial, coverage in any particular case. As a result,
        a
        judgment against us in any such litigation could have a material adverse
        effect
        on our financial condition and results of operation.
  *Changes
        in tax legislation could have a material impact on our results of operations.
        C* hanges
        in
        tax legislation could have a material impact on our results of operations.
 
 ITEM
        2. PROPERTIES
 
 The
        Company operates 18 branch offices and one commercial lending and administration
        facility that are located in the central and northern New Hampshire communities
        of Berlin, Conway (four offices), Gorham, Groveton, Littleton, West Ossipee,
        West Plymouth, Plymouth, Campton, Ashland, North Woodstock, Tilton, Franklin,
        Laconia, Belmont, and Pittsfield. Fourteen of these offices are located on
        properties the Company owns. The Company leases five of its branches under
        contracts that expire between April 30, 2006 and December 31, 2015. Furthermore,
        two of the leases have an option to renew for an additional five years.
        Seventeen of the Company’s branches have drive-up facilities and all are
        equipped with automated teller machines.
  ITEM
        3. LEGAL PROCEEDINGS
 
 The
        Company is not a party to, nor are any of its subsidiaries the subject of,
        any
        material pending legal proceedings, other than ordinary routine litigation
        incidental to the business.
  11
 *Table
            of Contents*
  ITEM
        4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
        HOLDERS
 
 No
        matters were submitted to a vote of security holders during the quarter ended
        December 31, 2005.
 
 **PART
        II**
 
 ITEM
        5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
        MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
 The
        Company’s common stock is traded on The Nasdaq Stock Market, Inc.’s National
        Market under the symbol “NWFI”. The following table sets forth, for the periods
        indicated, the high and low closing sale prices for the common stock, as
        reported by The Nasdaq National Market, and the dividends paid on the common
        stock:
 
 Price
                  Per Share
              
              DividendsLow
              
              High
              
              Per
                  Share2005
              
              
              4thQuarter
              
              $
              31.59
              
              $
              35.31
              
              $
              0.183rdQuarter
              
              
              30.27
              
              
              35.56
              
              
              0.182ndQuarter
              
              
              29.61
              
              
              33.77
              
              
              0.181stQuarter
              
              
              32.37
              
              
              35.24
              
              
              0.172004
              
              
              4thQuarter
              
              $
              31.30
              
              $
              34.96
              
              $
              0.173rdQuarter
              
              
              29.30
              
              
              35.12
              
              
              0.172ndQuarter
              
              
              33.50
              
              
              38.60
              
              
              0.171stQuarter
              
              
              34.03
              
              
              38.00
              
              
              0.17
 
 The
        Company intends to continue to pay dividends on a quarterly basis subject
        to,
        among other things, the financial condition and earnings of the Company,
        capital
        requirements, and other factors, including applicable governmental regulations.
        No dividends will be payable unless declared by the Board of Directors and
        then
        only to the extent funds are legally available for the payment of such
        dividends.
 
 On
        March
        1, 2006, the closing sales price of the common stock on the Nasdaq National
        Market was $37.49 per share. As of such date, there were approximately 1,130
        holders of record of the Company common stock.
 
 The
        following table sets forth, for the periods indicated, information regarding
        stock repurchases:
 Period
                Total
                    Number of
                  Shares
                    Purchased
                Average
                    Price Paid
                  per
                    Share
                Maximum
                    Number
                  of
                    Shares that May
                  Yet
                    Be Purchased
                  Under
                    the PlanOctober
                    1, 2005 toOctober
                    31, 2005
                -
                -
                81,515November
                    1, 2005 to November 30, 2005
                6,000
                $33.50
                75,515December
                    1, 2005 to December 31, 2005
                -
                -
                75,515Total
                6,000
                $33.50
  12
 *Table
            of Contents*
  ITEM
        6. SELECTED FINANCIALDATA
 
 The
        following table sets forth the selected consolidated financial information
        of
        the Company for the five years in the period ended December 31, 2005. This
        selected consolidated financial information should be read in conjunction
        with
“Management’s Discussion and Analysis of Financial Condition and Results of
        Operations” appearing under Item 7 of this report and “Financial Statements and
        Supplementary Data” appearing under Item 8 of this report.
  At
                  or for the years ended December 31,
              
              2005
              
              2004
              
              2003
              
              2002
              
              2001(Dollars
                  in thousands, except per share data)*Balance
                  Sheet Data:*Total
                  assets
              
              $
              632,734
              
              $
              638,418
              
              $
              609,216
              
              $
              598,945
              
              $
              513,939Securities
                  available-for-sale, at fair value
              
              
              103,244
              
              
              101,133
              
              
              68,082
              
              
              87,776
              
              
              55,564Loans,
                  net of unearned income
              
              
              460,373
              
              
              474,706
              
              
              473,619
              
              
              445,773
              
              
              400,316Allowance
                  for loan losses
              
              
              5,150
              
              
              5,204
              
              
              5,036
              
              
              4,920
              
              
              4,642Other
                  real estate owned
              
              
              196
              
              
              -
              
              
              175
              
              
              22Unidentifiable
                  intangible assets
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              8,080Goodwill
              
              
              10,152
              
              
              10,152
              
              
              10,152
              
              
              10,152
              
              
              -Core
                  deposit intangibles, net
              
              
              1,995
              
              
              2,949
              
              
              3,903
              
              
              4,857
              
              
              -Deposits
              
              
              464,456
              
              
              475,359
              
              
              463,307
              
              
              476,194
              
              
              412,840Long-term
                  debt
              
              
              105,620
              
              
              98,620
              
              
              87,620
              
              
              66,620
              
              
              48,028Stockholders’
                  equity
              
              
              50,250
              
              
              49,510
              
              
              47,872
              
              
              44,266
              
              
              43,339*Income
                  Statement Data:*Net
                  interest and dividend income
              
              $
              23,176
              
              $
              22,846
              
              $
              23,050
              
              $
              21,664
              
              $
              20,721Provision
                  for loan losses
              
              
              75
              
              
              495
              
              
              805
              
              
              900
              
              
              900Noninterest
                  income
              
              
              3,996
              
              
              5,097
              
              
              5,375
              
              
              3,396
              
              
              2,909Noninterest
                  expense
              
              
              23,582
              
              
              22,394
              
              
              22,136
              
              
              20,035
              
              
              17,149Net
                  income
              
              
              2,673
              
              
              3,388
              
              
              3,617
              
              
              2,598
              
              
              3,873*Per
                  Common Share Data:*Net
                  income - basic
              
              $
              1.78
              
              $
              2.26
              
              $
              2.40
              
              $
              1.71
              
              $
              2.55Net
                  income - assuming dilution
              
              
              1.77
              
              
              2.24
              
              
              2.39
              
              
              1.71
              
              
              2.54Cash
                  dividends declared
              
              
              0.71
              
              
              0.68
              
              
              0.68
              
              
              0.68
              
              
              0.68Book
                  value
              
              
              33.70
              
              
              32.93
              
              
              31.92
              
              
              29.19
              
              
              28.68Tangible
                  book value
              
              
              25.39
              
              
              24.02
              
              
              22.30
              
              
              19.07
              
              
              23.16*Selected
                  Ratios:*Return
                  on average assets
              
              
              0.43
              %
              
              0.54
              %
              
              0.59
              %
              
              0.49
              %
              
              0.78
              %Return
                  on average equity
              
              
              5.33
              
              
              6.97
              
              
              7.82
              
              
              5.86
              
              
              9.14Dividend
                  payout
              
              
              39.96
              
              
              30.10
              
              
              28.28
              
              
              39.65
              
              
              26.54Average
                  equity to average assets
              
              
              7.99
              
              
              7.75
              
              
              7.61
              
              
              8.33
              
              
              8.58
  13
 *Table
            of Contents*
  ITEM
        7. MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS
 
 The
        purpose of this discussion is to focus on significant changes in the financial
        condition and results of operations of the Company. It is intended to supplement
        and highlight information contained in the accompanying consolidated financial
        statements and the selected financial data presented elsewhere in this report.
        The discussion set forth below contains certain statements that may be
        considered “forward-looking statements.” Forward-looking statements involve
        risks, uncertainties and other factors that may cause the Company’s actual
        results to materially differ from those projected in the forwarding-looking
        statements. For further information regarding forward-looking statements,
        you
        should review the discussion under the caption “FORWARD-LOOKING STATEMENTS” on
        page 1 of this report.
 
 **OVERVIEW
        OF PERFORMANCE**
 
 The
        Company derives substantially all of its revenue and income from community
        bank-related activities. The Bank operates as a typical community banking
        institution and does not engage in any specialized finance or capital markets
        activities. Northway functions primarily as the holder of stock of its
        subsidiary and assists in the management of the operations of its subsidiary
        as
        appropriate.
 
 The
        principal components of the Company’s income sources are net interest and
        dividend income. Net interest and dividend income is the difference between
        interest and fee income received on income earning assets, such as loans
        and
        investments, and the interest expense paid on interest bearing liabilities,
        such
        as deposits and borrowed funds. Our other sources of income include revenues
        from deposit account service fees and fee-based services, such as debit card
        and
        ATM fees and sales of securities.
 
 Economic
        and industry factors that could cause the Company’s financial performance to
        differ from expected results include changes in applicable federal and state
        regulations, changes in the hospitality industry on which the Company’s business
        is largely dependent, interest rate volatility, significant changes in loan
        losses which may affect the Company’s allowance for loan losses and the related
        provision for loan losses, and changes in the securities market that would
        affect the performance of the Company’s investment portfolio. Management
        evaluates each of these factors on an ongoing basis to determine their impact
        and to effect any strategies necessary to mitigate these risks.
 
 The
        Company reported net income of $2,673,000, or $1.78 per common share, in
        2005
        compared to net income of $3,388,000, or $2.26 per common share, in 2004
        and
        $3,617,000, or $2.40 per common share, in 2003. Return on average equity
        was
        5.33% in 2005, compared to 6.97% in 2004 and 7.82% in 2003. Return on average
        assets was 0.43% in 2005, compared to 0.54% in 2004 and 0.59% in 2003.
 
 During
        2005, the Company recorded an increase in net interest and dividend income
        of
        $330,000, as an increase in the average yield on earning assets of 0.33%
        and an
        increase in average earning assets of $2,079,000 was only partially offset
        by an
        increase in the cost of interest bearing liabilities of 0.31%. During 2005,
        interest income increased $1,827,000 due primarily to an improvement in the
        yield on loans as well as an increase in investment balances. Partially
        offsetting this, interest expense increased $1,497,000 as money market and
        certificates of deposit rates increased, keeping pace with the rise in interest rates. The Company recorded
        a
        reduction in the provision for loan losses of $420,000 as the total provision
        for 2005 was $75,000 compared to $495,000 for 2004. The decrease in the
        provision for loan losses was the result of an ongoing review of the adequacy
        of
        the allowance for loan losses. Noninterest income, excluding securities gains,
        increased $203,000 from last year due primarily to improvements in overdraft
        income, commissions on alternative investments and debit card fees, which
        was
        partially offset by decreases in gains on sales of loans and loan fees. During
        2005, the Company realized net securities losses totaling $551,000 compared
        to
        net securities gains of $753,000 for the prior year. These net losses in
        2005
        were the result of the restructuring of the investment portfolio as well
        as the
        sale of corporate bonds at a loss of $499,000. Noninterest expense increased
        $1,188,000 due primarily to one-time costs of $1,161,000 associated with
        the
        merger of the two banks.
 
 During
        2004, the Company recorded a decrease in interest and dividend income of
        $1,230,000, as a decrease in the average yield on earning assets of 0.39%
        was
        only partially offset by an increase in average earning assets of $18,885,000.
        This was partially offset by the fact that the continuation of a low interest
        rate environment provided the Company further opportunity to reduce its average
        cost of interest bearing liabilities. During 2004, the cost of interest bearing
        liabilities decreased 0.25%, resulting in a decrease in interest expense
        of
        $1,026,000. The Company recorded a reduction in the provision for loan losses
        of
        $310,000 as the total provision for 2004 was $495,000 compared to $805,000
        for
        2003. The decrease in the provision for loan losses was the result of an
        ongoing
        review of the adequacy of the allowance for loan losses. Noninterest income,
        excluding securities gains, increased $491,000 from 2003. This reflects,
        in
        part, the impact of a new non-deposit product line introduced earlier in
        2004,
        in addition to our continuing efforts to maximize all components of noninterest
        income, including the introduction of Bounce ProtectionTM in 2004. Less favorable
        market conditions for investment securities resulted in lower securities
        gains
        for 2004 than in 2003, as realized gains decreased $769,000 to $753,000.
        Noninterest expense increased $258,000 to $22,394,000 in 2004 compared to
        $22,136,000 in 2003 due primarily to an increase in salaries and benefits
        expense.
  14
 *Table
            of Contents*
 
 **NET
        INTEREST AND DIVIDEND INCOME ANALYSIS**
 
 Fluctuations
        in interest rates as well as changes in volume and mix of income earning
        assets
        and interest bearing liabilities can materially impact net interest and dividend
        income, the principal source of our income. The discussion of net interest
        and
        dividend income is presented on a taxable equivalent basis, unless otherwise
        noted, to facilitate performance comparisons among various taxable and
        tax-exempt assets.
 
 The
        table
        below under the caption “Consolidated Average Balances, Interest and Dividend
        Income/Expense and Average Yields/Rates,” presents the average balances, income
        earned or interest paid, and average yields earned or rates paid on the
        Company’s assets and liabilities for the years ended December
        31, 2005, 2004, and 2003.
 
 Net
        interest and dividend income for 2005 increased $489,000, or 2%, compared
        to
        2004. Interest and dividend income increased $1,986,000, or 7%, in 2005 compared
        to 2004. Rising interest rates resulted in an improvement in the yield on
        loans
        of 0.42% which was partially offset by a decline in average balances of
        $19,824,000, resulting in an increase in interest and fees on loans of $821,000.
        Further, the average balance of investments increased $23,097,000 resulting
        in
        an improvement in investment income of $966,000.
 
 The
        increase in interest income was partially offset by an increase in interest
        expense of $1,497,000, or 20%, in 2005 compared to 2004. Interest expense
        increased due primarily to an increase in the cost of interest bearing
        liabilities of 0.31%. This increase was the result of an increase in rates
        paid
        on money market accounts, certificates of deposit, securities sold under
        agreements to repurchase, and junior subordinated debentures. These rates
        increased as a result of the increase in general interest rates during 2005.
 
 Net
        interest and dividend income for 2004 decreased $162,000, or 1%, compared
        to
        2003. Interest and dividend income decreased $1,188,000, or 4%, in 2004 compared
        to 2003. The continued suppression of market interest rates during 2004 resulted
        in a 0.39% decrease in the yield on average earning assets. A 0.48% decrease
        in
        the yield on loans was partially offset by an increase in average loan balances
        of $17,105,000. This resulted in a net decrease of $1,294,000, or 5%, in
        interest and fees on loans. The decrease in interest and fees on loans was
        partially offset by an increase in interest and dividend income on securities
        of
        $100,000, which was the result of an increase in average balances of $6,450,000
        partially offset by a decrease in average yield of 0.22%.
 
 Interest
        expense decreased $1,026,000, or 12%, in 2004 compared to 2003. The decrease
        in
        interest expense was due primarily to a 0.25% decrease in rates paid on interest
        bearing liabilities partially offset by an increase in average balances of
        $11,061,000. The increase in average balances was primarily the result of
        increases in average Federal Home Loan Bank (“FHLB”) advances of $17,473,000.
        Total average deposits, including noninterest bearing DDA, decreased $1,373,000
        but a shift in the mix of deposits resulted in a decrease in time deposits
        of
        $20,791,000 partially offset by higher average balances in demand deposits,
        NOW
        accounts and savings accounts, which are all lower cost sources of funds
        for the
        Company.
 
 The
        trend
        in net interest and dividend income is commonly evaluated in terms of average
        rates using net interest margin and interest rate spread. The net interest
        margin is computed by dividing fully taxable equivalent net interest and
        dividend income by average total earning assets. This ratio represents the
        difference between the average yield returned on average earning assets and
        the
        average rate paid for all funds used to support those earning assets, including
        both interest bearing and noninterest bearing sources of funds. The net interest
        margin increased 0.07% to 4.06% in 2005 after having decreased 0.17% to 3.99%
        in
        2004. The increase in the net interest margin for 2005 was a direct result
        of
        the increase in the yield on earning assets, which increase was only partially
        offset by the increase in the cost of funds.
  The
        interest rate spread measures the difference between the average yield on
        earning assets and the average rate paid on interest bearing liabilities.
        The
        interest rate spread eliminates the impact of noninterest bearing funds and
        gives a direct perspective on the effect of interest rate fluctuations. During
        2005, the net interest rate spread increased 0.02% to 3.80% as the yield
        on
        earning assets increased 0.33% and was only partially offset by an increase
        in
        the cost of interest bearing liabilities of 0.31%. During 2004, the net interest
        rate spread decreased 0.14% to 3.78% as the yield on earning assets declined
        0.39% and was only partially offset by a decrease in the cost of interest
        bearing liabilities of 0.25%.
 
 See
        the
        tables below under the captions “Consolidated Average Balances, Interest and
        Dividend Income/Expense and Average Yields/Rates” and “Consolidated Rate/Volume
        Variance Analysis” for more information.
  15
 *Table
            of Contents*
  **CONSOLIDATED
        AVERAGE BALANCES, INTEREST AND DIVIDEND INCOME/EXPENSE**
 **AND
        AVERAGE YIELDS/RATES**
 ($000
        Omitted)
 For
        the
        Year Ended December 31,
 2005
                
                2004
                
                2003Average
                  Balance
                
                Income/
                  Expense
                
                Average
                  Yield/
                  Rate
                
                Average
                  Balance
                
                Income/
                  Expense
                
                Average
                  Yield/
                  Rate
                
                Average
                  Balance
                
                Income/
                  Expense
                
                Average
                  Yield/
                  RateAssetsInterest
                    earning assets:Federal
                    funds sold
                
                $
                9,383
                
                $
                322
                
                
                3.43
                %
                $
                10,564
                
                $
                125
                
                
                1.18
                %
                $
                15,153
                
                $
                118
                
                
                0.78
                %Interest
                    bearing deposits
                
                
                130
                
                
                3
                
                
                2.31
                
                
                143
                
                
                1
                
                
                0.70
                
                
                224
                
                
                2
                
                
                0.89Securities
                    (1) (2)
                
                
                109,333
                
                
                4,650
                
                
                4.25
                
                
                86,236
                
                
                3,684
                
                
                4.27
                
                
                79,786
                
                
                3,584
                
                
                4.49Loans,
                    net (3) (4)
                
                
                464,041
                
                
                27,642
                
                
                5.96
                
                
                483,865
                
                
                26,821
                
                
                5.54
                
                
                466,760
                
                
                28,115
                
                
                6.02Total
                    interest earning assets (5)
                
                
                582,887
                
                
                32,617
                
                
                5.60
                
                
                580,808
                
                
                30,631
                
                
                5.27
                
                
                561,923
                
                
                31,819
                
                
                5.66Cash
                    and due from banks
                
                
                14,942
                
                
                
                
                
                
                
                
                15,637
                
                
                
                
                
                
                
                
                14,907Allowance
                    for loan losses
                
                
                (5,254
                )
                
                
                
                
                
                
                
                (5,104
                )
                
                
                
                
                
                
                
                (4,983
                )Premises
                    and equipment, net
                
                
                13,453
                
                
                
                
                
                
                
                
                13,444
                
                
                
                
                
                
                
                
                12,447Other
                    assets
                
                
                21,750
                
                
                
                
                
                
                
                
                22,574
                
                
                
                
                
                
                
                
                23,753Total
                    assets
                
                $
                627,778
                
                
                
                
                
                
                
                $
                627,359
                
                
                
                
                
                
                
                $
                608,047LiabilitiesInterest
                    bearing liabilities:Regular
                    savings
                
                $
                81,534
                
                
                201
                
                
                0.25
                
                $
                85,319
                
                
                220
                
                
                0.26
                
                $
                80,741
                
                
                338
                
                
                0.42NOW
                    and super NOW
                
                
                96,713
                
                
                356
                
                
                0.37
                
                
                97,170
                
                
                334
                
                
                0.34
                
                
                87,212
                
                
                285
                
                
                0.33Money
                    market accounts
                
                
                68,398
                
                
                767
                
                
                1.12
                
                
                65,286
                
                
                460
                
                
                0.70
                
                
                66,159
                
                
                495
                
                
                0.75Certificates
                    of deposit
                
                
                135,751
                
                
                2,769
                
                
                2.04
                
                
                140,614
                
                
                2,136
                
                
                1.52
                
                
                161,405
                
                
                3,304
                
                
                2.05Securities
                    sold under agreements to repurchase
                
                
                8,836
                
                
                183
                
                
                2.07
                
                
                8,611
                
                
                87
                
                
                1.01
                
                
                7,895
                
                
                123
                
                
                1.56FHLB
                    advances
                
                
                84,437
                
                
                3,189
                
                
                3.78
                
                
                80,744
                
                
                3,115
                
                
                3.86
                
                
                63,271
                
                
                2,876
                
                
                4.55Junior
                    subordinated debentures
                
                
                20,620
                
                
                1,463
                
                
                7.10
                
                
                20,620
                
                
                1,079
                
                
                5.23
                
                
                20,620
                
                
                1,036
                
                
                5.02Total
                    interest bearing liabilities
                
                
                496,289
                
                
                8,928
                
                
                1.80
                
                
                498,364
                
                
                7,431
                
                
                1.49
                
                
                487,303
                
                
                8,457
                
                
                1.74Noninterest
                    bearing deposits
                
                
                77,845
                
                
                
                
                
                
                
                
                76,915
                
                
                
                
                
                
                
                
                71,160Other
                    liabilities
                
                
                3,466
                
                
                
                
                
                
                
                
                3,475
                
                
                
                
                
                
                
                
                3,307Total
                    liabilities
                
                
                577,600
                
                
                
                
                
                
                
                
                578,754
                
                
                
                
                
                
                
                
                561,770Stockholders'
                    equity
                
                
                50,178
                
                
                
                
                
                
                
                
                48,605
                
                
                
                
                
                
                
                
                46,277Total
                    liabilities and stockholders' equity
                
                $
                627,778
                
                
                
                
                
                
                
                $
                627,359
                
                
                
                
                
                
                
                $
                608,047Net
                    interest and dividend income (6)
                
