EXHIBIT
(13)
   
     APPENDIX
A
         
  PEOPLES
BANCORP OF NORTH CAROLINA, INC.
 
 General
Description of Business
 Peoples
Bancorp of North Carolina, Inc. (the “Company”), was formed in 1999 to serve as
the holding company for Peoples Bank (the “Bank”).  The Company is a
bank holding company registered with the Board of Governors of the Federal
Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of
1956, as amended (the “BHCA”).  The Company’s principal source of
income is any dividends, which are declared and paid by the Bank on its capital
stock.  The Company has no operations and conducts no business of its
own other than owning the Bank.  Accordingly, the discussion of the
business which follows concerns the business conducted by the Bank, unless
otherwise indicated.
 
 The Bank,
founded in 1912, is a state-chartered commercial bank serving the citizens and
business interests of the Catawba Valley and surrounding communities through 19
banking offices located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden,
Claremont, Hiddenite, Hickory, Charlotte, Monroe and Cornelius, North
Carolina.  The Bank also operates a loan production office in Denver,
North Carolina.  In January 2008, the Bank opened a traditional
banking office in Iredell County, in Mooresville, North Carolina and a Banco de
la Gente office in Wake County, in Raleigh, North Carolina.  At
December 31, 2007, the Company had total assets of $907.3 million, net loans of
$713.2 million, deposits of $693.7 million, total securities of $127.4 million,
and shareholders’ equity of $70.1 million.
 
 The Bank
has a diversified loan portfolio, with no foreign loans and few agricultural
loans.  Real estate loans are predominately variable rate commercial
property loans, which include residential development loans to commercial
customers.  Commercial loans are spread throughout a variety of
industries with no one particular industry or group of related industries
accounting for a significant portion of the commercial loan
portfolio.  The majority of the Bank's deposit and loan customers are
individuals and small to medium-sized businesses located in the Bank's market
area.  The Bank’s loan portfolio also includes Individual Taxpayer
Identification Number (ITIN) mortgage loans generated thorough the Bank’s Banco
de le Gente offices.  Additional discussion of the Bank’s loan
portfolio and sources of funds for loans can be found in “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” on
pages A-4 through A-25 of the Annual Report, which is included in this Form 10-K
as Exhibit 13.
 
 The
operations of the Bank and depository institutions in general are significantly
influenced by general economic conditions and by related monetary and fiscal
policies of depository institution regulatory agencies, including the Federal
Reserve, the Federal Deposit Insurance Corporation (the “FDIC”) and the North
Carolina Commissioner of Banks (the "Commissioner").
 
 At
December 31, 2007, the Bank employed 264 full-time equivalent
employees.
 
 The Bank
is a subsidiary of the Company.  The Bank has two subsidiaries,
Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. Through a relationship
with Raymond James Financial Services, Inc., Peoples Investment Services, Inc.
provides the Bank's customers access to investment counseling and non-deposit
investment products such as stocks, bonds, mutual funds, tax deferred annuities,
and related brokerage services.  Real Estate Advisory Services, Inc.,
provides real estate appraisal and real estate brokerage services.
 
 In June
2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital
Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred
beneficial interests in the Company’s junior subordinated deferrable interest
debentures.  All of the common securities of PEBK Trust II are owned
by the Company.  The proceeds from the issuance of the common
securities and the trust preferred securities were used by PEBK Trust II to
purchase $20.6 million of junior subordinated debentures of the Company, which
pay a floating rate equal to three month LIBOR plus 163 basis
points.  The proceeds received by the Company from the sale of the
junior subordinated debentures were used in December 2006 to repay the trust
preferred securities issued by PEBK Trust in December 2001 and for general
purposes.  The debentures represent the sole asset of PEBK Trust
II.  PEBK Trust II is not included in the consolidated financial
statements.
 
 The trust
preferred securities issued by PEBK Trust II accrue and pay quarterly at a
floating rate of three-month LIBOR plus 163 basis points.  The Company
has guaranteed distributions and other payments due on the trust preferred
securities to the extent PEBK Trust II does not have funds with which to make
the distributions and other payments.  The net combined effect of the
trust preferred securities transaction is that the Company is obligated to make
the distributions and other payments required on the trust preferred
securities.
 
 These
trust preferred securities are mandatorily redeemable upon maturity of the
debentures on June 28, 2036, or upon earlier redemption as provided in the
indenture.  The Company has the right to redeem the debentures
purchased by PEBK Trust II, in whole or in part, on or after June 28,
2011.  As specified in the indenture, if the debentures are redeemed
prior to maturity, the redemption price will be the principal amount and any
accrued but unpaid interest.
   A-1
  This
report contains certain forward-looking statements with respect to the financial
condition, results of operations
and business of Peoples Bancorp of North Carolina, Inc. (the
“Company”).  These forward-looking statements involve risks and
uncertainties and are based on the beliefs and assumptions of management of the
Company and on the information available to management at the time that these
disclosures were prepared. These statements can be identified by the use of
words like “expect,” “anticipate,” “estimate” and “believe,” variations of these
words and other similar expressions.  Readers should not place undue
reliance on forward-looking statements as a number of important factors could
cause actual results to differ materially from those in the forward-looking
statements.  Factors that could cause actual results to differ
materially include, but are not limited to, (1) competition in the markets
served by Peoples Bank (the “Bank”), (2) changes in the interest rate
environment, (3) general national, regional or local economic conditions may be
less favorable than expected, resulting in, among other things, a deterioration
in credit quality and the possible impairment of collectibility of loans, (4)
legislative or regulatory changes, including changes in accounting standards,
(5) significant changes in the federal and state legal and regulatory
environment and tax laws, (6) the impact of changes in monetary and fiscal
policies, laws, rules and regulations and (7) other risks and factors identified
in the Company’s other filings with the Securities and Exchange
Commission.  The Company undertakes no obligation to update any
forward-looking statements.
 A-2
   SELECTED
      FINANCIAL DATADollars
      in Thousands Except Per Share Amounts2007
                
                
                2006
                
                
                2005
                
                
                2004
                
                
                2003Summary
      of OperationsInterest
      income
                
                $
                61,732
                
                
                
                55,393
                
                
                
                41,913
                
                
                
                35,095
                
                
                
                33,799Interest
      expense
                
                
                27,585
                
                
                
                23,110
                
                
                
                15,429
                
                
                
                12,335
                
                
                
                12,749Net
      interest income
                
                
                34,147
                
                
                
                32,283
                
                
                
                26,484
                
                
                
                22,760
                
                
                
                21,050Provision
      for loan losses
                
                
                2,038
                
                
                
                2,513
                
                
                
                3,110
                
                
                
                3,256
                
                
                
                6,744Net
      interest income after provision for loan losses
                
                
                32,109
                
                
                
                29,770
                
                
                
                23,374
                
                
                
                19,504
                
                
                
                14,306Non-interest
      income
                
                
                8,816
                
                
                
                7,554
                
                
                
                6,668
                
                
                
                6,000
                
                
                
                5,825Non-interest
      expense
                
                
                25,993
                
                
                
                22,983
                
                
                
                20,330
                
                
                
                18,840
                
                
                
                17,072Income
      before taxes
                
                
                14,932
                
                
                
                14,341
                
                
                
                9,712
                
                
                
                6,664
                
                
                
                3,059Income
      taxes
                
                
                5,340
                
                
                
                5,170
                
                
                
                3,381
                
                
                
                2,233
                
                
                
                1,055Net
      income
                
                $
                9,592
                
                
                
                9,171
                
                
                
                6,331
                
                
                
                4,431
                
                
                
                2,004Selected
      Year-End BalancesAssets
                
                $
                907,262
                
                
                
                818,948
                
                
                
                730,280
                
                
                
                686,348
                
                
                
                674,032Available
      for sale securities
                
                
                120,968
                
                
                
                117,581
                
                
                
                115,158
                
                
                
                105,598
                
                
                
                79,460Loans,
      net
                
                
                713,174
                
                
                
                643,078
                
                
                
                559,239
                
                
                
                527,419
                
                
                
                542,404Mortgage
      loans held for sale
                
                
                -
                
                
                
                -
                
                
                
                2,248
                
                
                
                3,783
                
                
                
                587Interest-earning
      assets
                
                
                853,878
                
                
                
                780,082
                
                
                
                692,835
                
                
                
                653,111
                
                
                
                639,934Deposits
                
                
                693,639
                
                
                
                633,820
                
                
                
                582,854
                
                
                
                556,522
                
                
                
                549,802Interest-bearing
      liabilities
                
                
                718,870
                
                
                
                650,364
                
                
                
                576,681
                
                
                
                553,135
                
                
                
                550,357Shareholders'
      equity
                
                $
                70,102
                
                
                
                62,835
                
                
                
                54,353
                
                
                
                50,938
                
                
                
                48,554Shares
      outstanding*
                
                
                5,624,234
                
                
                
                5,745,951
                
                
                
                5,677,328
                
                
                
                5,689,763
                
                
                
                5,690,392Selected
      Average BalancesAssets
                
                $
                846,836
                
                
                
                772,585
                
                
                
                706,843
                
                
                
                684,385
                
                
                
                661,077Available
      for sale securities
                
                
                120,296
                
                
                
                118,137
                
                
                
                108,690
                
                
                
                93,770
                
                
                
                72,072Loans
                
                
                665,379
                
                
                
                604,427
                
                
                
                550,545
                
                
                
                547,753
                
                
                
                539,559Interest-earning
      assets
                
                
                801,094
                
                
                
                732,244
                
                
                
                668,614
                
                
                
                650,528
                
                
                
                626,197Deposits
                
                
                659,174
                
                
                
                605,407
                
                
                
                570,997
                
                
                
                558,142
                
                
                
                533,703Interest-bearing
      liabilities
                
                
                665,727
                
                
                
                613,686
                
                
                
                563,210
                
                
                
                553,880
                
                
                
                540,676Shareholders'
      equity
                
                $
                70,586
                
                
                
                62,465
                
                
                
                55,989
                
                
                
                51,978
                
                
                
                49,971Shares
      outstanding*
                
                
                5,700,860
                
                
                
                5,701,829
                
                
                
                5,692,290
                
                
                
                5,707,975
                
                
                
                5,687,642Profitability
      RatiosReturn
      on average total assets
                
                
                1.13
                %
                
                
                1.19
                %
                
                
                0.90
                %
                
                
                0.65
                %
                
                
                0.30
                %Return
      on average shareholders' equity
                
                
                13.59
                %
                
                
                14.68
                %
                
                
                11.31
                %
                
                
                8.52
                %
                
                
                4.01
                %Dividend
      payout ratio
                
                
                24.30
                %
                
                
                20.78
                %
                
                
                22.34
                %
                
                
                28.37
                %
                
                
                62.56
                %Liquidity
      and Capital Ratios (averages)Loan
      to deposit
                
                
                100.94
                %
                
                
                99.84
                %
                
                
                96.42
                %
                
                
                98.14
                %
                
                
                101.10
                %Shareholders'
      equity to total assets
                
                
                8.34
                %
                
                
                8.09
                %
                
                
                7.92
                %
                
                
                7.59
                %
                
                
                7.56
                %Per
      share of common stock*Basic
      net income
                
                $
                1.68
                
                
                
                1.61
                
                
                
                1.11
                
                
                
                0.77
                
                
                
                0.35Diluted
      net income
                
                $
                1.65
                
                
                
                1.58
                
                
                
                1.09
                
                
                
                0.77
                
                
                
                0.35Cash
      dividends
                
                $
                0.41
                
                
                
                0.33
                
                
                
                0.25
                
                
                
                0.22
                
                
                
                0.22Book
      value
                
                $
                12.46
                
                
                
                10.94
                
                
                
                9.57
                
                
                
                8.95
                
                
                
                8.53*Shares
      outstanding and per share computations have been retroactively restated to
      reflect a 10% stock dividend during first quarter 2005, a 10% stock
      dividend during second quarter 2006 and a 3-for-2 stock split during
      second quarter 2007.
   A-3
  MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
 AND
RESULTS OF OPERATIONS
 
 The
following is a discussion of our financial position and results of operations
and should be read in conjunction with the information set forth under Item 1A
Risk Factors and the Company’s consolidated financial statements and notes
thereto on pages A-27  through A-56.
 
 Introduction
 Management's discussion and analysis of
earnings and related data are presented to assist in understanding the
consolidated financial condition and results of operations of the Company, for
the years ended December 31, 2007, 2006 and 2005.  The Company is a
registered bank holding company operating under the supervision of the Federal
Reserve Board and the parent company of Peoples Bank (the “Bank”). The Bank is a
North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander,
Mecklenburg, Iredell and Union Counties, operating under the banking laws of
North Carolina and the rules and regulations of the Federal Deposit Insurance
Corporation (the “FDIC”).
 
 Overview
 Our
business consists principally of attracting deposits from the general public and
investing these funds in loans secured by commercial real estate, secured and
unsecured commercial loans and consumer loans. Our profitability depends
primarily on our net interest income, which is the difference between the income
we receive on our loan and investment securities portfolios and our cost of
funds, which consists of interest paid on deposits and borrowed funds. Net
interest income also is affected by the relative amounts of interest-earning
assets and interest-bearing liabilities. When interest-earning assets
approximate or exceed interest-bearing liabilities, any positive interest rate
spread will generate net interest income. Our profitability is also affected by
the level of other income and operating expenses. Other income consists
primarily of miscellaneous fees related to our loans and deposits, mortgage
banking income and commissions from sales of annuities and mutual funds.
Operating expenses consist of compensation and benefits, occupancy related
expenses, federal deposit and other insurance premiums, data processing,
advertising and other expenses.
 
 Our
operations are influenced significantly by local economic conditions and by
policies of financial institution regulatory authorities. The earnings on our
assets are influenced by the effects of, and changes in, trade, monetary and
fiscal policies and laws, including interest rate policies of the Board of
Governors of the Federal Reserve System (the “Federal Reserve”), inflation,
interest rates, market and monetary fluctuations.  Lending activities
are affected by the demand for commercial and other types of loans, which in
turn is affected by the interest rates at which such financing may be
offered.  Our cost of funds is influenced by interest rates on
competing investments and by rates offered on similar investments by competing
financial institutions in our market area, as well as general market interest
rates. These factors can cause fluctuations in our net interest income and other
income. In addition, local economic conditions can impact the credit risk of our
loan portfolio, in that (1) local employers may be required to eliminate
employment positions of individual borrowers, and small businesses and (2)
commercial borrowers may experience a downturn in their operating performance
and become unable to make timely payments on their loans. Management evaluates
these factors in estimating its allowance for loan losses and changes in these
economic factors could result in increases or decreases to the provision for
loan losses.
 
 Our
business emphasis has been to operate as a well-capitalized, profitable and
independent community-oriented financial institution dedicated to providing
quality customer service. We are committed to meeting the financial needs of the
communities in which we operate. We believe that we can be more effective in
serving our customers than many of our non-local competitors because of our
ability to quickly and effectively provide senior management responses to
customer needs and inquiries. Our ability to provide these services is enhanced
by the stability of our senior management team.
 
 The
Company qualified as an accelerated filer in accordance with Rule 12b-2 of the
Securities Exchange Act of 1934, effective December 31,
2006.  Therefore, the Company is subject to the requirements of
Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”).  The
Company incurred additional consulting and audit expenses in becoming compliant
with SOX 404, and will continue to incur additional audit expenses to comply
with SOX 404 going forward.  Management does not expect expenses
related to SOX 404 to have a material impact on the Company’s financial
statements.
 
 The Bank
opened a new office in Mecklenburg County, in Cornelius, North Carolina in June
2007and a new office in Iredell County, in Mooresville, North Carolina in
January 2008.  Also in January 2008, the Bank opened a new Banco de la
Gente office in Wake County, in Raleigh, North Carolina in a continuing effort
to serve the Latino community.  While there are no additional
traditional offices planned in 2008, management will consider opening at least
one new traditional office in Mecklenburg or Iredell counties in the next two to
three years and additional Banco de la Gente offices in other metropolitan areas
in North Carolina.
   A-4
  Summary
of Significant Accounting Policies
 The
consolidated financial statements include the financial statements of Peoples
Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank,
along with its wholly owned subsidiaries, Peoples Investment Services, Inc. and
Real Estate Advisory Services, Inc (collectively called the
“Company”).  All significant intercompany balances and transactions
have been eliminated in consolidation.
 
 The
Company’s accounting policies are fundamental to understanding management’s
discussion and analysis of results of operations and financial
condition.  Many of the Company’s accounting policies require
significant judgment regarding valuation of assets and liabilities and/or
significant interpretation of specific accounting guidance.  The
following is a summary of some of the more subjective and complex accounting
policies of the Company.  A more complete description of the Company’s
significant accounting policies can be found in Note 1 of the Notes to
Consolidated Financial Statements in the Company’s 2007 Annual Report to
Shareholders which is Appendix A to the Proxy Statement for the May 1, 2008
Annual Meeting of Shareholders.
 
 Many of
the Company’s assets and liabilities are recorded using various techniques that
require significant judgment as to recoverability.  The collectability
of loans is reflected through the Company’s estimate of the allowance for loan
losses.  The Company performs periodic and systematic detailed reviews
of its lending portfolio to assess overall collectability.  In
addition, certain assets and liabilities are reflected at their estimated fair
value in the consolidated financial statements.  Such amounts are
based on either quoted market prices or estimated values derived from dealer
quotes used by the Company, market comparisons or internally generated modeling
techniques.  The Company’s internal models generally involve present
value of cash flow techniques.  The various techniques are discussed
in greater detail elsewhere in management’s discussion and analysis and the
Notes to Consolidated Financial Statements.
 
 There are
other complex accounting standards that require the Company to employ
significant judgment in interpreting and applying certain of the principles
prescribed by those standards.  These judgments include, but are not
limited to, the determination of whether a financial instrument or other
contract meets the definition of a derivative in accordance with Statement of
Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative
Instruments and Hedging Activities” (SFAS 133).  For a more complete
discussion of policies, see the notes to consolidated financial
statements.
 
 In June 2006, FASB issued Financial
Interpretation No. 48 (“FIN 48”) “Accounting for Uncertainty in Income Taxes –
an interpretation of SFAS No. 109.” FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in the financial statements and
prescribes a recognition threshold and measurement attribute for a tax position
taken or expected to be taken in a tax return.  This interpretation
also provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition.  This
interpretation was effective for the Company beginning in January of
2007.  The Company assessed the impact of FIN 48 and determined that
there are no significant positions taken in the preparation of its tax return,
and therefore FIN 48 did not have a material impact on its financial position or
its results of operations.
 
 In September 2006, the FASB ratified
the conclusions reached by the Emerging Issues Task Force (EITF) on EITF 06-4,
“Accounting for Deferred Compensation and Postretirement Benefit Aspects of
Endorsement Split-Dollar Life Insurance Arrangements.”  This issue
will require companies to recognize an obligation for either the present value
of the entire promised death benefit or the annual “cost of insurance” required
to keep the policy in force during the post-retirement years.  EITF
06-4 is effective for the Company as of January 1, 2008.  This
standard is not expected to have a material effect on the Company's financial
position, results of operations or disclosures.
 
 In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS
157).  SFAS 157 defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles (GAAP), and expands
disclosures about fair value measurements.  SFAS 157 applies under other
accounting pronouncements that require or permit fair value measurements.
 SFAS 157 is effective for the Company as of January 1,
2008.  This standard is not expected to have a material effect on the
Company's financial position or results of operations.
 
 In September 2006, the FASB issued SFAS
No. 158, “Employers’ Accounting for Defined Benefit Pension and Other
Postretirement Plans” (SFAS 158) – an amendment of FASB Statements No. 87, 88,
106 and 132(R).  SFAS 158 requires employers to recognize the overfunded or
underfunded status of a defined benefit postretirement plan as an asset or
liability in its statement of financial position and to recognize changes in
that funded status in the year in which the changes occur through comprehensive
income.  SFAS 158 requires an employer to measure the funded status of a
plan as of the date of its year-end statement of financial position, with
limited exceptions and includes expanded disclosures.   SFAS 158
was effective for the Company as of January 1, 2007.  This standard
did not have a material effect on the Company's financial position, results of
operations or disclosures.
   A-5
  In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (SFAS 159), which permits entities
to choose to measure financial instruments and certain other instruments at fair
value.  SFAS 159 is effective for the Company as of January 1,
2008.  The Company does not expect to choose this option for any asset
or liability and therefore does not expect SFAS 159 to have a material effect on
the Company's financial position, results of operations or
disclosures.
 
 Management of the Company has made a
number of estimates and assumptions relating to reporting of assets and
liabilities and the disclosure of contingent assets and liabilities to prepare
the accompanying consolidated financial statements in conformity with
GAAP.  Actual results could differ from those estimates.
 
 The
remainder of management’s discussion and analysis of the Company’s results of
operations and financial position should be read in conjunction with the
consolidated financial statements and related notes presented on pages A-27
through A-56.
 
 Results
of Operations
 Summary.The
Company reported earnings of $9.6 million in 2007, or $1.68 basic net earnings
per share and $1.65 diluted net earnings per share, a 5% increase as compared to
$9.2 million, or $1.61 basic net earnings per share and $1.58 diluted net
earnings per share, for 2006. The Company’s increase in net earnings for 2007 is
primarily attributable to growth in interest-earning assets, which contributed
to increases in net interest income and an increase in non-interest
income.  In addition, the Company had a decrease in the provision for
loan losses for the year ended December 31, 2007 as compared to the same period
one year ago.  The increases in net interest income and non-interest
income and the decrease in the provision for loan losses were partially offset
by an increase in non-interest expense.
 
 Net
earnings for 2006 represented an increase of 45% as compared to 2005 net
earnings of $6.3 million or $1.11 basic net earnings per share and $1.09 diluted
net earnings per share.  The increase in 2006 net earnings was
primarily attributable to an increase in net interest income, an increase in
non-interest income and a decrease in the provision for loan losses, which were
partially offset by an increase in non-interest expense.
 
 The
return on average assets in 2007 was 1.13%, compared to 1.19% in 2006 and 0.90%
in 2005. The return on average shareholders’ equity was 13.59% in 2007 compared
to 14.68% in 2006 and 11.31% in 2005.
 
 Net Interest
Income.Net interest income, the major component of the
Company's net income, is the amount by which interest and fees generated by
interest-earning assets exceed the total cost of funds used to carry
them.  Net interest income is affected by changes in the volume and
mix of interest-earning assets and interest-bearing liabilities, as well as
changes in the yields earned and rates paid.  Net interest margin is
calculated by dividing tax-equivalent net interest income by average
interest-earning assets, and represents the Company’s net yield on its
interest-earning assets.
 
 Net
interest income was $34.1 million for 2007, or 6% over net interest income of
$32.3 million in 2006.  The increase was attributable to an increase
in interest income due to an increase in the average outstanding balance of
loans.  Net interest income increased 22% in 2006 from $26.5 million
in 2005.
 
