10-K filing for December 31, 2005

0001093672-06-000012.txt : 20060324 0001093672-06-000012.hdr.sgml : 20060324 20060324091123 ACCESSION NUMBER: 0001093672-06-000012 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 20051231 FILED AS OF DATE: 20060324 DATE AS OF CHANGE: 20060324 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PEOPLES BANCORP OF NORTH CAROLINA INC CENTRAL INDEX KEY: 0001093672 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 562132396 STATE OF INCORPORATION: NC FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-27205 FILM NUMBER: 06707556 BUSINESS ADDRESS: STREET 1: 518 WEST C STREET CITY: NEWTON STATE: NC ZIP: 28658-4007 BUSINESS PHONE: 8284645620 MAIL ADDRESS: STREET 1: PO BOX 467 CITY: NEWTON STATE: NC ZIP: 28658-0467 10-K 1 form10-kfordec312005.htm 10-K FILING FOR DECEMBER 31, 2005 10-K filing for December 31, 2005

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended: December 31, 2005

Peoples Bancorp of North Carolina, Inc.

(Exact Name of Registrant as Specified in Its Charter)

North Carolina

(State or Other Jurisdiction of Incorporation)

000-27205

56-2132396

(Commission File No.)

(IRS Employer Identification No.)

518 West C Street, Newton, North Carolina

28658

(Address of Principal Executive Offices)

(Zip Code)

(828) 464-5620

(Registrant’s Telephone Number, Including Area Code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, no par value

(title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act

Yes

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes

Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in

Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, and accelerated filer, or a non-accelerated filer.

Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $51,287,958 based on the closing price of such common stock on June 30, 2005, which was $ 18.65 per share.

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.

3,454,785 shares of common stock, outstanding at March 17, 2006.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Annual Report of Peoples Bancorp of North Carolina, Inc. for the year ended December 31, 2005 (the “Annual Report”), which is included as Appendix A to the Proxy Statement for the 2006 Annual Meeting of Shareholders, are incorporated by reference into Part I and Part II.

Portions of the Proxy Statement for the 2006 Annual Meeting of Shareholders of Peoples Bancorp of North Carolina, Inc. to be held on May 4, 2006 (the “Proxy Statement”), are incorporated by reference into Part III.

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.

PART I

ITEM 1. BUSINESS

General

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 sole activity consists of owning the Bank. 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 17 banking offices located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden, Claremont, Hiddenite, Hickory and Charlotte, North Carolina. The Bank also operates a Loan Production Office in Davidson, North Carolina. At December 31, 2005, the Company had total assets of $730.3 million, net loans of $559.2 million, deposits of $582.9 million, investment securities of $115.2 million, and shareholders’ equity of $54.4 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. 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 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, 2005, the Bank employed 222 full-time equivalent employees.

Subsidiaries

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 December 2001 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust I (“PEBK Trust”), which issued $14.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures that qualify as Tier I capital under Federal Reserve Board guidelines. All of the common securities of PEBK Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust to purchase $14.4 million of junior subordinated debentures of the Company, which pay interest at a floating rate equal to the prime rate plus 50 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of PEBK Trust. As discussed under the heading entitled “Recent Accounting Pronouncements” in note 1 to the consolidated financial statements included in the 2005 Annual Report of Peoples Bancorp, Inc., attached hereto as Exhibit 13, PEBK Trust was deconsolidated by the Company under FIN 46 as of December 31, 2003.

Market Area

The Bank's primary market consists of the communities in an approximately 25-mile radius around its headquarters office in Newton, North Carolina. This area includes Catawba County, Alexander County, Lincoln County, Iredell County and portions of northeast Gaston County. The Bank is located only 40 miles north of Charlotte, North Carolina and the Bank's primary market area is and will continue to be significantly affected by its close proximity to this major metropolitan area. The Bank has two offices in Mecklenburg County specifically designed to serve the growing Latino market.

Employment in the Bank's primary market area is diversified among manufacturing, agricultural, retail and wholesale trade, technology, services and utilities. Catawba County’s largest employers include Catawba County Schools, Frye Regional Medical Center, CommScope, Inc. (manufacturer of fiber optic cable and accessories), Merchant Distributors, Inc (wholesale food distributor), Hickory Springs (manufacturer of foam rubber cushions), Catawba Valley Medical Center, Sherrill Furniture Company, CV Industries (furniture manufacturer) and Catawba County.

Competition

The Bank has operated in the Catawba Valley region for more than 90 years and is the only financial institution headquartered in Newton. Nevertheless, the Bank faces strong competition both in attracting deposits and making loans. Its most direct competition for deposits has historically come from other commercial banks, credit unions and brokerage firms located in its primary market area, including large financial institutions. Two national money center commercial banks are headquartered in Charlotte, North Carolina, only 40 miles from the Bank's primary market area. Based upon June 30, 2005 comparative data, the Bank had 20.72% of the deposits in Catawba County, placing it second in deposit size among a total of 13 banks with branch offices in Catawba County. Based upon June 30, 2005 comparative data, the Bank had 7.90% of the deposits in Lincoln County, placing it seventh in deposit size among a total of eight banks with branch offices in Lincoln County.