                
                
                
                $
                23,689
                
                
                
                
                
                
                
                $
                23,200
                
                
                
                
                
                
                
                $
                23,362Interest
                    rate spread (7)
                
                
                
                
                
                
                
                
                3.80
                %
                
                
                
                
                
                
                
                3.78
                %
                
                
                
                
                
                
                
                3.92
                %Net
                    interest margin (8)
                
                
                
                
                
                
                
                
                4.06
                %
                
                
                
                
                
                
                
                3.99
                %
                
                
                
                
                
                
                
                4.16
                %
 (1)
              Reported
                  on a tax equivalent basis. Reported interest on securities of $4,465,000,
                  $3,582,000 and $3,470,000 was adjusted by $185,000, $102,000 and
                  $114,000,
                  for 2005, 2004 and 2003, respectively, to reflect the tax equivalent
                  adjustment.
 (2)
              Average
                  balances are calculated using the adjusted cost
                  basis.
 (3)
              Reported
                  on a tax equivalent basis. Reported interest and fees on loans
                  of
                  $27,314,000, $26,569,000 and $27,917,000 was adjusted by $328,000,
                  $252,000 and $198,000 for 2005, 2004 and 2003, respectively, to
                  reflect
                  the tax equivalent adjustment.
 (4)
              Net
                  of unamortized cost/unearned income. Includes loans held for sale
                  and
                  nonperforming loans.
 (5)
              Reported
                  on a tax equivalent basis. Reported interest and dividend income
                  of
                  $32,104,000, $30,277,000 and $31,507,000 was adjusted by $513,000,
                  $354,000 and $312,000 for 2005, 2004 and 2003, respectively, to
                  reflect
                  the tax equivalent adjustment.
 (6)
              Reported
                  on a tax equivalent basis. Reported net interest and dividend income
                  of
                  $23,176,000, $22,846,000 and $23,050,000 was adjusted by $513,000,
                  $354,000 and $312,000 for 2005, 2004 and 2003, respectively, to
                  reflect
                  the tax equivalent adjustment.
 (7)
              Interest
                  rate spread equals the yield on interest earning assets minus the
                  rate
                  paid on interest bearing
                  liabilities.
 (8)
              The
                  net interest margin equals net interest and dividend income divided
                  by
                  total average interest earning
                  assets.
  16
 *Table
            of Contents*
 
 **CONSOLIDATED
        RATE/VOLUME VARIANCE ANALYSIS** **(1)**
 
 ($000
                  Omitted)2005
                  Compared to 2004
                Increase
                  (Decrease) Due to Change In
              
              2004
                  Compared to 2003
                Increase
                  (Decrease) Due to Change InVolume
              
              Rate
              
              Mix
              
              Total
              
              Volume
              
              Rate
              
              Mix
              
              TotalInterest
                  and dividend income:Federal
                  funds sold
              
              $
              (14
              )
              $
              238
              
              $
              (27
              )
              $
              197
              
              $
              (36
              )
              $
              61
              
              $
              (18
              )
              $
              7Interest
                  bearing deposits
              
              
              -
              
              
              2
              
              
              -
              
              
              2
              
              
              (1
              )
              
              -
              
              
              -
              
              
              (1
              )Securities
              
              
              987
              
              
              (16
              )
              
              (5
              )
              
              966
              
              
              290
              
              
              (176
              )
              
              (14
              )
              
              100Loans,
                  net
              
              
              (1,099
              )
              
              2,002
              
              
              (82
              )
              
              821
              
              
              1,030
              
              
              (2,242
              )
              
              (82
              )
              
              (1,294
              )Total
                  interest and dividend income
              
              
              (126
              )
              
              2,226
              
              
              (114
              )
              
              1,986
              
              
              1,283
              
              
              (2,357
              )
              
              (114
              )
              
              (1,188
              )Interest
                  expense:Regular
                  savings
              
              
              (10
              )
              
              (9
              )
              
              -
              
              
              (19
              )
              
              19
              
              
              (130
              )
              
              (7
              )
              
              (118
              )NOW
                  and super NOW
              
              
              (2
              )
              
              24
              
              
              -
              
              
              22
              
              
              32
              
              
              15
              
              
              2
              
              
              49Money
                  market accounts
              
              
              22
              
              
              272
              
              
              13
              
              
              307
              
              
              (6
              )
              
              (29
              )
              
              -
              
              
              (35
              )Certificates
                  of deposit
              
              
              (74
              )
              
              732
              
              
              (25
              )
              
              633
              
              
              (426
              )
              
              (852
              )
              
              110
              
              
              (1,168
              )Securities
                  sold under agreements to repurchase
              
              
              2
              
              
              91
              
              
              3
              
              
              96
              
              
              11
              
              
              (43
              )
              
              (4
              )
              
              (36
              )FHLB
                  advances
              
              
              143
              
              
              (66
              )
              
              (3
              )
              
              74
              
              
              794
              
              
              (435
              )
              
              (120
              )
              
              239Junior
                  subordinated debentures
              
              
              -
              
              
              384
              
              
              -
              
              
              384
              
              
              -
              
              
              43
              
              
              -
              
              
              43Total
                  interest expense
              
              
              81
              
              
              1,428
              
              
              (12
              )
              
              1,497
              
              
              424
              
              
              (1,431
              )
              
              (19
              )
              
              (1,026
              )Net
                  interest and dividend income
              
              $
              (207
              )
              $
              798
              
              $
              (102
              )
              $
              489
              
              $
              859
              
              $
              (926
              )
              $
              (95
              )
              $
              (162
              )
 
 (1)
              Reported
                  on a tax equivalent basis.
 
 **PROVISION
        FOR LOAN LOSSES**
 
 The
        provision for loan losses represents the annual cost of providing an allowance
        for losses inherent in the loan portfolio. The size of the provision for
        each
        year is determined by management based upon many factors, including loan
        growth,
        net charge-offs, changes in the composition of the loan portfolio,
        delinquencies, management’s assessment of loan portfolio quality, the value of
        collateral and general economic factors.
  The
        provision for loan losses was $75,000 in 2005, a decrease of $420,000 from
        the
        provision recorded in 2004. The 2004 provision of $495,000 decreased $310,000
        from the provision recorded in 2003. The provision for each of the three
        years
        was based upon a review of the adequacy of the allowance for loan losses,
        which
        is conducted on a quarterly basis. These reviews are based upon many factors,
        including the risk characteristics of the portfolio, trends in loan
        delinquencies, and an assessment of existing economic conditions. In addition,
        various regulatory agencies, as part of their examination process, review
        the
        Company’s allowance for loan losses and such review may result in changes to the
        allowance based on judgments different from those of management.
 
 The
        decrease in the 2005 provision was due in part to a reduction in average
        loans
        of $19,824,000, which was primarily the result of a decrease in average indirect
        installment loans which declined $53,234,000. The decrease in the 2004 provision
        was due in part to a reduction in average impaired loans of $1,100,000 as
        well
        as the fact that the Company realized significant recoveries during 2004,
        which
        allowed the Company to maintain its coverage ratio.
 
 Although
        management utilizes its best judgment in providing for losses, there can
        be no
        assurance that the Company will not have to change its provision for loan
        losses
        in subsequent periods. Management will continue to monitor the allowance
        for
        loan losses and modify the provision to the allowance for loan losses as
        appropriate. For additional information regarding estimates in the assessment
        of
        the allowance for loan losses see “Application of Critical Accounting Policies”
below.
  17
 *Table
            of Contents*
 
 **NONINTEREST
        INCOME**
 
 Noninterest
        income consists of revenues generated from a broad range of financial services
        and activities, including fee-based services and income earned through
        securities sales.
 
 The
        following table sets forth the components of the Company’s noninterest
        income:
 
 ($000
                  Omitted)
                Years
                  Ended December 31,2005
              
              2004
              
              2003Service
                  charges and fees on deposit accounts
              
              $
              2,430
              
              $
              2,229
              
              $
              1,673Loss
                  (gain) on sales of securities available-for-sale, net
              
              
              (551
              )
              
              753
              
              
              1,522Gain
                  on sales of loans, net
              
              
              260
              
              
              374
              
              
              422Other
              
              
              1,857
              
              
              1,741
              
              
              1,758Total
                  noninterest income
              
              $
              3,996
              
              $
              5,097
              
              $
              5,375
 
 Fee
        income from service charges and fees on deposit accounts increased 9% in
        2005,
        33% in 2004 and 14% in 2003. The improvement in 2005 is due primarily to
        an
        increase in overdraft income due to the full year impact of the introduction
        of
        Bounce ProtectionTM, an overdraft privilege program, in April 2004. The
        improvement in 2004 was due principally to increases in overdraft fee income
        as
        the Company introduced new fee schedules in December 2003. In addition, 2004
        overdraft income was positively impacted by the Bounce ProtectionTM introduction.
        The improvement in 2003 was due principally to increases in overdraft fee
        income
        and service charge income resulting from the full year impact of the branch
        acquisitions completed in October 2002.
 
 During
        2005, the Company recognized a net loss on sales of securities of $551,000
        compared to net gains on sales of securities of $753,000 in 2004 and $1,522,000
        in 2003. Securities losses in 2005 were primarily due to the restructuring of the investment portfolio, which resulted in the sale of
        U.S.
        Government Agency bonds at a loss, as well as the sale of corporate bonds
        at a
        loss of $499,000. Securities gains in 2004 and 2003 were the result of improved
        market conditions for investment securities. Securities losses, net, in 2005
        included $117,000 of net gains on sales of equity securities compared to
        net
        gains of $253,000 in 2004 and net losses of $147,000 in 2003. Net losses
        on the
        sales of debt securities totaled $668,000 in 2005 compared to net gains of
        $500,000 in 2004 and $1,669,000 in 2003.
 
 Gains
        on
        sales of loans, net, decreased $114,000 in 2005 compared to 2004. Gains on
        sales
        of mortgage loans remained relatively unchanged at $112,000 from the prior
        year.
        Gains on sales of commercial loans declined $109,000 due to the fact that
        during
        2004 the Company sold a portfolio of commercial loans guaranteed by the Small
        Business Administration for a gain of $178,000. Gains on sales of loans,
        net,
        decreased $48,000 in 2004 compared to 2003. Gains on sales of mortgage loans
        decreased $228,000 as the Company opted to retain a greater portion of fixed
        rate mortgages in portfolio in 2004 compared to 2003. This was partially
        offset
        by the Company’s sale of a portfolio of commercial loans guaranteed by the Small
        Business Administration for a gain of $178,000 in 2004. The low interest
        rate
        environment in 2003 resulted in significant mortgage refinancing activity.
        Therefore, during 2003 the Company decided to sell a portion of this loan
        volume
        in the secondary market based on the Company’s underwriting standards. The
        result of these sales was an increase in gain on sale of loans of $163,000
        to
        $422,000 in 2003.
 
 Other
        noninterest income (sources of which include debit card interchange fees,
        credit
        card merchant and fee income, automated teller machine fees, loan fees, safe
        deposit fees and commissions on alternative investment products) increased
        $116,000, or 7%, to $1,857,000 in 2005 following a decrease of $17,000, or
        1%,
        to $1,741,000 in 2004 and an increase of $245,000, or 16%, to $1,758,000
        in
        2003. The increase in 2005 was due primarily to an increase in income from
        alternative investments products as well as an increase in debit card income.
        The decrease in 2004 compared to 2003 was due primarily to the recognition
        of
        approximately $191,000 in other loan fees resulting from transactions with
        Federal Home Loan Mortgage Corporation (“FHLMC”). This decrease was partially
        offset by the introduction of alternative investment products offered by
        the
        Company, which increased fee income by approximately $126,000. The increase
        in
        2003 compared to 2002 was due primarily to the increase in other loan fees.
 
 **NONINTEREST
        EXPENSE**
 
 Total
        noninterest expense increased $1,188,000, or 5%, during 2005 following an
        increase $258,000, or 1%, during 2004 and an increase of $2,101,000, or 10%,
        during 2003. The increase in expenses during 2005 is due primarily to one-time
        merger related expenses of $1,161,000. The increase in expenses during 2004
        was
        due primarily to an increase in salaries and employee benefits. The increase
        in
        expenses during 2003 was due in large part to the full year impact of the
        October 2002 branch purchases, which contributed to the overall increase
        in
        salaries and benefits expense, office occupancy and equipment expense and
        increased expenses associated with the amortization of core deposit intangibles.
  18
 *Table
            of Contents*
  **NONINTEREST
        EXPENSE (CONTINUED)**
 
 The
        following table sets forth information relating to the Company's noninterest
        expense during the periods indicated:
 
 ($000
                  Omitted)
                Years
                  Ended December 31,2005
              
              2004
              
              2003Salaries
                  and employee benefits
              
              $
              11,592
              
              $
              11,981
              
              $
              11,426Office
                  occupancy and equipment
              
              
              4,090
              
              
              3,731
              
              
              3,753Amortization
                  of core deposit intangibles
              
              
              954
              
              
              954
              
              
              954Write-down
                  of equity securities
              
              
              -
              
              
              -
              
              
              184Professional
                  fees
              
              
              1,523
              
              
              1,234
              
              
              1,166Advertising
              
              
              757
              
              
              326
              
              
              304Stationery
                  and supplies
              
              
              647
              
              
              429
              
              
              556Telecommunications
              
              
              619
              
              
              595
              
              
              571ATM
                  expense
              
              
              321
              
              
              295
              
              
              442Postage
                  and shipping
              
              
              317
              
              
              348
              
              
              378Other
              
              
              2,762
              
              
              2,501
              
              
              2,402Total
                  noninterest expense
              
              $
              23,582
              
              $
              22,394
              
              $
              22,136
 
 Merger
        related expenses totaled $1,161,000 for 2005 and consisted primarily of
        advertising expense of $386,000, stationery and supplies of $337,000, equipment
        expense of $141,000, professional fees of $83,000, legal fees of $81,000
        and
        state transfer tax of $71,000. These one-time costs related to marketing
        the
        Northway brand, replacing all existing forms, replacing all existing signage,
        transfer of real estate, and all necessary legal and computer systems issues
        related to the merger. These expenses are included in the table above in
        the
        appropriate expense categories.
 
 Salaries
        and employee benefits decreased $389,000, or 3%, from 2004 to 2005 and increased
        $555,000, or 5%, from 2003 to 2004. The decrease in 2005 was due primarily
        to a
        focus on staffing levels, an increase in SFAS No. 91 credits associated with
        deferred loan origination costs, and a decrease in the expense related to
        the
        Supplemental Employee Retirement Plan (“SERP”). The increase in 2004 reflects
        staff additions in connection with the expansion of the retail franchise,
        increased lending activities and normal salary and wage increases. Also,
        during
        2004 and 2003, the Company recorded a liability to deferred compensation
        related
        to the SERP. Refer to NOTE 15 to the Consolidated Financial Statements for
        a
        further discussion regarding the SERP.
 
 Office
        occupancy and equipment expense increased $218,000, net of merger related
        expenses of $141,000, during 2005 compared to 2004 and decreased $22,000
        from
        2003 to 2004. The increase in 2005 was due primarily to increases in building
        maintenance costs as well as one-time expenses associated with the write-down
        of
        leasehold improvements associated with the closure of two supermarket branch
        facilities.
 
 During
        2005 and 2004, the Company recorded no write-down of equity securities compared
        to $184,000 in 2003. During 2003, five equity securities were determined
        to be
        other than temporarily impaired due to sustained weakness in their market
        sectors as well as weaknesses related to the individual companies.
 
 **INCOME
        TAX EXPENSE**
 
 The
        Company recognized $842,000, $1,666,000 and $1,867,000 in income tax expense
        for
        the years ended December 31, 2005, 2004 and 2003, respectively. The effective
        tax rate was 24.0% for 2005, 33.0% for 2004 and 34.1% for 2003. For additional
        information relating to income taxes, see NOTE 14 to the Consolidated Financial
        Statements.
  19
 *Table
            of Contents*
  **ASSETS**
 
 Total
        assets decreased $5,684,000, or 1%, to $632,734,000 at December 31, 2005
        compared to $638,418,000 at December 31, 2004. The following is a summary
        of
        significant balance sheet changes.
 
 ($000
                  Omitted)
                December
                  312005
              
              2004
              
              Change
              
              %
                  ChangeTotal
                  assets
              
              $
              632,734
              
              $
              638,418
              
              $
              (5,684
              )
              
              (0.9)
              %Earning
                  assets
              
              
              582,558
              
              
              592,973
              
              
              (10,415
              )
              
              (1.8
              )Federal
                  funds sold
              
              
              14,775
              
              
              10,975
              
              
              3,800
              
              
              34.6Securities
                  available-for-sale, at fair value(1)
              
              
              108,785
              
              
              107,013
              
              
              1,772
              
              
              1.7Loans,
                  net of unamortized cost/unearned income
              
              
              460,373
              
              
              474,706
              
              
              (14,333
              )
              
              (3.0
              )Deposits
              
              
              464,456
              
              
              475,359
              
              
              (10,903
              )
              
              (2.3
              )Borrowings
              
              
              114,983
              
              
              109,888
              
              
              5,095
              
              
              4.6Stockholders’
                  equity
              
              
              50,250
              
              
              49,510
              
              
              740
              
              
              1.5
 
 (1)
              2005
                  includes Federal Home Loan Bank stock and 2004 includes Federal
                  Home Loan
                  Bank stock and Federal Reserve Bank
                  stock.
 
 The
        decrease in earning assets of $10,415,000 was due primarily to a decrease
        in
        loans partially offset by an increase in federal funds sold and securities
        available-for-sale. The decrease in earning assets was accompanied by a decline
        in deposits which was partially offset by an increase in borrowings.
 
 
 **SECURITIES
        AVAILABLE-FOR-SALE**
 
 The
        Company’s securities are classified into one of two categories based on
        management’s intent to hold the securities: (i) “held-to-maturity” securities,
        or (ii) securities “available-for-sale.” Securities designated to be
        held-to-maturity are reported at amortized cost. Securities classified as
        available-for-sale are required to be reported at fair value with unrealized
        gains and losses, net of taxes, excluded from earnings and shown separately
        as a
        component of stockholders’ equity. At December 31, 2005 and 2004 the Company had
        no securities designated as held-to-maturity.
 
 The
        following table summarizes the Company's securities portfolio at December
        31,
        2005 and 2004, showing amortized cost and fair value for each
        category:
  ($000
                  Omitted)
                December
                  31,2005
              
              2004Amortized
                Cost
              
              Fair
                Value
              
              Amortized
                Cost
              
              Fair
                ValueSecurities
                  available-for-sale:U.S.
                  Treasury and U.S. government agency securities
              
              $
              48,728
              
              $
              47,751
              
              $
              54,914
              
              $
              54,563Mortgage-backed
                  securities
              
              
              24,704
              
              
              23,931
              
              
              29,447
              
              
              29,291Collateralized
                  mortgage obligations
              
              
              8
              
              
              8
              
              
              10
              
              
              10Marketable
                  equity securities
              
              
              2,695
              
              
              2,809
              
              
              1,827
              
              
              1,931Corporate
                  bonds
              
              
              5,541
              
              
              5,569
              
              
              12,001
              
              
              12,287State
                  and political subdivision bonds and notes
              
              
              23,396
              
              
              23,176
              
              
              2,966
              
              
              3,051Total
                  securities available-for-sale
              
              $
              105,072
              
              $
              103,244
              
              $
              101,165
              
              $
              101,133
 
 Total
        securities available-for-sale increased $2,111,000 during 2005 to $103,244,000.
        While the overall balance of the investment portfolio was relatively unchanged,
        the Company restructured a portion of portfolio as U.S. government agencies,
        mortgage-backed securities and corporate bond sales and maturities were
        redeployed to state and political subdivisions, which provide a higher yield
        to
        the Company.
 
 The
        net
        unrealized loss on securities available-for-sale was $1,828,000 at December
        31,
        2005 compared to a net unrealized loss of $32,000 at December 31, 2004. At
        December 31, 2005, the net unrealized loss on debt securities was $1,942,000
        and
        the net unrealized gain on marketable equity securities was $114,000. At
        December 31, 2004, the net unrealized loss on debt securities was $136,000
        and
        the net unrealized gain on marketable equity securities was $104,000.
  20
 *Table
            of Contents*
  **SECURITIES
        AVAILABLE-FOR-SALE (CONTINUED)**
  Due
        to
        the decline in the performance of securities in certain sectors and specific
        companies within those sectors, the Company determined, through the evaluations
        described in Note 1 to the Consolidated Financial Statements, that the market
        values of certain of its marketable equity securities were other than
        temporarily impaired. As a result, during 2003 net losses on sales of marketable
        equity securities amounted to $147,000 and write-downs of marketable equity
        securities amounted to $184,000.
 
 At
        December 31, 2005, the Company’s investment in equity securities totaled
        $2,809,000. This amount is net of a market value adjustment of $114,000,
        of
        which the full amount was reflected as a gain in accumulated other comprehensive
        loss in stockholders’ equity.
 
 The
        Company has a general policy of purchasing investment grade securities and
        U.S.
        government securities to minimize credit risk. All securities, however, carry
        interest rate risk, which affect their market values such that as market
        yields
        increase, the value of the Company's securities decline and vice versa.
        Additionally, mortgage-backed securities carry prepayment risk whereby expected
        yields may not be achieved due to the inability to reinvest proceeds from
        prepayment at comparable yields. Moreover, such mortgage-backed securities
        may
        not benefit from price appreciation in periods of declining rates to the
        same
        extent as the remainder of the portfolio.
 
 A
        portion
        of the securities portfolio is pledged to secure public deposits, securities
        sold under agreements to repurchase, FHLB advances and treasury, tax and
        loan
        accounts. Refer to NOTE 3 to the Consolidated Financial Statements for a
        further
        discussion of pledging of securities.
 