 Table 1
sets forth for each category of interest-earning assets and interest-bearing
liabilities, the average amounts outstanding, the interest incurred on such
amounts and the average rate earned or incurred for the years ended December 31,
2007, 2006 and 2005. The table also sets forth the average rate earned on total
interest-earning assets, the average rate paid on total interest-bearing
liabilities, and the net yield on average total interest-earning assets for the
same periods.  Yield information does not give effect to changes in
fair value that are reflected as a component of shareholders’
equity.  Yields and interest income on tax-exempt investments have
been adjusted to tax equivalent basis using an effective tax rate 38.55% for
securities that are both federal and state tax exempt and an effective tax rate
of 6.90% for state tax exempt securities.  Non-accrual loans and the
interest income that was recorded on these loans, if any, are included in the
yield calculations for loans in all periods reported.
   A-6
   Table
      1- Average Balance TableDecember
      31, 2007
                  
                  
                  December
      31, 2006
                  
                  
                  December
      31, 2005(Dollars
      in Thousands)
                  
                  Average
                    Balance
                  Interest
                  Yield
      /
                    Rate
                  Average
                    Balance
                  Interest
                  Yield
      /
                    Rate
                  Average
                    Balance
                  Interest
                  Yield
      /
                    RateInterest-earning
      assets:Loans
                  
                  $
                  665,379
                  
                  
                  55,109
                  
                  
                  8.28
                  %
                  
                  
                  604,427
                  
                  
                  49,665
                  
                  
                  8.22
                  %
                  
                  
                  550,545
                  
                  
                  37,234
                  
                  
                  6.76
                  %Interest
      rate swap agreements
                  
                  
                  -
                  
                  
                  (406
                  )
                  
                  -0.06
                  %
                  
                  
                  -
                  
                  
                  (698
                  )
                  
                  -0.12
                  %
                  
                  
                  -
                  
                  
                  (575
                  )
                  
                  -0.14
                  %Loan
      fees
                  
                  
                  -
                  
                  
                  698
                  
                  
                  0.10
                  %
                  
                  
                  -
                  
                  
                  701
                  
                  
                  0.12
                  %
                  
                  
                  -
                  
                  
                  464
                  
                  
                  0.80
                  %Total
      loans
                  
                  
                  665,379
                  
                  
                  55,401
                  
                  
                  8.33
                  %
                  
                  
                  604,427
                  
                  
                  49,668
                  
                  
                  8.22
                  %
                  
                  
                  550,545
                  
                  
                  37,123
                  
                  
                  6.74
                  %Investments
      - taxable
                  
                  
                  20,305
                  
                  
                  868
                  
                  
                  4.27
                  %
                  
                  
                  29,784
                  
                  
                  1,306
                  
                  
                  4.38
                  %
                  
                  
                  37,487
                  
                  
                  1,595
                  
                  
                  4.25
                  %Investments
      - nontaxable*
                  
                  
                  99,991
                  
                  
                  5,470
                  
                  
                  5.47
                  %
                  
                  
                  88,353
                  
                  
                  4,642
                  
                  
                  5.25
                  %
                  
                  
                  71,202
                  
                  
                  3,472
                  
                  
                  4.88
                  %Federal
      funds sold
                  
                  
                  7,378
                  
                  
                  383
                  
                  
                  5.19
                  %
                  
                  
                  1,766
                  
                  
                  85
                  
                  
                  4.81
                  %
                  
                  
                  2,272
                  
                  
                  73
                  
                  
                  3.21
                  %Other
                  
                  
                  8,041
                  
                  
                  444
                  
                  
                  5.52
                  %
                  
                  
                  7,914
                  
                  
                  424
                  
                  
                  5.36
                  %
                  
                  
                  7,108
                  
                  
                  269
                  
                  
                  3.61
                  %Total
      interest-earning assets
                  
                  
                  801,094
                  
                  
                  62,566
                  
                  
                  7.81
                  %
                  
                  
                  732,244
                  
                  
                  56,125
                  
                  
                  7.66
                  %
                  
                  
                  668,614
                  
                  
                  42,532
                  
                  
                  6.36
                  %Cash
      and due from banks
                  
                  
                  20,081
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  17,022
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  15,149Other
      assets
                  
                  
                  34,287
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  31,218
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  30,891Allowance
      for loan losses
                  
                  
                  (8,626
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  (7,899
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  (7,811
                  )Total
      assets
                  
                  $
                  846,836
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  772,585
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  706,843Interest-bearing
      liabilities:NOW
      accounts
                  
                  $
                  79,550
                  
                  
                  1,127
                  
                  
                  1.42
                  %
                  
                  
                  87,329
                  
                  
                  1,214
                  
                  
                  1.39
                  %
                  
                  
                  110,852
                  
                  
                  1,468
                  
                  
                  1.32
                  %Regular
      savings accounts
                  
                  
                  18,685
                  
                  
                  54
                  
                  
                  0.29
                  %
                  
                  
                  19,768
                  
                  
                  57
                  
                  
                  0.29
                  %
                  
                  
                  21,205
                  
                  
                  65
                  
                  
                  0.31
                  %Money
      market accounts
                  
                  
                  87,916
                  
                  
                  2,918
                  
                  
                  3.32
                  %
                  
                  
                  66,035
                  
                  
                  1,789
                  
                  
                  2.71
                  %
                  
                  
                  56,858
                  
                  
                  1,112
                  
                  
                  1.96
                  %Time
      deposits
                  
                  
                  361,859
                  
                  
                  17,430
                  
                  
                  4.82
                  %
                  
                  
                  335,092
                  
                  
                  14,189
                  
                  
                  4.23
                  %
                  
                  
                  292,807
                  
                  
                  8,923
                  
                  
                  3.05
                  %FHLB
      borrowings
                  
                  
                  80,058
                  
                  
                  3,759
                  
                  
                  4.70
                  %
                  
                  
                  74,082
                  
                  
                  3,588
                  
                  
                  4.84
                  %
                  
                  
                  65,934
                  
                  
                  2,889
                  
                  
                  4.38
                  %Demand
      notes payable to U.S. Treasury
                  
                  
                  814
                  
                  
                  39
                  
                  
                  4.79
                  %
                  
                  
                  722
                  
                  
                  34
                  
                  
                  4.71
                  %
                  
                  
                  702
                  
                  
                  21
                  
                  
                  3.02
                  %Trust
      preferred securities
                  
                  
                  20,619
                  
                  
                  1,476
                  
                  
                  7.16
                  %
                  
                  
                  24,878
                  
                  
                  1,963
                  
                  
                  7.89
                  %
                  
                  
                  14,433
                  
                  
                  938
                  
                  
                  6.50
                  %Other
                  
                  
                  16,226
                  
                  
                  782
                  
                  
                  4.82
                  %
                  
                  
                  5,780
                  
                  
                  276
                  
                  
                  4.78
                  %
                  
                  
                  419
                  
                  
                  13
                  
                  
                  3.00
                  %Total
      interest-bearing liabilities
                  
                  
                  665,727
                  
                  
                  27,585
                  
                  
                  4.14
                  %
                  
                  
                  613,686
                  
                  
                  23,110
                  
                  
                  3.77
                  %
                  
                  
                  563,210
                  
                  
                  15,429
                  
                  
                  2.74
                  %Demand
      deposits
                  
                  
                  111,164
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  97,183
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  89,275Other
      liabilities
                  
                  
                  3,022
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  3,044
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,275Shareholders'
      equity
                  
                  
                  70,586
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  62,465
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  55,989Total
      liabilities and shareholder's equity
                  
                  $
                  850,499
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  776,378
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  709,749Net
      interest spread
                  
                  
                  
                  
                  $
                  34,981
                  
                  
                  3.67
                  %
                  
                  
                  
                  
                  
                  33,015
                  
                  
                  3.89
                  %
                  
                  
                  
                  
                  
                  27,103
                  
                  
                  3.62
                  %Net
      yield on interest-earning assets
                  
                  
                  
                  
                  
                  
                  
                  
                  4.37
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  4.51
                  %
                  
                  
                  
                  
                  
                  
                  
                  
                  4.05
                  %Taxable
      equivalent adjustmentInvestment
      securities
                  
                  
                  
                  
                  $
                  834
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  731
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  619Net
      interest income
                  
                  
                  
                  
                  $
                  34,147
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  32,284
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  26,484*Includes
      U.S. government agency securities that are non-taxable for state income
      tax purposes of $74.9 million in 2007, $65.9 million in 2006 and $50.7
      million in 2005. An effective tax rate of 6.90% was used to calculate
      the tax equivalent yield on these securities.
  Changes in interest income and interest
expense can result from variances in both volume and rates.  Table 2
describes the impact on the Company’s tax equivalent net interest income
resulting from changes in average balances and average rates for the periods
indicated.  The changes in interest due to both volume and rate have
been allocated to volume and rate changes in proportion to the relationship of
the absolute dollar amounts of the changes in each.
   A-7
  
  Table
      2 - Rate/Volume Analysis-Tax Equivalent BasisDecember
      31, 2007
                    December
      31, 2006(Dollars
      in Thousands)
                    Changes
      in
                      average
                      volume
                    Changes
      in
                      average
                      rates
                    Total
                      increase
                      (decrease)
                    Changes
      in
                      average
                      volume
                    Changes
      in
                      average
                      rates
                    Total
                      increase
                      (decrease)Interest
      income:
  Loans:
      net of unearned income
                  
                  $
                  5,042
                  
                  
                  
                  691
                  
                  
                  
                  5,733
                  
                  
                  $
                  4,030
                  
                  
                  
                  8,515
                  
                  
                  
                  12,545Investments
      - taxable
                  
                  
                  (411
                  )
                  
                  
                  (27
                  )
                  
                  
                  (438
                  )
                  
                  
                  (333
                  )
                  
                  
                  44
                  
                  
                  
                  (289
                  )Investments
      - nontaxable
                  
                  
                  624
                  
                  
                  
                  204
                  
                  
                  
                  828
                  
                  
                  
                  869
                  
                  
                  
                  301
                  
                  
                  
                  1,170Federal
      funds sold
                  
                  
                  281
                  
                  
                  
                  17
                  
                  
                  
                  298
                  
                  
                  
                  (20
                  )
                  
                  
                  32
                  
                  
                  
                  12Other
                  
                  
                  7
                  
                  
                  
                  13
                  
                  
                  
                  20
                  
                  
                  
                  37
                  
                  
                  
                  118
                  
                  
                  
                  155Total
      interest income
                  
                  
                  5,543
                  
                  
                  
                  898
                  
                  
                  
                  6,441
                  
                  
                  
                  4,583
                  
                  
                  
                  9,010
                  
                  
                  
                  13,593Interest
      expense:NOW
      accounts
                  
                  
                  (109
                  )
                  
                  
                  22
                  
                  
                  
                  (87
                  )
                  
                  
                  (320
                  )
                  
                  
                  66
                  
                  
                  
                  (254
                  )Regular
      savings accounts
                  
                  
                  (3
                  )
                  
                  
                  0
                  
                  
                  
                  (3
                  )
                  
                  
                  (4
                  )
                  
                  
                  (4
                  )
                  
                  
                  (8
                  )Money
      market accounts
                  
                  
                  660
                  
                  
                  
                  469
                  
                  
                  
                  1,129
                  
                  
                  
                  214
                  
                  
                  
                  463
                  
                  
                  
                  677Time
      deposits
                  
                  
                  1,211
                  
                  
                  
                  2,030
                  
                  
                  
                  3,241
                  
                  
                  
                  1,540
                  
                  
                  
                  3,726
                  
                  
                  
                  5,266FHLB
      borrowings
                  
                  
                  285
                  
                  
                  
                  (114
                  )
                  
                  
                  171
                  
                  
                  
                  375
                  
                  
                  
                  324
                  
                  
                  
                  699Demand
      notes payable toU.S.
      Treasury
                  
                  
                  4
                  
                  
                  
                  1
                  
                  
                  
                  5
                  
                  
                  
                  1
                  
                  
                  
                  12
                  
                  
                  
                  13Trust
      Preferred Securities
                  
                  
                  (320
                  )
                  
                  
                  (167
                  )
                  
                  
                  (487
                  )
                  
                  
                  752
                  
                  
                  
                  273
                  
                  
                  
                  1,025Other
                  
                  
                  501
                  
                  
                  
                  5
                  
                  
                  
                  506
                  
                  
                  
                  208
                  
                  
                  
                  55
                  
                  
                  
                  263Total
      interest expense
                  
                  
                  2,229
                  
                  
                  
                  2,246
                  
                  
                  
                  4,475
                  
                  
                  
                  2,766
                  
                  
                  
                  4,915
                  
                  
                  
                  7,681Net
      interest income
                  
                  $
                  3,314
                  
                  
                  
                  (1,348
                  )
                  
                  
                  1,966
                  
                  
                  $
                  1,817
                  
                  
                  
                  4,095
                  
                  
                  
                  5,912
  Net
interest income on a tax equivalent basis totaled $35.0 million in 2007,
increasing 6% or $2.0 million from 2006.  The increase was
attributable to an increase interest income due to increases in the average
outstanding balance of loans.  The interest rate spread, which
represents the rate earned on interest-earning assets less the rate paid on
interest-bearing liabilities, was 3.67% in 2007, a decrease from the 2006 net
interest spread of 3.89%.  The net yield on interest-earning assets in
2007 decreased to 4.37% from the 2006 net interest margin of 4.51%.
 
 Tax
equivalent interest income increased $6.4 million or 11% in 2007 primarily due
to an increase in the Bank’s average outstanding balance of loans combined with
an increase in the yield of interest-earning assets.  The yield on
interest-earning assets increased to 7.81% in 2007 from 7.66% in 2006 as a
result of a higher Prime Rate in effect for the first six months of 2007 being
earned on higher loan balances plus an increase in the balance outstanding of
higher yielding adjustable rate mortgage loans.  Average
interest-earning assets increased $68.9 million primarily as the result of a
$61.0 million increase in average loans. Average investment securities in 2007
increased 2% to $120.3 million when compared to 2006.  All other
interest-earning assets including federal funds sold were $15.4 million in 2007
and $9.7 million in 2006.
 
 Interest
expense increased $4.5 million or 19% in 2007 due to an increase in the average
rate paid on interest-bearing liabilities combined with a $52.0 million increase
in volume of interest-bearing liabilities.   The cost of funds
increased to 4.14% in 2007 from 3.77% in 2006.  This increase in the
cost of funds was primarily attributable to increases in the average rate paid
on interest-bearing checking and savings accounts and certificates of
deposit.  The $52.0 million growth in average interest-bearing
liabilities was primarily attributable to an increase in time deposits of $26.8
million to $361.9 million in 2007 from $335.1 million in 2006 and an increase in
interest-bearing checking and savings accounts of $13.1 million to $186.2
million in 2007 from $173.1 million in 2006.
 
 In 2006
net interest income on a tax equivalent basis increased $5.9 million or 22% to
$33.0 million in 2006 from $27.1 million in 2005.  The interest rate
spread was 3.89% in 2006, an increase from the 2005 net interest spread of
3.62%.  The net yield on interest-earning assets in 2006 increased to
4.51% from the 2005 net interest margin of 4.05%.
   A-8
  Provision for Loan
Losses.Provisions for loan losses are charged to income in
order to bring the total allowance for loan losses to a level deemed appropriate
by management of the Company based on factors such as management’s judgment as
to losses within the Company’s loan portfolio, including the valuation of
impaired loans in accordance with SFAS No. 114 and No. 118, loan growth, net
charge-offs, changes in the composition of the loan portfolio, delinquencies and
management’s assessment of the quality of the loan portfolio and general
economic climate.
 
 The
provision for loan losses was $2.0 million, $2.5 million, and $3.1 million for
the years ended December 31, 2007, 2006 and 2005, respectively.  The
decrease in the provision for loan losses for 2007 is primarily attributable to
a decrease in net charge-offs of $396,000 for the year ended December 31, 2007
when compared to the year ended December 31, 2006, offset by the effect of loan
growth.  Please see the section below entitled “Allowance for Loan
Losses” for a more complete discussion of the Bank’s policy for addressing
potential loan losses.
 
 Non-Interest
Income.  Non-interest income for 2007 totaled $8.8 million, an
increase of $1.2 million or 17% from non-interest income of $7.6 million for
2006.  The increases in non-interest income for 2007 are primarily due
to an increase in service charges and fees resulting from growth in deposit base
coupled with normal pricing changes, an increase in insurance and brokerage
commissions, an increase in mortgage banking income and an increase in
miscellaneous income.  Non-interest income for 2006 increased $886,000
or 13% from non-interest income of $6.7 million for 2005.  The
increase in non-interest income for 2006 is primarily due to an increase in
service charges and fees resulting from activity in new branches and an increase
in miscellaneous income.
 
 Service
charges on deposit accounts totaled $4.3 million during 2007, an increase of
$349,000, or 9% over 2006.  Service charge income increased $150,000,
or 4% in 2006 compared to 2005.  These increases are primarily
attributable to growth in the deposit base coupled with normal pricing changes,
which resulted in an increase in account maintenance fees.
 
 Other
service charges and fees increased 26% to $1.9 million for the year ended
December 31, 2007 as compared to $1.5 million for the same period one year
ago.  This increase is primarily attributable to fee income from new
branches.
 
 The
Company reported net losses on sale and writedown of securities of $562,000,
$592,000 and $730,000 in 2007, 2006 and 2005, respectively.  The
Company periodically evaluates its investments for any impairment which would be
deemed other than temporary.   As part of its evaluation in 2007, the
Company determined that the fair value of two investments was less than the
original cost of the investments and that the decline in fair value was not
temporary in nature.  As a result, the Company wrote down its original
investment by $430,000.  The remaining value of the investments at December
31, 2007 is $348,000.  Losses on the sale of securities in 2006 and
2005 were primarily due to restructuring of the Bank’s investment portfolio to
reduce exposure to a decrease in interest rates.
 
 Mortgage
banking income increased to $118,000 in 2007 from $108,000 in 2006 primarily due
to an increase in brokered loan activity.  During 2006 mortgage
banking income decreased $180,000 from the $469,000 reported in
2005.  The decrease in mortgage banking income for 2006 was primarily
attributable to the $185,000 write-down of the Bank’s mortgage servicing asset
due to Management’s assessment that there was minimal fair value in the mortgage
servicing rights due to the small remaining balance in the loans serviced for
others.
 
 Net
losses on repossessed assets were $118,000 for 2007 compared to net losses on
repossessed assets of $108,000 for 2006.  During 2005 a net loss on
repossessed assets of $38,000 was recognized.  The increase in net
losses on repossessed assets during 2006 was primarily attributable to a
$110,000 write-down on foreclosed property partially offset by a gain on the
disposition of assets.  Management determined that the market value of
these assets had decreased significantly and charges were appropriate during
fourth quarter 2006.
 
 Miscellaneous
income for 2007 totaled $2.2 million, an increase of 4% from $2.1 million for
2006.  During 2006, miscellaneous income increased 27% primarily due
to an increase in debit card fee income.  The 2006 increase in
miscellaneous income was primarily attributable to an increase in debit card fee
income primarily associated with increased card usage due to an increased number
of demand accounts and income amounting to $118,000 distributed by a SBIC
investment owned by the Bank.
 
 
 A-9
  Table 3
presents a summary of non-interest income for the years ended December 31, 2007,
2006 and 2005.
 
  Table
      3 - Non-Interest Income(Dollars
      in Thousands)
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005Service
      charges
                  
                  $
                  4,279
                  
                  
                  
                  3,930
                  
                  
                  
                  3,780Other
      service charges and fees
                  
                  
                  1,938
                  
                  
                  
                  1,540
                  
                  
                  
                  1,142Gain
      (loss) on sale of securities
                  
                  
                  (562
                  )
                  
                  
                  (592
                  )
                  
                  
                  (730
                  )Mortgage
      banking income
                  
                  
                  560
                  
                  
                  
                  289
                  
                  
                  
                  469Insurance
      and brokerage commissions
                  
                  
                  521
                  
                  
                  
                  389
                  
                  
                  
                  387Loss
      on foreclosed and repossessed assets
                  
                  
                  (118
                  )
                  
                  
                  (108
                  )
                  
                  
                  (38
                  )Miscellaneous
                  
                  
                  2,198
                  
                  
                  
                  2,106
                  
                  
                  
                  1,658Total
      non-interest income
                  
                  $
                  8,816
                  
                  
                  
                  7,554
                  
                  
                  
                  6,668
  Non-Interest
Expense.  Total non-interest expense amounted to $26.0 million
for 2007, an increase of 13% from 2006.  Non-interest expense for 2006
increased 13% to $23.0 million from non-interest expense of $20.3 million for
2005.
 
 Salary
and employee benefit expense was $13.9 million in 2007, compared to $11.8
million during 2006, an increase of $2.1 million or 18%, following a $921,000 or
8% increase in salary and employee benefit expense in 2006 over
2005.  The increase in salary and employee benefits in 2007 and 2006
is primarily due to normal salary increases and expense associated with
additional staff for new branches.
 
 The
Company recorded occupancy expenses of $4.8 million in 2007, compared to $4.2
million during 2006, an increase of $571,000 or 14%, following an increase of
$231,000 or 6% in occupancy expenses in 2006 over 2005.  The increases
in 2007 and 2006 are primarily due to an increase in furniture and equipment
expense and lease expense associated with new branches.  During 2003,
the Company sold a branch location with net book value of approximately $2.4
million and was leasing the facility from the buyer.  As a result of
the sale, the Company deferred a gain of approximately $633,000 and was
recognizing the gain over the lease term.  For the period ended
December 31, 2007 the Company recognized approximately $10,000 of the deferred
gain and for the periods ended December 31, 2006 and 2005, respectively,
approximately $21,000 and $22,000 of the deferred gain was
recognized.  In 2007, the Company repurchased the branch location for
$3.0 million, which was $588,000 greater than the original cost of the
building.  The remaining deferred gain was netted against the purchase
price resulting in a net cost of $2.5 million. This cost is being depreciated
over 39 years.
 
 The total
of all other operating expenses increased $336,000 or 5% during
2007.  The increase in other expense for 2007 is primarily
attributable to an increase of $215,000 in advertising expense.  Other
operating expense increased $1.5 million or 27% in 2006 over
2005.  The increase in other expense for 2006 is primarily
attributable to increases of $342,000 in consulting expenses due to
Sarbanes-Oxley 404 compliance related expenses and disaster recovery planning
expenses, and increase of $444,000 in amortization of the issuance costs of the
trust preferred securities issued in 2001 that were called on December 31, 2006,
an increase in $206,000 in debit card expense and an increase of $117,000 in
advertising expense.
 
  A-10
  Table 4
presents a summary of non-interest expense for the years ended December 31,
2007, 2006 and 2005.
  Table
      4 - Non-Interest Expense(Dollars
      in Thousands)
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005Salaries
      and wages
                  
                  $
                  10,276
                  
                  
                  
                  9,368
                  
                  
                  
                  7,162Employee
      benefits
                  
                  
                  3,612
                  
                  
                  
                  2,417
                  
                  
                  
                  3,702Total
      personnel expense
                  
                  
                  13,888
                  
                  
                  
                  11,785
                  
                  
                  
                  10,864Occupancy
      expense
                  
                  
                  4,751
                  
                  
                  
                  4,180
                  
                  
                  
                  3,949Office
      supplies
                  
                  
                  554
                  
                  
                  
                  436
                  
                  
                  
                  314FDIC
      deposit insurance
                  
                  
                  140
                  
                  
                  
                  75
                  
                  
                  
                  76Professional
      services
                  
                  
                  400
                  
                  
                  
                  239
                  
                  
                  
                  389Postage
                  
                  
                  320
                  
                  
                  
                  307
                  
                  
                  
                  264Telephone
                  
                  
                  405
                  
                  
                  
                  338
                  
                  
                  
                  403Director
      fees and expense
                  
                  
                  499
                  
                  
                  
                  423
                  
                  
                  
                  334Advertising
                  
                  
                  988
                  
                  
                  
                  772
                  
                  
                  
                  656Consulting
      fees
                  
                  
                  460
                  
                  
                  
                  575
                  
                  
                  
                  233Taxes
      and licenses
                  
                  
                  272
                  
                  
                  
                  293
                  
                  
                  
                  218Other
      operating expense
                  
                  
                  3,316
                  
                  
                  
                  3,560
                  
                  
                  
                  2,630Total
      non-interest expense
                  
                  $
                  25,993
                  
                  
                  
                  22,983
                  
                  
                  
                  20,330
  Income
Taxes.Total income tax expense was $5.3 million in 2007
compared with $5.2 million in 2006 and $3.4 million in
2005.   The primary reason for the increase in taxes for 2007 and
2006 as compared to 2005 was the increase in pretax income, which reduced the
impact of non-taxable income. The Company’s effective tax rates were 35.76%,
36.05% and 34.81% in 2007, 2006 and 2005, respectively.
 
 Liquidity.The objectives of
the Company’s liquidity policy are to provide for the availability of adequate
funds to meet the needs of loan demand, deposit withdrawals, maturing
liabilities and to satisfy regulatory requirements.  Both deposit and
loan customer cash needs can fluctuate significantly depending upon business
cycles, economic conditions and yields and returns available from alternative
investment opportunities.  In addition, the Company’s liquidity is
affected by off-balance sheet commitments to lend in the form of unfunded
commitments to extend credit and standby letters of credit.  As of
December 31, 2007 such unfunded commitments to extend credit were $190.7
million, while commitments in the form of standby letters of credit totaled $3.9
million.
 
 The Company uses several sources to
meet its liquidity requirements.  The primary source is core deposits,
which includes demand deposits, savings accounts and certificates of deposits of
denominations less than $100,000.  The Company considers these to be a
stable portion of the Company’s liability mix and the result of on-going
consumer and commercial banking relationships.  As of December 31,
2007, the Company’s core deposits totaled $490.1 million, or 71% of total
deposits.
 
 The other sources of funding for the
Company are through large denomination certificates of deposit, including
brokered deposits, federal funds purchased and FHLB advances.  The
Bank is also able to borrow from the Federal Reserve on a short-term
basis.
 
 At
December 31, 2007, the Bank had a significant amount of deposits in amounts
greater than $100,000, including brokered deposits of $53.9 million, which
mature over the next two years.  The balance and cost of these
deposits are more susceptible to changes in the interest rate environment than
other deposits.   For additional information, please see the
section below entitled “Deposits.”
 
 The Bank
has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with
an outstanding balance of $87.5 million at December 31, 2007.  The
remaining availability at FHLB was $63.9 million at December 31,
2007.  The Bank also had the ability to borrow up to $35.0 million for
the purchase of overnight federal funds from three correspondent financial
institutions as of December 31, 2007.
 
 The
liquidity ratio for the Bank, which is defined as net cash, interest-bearing
deposits with banks, federal funds sold, certain investment securities and
certain FHLB advances available under the line of credit, as a percentage of net
deposits (adjusted for deposit runoff projections) and short-term liabilities
was 28.04% at December 31, 2007, 31.15% at December 31, 2006 and 36.81% at
December 31, 2006.  The minimum required liquidity ratio as defined in
the Bank’s Asset/Liability and Interest Rate Risk Management Policy is
20%.
   A-11
  As
disclosed in the Company’s Consolidated Statements of Cash Flows included
elsewhere herein, net cash provided by operating activities was approximately
$14.5 million during 2007.  Net cash used in investing activities of
$80.6 million consisted primarily of a net increase in loans of $72.8
million.  Net cash provided by financing activities amounted to $74.4
million, primarily from $59.8 million net increase in deposits.
 
 Asset Liability and Interest Rate
Risk Management.The objective of the Company’s Asset
Liability and Interest Rate Risk strategies is to identify and manage the
sensitivity of net interest income to changing interest rates and to minimize
the interest rate risk between interest-earning assets and interest-bearing
liabilities at various maturities.  This is done in conjunction with
the need to maintain adequate liquidity and the overall goal of maximizing net
interest income. Table 5 presents an interest rate sensitivity analysis for the
interest-earning assets and interest-bearing liabilities for the year ended
December 31, 2007.
 