The Bank also faces additional significant competition for investors' funds from short-term money market securities and other corporate and government securities. The Bank's deposit base has grown principally due to economic growth in the Bank's market area coupled with the implementation of new and competitive deposit products. The ability of the Bank to attract and retain deposits depends on its ability to generally provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities.

The Bank experiences strong competition for loans from commercial banks and mortgage banking companies. The Bank competes for loans primarily through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Competition is increasing as a result of the continuing reduction of restrictions on the interstate operations of financial institutions.

Supervision and Regulation

Bank holding companies and commercial banks are extensively regulated under both federal and state law. The following is a brief summary of certain statutes and rules and regulations that affect or will affect the Company, the Bank and any subsidiaries. This summary is qualified in its entirety by reference to the particular statute and regulatory provisions cited below and is not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company and the Bank. Supervision, regulation and examination of the Company and the Bank by the regulatory agencies are intended primarily for the protection of depositors rather than shareholders of the Company. Statutes and regulations which contain wide-ranging proposals for altering the structures, regulations and competitive relationship of financial institutions are introduced regularly. The Company cannot predict whether or in what form any proposed statute or regulation will be adopted or the extent to which the business of the Company and the Bank may be affected by such statute or regulation.

General. There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and the FDIC insurance funds in the event the depository institution becomes in danger of default or in default. For example, to avoid receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” with the terms of the capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the bank's total assets at the time the bank became

undercapitalized or (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all acceptable capital standards as of the time the bank fails to comply with such capital restoration plan. The Company, as a registered bank holding company, is subject to the regulation of the Federal Reserve. Under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. The Federal Reserve under the BHCA also has the authority to require a bank holding company to terminate any activity or to relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal Reserve's determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the bank holding company.

In addition, insured depository institutions under common control are required to reimburse the FDIC for any loss suffered by its deposit insurance funds as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the deposit insurance funds. The FDIC's claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

As a result of the Company's ownership of the Bank, the Company is also registered under the bank holding company laws of North Carolina. Accordingly, the Company is also subject to regulation and supervision by the Commissioner.

Capital Adequacy Guidelines for Holding Companies. The Federal Reserve has adopted capital adequacy guidelines for bank holding companies and banks that are members of the Federal Reserve System and have consolidated assets of $150 million or more. Bank holding companies subject to the Federal Reserve’s capital adequacy guidelines are required to comply with the Federal Reserve's risk-based capital guidelines. Under these regulations, the minimum ratio of total capital to risk-weighted assets is 8%. At least half of the total capital is required to be “Tier I capital,” principally consisting of common stockholders' equity, noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less certain goodwill items. The remainder (“Tier II capital”) may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock, and a limited amount of the general loan loss allowance. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier I capital (leverage) ratio, under which a bank holding company must maintain a minimum level of Tier I capital to average total consolidated assets of at least 3% in the case of a bank holding company which has the highest regulatory examination rating and is not contemplating significant growth or expansion. All other bank holding companies are expected to maintain a Tier I capital (leverage) ratio of at least 1% to 2% above the stated minimum.

Capital Requirements for the Bank. The Bank, as a North Carolina commercial bank, is required to maintain a surplus account equal to 50% or more of its paid-in capital stock. As a North Carolina chartered, FDIC-insured commercial bank which is not a member of the Federal Reserve System, the Bank is also subject to capital requirements imposed by the FDIC. Under the FDIC's regulations, state nonmember banks that (a) receive the highest rating during the examination process and (b) are not anticipating or experiencing any significant growth, are required to maintain a minimum leverage ratio of 3% of total consolidated assets; all other banks are required to maintain a minimum ratio of 1% or 2% above the stated minimum, with a minimum leverage ratio of not less than 4%. The Bank exceeded all applicable capital requirements as of December 31, 2005.

Dividend and Repurchase Limitations. The Company must obtain Federal Reserve approval prior to repurchasing Common Stock for in excess of 10% of its net worth during any twelve-month period unless the Company (i) both before and after the redemption satisfies capital requirements for "well capitalized" state member banks; (ii) received a one or two rating in its last examination; and (iii) is not the subject of any unresolved supervisory issues.

Although the payment of dividends and repurchase of stock by the Company are subject to certain requirements and limitations of North Carolina corporate law, except as set forth in this paragraph, 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 or repurchase shares may be dependent upon the Company's receipt of dividends from the Bank.

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).

Deposit Insurance Assessments. The Bank is subject to insurance assessments imposed by the FDIC. Under current law, the insurance assessment to be paid by members of the Bank Insurance Fund, such as the Bank, shall be as specified in a schedule required to be issued by the FDIC. FDIC assessments for deposit insurance range from 0 to 27 basis points per $100 of insured deposits, depending on the institution's capital position and other supervisory factors.