 **LOANS**
 
 Gross
        loans decreased $14,523,000, or 3%, to $460,289,000 at December 31, 2005
        compared to December 31, 2004. This decrease was due primarily to a decrease
        in
        indirect installment loans of $54,299,000, which was partially offset by
        increases in residential real estate, commercial real estate, construction
        loans
        and installment loans. Gross loans remained relatively unchanged in 2004,
        increasing $946,000 due primarily to increases in residential real estate,
        commercial real estate and commercial loans, partially offset by a decrease
        in
        indirect installment loans. The following table presents the composition
        of the
        loan portfolio as of December 31, 2005 and 2004:
 
 ($000
                  Omitted)2005
              
              Percent
                of
                  Total
              
              2004
              
              Percent
                of
                  TotalReal
                  estate:Residential
              
              $
              158,729
              
              
              34.5
              %
              $
              147,333
              
              
              31.0
              %Commercial
              
              
              143,456
              
              
              31.1
              
              
              130,334
              
              
              27.5Construction
              
              
              13,241
              
              
              2.9
              
              
              5,366
              
              
              1.1Commercial
              
              
              27,349
              
              
              6.0
              
              
              27,013
              
              
              5.7Installment
              
              
              35,786
              
              
              7.8
              
              
              29,345
              
              
              6.2Indirect
                  installment
              
              
              62,221
              
              
              13.5
              
              
              116,520
              
              
              24.5Other
              
              
              19,507
              
              
              4.2
              
              
              18,901
              
              
              4.0$
              460,289
              
              
              100.0
              %
              $
              474,812
              
              
              100.0
              %
 
 During
        2005, the loan portfolio mix continued to shift as runoff from the indirect
        installment loan portfolio was redeployed into residential real estate,
        commercial real estate, construction and installment loans. Indirect installment
        loans comprised 13.5% of the loan portfolio at December 31, 2005 as compared
        to
        24.5% at the end of 2004. Effective August 31, 2004, the Company discontinued
        the origination of indirect installment loans; therefore, this portfolio
        continues to decrease. Residential real estate loans increased to account
        for
        34.5% of the portfolio from 31.0% at December 31, 2004 due in part to the
        decision to retain high credit quality fixed-rate mortgages in the portfolio
        rather than sell in the secondary market. Commercial real estate and
        construction loans now comprise 31.1% and 2.9%, respectively of total loans
        compared to 27.5% and 1.1%, respectively at December 31, 2004 due to the
        continued efforts of our seasoned commercial lenders. Installment loans comprise
        7.8% of the loan portfolio compared to 6.2% a year ago due primarily to an
        increase in fixed rate home improvement loans.
 
 Commercial
        real estate loans consist of loans secured by income producing and
        owner-occupied commercial real estate and commercial loans consist of loans
        that
        are either unsecured or are secured by inventories, receivables or other
        corporate assets, and some are additionally secured by a guarantee of the
        federal Small Business Administration. Commercial real estate and commercial
        loans increased by $13,458,000 in 2005 as compared to 2004. The Company
        continues to emphasize commercial real estate and commercial loans in order
        to
        enhance earnings and maintain the balance of its portfolio.
  21
 *Table
            of Contents*
 
 **LOANS
        (CONTINUED)**
 
 Residential
        real estate loans increased by $11,396,000, an 8% increase from 2004, compared
        to an increase of $17,840,000, or 14%, in 2004 compared to 2003. The Company
        originates both fixed-rate and adjustable-rate residential loans for its
        portfolio. Some fixed-rate residential loans are originated for sale to
        investors in the secondary market. The increase in residential real estate
        loans
        in 2005 and 2004 resulted primarily from the Company’s decision to retain a
        greater percentage of fixed-rate residential mortgage loans.
 
 During
        2005, installment loan balances increased $6,441,000, or 22%, from 2004,
        compared to a decrease of $946,000, or 3%, in 2004 compared to 2003. Indirect
        installment loans decreased by $54,299,000, or 47 %,
        in
        2005 compared to a decrease of $34,287,000, or 23%, in 2004. As previously
        mentioned, indirect installment originations ceased on August 31, 2004.
 
 **NONPERFORMING
        ASSETS**
  Nonperforming
        assets were $3,321,000, or 0.53%, of total assets, at December 31, 2005 compared
        to $2,949,000, or 0.46% of total assets, at December 31, 2004, an increase
        of
        $372,000, or 13%. However, during January 2006, nonperforming loans totaling
        $1,591,000 were paid in full. Nonperforming assets are comprised primarily
        of
        nonaccrual loans, other chattels owned and real estate acquired by foreclosure
        or a similar conveyance of title. The accrual of interest on a loan is
        discontinued when there is reasonable doubt as to its collectibility or whenever
        the payment of principal or interest is more than 90 days past due. However,
        there are loans within this nonaccrual classification that provide periodic
        payments, but which have a weakness with respect to the collateral securing
        the
        loan.
 
 At
        December 31, 2005, nonaccrual loans totaled $3,013,000, or 0.66% of total
        loans,
        compared to $2,867,000, or 0.60% of total loans, in 2004. At December 31,
        2005
        other real estate owned totaled $196,000 compared to zero at December 31,
        2004.
        Other chattels owned increased $30,000 to $112,000 at December 31, 2005 compared
        to $82,000 at December 31, 2004.
  **ALLOWANCE
        FOR LOAN LOSSES**
 
 The
        Company maintains an allowance for loan losses to absorb losses inherent
        in the
        existing loan portfolio. When a loan, or portion thereof, is considered
        uncollectible, it is charged against the allowance. Recoveries of amounts
        previously charged-off are added to the allowance when collected. The adequacy
        of the allowance for loan losses is evaluated on a regular basis by management.
        Factors considered in evaluating the adequacy of the allowance include previous
        loss experience, current economic conditions and their effect on borrowers
        and
        the market area in general, and the performance of individual credits in
        relation to the contract terms. In addition various federal and state regulatory
        agencies, as an integral part of their examination process, periodically
        review
        the adequacy of the Company’s allowance for loan losses. For additional
        information regarding estimates in the assessment of the allowance for loan
        losses see “Application of Critical Accounting Policies-Allowance for Loan
        Losses” below.
 
 The
        Company’s allowance for loan losses decreased $54,000 from December 31, 2004 to
        $5,150,000, or 1.12% of total loans, at December 31, 2005.
 
 The
        following table sets forth the composition of the allowance for loan losses
        for
        the periods indicated:
 
 ($000
                  Omitted)
                Years
                  Ended December 312005
              
              2004
              
              2003Beginning
                  allowance
              
              $
              5,204
              
              $
              5,036
              
              $
              4,920Provision
                  for loan losses
              
              
              75
              
              
              495
              
              
              805Loans
                  charged-off
              
              
              (415
              )
              
              (665
              )
              
              (870
              )Recoveries
                  on loans previously charged-off
              
              
              286
              
              
              338
              
              
              181Net
                  charge-offs
              
              
              (129
              )
              
              (327
              )
              
              (689
              )Ending
                  allowance
              
              $
              5,150
              
              $
              5,204
              
              $
              5,036Allowance
                  as a percentage of loans outstanding
              
              
              1.12
              %
              
              1.10
              %
              
              1.06
              %Allowance
                  as a percentage of nonperforming loans
              
              
              170.93
              
              
              181.51
              
              
              123.16Net
                  charge-offs as a percentage of average loans
              
              
              0.03
              
              
              0.07
              
              
              0.15
 22
 *Table
              of Contents*
  **DEPOSITS**
 
 Total
        deposits at December 31, 2005 were $464,456,000, a decrease of $10,903,000,
        or
        2%, compared to $475,359,000 at December 31, 2004. The decrease in deposits
        was
        due primarily to a decrease in savings, NOW and money market deposits partially
        offset by an increase in time deposits.
 
 The
        following table sets forth the components of deposits for the periods
        indicated:
 
 ($000
                  Omitted)
                December
                  31,2005
              
              2004Demand
              
              $
              77,436
              
              $
              78,669Regular
                  savings, NOWand
                  money market
              
              
              238,689
              
              
              263,685Time
              
              
              148,331
              
              
              133,005Total
                  deposits
              
              $
              464,456
              
              $
              475,359
 
 At
        December 31, 2005, time deposits of $100,000 or more are scheduled to mature
        as
        follows:
 
  ($000
                  Omitted)3
                  months or less
              
              $
              6,503Over
                  3 to 6 months
              
              
              3,612Over
                  6 to 12 months
              
              
              15,662Over
                  12 months
              
              
              2,520$
              28,297
 
 **BORROWINGS**
 
 At
        December 31, 2005 short-term borrowings consisted of securities sold under
        agreements to repurchase of $9,363,000 compared to $11,268,000 for 2004.
 
 Long-term
        debt in 2005 consists of FHLB term advances of $85,000,000 as well as
        $20,620,000 of junior subordinated debentures, compared to $78,000,000 of
        FHLB
        term advances and $20,620,000 of junior subordinated debentures in 2004.
        Seven
        of the long-term term FHLB advances are callable quarterly with their next
        call
        dates in January, February and March 2006. The increase in FHLB advances
        is the
        result of new advances totaling $13,000,000, which was partially offset by
        the
        maturity of $6,000,000 in advances.
 
 Junior
        subordinated debentures consist of two issues of floating rate trust preferred
        securities acquired during April and July 2002 in the amount of $7,217,000
        and
        $13,403,000, respectively, due in 2032. These trust preferred securities
        were
        offered for the purpose of providing capital to the subsidiary bank to ensure
        adequate capital following the recent branch acquisitions and for general
        corporate purposes. As of December 31, 2005, of the $20,620,000 principal
        amount
        outstanding, $16,583,000 qualified as Tier 1 capital and $4,037,000 was
        allocated to Tier 2 capital.
 
 See
        NOTES
        9 and 10 to the Consolidated Financial Statements for additional information
        regarding the Company’s borrowings.
 
 The
        following table sets forth certain information concerning the Company’s
        borrowings at the dates indicated:
 
 ($000
                  Omitted)
                December
                  31,2005
              
              2004Short-term
                  borrowings
              
              $
              9,363
              
              $
              11,268Long-term
                  debt
              
              
              105,620
              
              
              98,620$
              114,983
              
              $
              109,888
 
 
 At
        December 31, 2005, long-term debt is scheduled to mature as
        follows:
  ($000
                  Omitted)Less
                  than one year
              
              $
              31,000One
                  to three years
              
              
              22,000Three
                  to five years
              
              
              26,000Over
                  five years
              
              
              26,620$
              105,620
  23
 *Table
            of Contents*
  **OFF-BALANCE
        SHEET ARRANGEMENTS**
 
 The
        Company is party to financial instruments with off-balance sheet risk in
        the
        normal course of business to meet the financing needs of its customers and
        to
        reduce its own exposure to fluctuations in interest rates. These financial
        instruments include commitments to originate loans and standby letters of
        credit. The instruments involve, to varying degrees, elements of credit and
        interest rate risk in excess of the amount recognized in the balance sheet.
        The
        amounts of those instruments reflect the extent of involvement the Company
        has
        in particular classes of financial instruments.
 
 The
        Company’s exposure to credit loss in the event of nonperformance by the other
        party to the financial instrument for loan commitments and standby letters
        of
        credit is represented by the contractual amount of those instruments. The
        Company uses the same credit policies in making commitments and conditional
        obligations as it does for balance sheet instruments.
 
 Financial
        instruments with off-balance sheet credit risk at December 31, 2005 and 2004
        totaled $60,418,000 and $60,290,000, respectively.
 
 At
        December 31, 2005, the Bank had commitments to purchase state and political
        subdivision bonds totaling $2,206,000.
 
 On
        December 13, 2005, the Bank entered into an agreement with Washington Mutual
        Bank to purchase two branches located in Belmont and Tilton, New Hampshire.
        The
        Bank expects to acquire approximately $31,000,000 of deposits and $10,000,000
        of
        loans. The transaction is expected to close on or about April 7,
        2006.
 
 See
        NOTE
        16 to the Consolidated Financial Statements for additional information regarding
        off-balance sheet arrangements.
 
 **CAPITAL**
 
 The
        Company's stockholders’ equity serves to support growth and provide depositors
        and other creditors protection against loss. Equity capital represents the
        stockholders’ investment in the Company. Management strives to maintain an
        optimal level of capital on which an attractive return to the stockholders
        will
        be realized over both the short-term and long-term, while serving depositors’
and creditors’ needs.
 
 The
        Company must also observe the minimum requirements enforced by the federal
        banking regulators. There are three capital requirements that banks and bank
        holding companies must meet: Tier 1 capital, total capital (combination of
        Tier
        1 capital and Tier 2 capital), and leverage (Tier 1 capital to average assets)
        ratios. Tier 1 capital consists of stockholders’ equity, net of intangible
        assets as well as a portion of junior subordinated debentures. Tier 2 capital
        consists of a limited amount of allowance for loan losses and the portion
        of
        junior subordinated debentures not allocated to Tier 1 capital. Tier 1 capital,
        total capital and leverage ratios do not include any adjustments for unrealized
        gains and losses relating to securities available-for-sale except net unrealized
        losses relating to marketable equity securities. The minimum requirements
        for
        the leverage ratio, risk-based Tier 1 capital and risk-based total capital
        are
        4%, 4% and 8%, respectively. As of December 31, 2005 and 2004, the Bank was
        “well capitalized” as defined under FDIC regulations.
 
 The
        following table sets forth the Company’s risk-based capital and leverage
        ratios:
 
 ($000
                  Omitted)
                December
                  31,2005
              
              2004Risk-adjusted
                  assets
              
              $
              426,731
              
              $
              446,807Tier
                  1 capital (to average assets)
              
              
              8.96
              %
              
              8.43
              %Tier
                  1 capital (to risk weighted assets)
              
              
              13.07
              
              
              11.80Total
                  capital (to risk weighted assets)
              
              
              15.24
              
              
              13.94
 
 Total
        stockholders’ equity includes a $1,104,000 negative adjustment for accumulated
        other comprehensive loss, net of tax, at December 31, 2005 and a $691,000
        negative adjustment for accumulated other comprehensive loss, net of tax,
        at
        December 31, 2004. At December 31, 2005, this adjustment was comprised solely
        of
        a net unrealized loss on securities available-for-sale, net of taxes.
 
 The
        Company intends to continue to pay dividends on a quarterly basis subject
        to the
        financial condition and earnings of the Company, capital requirements, and
        other
        factors, including applicable governmental regulations. No dividends will
        be
        payable unless declared by the Board of Directors and then only to the extent
        funds are legally available for the payment of such dividends.
  24
 *Table
            of Contents*
 
 **APPLICATION
        OF CRITICAL ACCOUNTING POLICIES**
 
 The
        Company’s accounting policies are more fully described in NOTE 1 of the
        Consolidated Financial Statements. As disclosed in NOTE 1, the preparation
        of
        financial statements in conformity with generally accepted accounting principles
        requires management to make estimates and assumptions about future events
        that
        affect the amounts reported in the financial statements and accompanying
        notes.
        Actual results could differ significantly from those estimates. The Company
        believes that the following discussion addresses the Company’s most critical
        accounting policies, which are those that are most important to the portrayal
        of
        the Company’s financial condition and results of operations and require
        management’s most difficult, subjective and complex judgments.
 
 Allowance
        for Loan Losses .
        The
        allowance for loan losses, which is established through a charge to the
        provision for loan losses, is estimated at the Bank based on estimates of
        losses
        related to customer loan balances. In establishing the appropriate provisions
        for customer loan balances, the Company makes assumptions with respect to
        their
        future collectibility. The Company’s assumptions are based on an individual
        assessment of the customer’s credit quality as well as subjective factors and
        trends, including the credit rating of the loans. Generally, these individual
        credit assessments occur prior to the inception of the credit exposure and
        at
        regular reviews during the life of the exposure and consider (a) the customer’s
        ability to meet and sustain their financial commitments; (b) a customer’s
        current and projected financial condition; (c) the positive or negative effects
        of the current and projected industry outlook; and (d) the economy in general.
        Once the Company considers all of these factors, a determination is made
        as to
        the probability of default. An appropriate provision is made, which takes
        into
        account the severity of the likely loss on the outstanding loan balances
        based
        on the Company’s experience in collecting these amounts. The Company’s level of
        allowance for loan losses fluctuates depending upon all of the factors mentioned
        above. The use of different estimates or assumptions could produce different
        provisions for loan losses.
 
 Goodwill
        and Core Deposit Intangibles .
        Effective January 1, 2002, the Company adopted Statement of Financial Accounting
        Standards No. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets.”
Under SFAS No. 142, the Company is required to perform annual impairment
        tests
        of its goodwill and intangible assets and more frequently in certain
        circumstances. The Company has elected to test for goodwill and intangible
        asset
        impairment in the fourth quarter of each year. In that goodwill is carried
        on
        the books of the Bank and the Company owns 100% of their outstanding stock,
        there is no market value for their common stock. The Company utilizes a multiple
        of earnings approach in analyzing the valuation of goodwill. Core deposit
        intangibles are carried on the books of the Bank as well. The valuation of
        core
        deposit intangibles incorporate deposits acquired compared with current deposit
        levels, considers deposit outflow assumptions made at acquisition as well
        as
        other factors.
 
 The
        most
        recent impairment test of goodwill and core deposit intangibles indicated
        that
        no adjustments were required. The Company cannot predict the occurrence of
        certain future events that might adversely affect the reported value of goodwill
        and core deposit intangibles that totaled $10,152,000 and $1,995,000,
        respectively, at December 31, 2005. Such events include, but are not limited
        to,
        strategic decisions made in response to economic and competitive conditions,
        the
        impact of the economic environment on the Company’s customer base, or the impact
        of changes in federal and state laws and regulations.
 
 Pension
        Benefits .
        The
        Company maintains a trusteed non-contributory pension plan (the “Plan”) covering
        substantially all full-time employees. Several statistical and other factors,
        which attempt to anticipate future events, are used in calculating the expense
        and liability related to the Plan. Key factors include assumptions about
        the
        expected rates of return on plan assets and discount rates. The Company
        considers market conditions, including changes in investment returns and
        interest rates, in making these assumptions.
 
 The
        Company determines the expected long-term rate of return on plan assets based
        on
        the building block method, which consists of aggregating the expected rates
        of
        return for each component of the plan’s asset mix. Plan assets are comprised
        primarily of mutual funds including bond funds, US equity funds, international
        equity funds, real estate funds and short-term money market funds. The Company
        uses historic plan asset returns combined with current market conditions
        to
        estimate the rate of return. The expected rate of return on plan assets is
        a
        long-term assumption and generally does not change annually. The discount
        rate
        reflects the market rate for high-quality fixed income debt instruments on
        the
        Company’s annual measurement date (December 31) and is subject to change each
        year.
 
 Unrecognized
        actuarial gains and losses are being recognized over approximately
        a 17-year period, which
        represents the expected remaining service life of the employee group.
        Unrecognized actuarial gains and losses arise from several factors including
        experience and assumption changes in the obligations and from the difference
        between expected returns and actual returns on plan assets. These unrecognized
        losses will be systematically recognized as an increase in future net periodic
        pension expense in accordance with FAS 87, “Employers’ Accounting for
        Pensions.”
 
 The
        actuarial assumptions used by the Company in determining its pension benefits
        may differ materially from actual results due to changing market and economic
        conditions, higher or lower withdrawal rates or longer or shorter life spans
        of
        the participants. While the Company believes that the assumptions used are
        appropriate, differences in actual experience or changes in assumptions may
        materially affect the Company’s financial position or results of
        operations.
  25
 *Table
            of Contents*
 
 **APPLICATION
        OF CRITICAL ACCOUNTING POLICIES (CONTINUED)**
 
 Mortgage
        Servicing Rights (MSR or MSRs). Servicing assets are recognized as separate assets when rights are acquired
        through purchase or through sale of financial assets. Capitalized servicing
        rights are reported in other assets and are amortized into noninterest income
        in
        proportion to, and over the period of, the estimated future net servicing
        income
        of the underlying financial assets. Servicing assets are evaluated for
        impairment based upon the fair value of the rights as compared to amortized
        cost. Impairment is determined by stratifying rights by predominant
        characteristics, such as interest rates and original loan terms (primarily
        15
        and 30 year). Fair value is determined using prices for similar assets with
        similar characteristics, when available, or based upon discounted cash flows
        using market-based assumptions. In periods of falling market interest rates,
        accelerated loan prepayment speeds can adversely impact the fair value of
        these
        mortgage-servicing rights relative to their book value. In the event that
        the
        fair value of these assets were to increase in the future, the Company can
        recognize the increased fair value to the extent of the impairment allowance
        but
        cannot recognize an asset in excess of its amortized book value. When the
        book
        value of an individual stratum exceeds its fair value, an impairment reserve
        must be recognized. Future changes in management's assessment of the impairment
        of these servicing assets, as a result of changes in observable market data
        relating to market interest rates, loan prepayment speeds, and other factors,
        could impact the Company's financial condition and results of operations
        either
        positively or adversely.
  **MARKET
        RISK**
 
 Market
        risk is the risk of loss in a financial instrument arising from adverse changes
        in market rates and prices, such as interest rates, foreign currency exchange
        rates, commodity prices and equity prices. The Company’s primary market risk
        exposure is interest rate risk. The ongoing monitoring and management of
        this
        risk is an important component of the Company's asset/liability management
        process which is governed by policies established by the Company’s Boards of
        Directors that are reviewed and approved annually. The Board of Directors
        delegates responsibility for carrying out the asset/liability management
        policies to the Company's Asset Liability Committee (“ALCO”). In this capacity
        ALCO develops guidelines and strategies impacting the Company's asset/liability
        management-related activities based upon estimated market risk sensitivity,
        policy limits and overall market interest rate levels/trends.
 
 Interest
        Rate Risk
 
 Interest
        rate risk represents the sensitivity of earnings to changes in market interest
        rates. As interest rates change, the interest income and interest expenses
        associated with the Company's financial instruments also change, thereby
        impacting net interest income ("NII"), the primary component of the Company's
        earnings. ALCO utilizes the results of a detailed and dynamic simulation
        model
        to quantify the estimated exposure of NII to sustained interest rate changes.
        While ALCO routinely monitors simulated NII sensitivity over a rolling 2-year
        horizon, it also utilizes additional tools to monitor potential longer-term
        interest rate risk.
 
 The
        simulation model captures the impact of changing interest rates on the interest
        income received and interest expense paid on all interest-earning assets
        and
        interest--bearing liabilities reflected on the Company's balance sheet. The
        Company uses computer simulations to determine the impact on net interest
        income
        of various interest rate scenarios, balance sheet trends and strategies.
        These
        simulations incorporate assumptions about balance sheet dynamics such as
        loan
        and deposit growth, loan and deposit pricing, changes in funding mix, and
        asset
        and liability repricing and maturity characteristics. Simulations based on
        numerous assumptions are run under various interest rate scenarios to determine
        the impact on net interest income and capital. From these scenarios, interest
        rate risk is quantified and appropriate strategies are developed and
        implemented.
 