  Table
      5 - Interest Sensitivity Analysis(Dollars
      in Thousands)
                  
                  Immediate
                  
                  
                  1-3
                    months
                  
                  
                  4-12
                    months
                  
                  
                  Total
                    Within
      One
                    Year
                  
                  
                  Over
      One
                    Year
      & Non-sensitive
                  
                  
                  TotalInterest-earning
      assets:Loans
                  
                  $
                  481,495
                  
                  
                  
                  4,941
                  
                  
                  
                  13,170
                  
                  
                  
                  499,606
                  
                  
                  
                  222,671
                  
                  
                  
                  722,277Mortgage
      loans available for sale
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Investment
      securities
                  
                  
                  -
                  
                  
                  
                  8,881
                  
                  
                  
                  -
                  
                  
                  
                  8,881
                  
                  
                  
                  112,087
                  
                  
                  
                  120,968Federal
      funds sold
                  
                  
                  2,152
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,152
                  
                  
                  
                  -
                  
                  
                  
                  2,152Interest-bearing
      deposit accounts
                  
                  
                  1,539
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,539
                  
                  
                  
                  -
                  
                  
                  
                  1,539Other
      interest-earning assets
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  6,942
                  
                  
                  
                  6,942Total
      interest-earning assets
                  
                  
                  485,186
                  
                  
                  
                  13,822
                  
                  
                  
                  13,170
                  
                  
                  
                  512,178
                  
                  
                  
                  341,700
                  
                  
                  
                  853,878Interest-bearing
      liabilities:NOW,
      savings, and money market deposits
                  
                  
                  196,960
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  196,960
                  
                  
                  
                  -
                  
                  
                  
                  196,960Time
      deposits
                  
                  
                  69,515
                  
                  
                  
                  101,204
                  
                  
                  
                  192,517
                  
                  
                  
                  363,236
                  
                  
                  
                  21,372
                  
                  
                  
                  384,608Other
      short term borrowings
                  
                  
                  1,600
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,600
                  
                  
                  
                  -
                  
                  
                  
                  1,600FHLB
      borrowings
                  
                  
                  10,500
                  
                  
                  
                  5,000
                  
                  
                  
                  -
                  
                  
                  
                  15,500
                  
                  
                  
                  72,000
                  
                  
                  
                  87,500Securities
      sold under agreement to repurchase
                  
                  
                  27,583
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  27,583
                  
                  
                  
                  -
                  
                  
                  
                  27,583Trust
      preferred securities
                  
                  
                  -
                  
                  
                  
                  20,619
                  
                  
                  
                  -
                  
                  
                  
                  20,619
                  
                  
                  
                  -
                  
                  
                  
                  20,619Total
      interest-bearing liabilities
                  
                  
                  306,158
                  
                  
                  
                  126,823
                  
                  
                  
                  192,517
                  
                  
                  
                  625,498
                  
                  
                  
                  93,372
                  
                  
                  
                  718,870Interest-sensitive
      gap
                  
                  $
                  179,028
                  
                  
                  
                  (113,001
                  )
                  
                  
                  (179,347
                  )
                  
                  
                  (113,320
                  )
                  
                  
                  248,328
                  
                  
                  
                  135,008Cumulative
      interest-sensitive gap
                  
                  $
                  179,028
                  
                  
                  
                  66,027
                  
                  
                  
                  (113,320
                  )
                  
                  
                  (113,320
                  )
                  
                  
                  135,008Interest-earning
      assets as a percentage ofinterest-bearing
      liabilities
                  
                  
                  158.48
                  %
                  
                  
                  10.90
                  %
                  
                  
                  6.84
                  %
                  
                  
                  81.88
                  %
                  
                  
                  365.96
                  %
  The Company manages its exposure to
fluctuations in interest rates through policies established by the
Asset/Liability Committee (“ALCO”) of the Bank.  The ALCO meets
monthly and has the responsibility for approving asset/liability management
policies, formulating and implementing strategies to improve balance sheet
positioning and/or earnings and reviewing the interest rate sensitivity of the
Company.  ALCO tries to minimize interest rate risk between
interest-earning assets and interest-bearing liabilities by attempting to
minimize wide fluctuations in net interest income due to interest rate
movements.  The ability to control these fluctuations has a direct
impact on the profitability of the Company. Management monitors this activity on
a regular basis through analysis of its portfolios to determine the difference
between rate sensitive assets and rate sensitive liabilities.
 
 The Company’s rate sensitive assets are
those earning interest at variable rates and those with contractual maturities
within one year.  Rate sensitive assets therefore include both loans
and available for sale securities.  Rate sensitive liabilities include
interest-bearing checking accounts, money market deposit accounts, savings
accounts, time deposits and borrowed funds.  As shown in Table 5, the
Company’s balance sheet is asset-sensitive, meaning that in a given period there
will be more assets than liabilities subject to immediate repricing as interest
rates change in the market. Because most of the Company’s loans are tied to the
prime rate, they reprice more rapidly than rate sensitive interest-bearing
deposits.  During periods of rising rates, this results in increased
net interest income.  The opposite occurs during periods of declining
rates.  Rate sensitive assets at December 31, 2007 totaled $853.9
million, exceeding rate sensitive liabilities of $718.9 million by $135.0
million.
   A-12
  In order
to assist in achieving a desired level of interest rate sensitivity, the Company
entered into off-balance sheet contracts that are considered derivative
financial instruments.  As of December 31, 2007, the Company had cash
flow hedges with a notional amount of $185.0 million.  These
derivative instruments consist of five interest rate floor contracts that are
used to hedge future cash flows from payments on the first $185.0 million of
certain variable rate loans against the downward effects of their repricing in
the event of a decreasing rate environment for periods ending in July 2008,
November 2008, January 2009, June 2009 and December 2009.  If the
prime rate falls below 6.25% during the term of the contract on the first floor,
the Company will receive payments based on the $35.0 million notional amount
times the difference between 6.25% and the weighted average prime rate for the
quarter.  No payments will be received by the Company if the weighted
average prime rate is 6.25% or higher.  The Company paid a premium of
$161,000 on this contact.  On the second floor if the prime rate falls
below 7.00% during the term of the contract, the Company will receive payments
based on the $35.0 million notional amount times the difference between 7.00%
and the weighted average prime rate for the quarter.  No payments will
be received by the Company if the weighted average prime rate is 7.00% or
higher.  The Company paid a premium of $203,000 on this contract. On
the third floor if the prime rate falls below 7.50% during the term of the
contract, the Company will receive payments based on the $45.0 million notional
amount times the difference between 7.50% and the weighted average prime rate
for the quarter.  No payments will be received by the Company if the
weighted average prime rate is 7.50% or higher.  The Company paid a
premium of $562,500 on this contract.  On the fourth floor if the
prime rate falls below 8.00% during the term of the contract, the Company will
receive payments based on the $35.0 million notional amount times the difference
between 8.00% and the weighted average prime rate for the quarter.  No
payments will be received by the Company if the weighted average prime rate is
8.00% or higher.  The Company paid a premium of $399,000 on this
contract.  On the fifth floor if the prime rate falls below 7.25%
during the term of the contract, the Company will receive payments based on the
$35.0 million notional amount times the difference between 7.25% and the
weighted average prime rate for the quarter.  No payments will be
received by the Company if the weighted average prime rate is 7.25% or higher.
The Company paid a premium of $634,000 on this contract.
 
 The Company recognized $47,000 in interest income from payments on interest rate
floor contracts in 2007. Based on
the current interest rate environment, it is expected the Company will continue
to receive income on these interest rate contracts in 2008.
 
 Included
in the rate sensitive assets are $471.6 million in variable rate loans indexed
to prime rate subject to immediate repricing upon changes by the
FOMC.  The Bank utilizes interest rate floors on certain variable rate
loans to protect against further downward movements in the prime
rate.  At December 31, 2007, the Bank had $75.6 million in loans with
interest rate floors.  The floors were in effect on $27.7 million of
these loans pursuant to the terms of the promissory notes on these
loans.   The weighted average rate on these loans is 0.25% higher
than the indexed rate on the promissory notes without interest rate
floors.
 
 The Bank
also had $1.6 million in loans that are tied to the prime rate and had interest
rate caps in effect pursuant to the terms of the promissory notes on these
loans.  The weighted average rate on these loans is 0.47% lower than
the indexed rate on the promissory notes without the interest rate
caps.
 
 An
analysis of the Company’s financial condition and growth can be made by
examining the changes and trends in interest-earning assets and interest-bearing
liabilities.  A discussion of these changes and trends
follows.
 
 Analysis
of Financial Condition
 Investment
Securities.All of the Company’s investment securities are
held in the available-for-sale (“AFS”) category.At December 31, 2007 the
market value of AFS securities totaled $121.0 million, compared to $117.6
million and $115.2 million at December 31, 2006 and 2005,
respectively.  The increase in 2007 investment securities is the
result of net securities purchases that are part of management’s objective to
grow the investment portfolio in an effort to manage the credit risk in the
balance sheet.  This increase in AFS securities was partially offset
by paydowns on mortgage-backed securities, calls and
maturities.  Table 6 presents the market value of the AFS securities
held at December 31, 2007, 2006 and 2005.
   A-13
   Table
      6 - Summary of Investment Portfolio(Dollars
      in Thousands)
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005Obligations
      of United States governmentagencies
      and corporations
                  
                  $
                  76,992
                  
                  
                  
                  72,744
                  
                  
                  
                  60,243Obligations
      of states and political subdivisions
                  
                  
                  25,905
                  
                  
                  
                  24,366
                  
                  
                  
                  21,609Mortgage-backed
      securities
                  
                  
                  16,271
                  
                  
                  
                  19,220
                  
                  
                  
                  31,004Trust
      preferred securities
                  
                  
                  250
                  
                  
                  
                  750
                  
                  
                  
                  1,750Equity
      securities
                  
                  
                  1,550
                  
                  
                  
                  501
                  
                  
                  
                  552Total
      securities
                  
                  $
                  120,968
                  
                  
                  
                  117,581
                  
                  
                  
                  115,158
  The
composition of the investment securities portfolio reflects the Company’s
investment strategy of maintaining an appropriate level of liquidity while
providing a relatively stable source of income.  The investment
portfolio also provides a balance to interest rate risk and credit risk in other
categories of the balance sheet while providing a vehicle for the investment of
available funds, furnishing liquidity, and supplying securities to pledge as
required collateral for certain deposits.
 
 The
Company’s investment portfolio consists of U.S. government agency securities,
municipal securities, U.S. government agency sponsored mortgage-backed
securities, trust preferred securities and equity securities.  AFS
securities averaged $120.3 million in 2007, $118.1 million in 2006 and $108.7
million in 2005.  Table 7 presents the amortized cost of AFS
securities held by the Company by maturity category at December 31,
2007.   Yield information does not give effect to changes in fair
value that are reflected as a component of shareholders’
equity.  Yields are calculated on a tax equivalent basis.Yields
and interest income on tax-exempt investments have been adjusted to tax
equivalent basis using an effective tax rate 38.55% for securities that are both
federal and state tax exempt and an effective tax rate of 6.90% for state tax
exempt securities.
 
 Table
      7 - Maturity Distribution and Weighted Average Yield on
      InvestmentsAfter
      One Year
                  
                  After
      5 YearsOne
      Year or Less
                  
                  Through
      5 Years
                  
                  Through
      10 Years
                  
                  After
      10 Years
                  
                  Totals(Dollars
      in Thousands)
                  
                  Amount
                  
                  Yield
                  
                  Amount
                  
                  Yield
                  
                  Amount
                  
                  Yield
                  
                  Amount
                  
                  Yield
                  
                  Amount
                  
                  YieldBook
      value:United
      States Government agencies
                  
                  $
                  4,999
                  
                  
                  4.52%
                  
                  
                  45,249
                  
                  
                  4.93%
                  
                  
                  22,228
                  
                  
                  5.47%
                  
                  
                  2,679
                  
                  
                  6.08%
                  
                  
                  75,155
                  
                  
                  5.11%States
      and political subdivisions
                  
                  
                  2,320
                  
                  
                  6.23%
                  
                  
                  11,173
                  
                  
                  4.76%
                  
                  
                  7,052
                  
                  
                  6.13%
                  
                  
                  5,311
                  
                  
                  6.58%
                  
                  
                  25,856
                  
                  
                  5.64%Mortgage
      backed securities
                  
                  
                  -
                  
                  
                  -
                  
                  
                  673
                  
                  
                  4.55%
                  
                  
                  3,591
                  
                  
                  4.46%
                  
                  
                  12,206
                  
                  
                  4.71%
                  
                  
                  16,470
                  
                  
                  4.65%Trust
      preferred securities
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  250
                  
                  
                  8.11%
                  
                  
                  250
                  
                  
                  8.11%Equity
      securities
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,693
                  
                  
                  0.92%
                  
                  
                  1,693
                  
                  
                  0.92%Total
      securities
                  
                  $
                  7,319
                  
                  
                  5.06%
                  
                  
                  57,095
                  
                  
                  4.90%
                  
                  
                  32,871
                  
                  
                  5.50%
                  
                  
                  22,139
                  
                  
                  5.07%
                  
                  
                  119,424
                  
                  
                  5.10%
  Loans.The loan
portfolio is the largest category of the Company’s earning assets and is
comprised of commercial loans, real estate mortgage loans, real estate
construction loans and consumer loans. The Company grants loans and extensions
of credit primarily within the Catawba Valley region of North Carolina, which
encompasses Catawba, Alexander, Iredell and Lincoln counties and also in
Mecklenburg and Union counties.  Although the Company  has a
diversified loan portfolio, a substantial portion of the loan portfolio is
collateralized by real estate, which is dependent upon the real estate
market.  Non-real estate loans also can be affected by local economic
conditions.
   A-14
  In
management’s opinion, there are no significant concentrations of credit with
particular borrowers engaged in similar activities.
 
 Real
estate mortgage loans include both commercial and residential mortgage
loans.  At December 31, 2007, the Company had $94.8 million in
residential mortgage loans, $79.3 million in home equity loans and $243.6
million in commercial mortgage loans, which include $195.1 million using
commercial property as collateral and $48.5 million using residential property
as collateral.
 
 Residential
mortgage loans include $36.9 million made to customers in the Company’s
traditional banking offices and $57.9 million in mortgage loans originated in
the Company’s Latino banking operations.  All residential mortgage
loans are originated as fully amortizing loans, with no negative
amortization.   Also, the Company does not  have credit
exposure for residential mortgage loans originated that are  not
reflected in the Company’s assets and does not have any residential mortgage
loans with a loan-to-value ratio in excess of 100%.
 
 The
mortgage loans originated in the traditional banking offices are generally 15 to
30 year fixed rate loans with attributes that cause the loans to not be sellable
in the secondary market.  These factors may include higher
loan-to-value ratio, limited documentation on income, non-conforming appraisal
or non-conforming property type and are generally made to existing Bank
customers.  These loans have been originated throughout the Company’s
five county service area, with no geographic concentration.  At
December 31, 2007 there were 14loans with an
outstanding balance of $2.0 million more than 30 days past due and no loans more
than 90 days past due.
 
 The
mortgage loans originated in the Company’s Latino operations are primarily
adjustable rate mortgage loans that adjust annually after the end of the first
five years of the loan.  The loans are tied to the one-year T-Bill
index and, if they were to adjust at 12/31/07, would have a reduction in the
interest rate on the loan.  The underwriting on these loans includes
both full income verification and no income verification, with loan-to-value
ratios of up to 95% without private mortgage insurance.  A majority of
these loans would be considered subprime loans, as they were underwritten using
stated income rather than fully documented income verification.  No
other loans in the Company’s portfolio would be considered
subprime.  The majority of these loans have been originated within the
Charlotte, NC metro area.  At this time, Charlotte has not experienced
a decline in values within the residential real estate market.  At
December 31, 2007 there were 46 loans with an outstanding balance of $4.9
million more than 30 days past due and no loans more than 90 days past
due.  Total losses on this portfolio, since the first loans were
originated in 2004 have amounted to approximately $15,000through December 31,
2007.
 
 The
composition of the Company’s loan portfolio is presented in Table
8.
 
  Table
      8 - Loan Portfolio2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004
                  
                  
                  2003(Dollars
      in Thousands)
                  
                  Amount
                  
                  
                  %
      of Loans
                  
                  
                  Amount
                  
                  
                  %
      of Loans
                  
                  
                  Amount
                  
                  
                  %
      of Loans
                  
                  
                  Amount
                  
                  
                  %
      of Loans
                  
                  
                  Amount
                  
                  
                  %
      of LoansBreakdown
      of loan receivables:Commercial
                  
                  $
                  82,190
                  
                  
                  
                  11.38
                  %
                  
                  
                  85,064
                  
                  
                  
                  13.06
                  %
                  
                  
                  79,902
                  
                  
                  
                  14.10
                  %
                  
                  
                  79,189
                  
                  
                  
                  14.79
                  %
                  
                  
                  90,558
                  
                  
                  
                  16.41
                  %Real
      estate - mortgage
                  
                  
                  417,709
                  
                  
                  
                  57.83
                  %
                  
                  
                  364,595
                  
                  
                  
                  55.97
                  %
                  
                  
                  330,227
                  
                  
                  
                  58.28
                  %
                  
                  
                  312,988
                  
                  
                  
                  58.45
                  %
                  
                  
                  332,730
                  
                  
                  
                  60.26
                  %Real
      estate - construction
                  
                  
                  209,644
                  
                  
                  
                  29.03
                  %
                  
                  
                  187,960
                  
                  
                  
                  28.86
                  %
                  
                  
                  141,420
                  
                  
                  
                  24.96
                  %
                  
                  
                  127,042
                  
                  
                  
                  23.73
                  %
                  
                  
                  110,392
                  
                  
                  
                  19.99
                  %Consumer
                  
                  
                  12,734
                  
                  
                  
                  1.76
                  %
                  
                  
                  13,762
                  
                  
                  
                  2.11
                  %
                  
                  
                  15,115
                  
                  
                  
                  2.66
                  %
                  
                  
                  16,249
                  
                  
                  
                  3.03
                  %
                  
                  
                  18,446
                  
                  
                  
                  3.34
                  %Total
      loans
                  
                  $
                  722,277
                  
                  
                  
                  100.00
                  %
                  
                  
                  651,381
                  
                  
                  
                  100.00
                  %
                  
                  
                  566,664
                  
                  
                  
                  100.00
                  %
                  
                  
                  535,468
                  
                  
                  
                  100.00
                  %
                  
                  
                  552,126
                  
                  
                  
                  100.00
                  %Less:
      Allowance for loan losses
                  
                  
                  9,103
                  
                  
                  
                  
                  
                  
                  
                  8,303
                  
                  
                  
                  
                  
                  
                  
                  7,425
                  
                  
                  
                  
                  
                  
                  
                  8,049
                  
                  
                  
                  
                  
                  
                  
                  9,722Net
      loans
                  
                  $
                  713,174
                  
                  
                  
                  
                  
                  
                  
                  643,078
                  
                  
                  
                  
                  
                  
                  
                  559,239
                  
                  
                  
                  
                  
                  
                  
                  527,419
                  
                  
                  
                  
                  
                  
                  
                  542,404
  As of December 31, 2007, gross loans
outstanding were $722.3 million, an increase of $70.9 million or 11% from the
December 31, 2006 balance of $651.4 million.  Commercial loans
decreased $2.9 million in 2007.  Real estate mortgage loans grew $53.1
million when compared to 2006 due to an increase in non-conforming mortgage
loans and commercial real estate loans. Real estate construction loans increased
$21.7 million in 2007 as a result of an increase in real estate development
loans.  Consumer loans decreased $1.0 million in
2007.
 
 
 A-15
  Table 9
identifies the maturities of all loans as of December 31, 2007 and addresses the
sensitivity of these loans to changes in interest rates.
 
  Table
      9 - Maturity and Repricing Data for Loans(Dollars
      in Thousands)
                  
                  Within
      one
                    year
      or less
                  
                  After
      one year through five years
                  
                  After
      five
                    years
                  
                  Total
      loansCommercial
                  
                  $
                  65,308
                  
                  
                  
                  14,835
                  
                  
                  
                  2,047
                  
                  
                  
                  82,190Real
      estate - mortgage
                  
                  
                  233,365
                  
                  
                  
                  138,492
                  
                  
                  
                  45,852
                  
                  
                  
                  417,709Real
      estate - construction
                  
                  
                  195,626
                  
                  
                  
                  12,402
                  
                  
                  
                  1,616
                  
                  
                  
                  209,644Consumer
                  
                  
                  5,307
                  
                  
                  
                  6,544
                  
                  
                  
                  883
                  
                  
                  
                  12,734Total
      loans
                  
                  $
                  499,606
                  
                  
                  
                  172,273
                  
                  
                  
                  50,398
                  
                  
                  
                  722,277Total
      fixed rate loans
                  
                  $
                  18,484
                  
                  
                  
                  113,733
                  
                  
                  
                  50,398
                  
                  
                  
                  182,615Total
      floating rate loans
                  
                  
                  481,122
                  
                  
                  
                  58,540
                  
                  
                  
                  -
                  
                  
                  
                  539,662Total
      loans
                  
                  $
                  499,606
                  
                  
                  
                  172,273
                  
                  
                  
                  50,398
                  
                  
                  
                  722,277
  In the
normal course of business, there are various commitments outstanding to extend
credit that are not reflected in the financial statements. At December 31, 2007,
outstanding loan commitments totaled $190.7 million.  Commitments to
extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee.  Since many of the commitments may expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.  Additional information regarding
commitments is provided below in the section entitled “Contractual Obligations”
and in Note 10 to the Consolidated Financial Statements.
 
 Allowance for Loan
Losses.The allowance for loan losses reflects management's
assessment and estimate of the risks associated with extending credit and its
evaluation of the quality of the loan portfolio.  The Bank
periodically analyzes the loan portfolio in an effort to review asset quality
and to establish an allowance for loan losses that management believes will be
adequate in light of anticipated risks and loan losses.  In assessing
the adequacy of the allowance, size, quality and risk of loans in the portfolio
are reviewed. Other factors considered are:
 
 ·
                the
      Bank’s loan loss experience;
 ·
                the
      amount of past due and non-performing
loans;
 ·
                specific
      known risks;
 ·
                the
      status and amount of other past due and non-performing
    assets;
 ·
                underlying
      estimated values of collateral securing
loans;
 ·
                current
      and anticipated economic conditions;
and
 ·
                other
      factors which management believes affect the allowance for potential
      credit losses.
 
 Management
uses several measures to assess and monitor the credit risks in the loan
portfolio, including a loan grading system that begins upon loan origination and
continues until the loan is collected or collectibility becomes doubtful. Upon
loan origination, the Bank’s originating loan officer evaluates the quality of
the loan and assigns one of nine risk grades, each grade indicating a different
level of loss reserves. The loan officer monitors the loan’s performance and
credit quality and makes changes to the credit grade as conditions warrant. When
originated or renewed, all loans over a certain dollar amount receive in-depth
reviews and risk assessments by the Bank’s Credit Administration. Before making
any changes in these risk grades, management considers assessments as determined
by the third party credit review firm (as described below), regulatory examiners
and the Bank’s Credit Administration. Any issues regarding the risk assessments
are addressed by the Bank’s senior credit administrators and factored into
management’s decision to originate or renew the loan as well as the level of
reserves deemed appropriate for the loan. The Bank’s Board of Directors reviews,
on a monthly basis, an analysis of the Bank’s reserves relative to the range of
reserves estimated by the Bank’s Credit Administration.
 
 As an
additional measure, the Bank engages an independent third party to review the
underwriting, documentation, risk grading analyses and the methodology of
determining the adequacy of the allowance for losses. This independent third
party reviews and evaluates all loan relationships greater than $1.0
million.  The third party’s evaluation and report is shared with
management and the Bank’s Board of Directors.
   A-16
  Management
considers certain commercial loans with weak credit risk grades to be
individually impaired and measures such impairment based upon available cash
flows and the value of the collateral. Allowance or reserve levels are estimated
for all other graded loans in the portfolio based on their assigned credit risk
grade, type of loan and other matters related to credit risk.
 
 Management
uses the information developed from the procedures described above in evaluating
and grading the loan portfolio. This continual grading process is used to
monitor the credit quality of the loan portfolio and to assist management in
determining the appropriate levels of the allowance for loan
losses.
 
 The
allowance for loan losses is comprised of three components: specific reserves,
general reserves and unallocated reserves.  After a loan has been
identified as impaired, management measures impairment in accordance with SFAS
No. 114, “Accounting By
Creditors for Impairment of a Loan.”When the measure of the impaired
loan is less than the recorded investment in the loan, the amount of the
impairment is recorded as a specific reserve. These specific reserves are
determined on an individual loan basis based on management’s current evaluation
of the Company’s loss exposure for each credit, given the payment status,
financial condition of the borrower, and value of any underlying collateral.
Loans for which specific reserves are provided are excluded from the general
allowance calculations as described below.  At December 31, 2007 and
2006, the recorded investment in loans that were considered to be impaired under
SFAS No. 114 was approximately $8.0 million and $7.6 million, respectively, with
related allowance for loan losses of approximately $1.2 million for December 31,
2007 and 2006.
 
 The
general allowance reflects reserves established under the provisions of SFAS No.
5, “Accounting for Contingencies” for collective loan
impairment.  These reserves are based upon historical net charge-offs
using the last three years’ experience.  This charge-off experience
may be adjusted to reflect the effects of current conditions.  The
Bank considers information derived from its loan risk ratings and external data
related to industry and general economic trends.
 
 The
unallocated allowance is determined through management’s assessment of probable
losses that are in the portfolio but are not adequately captured by the other
two components of the allowance, including consideration of current economic and
business conditions and regulatory requirements. The unallocated allowance also
reflects management’s acknowledgement of the imprecision and subjectivity that
underlie the modeling of credit risk.  Due to the subjectivity
involved in determining the overall allowance, including the unallocated
portion, this unallocated portion may fluctuate from period to period based on
management’s evaluation of the factors affecting the assumptions used in
calculating the allowance.
 
 Management
considers the allowance for loan losses adequate to cover the estimated losses
inherent in the Company’s loan portfolio as of the date of the financial
statements. Management believes it has established the allowance in accordance
with accounting principles generally accepted in the United States of America
and in consideration of the current economic environment. Although management
uses the best information available to make evaluations, significant future
additions to the allowance may be necessary based on changes in economic and
other conditions that adversely affect the operating results of the
Company.
 
 There
were no significant changes in the estimation methods or fundamental assumptions
used in the evaluation of the allowance for loan losses for the year ended
December 31, 2007 as compared to the year ended December 31, 2006.
Such revisions, estimates and assumptions are made in any period in which the
supporting factors indicate that loss levels may vary from the previous
estimates.
 
 Additionally,
various regulatory agencies, as an integral part of their examination process,
periodically review the Bank’s allowances for loan losses. Such agencies may
require adjustments to the allowances based on their judgments of information
available to them at the time of their examinations.
 
 Net
charge-offs for 2007 were $1.2 million.  The ratio of net charge-offs
to average total loans was 0.19%in 2007, 0.27% in 2006
and 0.68% in 2005.  Management expects the ratio of net charge-offs to
average total loans in 2008 to be in a range similar to the ratios for 2007 and
2006.  The allowance for loan losses increased to $9.1 million or
1.26% of total loans outstanding at December 31, 2007.  For December
31, 2006 and 2005, the allowance for loan losses amounted to $8.3 million or
1.27% of total loans outstanding and $7.4 million, or 1.31% of total loans
outstanding, respectively.
 