Federal Home Loan Bank System. The FHLB system provides a central credit facility for member institutions. As a member of the FHLB of Atlanta, the Bank is required to own capital stock in the FHLB of Atlanta in an amount at least equal to 0.20% (or 20 basis points) of the Bank’s total assets at the end of each calendar year, plus 4.5% of its outstanding advances (borrowings) from the FHLB of Atlanta under the new activity-based stock ownership requirement. On December 31, 2005, the Bank was in compliance with this requirement.

Community Reinvestment. Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the FDIC, an insured institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution’s discretion to develop, consistent with the CRA, the types of products and services that it believes are best suited to its particular community. The CRA requires the federal banking regulators, in connection with their examinations of insured institutions, to assess the institutions’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those institutions. All institutions are required to make public disclosure of their CRA performance ratings. The Bank received a “satisfactory” rating in its last CRA examination, which was conducted during March 2004.

Prompt Corrective Action. The FDIC has broad powers to take corrective action to resolve the problems of insured depository institutions. The extent of these powers will depend upon whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." Under the regulations, an institution is considered: (A) "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier I risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure; (B) "adequately capitalized" if it has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier I risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of an institution with the highest examination rating); (C)"undercapitalized" if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest examination rating); (D) "significantly undercapitalized" if it has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3%; and (E) "critically undercapitalized" if the institution has a ratio of tangible equity to total assets equal to or less than 2%.

Changes in Control. The BHCA prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding voting stock or substantially all of the assets of any bank or savings bank or merging or consolidating with another bank holding company or savings bank holding company without prior approval of the Federal Reserve. Similarly, Federal Reserve approval (or, in certain cases, non-disapproval) must be obtained prior to any person acquiring control of the Company. Control is conclusively presumed to exist if, among other things, a person acquires more than 25% of any class of voting stock of the Company or controls in any manner the election of a majority of the directors of the Company. Control is presumed to exist if a person acquires more than 10% of any class of voting stock and the stock is registered under Section 12 of the Securities Exchange Act of 1934 or the acquiror will be the largest shareholder after the acquisition.

Federal Securities Law. The Company has registered its Common Stock with the SEC pursuant to Section 12(g) of the Securities Exchange Act of 1934. As a result of such registration, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Exchange Act are applicable to the Company.

Transactions with Affiliates. Under current federal law, depository institutions are subject to the restrictions contained in Section 22(h) of the Federal Reserve Act with respect to loans to directors, executive officers and principal shareholders. Under Section 22(h), loans to directors, executive officers and shareholders who own more than 10% of a depository institution (18% in the case of institutions located in an area with less than 30,000 in population), and certain affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the institution's loans-to-one-borrower limit (as discussed below). Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and shareholders who own more than 10% of an institution, and their respective affiliates, unless such loans are approved in advance by a majority of the board of directors of the institution. Any "interested" director may not participate in the voting. The FDIC has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further, pursuant to Section 22(h), the Federal Reserve requires that loans to directors, executive officers, and principal shareholders be made on terms substantially the same as offered in comparable transactions with non-executive employees of the Bank. The FDIC has imposed additional limits on the amount a bank can loan to an executive officer.

Loans to One Borrower. The Bank is subject to the Commissioner's loans to one borrower limits which are substantially the same as those applicable to national banks. Under these limits, no loans and extensions of credit to any borrower outstanding at one time and not fully secured by readily marketable collateral shall exceed 15% of the unimpaired capital and unimpaired surplus of the bank. Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of unimpaired capital and unimpaired surplus.

Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act enacted in 1999 (the “GLB Act”) dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act has expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, this expanded authority also may present us with new challenges as our larger competitors are able to expand their services and products into areas that are not feasible for smaller, community oriented financial institutions. The GLB Act likely will have a significant economic impact on the banking industry and on competitive conditions in the financial services industry generally.

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

Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law and became some of the most sweeping federal legislation addressing accounting, corporate governance and disclosure issues. The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and imposes significant new requirements for public company governance and disclosure requirements. Some of the provisions of the Sarbanes-Oxley Act became effective immediately while others are still being implemented.

In general, the Sarbanes-Oxley Act mandates important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It establishes new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and creates a new regulatory body to oversee auditors of public companies. It backs these requirements with new SEC enforcement tools, increases criminal penalties for federal mail, wire and securities fraud, and creates new criminal penalties for document and record destruction in connection with federal investigations. It also increases the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.

The economic and operational effects of this new legislation on public companies, including us, will be significant in terms of the time, resources and costs associated with complying with the new law. Because the Sarbanes-Oxley Act, for the most part, applies equally to larger and smaller public companies, we will be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our market.

Other. Additional regulations require annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state chartered institutions examined by state regulators. Additional regulations also establish operational and managerial, asset quality, earnings and stock valuation standards for insured depository institutions, as well as compensation standards.