 This
        sensitivity analysis is compared to ALCO policy limits which specify a maximum
        tolerance level for NII exposure over a 1-year horizon given both an immediate
        300 basis point, or 3%, upward and downward shift in interest rates. Given
        the
        current level of interest rates, the Company has modeled an upward shift
        in
        rates of 300 basis points and a downward shift in rates of 200 basis points.
        Using an immediate rate shock simulation where interest rates increase 300
        basis
        points, the December 31, 2005 earnings simulation model projects that net
        interest income for the twelve months ending December 31, 2006 would decrease
        by
        an amount equal to approximately 3.00%. In addition, utilizing an immediate
        rate
        shock simulation where interest rates decrease 200 basis points, the December
        31, 2005 earnings simulation model projects that net interest income for
        the
        twelve months ending December 31, 2006 would decrease by an amount equal
        to
        approximately 7.14%.
 
 Using
        an
        immediate rate shock simulation where interest rates increase 300 basis points,
        the December 31, 2005 earnings simulation model projected that net interest
        income for the twelve months ending December 31, 2007 would decrease by an
        amount equal to approximately 4.79%. In addition, utilizing an immediate
        rate
        shock simulation where interest rates decrease 200 basis points, the December
        31, 2005 earnings simulation model projected that net interest income for
        the
        twelve months ending December 31, 2007 would increase by an amount equal
        to
        approximately 7.45%. The projected results are within Company’s ALCO policy
        limits for both years.
  26
 *Table
            of Contents*
 
 **MARKET
        RISK (CONTINUED)**
 
 The
        preceding sensitivity analysis does not represent a Company forecast and
        should
        not be relied upon as being indicative of expected operating results. These
        hypothetical estimates are based upon numerous assumptions including, among
        others, the nature and timing of interest rate levels, yield curve shape,
        prepayments on loans and securities, deposit decay rates, pricing decisions
        on
        loans and deposits, and reinvestment/replacement of asset and liability
        cashflows-. The assumptions differed in each of the periods included in the
        sensitivity analysis above. While assumptions are developed based upon current
        economic and local market conditions, the Company cannot make any assurances
        as
        to the predictive nature of these assumptions, including how customer
        preferences or competitor influences might change.
 
 The
        most
        significant factors affecting the changes in market risk exposure during
        2005
        compared to 2004 was the increase in interest rates, changes in the yield
        curve
        for investment securities, the increase in the aggregate principal amount
        in
        fixed-rate loans extended by the Bank, the aggregate increase in securities
        available-for-sale, the decrease in total deposits, and the increase in
        long-term debt.
 
 **LIQUIDITY
        RISK**
 
 Liquidity
        risk management involves the Company’s ability to raise funds in order to meet
        its existing and anticipated financial obligations. These obligations are
        the
        withdrawal of deposits on demand or at contractual maturity, the repayment
        of
        debt as it matures, the ability to fund new and existing loan commitments
        and
        the ability to take advantage of new business opportunities. Liquidity may
        be
        provided through amortization, maturity or sale of assets such as loans and
        securities available-for-sale, liability sources such as increased deposits,
        utilization of the FHLB credit facility, purchased or other borrowed funds,
        and
        access to the capital markets. Liquidity targets are subject to change based
        on
        economic and market conditions and are controlled and monitored by ALCO.
        At the
        bank level, liquidity is managed by measuring the net amount of marketable
        assets after deducting pledged assets, plus lines of credit, primarily with
        the
        FHLB, which are available to fund liquidity requirements. Management then
        measures the adequacy of that aggregate amount relative to the aggregate
        amount
        of liabilities deemed to be sensitive or volatile. These include brokered
        deposits, deposits in excess of $100,000, term deposits with short maturities,
        and credit commitments outstanding.
 
 Additionally,
        the Company requires cash for various operating needs including dividends
        to
        stockholders, the purchase of treasury stock, capital injections to the Bank,
        and the payment of general corporate expenses. The primary sources of liquidity
        for the Company are dividends from the Bank and reimbursement for services
        performed on behalf of the Bank. Additionally, the Company may utilize outside
        sources of funding such as the issuance of the trust preferred
        securities.
 
 Cash
        and
        cash equivalents increased $4,593,000 during 2005. Cash provided from investing
        activities totaled $7,631,000 with lending activities providing $13,631,000,
        net, and investment activities using $7,173,000, net. Cash used by financing
        activities totaled $7,340,000. This cash consisted of a decrease in deposits
        of
        $10,903,000, a decrease in repurchase agreements of $1,905,000, advances
        of
        $13,000,000 from the FHLB advances partially offset by the repayment of maturing
        FHLB advances in the amount of $6,000,000. The net cash provided by operating
        activities totaled $4,302,000 and consisted primarily of net income of
        $2,673,000 and a decrease in other assets and other liabilities,
        net.
  27
 *Table
            of Contents*
 
 **CAPITAL
        EXPENDITURES AND COMMITMENTS**
 
 During
        2005, the Company incurred approximately $1,257,000 in capital expenditures,
        which included new signage related to the name change and merger of PNB into
        the
        Bank, ATM upgrades, security camera upgrades, renovations to the Belmont
        facility, renovations to the Berlin facility due to the relocation of item
        processing, as well as the normal replacement of, or upgrades in, existing
        property and equipment. During 2005, the Company disposed of assets with
        a total
        net book value of approximately $1,747,000, which consisted primarily of
        the
        West Plymouth branch facility.
 
 During
        2004, the Company incurred approximately $2,267,000 in capital expenditures,
        which included improvements and office furnishing for the commercial lending
        and
        administration facility in North Conway, New Hampshire, an upgrade to the
        AS400
        computer system and the normal replacement of, or upgrades in, existing property
        and equipment.
 
 The
        Company’s estimated capital expenditures for 2006 total $2,900,000. This budget
        includes purchasing buildings and equipment for a pending acquisition of
        two
        branches, renovations for thirteen branch locations, new item processing
        equipment, and various software upgrades.
  28
 *Table
            of Contents*
 
 **CONTRACTUAL
        OBLIGATIONS**
 
 The
        table
        below contains information on the Company’s contractual obligations as of the
        fiscal year ended December 31, 2005:
 
 ($000
                  Omitted)Contractual
                  Obligations
              
              Total
              
              Less
                  Than
                One
                  Year
              
              1-3
                Years
              
              3-5
                Years
              
              More
                  than
                Five
                  YearsFHLB
                  Advances
              
              $
              85,000
              
              $
              31,000
              
              $
              22,000
              
              $
              26,000
              
              $
              6,000Junior
                  subordinated debentures
              
              
              20,620
              
              
              -
              
              
              -
              
              
              -
              
              
              20,620Total
              
              $
              105,620
              
              $
              31,000
              
              $
              22,000
              
              $
              26,000
              
              $
              26,620
 
 
 ITEM
        7A. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET
        RISK
 
 Information
        regarding quantitative and qualitative disclosures about market risk is included
        in “Management’s Discussion and Analysis of Financial Condition and Results of
        Operations” appearing under Item 7 of this report and is hereby incorporated by
        reference in this Item 7A.
  29
 *Table
            of Contents*
  ITEM
        8. FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA
 
 
 **CONSOLIDATED
        STATEMENTS OF INCOME**
 
 ($000
                  Omitted, Except Per Share Data)FOR
                  THE YEAR ENDED DECEMBER 31,
              
              2005
              
              2004
              
              2003Interest
                  and dividend incomeInterest
                  and fees on loans
              
              $
              27,314
              
              $
              26,569
              
              $
              27,917Interest
                  on debt securities available-for-sale:Taxable
              
              
              3,843
              
              
              3,201
              
              
              3,075Tax-exempt
              
              
              299
              
              
              142
              
              
              158Dividends
              
              
              323
              
              
              239
              
              
              237Interest
                  on federal funds sold
              
              
              322
              
              
              125
              
              
              118Interest
                  on interest-bearing deposits
              
              
              3
              
              
              1
              
              
              2Total
                  interest and dividend income
              
              
              32,104
              
              
              30,277
              
              
              31,507Interest
                  expenseInterest
                  on deposits
              
              
              4,092
              
              
              3,150
              
              
              4,422Interest
                  on short-term borrowings
              
              
              257
              
              
              110
              
              
              126Interest
                  on long-term debt
              
              
              4,579
              
              
              4,171
              
              
              3,909Total
                  interest expense
              
              
              8,928
              
              
              7,431
              
              
              8,457Net
                  interest and dividend income
              
              
              23,176
              
              
              22,846
              
              
              23,050Provision
                  for loan losses
              
              
              75
              
              
              495
              
              
              805Net
                  interest and dividend income after provision for loan
                  losses
              
              
              23,101
              
              
              22,351
              
              
              22,245Noninterest
                  incomeService
                  charges and fees on deposit accounts
              
              
              2,430
              
              
              2,229
              
              
              1,673(Loss)
                  gain on sales of securities available-for-sale, net
              
              
              (551
              )
              
              753
              
              
              1,522Gain
                  on sales of loans, net
              
              
              260
              
              
              374
              
              
              422Other
              
              
              1,857
              
              
              1,741
              
              
              1,758Total
                  noninterest income
              
              
              3,996
              
              
              5,097
              
              
              5,375Noninterest
                  expenseSalaries
                  and employee benefits
              
              
              11,592
              
              
              11,981
              
              
              11,426Office
                  occupancy and equipment
              
              
              4,090
              
              
              3,731
              
              
              3,753Amortization
                  of core deposit intangibles
              
              
              954
              
              
              954
              
              
              954Write-down
                  of equity securities
              
              
              -
              
              
              -
              
              
              184Other
              
              
              6,946
              
              
              5,728
              
              
              5,819Total
                  noninterest expense
              
              
              23,582
              
              
              22,394
              
              
              22,136Income
                  before income tax expense
              
              
              3,515
              
              
              5,054
              
              
              5,484Income
                  tax expense
              
              
              842
              
              
              1,666
              
              
              1,867Net
                  income
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617Basic
                  earnings per common share
              
              $
              1.78
              
              $
              2.26
              
              $
              2.40Earnings
                  per common share assuming dilution
              
              $
              1.77
              
              $
              2.24
              
              $
              2.39
 See
        Notes
        to Consolidated Financial Statements
  30
 *Table
            of Contents*
  **CONSOLIDATED
        BALANCE SHEETS**
 
 ($000
                  Omitted)AS
                  OF DECEMBER 31,
              
              2005
              
              2004AssetsCash
                  and cash equivalentsCash
                  and due from banks and interest-bearing deposits
              
              $
              14,587
              
              $
              13,794Federal
                  funds sold
              
              
              14,775
              
              
              10,975Total
                  cash and cash equivalents
              
              
              29,362
              
              
              24,769Securities
                  available-for-sale, at fair value
              
              
              103,244
              
              
              101,133Federal
                  Home Loan Bank stock
              
              
              5,541
              
              
              5,515Federal
                  Reserve Bank stock
              
              
              -
              
              
              365Loans
                  held-for-sale
              
              
              453
              
              
              311Loans,
                  net before allowance for loan losses
              
              
              460,373
              
              
              474,706Less:
                  allowance for loan losses
              
              
              5,150
              
              
              5,204Net
                  loans
              
              
              455,223
              
              
              469,502Premises
                  and equipment, net
              
              
              11,735
              
              
              13,701Other
                  real estate owned
              
              
              196
              
              
              -Goodwill
              
              
              10,152
              
              
              10,152Core
                  deposit intangibles, net
              
              
              1,995
              
              
              2,949Other
                  assets
              
              
              14,833
              
              
              10,021Total
                  assets
              
              $
              632,734
              
              $
              638,418Liabilities
                  and Stockholders’ EquityLiabilitiesDepositsDemand
              
              $
              77,436
              
              $
              78,669Regular
                  savings, NOW and money market deposit accounts
              
              
              238,689
              
              
              263,685Certificates
                  of deposit (in denominations of $100,000 or more)
              
              
              28,297
              
              
              18,935Other
                  time
              
              
              120,034
              
              
              114,070Total
                  deposits
              
              
              464,456
              
              
              475,359Short-term
                  borrowings
              
              
              9,363
              
              
              11,268Long-term
                  debt
              
              
              105,620
              
              
              98,620Other
                  liabilities
              
              
              3,045
              
              
              3,661Total
                  liabilities
              
              
              582,484
              
              
              588,908Stockholders'
                  equityPreferred
                  stock, $1.00 par value; 1,000,000 shares authorized; none
                  issued
              
              
              -
              
              
              -Common
                  stock, $1.00 par value; 9,000,000 shares authorized; 1,731,969
                  shares
                  issued and 1,491,174 shares outstanding in 2005 and 1,503,574 shares
                  outstanding in 2004
              
              
              1,732
              
              
              1,732Additional
                  paid-in capital
              
              
              2,064
              
              
              2,075Retained
                  earnings
              
              
              54,089
              
              
              52,484Treasury
                  stock (240,795 shares at December 31, 2005 and 228,395 shares at
                  December
                  31, 2004)
              
              
              (6,531
              )
              
              (6,090
              )Accumulated
                  other comprehensive loss, net of tax
              
              
              (1,104
              )
              
              (691
              )Total
                  stockholders’ equity
              
              
              50,250
              
              
              49,510Total
                  liabilities and stockholders’ equity
              
              $
              632,734
              
              $
              638,418
 See
        Notes
        to Consolidated Financial Statements
  31
 *Table
            of Contents*
  **CONSOLIDATED
        STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY**
  ($000
                    Omitted)AccumulatedAdditional
                
                
                
                
                
                Other
                
                TotalCommon
                
                Paid-In
                
                Retained
                
                Treasury
                
                Comprehensive
                
                Stockholders'Stock
                
                Capital
                
                Earnings
                
                Stock
                
                Income
                    (Loss)1
                
                EquityBalance
                    at December 31, 2002
                
                $
                1,732
                
                $
                2,088
                
                $
                47,523
                
                $
                (5,711
                )
                $
                (1,366
                )
                $
                44,266Net
                    income - 2003
                
                
                -
                
                
                -
                
                
                3,617
                
                
                -
                
                
                -
                
                
                3,617Net
                    change in unrealized gain (loss) on
                  securities
                    available-for-sale, net of tax
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,110
                
                
                1,110Net
                    change in unfunded pension
                  accumulated
                    benefit obligation, net of tax
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                405
                
                
                405Treasury
                    stock purchased
                
                
                -
                
                
                -
                
                
                -
                
                
                (502
                )
                
                -
                
                
                (502
                )Cash
                    dividends declared ($0.68 per share)
                
                
                -
                
                
                -
                
                
                (1,024
                )
                
                -
                
                
                -
                
                
                (1,024
                )Balance
                    at December 31, 2003
                
                
                1,732
                
                
                2,088
                
                
                50,116
                
                
                (6,213
                )
                
                149
                
                
                47,872Net
                    income - 2004
                
                
                -
                
                
                -
                
                
                3,388
                
                
                -
                
                
                -
                
                
                3,388Net
                    change in unrealized gain (loss) on
                  securities
                    available-for-sale, net of tax
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (889
                )
                
                (889
                )Net
                    change in unfunded pension
                  accumulated
                    benefit obligation, net of tax
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                49
                
                
                49Exercise
                    of stock options, net of tax benefit
                
                
                -
                
                
                (13
                )
                
                -
                
                
                123
                
                
                -
                
                
                110Cash
                    dividends declared ($0.68 per share)
                
                
                -
                
                
                -
                
                
                (1,020
                
                
                -
                
                
                -
                
                
                (1,020
                )Balance
                    at December 31, 2004
                
                
                1,732
                
                
                2,075
                
                
                52,484
                
                
                (6,090
                )
                
                (691
                )
                
                49,510Net
                    income - 2005
                
                
                -
                
                
                -
                
                
                2,673
                
                
                -
                
                
                -
                
                
                2,673Net
                    change in unrealized gain (loss) on
                  securities
                    available-for-sale, net of tax
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (1,085
                )
                
                (1,085
                )Net
                    change in unfunded pension
                  accumulated
                    benefit obligation, net of tax
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                672
                
                
                672Exercise
                    of stock options, net of tax benefit
                
                
                -
                
                
                (11
                )
                
                -
                
                
                122
                
                
                -
                
                
                111Treasury
                    stock purchased
                
                
                -
                
                
                -
                
                
                -
                
                
                (563
                )
                
                -
                
                
                (563
                )Cash
                    dividends declared ($0.71 per share)
                
                
                -
                
                
                -
                
                
                (1,068
                )
                
                -
                
                
                -
                
                
                (1,068
                )Balance
                    atDecember
                    31, 2005
                
                $
                1,732
                
                $
                2,064
                
                $
                54,089
                
                $
                (6,531
                )
                $
                (1,104
                )
                $
                50,250
  1
                Accumulated
                    other comprehensive loss as of December 31, 2005 consists of
                    net
                    unrealized holding losses on available-for-sale securities of
                    $1,104, net
                    of tax. Accumulated other comprehensive loss as of December 31,
                    2004
                    consists of net unrealized holding losses on available-for-sale
                    securities
                    of $19, net of tax, and net unfunded pension accumulated benefit
                    obligation of $672, net of tax. Accumulated other comprehensive
                    income as
                    of December 31, 2003 consists of net unrealized holding gains
                    on
                    available-for-sale securities of $870, net of tax, and net unfunded
                    pension accumulated benefit obligation of $721, net of
                    tax.
 
 **CONSOLIDATED
        STATEMENTS OF COMPREHENSIVE INCOME**
 
 ($000
                  Omitted)FOR
                  THE YEAR ENDED DECEMBER 31,
              
              2005
              
              2004
              
              2003Net
                  income
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617Other
                  comprehensive (loss) incomeNet
                  unrealized holding (losses) gains on securities
                  available-for-sale
              
              
              (2,347
              )
              
              (720
              )
              
              2,662Reclassification
                  adjustment for realized losses (gains) in net income
              
              
              551
              
              
              (753
              )
              
              (1,338
              )Net
                  unrealized (losses) gains on securities
              
              
              (1,796
              )
              
              (1,473
              )
              
              1,324Minimum
                  pension liability adjustment
              
              
              1,018
              
              
              74
              
              
              615Other
                  comprehensive (loss) income
              
              
              (778
              )
              
              (1,399
              )
              
              1,939Income
                  tax (benefit) expense
              
              
              (365
              )
              
              (559
              )
              
              424Other
                  comprehensive (loss) income, net of tax
              
              
              (413
              )
              
              (840
              )
              
              1,515Comprehensive
                  income
              
              $
              2,260
              
              $
              2,548
              
              $
              5,132
 See
        Notes
        to Consolidated Financial Statements
  32
 *Table
            of Contents*
 
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 
 ($000
                  Omitted)FOR
                  THE YEAR ENDED DECEMBER 31,
              
              2005
              
              2004
              
              2003Cash
                  flows from operating activities:Net
                  income
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617Adjustments
                  to reconcile net income to net cash provided by operating
                  activities:Provision
                  for loan losses
              
              
              75
              
              
              495
              
              
              805Depreciation
                  and amortization
              
              
              2,367
              
              
              2,369
              
              
              2,381Deferred
                  income tax (benefit) expense
              
              
              (4
              )
              
              43
              
              
              (249
              )Write-down
                  of equity securities
              
              
              -
              
              
              -
              
              
              184Loss
                  (gain) on sales of securities available-for-sale, net
              
              
              551
              
              
              (753
              )
              
              (1,522
              )Loss
                  on sale, disposal and write-down of premises and equipment
              
              
              57
              
              
              9
              
              
              28Amortization
                  of premiums and accretion of discounts on securities, net
              
              
              54
              
              
              90
              
              
              408Change
                  in unearned income/unamortized cost, net
              
              
              (190
              )
              
              (141
              )
              
              40Accretion
                  of discount on loans acquired
              
              
              (140
              )
              
              (160
              )
              
              (106
              )Loss
                  (gain) on sales of other real estate owned and other personal property,
                  net
              
              
              -
              
              
              9
              
              
              (58
              )Net
                  (increase) decrease in loans held-for-sale
              
              
              (142
              )
              
              200
              
              
              158Net
                  change in other assets and other liabilities
              
              
              (999
              )
              
              587
              
              
              1,488Net
                  cash provided by operating activities
              
              
              4,302
              
              
              6,136
              
              
              7,174Cash
                  flows from investing activities:Proceeds
                  from sales of securities available-for-sale
              
              
              16,002
              
              
              16,964
              
              
              24,520Proceeds
                  from maturities of securities available-for-sale
              
              
              17,315
              
              
              25,690
              
              
              76,716Purchases
                  of securities available-for-sale
              
              
              (40,829
              )
              
              (76,515
              )
              
              (80,314
              )Purchases
                  of Federal Home Loan Bank stock
              
              
              (26
              )
              
              (810
              )
              
              (73
              )Purchases
                  of Federal Reserve Bank stock
              
              
              -
              
              
              -
              
              
              (285
              )Proceeds
                  from sales of Federal Reserve Bank stock
              
              
              365
              
              
              -
              
              
              -Loan
                  originations and principal collections, net
              
              
              13,345
              
              
              (7,142
              )
              
              (28,494
              )Recoveries
                  of previously charged-off loans
              
              
              286
              
              
              338
              
              
              181Proceeds
                  from sale of commercial loans
              
              
              -
              
              
              5,088
              
              
              -Proceeds
                  from sales of and payments received on other real estate
                  owned
              
              
              25
              
              
              -
              
              
              285Proceeds
                  from sales of and payments received on other personal
                  property
              
              
              652
              
              
              604
              
              
              822Disposal
                  of (additions to) premises and equipment, net
              
              
              496
              
              
              (2,267
              )
              
              (1,810
              )Purchase
                  of company owned life insurance policies
              
              
              -
              
              
              (400
              )
              
              (800
              )Net
                  cash provided by (used by) investing activities
              
              
              7,631
              
              
              (38,450
              )
              
              (9,252
              )Cash
                  flows from financing activities:Net
                  (decrease) increase in deposits
              
              
              (10,903
              )
              
              12,052
              
              
              (12,887
              )Net
                  (decrease) increase in short-term borrowings
              
              
              (1,905
              )
              
              3,867
              
              
              (850
              )Advances
                  from Federal Home Loan Bank (FHLB)
              
              
              13,000
              
              
              20,000
              
              
              28,000Repayment
                  of FHLB advances
              
              
              (6,000
              )
              
              (9,000
              )
              
              (7,000
              )Exercise
                  of stock options
              
              
              99
              
              
              99
              
              
              -Purchases
                  of treasury stock
              
              
              (563
              )
              
              -
              
              
              (502
              )Cash
                  dividends paid
              
              
              (1,068
              )
              
              (1,020
              )
              
              (1,024
              )Net
                  cash (used by) provided by financing activities
              
              
              (7,340
              )
              
              25,998
              
              
              5,737Net
                  increase (decrease) in cash and cash equivalents
              
              
              4,593
              
              
              (6,316
              )
              
              3,659Cash
                  and cash equivalents at beginning of year
              
              
              24,769
              
              
              31,085
              
              
              27,426Cash
                  and cash equivalents at end of year
              
              $
              29,362
              
              $
              24,769
              
              $
              31,085
 See
        Notes
        to Consolidated Financial Statements
  33
 *Table
            of Contents*
 
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS (CONTINUED)**
 
 ($000
                  Omitted)FOR
                  THE YEAR ENDED DECEMBER 31,
              
              2005
              
              2004
              
              2003Supplemental
                  disclosures of cash flows:Interest
                  paid
              
              $
              8,662
              
              $
              7,519
              
              $
              8,617Income
                  taxes paid
              
              
              1,106
              
              
              2,090
              
              
              1,610Loans
                  transferred to other real estate owned
              
              
              221
              
              
              -
              
              
              46Loans
                  transferred to other personal property
              
              
              682
              
              
              603
              
              
              824Amount
                  due from customer for pending municipal security maturity
              
              
              3,000
              
              
              -
              
              
              -
 
 See
        Notes
        to Consolidated Financial Statements
  34
 *Table
            of Contents*
 
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **NOTE
        1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**
 
 ***Nature
        of Operations***
 
 Northway
        is a bank holding company formed in 1997 under the laws of New Hampshire
        and is
        registered under the Bank Holding Company Act of 1956. Northway’s only business
        activity has been to own all of the shares of, and provide management, capital
        and operational support to Northway Bank (“Bank”), formerly known as The Berlin
        City Bank, and its Delaware statutory business trusts Northway Capital Trust
        I
        and Northway Capital Trust II. October 1, 2005 The Berlin City Bank was renamed
        Northway Bank and The Pemigewasset National Bank of Plymouth, New Hampshire
        was
        merged into Northway Bank. The Company’s headquarters are in Berlin, New
        Hampshire. The banking subsidy is engaged principally in the business of
        attracting deposits from the general public and investing those deposits
        in
        securities, commercial loans, real estate loans, and consumer loans.
 