 
 A-17
  Table 10
presents the percentage of loans assigned to each risk grade along with the
general reserve percentage applied to loans in each risk grade at December 31,
2007 and 2006.
 Table
      10 - Loan Risk Grade AnalysisPercentage
      of LoansBy
      Risk Grade*Risk
      Grade
                  
                  2007
                  2006Risk
      1 (Excellent Quality)
                  
                  11.06%
                  12.03%Risk
      2 (High Quality)
                  
                  14.06%
                  14.89%Risk
      3 (Good Quality)
                  
                  62.53%
                  60.31%Risk
      4 (Management Attention)
                  
                  9.51%
                  10.46%Risk
      5 (Watch)
                  
                  1.57%
                  0.41%Risk
      6 (Substandard)
                  
                  0.13%
                  0.70%Risk
      7 (Low Substandard)
                  
                  0.03%
                  0.02%Risk
      8 (Doubtful)
                  
                  0.00%
                  0.00%Risk
      9 (Loss)
                  
                  0.00%
                  0.00%*
      Excludes non-accrual loans
  Table 11
presents an analysis of the allowance for loan losses, including charge-off
activity.
 
 Table
      11 - Analysis of Allowance for Loan Losses(Dollars
      in Thousands)
                  
                  2007
                  2006
                  2005
                  2004
                  2003Reserve
      for loan losses at beginning
                  
                  $
                  8,303
                  
                  
                  
                  7,425
                  
                  
                  
                  8,049
                  
                  
                  
                  9,722
                  
                  
                  
                  7,248Loans
      charged off:Commercial
                  
                  
                  414
                  
                  
                  
                  505
                  
                  
                  
                  293
                  
                  
                  
                  1,004
                  
                  
                  
                  1,179Real
      estate - mortgage
                  
                  
                  471
                  
                  
                  
                  568
                  
                  
                  
                  2,141
                  
                  
                  
                  3,842
                  
                  
                  
                  2,422Real
      estate - construction
                  
                  
                  252
                  
                  
                  
                  250
                  
                  
                  
                  1,250
                  
                  
                  
                  4
                  
                  
                  
                  251Consumer
                  
                  
                  489
                  
                  
                  
                  636
                  
                  
                  
                  516
                  
                  
                  
                  535
                  
                  
                  
                  630Total
      loans charged off
                  
                  
                  1,626
                  
                  
                  
                  1,959
                  
                  
                  
                  4,200
                  
                  
                  
                  5,385
                  
                  
                  
                  4,482Recoveries
      of losses previously charged off:Commercial
                  
                  
                  86
                  
                  
                  
                  64
                  
                  
                  
                  144
                  
                  
                  
                  162
                  
                  
                  
                  36Real
      estate - mortgage
                  
                  
                  21
                  
                  
                  
                  108
                  
                  
                  
                  162
                  
                  
                  
                  144
                  
                  
                  
                  18Real
      estate - construction
                  
                  
                  102
                  
                  
                  
                  2
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1Consumer
                  
                  
                  179
                  
                  
                  
                  150
                  
                  
                  
                  160
                  
                  
                  
                  150
                  
                  
                  
                  157Total
      recoveries
                  
                  
                  388
                  
                  
                  
                  324
                  
                  
                  
                  466
                  
                  
                  
                  456
                  
                  
                  
                  212Net
      loans charged off
                  
                  
                  1,238
                  
                  
                  
                  1,635
                  
                  
                  
                  3,734
                  
                  
                  
                  4,929
                  
                  
                  
                  4,270Provision
      for loan losses
                  
                  
                  2,038
                  
                  
                  
                  2,513
                  
                  
                  
                  3,110
                  
                  
                  
                  3,256
                  
                  
                  
                  6,744Reserve
      for loan losses at end of year
                  
                  $
                  9,103
                  
                  
                  
                  8,303
                  
                  
                  
                  7,425
                  
                  
                  
                  8,049
                  
                  
                  
                  9,722Loans
      charged off net of recoveries, asa
      percent of average loans outstanding
                  
                  
                  0.19
                  %
                  
                  
                  0.27
                  %
                  
                  
                  0.68
                  %
                  
                  
                  0.90
                  %
                  
                  
                  0.79
                  %
  Non-performing
Assets.Non-performing assets, comprised of non-accrual loans,
other real estate owned, other repossessed assets and loans for which payments
are more than 90 days past due totaled $8.5 million at December 31, 2007
compared to $8.0 million at December 31, 2006.   Non-accrual
loans were $8.0 million at December 31, 2007, an increase of $427,000 from
non-accruals of $7.6 million at December 31, 2006.  As a percentage of
loans outstanding, non-accrual loans were 1.11% and 1.16% at December 31, 2007
and 2006, respectively. The Bank had no loans 90 days past due and still
accruing at December 31, 2007 as compared to $78,000 for the same period in
2006.  Other real estate owned totaled $483,000 and $344,000 as of
December 31, 2007 and 2006, respectively.  The Bank had no repossessed
assets as of December 31, 2007 and 2006.
   A-18
  At
December 31, 2007 the Company had non-performing loans, defined as non-accrual
and accruing loans past due more than 90 days, of $8.0 million or 1.11% of total
loans.  Non-performing loans for 2006 were $7.6 million, or 1.17% of
total loans and $4.4 million, or 0.79% of total loans for 2005. Interest that
would have been recorded on non-accrual loans for the years ended December 31,
2007, 2006 and 2005, had they performed in accordance with their original terms,
amounted to approximately $693,000, $429,000 and $507,000, respectively.
Interest income on impaired loans included in the results of operations for
2007, 2006, and 2005 amounted to approximately $29,000, $144,000 and $77,000,
respectively.
 
 Management
continually monitors the loan portfolio to ensure that all loans potentially
having a material adverse impact on future operating results, liquidity or
capital resources have been classified as non-performing.  Should
economic conditions deteriorate, the inability of distressed customers to
service their existing debt could cause higher levels of non-performing
loans.
 
 It is the
general policy of the Company to stop accruing interest income and place the
recognition of interest on a cash basis when a loan is placed on non-accrual
status and any interest previously accrued but not collected is reversed against
current income.  Generally a loan is placed on non-accrual status when
it is over 90 days past due and there is reasonable doubt that all principal
will be collected.
 
 A summary
of non-performing assets at December 31 for each of the years presented is shown
in Table 12.
  Table
      12 - Non-performing Assets(Dollars
      in Thousands)
                  
                  2007
                  2006
                  2005
                  2004
                  2003Non-accrual
      loans
                  
                  $
                  7,987
                  
                  
                  
                  7,560
                  
                  
                  
                  3,492
                  
                  
                  
                  5,097
                  
                  
                  
                  4,343Loans
      90 days or more past due and still accruing
                  
                  
                  -
                  
                  
                  
                  78
                  
                  
                  
                  946
                  
                  
                  
                  245
                  
                  
                  
                  271Total
      non-performing loans
                  
                  
                  7,987
                  
                  
                  
                  7,638
                  
                  
                  
                  4,438
                  
                  
                  
                  5,342
                  
                  
                  
                  4,614All
      other real estate owned
                  
                  
                  483
                  
                  
                  
                  344
                  
                  
                  
                  531
                  
                  
                  
                  682
                  
                  
                  
                  1,447All
      other repossessed assets
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  206Total
      non-performing assets
                  
                  $
                  8,470
                  
                  
                  
                  7,982
                  
                  
                  
                  4,969
                  
                  
                  
                  6,024
                  
                  
                  
                  6,267As
      a percent of total loans at year endNon-accrual
      loans
                  
                  
                  1.11
                  %
                  
                  
                  1.16
                  %
                  
                  
                  0.62
                  %
                  
                  
                  0.95
                  %
                  
                  
                  0.79
                  %Loans
      90 days or more past due and still accruing
                  
                  
                  0.00
                  %
                  
                  
                  0.01
                  %
                  
                  
                  0.17
                  %
                  
                  
                  0.05
                  %
                  
                  
                  0.05
                  %Total
      non-performing assets
                  
                  
                  1.17
                  %
                  
                  
                  1.23
                  %
                  
                  
                  0.88
                  %
                  
                  
                  1.12
                  %
                  
                  
                  1.14
                  %
  Deposits.The
Company primarily uses deposits to fund its loan and investment portfolios. The
Company offers a variety of deposit accounts to individuals and businesses.
Deposit accounts include checking, savings, money market and time deposits. As
of December 31, 2007, total deposits were $693.6 million, an increase of $59.8
million or 9% increase over the December 31, 2006 balance of $633.8 million.
Core deposits,
which include demand deposits, savings accounts and certificates of deposits of
denominations less than $100,000, increased to $490.1 million at December 31,
2007 from $439.6 million at December 31, 2006.
 
 Time deposits in amounts of $100,000 or
more totaled $203.5 million at December 31, 2007, $194.2 million and $152.4
million at December 31, 2006 and 2005, respectively.  At December 31,
2007, brokered deposits amounted to $53.9 million as compared to $60.0 million
at December 31, 2006.  Brokered deposits are generally considered to
be more susceptible to withdrawal as a result of interest rate changes and to be
a less stable source of funds, as compared to deposits from the local
market.  Brokered deposits outstanding as of December 31, 2007 have a
weighted average rate of 5.06% with a weighted average original term of 7
months.
 
  A-19
  Table 13 is a summary of the maturity
distribution of time deposits in amounts of $100,000 or more as of December 31,
2007.
 
  Table
      13 - Maturities of Time Deposits over $100,000(Dollars
      in Thousands)
                  
                  2007Three
      months or less
                  
                  $
                  84,001Over
      three months through six months
                  
                  
                  70,734Over
      six months through twelve months
                  
                  
                  35,917Over
      twelve months
                  
                  
                  12,848Total
                  
                  $
                  203,500
  Borrowed Funds.The Company
has access to various short-term borrowings, including the purchase of federal
funds and borrowing arrangements from the FHLB and other financial
institutions.  At December 31, 2007, FHLB borrowings totaled $87.5
million compared to $89.3 million at December 31, 2006 and $71.6 million at
December 31, 2005. Average FHLB borrowings for 2007 were $80.1 million, compared
to average balances of $74.1 million for 2006 and $65.9 million for 2005. The
maximum amount of outstanding FHLB borrowings was $95.0 million in 2007, and
$99.5 in 2006 and $77.6 in 2005.The FHLB advances
outstanding at December 31, 2007 had both fixed and adjustable interest rates
ranging from 3.71% to 6.49%.  Currently $10.5 million of the FHLB
advances outstanding have contractual maturities prior to December 31,
2008.  The FHLB has the option to convert $72.0 million of the total
advances to a floating rate and, if converted, the Bank may repay advances
without a prepayment fee.  The Company also has an additional $5.0
million in variable rate convertible advances, which may be repaid without a
prepayment fee if converted by the FHLB.  Additional information
regarding FHLB advances is provided in Note 6 to the Consolidated Financial
Statements.
 
 Demand notes payable to the U. S.
Treasury, which represent treasury tax and loan payments received from
customers, amounted to approximately $1.6 million at December 31, 2007 and 2006
and $1.5 million at December 31, 2005.
 
 Securities sold under agreements to
repurchase amounted to $27.6 million, $6.4 million and $981,000 as of December
31, 2007, 2006 and 2005, respectively.
 
 Junior Subordinated Debentures
(related to Trust Preferred Securities).In June 2007 the
Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II
(“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial
interests in the Company’s junior subordinated deferrable interest
debentures.  All of the common securities of PEBK Trust II are owned
by the Company.  The proceeds from the issuance of the common
securities and the trust preferred securities were used by PEBK Trust II to
purchase $20.6 million of junior subordinated debentures of the Company, which
pay a floating rate equal to three-month LIBOR plus 163 basis
points.  The proceeds received by the Company from the sale of the
junior subordinated debentures were used to repay in December 2007 the trust
preferred securities issued by PEBK Trust in December 2001 and for general
purposes.  The debentures represent the sole asset of PEBK Trust
II.  PEBK Trust II is not included in the consolidated financial
statements.
 
 The trust
preferred securities issued by PEBK Trust II accrue and pay quarterly at a
floating rate of three-month LIBOR plus 163 basis points.  The Company
has guaranteed distributions and other payments due on the trust preferred
securities to the extent PEBK Trust II has funds with which to make the
distributions and other payments.  The net combined effect of the
trust preferred securities transaction is that the Company is obligated to make
the distributions and other payments required on the trust preferred
securities.
 
 These
trust preferred securities are mandatorily redeemable upon maturity of the
debentures on June 28, 2036, or upon earlier redemption as provided in the
indenture.  The Company has the right to redeem the debentures
purchased by PEBK Trust II, in whole or in part, on or after June 28,
2011.  As specified in the indenture, if the debentures are redeemed
prior to maturity, the redemption price will be the principal amount and any
accrued but unpaid interest.
 
 Contractual Obligations and
Off-Balance Sheet Arrangements.The Company’s contractual
obligations and other commitments as of December 31, 2007 are summarized in
Table 14 below.  The Company’s contractual obligations include the
repayment of principal and interest related to FHLB advances and junior
subordinated debentures, as well as certain payments under current lease
agreements.  Other commitments include commitments to extend
credit.  Because not all of these commitments to extend credit will be
drawn upon, the actual cash requirements are likely to be significantly less
than the amounts reported for other commitments below.
   A-20
 
 Table
      14 - Contractual Obligations and Other Commitments(Dollars
      in Thousands)
                  
                  Within
      One
                    Year
                  One
      to
                    Three
      Years
                  Three
      to
                    Five
      Years
                  Five
      Years
                    or
      More
                  TotalContractual
      Cash ObligationsLong-term
      borrowings*
                  
                  $
                  -
                  
                  
                  
                  7,000
                  
                  
                  
                  5,000
                  
                  
                  
                  65,000
                  
                  
                  
                  77,000Junior
      subordinated debentures
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  20,619
                  
                  
                  
                  20,619Operating
      lease obligations
                  
                  
                  897
                  
                  
                  
                  1,381
                  
                  
                  
                  863
                  
                  
                  
                  2,149
                  
                  
                  
                  5,290Total
                  
                  $
                  897
                  
                  
                  
                  8,381
                  
                  
                  
                  5,863
                  
                  
                  
                  87,768
                  
                  
                  
                  102,909Other
      CommitmentsCommitments
      to extend credit
                  
                  $
                  62,838
                  
                  
                  
                  40,706
                  
                  
                  
                  5,160
                  
                  
                  
                  81,950
                  
                  
                  
                  190,654Standby
      letters of creditand
      financial guarantees written
                  
                  
                  3,792
                  
                  
                  
                  102
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  3,894Total
                  
                  $
                  66,630
                  
                  
                  
                  40,808
                  
                  
                  
                  5,160
                  
                  
                  
                  81,950
                  
                  
                  
                  194,548*Excludes
      $10.5 million adjustable rate credit due to the FHLB, which matured in
      February 2008.
  The
Company enters into derivative contracts to manage various financial
risks.  A derivative is a financial instrument that derives its cash
flows, and therefore its value, by reference to an underlying instrument, index
or referenced interest rate.  Derivative contracts are carried at fair
value on the consolidated balance sheet with the fair value representing the net
present value of expected future cash receipts or payments based on market
interest rates as of the balance sheet date.  Derivative contracts are
written in amounts referred to as notional amounts, which only provide the basis
for calculating payments between counterparties and are not a measure of
financial risk.  Therefore, the derivative amounts recorded on the
balance sheet do not represent the amounts that may ultimately be paid under
these contracts.  Further discussions of derivative instruments are
included above in the section entitled “Asset Liability and Interest Rate Risk
Management” beginning on page A-12 and in Notes 1, 10, 11 and 16 to the
Consolidated Financial Statements.
 
 Capital
Resources.Shareholders’ equity at December 31, 2007 was $70.1
million compared to $62.8 million at December 31, 2006 and $54.4 million at
December 31, 2005.  Unrealized gains and losses, net of taxes, at
December 31, 2007 amounted to a gain of $1.7 million.  At December 31,
2006 and 2005, unrealized gains and losses, net of taxes, amounted to losses of
$771,000 and $1.4 million, respectively.  Average shareholders’ equity
as a percentage of total average assets is one measure used to determine capital
strength.   Average shareholders’ equity as a percentage of total
average assets was 8.34%, 8.09% and 7.92% for 2007, 2006 and
2005.   The return on average shareholders’ equity was 13.59% at
December 31, 2007 as compared to 14.68% and 11.31% as of December 31, 2006 and
December 31, 2005, respectively.  Total cash dividends paid during
2007 amounted to $2.3 million.  Cash dividends totaling $1.9 million
and $1.4 million were paid during 2006 and 2005, respectively.
 
 In
November 2006, the Company’s Board of Directors authorized the repurchase of up
to $2.0 million in common shares of the Company’s outstanding common stock
through its existing Stock Repurchase Plan effective through the end of November
2007.  During 2007 the Company repurchased $1.9 million, or 100,000
shares, of its common stock under this plan.
 
 In August
2007, the Company’s Board of Directors authorized the repurchase of up to 75,000
common shares of the Company’s outstanding common stock through its existing
Stock Repurchase Plan effective through the end of August 2008.  The
Company has repurchased 50,497 shares, or $873,000, of its common stock under
this plan as of December 31, 2007.
 
 Under
regulatory capital guidelines, financial institutions are currently required to
maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1
risk-based capital ratio of 4.0% or greater.  Tier 1 capital is
generally defined as shareholders' equity and trust preferred securities less
all intangible assets and goodwill.  Tier 1 capital at December 31,
2007 and 2006 includes $20.0 million in trust preferred
securities.  At December 31, 2005, Tier 1 capital includes $14.0
million in trust preferred securities.  The Company’s Tier 1 capital
ratio was 11.03%, 11.70% and 11.02% at December 31, 2007, 2006 and 2005,
respectively.  Total risk-based capital is defined as Tier 1 capital
plus supplementary capital.  Supplementary capital, or Tier 2 capital,
consists of the Company's allowance for loan losses, not exceeding 1.25% of the
Company's risk-weighted assets. Total risk-based capital ratio is therefore
defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to
risk-weighted assets.  The Company’s total risk-based capital ratio
was 12.16%, 12.86% and 12.19% at December 31, 2007, 2006 and 2005,
respectively.  In addition to the Tier 1 and total risk-based capital
requirements, financial institutions are also required to maintain a leverage
ratio of Tier 1 capital to
   A-21
 
  total
average assets of 4.0% or greater.  The Company’s Tier 1 leverage
capital ratio was 10.43%, 10.80% and 9.84% at December 31, 2007, 2006 and 2005,
respectively.
 
 The
Bank’s Tier 1 risk-based capital ratio was 9.80%, 10.21% and 10.46% at December
31, 2007, 2006 and 2005, respectively.  The total risk-based capital
ratio for the Bank was 10.93%, 11.37% and 11.64% at December 31, 2007, 2006 and
2005, respectively.   The Bank’s Tier 1 leverage capital ratio
was 9.26%, 9.41% and 9.33% at December 31, 2007, 2006 and 2005
respectively.
 
 A bank is
considered to be "well capitalized" if it has a total risk-based capital ratio
of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and
has a leverage ratio of 5.0% or greater.  Based upon these guidelines,
the Bank was considered to be "well capitalized" at December 31, 2007, 2006 and
2005.
 
 The
Company’s key equity ratios as of December 31, 2007, 2006 and 2005 are presented
in Table 15.
 
  Table
      15 - Equity Ratios2007
                  2006
                  2005Return
      on average assets
                  
                  
                  1.13
                  %
                  
                  
                  1.19
                  %
                  
                  
                  0.90
                  %Return
      on average equity
                  
                  
                  13.59
                  %
                  
                  
                  14.68
                  %
                  
                  
                  11.31
                  %Dividend
      payout ratio
                  
                  
                  24.30
                  %
                  
                  
                  20.78
                  %
                  
                  
                  22.34
                  %Average
      equity to average assets
                  
                  
                  8.34
                  %
                  
                  
                  8.09
                  %
                  
                  
                  7.92
                  %
   Quarterly Financial
Data.The Company’s consolidated quarterly operating results
for the years ended December 31, 2007 and 2006 are presented in Table
16.
 
  Table
      16 - Quarterly Financial Data2007
                  
                  
                  2006(Dollars
      in thousands, except
                    per
      share amounts)
                  
                  First
                  Second
                  Third
                  Fourth
                  First
                  Second
                  Third
                  FourthTotal
      interest income
                  
                  $
                  15,200
                  
                  
                  
                  15,446
                  
                  
                  
                  15,625
                  
                  
                  
                  15,461
                  
                  
                  
                  12,484
                  
                  
                  
                  13,559
                  
                  
                  
                  14,390
                  
                  
                  
                  14,961Total
      interest expense
                  
                  
                  6,607
                  
                  
                  
                  6,735
                  
                  
                  
                  7,038
                  
                  
                  
                  7,205
                  
                  
                  
                  4,863
                  
                  
                  
                  5,429
                  
                  
                  
                  6,243
                  
                  
                  
                  6,575Net
      interest income
                  
                  
                  8,593
                  
                  
                  
                  8,711
                  
                  
                  
                  8,587
                  
                  
                  
                  8,256
                  
                  
                  
                  7,621
                  
                  
                  
                  8,130
                  
                  
                  
                  8,147
                  
                  
                  
                  8,386Provision
      for loan losses
                  
                  
                  323
                  
                  
                  
                  634
                  
                  
                  
                  296
                  
                  
                  
                  785
                  
                  
                  
                  759
                  
                  
                  
                  413
                  
                  
                  
                  686
                  
                  
                  
                  655Other
      income
                  
                  
                  2,122
                  
                  
                  
                  2,139
                  
                  
                  
                  2,007
                  
                  
                  
                  2,548
                  
                  
                  
                  1,929
                  
                  
                  
                  2,017
                  
                  
                  
                  2,043
                  
                  
                  
                  1,564Other
      expense
                  
                  
                  6,021
                  
                  
                  
                  6,180
                  
                  
                  
                  6,214
                  
                  
                  
                  7,578
                  
                  
                  
                  5,307
                  
                  
                  
                  5,548
                  
                  
                  
                  5,787
                  
                  
                  
                  6,341Income
      before income taxes
                  
                  
                  4,371
                  
                  
                  
                  4,036
                  
                  
                  
                  4,084
                  
                  
                  
                  2,441
                  
                  
                  
                  3,484
                  
                  
                  
                  4,186
                  
                  
                  
                  3,717
                  
                  
                  
                  2,954Income
      taxes
                  
                  
                  1,584
                  
                  
                  
                  1,446
                  
                  
                  
                  1,471
                  
                  
                  
                  839
                  
                  
                  
                  1,249
                  
                  
                  
                  1,525
                  
                  
                  
                  1,344
                  
                  
                  
                  1,052Net
      earnings
                  
                  $
                  2,787
                  
                  
                  
                  2,590
                  
                  
                  
                  2,613
                  
                  
                  
                  1,602
                  
                  
                  
                  2,235
                  
                  
                  
                  2,661
                  
                  
                  
                  2,373
                  
                  
                  
                  1,902Basic
      earnings per share
                  
                  $
                  0.49
                  
                  
                  
                  0.45
                  
                  
                  
                  0.46
                  
                  
                  
                  0.28
                  
                  
                  
                  0.39
                  
                  
                  
                  0.47
                  
                  
                  
                  0.42
                  
                  
                  
                  0.33Diluted
      earnings per share
                  
                  $
                  0.48
                  
                  
                  
                  0.44
                  
                  
                  
                  0.45
                  
                  
                  
                  0.28
                  
                  
                  
                  0.38
                  
                  
                  
                  0.46
                  
                  
                  
                  0.41
                  
                  
                  
                  0.33
   A-22
  QUANTATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 Market
risk reflects the risk of economic loss resulting from adverse changes in market
prices and interest rates.  This risk of loss can be reflected in
either diminished current market values or reduced potential net interest income
in future periods.
 
 The
Company’s market risk arises primarily from interest rate risk inherent in its
lending and deposit taking activities. The structure of the Company’s loan and
deposit portfolios is such that a significant decline (increase) in interest
rates may adversely (positively)impact net market values
and interest income. Management seeks to manage the risk through the utilization
of its investment securities and off-balance sheet derivative instruments.
During the years ended December 31, 2007, 2006 and 2005, the Company used
interest rate contracts to manage market risk as discussed above in the section
entitled “Asset Liability and Interest Rate Risk Management.”
 