The Bank is subject to examination by the FDIC and the Commissioner. In addition, the Bank is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking. The Bank, as an insured North Carolina commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards.

Under Chapter 53 of the North Carolina General Statutes, if the capital stock of a North Carolina commercial bank is impaired by losses or otherwise, the Commissioner is authorized to require payment of the deficiency by assessment upon the bank's shareholders, pro rata, and to the extent necessary, if any such assessment is not paid by any shareholder, upon 30 days notice, to sell as much as is necessary of the stock of such shareholder to make good the deficiency.

ITEM 1A. RISK FACTORS

The following are potential risks that management considers material and that could affect the future operating results and financial condition of the Bank and the Company. The risks are not listed in any particular order of importance, and there is the potential that there are other risks that have either not been identified or that management believed to be immaterial but which could in fact adversely affect the Bank’s operating results and financial condition.

Loss of key personnel could adversely impact results

The success of the Bank has been and will continue to be greatly influenced by the ability to retain the services of existing senior management The Bank has benefited from consistency within its senior management team, with its top five executives averaging over 13 years of service with the Bank. The Company has entered into employment contracts with each of these top management officials. Nevertheless, the unexpected loss of the services of any of the key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse impact on the business and financial results of the Bank.

A significant amount of the Bank’s business is concentrated in lending which is secured by property located in the Catawba Valley and surrounding areas

In addition to the financial strength and cash flow characteristics of the borrower in each case, the Bank often secures its loans with real estate collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If the Bank is required to liquidate the collateral securing a loan during a period of reduced real estate values to satisfy the debt, the Bank’s earnings and capital could be adversely affected.

Additionally, with most of the Bank’s loans concentrated in the Catawba Valley and surrounding areas, a decline in local economic conditions could adversely affect the values of the Bank’s real estate collateral. Consequently, a decline in local economic conditions may have a greater effect on the Bank’s earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse.

An inadequate allowance for loan losses would reduce our earnings

The risk of credit losses on loans varies with, among other things, general economic conditions, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. Management maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Considering such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances within assigned risk grades and for specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb

future losses, or if the bank regulatory authorities require the Bank to increase the allowance for loan losses as a part of their examination process, the Bank’s earnings and capital could be significantly and adversely affected. For further discussion related to our process for determining the appropriate level of the allowance for loan losses, see “Allowance for Loan Losses” within “Item 7. Management’s Discussion and Analysis of Financial Condition and Results and Operation” of this Annual Report on Form 10-K.

Changes in interest rates affect profitability and assets

Changes in prevailing interest rates may hurt the Bank’s business. The Bank derives its income primarily from the difference or “spread” between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. In general, the larger the spread, the more the Bank earns. When market rates of interest change, the interest the Bank receives on its assets and the interest the Bank pays on its liabilities will fluctuate. This can cause decreases in the “spread” and can adversely affect the Bank’s income. Changes in market interest rates could reduce the value of the Bank’s financial assets. Fixed-rate investments, mortgage-backed and related securities and mortgage loans generally decrease in value as interest rates rise. In addition, interest rates affect how much money the Bank lends. For example, when interest rates rise, the cost of borrowing increases and the loan originations tend to decrease. If the Bank is unsuccessful in managing the effects of changes in interest rates, the financial condition and results of operations could suffer.

We measure interest rate risk under various rate scenarios using specific criteria and assumptions. A summary of this process, along with the results of our net interest income simulations is presented within “Item 7A. Quantitative and Qualitative Disclosures About Market Risk” of this Annual Report on Form 10-K.

Regional economic factors may have an adverse impact on our business

Substantially all of the Bank’s business is with customers in its local market areas. Most of the Bank’s customers are individuals and medium-sized businesses which are dependent upon the regional economy. Adverse changes in economic and business conditions in the Bank’s markets could adversely affect its borrowers, their ability to repay their loans and to borrow additional funds or buy financial services and products from the Bank.

The Bank faces strong competition from other banks and financial institutions which can hurt its business

The financial services industry is highly competitive. The Bank competes against commercial banks, savings banks, savings and loan associations, credit unions, mortgage banks, brokerage firms, investment advisory firms, insurance companies and other financial institutions. Many of these entities are larger organizations with significantly greater financial, management and other resources than the Bank has. Moreover, two national money center commercial banks are headquartered in Charlotte, North Carolina, only 40 miles from the Bank's primary market area.

While management believes it can and does successfully compete with other financial institutions in our market, we may face a competitive disadvantage as a result of our smaller size and lack of geographic diversification.

Government regulations and policies impose limitations and may result in higher operating costs and competitive disadvantages

The Bank is subject to extensive federal government supervision and regulation that is intended primarily to protect depositors and the FDIC’s Bank Insurance Fund, rather than the Company’s shareholders. Existing banking laws subject the Bank to substantial limitations with respect to loans, the purchase of securities, the payment of dividends and many other aspects of banking business. Some of the banking laws may increase the cost of doing business or otherwise adversely affect the Bank and create competitive advantages for non-bank competitors. There can be no assurance that future legislation or government policy will not adversely affect the banking industry or the Bank’s operations. Federal economic and monetary policy may also affect the Bank’s ability to attract deposits, make loans and achieve satisfactory interest spreads.