 ***Basis
        of Presentation***
 
 The
        consolidated financial statements include the accounts of the Company and
        its
        wholly-owned subsidiaries. All significant intercompany accounts and
        transactions have been eliminated in the consolidation.
 
 Northway
        Capital Trust I and Northway Capital Trust II, subsidiaries of the Company,
        were
        formed to sell capital securities to the public through a third party trust
        pool. In accordance with FASB Interpretation No. 46, “Consolidation of Variable
        Interest Entities” (“FIN 46”), these subsidiaries have not been included in the
        consolidated financial statements.
 
 The
        accounting and reporting policies of the Company conform to accounting
        principles generally accepted in the United States of America and to general
        practices within the banking industry.
 
 In
        preparing the financial statements, management is required to make estimates
        and
        judgments that affect the reported amounts of assets and liabilities as of
        the
        dates of the consolidated balance sheets, and income and expense for the
        periods. Actual results could differ from those estimates. Material estimates
        that are particularly susceptible to change in the near-term relate to the
        determination of the allowance for loan losses.
  ***Reclassifications***
 
 Certain
        amounts in the prior years’ financial statements have been reclassified to
        conform with the current year’s presentation.
 
 ***Cash
        and Cash Equivalents***
 
 For
        purposes of the statement of cash flows, cash and cash equivalents include
        cash
        and due from banks, interest-bearing deposits, and federal funds
        sold.
  ***Securities***
 
 Debt
        securities that the Company has the positive intent and ability to hold to
        maturity are classified as held-to-maturity and reported at amortized cost;
        if
        debt and equity securities are bought and held principally for the purpose
        of
        selling in the near term they would be classified as trading and reported
        at
        fair value, with unrealized gains and losses included in earnings; and debt
        and
        equity securities not classified as either held-to-maturity or trading are
        classified as available-for-sale and reported at fair value, with unrealized
        gains and losses excluded from earnings and reported as a separate component
        of
        stockholders’ equity, net of estimated income taxes. At this time, the Company
        has not established a trading account.
 
 Premiums
        and discounts are amortized and accreted primarily on the level yield method
        over the contractual life of the securities adjusted for expected
        prepayments.
 
 If
        a
        decline in the fair value below the adjusted cost basis of an investment
        is
        judged to be other than temporary, the cost basis of the investment is written
        down to fair value as the new cost basis and the amount of the write-down
        is
        included in noninterest expense.
 
 Gains
        and
        losses on sales of securities available-for-sale are recognized at the time
        of
        the sale on a specific identification basis.
  35
 *Table
            of Contents*
 
 **NOTE
        1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
        (CONTINUED)**
 
 ***Loans
        Held-for-Sale***
 
 Loans
        held-for-sale are generally identified as such at origination and are stated
        at
        the lower of aggregate cost or market. Market value is based on outstanding
        investor commitments. When loans are sold, a gain or loss is recognized to
        the
        extent that the sale proceeds exceed or are less than the carrying value
        of the
        loans. Gains and losses are determined using the specific identification
        method.
        All loans sold are without recourse to the Company.
 
 ***Loans***
 
 Loans
        are
        carried at the principal amounts outstanding, net of any unearned income
        or
        unamortized cost, premiums on originated loans and discounts on acquired
        loans.
        Unearned income and unamortized cost includes loan origination fees, net
        of
        direct loan origination costs. This income or expense is deferred and recognized
        as adjustments to loan income over the contractual life of the related notes
        using a method the result of which approximates that of the interest
        method.
 
 Loans
        are
        placed on nonaccrual when payment of principal or interest is considered
        to be
        in doubt or is past due 90 days or more. The Company may choose to place
        a loan
        on nonaccrual status due to payment delinquency or uncertain collectibility,
        while not classifying the loan as impaired, if (i) it is probable that the
        Company will collect all amounts due in accordance with the contractual terms
        of
        the loan or (ii) the loan is not a commercial, commercial real estate or
        an
        individually significant mortgage or consumer loan. Previously accrued income
        on
        nonaccrual loans that has not been collected is reversed from current income,
        and subsequent cash receipts are recorded as income if principal on the loans
        is
        deemed collectible. Loans are returned to accrual status when collection
        of all
        contractual principal and interest is reasonably assured and there has been
        sustained repayment performance.
 
 The
        Company’s loans are primarily secured by real estate in New Hampshire. In
        addition, other real estate owned is located in this market. Accordingly,
        the
        ultimate collectibility of a substantial portion of the Company’s loan portfolio
        and the recovery of other real estate owned are susceptible to changing
        conditions in this market.
 
 ***Allowance
        for Loan Losses***
 
 The
        allowance for loan losses is maintained at a level considered adequate by
        management on the basis of many factors including the risk characteristics
        of
        the portfolio, trends in loan delinquencies and an assessment of existing
        economic conditions. Additions to the allowance are charged to earnings;
        realized losses, net of recoveries, are charged directly to the
        allowance.
 
 While
        management uses available information in establishing the allowance for loan
        losses, future additions to the allowance may be necessary if economic
        conditions differ substantially from the estimates used in making the
        evaluations. In addition, various regulatory agencies, as an integral part
        of
        their examination process, periodically review the Company’s allowance for loan
        losses. Such agencies may require the Company to recognize additions to the
        allowance based on judgments different from those of management.
 
 Commercial,
        commercial real estate and individually significant mortgage and consumer
        loans
        are considered impaired, and are placed on nonaccrual, when it is probable
        that
        the Company will not be able to collect all amounts due according to the
        contractual terms of the loan agreement. Mortgage and consumer loans, which
        are
        not individually significant, are measured for impairment collectively. Loans
        that experience insignificant payment delays and insignificant shortfalls
        in
        payment amounts generally are not classified as impaired. The amount of
        impairment for all impaired loans is determined by the difference between
        the
        present value of the expected cash flows related to the loan, using the original
        contractual interest rate, and its recorded value, or, as a practical expedient
        in the case of collateralized loans, the difference between the fair value
        of
        the collateral and the recorded amount of the loan.
 
 When
        foreclosure is probable, impairment is measured based on the fair value of
        the
        collateral.
 
 ***Servicing
        Assets***
 
 Servicing
        assets are recognized as separate assets when rights are acquired through
        purchase or through sale of financial assets. Capitalized servicing rights
        are
        reported in other assets and are amortized into noninterest income in proportion
        to, and over the period of, the estimated future net servicing income of
        the
        underlying financial assets. Servicing assets are evaluated for impairment
        based
        upon the fair value of the rights as compared to amortized cost. Impairment
        is
        determined by stratifying rights by predominant characteristics, such as
        interest rates and terms. Fair value is determined using prices for similar
        assets with similar characteristics, when available, or based upon discounted
        cash flows using market-based assumptions. Impairment is recognized through
        a
        valuation allowance for an individual stratum, to the extent that fair value
        is
        less than the capitalized amount for the stratum.
  36
 *Table
            of Contents*
 
 **NOTE
        1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
        (CONTINUED)**
 
 ***Premises
        and Equipment***
 
 Premises
        and equipment are carried at cost less accumulated depreciation. Depreciation
        is
        computed on the straight-line method over the estimated useful lives of the
        respective assets. Estimated lives are thirty-nine years for buildings, ten
        to
        fifteen years for building improvements and three to seven years for furniture
        and equipment.
 
 Amortization
        of leasehold improvements is accumulated on a straight-line basis over the
        lesser of the term of the respective lease or the asset’s useful life, not to
        exceed ten years.
 
 ***Other
        Real Estate Owned***
 
 Other
        real estate owned is comprised of properties acquired either through foreclosure
        proceedings or acceptance of a deed in lieu of foreclosure, and for which
        the
        Company has taken physical possession. The Company classifies loans as
        repossessed or foreclosed if the Company receives physical possession of
        the
        debtor’s assets, regardless of whether or not foreclosure proceedings take
        place.
 
 Assets
        acquired through foreclosure or a similar conveyance of title are initially
        recorded at the lower of the carrying value of the loan or the fair value,
        less
        estimated costs to sell, of the property constructively or actually received.
        Gains and losses upon disposition are reflected in the statement of income
        as
        realized.
 
 ***Advertising***
 
 The
        Company directly expenses costs associated with advertising as they are
        incurred.
 
 ***Income
        Taxes***
 
 The
        Company uses the asset and liability method of accounting for income taxes.
        Under the asset and liability method, deferred tax assets and liabilities
        are
        recognized for the future tax consequences attributable to differences between
        the financial statement carrying amounts of existing assets and liabilities
        and
        the respective tax bases and operating loss and tax credit carry forwards.
        Deferred tax assets and liabilities are measured using enacted tax rates
        expected to apply to taxable income in the years in which those temporary
        differences are expected to be recovered or settled. The effect on deferred
        tax
        assets and liabilities of a change in tax rates is recognized in income in
        the
        period that includes the enactment date.
 
 ***Stock-Based
        Compensation***
 
 At
        December 31, 2005, the Company has a stock-based employee compensation plan
        which is described more fully in NOTE 15. The Company accounts for this plan
        under the recognition and measurement principles of Accounting Principles
        Board
        (“APB”) Opinion No. 25, *Accounting
        for Stock Issued to Employees* ,
        and
        related Interpretations. No stock-based employee compensation cost is reflected
        in net income, as all options granted under this plan had an exercise price
        equal to the market value of the underlying common stock on the date of the
        grant. The following table illustrates the effect on net income and earnings
        per
        share if the Company had applied the fair value recognition provisions of
        Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004),
“Share-Based Payment”, to stock-based employee compensation.
 
 ($000
                  Omitted, except per share data)2005
              
              2004
              
              2003Net
                  income
              
              
              As
                  reported
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617Deduct:
                  Total stock-based employee compensation expense determined under
                  fair
                  value based methods awards, net of related tax effects
              
              
              
              
              
              -
              
              
              -
              
              
              39Pro
                  forma
              
              $
              2,673
              
              $
              3,388
              
              $
              3,578Earnings
                  per common share
              
              
              As
                  reported
              
              $
              1.78
              
              $
              2.26
              
              $
              2.40Pro
                  forma
              
              
              1.78
              
              
              2.26
              
              
              2.37Earnings
                  per common share
              
              
              As
                  reported
              
              $
              1.77
              
              $
              2.24
              
              $
              2.39(assuming
                  dilution)
              
              
              Pro
                  forma
              
              
              1.77
              
              
              2.24
              
              
              2.36
 37
 *Table
              of Contents*
  **NOTE
        1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
        (CONTINUED)**
 
 ***Earnings
        Per Share***
 
 Basic
        earnings per share (“EPS”) excludes dilution and is computed by dividing income
        available to common stockholders by the weighted-average number of common
        shares
        outstanding for the period. Diluted EPS, if applicable, reflects the potential
        dilution that could occur if securities or other contracts to issue common
        stock
        were exercised or converted into common stock or resulted in the issuance
        of
        common stock that then shared in the earnings of the entity.
 
 Earnings
        per common share have been computed based on the following:
  ($000
                  Omitted)
                Years
                  Ended December 31,2005
              
              2004
              
              2003Net
                  income
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617Less:
                  Preferred stock dividends
              
              
              -
              
              
              -
              
              
              -Net
                  income applicable to common stock
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617Average
                  number of common shares outstanding
              
              
              1,502.1
              
              
              1,500.1
              
              
              1,504.4Effect
                  of dilutive options
              
              
              9.3
              
              
              11.6
              
              
              7.8Average
                  number of common shares outstanding used to calculate diluted earnings
                  per
                  common share
              
              
              1,511.4
              
              
              1,511.7
              
              
              1,512.2
  ***Recent
        Accounting Pronouncements***
 
 In
        December 2003, the American Institute of Certified Public Accountants ("AICPA")
        issued Statement of Position 03-3 ("SOP 03-3") "Accounting for Certain Loans
        or
        Debt Securities Acquired in a Transfer." SOP 03-3 requires loans acquired
        through a transfer, such as a business combination, where there are differences
        in expected cash flows and contractual cash flows due in part to credit quality
        be recognized at their fair value. The excess of contractual cash flows over
        expected cash flows is not to be recognized as an adjustment of yield, loss
        accrual, or valuation allowance. Valuation allowances cannot be created nor
        "carried over" in the initial accounting for loans acquired in a transfer
        on
        loans subject to SFAS 114, "Accounting by Creditors for Impairment of a Loan."
        This SOP is effective for loans acquired in fiscal years beginning after
        December 15, 2004, with early adoption encouraged. The adoption of SOP 03-3
        did
        not have a material impact on the Company's financial position or results
        of
        operations.
 
 In
        December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
        Payment” (“SFAS 123R”). This
        Statement revises FASB Statement No. 123, “Accounting for Stock Based
        Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to
        Employees,” and its related implementation guidance. SFAS 123R requires that the
        cost resulting from all share-based payment transactions be recognized in
        the
        financial statements. It establishes fair value as the measurement objective
        in
        accounting for share-based payment arrangements and requires all entities
        to
        apply a fair-value based measurement method in accounting for share-based
        payment transactions with employees except for equity instruments held by
        employee share ownership plans. This Statement is effective for the Company
        as
        of the beginning of the first interim reporting period that begins after
        December 15, 2005. The Company does not believe the adoption of this Statement
        will have a material impact on the Company’s financial position or results of
        operations.
  
 **NOTE
        2 CASH AND DUE FROM BANKS**
 
 There
        was
        no cash due from banks at December 31, 2005 subject to withdrawals and usage
        restrictions to satisfy the reserve requirements of the Federal Reserve Bank.
        At
        December 31, 2004, there was $3,753,000, which was subject to withdrawals
        and
        usage restrictions to satisfy the reserve requirements of the Federal Reserve
        Bank.
  38
 *Table
            of Contents*
 
 **NOTE
        3 SECURITIES AVAILABLE-FOR-SALE**
 
 The
        amortized cost, gross unrealized gains, gross unrealized losses, and fair
        value
        of securities at December 31, 2005 and 2004 follows:
  ($000
                  Omitted)Amortized
                Cost
              
              Gross
                Unrealized
                Gains
              
              Gross
                Unrealized
                Losses
              
              Fair
                ValueDecember
                  31, 2005U.S.
                  Treasury and other U.S. government agency securities
              
              $
              48,728
              
              $
              -
              
              $
              977
              
              $
              47,751Marketable
                  equity securities
              
              
              2,695
              
              
              178
              
              
              64
              
              
              2,809Mortgage-backed
                  securities
              
              
              24,704
              
              
              1
              
              
              774
              
              
              23,931Collateralized
                  mortgage obligations
              
              
              8
              
              
              -
              
              
              -
              
              
              8Corporate
                  bonds
              
              
              5,541
              
              
              37
              
              
              9
              
              
              5,569State
                  and political subdivision bonds and notes
              
              
              23,396
              
              
              45
              
              
              265
              
              
              23,176$
              105,072
              
              $
              261
              
              $
              2,089
              
              $
              103,244December
                  31, 2004U.S.
                  Treasury and other U.S. government agency securities
              
              $
              54,914
              
              $
              1
              
              $
              352
              
              $
              54,563Marketable
                  equity securities
              
              
              1,827
              
              
              136
              
              
              32
              
              
              1,931Mortgage-backed
                  securities
              
              
              29,447
              
              
              92
              
              
              248
              
              
              29,291Collateralized
                  mortgage obligations
              
              
              10
              
              
              -
              
              
              -
              
              
              10Corporate
                  bonds
              
              
              12,001
              
              
              293
              
              
              7
              
              
              12,287State
                  and political subdivision bonds and notes
              
              
              2,966
              
              
              85
              
              
              -
              
              
              3,051$
              101,165
              
              $
              607
              
              $
              639
              
              $
              101,133
  The
        contractual maturity distribution of investments in debt obligations at December
        31, 2005 follows:
 
 ($000
                  Omitted)Within
                One
                Year
              
              One
                  to
                Five
                Years
              
              Five
                  to
                Ten
                Years
              
              Over
                Ten
                Years
              
              Total
                Amortized
                CostU.S.
                  Treasury and other U.S. government agency securities
              
              $
              5,998
              
              $
              37,730
              
              $
              5,000
              
              $
              -
              
              $
              48,728Mortgage-backed
                  securities
              
              
              -
              
              
              29
              
              
              -
              
              
              24,675
              
              
              24,704Collateralized
                  mortgage obligations
              
              
              -
              
              
              -
              
              
              -
              
              
              8
              
              
              8Corporate
                  bonds
              
              
              2,003
              
              
              3,538
              
              
              -
              
              
              -
              
              
              5,541State
                  and political subdivision bonds and notes
              
              
              1,101
              
              
              425
              
              
              562
              
              
              21,308
              
              
              23,396Total
                  amortized cost
              
              $
              9,102
              
              $
              41,722
              
              $
              5,562
              
              $
              45,991
              
              $
              102,377Fair
                  value
              
              $
              9,052
              
              $
              40,916
              
              $
              5,485
              
              $
              44,982
              
              $
              100,435
 
 Actual
        maturities of state and political subdivision bonds and notes, mortgage-backed
        securities and collateralized mortgage obligations will differ from the
        maturities presented because borrowers have the right to prepay obligations
        without prepayment penalties.
 
 An
        analysis of gross realized gains and losses on sales of securities
        available-for-sale during the years ended December 31, follows:
 
 ($000
                  Omitted)2005
              
              2004
              
              2003Realized
                Gains
              
              Realized
                Losses
              
              Realized
                Gains
              
              Realized
                Losses
              
              Realized
                Gains
              
              Realized
                LossesMarketable
                  equity securities
              
              $
              221
              
              $
              104
              
              $
              402
              
              $
              149
              
              $
              97
              
              $
              244U.S.
                  Treasury and other U.S. government agency securities
              
              
              -
              
              
              200
              
              
              5
              
              
              -
              
              
              15
              
              
              -Mortgage-backed
                  securities
              
              
              12
              
              
              11
              
              
              -
              
              
              -
              
              
              -
              
              
              -Corporate
                  bonds
              
              
              30
              
              
              499
              
              
              539
              
              
              50
              
              
              1,682
              
              
              28State
                  and political subdivision bonds and notes
              
              
              -
              
              
              -
              
              
              6
              
              
              -
              
              
              -
              
              
              -$
              263
              
              $
              814
              
              $
              952
              
              $
              199
              
              $
              1,794
              
              $
              272
  39
 *Table
            of Contents*
 
 **NOTE
        3 SECURITIES AVAILABLE-FOR-SALE (CONTINUED)**
 
 
 The
        tax
        (benefit) provision applicable to these net realized (losses)/gains amounted to
        $(218,000), $298,000 and $603,000 for 2005, 2004, and 2003,
        respectively.
 
 Securities
        with a carrying amount totaling $73,651,000
        and $72,106,000 were pledged to secure public deposits, securities sold under
        agreements to repurchase, FHLB advances and treasury, tax and loan accounts
        at
        December 31, 2005 and 2004, respectively.
 
 The
        aggregate fair value and unrealized losses of securities that have been in
        a
        continuous unrealized loss position for less than twelve months and for twelve
        months or more, and are not other than temporarily impaired, are as follows
        as
        of December 31, 2005:
 
 ($000
                  Omitted)Less
                  than 12 Months
              
              12
                  Months or Longer
              
              TotalFair
                Value
              
              Unrealized
                Losses
              
              Fair
                Value
              
              Unrealized
                Losses
              
              Fair
                Value
              
              Unrealized
                LossesU.S.
                  Treasury and other U.S. government agency securities
              
              $
              13,774
              
              $
              218
              
              $
              33,977
              
              $
              759
              
              $
              47,751
              
              $
              977Marketable
                  equity securities
              
              
              881
              
              
              53
              
              
              64
              
              
              11
              
              
              945
              
              
              64Mortgage-backed
                  securities
              
              
              5,806
              
              
              97
              
              
              18,095
              
              
              677
              
              
              23,901
              
              
              774Corporate
                  bonds
              
              
              1,525
              
              
              9
              
              
              -
              
              
              -
              
              
              1,525
              
              
              9State
                  and political subdivision bonds and notes
              
              
              17,026
              
              
              265
              
              
              -
              
              
              -
              
              
              17,026
              
              
              265Total
                  temporarily impaired securities
              
              $
              39,012
              
              $
              642
              
              $
              52,136
              
              $
              1,447
              
              $
              91,148
              
              $
              2,089
 
 At
        December 31, 2005, securities with a total fair value of $91,149,000 were
        in a
        loss position. These securities included twenty U.S. government agency
        securities with a fair value of $47,751,000 and an unrealized loss of $977,000.
        These securities had an unrealized loss due to the current interest rate
        environment. As these securities are guaranteed by U.S. government agencies
        such
        as FHLB, FHLMC or FNMA there is no credit risk associated with them. These
        securities are not other-than-temporarily impaired as the Company has the
        ability and the intent to hold these securities until recovery to cost basis.
 