 Table 17 presents in tabular form the
contractual balances and the estimated fair value of the Company’s on-balance
sheet financial instruments and the notional amount and estimated fair value of
the Company’s off-balance sheet derivative instruments at their expected
maturity dates for the period ended December 31, 2007. The expected maturity
categories take into consideration historical prepayment experience as well as
management’s expectations based on the interest rate environment at December 31,
2007.  As of December 31, 2007, all fixed rate advances are callable
at the option of FHLB.  For core deposits without contractual maturity
(i.e. interest bearing checking, savings, and money market accounts), the table
presents principal cash flows based on management’s judgment concerning their
most likely runoff or repricing behaviors.
  Table
      17 - Market Risk Table(Dollars
      In Thousands)
                  
                  Principal/Notional
      Amount Maturing in Year Ended December 31,Loans
      Receivable
                  
                  2008
                  2009
                  2010
                  2011
      &
                    2012
                  Thereafter
                  Total
                  Fair
      ValueFixed
      rate
                  
                  $
                  34,493
                  
                  
                  26,881
                  
                  
                  27,894
                  
                  
                  54,865
                  
                  
                  38,483
                  
                  
                  182,615
                  
                  
                  183,130Average
      interest rate
                  
                  
                  7.41
                  %
                  
                  7.53
                  %
                  
                  7.39
                  %
                  
                  7.65
                  %
                  
                  7.64
                  %Variable
      rate
                  
                  $
                  206,001
                  
                  
                  75,033
                  
                  
                  51,738
                  
                  
                  54,833
                  
                  
                  152,058
                  
                  
                  539,662
                  
                  
                  539,662Average
      interest rate
                  
                  
                  7.70
                  %
                  
                  7.64
                  %
                  
                  7.67
                  %
                  
                  7.77
                  %
                  
                  7.94
                  %-
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  722,277
                  
                  
                  722,792Investment
      Securities
                  
                  
                  .Interest
      bearing cash
                  
                  $
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,539
                  
                  
                  1,539
                  
                  
                  1,539Average
      interest rate
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  4.60
                  %Federal
      funds sold
                  
                  $
                  2,152
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  2,152
                  
                  
                  2,152Average
      interest rate
                  
                  
                  4.10
                  %
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -Securities
      available for sale
                  
                  $
                  24,240
                  
                  
                  28,056
                  
                  
                  17,799
                  
                  
                  38,646
                  
                  
                  12,226
                  
                  
                  120,968
                  
                  
                  120,968Average
      interest rate
                  
                  
                  4.91
                  %
                  
                  4.96
                  %
                  
                  4.61
                  %
                  
                  4.27
                  %
                  
                  3.64
                  %Nonmarketable
      equity securities
                  
                  $
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  6,434
                  
                  
                  6,434
                  
                  
                  6,434Average
      interest rate
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  5.74
                  %Debt
      ObligationsDeposits
                  
                  $
                  372,596
                  
                  
                  27,540
                  
                  
                  11,245
                  
                  
                  1,130
                  
                  
                  281,128
                  
                  
                  693,639
                  
                  
                  694,059Average
      interest rate
                  
                  
                  4.02
                  %
                  
                  4.12
                  %
                  
                  4.20
                  %
                  
                  3.88
                  %
                  
                  1.58
                  %Advances
      from FHLB
                  
                  $
                  10,500
                  
                  
                  20,000
                  
                  
                  52,000
                  
                  
                  5,000
                  
                  
                  -
                  
                  
                  87,500
                  
                  
                  90,233Average
      interest rate
                  
                  
                  4.40
                  %
                  
                  4.41
                  %
                  
                  4.71
                  %
                  
                  4.21
                  %
                  
                  -Demand
      notes payable to U.S. Treasury
                  
                  $
                  1,600
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,600
                  
                  
                  1,600Average
      interest rate
                  
                  
                  3.27
                  %
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -Securities
      sold under agreement to repurchase
                  
                  $
                  27,583
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  27,583
                  
                  
                  27,583Average
      interest rate
                  
                  
                  4.15
                  %
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -Junior
      subordinated debentures
                  
                  $
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  20,619
                  
                  
                  20,619
                  
                  
                  20,619Average
      interest rate
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  6.62
                  %Derivative
      Instruments (notional amount)Interest
      rate floor contracts
                  
                  $
                  70,000
                  
                  
                  115,000
                  
                  
                  -
                  
                  
                  -
                  
                  
                  -
                  
                  
                  185,000
                  
                  
                  1,907Average
      interest rate
                  
                  
                  6.63
                  %
                  
                  7.58
                  %
                  
                  -
                  
                  
                  -
                  
                  
                  -
  A-23
  Table 18
presents the simulated impact to net interest income under varying interest rate
scenarios and the theoretical impact of rate changes over a twelve-month period
referred to as “rate ramps.”  The table shows the estimated
theoretical impact on the Company’s tax equivalent net interest income from
hypothetical rate changes of plus and minus 1% and 2% as compared to the
estimated theoretical impact of rates remaining unchanged.  The table
also shows the simulated impact to market value of equity under varying interest
rate scenarios and the theoretical impact of immediate and sustained rate
changes referred to as “rate shocks” of plus and minus 1% and 2% compared to the
theoretical impact of rates remaining unchanged.  The prospective
effects of the hypothetical interest rate changes are based upon various
assumptions, including relative and estimated levels of key interest
rates.  This type of modeling has limited usefulness because it does
not allow for the strategies management would utilize in response to sudden and
sustained rate changes.  Also, management does not believe that rate
changes of the magnitude presented are likely in the forecast period
presented.
 
  Table
      18 - Interest Rate Risk(Dollars
      in thousands)Estimated
      Resulting Theoretical Net
                    Interest
      IncomeHypothetical
      rate change (ramp over 12 months)
                  
                  Amount
                  
                  %
      Change+2%
                  
                  $
                  39,311
                  
                  6.29%+1%
                  
                  $
                  38,037
                  
                  2.85%0%
                  
                  $
                  36,983
                  
                  0.00%-1%
                  
                  $
                  36,349
                  
                  -1.72%-2%
                  
                  $
                  35,711
                  
                  -3.44%Estimated
      Resulting Theoretical
                    Market
      Value of EquityHypothetical
      rate change (immediate shock)
                  
                  Amount
                  
                  %
      Change+2%
                  
                  $
                  68,006
                  
                  -7.82%+1%
                  
                  $
                  70,737
                  
                  -4.11%0%
                  
                  $
                  73,772
                  
                  0.00%-1%
                  
                  $
                  77,197
                  
                  4.64%-2%
                  
                  $
                  81,030
                  
                  9.84%
 A-24
  MARKET
FOR THE COMPANY’S COMMON EQUITY
 AND
RELATED SHAREHOLDER MATTERS
 
 Peoples Bancorp common stock is traded
on the over-the-counter (OTC) market and quoted on the Nasdaq Global Market,
under the symbol “PEBK.”   Scott and Stringfellow, Inc., Ryan,
Beck & Co. and Sterne Agee & Leach, Inc. are market makers for the
Company’s shares.
 
 Although the payment of dividends by
the Company is subject to certain requirements and limitations of North Carolina
corporate law, neither the Commissioner nor the FDIC have promulgated any
regulations specifically limiting the right of the Company to pay dividends and
repurchase shares.  However, the ability of the Company to pay
dividends and repurchase shares may be dependent upon the Company’s receipt of
dividends from the Bank.  The Bank’s ability to pay dividends is
limited.  North Carolina commercial banks, such as the Bank, are
subject to legal limitations on the amounts of dividends they are permitted to
pay.   Dividends may be paid by the Bank from undivided profits,
which are determined by deducting and charging certain items against actual
profits, including any contributions to surplus required by North Carolina
law.   Also, an insured depository institution, such as the Bank,
is prohibited from making capital distributions, including the payment of
dividends, if, after making such distribution, the institution would become
“undercapitalized” (as such term is defined in the applicable law and
regulations).   Based on its current financial condition, the
Bank does not expect that this provision will have any impact on the Bank’s
ability to pay dividends.
 
 As of March 10, 2008, the Company had
700 shareholders of record, not including the number of persons or entitieswhose stock is held in
nominee or street name through various brokerage firms or
banks.   The market price for the Company’s common stock was$13.34onMarch 10, 2008.
 
 Table 19
presents certain market and dividend information for the last two fiscal
years.  Over-the-counter quotations reflect inter-dealer prices,
without retail mark-up, mark down or commission and may not necessarily
represent actual transactions.
  Table
      19 - Market and Dividend DataCash
      Dividend2007
                  
                  Low
      Bid
                  High
      Bid
                  Per
      ShareFirst
      Quarter
                  
                  $
                  17.37
                  
                  
                  19.26
                  
                  
                  0.08Second
      Quarter
                  
                  $
                  17.89
                  
                  
                  21.15
                  
                  
                  0.09Third
      Quarter
                  
                  $
                  17.13
                  
                  
                  20.03
                  
                  
                  0.12Fourth
      Quarter
                  
                  $
                  14.75
                  
                  
                  18.00
                  
                  
                  0.12Cash
      Dividend2006
                  
                  Low
      Bid
                  High
      Bid
                  Per
      ShareFirst
      Quarter
                  
                  $
                  13.37
                  
                  
                  16.37
                  
                  
                  0.07Second
      Quarter
                  
                  $
                  15.77
                  
                  
                  19.47
                  
                  
                  0.07Third
      Quarter
                  
                  $
                  16.18
                  
                  
                  19.47
                  
                  
                  0.07Fourth
      Quarter
                  
                  $
                  17.97
                  
                  
                  20.09
                  
                  
                  0.12
   A-25
  STOCK
PERFORMANCE GRAPH
 
 The
following graph compares the Company’s cumulative shareholder return on its
Common Stock with a NASDAQ index and with a southeastern bank
index.  The graph was prepared by SNL Securities, L.C.,
Charlottesville, Virginia, using data as of December 31, 2007.
 
 
 COMPARISON
OF SIX-YEAR CUMULATIVE TOTAL RETURNS
 Performance
Report for
 Peoples
Bancorp of North Carolina, Inc.
    
  A-26
   PEOPLES
      BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated
      Financial StatementsDecember
      31, 2007, 2006 and 2005INDEXPAGE(S)Management's
      Report on Internal Control Over Financial Reporting
              A-28Report
      of Independent Registered Public Accounting Firm on the Consolidated
      Financial Statementsand
      Internal Control Over Financial Reporting
              A-29
      - A-30Financial
      StatementsConsolidated
      Balance Sheets at December 31, 2007 and December 31, 2006
              A-31Consolidated
      Statements of Earnings for the years ended December 31, 2007, 2006 and
      2005
              A-32Consolidated
      Statements of Changes in Shareholders' Equity for the years ended December
      31, 2007, 2006 and 2005
              A-33Consolidated
      Statements of Comprehensive Income for the years ended December 31, 2007,
      2006 and 2005
              A-34Consolidated
      Statements of Cash Flows for the years ended December 31, 2007, 2006 and
      2005
              A-35
      - A-36Notes
      to Consolidated Financial Statements
              A-37
      - A-56






A-27




MANAGEMENT’S
REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING
 
 The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting.  Internal control over
financial reporting is defined in Rule 13a-15(f) promulgated under the
Securities Exchange Act of 1934.  The Company’s internal control over
financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with accounting
principles generally accepted in the United States of
America.  Internal control over financial reporting includes those
policies and procedures that (1) pertain to the maintenance of records that in
reasonable detail accurately and fairly reflect the transactions and depositions
of the assets of the company, (2) provide reasonable assurance that transactions
are recorded as necessary to permit preparation of financial statements in
accordance with accounting principles generally accepted in the United States of
America, and that receipts and expenditures of the company are being made only
in accordance with authorizations of management and directors of the company and
(3) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of the company’s assets that could
have a material effect on the financial statements.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
 
 Management
assessed the effectiveness of the internal control over financial reporting as
of December 31, 2007.  In making this assessment, management used the
criteria established in Internal Control – Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission
(COSO).  Based on our assessment and those criteria, management
believes that the Company maintained effective internal control over financial
reporting as of December 31, 2007.
 
 The
Company’s independent registered public accountants have issued an audit report
on our assessment of the company’s internal control over financial
reporting.  Their report is included herein.






/s/
      Tony W. Wolfe
              
              /s/
      A. Joseph LampronTony
      W. Wolfe
              
              A.
      Joseph LampronChief
      Executive Officer
              
              Chief
      Financial OfficerMarch
      12, 2008
              
              March
      12, 2008






A-28




Porter
Keadle Moore,
LLP


REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
 
 
 
 To the
Board of Directors and shareholders
 Peoples
Bancorp of North Carolina, Inc.
 Newton,
North Carolina
 
 We have
audited the accompanying consolidated balance sheets of Peoples Bancorp of North
Carolina, Inc. and subsidiaries (the “Company”) as of December 31, 2007 and
2006, and the related consolidated statements of earnings, changes in
shareholders’ equity, comprehensive income, and cash flows for each of the years
in the three-year period ended December 31, 2007.  We have also
audited the Company’s internal controls over financial reporting as of December
31, 2007, based on the criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission(COSO). The Company’s management is responsible for these
financial statements, for maintaining effective control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting included in the accompanying Management’s Report of Internal Controls
Over Financial Reporting.  Our responsibility is to express an opinion
on these financial statements and an opinion on the Company’s internal control
over financial reporting based on our audits.
 
 We
conducted our audits in accordance with the auditing standards of the Public
Company Accounting Oversight Board (United States).  Those standards
require that we plan and perform the audits to obtain reasonable assurance about
whether the financial statements are free of material misstatement and whether
effective internal control over financial reporting was maintained in all
material respects.  Our audits of the financial statements included
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements.  Our audits also include assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation.  Our audit
of internal control over financial reporting included obtaining an understanding
of internal control over financial reporting, assessing the risk that a material
weakness exists, and testing and evaluating the design and operating
effectiveness of internal control based on the assessed risk. Our audits also
included performing such other procedures as we considered necessary in the
circumstances. We believe that our audits provide a reasonable basis for our
opinions.
 
 A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of the financial statements for external purposes in
accordance with generally accepted accounting principles. A company’s internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made  only in accordance with authorizations of management and
directors of the company; and (3) provide reasonable assurance regarding
prevention or timely detection of unauthorized acquisition, use, or disposition
of the company’s assets that could have a material effect on the financial
statements.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.




A-29




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Peoples Bancorp of North
Carolina, Inc. and subsidiaries as of December 31, 2007 and 2006, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2007, in conformity with accounting
principles generally accepted in the United States of America. Also, in our
opinion, Peoples Bancorp of North Carolina, Inc. maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2007, based on criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission(COSO).
 
  
   Atlanta,
Georgia
 February
29, 2008
 
 
                
 
 Certified
Public Accountants
     Suite
1800 Ÿ 235
Peachtree Street NE Ÿ  Atlanta,
Georgia 30303 Ÿ
Phone 404-588-4200  Ÿ Fax
404-588-4222  Ÿ
www.pkm.com




A-30






PEOPLES
      BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated
      Balance SheetsDecember
      31, 2007 and 2006Assets
            
            2007
            
            2006Cash
      and due from banks, including reserve requirements
            
            $
            26,108,437
            
            
            
            17,389,046of
      $7,439,000 and $6,243,000Interest
      bearing deposits
            
            
            1,539,190
            
            
            
            1,471,272Federal
      funds sold
            
            
            2,152,000
            
            
            
            2,640,000Cash
      and cash equivalents
            
            
            29,799,627
            
            
            
            21,500,318Investment
      securities available for sale
            
            
            120,968,358
            
            
            
            117,581,000Other
      investments
            
            
            6,433,947
            
            
            
            7,295,449Total
      securities
            
            
            127,402,305
            
            
            
            124,876,449Loans
            
            
            722,276,948
            
            
            
            651,381,129Less
      allowance for loan losses
            
            
            (9,103,058
            )
            
            
            (8,303,432
            )Net
      loans
            
            
            713,173,890
            
            
            
            643,077,697Premises
      and equipment, net
            
            
            18,234,393
            
            
            
            12,816,385Cash
      surrender value of life insurance
            
            
            6,776,379
            
            
            
            6,532,406Accrued
      interest receivable and other assets
            
            
            11,875,202
            
            
            
            10,144,283Total
      assets
            
            $
            907,261,796
            
            
            
            818,947,538Liabilities and
      Shareholders' EquityDeposits:Non-interest
      bearing demand
            
            $
            112,071,090
            
            
            
            101,393,142NOW,
      MMDA & savings
            
            
            196,959,895
            
            
            
            174,577,641Time,
      $100,000 or more
            
            
            203,499,504
            
            
            
            194,176,291Other
      time
            
            
            181,108,214
            
            
            
            163,673,215Total
      deposits
            
            
            693,638,703
            
            
            
            633,820,289Demand
      notes payable to U.S. Treasury
            
            
            1,600,000
            
            
            
            1,600,000Securities
      sold under agreement to repurchase
            
            
            27,583,263
            
            
            
            6,417,803FHLB
      borrowings
            
            
            87,500,000
            
            
            
            89,300,000Junior
      subordinated debentures
            
            
            20,619,000
            
            
            
            20,619,000Accrued
      interest payable and other liabilities
            
            
            6,219,248
            
            
            
            4,355,073Total
      liabilities
            
            
            837,160,214
            
            
            
            756,112,165Shareholders'
      equity:Preferred
      stock, no par value; authorized5,000,000
      shares; no shares issuedand
      outstanding
            
            
            -
            
            
            
            -Common
      stock, no par value; authorized20,000,000
      shares; issued andoutstanding
      5,624,234 shares in 2007and
      3,830,634 shares in 2006
            
            
            48,651,895
            
            
            
            51,122,147Retained
      earnings
            
            
            19,741,876
            
            
            
            12,484,463Accumulated
      other comprehensive income (loss)
            
            
            1,707,811
            
            
            
            (771,237
            )Total
      shareholders' equity
            
            
            70,101,582
            
            
            
            62,835,373Total
      liabilities and shareholders' equity
            
            $
            907,261,796
            
            
            
            818,947,538See
      accompanying notes to consolidated financial statements.





A-31


PEOPLES
      BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated
      Statements of EarningsFor
      the Years Ended December 31, 2007, 2006 and 20052007
              
              
              2006
              
              
              2005Interest
      income:Interest
      and fees on loans
              
              $
              55,400,514
              
              
              
              49,667,700
              
              
              
              37,123,327Interest
      on federal funds sold
              
              
              383,492
              
              
              
              85,307
              
              
              
              72,578Interest
      on investment securities:U.S.
      Government agencies
              
              
              4,571,571
              
              
              
              4,321,346
              
              
              
              3,584,755States
      and political subdivisions
              
              
              887,584
              
              
              
              798,185
              
              
              
              735,892Other
              
              
              488,465
              
              
              
              521,077
              
              
              
              396,020Total
      interest income
              
              
              61,731,626
              
              
              
              55,393,615
              
              
              
              41,912,572Interest
      expense:NOW,
      MMDA & savings deposits
              
              
              4,098,892
              
              
              
              3,060,201
              
              
              
              2,644,413Time
      deposits
              
              
              17,430,012
              
              
              
              14,188,623
              
              
              
              8,923,488FHLB
      borrowings
              
              
              3,758,996
              
              
              
              3,588,169
              
              
              
              2,888,785Junior
      subordinated debentures
              
              
              1,475,701
              
              
              
              1,962,692
              
              
              
              938,145Other
              
              
              821,331
              
              
              
              310,188
              
              
              
              33,790Total
      interest expense
              
              
              27,584,932
              
              
              
              23,109,873
              
              
              
              15,428,621Net
      interest income
              
              
              34,146,694
              
              
              
              32,283,742
              
              
              
              26,483,951Provision
      for loan losses
              
              
              2,038,000
              
              
              
              2,513,282
              
              
              
              3,110,000Net interest income after provision for loan losses
              
              
              32,108,694
              
              
              
              29,770,460
              
              
              
              23,373,951Other
      income:Service
      charges
              
              
              4,278,238
              
              
              
              3,929,956
              
              
              
              3,779,933Other
      service charges and fees
              
              
              1,938,137
              
              
              
              1,539,367
              
              
              
              1,141,879Loss
      on sale and writedown of securities
              
              
              (561,832
              )
              
              
              (591,856
              )
              
              
              (729,727
              )Mortgage
      banking income
              
              
              560,291
              
              
              
              289,293
              
              
              
              469,109Insurance
      and brokerage commissions
              
              
              521,095
              
              
              
              388,559
              
              
              
              386,662Loss
      on sale of repossessed assets
              
              
              (117,880
              )
              
              
              (107,712
              )
              
              
              (37,811
              )Miscellaneous
              
              
              2,197,645
              
              
              
              2,106,188
              
              
              
              1,658,189Total
      other income
              
              
              8,815,694
              
              
              
              7,553,795
              
              
              
              6,668,234Other
      expense:Salaries
      and employee benefits
              
              
              13,887,841
              
              
              
              11,785,094
              
              
              
              10,863,779Occupancy
              
              
              4,750,634
              
              
              
              4,180,058
              
              
              
              3,948,694Other
              
              
              7,354,401
              
              
              
              7,017,986
              
              
              
              5,517,832Total
      other expenses
              
              
              25,992,876
              
              
              
              22,983,138
              
              
              
              20,330,305Earnings
      before income taxes
              
              
              14,931,512
              
              
              
              14,341,117
              
              
              
              9,711,880Income
      taxes
              
              
              5,339,541
              
              
              
              5,170,300
              
              
              
              3,380,900Net
      earnings
              
              $
              9,591,971
              
              
              
              9,170,817
              
              
              
              6,330,980Basic
      earnings per share
              
              $
              1.68
              
              
              
              1.61
              
              
              
              1.11Diluted
      earnings per share
              
              $
              1.65
              
              
              
              1.58
              
              
              
              1.09Cash
      dividends declared per share
              
              $
              0.41
              
              
              
              0.33
              
              
              
              0.25See
      accompanying notes to consolidated financial statements.


A-32
  
 PEOPLES
      BANCORP OF NORTH CAROLINA, INC.Consolidated
      Statements of Changes in Shareholders' EquityFor
      the Years Ended December 31, 2007, 2006 and 2005AccumulatedOtherCommon
      Stock
              
              Retained
              
              ComprehensiveShares
              
              Amount
              
              Earnings
              
              Income
      (Loss)
              TotalBalance,
      December 31, 2004
              
              
              3,135,074
              
              
              $
              35,040,390
              
              
              
              16,018,206
              
              
              
              (120,744
              )
              
              
              50,937,85210%
      stock dividend
              
              
              313,546
              
              
              
              6,274,087
              
              
              
              (6,274,087
              )
              
              
              -
              
              
              
              -Cash
      paid in lieu of fractional shares
              
              
              -
              
              
              
              -
              
              
              
              (4,700
              )
              
              
              -
              
              
              
              (4,700
              )Cash
      dividends declared
              
              
              -
              
              
              
              -
              
              
              
              (1,414,239
              )
              
              
              -
              
              
              
              (1,414,239
              )Repurchase
      and retirement of commonstock
              
              
              (15,000
              )
              
              
              (314,750
              )
              
              
              -
              
              
              
              -
              
              
              
              (314,750
              )Exercise
      of stock options
              
              
              7,185
              
              
              
              96,773
              
              
              
              -
              
              
              
              -
              
              
              
              96,773Net
      earnings
              
              
              -
              
              
              
              -
              
              
              
              6,330,980
              
              
              
              -
              
              
              
              6,330,980Change
      in accumulated othercomprehensive
      income (loss), net of tax
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (1,278,922
              )
              
              
              (1,278,922
              )Balance,
      December 31, 2005
              
              
              3,440,805
              
              
              
              41,096,500
              
              
              
              14,656,160
              
              
              
              (1,399,666
              )
              
              
              54,352,99410%
      stock dividend
              
              
              343,850
              
              
              
              9,430,532
              
              
              
              (9,430,532
              )
              
              
              -
              
              
              
              -Cash
      paid in lieu of fractional shares
              
              
              -
              
              
              
              -
              
              
              
              (6,426
              )
              
              
              -
              
              
              
              (6,426
              )Cash
      dividends declared
              
              
              -
              
              
              
              -
              
              
              
              (1,905,556
              )
              
              
              -
              
              
              
              (1,905,556
              )Repurchase
      and retirement of commonstock
              
              
              (19,250
              )
              
              
              (425,000
              )
              
              
              -
              
              
              
              -
              
              
              
              (425,000
              )Exercise
      of stock options
              
              
              65,229
              
              
              
              771,325
              
              
              
              -
              
              
              
              -
              
              
              
              771,325Stock
      option tax benefit
              
              
              -
              
              
              
              243,100
              
              
              
              -
              
              
              
              -
              
              
              
              243,100Stock
      option compensation expense
              
              
              -
              
              
              
              5,690
              
              
              
              -
              
              
              
              -
              
              
              
              5,690Net
      earnings
              
              
              -
              
              
              
              -
              
              
              
              9,170,817
              
              
              
              -
              
              
              
              9,170,817Change
      in accumulated othercomprehensive
      income (loss), net of tax
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              628,429
              
              
              
              628,429Balance,
      December 31, 2006
              
              
              3,830,634
              
              
              $
              51,122,147
              
              
              
              12,484,463
              
              
              
              (771,237
              )
              
              
              62,835,3733
      for 2 stock split
              
              
              1,915,147
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Cash
      paid in lieu of fractional shares
              
              
              -
              
              
              
              -
              
              
              
              (3,355
              )
              
              
              -
              
              
              
              (3,355
              )Cash
      dividends declared
              
              
              -
              
              
              
              -
              
              
              
              (2,331,203
              )
              
              
              -
              
              
              
              (2,331,203
              )Repurchase
      and retirement of commonstock
              
              
              (150,497
              )
              
              
              (2,810,907
              )
              
              
              -
              
              
              
              -
              
              
              
              (2,810,907
              )Exercise
      of stock options
              
              
              28,950
              
              
              
              239,182
              
              
              
              -
              
              
              
              -
              
              
              
              239,182Stock
      option tax benefit
              
              
              -
              
              
              
              91,815
              
              
              
              -
              
              
              
              -
              
              
              
              91,815Stock
      option compensation expense
              
              
              -
              
              
              
              9,658
              
              
              
              -
              
              
              
              -
              
              
              
              9,658Net
      earnings
              
              
              -
              
              
              
              -
              
              
              
              9,591,971
              
              
              
              -
              
              
              
              9,591,971Change
      in accumulated othercomprehensive
      income (loss), net of tax
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              2,479,048
              
              
              
              2,479,048Balance,
      December 31, 2007
              
              
              5,624,234
              
              
              $
              48,651,895
              
              
              
              19,741,876
              
              
              
              1,707,811
              
              
              
              70,101,582See
      accompanying notes to consolidated financial statements.
   A-33




PEOPLES
      BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIESConsolidated
      Statements of Comprehensive IncomeFor
      the Years Ended December 31, 2007, 2006 and 20052007
              
              
              2006
              
              
              2005Net
      earnings
              
              $
              9,591,971
              
              
              
              9,170,817
              
              
              
              6,330,980Other
      comprehensive income (loss):Unrealized
      holding gains (losses) on securitiesavailable
      for sale
              
              
              1,964,861
              
              
              
              197,569
              
              
              
              (3,045,565
              )Reclassification
      adjustment for losses onsales
      of securities available for sale includedin
      net earnings
              
              
              561,832
              
              
              
              591,856
              
              
              
              729,727Unrealized
      holding gains (losses) on derivativefinancial
      instruments qualifying as cash flowhedges
              
              
              1,244,910
              
              
              
              (345,049
              )
              
              
              (283,493
              )Reclassification
      adjustment for losses (gains) onderivative
      financial instruments qualifying ascash
      flow hedges included in net earnings
              
              
              -
              
              
              
              386,285
              
              
              
              483,715Total
      other comprehensive income (loss),before
      income taxes
              
              
              3,771,603
              
              
              
              830,661
              
              
              
              (2,115,616
              )Income
      tax expense (benefit) related to othercomprehensive
      income:Unrealized
      holding gains (losses) on securitiesavailable
      for sale
              
              
              765,313
              
              
              
              76,953
              
              
              
              (1,186,248
              )Reclassification
      adjustment for losses onsales
      of securities available for sale includedin
      net earnings
              
              
              218,834
              
              
              
              230,528
              
              
              
              284,229Unrealized
      holding gains (losses) on derivativefinancial
      instruments qualifying as cash flowhedges
              
              
              308,408
              
              
              
              (255,707
              )
              
              
              (123,082
              )Reclassification
      adjustment for losses (gains) onderivative
      financial instruments qualifying ascash
      flow hedges included in net earnings
              
              
              -
              
              
              
              150,458
              
              
              
              188,407Total
      income tax expense (benefit) related toother
      comprehensive income
              
              
              1,292,555
              
              
              
              202,232
              
              
              
              (836,694
              )Total
      other comprehensive income (loss),net
      of tax
              
              
              2,479,048
              
              
              
              628,429
              
              
              
              (1,278,922
              )Total
      comprehensive income
              
              $
              12,071,019
              
              
              
              9,799,246
              
              
              
              5,052,058See
      accompanying notes to consolidated financial statements.