Changes in technology may impact the Bank’s business

The Bank uses various technologies in its business and the banking industry is undergoing rapid technological changes. The effective use of technology increases efficiency and enables financial institutions to reduce costs. The Bank’s future success will depend in part on its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands for convenience as well as create additional efficiencies in the Bank’s operations. The Bank’s competitors may have substantially greater resources to invest in technological improvements.

The trading volume in our common stock is less than that of larger public companies which can cause price volatility.

The trading history of our common stock has been characterized by relatively low trading volume. The value of a shareholder’s investment may be subject to sudden decreases due to the volatility of the price of our common stock, which trades on the NASDAQ National Market.

The market price of our common stock may be volatile and subject to fluctuations in response to numerous factors, including, but not limited to, the factors discussed in other risk factors and the following:

·	actual or anticipated fluctuation in our operating results;

·	changes in interest rates;

·	changes in the legal or regulatory environment in which we operate;

·	press releases, announcements or publicity relating to us or our competitors or relating to trends in our industry;

·	changes in expectations as to our future financial performance, including financial estimates or recommendations by securities analysts and investors;

·	future sales of our common stock;

·	changes in economic conditions in our market, general conditions in the U.S. economy, financial markets or the banking industry; and

·	other developments affecting us or our competitors.

These factors may adversely affect the trading price of our common stock, regardless of our actual operating performance, and could prevent a shareholder from selling common stock at or above the current market price.

We may be subject to examinations by taxing authorities which could adversely affect our results of operations.

In the normal course of business, we may be subject to examinations from federal and state taxing authorities regarding the amount of taxes due in connection with investments we have made and the businesses in which we are engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. The challenges made by taxing authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in our favor, they could have an adverse effect on our financial condition and results of operations.

We may not be able to pay dividends in the future in accordance with past practice.

We have in the past paid a quarterly dividend to shareholders. However, we are dependent primarily upon the Bank for our earnings and funds to pay dividends on our common stock. The payment of dividends also is subject to legal and regulatory restrictions. Any payment of dividends in the future will depend, in large part, on the Bank’s earnings, capital requirements, financial condition and other factors considered relevant by our Board of Directors.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

At December 31, 2005, the Bank conducted its business from the headquarters office in Newton, North Carolina, and its 17 other branch offices in Lincolnton, Hickory, Newton, Catawba, Conover, Claremont, Maiden, Denver, Triangle, Hiddenite and Charlotte, North Carolina. The following table sets forth certain information regarding the Bank's properties at December 31, 2005.

	Owned		Leased

	Corporate Office		1333 2nd Street NE
	518 West C Street		Hickory, North Carolina 28601
	Newton, North Carolina 28658
			1910 East Main Street
	420 West A Street		Lincolnton, North Carolina 28092
	Newton, North Carolina 28658
			2050 Catawba Valley Boulevard
	2619 North Main Avenue		Hickory, North Carolina 28601
	Newton, North Carolina 28658
			760 Highway 27 West
	213 1st Street, West		Lincolnton, North Carolina 28092
	Conover, North Carolina 28613
			102 Leonard Avenue
	3261 East Main Street		Newton, North Carolina 28658
	Claremont, North Carolina 28610
			6300 South Boulevard
	6125 Highway 16 South		Suite 100
	Denver, North Carolina 28037		Charlotte, North Carolina 28217

	5153 N.C. Highway 90E		4451 Central Avenue
	Hiddenite, North Carolina 28636		Suite A
			Charlotte, North Carolina 28205
	200 Island Ford Road
	Maiden, North Carolina 28650		3752/3754 Highway 16 North
			Denver, North Carolina 28037
	3310 Springs Road NE
	Hickory, North Carolina 28601		209 Delburg Street
			Suite 105
	142 South Highway 16		Davidson, North Carolina 28036
	Denver, North Carolina 28037

	106 North Main Street
	Catawba, North Carolina 28609

ITEM 3. LEGAL PROCEEDINGS

In the opinion of management, the Company is not involved in any pending legal proceedings other than routine, non-material proceedings occurring in the ordinary course of business.

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

No matter was submitted to a vote of the Bank's shareholders during the quarter ended December 31, 2005.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER

PURCHASES OF EQUITY SECURITIES

The information required by this Item is set forth under the section captioned "Market for the Company’s Common Equity and Related Shareholder Matters" on page A-22 of the Annual Report, which section is incorporated herein by reference. See "Item 1. BUSINESS--Supervision and Regulation" above for regulatory restrictions which limit the ability of the Company to pay dividends.