 Mortgage-backed
        securities with a fair value of $23,901,000 had an unrealized loss of $774,000
        at December 31, 2005. As with the U.S. government agency securities, these
        securities have an unrealized loss due to the current interest rate environment.
        As all of these mortgage-backed securities are guaranteed by U.S. government
        agencies such as FHLMC, GNMA or FNMA there is no credit risk associated with
        them. These securities have not been classified as other-than-temporarily
        impaired as the Company has the ability and intent to hold these securities
        until recovery to cost basis.
 
 Nineteen
        marketable equity securities with a fair value of $945,000 had an unrealized
        loss of $64,000 at December 31, 2005. Marketable equity securities are subject
        to internal testing on a quarterly basis to determine impairment. Testing
        includes review of industry analyst reports, credit ratings, sector analysis
        and
        earnings projections. Based upon the December 31, 2005 review, these securities
        were not determined to be other-than-temporarily impaired.
 
 Two
        corporate bond securities with a fair value of $1,525,000 had an unrealized
        loss
        of $9,000 at December 31, 2005. Corporate bond securities are subject to
        internal testing on a quarterly basis to determine other-than-temporary
        impairment. Based upon the December 31, 2005 review, these securities were
        not
        determined to be other-than-temporarily impaired.
 
 Thirty-six
        state and political subdivision securities with a fair value of $17,026,000
        had
        an unrealized loss of $265,000 at December 31, 2005. As all of these state
        and
        political subdivision securities are guaranteed by municipalities there is
        minimal credit risk associated with them. These securities have not been
        classified as other-than-temporarily impaired as the Company had the ability
        to
        hold these securities until recovery to cost basis.
  40
 *Table
            of Contents*
  **NOTE
        4 LOANS**
 
 Loan
        balances were comprised of the following:
 ($000
                  Omitted)December
                  31,
              
              2005
              
              2004Real
                  estate:Residential
              
              $
              158,729
              
              $
              147,333Commercial
              
              
              143,456
              
              
              130,334Construction
              
              
              13,241
              
              
              5,366Commercial
              
              
              27,349
              
              
              27,013Installment
              
              
              35,786
              
              
              29,345Indirect
                  installment
              
              
              62,221
              
              
              116,520Other
              
              
              19,507
              
              
              18,901Total
                  loans
              
              
              460,289
              
              
              474,812Less:(Unamortized
                  cost) unearned income
              
              
              (84
              )
              
              106Allowance
                  for loan losses
              
              
              5,150
              
              
              5,204Total
                  (unamortized cost) unearned income and allowance for loan
                  losses
              
              
              5,066
              
              
              5,310Net
                  loans
              
              $
              455,223
              
              $
              469,502
 
 Total
        loans above are net of unearned discount on loans acquired in the amount
        of
        $275,000 and $415,000 at December 31, 2005 and 2004, respectively. In addition,
        total loans above are net of unamortized premium on indirect installment
        loans
        originated in the amount of $789,000 and $2,005,000 at December 31, 2005
        and
        2004, respectively.
 
 Loans
        are
        made in the ordinary course of business to directors, executive officers,
        and
        their immediate families and to organizations in which such persons have
        more
        than a 10% ownership interest. These loans are made on substantially the
        same
        terms, including interest rate and collateral, as those prevailing at the
        same
        time for comparable transactions with unrelated persons and did not involve
        more
        than the normal risk of collectibility or present other unfavorable features.
        Total loans to such persons and their companies amounted to $544,000 as of
        December 31, 2005. During 2005, principal payments were $125,000 and principal
        advances amounted to $156,000.
 
 The
        Company’s lending activities are conducted principally in New Hampshire.
        Although the loan portfolio is diversified, a portion of its debtors’ ability to
        repay is dependent upon the economic conditions prevailing in New Hampshire.
        The
        Company maintains significant credit relationships with borrowers in the
        hotel
        and motel industry. The aggregate loan balances to these industries totaled
        $67,152,000 at December 31, 2005 and $59,730,000 at December 31,
        2004.
 
 Loans
        serviced for others are not included in the accompanying consolidated balance
        sheets. The unpaid principal balances of these loans total $39,219,000 and
        $43,979,000 at December 31, 2005 and 2004, respectively. The Company sold
        $15,705,000 of mortgage loans in 2005 and $15,228,000 of mortgage loans and
        $5,088,000 of SBA guaranteed commercial loans in 2004.
 
 The
        Company capitalized $79,000 and $80,000 of servicing rights and amortized
        $144,000 and $168,000 of total servicing rights in 2005 and 2004, respectively.
        The impairment valuation allowance of mortgage servicing rights was reduced
        by
        $3,000 and $2,000 in 2005 and 2004, respectively. Impairment of mortgage
        servicing rights is assessed based on the fair value of those rights. Fair
        values are estimated using discounted cash flows based on a current market
        interest rate. The amount of the impairment recognized is the amount by which
        the capitalized mortgage servicing rights exceed their fair value. At December
        31, 2005 and 2004, respectively, the carrying amount of servicing rights
        was
        $236,000 and $298,000, and is included in other assets. At December 31, 2005
        and
        2004, respectively, the fair value of servicing rights was $389,000 and
        $415,000.
 
 Restructured,
        accruing loans entered into prior to the adoption of SFAS No. 114 and 118
        are
        not required to be reported as impaired loans unless such loans are not
        performing in accordance with the restructured terms at adoption of SFAS
        No.
        114. Restructured, accruing loans entered into subsequent to the adoption
        of
        these statements are reported as impaired loans. In the year subsequent to
        restructure these loans may be removed from the impaired loan disclosure
        provided that the loan bears a market rate of interest at the time of
        restructure and is performing under the restructured terms.
 
 At
        December 31, 2005 and 2004, loans restructured in a troubled debt restructuring
        before January 1, 1995, the effective date of SFAS No. 114, that are not
        impaired based on the terms specified by the restructuring agreement totaled
        $0
        and $838,000, respectively. The gross interest income that would have been
        recorded in the year ended December 31, 2004 if such restructured loans had
        been
        current in accordance with their original terms was $60,000. The amount of
        interest income recognized on such restructured loans for the year ended
        December 31, 2004 was $43,000.
  41
 *Table
            of Contents*
 
 **NOTE
        4 LOANS (CONTINUED)**
 
 At
        December 31, 2005 and 2004, nonperforming loans totaled $3,013,000 and
        $2,867,000, respectively. No nonperforming loans were past due 90 days or
        more
        and still accruing interest at December 31, 2005 and 2004. During January
        2006,
        nonperforming loans totaling $1,591,000 were paid in full.
 
 The
        recorded investment in loans that are considered to be impaired under SFAS
        No.
        114 was $2,082,000 and $1,914,000 at December 31, 2005 and 2004, respectively,
        for which the related allowance for loan losses is $0 and $307,000 as of
        December 31, 2005 and 2004, respectively. All of the Company’s impaired loans
        are collateralized and therefore all impaired loans are measured by the
        difference between the fair value of the collateral and the recorded amount
        of
        the loan. The average recorded investment in impaired loans during the twelve
        months ended December 31, 2005 and 2004 was approximately $2,147,000 and
        $2,305,000, respectively. For the twelve months ended December 31, 2005 and
        2004
        the Company recognized interest income on impaired loans of $97,000 and
        $147,000, respectively, which included $88,000 and $128,000 of interest income
        recognized using the cash-basis method of income recognition,
        respectively.
  
 **NOTE
        5 ALLOWANCE FOR LOAN LOSSES**
 
 Changes
        in the allowance for loan losses for the years ended December 31,
        follows:
 
 ($000
                  Omitted)2005
              
              2004
              
              2003Balance
                  at beginning of year
              
              $
              5,204
              
              $
              5,036
              
              $
              4,920Provision
                  for loan losses
              
              
              75
              
              
              495
              
              
              805Recoveries
                  on loans previously charged-off
              
              
              286
              
              
              338
              
              
              181Loans
                  charged-off
              
              
              (415
              )
              
              (665
              )
              
              (870
              )Balance
                  at end of year
              
              $
              5,150
              
              $
              5,204
              
              $
              5,036
 
 
 **NOTE
        6 PREMISES AND EQUIPMENT**
 
 A
        summary
        of premises and equipment follows:
 
 ($000
                  Omitted)
                December
                  31,2005
              
              2004Land
              
              $
              2,455
              
              $
              2,650Buildings
              
              
              9,718
              
              
              11,509Leasehold
                  improvements
              
              
              120
              
              
              365Construction
                  in progress
              
              
              129
              
              
              36Equipment
              
              
              9,359
              
              
              8,90621,781
              
              
              23,466Less
                  accumulated depreciation and amortization
              
              
              10,046
              
              
              9,765$
              11,735
              
              $
              13,701
 
 Depreciation
        expense for the years ended December 31, 2005, 2004 and 2003 amounted to
        $1,413,000, $1,415,000 and $1,427,000, respectively.
 
 The
        Company leases five of its branch locations and an automobile under
        non-cancelable operating leases. In addition, the Company leases one storage
        facility under a non-cancelable lease and one storage facility as a
        tenant-at-will. Minimum lease payments in future periods under non-cancelable
        operating leases at December 31, 2005 are as follows:
 
 ($000
                  Omitted)2006
              
              $
              1952007
              
              
              1512008
              
              
              522009
              
              
              222010
              
              
              22Thereafter
              
              
              112$
              554
 42
 *Table
              of Contents*
 
 **NOTE
        6 PREMISES AND EQUIPMENT (CONTINUED)**
 
 The
        terms
        of two of the leases provide that the Company can, at the end of the current
        five-year term, renew the lease under one five-year option. The terms of
        a third
        lease provide that the Company can, at the end of a ten-year term, renew
        the
        lease under two five-year options. All branch leases contain a provision
        that
        the Company shall pay its pro-rata share of operating costs. Additionally,
        two
        of the leases require that the Company pay all real estate taxes. The automobile
        lease contains a purchase option at the end of the lease term.
 
 Rent
        expense for the years ended December 31, 2005, 2004, and 2003 amounted to
        $359,000, $404,000 and $421,000, respectively.
 
 **NOTE
        7 OTHER REAL ESTATE OWNED**
 
 Other
        real estate owned consists of real estate acquired by foreclosure or a similar
        conveyance of title. At December 31, 2005 other real estate owned was comprised
        of commercial real estate of $196,000. At December 31, 2004, the Company
        had no
        other real estate owned.
 
 Sales
        of
        other real estate owned by the Company resulted in no gains or losses for
        each
        of the years ended December 31, 2005, 2004, 2003, respectively.
 
 There
        were no write-downs on other real estate owned for the years ended December
        31,
        2005, 2004, and 2003.
 
 **NOTE
        8 DEPOSITS**
 
 The
        aggregate amount of maturities for time deposits as of December 31, 2005
        for
        each of the following five years is as follows:
 
 ($000
                  Omitted)2006
              
              $
              134,7862007
              
              
              12,0422008
              
              
              1,0782009
              
              
              2982010
              
              
              127$
              148,331
 
 Deposits
        from related parties held by the Bank at December 31, 2005 and 2004 amounted
        to
        $3,785,000 and $2,953,000, respectively.
 
 
 **NOTE
        9 SHORT-TERM BORROWINGS**
 
 Short-term
        borrowings consist of securities sold under agreements to repurchase. The
        securities sold under agreements to repurchase as of December 31, 2005 and
        2004
        are securities sold on a short term basis by the Company that have been
        accounted for not as sales but as borrowings. The underlying securities
        associated with securities sold under agreements to repurchase are under
        the
        control of the Company. The purchasers have agreed to sell to the Company
        substantially identical securities at the maturity of the
        agreements.
 
 
 **NOTE
        10 LONG-TERM DEBT**
 
 Long-term
        debt at December 31, 2005 and 2004 consisted of FHLB advances of $85,000,000
        and $78,000,000, respectively, as well as $20,620,000 of junior subordinated
        debentures, for each year.
 
 As
        of
        December 31, 2005, contractual principal payments due under long-term debt,
        which consists of FHLB advances and junior subordinated debentures, are as
        follows:
 
 ($000
                  Omitted)2006
              
              $
              31,0002007
              
              
              15,0002008
              
              
              7,0002009
              
              
              19,0002010
              
              
              7,0002011
                  and years thereafter
              
              
              26,620$
              105,620
  43
 *Table
            of Contents*
  **NOTE
        10 LONG-TERM DEBT (CONTINUED)**
 
 The
        FHLB
        long-term debt consisted of twenty eight separate advances. Seven of these
        advances are callable with the following rates and terms:
 
 ($000
                  Omitted)Amount
              
              Rate
              
              Maturity
                  Date
              
              Next
                Call
                  Date$
                  5,000
              
              6.11%
              
              03/28/07
              
              03/28/067,000
              
              5.54
              
              11/02/09
              
              02/01/067,000
              
              5.57
              
              11/09/09
              
              02/09/065,000
              
              5.91
              
              12/17/09
              
              03/17/062,000
              
              4.80
              
              12/27/10
              
              03/26/063,000
              
              4.50
              
              01/24/11
              
              01/22/061,000
              
              4.58
              
              02/07/11
              
              02/06/06$30,000
 
 The
        remaining twenty one advances, totaling $55,000,000, are at rates ranging
        from
        1.96% to 4.46% with a weighted average rate of 2.81%.
 
 The
        $20,620,000 of junior subordinated debentures consists of the following two
        issues:
 
 On
        April
        10, 2002, the Company completed the private placement of $7,217,000 aggregate
        liquidation amount of floating rate trust preferred securities (the “Trust I
        Capital Securities”) issued by its Delaware statutory business trust, Northway
        Capital Trust I (“Capital Trust I”). The Trust I Capital Securities were sold to
        a pooled investment vehicle. The proceeds from the sale of the Trust I Capital
        Securities, which included the proceeds from the sale by Capital Trust I
        of its
        common securities to the Company, were invested in Floating Rate Junior
        Subordinated Debt Securities of the Company due 2032 (the “Trust I Junior
        Subordinated Debt”), which were issued pursuant to an Indenture, dated April 10,
        2002, between the Company and Wilmington Trust Company, as Trustee. Both
        the
        Trust I Capital Securities and the Trust I Junior Subordinated Debt have
        a
        floating rate, which resets semi-annually, equal to six-month LIBOR plus
        3.70%,
        with a ceiling of 11.00% for the first five years. Currently, the interest
        rate
        on these securities is 8.15%. Payments of distributions and other amounts
        due on
        the Trust I Capital Securities are irrevocably guaranteed by the Company,
        to the
        extent that Capital Trust I has funds available for the payments of such
        distributions, pursuant to a Guarantee Agreement, dated April 10, 2002, between
        the Company and Wilmington Trust Company, as Guarantee Trustee. The Trust
        I
        Junior Subordinated Debt and the Trust I Capital Securities may be redeemed
        at
        the option of the Company on fixed semi-annual dates beginning on April 22,
        2007.
 
 On
        July
        11, 2002, the Company completed the private placement of $13,403,000 aggregate
        liquidation amount of floating rate trust preferred securities (the “Trust II
        Capital Securities”) issued by its Delaware statutory business trust, Northway
        Capital Trust II (the “Capital Trust II”). The Trust II Capital Securities were
        sold to a pooled investment vehicle. The proceeds from the sale of the Trust
        II
        Capital Securities, which include the proceeds from the sale by Capital Trust
        II
        of its common securities to the Company, were invested in Floating Rate Junior
        Subordinated Debt Securities of the Company due 2032 (the “Trust II Junior
        Subordinated Debt”), which were issued pursuant to an Indenture, dated July 11,
        2002, between the Company and Wilmington Trust Company, as Trustee. Both
        the
        Trust II Capital Securities and the Trust II Junior Subordinated Debt have
        a
        floating rate, which resets quarterly, equal to three-month LIBOR plus 3.65%,
        with a ceiling of 12.50% for the first five years. Currently, the interest
        rate
        on these securities is 7.80%. Payments of distributions and other amounts
        due on
        the Trust II Capital Securities are irrevocably guaranteed by the Company,
        to
        the extent that Capital Trust II has funds available for the payments of
        such
        distributions, pursuant to a Guarantee Agreement, dated July 11, 2002, between
        the Company and Wilmington Trust Company, as Guarantee Trustee. The Trust
        II
        Junior Subordinated Debt and the Trust II Capital Securities may be redeemed
        at
        the option of the Company on fixed quarterly dates beginning on July 7,
        2007.
  44
 *Table
            of Contents*
 
 **NOTE
        11 GOODWILL AND OTHER INTANGIBLE ASSETS**
 
 At
        December 31, 2005, the Company has goodwill and core deposit intangibles
        totaling $12,147,000. Core deposit intangibles are being amortized over their
        useful lives and goodwill is tested for impairment at least
        annually.
 
 The
        changes in the carrying amount of goodwill and core deposit intangibles for
        the
        years ended December 31, 2005 and 2004 are as follows:
 
 ($000
                  Omitted)Goodwill
              
              Core
                  Deposit
                IntangiblesBalance,
                  December 31, 2003
              
              $
              10,152
              
              $
              3,903Amortization
                  expense
              
              
              -
              
              
              (954
              )Balance,
                  December 31, 2004
              
              
              10,152
              
              
              2,949Amortization
                  expense
              
              
              -
              
              
              (954
              )Balance,
                  December 31, 2005
              
              $
              10,152
              
              $
              1,995
 
 Estimated
        annual amortization expense:
 
 ($000
                  Omitted)Goodwill
              
              Core
                  Deposit
                Intangibles2006
              
              
              -
              
              $
              9272007
              
              
              -
              
              
              3202008
              
              
              -
              
              
              3202009
              
              
              -
              
              
              3202010
              
              
              -
              
              
              108
 
 The
        following table reflects the gross carrying amount and accumulated amortization
        of core deposit intangibles as of December 31, 2005:
  ($000
                  Omitted)Gross
                Carrying
                Amount
              
              Accumulated
                Amortization
              
              Net
                Carrying
                AmountCore
                  deposit intangibles
              
              $
              5,332
              
              $
              3,337
              
              $
              1,995
 
 Management
        reviews the carrying amount of intangible assets on an ongoing basis, taking
        into consideration any events and circumstances that might have diminished
        such
        amount. During 2005 and 2004, the Company reviewed the carrying amount of
        intangible assets and determined that no impairment was required.
 
 
 **NOTE
        12 REGULATORY MATTERS**
 
 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’s and the Bank’s financial statements. Under
        capital adequacy guidelines and the regulatory framework for 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
        capital amounts and classifications 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). As of December 31, 2005, the most recent notification
        from
        the FDIC categorized the Bank as “well-capitalized” under the regulatory
        framework for prompt corrective action. To be categorized as “well-capitalized”
the Bank must maintain total risk-based, Tier 1 risk-based and Tier 1 leverage
        ratios above regulatory prescribed minimum levels. There are no conditions
        or
        events since that notification that management believes have changed the
        Bank’s
        category. Management believes, as of December 31, 2005 and 2004, that the
        Company and the Bank meet all capital adequacy requirements to which they
        are
        subject.
  45
 *Table
            of Contents*
  **NOTE
        12 REGULATORY MATTERS (CONTINUED)**
 
 These
        minimum capital amounts and ratios, as well as the Company’s and Bank’s actual
        capital amounts and ratios, are presented in the following table:
  ($000
                  Omitted)Actual
              
              For
                  Capital
                Adequacy
                Purposes
              
              To
                  Be Well
                Capitalized
                Under
                  Prompt
                Corrective
                Action
                ProvisionsAmount
              
              Ratio
              
              Amount
              
              Ratio
              
              Amount
              
              RatioAs
                  of December 31, 2005Tier
                  1 capital (to average assets)Consolidated
              
              $
              55,765
              
              
              8.96
              %
              $
              24,888
              
              
              >4.00
              %
              
              N/ANorthway
                  Bank
              
              
              50,450
              
              
              8.19
              
              
              24,644
              
              
              >4.00
              
              $
              30,806
              
              
              >5.00
              %Total
                  capital (to risk weighted assets)Consolidated
              
              
              65,025
              
              
              15.24
              
              
              34,138
              
              
              >8.00
              
              
              N/ANorthway
                  Bank
              
              
              55,673
              
              
              13.25
              
              
              33,623
              
              
              >8.00
              
              
              42,029
              
              
              >10.00Tier
                  1 capital (to risk weighted assets)Consolidated
              
              
              55,765
              
              
              13.07
              
              
              17,069
              
              
              >4.00
              
              
              N/ANorthway
                  Bank
              
              
              50,450
              
              
              12.00
              
              
              16,812
              
              
              >4.00
              
              
              25,217
              
              
              >6.00As
                  of December 31, 2004Tier
                  1 capital (to average assets)Consolidated
              
              
              52,736
              
              
              8.43
              
              
              25,014
              
              
              >4.00
              
              
              N/ANorthway
                  Bank
              
              
              48,150
              
              
              7.72
              
              
              24,940
              
              
              >4.00
              
              
              31,176
              
              
              >5.00Total
                  capital (to risk weighted assets)Consolidated
              
              
              62,305
              
              
              13.94
              
              
              35,745
              
              
              >8.00
              
              
              N/ANorthway
                  Bank
              
              
              53,437
              
              
              12.14
              
              
              35,206
              
              
              >8.00
              
              
              44,007
              
              
              >10.00Tier
                  1 capital (to risk weighted assets)Consolidated
              
              
              52,736
              
              
              11.80
              
              
              17,872
              
              
              >4.00
              
              
              N/ANorthway
                  Bank
              
              
              48,150
              
              
              10.94
              
              
              17,603
              
              
              >4.00
              
              
              26,404
              
              
              >6.00
 
 Federal
        regulations prohibit banking companies from paying dividends on their stock
        if
        the effect would cause stockholders' equity to be reduced below applicable
        regulatory capital requirements or if such declaration and payment would
        otherwise violate regulatory requirements.
 