A-34






PEOPLES
      BANCORP OF NORTH CAROLINA, INC.Consolidated
      Statements of Cash FlowsFor
      the Years Ended December 31, 2007, 2006 and 20052007
              
              
              2006
              
              
              2005Cash
      flows from operating activities:Net
      earnings
              
              $
              9,591,971
              
              
              
              9,170,817
              
              
              
              6,330,980Adjustments
      to reconcile net earnings tonet
      cash provided by operating activities:Depreciation,
      amortization and accretion
              
              
              1,553,251
              
              
              
              1,616,558
              
              
              
              1,643,459Provision
      for loan losses
              
              
              2,038,000
              
              
              
              2,513,282
              
              
              
              3,110,000Deferred
      income taxes
              
              
              (479,806
              )
              
              
              (615,626
              )
              
              
              332,806Loss
      on sale and writedown of investment securities
              
              
              561,832
              
              
              
              591,856
              
              
              
              729,727Recognition
      of gain on sale ofderivative
      instruments
              
              
              -
              
              
              
              386,285
              
              
              
              483,715Amortization
      of deferred gain on sale of premises
              
              
              (10,337
              )
              
              
              (20,896
              )
              
              
              (21,984
              )Loss
      (gain) on sale of repossessed assets
              
              
              83,294
              
              
              
              (2,288
              )
              
              
              (2,189
              )Writedown
      of other real estate and repossessions
              
              
              34,586
              
              
              
              110,000
              
              
              
              40,000Amortization
      of deferred issuance costs ontrust
      preferred securities
              
              
              -
              
              
              
              461,298
              
              
              
              17,742Stock
      option compensation expense
              
              
              9,658
              
              
              
              5,690
              
              
              
              -Change
      in:Mortgage
      loans held for sale
              
              
              -
              
              
              
              2,247,900
              
              
              
              1,535,275Cash
      surrender value of life insurance
              
              
              (243,973
              )
              
              
              (220,649
              )
              
              
              (277,569
              )Other
      assets
              
              
              (1,013,866
              )
              
              
              (1,206,937
              )
              
              
              444,944Other
      liabilities
              
              
              2,403,990
              
              
              
              (230,144
              )
              
              
              651,204Net
      cash provided by operating activities
              
              
              14,528,600
              
              
              
              14,807,146
              
              
              
              15,018,110Cash
      flows from investing activities:Purchases
      of investment securities available for sale
              
              
              (15,858,155
              )
              
              
              (30,579,262
              )
              
              
              (49,431,813
              )Proceeds
      from calls and maturities of investment securitiesavailable
      for sale
              
              
              7,470,991
              
              
              
              8,562,058
              
              
              
              9,655,995Proceeds
      from sales of investment securities availablefor
      sale
              
              
              8,362,525
              
              
              
              19,871,979
              
              
              
              27,768,392Purchases
      of other investments
              
              
              (8,356,900
              )
              
              
              (12,748,200
              )
              
              
              (5,367,790
              )Proceeds
      from sale of other investments
              
              
              8,424,000
              
              
              
              11,263,500
              
              
              
              4,239,000Net
      change in loans
              
              
              (72,815,928
              )
              
              
              (86,825,349
              )
              
              
              (35,062,738
              )Purchases
      of premises and equipment
              
              
              (7,672,018
              )
              
              
              (1,624,299
              )
              
              
              (1,373,019
              )Proceeds
      from sale of premises and equipment
              
              
              55,630
              
              
              
              -
              
              
              
              1,750Proceeds
      from sale of repossessed assets
              
              
              425,158
              
              
              
              825,115
              
              
              
              246,218Purchases
      of derivative financial instruments
              
              
              (634,000
              )
              
              
              (961,500
              )
              
              
              (364,000
              )Payment
      on settlement of derivativefinancial
      instruments
              
              
              -
              
              
              
              -
              
              
              
              (870,000
              )Net
      cash used by investing activities
              
              
              (80,598,697
              )
              
              
              (92,215,958
              )
              
              
              (50,558,005
              )Cash
      flows from financing activities:Net
      change in deposits
              
              
              59,818,414
              
              
              
              50,966,628
              
              
              
              26,331,588Net
      change in demand notes payable to U.S. Treasury
              
              
              -
              
              
              
              126,307
              
              
              
              289,301Net
      change in securities sold under agreement to repurchase
              
              
              21,165,460
              
              
              
              5,436,753
              
              
              
              981,050Proceeds
      from FHLB borrowings
              
              
              275,300,000
              
              
              
              700,800,000
              
              
              
              162,300,000Repayments
      of FHLB borrowings
              
              
              (277,100,000
              )
              
              
              (683,100,000
              )
              
              
              (149,700,000
              )Proceeds
      from issuance of trust preferred securities
              
              
              -
              
              
              
              20,619,000
              
              
              
              -Repayments
      of trust preferred securities
              
              
              -
              
              
              
              (14,433,000
              )
              
              
              -Proceeds
      from exercise of stock options
              
              
              330,997
              
              
              
              1,014,425
              
              
              
              96,773Common
      stock repurchased
              
              
              (2,810,907
              )
              
              
              (425,000
              )
              
              
              (314,750
              )Cash
      paid in lieu of fractional shares
              
              
              (3,355
              )
              
              
              (6,426
              )
              
              
              (4,700
              )Cash
      dividends paid
              
              
              (2,331,203
              )
              
              
              (1,905,556
              )
              
              
              (1,414,239
              )Net
      cash provided by financing activities
              
              
              74,369,406
              
              
              
              79,093,131
              
              
              
              38,565,023Net
      change in cash and cash equivalent
              
              
              8,299,309
              
              
              
              1,684,319
              
              
              
              3,025,128Cash
      and cash equivalents at beginning of period
              
              
              21,500,318
              
              
              
              19,815,999
              
              
              
              16,790,871Cash
      and cash equivalents at end of period
              
              $
              29,799,627
              
              
              
              21,500,318
              
              
              
              19,815,999






A-35






PEOPLES
      BANCORP OF NORTH CAROLINA, INC.Consolidated
      Statements of Cash Flows, continuedFor
      the Years ended December 31, 2007, 2006 and 20052007
              
              
              2006
              
              
              2005Supplemental
      disclosures of cash flow information:Cash
      paid during the year for:Interest
              
              $
              27,420,245
              
              
              
              23,171,572
              
              
              
              15,189,559Income
      taxes
              
              $
              5,689,500
              
              
              
              6,398,100
              
              
              
              2,245,000Noncash
      investing and financing activities:Change
      in unrealized gain (loss) on investment securitiesavailable
      for sale, net
              
              $
              1,542,546
              
              
              
              481,944
              
              
              
              (1,413,819
              )Change
      in unrealized gain on derivative financialinstruments,
      net
              
              $
              936,502
              
              
              
              146,485
              
              
              
              134,897Transfer
      of loans to other real estate and repossessions
              
              $
              681,735
              
              
              
              746,004
              
              
              
              133,210Financed
      portion of sale of other real estate
              
              $
              -
              
              
              
              273,000
              
              
              
              -Reclassification
      of an investment from other assetsto
      securities available for sale
              
              $
              499,995
              
              
              
              -
              
              
              
              -Reclassification
      of a security from other investmentsto
      securities available for sale
              
              $
              600,000
              
              
              
              -
              
              
              
              715,000Transfer
      of retained earnings to common stock forissuance
      of stock dividend
              
              $
              -
              
              
              
              9,430,532
              
              
              
              6,274,087Deferred
      gain rolled into cost basis ofacquired
      building
              
              $
              539,815
              
              
              
              -
              
              
              
              -See
      accompanying notes to consolidated financial statements.






A-36




PEOPLES
BANCORP OF NORTH CAROLINA, INC.
 
 Notes
to Consolidated Financial Statements
 
 (1)
              Summary
      of Significant Accounting Policies
  Organization
 Peoples
Bancorp of North Carolina, Inc. (“Bancorp”) received regulatory approval to
operate as a bank holding company on July 22, 1999, and became effective August
31, 1999.  Bancorp is primarily regulated by the Board of Governors of
the Federal Reserve System, and serves as the one-bank holding company for
Peoples Bank.
 
 Peoples
Bank (the “Bank”) commenced business in 1912 upon receipt of its banking charter
from the North Carolina State Banking Commission (the “SBC”). The Bank is
primarily regulated by the SBC and the Federal Deposit Insurance Corporation and
undergoes periodic examinations by these regulatory agencies. The Bank, whose
main office is in Newton, North Carolina, provides a full range of commercial
and consumer banking services primarily in Catawba, Alexander, Lincoln,
Mecklenburg, Iredell and Union counties in North Carolina.
 
 Peoples
Investment Services, Inc. is a wholly owned subsidiary of the Bank and began
operations in 1996 to provide investment and trust services through agreements
with an outside party.
 
 Real
Estate Advisory Services, Inc. is a wholly owned subsidiary of the Bank and
began operations in 1997 to provide real estate appraisal and property
management services to individuals and commercial customers of the
Bank.
 
 Principles of
Consolidation
 The
consolidated financial statements include the financial statements of Peoples
Bancorp of North Carolina, Inc. and its wholly owned subsidiary, the Bank, along
with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and
Real Estate Advisory Services, Inc. (collectively called the
“Company”).  All significant intercompany balances and transactions
have been eliminated in consolidation.
 
 Basis of
Presentation
 The
accounting principles followed by the Company, and the methods of applying these
principles, conform with accounting principles generally accepted in the United
States of America (“GAAP”) and with general practices in the banking industry.
In preparing the financial statements in conformity with GAAP, management is
required to make estimates and assumptions that affect the reported amounts in
the financial statements. Actual results could differ significantly from these
estimates. Material estimates common to the banking industry that are
particularly susceptible to significant change in the near term include, but are
not limited to, the determination of the allowance for loan losses and valuation
of real estate acquired in connection with or in lieu of foreclosure on
loans.
 
 Cash and Cash
Equivalents
 Cash and
due from banks and federal funds sold are considered cash and cash equivalents
for cash flow reporting purposes. Generally, federal funds are sold for one-day
periods.
 
 Investment
Securities
 The
Company classifies its securities in one of three categories: trading, available
for sale, or held to maturity. Trading securities are bought and held
principally for sale in the near term. Held to maturity securities are those
securities for which the Company has the ability and intent to hold until
maturity. All other securities not included in trading or held to maturity are
classified as available for sale. At December 31, 2007 and 2006, the Company had
classified all of its investment securities as available for sale.
 
 Available
for sale securities are recorded at fair value. Unrealized holding gains and
losses, net of the related tax effect, are excluded from earnings and are
reported as a separate component of shareholders’ equity until
realized.
 
 A decline
in the market value of any available for sale investment below cost that is
deemed other than temporary is charged to earnings and establishes a new cost
basis for the security.
 
 Premiums
and discounts are amortized or accreted over the life of the related security as
an adjustment to the yield.  Realized gains and losses for securities
classified as available for sale are included in earnings and are derived using
the specific identification method for determining the cost of securities
sold.
   A-37
  Other
Investments
 Other
investments include equity securities with no readily determinable fair
value.  These investments are carried at cost.
 
 Loans
 Loans
that management has the intent and ability to hold for the foreseeable future or
until maturity are reported at the principal amount outstanding, net of the
allowance for loan losses. Interest on loans is calculated by using the simple
interest method on daily balances of the principal amount
outstanding.   The recognition of certain loan origination fee
income and certain loan origination costs is deferred when such loans are
originated and amortized over the life of the loan.
 
 Impaired
loans are measured based on the present value of expected future cash flows,
discounted at the loan’s effective interest rate, or at the loan’s observable
market price, or the fair value of the collateral if the loan is collateral
dependent. A loan is impaired when, based on current information and events, it
is probable that all amounts due according to the contractual terms of the loan
will not be collected.
 
 Accrual
of interest is discontinued on a loan when management believes, after
considering economic conditions and collection efforts that the borrower’s
financial condition is such that collection of interest is doubtful. Interest
previously accrued but not collected is reversed against current period earnings
and interest is recognized on a cash basis when such loans are placed on
non-accrual status.
 
 Allowance for Loan
Losses
 
 The
allowance for loan losses reflects management's assessment and estimate of the
risks associated with extending credit and its evaluation of the quality of the
loan portfolio.  The Bank periodically analyzes the loan portfolio in
an effort to review asset quality and to establish an allowance for loan losses
that management believes will be adequate in light of anticipated risks and loan
losses.  In assessing the adequacy of the allowance, size, quality and
risk of loans in the portfolio are reviewed. Other factors considered
are:
 
 ·
              the
      Bank’s loan loss experience;
 ·
              the
      amount of past due and non-performing
loans;
 ·
              specific
      known risks;
 ·
              the
      status and amount of other past due and non-performing
    assets;
 ·
              underlying
      estimated values of collateral securing
loans;
 ·
              current
      and anticipated economic conditions;
and
 ·
              other
      factors which management believes affect the allowance for potential
      credit losses.
 
 The
allowance for loan losses is comprised of three components: specific reserves,
general reserves and unallocated reserves.  After a loan has been
identified as impaired, management measures impairment in accordance with SFAS
No. 114, “Accounting By
Creditors for Impairment of a Loan.”When the measure of the impaired
loan is less than the recorded investment in the loan, the amount of the
impairment is recorded as a specific reserve. These specific reserves are
determined on an individual loan basis based on management’s current evaluation
of the Company’s loss exposure for each credit, given the payment status,
financial condition of the borrower, and value of any underlying collateral.
Loans for which specific reserves are provided are excluded from the general
allowance calculations as described below.  At December 31, 2007 and
2006, the recorded investment in loans that were considered to be impaired under
SFAS No. 114 was approximately $8.0 million and $7.6 million, respectively, with
related allowance for loan losses of approximately $1.2 million for December 31,
2007 and 2006.
 
 The
general allowance reflects reserves established under the provisions of SFAS No.
5, “Accounting for Contingencies” for collective loan
impairment.  These reserves are based upon historical net charge-offs
using the last three years’ experience.  This charge-off experience
may be adjusted to reflect the effects of current conditions.  The
Bank considers information derived from its loan risk ratings and external data
related to industry and general economic trends.
 
 The
unallocated allowance is determined through management’s assessment of probable
losses that are in the portfolio but are not adequately captured by the other
two components of the allowance, including consideration of current economic and
business conditions and regulatory requirements. The unallocated allowance also
reflects management’s acknowledgement of the imprecision and subjectivity that
underlie the modeling of credit risk.  Due to
the  subjectivity involved in determining the overall allowance,
including the unallocated portion, this
   A-38
  unallocated
portion may fluctuate from period to period based on management’s evaluation of
the factors affecting the assumptions used in calculating the
allowance.
 
 Management
considers the allowance for loan losses adequate to cover the estimated losses
inherent in the Company’s loan portfolio as of the date of the financial
statements. Management believes it has established the allowance in accordance
with accounting principles generally accepted in the United States of America
and in consideration of the current economic environment. Although management
uses the best information available to make evaluations, significant future
additions to the allowance may be necessary based on changes in economic and
other conditions, thus adversely affecting the operating results of the
Company.
 
 There
were no significant changes in the estimation methods or fundamental assumptions
used in the evaluation of the allowance for loan losses for the year ended
December 31, 2007 as compared to the year ended December 31, 2006.
Such revisions, estimates and assumptions are made in any period in which the
supporting factors indicate that loss levels may vary from the previous
estimates.
 
 Additionally,
various regulatory agencies, as an integral part of their examination process,
periodically review the Bank’s allowances for loan losses. Such agencies may
require adjustments to the allowances based on their judgments of information
available to them at the time of their examinations.
 
 Mortgage Banking
Activities
 Mortgage
banking income represents net gains from the sale of mortgage loans and fees
received from borrowers and loan investors related to the Company’s origination
of single-family residential mortgage loans.
 
 Mortgage
servicing rights (“MSR's”) represent the unamortized cost of purchased and
originated contractual rights to service mortgages for others in exchange for a
servicing fee.  MSRs are amortized over the period of estimated net
servicing income and are periodically adjusted for actual prepayments of the
underlying mortgage loans. During the year ended December 31, 2006, the Company
fully amortized the remaining balance of the Bank’s MSRs.  Management determined
there was minimal fair value in the MSRs due to the small remaining balance in
the loans serviced for others.The Company amortized
approximately $227,000 and $56,000 during 2006 and 2005,
respectively.  No new servicing assets were recognized during 2007,
2006 and 2005.
 
 Mortgage
loans serviced for others are not included in the accompanying balance sheets.
The unpaid principal balances of mortgage loans serviced for others was
approximately $12.1 million, $14.8 million and $18.1 million at December 31,
2007, 2006 and 2005, respectively.
 
 Premises and
Equipment
 Premises
and equipment are stated at cost less accumulated depreciation. Depreciation is
computed primarily using the straight-line method over the estimated useful
lives of the assets. When assets are retired or otherwise disposed, the cost and
related accumulated depreciation are removed from the accounts, and any gain or
loss is reflected in earnings for the period. The cost of maintenance and
repairs that do not improve or extend the useful life of the respective asset is
charged to earnings as incurred, whereas significant renewals and improvements
are capitalized. The range of estimated useful lives for premises and equipment
are generally as follows:
  Buildings and
      improvements
                
                10 - 50
    yearsFurniture and
      equipment
                
                3 - 10
    years
 Foreclosed
Assets
 Foreclosed
assets include all assets received in full or partial satisfaction of a loan and
include real and personal property. Foreclosed assets are reported at the lower
of carrying amount or net realizable value, and are included in other assets on
the balance sheet.
 
 Income
Taxes
 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 their respective tax bases. Additionally,
the recognition of future tax benefits, such as net operating loss
carryforwards, is required to the extent that realization of such benefits is
more likely than not. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which the
assets and liabilities 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 tax expense in the period that includes the enactment date.
   A-39
  In the
event the future tax consequences of differences between the financial reporting
bases and the tax bases of the Company’s assets and liabilities results in
deferred tax assets, an evaluation of the probability of being able to realize
the future benefits indicated by such asset is required. A valuation allowance
is provided for the portion of the deferred tax asset when it is more likely
than not that some portion or all of the deferred tax asset will not be
realized. In assessing the realizability of the deferred tax assets, management
considers the scheduled reversals of deferred tax liabilities, projected future
taxable income, and tax planning strategies.
 
 Derivative Financial
Instruments and Hedging Activities
 In the
normal course of business, the Company enters into derivative contracts to
manage interest rate risk by modifying the characteristics of the related
balance sheet instruments in order to reduce the adverse effect of changes in
interest rates. All derivative financial instruments are recorded at fair value
in the financial statements.
 
 On the
date a derivative contract is entered into, the Company designates the
derivative as a fair value hedge, a cash flow hedge, or a trading instrument.
Changes in the fair value of instruments used as fair value hedges are accounted
for in the earnings of the period simultaneous with accounting for the fair
value change of the item being hedged. Changes in the fair value of the
effective portion of cash flow hedges are accounted for in other comprehensive
income rather than earnings. Changes in fair value of instruments that are not
intended as a hedge are accounted for in the earnings of the period of the
change.
 
 If a
derivative instrument designated as a fair value hedge is terminated or the
hedge designation removed, the difference between a hedged item’s then carrying
amount and its face amount is recognized into income over the original hedge
period. Likewise, if a derivative instrument designated as a cash flow hedge is
terminated or the hedge designation removed, related amounts accumulated in
other accumulated comprehensive income are reclassified into earnings over the
original hedge period during which the hedged item affects income.
 
 The
Company formally documents all hedging relationships, including an assessment
that the derivative instruments are expected to be highly effective in
offsetting the changes in fair values or cash flows of the hedged
items.
 
 Advertising
Costs
 The costs
of advertising costs are expensed as incurred.
 
 Accumulated Other
Comprehensive Income
 At
December 31, 2007, accumulated other comprehensive income (loss) consisted of
net unrealized gains on securities available for sale of $943,000 and net
unrealized gains on derivatives of $765,000.  At December 31, 2006,
accumulated other comprehensive income (loss) consisted of net unrealized losses
on securities available for sale of $600,000 and net unrealized losses on
derivatives of $171,000.
 
 Stock-Based
Compensation
 The
Company has an Omnibus Stock Ownership and Long Term Incentive Plan (the “Plan”)
whereby certain stock-based rights, such as stock options, restricted stock,
performance units, stock appreciation rights, or book value shares, may be
granted to eligible directors and employees.  A total of 636,687
shares are currently reserved for possible issuance under this
Plan.   All rights must be granted or awarded within ten years
from the May 13, 1999 effective date of the plan.
 
 Under the
Plan, the Company has granted incentive stock options to certain eligible
employees in order that they may purchase Company stock at a price equal to the
fair market value on the date of the grant.  The options granted in
1999 vested over a five-year period.  Options granted subsequent to
1999 vest over a three-year period.  All options expire after ten
years.  A summary of the activity in the Plan is presented
below:
   A-40
  Stock
      Option ActivityFor
      the years ended December 31, 2007, 2006 and 2005Shares
                
                Weighted
                  Average
      Option
                  Price
      Per Share
                
                Weighted
      Average
                  Remaining
                  Contractual
      Term (in
                  years)
                
                Aggregate
                  Intrinsic
                  ValueOutstanding,
      December 31, 2004
                
                
                333,978
                
                
                $
                8.11Granted
      during the period
                
                
                -
                
                
                $
                -Forfeited
      during the period
                
                
                (1,970
                )
                
                $
                7.77Exercised
      during the period
                
                
                (12,316
                )
                
                $
                7.86Outstanding,
      December 31, 2005
                
                
                319,692
                
                
                $
                8.13Granted
      during the period
                
                
                -
                
                
                $
                -Forfeited
      during the period
                
                
                (164
                )
                
                $
                7.38Exercised
      during the period
                
                
                (97,854
                )
                
                $
                7.87Outstanding,
      December 31, 2006
                
                
                221,674
                
                
                $
                8.24Granted
      during the period
                
                
                -
                
                
                $
                -Forfeited
      during the period
                
                
                -
                
                
                $
                -Exercised
      during the period
                
                
                (28,949
                )
                
                $
                8.26Outstanding,
      December 31, 2007
                
                
                192,725
                
                
                $
                8.24
                
                4.05
                
                $   1,303,460Exercisable,
      December 31, 2007
                
                
                192,725
                
                
                $
                8.24
                
                4.05
                
                $   1,303,460




Options
outstanding at December 31, 2007 are exercisable at option prices ranging from
$6.99 to $10.57, as presented in the table above.  Such options have a
weighted average remaining contractual life of approximately four
years.
 
 The
Company adopted Statement of Financial Accounting Standards (“SFAS”)
No. 123(R), “Share-Based Payment” (SFAS 123(R)), on January 1, 2006
using the “modified prospective” method. Under this method, awards that are
granted, modified, or settled after December 31, 2005, are measured and
accounted for in accordance with SFAS 123(R). Also under this method, expense is
recognized for unvested awards that were granted prior to January 1, 2006,
based upon the fair value determined at the grant date under SFAS No. 123,
“Accounting for Stock-Based Compensation” (SFAS 123).  The Company
recognized compensation expense for employee stock options of $10,000 and $6,000
for the years ended December 31, 2007 and 2006, respectively.  As of
December 31, 2007, there was no unrecognized compensation cost related to
nonvested employee stock options.
 
 Prior to
the adoption of SFAS 123(R), the Company accounted for stock compensation under
Accounting Principles Board Opinion No. 25 and related
interpretations.   Accordingly, the Company previously recognized
no compensation cost for employee stock options.  The following table
illustrates the effect on net earnings and earnings per share if the Company had
applied the fair value recognition provisions of SFAS 123 as of December 31,
2005.
 
  2005Net
      earnings
                As
      reported
                
                $
                6,330,980Effect
      of grants
                
                
                (143,747
                )Effect
      of forfeitures
                
                
                5,253Proforma
                
                $
                6,192,486Basic
      earnings per share
                As
      reported
                
                $
                1.11Proforma
                
                $
                1.09Diluted
      earnings per share
                As
      reported
                
                $
                1.09Proforma
                
                $
                1.07
   A-41
  No
options were granted during the years ended December 31, 2007 and
2006.  The total intrinsic value (amount by which the fair market
value of the underlying stock exceeds the exercise price of an option on
exercise date) of options exercised during the years ended December 31, 2007 and
2006 was $264,000 and $923,000, respectively.  There were 2,420
options vested during the years ended December 31, 2007 and
2006.  Cash received from option exercises for the years ended
December 31, 2007 and 2006 was $239,000 and $771,000,
respectively.  The tax benefit for the tax deductions from option
exercises totaled $92,000 and $243,000, respectively for the years ended
December 31, 2007 and 2006.
 