ISSUER PURCHASES OF EQUITY SECURITIES

Period	Total Number of Shares Purchased		Average Price Paid per Share	Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs			Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs

October 1 - 31, 2005	509	$	21.05	-		$	2,502,174

November 1 - 30, 2005	5,270	$	21.50	5,000	(1)	$	2,394,424

December 1 - 31, 2005	-		-	-		$	2,000,000	(2)

	5,779	$	21.46	5,000		$	2,000,000

(1) The Company purchased 5,000 shares in November 2005, pursuant to a $3.0 million stock repurchase program that expired November 30, 2005.

(2) The Company authorized a $2.0 million stock repurchase program effective December 1, 2005. This program will expire November 30, 2006. No shares were repurchased pursuant to this program in 2005.

ITEM 6. SELECTED FINANCIAL DATA

The information required by this Item is set forth in the table captioned "Selected Financial Data" on page A-2 of the Annual Report, which table is incorporated herein by reference.

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

The information required by this Item is set forth in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages A-3 through A-23 of the Annual Report, which section is incorporated herein by reference.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required by this Item is set forth in the section captioned “Quantitative and Qualitative Disclosures About Market Risk” on page A-20 of the Annual Report, which section is incorporated herein by reference.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements of the Company and supplementary data set forth on pages A-24 through A-48 of the Annual Report are incorporated herein by reference.

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

Not applicable.

ITEM 9A. CONTROLS AND PROCEDURES

The Company’s management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer of the Company (its principal executive officer and principal financial officer, respectively) have concluded, based on their evaluation as of the end of the period covered by this Report, that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms. The Company’s management has further concluded, that the controls and procedures are designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including the Chief Executive Officer and the Chief Financial Officer of the Company as appropriate to allow timely decisions regarding required disclosure.

There have been no significant changes in internal control over financial reporting during the period covered by this annual report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

None

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this Item regarding directors and executive officers of the Company is set forth under the sections captioned “Proposal 1 - Election of Directors - Nominees” on pages 6 and 7 of the Proxy Statement and “Proposal 1 - Election of Directors - Executive Officers” on page 10 of the Proxy Statement, which sections are incorporated herein by reference.

The information required by this Item regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 is set forth under the section captioned “Section 16(a) Beneficial Ownership Reporting Compliance” set forth on page 5 of the Proxy Statement, which section is incorporated herein by reference.

The information required by this Item regarding identification of members of the Company’s Audit Committee is set forth under the section captioned “Proposal 1 - Election of Directors - Committees of the Board” on page 8 of the Proxy Statement, which section is incorporated herein by reference. The Board of Directors of the Company has determined that each of the members of the Company’s Audit Committee qualifies as an “audit committee financial expert.” Those members are Robert C. Abernethy, Douglas S. Howard, Larry E. Robinson, Dan R. Timmerman, Sr., Gary E. Matthews and Dr. Billy L. Price, Jr. Each member of the Audit Committee is independent, as defined in the regulations enacted under the Securities Exchange Act of 1934.

The Company has adopted a Code of Ethics that applies to the Company’s employees, including the principal executive officer and principal financial officer. The Company will provide to any person, without charge, upon request, a copy of the Code of Ethics. To request a copy, a written request should be submitted to the Company’s corporate headquarters, addressed to the attention of A. Joseph Lampron, Chief Financial Officer.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item is set forth under the sections captioned “Proposal 1 - Election of Directors - Director Compensation” on pages 9 and 10 and “- Management Compensation,” “ - Stock Benefits Plan,” “- Employment Agreements,” “- Incentive Compensation Plans,” “- Profit Sharing and 401(k) Plans,” “- Deferred Compensation Plan,” “- Supplemental Retirement Plan,” and "- Discretionary Bonuses and Service Awards," on pages 11 through 20 of the Proxy Statement, which sections are incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item is incorporated by reference from the section captioned “Security Ownership of Certain Beneficial Owners” on pages 2 through 5 of the Proxy Statement and the section captioned “Equity Compensation Plan Information” on page 14 of the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

See the section captioned “Proposal 1 - Election of Directors - Indebtedness of and Transactions with Management and Directors” on page 20 of the Proxy Statement, which section is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

See the section captioned “Proposal 2 - Ratification of Selection of Independent Auditor” on page 23 of the Proxy Statement, which section is incorporated herein by reference.

PART IV

ITEM 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

15(a)1.	Consolidated Financial Statements (contained in the Annual Report attached hereto as Exhibit (13)
	and incorporated herein by reference)

	(a)	Report of Independent Registered Public Accounting Firm

	(b)	Consolidated Balance Sheets as of December 31, 2005 and 2004

	(c)	Consolidated Statements of Earnings for the Years Ended December 31, 2005, 2004 and
		2003

	(d)	Consolidated Statements of Changes in Shareholders' Equity for the Years Ended
		December 31, 2005, 2004 and 2003

	(e)	Consolidated Statements of Comprehensive Income for the Years Ended December 31,
		2005, 2004 and 2003

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

	(g)	Notes to Consolidated Financial Statements

15(a)2.	Financial Consolidated Statement Schedules

	All schedules have been omitted as the required information is either inapplicable or included in
	the Notes to Consolidated Financial Statements.