 As
        of
        December 31, 2005, the Bank is restricted from declaring dividends to the
        Company in an amount greater than approximately $22,050,000, as such declaration
        would decrease capital below the Bank’s required minimum level of regulatory
        capital.
 
 
 **NOTE
        13 OTHER NONINTEREST EXPENSE**
 
 The
        major
        components of other noninterest expense for the years ended December 31,
        are as
        follows:
 
 ($000
                  Omitted)2005
              
              2004
              
              2003Professional
                  fees
              
              $
              1,523
              
              $
              1,234
              
              $
              1,166Advertising
              
              
              757
              
              
              326
              
              
              304Stationery
                  and supplies
              
              
              647
              
              
              429
              
              
              556Telecommunications
              
              
              619
              
              
              595
              
              
              571ATM
                  expense
              
              
              321
              
              
              295
              
              
              442Postage
                  and shipping
              
              
              317
              
              
              348
              
              
              378Other
              
              
              2,762
              
              
              2,501
              
              
              2,402$
              6,946
              
              $
              5,728
              
              $
              5,819
  46
 *Table
            of Contents*
  **NOTE
        14 FEDERAL AND STATE TAXES**
 
 The
        components of federal and state tax expense for the years ended December
        31, are
        as follows:
 
 ($000
                  Omitted)2005
              
              2004
              
              2003CurrentFederal
              
              $
              820
              
              $
              1,289
              
              $
              1,713State
              
              
              26
              
              
              334
              
              
              403846
              
              
              1,623
              
              
              2,116DeferredFederal
              
              
              2
              
              
              44
              
              
              (181
              )State
              
              
              (6
              )
              
              (1
              )
              
              (37
              )(4
              )
              
              43
              
              
              (218
              )Change
                  in valuation allowance
              
              
              -
              
              
              -
              
              
              (31
              )(4
              )
              
              43
              
              
              (249
              )Total
              
              $
              842
              
              $
              1,666
              
              $
              1,867
 
 The
        temporary differences (the differences between the financial statement carrying
        amounts of existing assets and liabilities and their respective tax bases)
        that
        give rise to significant portions of the net deferred income tax asset at
        December 31, are as follows:
 
 ($000
                  Omitted)2005
              
              2004Deferred
                  income tax assetsAllowance
                  for loan losses
              
              $
              2,072
              
              $
              1,988Interest
                  on nonaccrual loans
              
              
              46
              
              
              19Loan
                  origination costs, net
              
              
              -
              
              
              4Unrealized
                  holding loss on securities available-for-sale
              
              
              724
              
              
              13Capital
                  loss carryforward
              
              
              24
              
              
              70Minimum
                  pension liability adjustment
              
              
              -
              
              
              346Amortization
                  of goodwill and core deposit intangible
              
              
              3
              
              
              130Supplemental
                  pension
              
              
              325
              
              
              250Other
              
              
              9
              
              
              103,203
              
              
              2,830Deferred
                  income tax liabilitiesDepreciation
              
              
              (621
              )
              
              (801
              )Prepaid
                  pension
              
              
              (454
              )
              
              (246
              )Mortgage
                  and consumer servicing rights
              
              
              (94
              )
              
              (118
              )(1,169
              )
              
              (1,165
              )Deferred
                  income tax asset, net
              
              $
              2,034
              
              $
              1,665
 
 The
        primary sources of recovery of the deferred income tax asset are taxes paid
        that
        are available for carryback and the expectation that the deductible temporary
        differences will reverse during periods in which the Company generates taxable
        income.
 
 Total
        income tax expense for the years ended December 31, 2005, 2004 and 2003 differs
        from the "expected" federal income tax expense at the 34% statutory rate
        for the
        following reasons:
 
 2005
              
              2004
              
              2003Expected
                  federal income taxes
              
              
              34.0
              %
              
              34.0
              %
              
              34.0
              %Interest
                  on municipal securities available-for-sale and municipal
                  loans
              
              
              (9.4
              )
              
              (4.5
              )
              
              (3.3
              )State
                  tax expense, net of federal benefit
              
              
              0.4
              
              
              4.3
              
              
              4.4Valuation
                  allowance for securities
              
              
              -
              
              
              -
              
              
              (0.6
              )Other
              
              
              (1.0
              )
              
              (0.8
              )
              
              (0.4
              )Effective
                  tax rates
              
              
              24.0
              %
              
              33.0
              %
              
              34.1
              %
 47
 *Table
              of Contents*
 
 **NOTE
        15 EMPLOYEE BENEFITS**
 
 *Pension
        Plan* ****
 
 The
        Company maintains a trusteed non-contributory pension plan (the “Plan”) covering
        substantially all full-time employees. Assuming retirement at age 65 after
        30
        years or more of service, the benefits are computed as the sum of one percent
        of
        final average earnings up to a covered compensation limit, plus 0.65 percent
        of
        final average earnings in excess of covered compensation, times years of
        service, up to 30. Final average earnings are defined as the five consecutive
        years out of the employee’s last ten years of employment during which
        compensation is highest. The amounts contributed to the Plan are determined
        annually on the basis of (a) the maximum amount that can be deducted for
        federal
        income tax purposes or (b) the amount certified by a consulting actuary as
        necessary to avoid an accumulated funding deficiency as defined by the Employee
        Retirement Income Security Act of 1974. Contributions are intended to provide
        not only benefits attributed to service to date but also for those expected
        to
        be earned in the future.
 
 The
        following table sets forth information about the Plan as of December 31,
        using a
        measurement date of December 31, and for the years then ended:
 
 ($000
                  Omitted)2005
              
              2004
              
              2003Change
                  in benefit obligationBenefit
                  obligation at beginning of year
              
              $
              5,805
              
              $
              4,901
              
              $
              4,356Service
                  cost
              
              
              515
              
              
              481
              
              
              444Interest
                  cost
              
              
              346
              
              
              303
              
              
              266Actuarial
                  loss (gain)
              
              
              235
              
              
              233
              
              
              (46
              )Benefits
                  paid
              
              
              (311
              )
              
              (113
              )
              
              (119
              )Benefit
                  obligation at end of year
              
              
              6,590
              
              
              5,805
              
              
              4,901Change
                  in plan assetsFair
                  value of plan assets at beginning of year
              
              
              4,601
              
              
              3,652
              
              
              2,685Actual
                  return on plan assets
              
              
              295
              
              
              401
              
              
              540Employer
                  contributions
              
              
              1,145
              
              
              661
              
              
              546Benefits
                  paid
              
              
              (311
              )
              
              (113
              )
              
              (119
              )Fair
                  value of plan assets at end of year
              
              
              5,730
              
              
              4,601
              
              
              3,652Funded
                  status at end of year
              
              
              (
                  860
              )
              
              (1,204
              )
              
              (1,249
              )Unrecognized
                  transition asset
              
              
              -
              
              
              -
              
              
              (1
              )Unrecognized
                  net actuarial loss
              
              
              2,989
              
              
              2,803
              
              
              2,824Unrecognized
                  prior service cost
              
              
              (792
              )
              
              (877
              )
              
              (961
              )Net
                  amount recognized
              
              $
              1,337
              
              $
              722
              
              $
              613Amounts
                  recognized in the consolidated balance sheets consist
                  of:Accrued
                  benefit liability
              
              $
              -
              
              $
              (1,018
              )
              $
              (1,092
              )Accumulated
                  other comprehensive loss, before income tax benefit
              
              
              -
              
              
              1,018
              
              
              1,092Prepaid
                  benefit cost
              
              
              1,337
              
              
              722
              
              
              613Net
                  amount recognized
              
              $
              1,337
              
              $
              722
              
              $
              613
  The
        accumulated benefit obligation for the plan was $5,475,000 and $4,896,000
        at
        December 31, 2005 and 2004, respectively.
 
 ($000
                  Omitted)Components
                  of net periodic benefit cost
              
              2005
              
              2004
              
              2003Service
                  cost
              
              $
              515
              
              $
              481
              
              $
              444Interest
                  cost
              
              
              346
              
              
              303
              
              
              266Expected
                  return on plan assets
              
              
              (384
              )
              
              (288
              )
              
              (211
              )Amortization
                  of prior service cost
              
              
              (85
              )
              
              (84
              )
              
              (84
              )Amortization
                  of net actuarial loss
              
              
              138
              
              
              141
              
              
              172Recognized
                  transition amount
              
              
              -
              
              
              (1
              )
              
              (5
              )Net
                  periodic benefit cost
              
              $
              530
              
              $
              552
              
              $
              582
  48
 *Table
            of Contents*
  **NOTE
        15 EMPLOYEE BENEFITS (CONTINUED)**
 
 Assumptions
                  used to determine benefit obligations and benefit cost as of and
                  for the
                  years ending December 31,
              
              2005
              
              2004
              
              2003Discount
                  rate:Benefit
                  obligation
              
              
              5.75
              %
              
              6.00
              %
              
              6.25
              %Benefit
                  cost
              
              
              6.00
              
              
              6.25
              
              
              6.25Long-term
                  rate of return on plan assets
              
              
              8.00
              
              
              8.00
              
              
              8.00Rate
                  of compensation increase
              
              
              3.50
              
              
              3.50
              
              
              4.00
 
 The
        expected long-term rate of return for the plan’s total assets is based on the
        expected return of asset categories identified below, weighted based on the
        target allocations for each class. Equity funds are expected to return 8%
        to 10%
        over the long-term and bond funds and short-term money markets are expected
        to
        return between 4% and 6%.
 
 At
        December 31, 2005 and 2004, the comprehensive loss for the unfunded pension
        accumulated benefit obligation was $0 and $672,000, net of taxes, respectively.
 
 The
        Company’s pension plan actual asset allocations by asset category are as
        follows:
 
 Plan
                  Assets at December 31,2005
              
              2004
              
              2003Asset
                  CategoryMutual
                  funds:Bond
                  funds
              
              
              32.7
              %
              
              32.6
              %
              
              32.3
              %Equity
                  securities
              
              
              42.5
              
              
              43.6
              
              
              43.9Real
                  estate funds
              
              
              8.5
              
              
              9.4
              
              
              8.8Short-term
                  money market
              
              
              16.3
              
              
              14.4
              
              
              15.0Total
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
 
 The
        investment policy, as established by the Company, is to provide for a moderate
        growth of capital with a moderate level of volatility by investing assets
        per
        the target allocations as follows:
 
 2005
              
              2004
              
              2003Asset
                  CategoryMutual
                  funds:Bond
                  funds
              
              
              40-60
              %
              
              40-60
              %
              
              40.0
              %Equity
                  securities
              
              
              30-50
              
              
              30-50
              
              
              50.0Real
                  estate funds
              
              
              0-15
              
              
              0-15
              
              
              10.0
 
 The
        assets will be re-allocated quarterly to meet the above target allocations.
        The
        investment policy is reviewed on an annual basis, under the advisement of
        the
        Company’s certified investment advisor, to determine if the policy should be
        changed.
 
 The
        plan
        assets do not include any Company common stock at December 31, 2005 and
        2004.
 
 The
        Company does not expect to make a contribution to its pension plan in
        2006.
 
 Estimated
        future benefit payments, which reflect future service, as appropriate, are
        as
        follows for the years ended December 31:
 
 ($000
                  Omitted)2006
              
              $
              1582007
              
              
              1662008
              
              
              1962009
              
              
              2282010
              
              
              2512011-2015
              
              
              2,134
 
 *401(k)
        Plan*
 
 The
        Company offers a contributory 401(k) Plan. Under the Northway Financial,
        Inc.
        401(k) and Profit Sharing Plan (the “401K Plan”) employees must have attained
        age 21, completed six months of service and be credited with 1,000 hours
        of
        service in order to participate. Employees of the Company are eligible to
        participate. Under the 401K Plan, the Company matches 50 percent of the first
        4
        percent of employee contributions. Total 401(k) matching expense in 2005,
        2004
        and 2003 amounted to $139,000, $143,000 and $130,000, respectively, and Profit
        Sharing contribution expense for 2005, 2004, and 2003 was $0, $38,000, and
        $0,
        respectively.
  49
 *Table
            of Contents*
 
 **NOTE
        15 EMPLOYEE BENEFITS (CONTINUED)**
 
 *Supplemental
        Executive Retirement Plan (SERP)*
 
 Effective
        May 29, 2003, the existing Executive Life program sponsored by the Company
        was
        terminated and replaced with a SERP. The existing Split Dollar Life Insurance
        policy designed to support the Executive Life program is now fully owned
        by
        Northway. This policy will be maintained by Northway and is used as the
        benchmark for the SERP.
 
 The
        total
        retirement SERP benefit is as follows: Upon Mr. Woodward’s termination of
        employment for reasons other than death or for cause, the account balance
        is
        paid out to him in ten (10) equal annual installments on the first day of
        the
        month following the month in which employment is terminated. Upon death after
        retirement, the unpaid account balance, if any, is paid out in a lump sum
        to the
        named beneficiary. During retirement, an additional retirement payment, based
        on
        the policy gains associated with the prior calendar year, will also be paid
        on
        an annual basis until the executive’s death. In the event of Mr. Woodward’s
        death while employed by the Company, the SERP permits a death benefit of
        $2,000,000 be paid to his beneficiary.
 
 *Stock-Based
        Compensation*
 
 The
        Board
        of Directors (the “Committee”) administers the 1999 Stock Option and Grant Plan
        (the “1999 Plan”) which is described below.
 
 Under
        the
        1999 Plan, the Committee may select the individuals to whom awards may from
        time
        to time be granted; determine the time or times of grant; and determines
        the
        extent, if any, of incentive stock options, non-qualified stock options,
        restricted stock awards, unrestricted stock awards, performance share awards,
        or
        any combination of the foregoing.
 
 The
        1999
        Plan expires in February 2009. The aggregate number of shares of the Company’s
        common stock which may be issued upon the exercise of options granted under
        the
        1999 Plan is 175,000. The option price is fixed by the Committee at the time
        of
        the grant and may not be less than 100 percent of the fair market value of
        the
        stock, as determined by the Committee, in good faith as of the grant date.
        Each
        option may be exercised at such times as shall be determined by the Committee
        at
        or after the grant date; provided, however, that no option may be exercised
        ten
        years after the date of grant. The fair value of each option granted is
        estimated on grant date using the Black-Scholes option pricing model.
 
 A
        summary
        of the status of the Company’s 1999 Plan as of December 31, 2005, 2004 and 2003
        and changes during the years then ended is presented below:
 
 2005
              
              2004
              
              2003Shares
              
              Weighted
                Average
                Exercise
                Price
              
              Shares
              
              Weighted
                Average
                Exercise
                Price
              
              Shares
              
              Weighted
                Average
                Exercise
                PriceOutstanding,
                  beginning of year
              
              
              38,000
              
              $
              24.96
              
              
              42,000
              
              $
              24.93
              
              
              42,000
              
              $
              24.93Exercised
              
              
              (4,000
              )
              
              24.64
              
              
              (4,000
              )
              
              24.64
              
              
              -
              
              
              -Outstanding,
                  end of year
              
              
              34,000
              
              $
              25.00
              
              
              38,000
              
              $
              24.96
              
              
              42,000
              
              $
              24.93Options
                  exercisable at year-end
              
              
              34,000
              
              
              
              
              
              38,000
              
              
              
              
              
              42,000
  The
        following table summarizes information about fixed stock options outstanding
        as
        of December 31, 2005:
 
 Options
                  Outstanding
              
              Options
                  ExercisableWeighted
                Average
                Exercise
                Price
              
              Number
                Outstanding
                as
                  of
                12/31/05
              
              Weighted
                Average
                Remaining
                Contractual
                Life
              
              Number
                Exercisable
                as
                  of
                12/31/05
              
              Weighted
                Average
                Exercise
                Price$28.00
              
              15,000
              
              3.50
                  years
              
              15,000
              
              $28.0022.63
              
              19,000
              
              4.63
                  years
              
              19,000
              
              22.63$25.00
              
              34,000
              
              4.13
                  years
              
              34,000
              
              $25.00
  50
 *Table
            of Contents*
  **NOTE
        15 EMPLOYEE BENEFITS (CONTINUED)**
 
 *Change
        in Control*
 
 The
        Company and its subsidiaries have entered into Key Employee agreements with
        the
        specific Executive Officers as well as other Senior Officers of the Company.
        These agreements provide for payments, under certain circumstances, to the
        officer upon the officer’s termination after a change in control. Payments will
        be made under these agreements upon the officer’s termination or resignation in
        connection with certain specified actions adverse to the officer’s employment
        status after a change in control. The amount of such payments ranges from
        1.0 to
        1.5 times such officer’s annual compensation.
 
 **NOTE
        16 FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK**
 
 The
        Company is party to financial instruments with off-balance sheet risk in
        the
        normal course of business to meet the financing needs of its customers and
        to
        reduce its own exposure to fluctuations in interest rates. These financial
        instruments include commitments to originate loans and standby letters of
        credit. The instruments involve, to varying degrees, elements of credit and
        interest rate risk in excess of the amount recognized in the consolidated
        balance sheets. The amounts of those instruments reflect the extent of
        involvement the Company has in particular classes of financial
        instruments.
 
 The
        Company’s exposure to credit loss in the event of nonperformance by the other
        party to the financial instrument for loan commitments and standby letters
        of
        credit is represented by the contractual amount of those instruments. The
        Company uses the same credit policies in making commitments and conditional
        obligations as it does for on-balance sheet instruments.
 
 Financial
        instruments with off-balance sheet credit risk at December 31, are as follows:
 
 ($000
                  Omitted)2005
              
              2004Financial
                  instrument whose contract amounts represent credit risk:Unadvanced
                  portions of home equity loans
              
              $
              18,718
              
              $
              17,748Unadvanced
                  portions of lines of credit
              
              
              7,897
              
              
              9,216Unadvanced
                  portions of commercial real estate loans
              
              
              2,467
              
              
              1,888Unadvanced
                  portions of Bounce ProtectionTM
              
              
              11,294
              
              
              12,091Commitments
                  to originate all other loans
              
              
              19,971
              
              
              15,952Commitments
                  to originate municipal notes
              
              
              -
              
              
              2,995Standby
                  letters of credit
              
              
              71
              
              
              400
 
 Commitments
        to originate loans and municipal notes, unadvanced portions of home equity
        loans, lines of credit and commercial real estate loans are agreements to
        lend
        to a customer provided there is no violation of any condition established
        in the
        contract. Commitments generally have fixed expiration dates or other termination
        clauses and may require payment of a fee. Since many of the commitments are
        expected to expire without having been drawn upon, the total commitment amounts
        do not necessarily represent future cash requirements. The Company evaluates
        each customer’s creditworthiness on a case-by-case basis. The amount of
        collateral obtained, if deemed necessary by the Company upon extension of
        credit, is based on management’s credit evaluation of the borrower.
 
 Unadvanced
        portions of Bounce ProtectionTM represent the unused portion of the Bank’s
        overdraft privilege program.
 
 Standby
        letters of credit are conditional commitments issued by the Company to guarantee
        the performance by a customer to a third party. The credit risk involved
        in
        issuing letters of credit is essentially the same as that involved in extending
        loan commitments to customers. As of December 31, 2005 and 2004, the maximum
        potential amount of the Company’s obligation was $71,000 and $400,000,
        respectively, for financial and standby letters of credit. The Company’s
        outstanding letters of credit generally have a term of less than one year.
        If a
        letter of credit is drawn upon, the Company may seek recourse through the
        customer’s underlying line of credit. If the customer’s line of credit is also
        in default, the Company may take possession of the collateral, if any, securing
        the line of credit.
 
 At
        December 31, 2005, the Bank had commitments to purchase state and political
        subdivision bonds totaling $2,206,000.
 
 On
        December 13, 2005, the Bank entered into an agreement with Washington Mutual
        Bank to purchase two branch locations located in Belmont and Tilton, New
        Hampshire. The Bank expects to acquire approximately $31,000,000 of deposits
        and
        $10,000,000 of loans. This transaction is expected to close on or about April
        7,
        2006.
  51
 *Table
            of Contents*
 
 **NOTE
        17 FAIR VALUE OF FINANCIAL INSTRUMENTS**
 
 The
        following methods and assumptions were used by the Company in estimating
        its
        fair value disclosures for financial instruments:
 
 Cash
        and
        cash equivalents: The carrying amounts reported in the consolidated balance
        sheets for cash and cash equivalents approximates the fair value of those
        assets.
 
 Securities:
        Fair values for securities are based on quoted market prices, where available.
        If quoted market prices are not available, fair values are based on quoted
        market prices of comparable instruments.
 
 FHLB
        and
        Federal Reserve Bank (“FRB”) Stock: The carrying amounts reported in the
        consolidated balance sheets for FHLB and FRB Stock approximates their fair
        value. If redeemed, the Company will receive an amount equal to the par value
        of
        the stocks.
 
 Loans
        held-for-sale: Fair values for loans held-for-sale are estimated based on
        outstanding investor commitments, or in the absence of such commitments,
        are
        based on current investor yield requirements.
 
 Loans:
        For variable-rate loans that reprice frequently and with no significant change
        in credit risk, fair values are based on carrying values. The fair values
        for
        other loans are estimated using discounted cash flow analyses, using interest
        rates currently being offered for loans with similar terms to borrowers of
        similar credit quality. The fair value of nonaccrual loans was estimated
        using
        discounted cash flow analysis or the estimated fair value of the underlying
        collateral where applicable.
 
 Accrued
        interest receivable: The carrying value of accrued interest receivable
        approximates its fair value because of the short-term nature of this financial
        instrument.
 
 Deposits:
        The fair value of demand deposits (e.g. NOW and super NOW checking, noninterest
        bearing checking, regular savings, money market accounts and mortgagors’ escrow
        accounts) are, by definition, equal to the amount payable on demand at the
        reporting date (i.e. their carrying amounts). Fair values for certificates
        of
        deposit are estimated using a discounted cash flow technique that applies
        interest rates currently being offered on certificates to a schedule of
        aggregated expected monthly maturities of time deposits.
 
 Short-term
        borrowings: The carrying value of short-term borrowings approximates its
        fair
        value because of the short-term nature of these financial
        instruments.
 
 Long-term
        debt: The fair values of long-term debt are determined by discounting the
        anticipated future cash payments by using the rates currently available to
        the
        Company for debt with similar terms and remaining maturities.
 