 The
Company granted 3,000 shares of restricted stock during the three months ended
September 30, 2007.  These restricted stock grants cliff vest three
years after issuance.  The fair value of the restricted stock granted
is $17.40 per share. As of September 30, 2007, there was $48,000 of total
unrecognized compensation cost related to restricted stock grants, which is
expected to be recognized over a period of 3 years.
 
 Net Earnings Per
Share
 Net
earnings per share is based on the weighted average number of common shares
outstanding during the period while the effects of potential common shares
outstanding during the period are included in diluted earnings per share. The
average market price during the year is used to compute equivalent
shares.
 
 The
reconciliations of the amounts used in the computation of both “basic earnings
per share” and “diluted earnings per share” for the years ended December 31,
2007, 2006 and 2005 are as follows:
   Common
                
                
                Per
      ShareFor
      the year ended December 31, 2007:
                
                
                Net
      Earnings
                
                Shares
                
                
                AmountBasic
      earnings per share
                
                $
                9,591,971
                
                
                
                5,700,860
                
                
                $
                1.68Effect
      of dilutive securities:Stock
      options
                
                
                -
                
                
                
                109,455Diluted
      earnings per share
                
                $
                9,591,971
                
                
                
                5,810,315
                
                
                $
                1.65For
      the year ended December 31, 2006:
                
                
                
                
                
                
                Common
                
                
                Per
      ShareNet
      Earnings
                
                Shares
                
                
                AmountBasic
      earnings per share
                
                $
                9,170,817
                
                
                
                5,701,829
                
                
                $
                1.61Effect
      of dilutive securities:Stock
      options
                
                
                -
                
                
                
                100,495Diluted
      earnings per share
                
                $
                9,170,817
                
                
                
                5,802,324
                
                
                $
                1.58For
      the year ended December 31, 2005:
                
                
                
                
                
                
                Common
                
                
                Per
      ShareNet
      Earnings
                
                Shares
                
                
                AmountBasic
      earnings per share
                
                $
                6,330,980
                
                
                
                5,692,290
                
                
                $
                1.11Effect
      of dilutive securities:Stock
      options
                
                
                -
                
                
                
                100,084Diluted
      earnings per share
                
                $
                6,330,980
                
                
                
                5,792,374
                
                
                $
                1.09
   On April
19, 2007, the Board of Directors of the Company authorized a 3-for-2 stock split
that was paid in conjunction with the Company’s regular cash dividend for the
second quarter of 2007.  As a result of the stock split, each
shareholder received three new shares of stock for every two shares of stock
they held as of the record date.  Shareholders received a cash payment
in lieu of any fractional shares resulting from the stock split.  The
cash dividend was paid based on the number of shares held by shareholders as
adjusted by the stock split.  All previously reported per share
amounts have been restated to reflect this stock split.
  Recent Accounting
Pronouncements
  In
June 2006, FASB issued Financial Interpretation No. 48 ("FIN 48") "Accounting
for Uncertainty in Income Taxes - an interpretation of SFAS No.
109".   FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in the financial statements and prescribes a recognition
threshold and measurement attribute for a tax position taken or expected to be
taken in a tax return.   This interpretation also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure and transition.  This interpretation was effective
for the Company beginning in January of 2007.   The Company assessed
the impact of FIN 48 and determined that there are no significant positions
taken in the preparation of its tax return, and therefore FIN 48 did not have a
material impact on its financial position or its results of
operations.
   A-42
  In
September 2006, the FASB ratified the conclusions reached by the Emerging Issues
Task Force (EITF) on EITF 06-4, "Accounting for Deferred Compensation and
Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements."   This issue will require companies to recognize an
obligation for either the present value of the entire promised death benefit or
the annual "cost of insurance" required to keep the policy in force during the
post-retirement years.  EITF 06-4 is effective for the Company as of
January 1, 2008.  This standard is not expected to have a material effect
on the Company's financial position, results of operations or
disclosures.
  In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS
157).  SFAS 157 defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles (GAAP), and expands
disclosures about fair value measurements.  SFAS 157 applies under other
accounting pronouncements that require or permit fair value measurements.
 SFAS 157 is effective for the Company as of January 1,
2008.  This standard is not expected to have a material effect on the
Company's financial position or results of operations
  In
September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans” (SFAS 158) – an amendment of
FASB Statements No. 87, 88, 106 and 132(R).  SFAS 158 requires employers to
recognize the overfunded or underfunded status of a defined benefit
postretirement plan as an asset or liability in its statement of financial
position and to recognize changes in that funded status in the year in which the
changes occur through comprehensive income.  SFAS 158 requires an employer
to measure the funded status of a plan as of the date of its year-end statement
of financial position, with limited exceptions and includes expanded
disclosures.  SFAS 158 was effective for the Company as of January 1,
2007.  This standard did not have a material effect on the Company's
financial position, results of operations or disclosures.
 
 In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (SFAS 159), which permits entities
to choose to measure financial instruments and certain other instruments at fair
value.  SFAS 159 is effective for the Company as of January 1,
2008.    The Company does not expect to choose this option
for any asset or liability and therefore does not expect SFAS 159 to have a
material effect on the Company's financial position, results of operations or
disclosures.
 
 Reclassification
 
 Certain
amounts in the 2005 consolidated financial statements have been reclassified to
conform to the 2007 and 2006 presentation.
 
 (2)
              Investment Securities
 
 Investment
securities available for sale at December 31, 2007 and 2006 are as
follows:
 
  December
      31, 2007Gross
                
                
                GrossAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                Estimated
      FairCost
                
                
                Gains
                
                
                Losses
                
                
                ValueMortgage-backed
      securities
                
                $
                16,469,053
                
                
                
                6,423
                
                
                
                204,509
                
                
                
                16,270,967U.S.
      government agencies
                
                
                75,155,693
                
                
                
                1,839,143
                
                
                
                3,035
                
                
                
                76,991,801State
      and political subdivisions
                
                
                25,856,311
                
                
                
                250,483
                
                
                
                201,406
                
                
                
                25,905,388Trust
      preferred securities
                
                
                250,000
                
                
                
                -
                
                
                
                -
                
                
                
                250,000Equity
      securities
                
                
                1,692,799
                
                
                
                246,000
                
                
                
                388,597
                
                
                
                1,550,202Total
                
                $
                119,423,856
                
                
                
                2,342,049
                
                
                
                797,547
                
                
                
                120,968,358
   A-43
   December
      31, 2006Amortized
                  Cost
                
                Gross
                  Unrealized
                  Gains
                
                Gross
                  Unrealized
                  Losses
                
                Estimated
      Fair ValueMortgage-backed
      securities
                $
                
                19,666,345
                
                
                
                -
                
                
                
                446,751
                
                
                
                19,219,594U.S.
      government agencies
                
                
                72,838,407
                
                
                
                171,828
                
                
                
                265,821
                
                
                
                72,744,414State
      and political subdivisions
                
                
                24,493,444
                
                
                
                242,204
                
                
                
                369,178
                
                
                
                24,366,470Trust
      preferred securities
                
                
                750,000
                
                
                
                -
                
                
                
                -
                
                
                
                750,000Equity
      securities
                
                
                814,995
                
                
                
                -
                
                
                
                314,473
                
                
                
                500,522Total
                $
                
                118,563,191
                
                
                
                414,032
                
                
                
                1,396,223
                
                
                
                117,581,000
  The
current fair value and associated unrealized losses on investments in debt
securities with unrealized losses at December 31, 2007 and 2006 are summarized
in the tables below, with the length of time the individual securities have been
in a continuous loss position.
 
  December
      31, 2007Less
      than 12 Months
                
                12
      Months or More
                
                TotalUnrealized
                
                
                Unrealized
                
                
                UnrealizedFair
      Value
                Losses
                Fair
      Value
                Losses
                Fair
      Value
                LossesMortgage-backed
      securities
                
                $
                24,591
                
                104
                
                14,320,043
                
                204,405
                
                14,344,634
                
                204,509U.S.
      government agencies
                
                
                -
                
                -
                
                689,775
                
                3,035
                
                689,775
                
                3,035State
      and political subdivisions
                
                
                2,059,746
                
                33,781
                
                11,188,720
                
                167,625
                
                13,248,466
                
                201,406Equity
      securities
                
                
                425,620
                
                88,134
                
                278,581
                
                300,463
                
                704,201
                
                388,597Total
                
                $
                2,509,957
                
                122,019
                
                26,477,119
                
                675,528
                
                28,987,076
                
                797,547
   December
      31, 2006Less
      than 12 Months
                
                12
      Months or More
                
                TotalUnrealized
                
                
                Unrealized
                
                
                UnrealizedFair
      Value
                Losses
                Fair
      Value
                Losses
                Fair
      Value
                LossesMortgage-backed
      securities
                
                $
                -
                
                -
                
                19,202,188
                
                446,751
                
                19,202,188
                
                446,751U.S.
      government agencies
                
                
                23,069,770
                
                13,361
                
                21,510,425
                
                252,460
                
                44,580,195
                
                265,821State
      and political subdivisions
                
                
                1,445,462
                
                35,988
                
                11,589,682
                
                333,190
                
                13,035,144
                
                369,178Equity
      securities
                
                
                -
                
                -
                
                500,522
                
                314,473
                
                500,522
                
                314,473Total
                
                $
                24,515,232
                
                49,349
                
                52,802,817
                
                1,346,874
                
                77,318,049
                
                1,396,223
   At
December 31, 2007, unrealized losses in the investment securities portfolio
related to debt securities totaled $409,000.  The unrealized losses on
these debt securities arose due to changing interest rates and are considered to
be temporary.  From the December 31, 2007 tables above, 32 out of 72
securities issued by state and political subdivisions contained unrealized
losses and 19 out of 59 securities issued by U.S. government agencies and
government sponsored corporations, including mortgage-backed securities,
contained unrealized losses.  These unrealized losses are considered
temporary because of acceptable investment grades on each security and the
repayment sources of principal and interest are government backed.
 
 The
Company periodically evaluates its investments for any impairment which would be
deemed other than temporary.   As part of its evaluation in 2007, the
Company determined that the fair value of two investments was less than the
original cost of the investments and that the decline in fair value was not
temporary in nature.  As a result, the Company wrote down its original
investment by $430,000.  The remaining value of the investments at December
31, 2007 is $348,000.
 
 The
amortized cost and estimated fair value of investment securities available for
sale at December 31, 2007, by contractual maturity, are shown below. Expected
maturities of mortgage-backed securities will differ from contractual maturities
because borrowers have the right to call or prepay obligations with or without
call or prepayment penalties.
   A-44
  Amortized
                
                
                
                Estimated
      FairCost
                
                
                
                ValueDue
      within one year
                
                $
                7,319,434
                
                
                
                7,331,682Due
      from one to five years
                
                
                56,422,798
                
                
                
                57,569,880Due
      from five to ten years
                
                
                29,280,174
                
                
                
                29,899,813Due
      after ten years
                
                
                8,239,598
                
                
                
                8,345,814Mortgage-backed
      securities
                
                
                16,469,053
                
                
                
                16,270,967Equity
      securities
                
                
                1,692,799
                
                
                
                1,550,202Total
                
                $
                119,423,856
                
                
                
                120,968,358
  Proceeds
from sales of securities available for sale during 2007, 2006 and 2005 were $8.4
million, $19.9 million and $27.8 million, respectively. Gross losses of
$132,000, $592,000 and $730,000 for 2007, 2006 and 2005, respectively, were
realized on those sales.
 
 Securities
with a fair value of approximately $50.4 million and $25.0 million at December
31, 2007 and 2006, respectively, were pledged to secure public deposits and for
other purposes as required by law.
  
 (3)
              Loans
 
 Major
classifications of loans at December 31, 2007 and 2006 are summarized as
follows:
 
   2007
                
                
                
                2006Commercial
                
                $
                82,190,391
                
                
                
                85,064,322Real
      estate - mortgage
                
                
                417,708,750
                
                
                
                364,595,188Real
      estate - construction
                
                
                209,643,836
                
                
                
                187,959,880Consumer
                
                
                12,733,971
                
                
                
                13,761,739Total
      loans
                
                
                722,276,948
                
                
                
                651,381,129Less
      allowance for loan losses
                
                
                9,103,058
                
                
                
                8,303,432Total
      net loans
                
                $
                713,173,890
                
                
                
                643,077,697
   The
Company grants loans and extensions of credit primarily within the Catawba
Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell
and Lincoln counties and also in Mecklenburg and Union
Counties.  Although the Bank has a diversified loan portfolio, a
substantial portion of the loan portfolio is collateralized by improved and
unimproved real estate, the value of which is dependent upon the real estate
market.
 
 At
December 31, 2007 and 2006, the recorded investment in loans that were
considered to be impaired was approximately $8.0 million and $7.6 million,
respectively. In addition, the Company had approximately $0 and $78,000 in loans
past due more than ninety days and still accruing interest at December 31, 2007
and 2006, respectively.  The related allowance for loan losses on
impaired loans was approximately $1.2 million at December 31, 2007 and 2006. The
average recorded investment in impaired loans for the twelve months ended
December 31, 2007, 2006 and 2005 was approximately $7.3 million, $4.7 million
and $6.2 million, respectively. For the years ended December 31, 2007, 2006 and
2005, the Company recognized approximately $29,000, $144,000 and $77,000,
respectively, of interest income on impaired loans.
 
 Changes
in the allowance for loan losses were as follows:
  2007
                
                
                
                2006
                
                
                
                2005Balance
      at beginning of year
                
                $
                8,303,432
                
                
                
                7,424,782
                
                
                
                8,048,627Amounts
      charged off
                
                
                (1,626,458
                )
                
                
                (1,958,551
                )
                
                
                (4,199,650
                )Recoveries
      on amounts previously charged off
                
                
                388,084
                
                
                
                323,919
                
                
                
                465,805Provision
      for loan losses
                
                
                2,038,000
                
                
                
                2,513,282
                
                
                
                3,110,000Balance
      at end of year
                
                $
                9,103,058
                
                
                
                8,303,432
                
                
                
                7,424,782
   A-45
  (4)
              Premises and Equipment
 
 Major
classifications of premises and equipment are summarized as
follows:
 
 2007
                
                
                
                2006Land
                
                $
                3,572,241
                
                
                
                2,349,041Buildings
      and improvements
                
                
                14,700,078
                
                
                
                10,618,896Furniture
      and equipment
                
                
                15,496,630
                
                
                
                13,992,524Total
      premises and equipment
                
                
                33,768,949
                
                
                
                26,960,461Less
      accumulated depreciation
                
                
                15,534,556
                
                
                
                14,144,076Total
      net premises and equipment
                
                $
                18,234,393
                
                
                
                12,816,385
  Depreciation
expense was approximately $1.7 million for the year ended December 31,
2007.  The Company recognized approximately $1.5 million in
depreciation expense for the years ended December 31, 2006 and
2005.
 
 During
2003, the Company sold a branch location with net book value of approximately
$2.4 million and was leasing the facility from the buyer.  As a result
of the sale, the Company deferred a gain of approximately $633,000 and was
recognizing the gain over the lease term.  For the period ended
December 31, 2007 the Company recognized approximately $10,000 of the deferred
gain and for the periods ended December 31, 2006 and 2005, respectively,
approximately $21,000 and $22,000 of the deferred gain was
recognized.  In 2007, the Company repurchased the branch location for
$3.0 million, which was $588,000 greater than the original cost of the
building.  The remaining deferred gain was netted against the purchase
price resulting in a net cost of $2.5 million. This cost is being depreciated
over 39 years.
 
 (5)
              Time Deposits
 
 At
December 31, 2007, the scheduled maturities of time deposits are as
follows:
  2008
                
                $
                363,236,0192009
                
                
                17,088,1272010
                
                
                3,153,1092011
                
                
                200,6482012
      and thereafter
                
                
                929,815Total
                
                $
                384,607,718
  At
December 31, 2007 and 2006, the Company has approximately $53.9 million and
$60.0 million, respectively, in time deposits purchased through third party
brokers.  The weighted average rate of brokered deposits as of
December 31, 2007 and 2006 was 5.06% and 5.11%, respectively.
 
 (6)
              Federal Home Loan Bank Advances
 
 The Bank
has advances from the Federal Home Loan Bank of Atlanta (“FHLB”) with monthly or
quarterly interest payments at December 31, 2007. The FHLB advances are
collateralized by a blanket assignment on all residential first mortgage loans,
commercial real estate loans, home equity lines of credit and loans secured by
multi-family real estate that the Bank owns.  At December 31, 2007,
the carrying value of loans pledged as collateral totaled approximately $239.0
million.
 
 Advances
from the FHLB outstanding at December 31, 2007 consist of the
following:
   A-46
  Maturity
      Date
                
                Call
      Date
                Rate
                
                Rate
      Type
                
                AmountFebruary
      4, 2008
                
                N/A
                
                4.400%
                
                Daily
      Rate
                
                $
                10,500,000March
      30, 2010
                
                September
      30, 2000 and everythree
      months thereafter
                
                5.880%
                
                Convertible
                
                
                5,000,000May
      24, 2010
                
                May
      24, 2001 and every threemonths
      thereafter
                
                6.490%
                
                Convertible
                
                
                2,000,000June
      24, 2015
                
                June
      24, 2010
                
                3.710%
                
                Convertible
                
                
                5,000,000March
      25, 2019
                
                March
      25, 2009
                
                4.360%
                
                Convertible
                
                
                5,000,000March
      31, 2016
                
                March
      31, 2009 and every threemonths
      thereafter
                
                4.620%
                
                Convertible
                
                
                5,000,000October
      5, 2016
                
                October
      5, 2009
                
                4.450%
                
                Convertible
                
                
                5,000,000December
      12, 2011
                
                December
      12, 2007 and every
                
                4.210%
                
                Convertible
                
                
                5,000,000three
      months thereafterJanuary
      30, 2017
                
                October
      30, 2008 and every
                
                4.500%
                
                Convertible
                
                
                5,000,000three
      months thereafterJune
      8, 2017
                
                December
      8, 2008 and every
                
                4.713%
                
                Convertible
                
                
                15,000,000three
      months thereafterJune
      9, 2014
                
                February
      11, 2008 and every
                
                4.685%
                
                Convertible
                
                
                15,000,000month
      thereafterJuly
      11, 2017
                
                January
      11, 2008 and every
                
                4.440%
                
                Convertible
                
                
                5,000,000three
      months thereafterJuly
      24, 2017
                
                April
      24, 2008 and every
                
                4.420%
                
                Convertible
                
                
                5,000,000month
      thereafter$
                87,500,000
   The FHLB
has the option to convert $72.0 million of the total advances to a floating rate
and, if converted, the Bank may repay advances without payment of a prepayment
fee.  The Company also has an additional $5.0 million in variable rate
convertible advances, which may be repaid without a prepayment fee if converted
by the FHLB.
 
 The Bank
is required to purchase and hold certain amounts of FHLB stock in order to
obtain FHLB borrowings. No ready market exists for the FHLB stock, and it has no
quoted market value. The stock is redeemable at $100 per share subject to
certain limitations set by the FHLB. At December 31, 2007 and 2006, the Bank
owned FHLB stock amounting to $5.4 million and $5.5 million,
respectively.
 
 (7)
              Junior Subordinated Debentures
 
 In June
2006 the Company formed a second wholly owned Delaware statutory trust, PEBK
Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed
preferred beneficial interests in the Company’s junior subordinated deferrable
interest debentures.  All of the common securities of PEBK Trust II
are owned by the Company.  The proceeds from the issuance of the
common securities and the trust preferred securities were used by PEBK Trust II
to purchase $20.6 million of junior subordinated debentures of the Company,
which pay a floating rate equal to three month LIBOR plus 163 basis
points.  The proceeds received by the Company from the sale of the
junior subordinated debentures were used to repay in December 2006 the trust
preferred securities issued by PEBK Trust in December 2001 and for general
purposes.  The debentures represent the sole asset of PEBK Trust
II.  PEBK Trust II is not included in the consolidated financial
statements.
 
 The trust
preferred securities issued by PEBK Trust II accrue and pay quarterly at a
floating rate of three-month LIBOR plus 163 basis points.  The Company
has guaranteed distributions and other payments due on the trust preferred
securities to the extent PEBK Trust II has funds with which to make the
distributions and other payments.  The net combined effect of all the
documents entered into in connection with the trust preferred securities is that
the Company is liable to make the distributions and other payments required on
the trust preferred securities.
   A-47
  These
trust preferred securities are mandatorily redeemable upon maturity of the
debentures on June 28, 2036, or upon earlier redemption as provided in the
indenture.  The Company has the right to redeem the debentures
purchased by PEBK Trust II, in whole or in part, on or after June 28,
2011.  As specified in the indenture, if the debentures are redeemed
prior to maturity, the redemption price will be the principal amount and any
accrued but unpaid interest.
 
 (8)
              Income Taxes
 
 The
provision for income taxes in summarized as follows:
  2007
                
                
                
                2006
                
                
                
                2005Current
                
                $
                5,819,347
                
                
                
                5,785,926
                
                
                
                3,048,094Deferred
                
                
                (479,806
                )
                
                
                (615,626
                )
                
                
                332,806Total
                
                $
                5,339,541
                
                
                
                5,170,300
                
                
                
                3,380,900
  The
differences between the provision for income taxes and the amount computed by
applying the statutory federal income tax rate to earnings before income taxes
are as follows:
 
 2007
                
                
                
                2006
                
                
                
                2005Pre-tax
      income at statutory rates (34%)
                
                $
                5,076,714
                
                
                
                4,875,980
                
                
                
                3,302,039Differences:Tax
      exempt interest income
                
                
                (307,169
                )
                
                
                (280,826
                )
                
                
                (263,555
                )Nondeductible
      interest and other expense
                
                
                55,871
                
                
                
                45,872
                
                
                
                30,511Cash
      surrender value of life insurance
                
                
                (82,951
                )
                
                
                (75,021
                )
                
                
                (73,973
                )State
      taxes, net of federal benefits
                
                
                559,905
                
                
                
                576,444
                
                
                
                363,264Other,
      net
                
                
                37,170
                
                
                
                27,851
                
                
                
                22,614Total
                
                $
                5,339,541
                
                
                
                5,170,300
                
                
                
                3,380,900
  The
following summarized the tax effects of temporary differences that give rise to
significant portions of the deferred tax assets and deferred tax
liabilities.  The net deferred tax asset is included as a component of
other assets at December 31, 2007 and 2006.




2007
                
                
                
                2006Deferred
      tax assets:Allowance
      for loan losses
                
                $
                3,531,076
                
                
                
                3,201,305Amortizable
      intangible assets
                
                
                76,398
                
                
                
                108,472Accrued
      retirement expense
                
                
                819,246
                
                
                
                664,581Income
      from non-accrual loans
                
                
                50,219
                
                
                
                72,475Deferred
      gain on sale of premises
                
                
                -
                
                
                
                212,820Unrealized
      loss on cash flow hedges
                
                
                20,525
                
                
                
                328,933Unrealized
      loss on available for sale securities
                
                
                -
                
                
                
                382,564Premises
      and equipment
                
                
                9,757
                
                
                
                -Total
      gross deferred tax assets
                
                
                4,507,221
                
                
                
                4,971,150Deferred
      tax liabilities:Deferred
      loan fees
                
                
                1,346,322
                
                
                
                1,310,178Premises
      and equipment
                
                
                -
                
                
                
                291,107Deferred
      income from servicing rights
                
                
                -
                
                
                
                -Unrealized
      gain on available for sale securities
                
                
                601,583
                
                
                
                -Other
                
                
                12,482
                
                
                
                10,283Total
      gross deferred tax liabilities
                
                
                1,960,387
                
                
                
                1,611,568Net
      deferred tax asset
                
                $
                2,546,834
                
                
                
                3,359,582
 
  (9)           Related
Party Transactions
 
 The
Company conducts transactions with its directors and executive officers,
including companies in which they have beneficial interests, in the normal
course of business. It is the policy of the Company that loan transactions with
directors and officers are made on substantially the same terms as those
prevailing at the time made for comparable loans to other persons. The following
is a summary of activity for related party loans for 2007:
   A-48
  Beginning
      balance
                
                $
                7,274,778New
      loans
                
                
                1,153,336Repayments
                
                
                2,812,215Ending
      balance
                
                $
                5,615,899
  At
December 31, 2007 and 2006, the Company had deposit relationships with related
parties of approximately $15.7 million and $9.1 million,
respectively.
 
 (10)
              Commitments and Contingencies
 
 The
Company leases various office spaces for banking and operational facilities and
equipment under operating lease arrangements. Future minimum lease payments
required for all operating leases having a remaining term in excess of one year
at December 31, 2007 are as follows:
   Year2008
                
                $
                897,1922009
                
                
                753,8272010
                
                
                626,9652011
                
                
                563,9012012
                
                
                298,771Thereafter
                
                
                2,149,222Total
      minimum obligation
                
                $
                5,289,878
  Total
rent expense was approximately $1.1 million, $959,000 and $956,000 for 2007,
2006 and 2005, respectively.
 
 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.  These financial instruments include commitments to extend
credit, standby letters of credit and financial guarantees.  Those
instruments involve, to varying degrees, elements of credit risk in excess of
the amount recognized in the balance sheet.  The contract amounts of
those instruments reflect the extent of involvement the Company has in
particular classes of financial instruments.
 
 The
exposure to credit loss in the event of nonperformance by the other party to the
financial instrument for commitments to extend credit and standby letters of
credit and financial guarantees written 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.
 
 In most
cases, the Company requires collateral or other security to support financial
instruments with credit risk.
  Contractual
      Amount2007
                
                
                2006Financial
      instruments whose contract amount represent credit risk:Commitments
      to extend credit
                
                $
                190,653,583
                
                
                
                157,358,229Standby
      letters of credit and financial guarantees written
                
                $
                3,894,259
                
                
                
                4,573,544
  Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Commitments
generally have fixed expiration dates and because they may expire without being
drawn upon, the total commitment amount of $194.5 million does not necessarily
represent future cash requirements.
 