15(a)3.	Exhibits

	Exhibit (3)(i)	Articles of Incorporation of Peoples Bancorp of North Carolina, Inc.,
		incorporated by reference to Exhibit (3)(i) to the Form 8-A filed with the
		Securities and Exchange Commission on September 2, 1999

	Exhibit (3)(ii)	Amended and Restated Bylaws of Peoples Bancorp of North Carolina,
		Inc., incorporated by reference to Exhibit (3)(ii) to the Form 10-K filed
		with the Securities and Exchange Commission on March 26, 2004

	Exhibit (4)	Specimen Stock Certificate, incorporated by reference to Exhibit (4) to
		the Form 8-A filed with the Securities and Exchange Commission on
		September 2, 1999

	Exhibit (10)(a)	Employment Agreement between Peoples Bank and Tony W. Wolfe
		incorporated by reference to Exhibit (10)(a) to the Form 10-K filed with
		the Securities and Exchange Commission on March 30, 2000

	Exhibit (10)(b)	Employment Agreement between Peoples Bank and Joseph F. Beaman,
		Jr. incorporated by reference to Exhibit (10)(b) to the Form 10-K filed
		with the Securities and Exchange Commission on March 30, 2000

	Exhibit (10)(c)	Employment Agreement between Peoples Bank and William D. Cable
		incorporated by reference to Exhibit (10)(d) to the Form 10-K filed with
		the Securities and Exchange Commission on March 30, 2000

	Exhibit (10)(d)	Employment Agreement between Peoples Bank and Lance A. Sellers
		incorporated by reference to Exhibit (10)(e) to the Form 10-K filed with
		the Securities and Exchange Commission on March 30, 2000

	Exhibit (10)(e)	Peoples Bancorp of North Carolina, Inc. Omnibus Stock Ownership and
		Long Term Incentive Plan incorporated by reference to Exhibit (10)(f) to
		the Form 10-K filed with the Securities and Exchange Commission on
		March 30, 2000

	Exhibit (10)(f)	Employment Agreement between Peoples Bank and A. Joseph Lampron,
		incorporated by reference to Exhibit (10)(g) to the Form 10-K filed with the
		Securities and Exchange Commission on March 28, 2002

	Exhibit (10)(g)	Peoples Bank Directors' and Officers' Deferral Plan, incorporated by
		reference to Exhibit (10)(h) to the Form 10-K filed with the Securities and
		Exchange Commission on March 28, 2002

	Exhibit (10)(h)	Rabbi Trust for the Peoples Bank Directors' and Officers' Deferral Plan,
		incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
		Securities and Exchange Commission on March 28, 2002

	Exhibit (10)(i)	Description of Service Recognition Program maintained by Peoples Bank,
		incorporated by reference to Exhibit (10)(i) to the Form 10-K filed with the
		Securities and Exchange Commission on March 27, 2003

	Exhibit (12)	Statement Regarding Computation of Ratios

	Exhibit (13)	2005 Annual Report of Peoples Bancorp of North Carolina, Inc.

	Exhibit (14)	Code of Business Conduct and Ethics of Peoples Bancorp of North
		Carolina, Inc., incorporated by reference to Exhibit (14) to the Form 10-K
		filed with the Securities and Exchange Commission on March 25, 2005

	Exhibit (21)	Subsidiaries of Peoples Bancorp of North Carolina, Inc., incorporated by
		reference to Exhibit 21 to the Form 10-K filed with the Securities and
		Exchange Commission on March 27, 2003

	Exhibit (23)(a)	Consent of Porter Keadle Moore, LLP for Registration Statement on
		Form S-3 filed with the Securities and Exchange Commission on August
		10, 2000

	Exhibit (23)(b)	Consent of Porter Keadle Moore, LLP for Registration Statement on
		Form S-8 filed with the Securities and Exchange Commission on
		September 28, 2000

	Exhibit (31)(a)	Certification of principal executive officer pursuant to section 302 of the
		Sarbanes-Oxley Act of 2002

	Exhibit (31)(b)	Certification of principal financial officer pursuant to section 302 of the
		Sarbanes-Oxley Act of 2002

	Exhibit (32)	Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
		Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		PEOPLES BANCORP OF NORTH CAROLINA, INC.
		(Registrant)

		By:	/s/ Tony W. Wolfe
		Tony W. Wolfe
		President and Chief Executive Officer

		Date: March 24, 2006


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

Signature	Title			Date

/s/ Tony W. Wolfe	President and Chief Executive Officer			March 24, 2006
Tony W. Wolfe	(Principal Executive Officer)

/s/ James S. Abernethy	Director			March 24, 2006
James S. Abernethy

/s/ Robert C. Abernethy	Chairman of the Board and Director			March 24, 2006
Robert C. Abernethy

/s/ Douglas S. Howard	Director			March 24, 2006
Douglas S. Howard

/s/ A. Joseph Lampron	Executive Vice President and Chief			March 24, 2006
A. Joseph Lampron	Financial Officer (Principal Financial
	and Principal Accounting Officer)

/s/ John W. Lineberger, Jr.	Director			March 24, 2006
John W. Lineberger, Jr.