 Junior
        subordinated debentures: The fair values of junior subordinated debentures
        are
        based on quoted market prices, where available. If quoted market prices are
        not
        available, fair values are based on quoted market prices of comparable
        instruments.
 
 Off-balance
        sheet instruments: The fair value of commitments to originate loans is estimated
        using the fees currently charged to enter similar agreements, taking into
        account the remaining terms of the agreements and the present creditworthiness
        of the counterparties. For fixed-rate loan commitments and the unadvanced
        portion of loans, fair value also considers the difference between current
        levels of interest rates and the committed rates. The fair value of letters
        of
        credit is based on fees currently charged for similar agreements or on the
        estimated cost to terminate them or otherwise settle the obligation with
        the
        counterparties at the reporting date. See NOTE 16 for further
        information.
 
 The
        estimated fair values of the Company’s financial instruments are as
        follows:
 
 ($000
                  Omitted)
                December
                  31,2005
              
              2004Carrying
                Amount
              
              Estimated
                Fair
                Value
              
              Carrying
                Amount
              
              Estimated
                Fair
                ValueFinancial
                  assets:Cash
                  and cash equivalents
              
              $
              29,362
              
              $
              29,362
              
              $
              24,769
              
              $
              24,769Securities
                  available-for-sale
              
              
              103,244
              
              
              103,244
              
              
              101,133
              
              
              101,133FHLB
                  stock
              
              
              5,541
              
              
              5,541
              
              
              5,515
              
              
              5,515FRB
                  stock
              
              
              -
              
              
              -
              
              
              365
              
              
              365Loans
                  held-for-sale
              
              
              453
              
              
              461
              
              
              311
              
              
              314Loans,
                  net
              
              
              455,223
              
              
              445,529
              
              
              469,502
              
              
              466,679Accrued
                  interest receivable
              
              
              2,614
              
              
              2,614
              
              
              2,405
              
              
              2,405
  52
 *Table
            of Contents*
  **NOTE
        17 FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)**
 
 ($000
                  Omitted)
                December
                  31,2005
              
              2004Carrying
                Amount
              
              Estimated
                Fair
                Value
              
              Carrying
                Amount
              
              Estimated
                Fair
                ValueFinancial
                  liabilities:Deposits
              
              $
              464,456
              
              $
              463,159
              
              $
              475,359
              
              $
              475,952Short-term
                  borrowings
              
              
              9,363
              
              
              9,363
              
              
              11,268
              
              
              11,268Long-term
                  debt
              
              
              85,000
              
              
              84,296
              
              
              78,000
              
              
              78,494Junior
                  subordinated debentures
              
              
              20,620
              
              
              20,908
              
              
              20,620
              
              
              21,270
 
 The
        carrying amounts of financial instruments shown in the above table are included
        in the consolidated balance sheets under the indicated captions except that
        accrued interest receivable is included with other assets and junior
        subordinated debentures is included with long-term debt.
 
 At
        December 31, 2005 and 2004, all the Company’s financial instruments were held
        for purposes other than trading.
 
 ***Limitations***
 
 Fair
        value estimates are made at a specific point in time, based on relevant market
        information and information about the financial instrument. These estimates
        do
        not reflect any premium or discount that could result from offering for sale
        at
        one time the Company’s entire holdings of a particular financial instrument.
        Because no market exists for some of the Company’s financial instruments, fair
        value estimates are based on judgments regarding future expected loss
        experience, cash flows, current economic conditions, risk characteristics,
        and
        other factors. These estimates are subjective in nature and involve
        uncertainties and matters of significant judgment and therefore cannot be
        determined with precision. Changes in assumptions and changes in the loan,
        debt
        and interest rate markets could significantly affect the estimates. Further,
        the
        income tax ramifications related to the realization of the unrealized gains
        and
        losses can have a significant effect on the fair value estimates and have
        not
        been considered. The fair value amounts presented do not represent the
        underlying value of the Company because fair values of certain other financial
        instruments, assets and liabilities have not been determined.
 
 **NOTE
        18 CONDENSED PARENT ONLY FINANCIAL STATEMENTS**
  Condensed
        financial statements of Northway Financial, Inc. (Parent Company only) as
        of
        December 31, 2005 and 2004 and for the three years ended December 31, 2005
        follow:
 
 ***Balance
        Sheets***
  ($000
                  Omitted)2005
              
              2004AssetsCash
                  and cash equivalents
              
              $
              3,780
              
              $
              3,843Investment
                  in subsidiary, Northway Bank
              
              
              61,517
              
              
              61,261Investment
                  in unconsolidated subsidiaries, Northway Capital Trust I &
                  II
              
              
              620
              
              
              620Equipment,
                  net
              
              
              1,571
              
              
              2,058Due
                  from subsidiary
              
              
              540
              
              
              808Other
                  assets
              
              
              4,751
              
              
              4,117Total
                  assets
              
              $
              72,779
              
              $
              72,707Liabilities
                  and stockholders’ equityAccrued
                  expenses
              
              $
              540
              
              $
              571Other
                  liabilities
              
              
              1,369
              
              
              2,006Junior
                  subordinated debentures
              
              
              20,620
              
              
              20,620Total
                  liabilities
              
              
              22,529
              
              
              23,197Stockholders’
                  equity:Common
                  stock
              
              
              1,732
              
              
              1,732Additional
                  paid-in capital
              
              
              2,064
              
              
              2,075Retained
                  earnings
              
              
              54,089
              
              
              52,484Treasury
                  stock
              
              
              (6,531
              )
              
              (6,090
              )Accumulated
                  other comprehensive loss
              
              
              (1,104
              )
              
              (691
              )Total
                  stockholders’ equity
              
              
              50,250
              
              
              49,510Total
                  liabilities and stockholders’ equity
              
              $
              72,779
              
              $
              72,707
 
 53
 *Table
            of Contents*
  **NOTE
        18 CONDENSED PARENT ONLY FINANCIAL STATEMENTS
        (CONTINUED)**
 
 
 ***Statements
        of Income***
  ($000
                  Omitted)2005
              
              2004
              
              2003Income:Dividends
                  from subsidiary
              
              $
              2,036
              
              $
              2,030
              
              $
              1,820Interest
                  income
              
              
              120
              
              
              48
              
              
              54Management
                  fee income from subsidiary
              
              
              8,750
              
              
              9,576
              
              
              9,112Other
              
              
              202
              
              
              178
              
              
              5711,108
              
              
              11,832
              
              
              11,043Expense:Interest
                  expense
              
              
              1,463
              
              
              1,079
              
              
              1,036Salaries
                  and employee benefits
              
              
              5,495
              
              
              5,639
              
              
              5,130Office
                  occupancy and equipment expense
              
              
              1,107
              
              
              1,204
              
              
              1,223Professional
                  fees
              
              
              741
              
              
              925
              
              
              933Other
              
              
              1,408
              
              
              1,825
              
              
              1,83010,214
              
              
              10,672
              
              
              10,152Income
                  before income tax benefit and equity in undistributed net income
                  of
                  subsidiary
              
              
              894
              
              
              1,160
              
              
              891Income
                  tax benefit
              
              
              (438
              )
              
              (345
              )
              
              (316
              )Income
                  before equity in undistributed net income of subsidiary
              
              
              1,332
              
              
              1,505
              
              
              1,207Equity
                  in undistributed net income of subsidiary
              
              
              1,341
              
              
              1,883
              
              
              2,410Net
                  income
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617
 
 
 ***Statements
        of Cash Flows***
 ($000
                  Omitted)2005
              
              2004
              
              2003Cash
                  flows from operating activities:Net
                  income
              
              $
              2,673
              
              $
              3,388
              
              $
              3,617Adjustments
                  to reconcile net income to net cash provided by operating
                  activities:Depreciation
                  and amortization
              
              
              630
              
              
              603
              
              
              467Decrease
                  (increase) in amount due from subsidiary
              
              
              268
              
              
              170
              
              
              (463
              )Increase
                  in other assets
              
              
              (622
              )
              
              (305
              )
              
              (1,271
              )Increase
                  in accrued expenses and other liabilities
              
              
              4
              
              
              535
              
              
              662Loss
                  on disposal of assets
              
              
              2
              
              
              -
              
              
              27Undistributed
                  net income of subsidiary
              
              
              (1,341
              )
              
              (1,883
              )
              
              (2,410
              )Net
                  cash provided by operating activities
              
              
              1,614
              
              
              2,508
              
              
              629Cash
                  flows from investing activities:Capital
                  contributions to subsidiary
              
              
              -
              
              
              -
              
              
              (1,000
              )Additions
                  to premises and equipment
              
              
              (145
              )
              
              (869
              )
              
              (466
              )Purchase
                  of company owned life insurance
              
              
              -
              
              
              (400
              )
              
              (800
              )Net
                  cash used by investing activities
              
              
              (
                  145
              )
              
              (1,269
              )
              
              (2,266
              )Cash
                  flows from financing activities:Exercise
                  of stock options
              
              
              99
              
              
              99
              
              
              -Purchases
                  of treasury stock
              
              
              (563
              )
              
              -
              
              
              (502
              )Cash
                  dividends paid
              
              
              (1,068
              )
              
              (1,020
              )
              
              (1,024
              )Net
                  cash used by financing activities
              
              
              (1,532
              )
              
              (
                  921
              )
              
              (1,526
              )Net
                  (decrease) increase in cash and cash equivalents
              
              
              (63
              )
              
              318
              
              
              (3,163
              )Cash
                  and cash equivalents at beginning of year
              
              
              3,843
              
              
              3,525
              
              
              6,688Cash
                  and cash equivalents at end of year
              
              $
              3,780
              
              $
              3,843
              
              $
              3,525
  54
 *Table
            of Contents*
 
 **QUARTERLY
        RESULTS OF OPERATIONS (UNAUDITED)**
 
 Summarized
        quarterly financial data for 2005 and 2004 follows:
  ($000
                  Omitted, except earnings per share)2005
                  Quarters EndedMar
                  31
              
              Jun
                  30
              
              Sep
                  30
              
              Dec
                  31Interest
                  and dividend income
              
              $
              7,833
              
              $
              7,742
              
              $
              8,177
              
              $
              8,352Interest
                  expense
              
              
              1,896
              
              
              2,068
              
              
              2,342
              
              
              2,622Net
                  interest and dividend income
              
              
              5,937
              
              
              5,674
              
              
              5,835
              
              
              5,730Provision
                  for loan losses
              
              
              75
              
              
              -
              
              
              -
              
              
              -Noninterest
                  income
              
              
              987
              
              
              1,295
              
              
              1,337
              
              
              377Noninterest
                  expense
              
              
              5,612
              
              
              5,752
              
              
              5,946
              
              
              6,272Income
                  before taxes
              
              
              1,237
              
              
              1,217
              
              
              1,226
              
              
              (165Income
                  tax expense
              
              
              414
              
              
              313
              
              
              349
              
              
              (234Net
                  income
              
              $
              823
              
              $
              904
              
              $
              877
              
              $
              69Basic
                  earnings per common share
              
              $
              0.55
              
              $
              0.60
              
              $
              0.58
              
              $
              0.05Earnings
                  per common share assuming dilution
              
              $
              0.54
              
              $
              0.60
              
              $
              0.58
              
              $
              0.05
 
 
 2004
                  Quarters EndedMar
                  31
              
              Jun
                  30
              
              Sep
                  30
              
              Dec
                  31Interest
                  and dividend income
              
              $
              7,371
              
              $
              7,571
              
              $
              7,595
              
              $
              7,740Interest
                  expense
              
              
              1,827
              
              
              1,873
              
              
              1,867
              
              
              1,864Net
                  interest and dividend income
              
              
              5,544
              
              
              5,698
              
              
              5,728
              
              
              5,876Provision
                  for loan losses
              
              
              150
              
              
              120
              
              
              120
              
              
              105Noninterest
                  income
              
              
              1,296
              
              
              1,264
              
              
              1,443
              
              
              1,094Noninterest
                  expense
              
              
              5,608
              
              
              5,702
              
              
              5,567
              
              
              5,517Income
                  before taxes
              
              
              1,082
              
              
              1,140
              
              
              1,484
              
              
              1,348Income
                  tax expense
              
              
              353
              
              
              392
              
              
              507
              
              
              414Net
                  income
              
              $
              729
              
              $
              748
              
              $
              977
              
              $
              934Basic
                  earnings per common share
              
              $
              0.49
              
              $
              0.50
              
              $
              0.65
              
              $
              0.62Earnings
                  per common share assuming dilution
              
              $
              0.49
              
              $
              0.49
              
              $
              0.64
              
              $
              0.62
  55
 *Table
            of Contents*
  **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 
 Shatswell,
        MacLeod & Company, P.C.
 Certified
        Public Accountants
 83
        Pine
        Street
 West
        Peabody, Massachusetts 01960
 
 The
        Board
        of Directors and Stockholders
 Northway
        Financial, Inc.
 Berlin,
        New Hampshire
 
 We
        have
        audited the accompanying consolidated balance sheets of Northway Financial,
        Inc.
        and Subsidiaries as of December 31, 2005 and 2004 and the related consolidated
        statements of income, comprehensive income, changes in stockholders’ equity and
        cash flows for each of the years in the three-year period ended December
        31,
        2005. These consolidated financial statements are the responsibility of the
        Company’s management. Our responsibility is to express an opinion on these
        consolidated financial statements based on our audits.
 
 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. The
        Company
        is not required to have, nor were we engaged to perform, an audit of its
        internal control over financial reporting. Our audit included consideration
        of
        internal control over financial reporting as a basis for designing audit
        procedures that are appropriate in the circumstances, but not for the purpose
        of
        expressing an opinion on the effectiveness of the Company’s internal control
        over financial reporting. Accordingly, we express no such opinion. 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 Northway
        Financial, Inc. and Subsidiaries as of December 31, 2005 and 2004 and the
        results of their operations and their cash flows for each of the years in
        the
        three-year period ended December 31, 2005, in conformity with accounting
        principles generally accepted in the United States of America.
 
 
  SHATSWELL,
                  MacLEOD & COMPANY, P.C.West
                  Peabody, MassachusettsJanuary
                  24, 2006
  56
 *Table
            of Contents*
  ITEM
        9. CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
 None.
 
 
 ITEM
        9A. CONTROLS AND PROCEDURES
 
 The
        Company’s management, with the participation of the Company’s Chief Executive
        Officer and Chief Financial Officer, has evaluated the effectiveness of the
        Company’s disclosure controls and procedures as of December 31, 2005. Based on
        that evaluation, the Company’s Chief Executive Officer and Chief Financial
        Officer concluded that the Company’s disclosure controls and procedures were
        effective as of December 31, 2005. There were no changes in the Company’s
        internal control over financial reporting during the fourth quarter 2005
        that
        has materially affected, or is reasonably likely to materially affect, the
        Company’s internal control over financial reporting.
 
 
 **PART
        III**
  ITEM
        10. DIRECTORS AND EXECUTIVE OFFICERSOF THE
        REGISTRANT
 
 Information
        required by this item is incorporated by reference to the information set
        forth
        under the captions “Information Concerning Directors and Nominees,” “Executive
        Officers” and “Audit and Compliance Committee” in the Company’s definitive proxy
        statement to be delivered in connection with its 2006 Annual Meeting of
        Stockholders.
 
 Furthermore,
        the Company has adopted a code of ethics that applies to all of its directors,
        officers and employees. The Company has filed a copy of this Code of Ethics
        as
        Exhibit 14 to this Form 10-K. The Company has also made the Code of Ethics
        available on its website at www.northwaybank.com .
 
 
 ITEM
        11. EXECUTIVE COMPENSATION
 
 The
        information required by this item is incorporated by reference to the
        information set forth under the caption “Executive Compensation” in the
        Company’s definitive proxy statement to be delivered in connection with its 2006
        Annual Meeting of Stockholders, provided however, that the “Report of the Human
        Resources, Compensation and Nominating Committee on Executive Compensation” and
        the “Stock Price Performance Graph” contained in such proxy statement are not
        incorporated by reference herein.
 
 
 ITEM
        12. SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND
        MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
 The
        information required by this item is incorporated by reference to the
        information set forth under the captions "Security Ownership of Management
        and
        Principal Stockholders,” “Information Concerning Directors and Nominees” and
“Equity Compensation Plan Information” in the Company’s definitive proxy
        statement to be delivered in connection with its 2006 Annual Meeting of
        Stockholders.
 
 
 ITEM
        13. CERTAIN RELATIONSHIPS AND RELATED
        TRANSACTIONS
 
 The
        information required by this item is incorporated by reference to the
        information set forth under the caption “Certain Relationships and Related
        Transactions” in the Company’s definitive proxy statement to be delivered in
        connection with its 2006 Annual Meeting of Stockholders.
 
 
 ITEM
        14. PRINCIPAL ACCOUNTANT FEESAND SERVICES
 
 The
        information required by this item is incorporated by reference to the
        information set forth under the caption “Fees Paid to Independent Auditors” in
        the Company’s definitive proxy statement to be delivered in connection with its
        2006 Annual Meeting of Stockholders.
  57
 *Table
            of Contents*
 
 ITEM
        15 EXHIBITS AND FINANCIAL STATEMENTSCHEDULES
 
 (a)
              (1)
              The
                  following financial statements are filed as part of this Report
                  on Form
                  10-K:Report
                  of Independent Registered Public Accounting FirmConsolidated
                  Statements of Income for the years ended December 31, 2005, 2004
                  and
                  2003Consolidated
                  Balance Sheets as of December 31, 2005 and 2004Consolidated
                  Statements of Changes in Stockholders’ Equity for the years ended December
                  31, 2005, 2004, and 2003Consolidated
                  Statements of Comprehensive Income for the years ended December
                  31, 2005,
                  2004 and 2003Consolidated
                  Statements of Cash Flows for the years ended December 31, 2005,
                  2004 and
                  2003Notes
                  to Consolidated Financial Statements(2)
              Financial
                  Statement Schedules:None(3)
              The
                  Exhibits which are filed with this report or which are incorporated
                  herein
                  by reference are set forth in the Exhibit Index. The Exhibit Index
                  is
                  incorporated herein by reference.
 58
 *Table
              of Contents*
  **SIGNATURES**
 
 Pursuant
        to 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.
 
 NORTHWAY
                  FINANCIAL, INC.March
                  24, 2006
              BY:
              /S/
                  William J. WoodwardWilliam
                  J. WoodwardChairman
                  of the Board, President & ChiefExecutive
                  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.
 
 Signature
              
              Title
              
              Date/S/
                  William J. Woodward
              
              Chairman
                  of the Board, President
              
              March
                  24, 2006William
                  J. Woodward
              
              and
                  CEO (Principal Executive Officer)/S/
                  Richard P. Orsillo
              
              Senior
                  Vice President and Chief
              
              March
                  24, 2006Richard
                  P. Orsillo
              
              Financial
                  Officer (Principal Financialand
                  Accounting Officer)/S/
                  John H. Noyes
              
              Director
              
              March
                  23, 2006John
                  H. Noyes/S/
                  Barry J. Kelley
              
              Director
              
              March
                  23, 2006Barry
                  J. Kelley/S/
                  Randall G. Labnon
              
              Director
              
              March
                  24, 2006Randall
                  G. Labnon/S/
                  Brien L. Ward
              
              Director
              
              March
                  23, 2006Brien
                  L. Ward/S/
                  Arnold P. Hanson, Jr.
              
              Director
              
              March
                  23, 2006Arnold
                  P. Hanson, Jr./S/
                  Frederick C. Anderson
              
              Director
              
              March
                  23, 2006Frederick
                  C. Anderson
  59
 *Table
            of Contents*
  **INDEX
        OF EXHIBITS**
  Exhibit
                    Number
                
                Description
                    of Exhibit2.1
                
                Agreement
                    and Plan of Merger, dated as of March 14, 1997, by and among
                    Northway
                    Financial, Inc., The Berlin City Bank, Pemi Bancorp, Inc. and
                    Pemigewasset
                    National Bank (the "Merger Agreement") (incorporated by reference
                    to
                    Exhibit 2.1 to Registration Statement No. 333-33033).3.1
                
                Amended
                    and Restated Articles of Incorporation of Northway Financial,
                    Inc.
                    (incorporated by reference to Exhibit 3.1 to Registration Statement
                    No.
                    333-33033).3.2
                
                By-laws
                    of Northway Financial, Inc(1)4
                
                Form
                    of Certificate representing the Company Common Stock (reference
                    is also
                    made to Exhibits 3.1 and 3.2) (incorporated by reference to Exhibit
                    4 to
                    Registration Statement No. 333-33033).10.1
                
                Employment
                    Agreement for William J. Woodward.(1)(2)10.3
                
                Amendment
                    to the Employment Agreement for William J. Woodward.(1)(2)10.5
                
                Northway
                    Financial, Inc. 1999 Stock Option and Grant Plan (incorporated
                    by
                    reference to Exhibit
                    4.1 to Registration Statement No. 333-83571 dated July 23,1999).(2)10.7
                
                Form
                    of Key Employee Agreement.(1)(2)10.8
                
                Supplemental
                    Executive Retirement Plan. (incorporated by reference to Exhibit
                    10.8 to
                    the Company’s Annual Report on Form 10-K for the year ended
                    2003).11
                
                Statement
                    re: Computation of Per Share Earnings(1)14
                
                Code
                    of Ethics(1)21
                
                List
                    of Subsidiaries(1)23
                
                Consent
                    of Shatswell, MacLeod & Company, P.C.(1)31.1
                
                Certification
                    of President of Northway Financial, Inc., pursuant to rules 13(a)-15(e)
                    and 15d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley
                    Act of 2002.(1)31.2
                
                Certification
                    of Chief Financial Officer of Northway Financial, Inc., pursuant
                    to rules
                    13(a)-15(e) and 5d-15(e), as adopted pursuant to Section 302
                    of the
                    Sarbanes-Oxley Act of 2002.(1)32.1
                
                Certification
                    of President of Northway Financial, Inc., pursuant to 18 U.S.C.
                    Section
                    1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
                    Act of
                    2002.(1)32.2
                
                Certification
                    of Chief Financial Officer of Northway Financial, Inc., pursuant
                    to 18
                    U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                    Sarbanes-Oxley Act of 2002.(1)
 
 (1)
              Filed
                  herewith.
 (2)
              Management
                  contract or compensatory plan required to be filed as an exhibit
                  to this
                  form pursuant to Item 15(a) of this
                  report.




60