 Standby
letters of credit and financial guarantees written are conditional commitments
issued by the Company to guarantee the performance of a customer to a third
party. Those guarantees are primarily issued to businesses in the Company’s
delineated market area. The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending loan facilities to customers.
The Company holds real estate, equipment, automobiles and customer deposits as
collateral supporting those commitments for which collateral is deemed
necessary.
   A-49
  The
Company has an overall interest rate-risk management strategy that incorporates
the use of derivative instruments to minimize significant unplanned fluctuations
in earnings that are caused by interest rate volatility.  By using
derivative instruments, the Company is exposed to credit and market
risk.  If the counterparty fails to perform, credit risk is equal to
the extent of the fair-value gain in the derivative.  The Company
attempts to minimize the credit risk in derivative instruments by entering into
transactions with counterparties that are reviewed periodically by the Company
and are believed to be of high quality.
 
 In the
normal course of business, the Company is a party (both as plaintiff and
defendant) to a number of lawsuits. In the opinion of management and counsel,
none of these cases should have a material adverse effect on the financial
position of the Bank or the Company.
 
 The
Company has employment agreements with certain key employees. The agreements,
among other things, include salary, bonus, incentive stock option, and change in
control provisions.
 
 The
Company has $35.0 million available for the purchase of overnight federal funds
from three correspondent financial institutions.
 
 (11)
              Derivative Financial Instruments and Hedging
  Transactions
 
 The
Company has an overall interest rate risk management strategy that incorporates
the use of derivative instruments to minimize significant unplanned fluctuations
in earnings that are caused by interest rate volatility.  By using
derivative instruments, the Company is exposed to credit and market
risk.  If the counterparty fails to perform, credit risk is equal to
the extent of the fair-value gain in the derivative.  The Company
minimizes the credit risk in derivative instruments by entering into
transactions with high-quality counterparties that are reviewed periodically by
the Company.
 
 As
of December 31, 2007, the Company had cash flow hedges with a notional amount of
$185.0 million.  These derivative instruments consist of five interest
rate floor contracts that are used to hedge future cash flows from payments on
the first $185.0 million of certain variable rate loans against the downward
effects of their repricing in the event of a decreasing rate environment for
periods ending in July 2008, November 2008, January 2009, June 2009 and December
2009.  If the prime rate falls below 6.25% during the term of the
contract on the first floor, the Company will receive payments based on the
$35.0 million notional amount times the difference between 6.25% and the
weighted average prime rate for the quarter.  No payments will be
received by the Company if the weighted average prime rate is 6.25% or
higher.  The Company paid a premium of $161,000 on this
contact.  On the second floor if the prime rate falls below 7.00%
during the term of the contract, the Company will receive payments based on the
$35.0 million notional amount times the difference between 7.00% and the
weighted average prime rate for the quarter.  No payments will be
received by the Company if the weighted average prime rate is 7.00% or
higher.  The Company paid a premium of $203,000 on this contract. On
the third floor if the prime rate falls below 7.50% during the term of the
contract, the Company will receive payments based on the $45.0 million notional
amount times the difference between 7.50% and the weighted average prime rate
for the quarter.  No payments will be received by the Company if the
weighted average prime rate is 7.50% or higher.  The Company paid a
premium of $562,500 on this contract.  On the fourth floor if the
prime rate falls below 8.00% during the term of the contract, the Company will
receive payments based on the $35.0 million notional amount times the difference
between 8.00% and the weighted average prime rate for the quarter.  No
payments will be received by the Company if the weighted average prime rate is
8.00% or higher.  The Company paid a premium of $399,000 on this
contract.  On the fifth floor if the prime rate falls below 7.25%
during the term of the contract, the Company will receive payments based on the
$35.0 million notional amount times the difference between 7.25% and the
weighted average prime rate for the quarter.  No payments will be
received by the Company if the weighted average prime rate is 7.25% or higher.
The Company paid a premium of $634,000 on this contract.
 
 The
Company recognized $47,000 in interest income from payments on interest rate
floor contracts in 2007.
 
 (12)
              Employee and Director Benefit
Programs
 
 The
Company has a profit sharing and 401(k) plan for the benefit of substantially
all employees subject to certain minimum age and service requirements. Under
this plan, the Company matches employee contributions to a maximum of five
percent of annual compensation. The Company’s contribution pursuant to this
formula was approximately $424,000, $405,000 and $360,000 for the years of 2007,
2006 and 2005, respectively. Investments of the plan are determined by the
compensation committee consisting of selected outside directors and senior
executive officers. No investments in Company stock have been made by the plan.
The vesting schedule for the
   A-50
  plan
begins at 20 percent after two years of employment and graduates 20 percent each
year until reaching 100 percent after six years of employment.
 
 In
December 2001, the Company initiated a postretirement benefit plan to provide
retirement benefits to key officers and its Board of Directors and to provide
death benefits for their designated beneficiaries.  Under the plan,
the Company purchased life insurance contracts on the lives of the key officers
and each director.  The increase in cash surrender value of the
contracts constitutes the Company’s contribution to the plan each
year.  Plan participants are to be paid annual benefits for a
specified number of years commencing upon retirement. Expenses incurred for
benefits relating to this plan were approximately $258,000, $240,000 and
$245,000 during 2007, 2006 and 2005, respectively.
 
 The
Company is currently paying medical benefits for certain retired employees.
Postretirement benefits expense, including amortization of the transition
obligation, as applicable, was approximately $23,000 for the years ended
December 31, 2007, 2006 and 2005. The following table sets forth the accumulated
postretirement benefit obligation as of December 31, 2007 and 2006, which
represents the liability for accrued postretirement benefit costs:
   2007
                
                
                2006Accumulated
      postretirement benefit obligation
                
                $
                170,302
                
                
                
                196,002Unrecognized
      gain (loss)
                
                
                (21,576
                )
                
                
                (38,327
                )Net
      liability recognized
                
                $
                148,726
                
                
                
                157,675
   In
September 2006, the FASB released SFAS No. 158, “Employers’ Accounting for
Defined Benefit Pension and Other Postretirement Plans” which requires employers
to recognize the overfunded or underfunded status of defined benefit
postretirement plans.  The effective date for public companies is for
years ending after December 15, 2006.  Management has compared the
accrued postretirement benefit expense and the charge to other comprehensive
income, as calculated in accordance with SFAS 106 and 132 to the requirement
under SFAS 158 and determined that the difference is immaterial.
 
 Members
of the Board of Directors are eligible to participate in the Company’s Omnibus
Stock Ownership and Long Term Incentive Plan (the “Stock Benefits
Plan”).  Each director has been awarded 9,737 book value shares
(adjusted to reflect a 10% stock dividend on April 24, 2000, a 10% stock
dividend on March 16, 2005, a 10% stock divided on June 16, 2006 and a 3-for-2
stock split on June 15, 2007) under the Stock Benefits Plan.  Five
directors were awarded book value shares on September 28, 1999.  The
book value of the common stock on September 28, 1999 was $6.31 (as
adjusted).  These book value shares are now fully vested.  One
director was awarded 9,737 book value shares upon his election to the Board of
Directors on May 3, 2001.  The book value of the common stock on May
3, 2001 was $7.69 (as adjusted).  These book value shares are now
fully vested.  Four directors were awarded 9,737 book value shares on
May 6, 2004.  The book value of the common stock on May 6, 2004 was
$8.64 (as adjusted).  Their shares vest at a rate of 20% annually,
with the first 20% vesting on May 6, 2005, and the final 20% vesting on May 6,
2009.  The Company recorded expenses of approximately $159,000,
$128,000 and $102,000 associated with the benefits of this plan in the years
ended December 31, 2007, 2006 and 2005, respectively.
 
 A summary
of book value shares activity under the Stock Benefits Plan for the years ended
December 31, 2007, 2006 and 2005 is presented below.
 
  2007
                
                2006
                
                
                2005Shares
                
                Weighted
      Average
                  Price
      of
                  Book
      Value Shares
                
                Shares
                
                Weighted
      Average
                  Price
      of
                  Book
      Value Shares
                
                Shares
                
                Weighted
      Average
                  Price
      of
                  Book
      Value SharesOutstanding,
      beginning of period
                
                
                97,377
                
                $
                7.38
                
                
                97,377
                
                $
                7.38
                
                
                116,850
                
                
                $
                7.20Exercised
      during the period
                
                
                -
                
                $
                -
                
                
                -
                
                $
                -
                
                
                (19,473
                )
                
                $
                6.31Outstanding,
      end of period
                
                
                97,377
                
                $
                7.38
                
                
                97,377
                
                $
                7.38
                
                
                97,377
                
                
                $
                7.38Number
      of shares exercisable
                
                
                81,791
                
                $
                7.89
                
                
                73,998
                
                $
                6.98
                
                
                66,208
                
                
                $
                6.79
   A-51
  (13)
              Regulatory Matters
 
 The
Company is 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 financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Company must meet
specific capital guidelines that involve quantitative measures of the assets,
liabilities and certain off-balance-sheet items as calculated under regulatory
accounting practices. The capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings, and
other factors.
 
 Quantitative
measures established by regulation to ensure capital adequacy require the
Company to maintain minimum amounts and ratios of capital in relation to both
on- and off-balance sheet items at various risk weights. Total capital consists
of two tiers of capital. Tier 1 Capital includes common shareholders’ equity and
trust preferred securities less adjustments for intangible assets. Tier 2
Capital consists of the allowance for loan losses up to 1.25% of risk-weighted
assets and other adjustments. Management believes, as of December 31, 2007, that
the Company and the Bank meet all capital adequacy requirements to which they
are subject.
 
 As of
December 31, 2007, the most recent notification from the FDIC categorized the
Bank as well capitalized under the regulatory framework for prompt corrective
action. To be categorized as well capitalized the Bank must maintain minimum
total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in
the table. There are no conditions or events since that notification that
management believes have changed the Bank’s category.
 The
Company’s and the Bank’s actual capital amounts and ratios are presented
below:
  Actual
                
                
                For
      Capital
                  Adequacy
      Purposes
                
                
                To
      Be Well
                  Capitalized
      Under
                  Prompt
      Corrective
                  Action
      ProvisionsAmount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio
                
                
                Amount
                
                
                Ratio(dollars
      in thousands)As
      of December 31, 2007:Total
      Capital (to Risk-Weighted Assets)Consolidated
                
                $
                97,410
                
                
                
                12.16
                %
                
                
                64,071
                
                
                
                8.00
                %
                
                
                N/A
                
                
                
                N/ABank
                
                $
                87,393
                
                
                
                10.93
                %
                
                
                63,940
                
                
                
                8.00
                %
                
                
                79,926
                
                
                
                10.00
                %Tier
      1 Capital (to Risk-Weighted Assets)Consolidated
                
                $
                88,307
                
                
                
                11.03
                %
                
                
                32,035
                
                
                
                4.00
                %
                
                
                N/A
                
                
                
                N/ABank
                
                $
                78,290
                
                
                
                9.80
                %
                
                
                31,970
                
                
                
                4.00
                %
                
                
                47,955
                
                
                
                6.00
                %Tier
      1 Capital (to Average Assets)Consolidated
                
                $
                88,307
                
                
                
                10.43
                %
                
                
                33,873
                
                
                
                4.00
                %
                
                
                N/A
                
                
                
                N/ABank
                
                $
                78,290
                
                
                
                9.26
                %
                
                
                33,827
                
                
                
                4.00
                %
                
                
                42,284
                
                
                
                5.00
                %As
      of December 31, 2006:Total
      Capital (to Risk-Weighted Assets)Consolidated
                
                $
                91,718
                
                
                
                12.86
                %
                
                
                57,056
                
                
                
                8.00
                %
                
                
                N/A
                
                
                
                N/ABank
                
                $
                80,857
                
                
                
                11.37
                %
                
                
                56,875
                
                
                
                8.00
                %
                
                
                71,094
                
                
                
                10.00
                %Tier
      1 Capital (to Risk-Weighted Assets)Consolidated
                
                $
                83,415
                
                
                
                11.70
                %
                
                
                28,528
                
                
                
                4.00
                %
                
                
                N/A
                
                
                
                N/ABank
                
                $
                72,554
                
                
                
                10.21
                %
                
                
                28,438
                
                
                
                4.00
                %
                
                
                42,656
                
                
                
                6.00
                %Tier
      1 Capital (to Average Assets)Consolidated
                
                $
                83,415
                
                
                
                10.80
                %
                
                
                30,903
                
                
                
                4.00
                %
                
                
                N/A
                
                
                
                N/ABank
                
                $
                72,554
                
                
                
                9.41
                %
                
                
                30,857
                
                
                
                4.00
                %
                
                
                38,571
                
                
                
                5.00
                %
   A-52
  (14)
              Shareholders’ Equity
 
 In
November 2006, the Company’s Board of Directors authorized the repurchase of up
to $2.0 million in common shares of the Company’s outstanding common stock
through its existing Stock Repurchase Plan effective through the end of November
2007.  During 2007 the Company repurchased 100,000 shares, or
$1,938,000 of its common stock under this plan.
 
 In August
2007, the Company’s Board of Directors authorized the repurchase of up to 75,000
common shares of the Company’s outstanding common stock through its existing
Stock Repurchase Plan effective through the end of August 2008.  The
Company has repurchased 50,497 shares, or $873,000, of its common stock under
this plan as of December 31, 2007.
 
 The Board
of Directors, at its discretion, can issue shares of preferred stock up to a
maximum of 5,000,000 shares. The Board is authorized to determine the number of
shares, voting powers, designations, preferences, limitations and relative
rights.
 
 The Board
of Directors of the Bank may declare a dividend of all of its retained earnings
as it may deem appropriate, subject to the requirements of the General Statutes
of North Carolina, without prior approval from the requisite regulatory
authorities. As of December 31, 2007, this amount was approximately $19.7
million.
 
 (15)
              Other Operating Expense
 
 Other
operating expense for the years ended December 31 included the following items
that exceeded one percent of total revenues:
   2007
                
                2006
                
                2005Advertising
                
                $
                988,116
                
                
                
                772,917
                
                
                
                656,184
   
 (16)
              Fair Value of Financial Instruments
 
 The
Company is required to disclose fair value information about financial
instruments, whether or not recognized on the face of the balance sheet, for
which it is practicable to estimate that value. The assumptions used in the
estimation of the fair value of the Company’s financial instruments are detailed
below. Where quoted prices are not available, fair values are based on estimates
using discounted cash flows and other valuation techniques. The use of
discounted cash flows can be significantly affected by the assumptions used,
including the discount rate and estimates of future cash flows. The following
disclosures should not be considered a surrogate of the liquidation value of the
Company, but rather a good faith estimate of the increase or decrease in value
of financial instruments held by the Company since purchase, origination, or
issuance.
 
 Cash and Cash
Equivalents
 For cash,
due from banks, interest bearing deposits and federal funds sold, the
carrying amount is a reasonable estimate of fair value.
 
 Investment Securities
Available for Sale
 Fair
values for investment securities are based on quoted market prices.
 
 Other
Investments
 For other
investments, the carrying value is a reasonable estimate of fair
value.
 
 Loans
 The fair
value of fixed rate loans is estimated by discounting the future cash flows
using the current rates at which similar loans would be made to borrowers with
similar credit ratings. For variable rate loans, the carrying amount is a
reasonable estimate of fair value.
 
 Cash Surrender Value of Life
Insurance
 For cash
surrender value of life insurance, the carrying value is a reasonable estimate
of fair value.
 
 Derivative
Instruments
 For
derivative instruments, fair value is estimated as the amount that the Company
would receive or pay to terminate the contracts at the reporting date, taking
into account the current unrealized gains or losses on open
contracts.
   A-53
  Deposits and Demand Notes
Payable
 The fair
value of demand deposits, interest-bearing demand deposits, savings, and demand
notes payable to U.S. Treasury is the amount payable on demand at the reporting
date. The fair value of certificates of deposit is estimated by discounting the
future cash flows using the rates currently offered for deposits of similar
remaining maturities.
 
 FHLB
Advances
 The fair
value of FHLB advances is estimated based upon discounted future cash flows
using a discount rate comparable to the current market rate for such
borrowings.
 
 Junior Subordinated
Debentures
 Because
the Company’s junior subordinated debentures were issued at a floating rate, the
carrying amount is a reasonable estimate of fair value.
 
 Commitments to Extend Credit
and Standby Letters of Credit
 Commitments
to extend credit and standby letters of credit are generally short-term and at
variable interest rates. Therefore, both the carrying value and estimated fair
value associated with these instruments are immaterial.
 
 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 a significant portion of the Company’s financial
instruments, fair value estimates are based on many judgments. These estimates
are subjective in nature and involve uncertainties and matters of significant
judgment and therefore cannot be determined with precision. Changes in
assumptions could significantly affect the estimates.
 
 Fair
value estimates are based on existing on and off-balance sheet financial
instruments without attempting to estimate the value of anticipated future
business and the value of assets and liabilities that are not considered
financial instruments. Significant assets and liabilities that are not
considered financial instruments include the deferred income taxes and premises
and equipment. In addition, the tax ramifications related to the realization of
the unrealized gains and losses can have a significant effect on fair value
estimates and have not been considered in the estimates.
 
 The
carrying amount and estimated fair value of the Company’s financial instruments
at December 31, 2007 and 2006 are as follows:
 
 2007
                
                
                2006Carrying
                
                
                Estimated
                
                
                Carrying
                
                
                EstimatedAmount
                
                
                Fair
      Value
                
                
                Amount
                
                
                Fair
      Value(dollars in thousands)Assets:Cash
      and cash equivalents
                $
                
                29,800
                
                
                
                29,800
                
                
                
                21,500
                
                
                
                21,500Investment
      securities available for sale
                $
                
                120,968
                
                
                
                120,968
                
                
                
                117,581
                
                
                
                117,581Other
      investments
                $
                
                6,434
                
                
                
                6,434
                
                
                
                7,295
                
                
                
                7,295Loans,
      net
                $
                
                713,174
                
                
                
                713,689
                
                
                
                643,078
                
                
                
                641,414Cash
      surrender value of life insurance
                $
                
                6,776
                
                
                
                6,776
                
                
                
                6,532
                
                
                
                6,532Derivative
      instruments
                $
                
                1,907
                
                
                
                1,907
                
                
                
                481
                
                
                
                481Liabilities:Deposits
      and demand notes payable
                $
                
                695,239
                
                
                
                695,659
                
                
                
                635,420
                
                
                
                635,371FHLB
      advances
                $
                
                87,500
                
                
                
                90,223
                
                
                
                89,300
                
                
                
                88,819Junior
      subordinated debentures
                $
                
                20,619
                
                
                
                20,619
                
                
                
                20,619
                
                
                
                20,619
   A-54
   (17)           Peoples
Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial
Statements
 
 Balance
      SheetsDecember
      31, 2007 and 2006Assets
                
                2007
                
                
                2006Cash
                
                $
                725,416
                
                
                
                1,646,880Interest-bearing
      time deposit
                
                
                8,000,000
                
                
                
                8,000,000Investment
      in subsidiaries
                
                
                80,703,540
                
                
                
                72,593,671Investment
      securities available for sale
                
                
                1,374,581
                
                
                
                750,521Other
      investments
                
                
                -
                
                
                
                600,000Other
      assets
                
                
                251,724
                
                
                
                293,049Total
      assets
                
                $
                91,055,261
                
                
                
                83,884,121Liabilities
      and Shareholders' EquityAccrued
      expenses
                
                $
                334,679
                
                
                
                429,748Junior
      subordinated debentures
                
                
                20,619,000
                
                
                
                20,619,000Shareholders'
      equity
                
                
                70,101,582
                
                
                
                62,835,373Total
      liabilities and shareholders' equity
                
                $
                91,055,261
                
                
                
                83,884,121
    Statements
      of EarningsFor
      the Years Ended December 31, 2007, 2006 and 2005Revenues:
                
                2007
                
                
                2006
                
                
                2005Dividends
      from subsidiaries
                
                $
                4,811,203
                
                
                
                3,855,556
                
                
                
                2,346,897Interest
      and dividend income
                
                
                463,866
                
                
                
                672,922
                
                
                
                111,777Loss
      on sale of securities
                
                
                (235,950
                )
                
                
                -
                
                
                
                -Total
      revenues
                
                
                5,039,119
                
                
                
                4,528,478
                
                
                
                2,458,674Expenses:Interest
                
                
                1,475,701
                
                
                
                1,962,692
                
                
                
                938,145Other
      operating expenses
                
                
                266,146
                
                
                
                786,014
                
                
                
                289,691Total
      expenses
                
                
                1,741,847
                
                
                
                2,748,706
                
                
                
                1,227,836Earnings
      before income tax benefit and equity inundistributed
      earnings of subsidiaries
                
                
                3,297,272
                
                
                
                1,779,772
                
                
                
                1,230,838Income
      tax benefit
                
                
                514,800
                
                
                
                705,800
                
                
                
                379,500Earnings
      before undistributed earnings in subsidiaries
                
                
                3,812,072
                
                
                
                2,485,572
                
                
                
                1,610,338Equity
      in undistributed earnings in subsidiaries
                
                
                5,779,899
                
                
                
                6,685,245
                
                
                
                4,720,642Net
      earnings
                
                $
                9,591,971
                
                
                
                9,170,817
                
                
                
                6,330,980
   A-55
   Statements
      of Cash FlowsFor
      the Years Ended December 31, 2007, 2006 and 20052007
                
                
                2006
                
                
                2005Cash
      flows from operating activities:Net
      earnings
                
                $
                9,591,971
                
                
                
                9,170,817
                
                
                
                6,330,980Adjustments
      to reconcile net earnings to netcash
      provided by operating activities:Amortization
                
                
                -
                
                
                
                461,298
                
                
                
                17,742Book
      value shares accrual
                
                
                158,678
                
                
                
                128,444
                
                
                
                21,818Equity
      in undistributed earnings of subsidiaries
                
                
                (5,779,899
                )
                
                
                (6,685,245
                )
                
                
                (4,720,642
                )Deferred
      income tax benefit
                
                
                (61,551
                )
                
                
                (49,520
                )
                
                
                (8,412
                )Loss
      on sale of investment securities
                
                
                235,950
                
                
                
                -
                
                
                
                -Change
      in:Accrued
      income
                
                
                1,603
                
                
                
                (1,421
                )
                
                
                17,930Accrued
      expense
                
                
                (253,748
                )
                
                
                25,975
                
                
                
                (21,063
                )Net
      cash provided by operating activities
                
                
                3,893,004
                
                
                
                3,050,348
                
                
                
                1,638,353Cash
      flows from investing activities:Net
      change in interest-bearing time deposit
                
                
                -
                
                
                
                (6,000,000
                )
                
                
                -Purchases
      of other investments
                
                
                -
                
                
                
                (600,000
                )
                
                
                -Purchase
      of equity in PEBK Capital Trust II
                
                
                -
                
                
                
                (619,000
                )
                
                
                -Proceeds
      from liquidation of PEBK Capital Trust I
                
                
                -
                
                
                
                433,000
                
                
                
                -Net
      cash used by investing activities
                
                
                -
                
                
                
                (6,786,000
                )
                
                
                -Cash
      flows from financing activities:Proceeds
      from issuance of trust preferred securities
                
                
                -
                
                
                
                20,619,000
                
                
                
                -Repayments
      of trust preferred securities
                
                
                -
                
                
                
                (14,433,000
                )
                
                
                -Cash
      dividends paid
                
                
                (2,331,203
                )
                
                
                (1,905,556
                )
                
                
                (1,414,239
                )Cash
      paid in lieu of fractional shares
                
                
                (3,355
                )
                
                
                (6,426
                )
                
                
                (4,700
                )Common
      stock repurchased
                
                
                (2,810,907
                )
                
                
                (425,000
                )
                
                
                (314,750
                )Proceeds
      from exercise of stock options
                
                
                330,997
                
                
                
                1,014,425
                
                
                
                96,773Net
      cash provided (used) by financing activities
                
                
                (4,814,468
                )
                
                
                4,863,443
                
                
                
                (1,636,916
                )Net
      change in cash
                
                
                (921,464
                )
                
                
                1,127,791
                
                
                
                1,437Cash
      at beginning of year
                
                
                1,646,880
                
                
                
                519,089
                
                
                
                517,652Cash
      at end of year
                
                $
                725,416
                
                
                
                1,646,880
                
                
                
                519,089






A-56




DIRECTORS
AND OFFICERS OF THE COMPANY
 
 DIRECTORS
 
 Robert C. Abernethy –
Chairman
 Chairman
of the Board, Peoples Bancorp of North Carolina, Inc. and Peoples
Bank;
 President,
Secretary and Treasurer, Carolina Glove Company, Inc. (glove
manufacturer)
 
 James S.
Abernethy
 President
and Assistant Secretary, Midstate Contractors, Inc. (paving
company)
 
 Douglas S.
Howard
 Vice
President, Howard Ventures, Inc. (private equity firm)
 
 John W. Lineberger,
Jr.
 President,
Lincoln Bonded Warehouse Company (commercial warehousing and distribution
facility)
 
 Gary E.
Matthews
 President
and Director, Matthews Construction Company, Inc. (general
contractor)
 
 Billy L. Price, Jr.
MD
 Practicing
Internist and Partner, Catawba Valley Internal Medicine, P.A.
 
 Larry E.
Robinson
 President
and Chief Executive Officer, The Blue Ridge Distributing Co., Inc. (beer and
wine distributor)
 
 William Gregory (Greg)
Terry
 Executive
Vice President, Drum & Willis-Reynolds Funeral Homes and
Crematory
 
 Dan Ray Timmerman,
Sr.
 President,
Timmerman Manufacturing, Inc. (wrought iron furniture manufacturer)
 
 Benjamin I.
Zachary
 President,
Treasurer, General Manager and Member of the Board of
Directors,
 Alexander
Railroad Company
 
 OFFICERS
 
 Tony W.
Wolfe
 President
and Chief Executive Officer
 
 Joseph F. Beaman,
Jr.
 Executive
Vice President and Corporate Secretary
 
 Lance A.
Sellers
 Executive
Vice President and Assistant Corporate Secretary
 
 William D. Cable,
Sr.
 Executive
Vice President and Assistant Corporate Treasurer
 
 A. Joseph
Lampron
 Executive
Vice President, Chief Financial Officer and Corporate
Treasurer






A-57