/s/ Gary E. Matthews	Director			March 24, 2006
Gary E. Matthews

/s/ Billy L. Price, Jr., M.D.	Director			March 24, 2006
Billy L. Price, Jr., M.D.

/s/ Larry E. Robinson	Director			March 24, 2006
Larry E. Robinson

/s/ William Gregory Terry	Director			March 24, 2006
William Gregory Terry

/s/ Dan Ray Timmerman, Sr.	Director			March 24, 2006
Dan Ray Timmerman, Sr.

/s/ Benjamin I. Zachary	Director			March 24, 2006
Benjamin I. Zachary

EX-12 2 ex12.htm STMT RE: COMPUTATION OF RATIOS Stmt Re: Computation of Ratios

EXHIBIT (12)

STATEMENT REGARDING COMPUTATION OF RATIOS

The averages used in computing the performance ratios provided in Item 6 represent average daily balances.

EX-13 3 ex13.htm 2005 ANNUAL REPORT OF PEOPLES BANCORP OF NORTH CAROLINA, INC.

PEOPLES BANCORP OF NORTH CAROLINA, INC.

General Description of Business

At December 31, 2005, the Bank employed 222 full-time equivalent employees.

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-1

SELECTED FINANCIAL DATA

Dollars in Thousands Except Per Share Amounts

	2005			2004			2003			2002			2001
Summary of Operations
Interest income	$	43,371			36,292			34,935			36,649			41,932
Interest expense		15,429			12,335			12,749			15,777			23,027

Net interest income		27,942			23,957			22,186			20,872			18,905
Provision for loan losses		3,110			3,256			6,744			5,432			3,545

Net interest income after provision for loan losses		24,832			20,701			15,442			15,440			15,360
Non-interest income		6,696			6,020			5,845			6,466			8,229
Non-interest expense		21,816			20,057			18,228			16,758			16,752

Income before taxes		9,712			6,664			3,059			5,148			6,837
Income taxes		3,381			2,233			1,055			1,712			2,262
Net income	$	6,331			4,431			2,004			3,436			4,575

Selected Year-End Balances
Assets	$	730,280			686,348			674,032			645,638			619,505
Available for sale securities		115,158			105,598			79,460			71,736			84,286
Loans, net		559,239			527,419			542,404			519,122			484,517
Mortgage loans held for sale		2,248			3,783			587			5,065			5,339
Interest-earning assets		692,402			652,678			639,501			608,619			586,496
Deposits		582,854			556,522			549,802			515,739			490,223
Interest-bearing liabilities		576,681			553,135			550,357			527,525			516,422
Shareholders' equity	$	54,353			50,938			48,554			48,605			45,401
Shares outstanding*		3,440,805			3,448,341			3,448,722			3,446,902			3,540,585

Selected Average Balances
Assets	$	706,843			684,385			661,077			625,227			575,142
Available for sale securities		108,690			93,770			72,072			77,414			84,549
Loans		550,545			547,753			539,559			507,879			454,371
Interest-earning assets		668,181			650,095			625,764			592,947			545,945
Deposits		570,997			558,142			533,703			499,224			481,289
Interest-bearing liabilities		563,210			553,880			540,676			516,747			472,435
Shareholders' equity	$	55,989			51,978			49,971			48,257			47,432
Shares outstanding*		3,449,873			3,459,379			3,447,056			3,467,173			3,540,585

Profitability Ratios
Return on average total assets		0.90	%		0.65	%		0.30	%		0.55	%		0.80	%
Return on average shareholders' equity		11.31	%		8.52	%		4.01	%		7.12	%		9.65	%
Dividend payout ratio		22.34	%		28.37	%		62.56	%		36.58	%		28.14	%

Liquidity and Capital Ratios (averages)
Loan to deposit		96.42	%		98.14	%		101.10	%		101.73	%		94.41	%
Shareholders' equity to total assets		7.92	%		7.59	%		7.56	%		7.72	%		8.25	%

Per share of common stock*
Basic net income	$	1.84			1.28			0.58			0.99			1.29
Diluted net income	$	1.80			1.26			0.58			0.99			1.29
Cash dividends	$	0.41			0.36			0.36			0.36			0.36
Book value	$	15.80			14.77			14.08			14.10			12.83

*Shares outstanding and per share computations have been retroactively restated to reflect a 10% stock dividend during first quarter 2005.

A-2

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

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 Peoples Bancorp of North Carolina, Inc. (the “Company”), for the years ended December 31, 2005, 2004 and 2003. 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 and Iredell 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, 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 local employers may be required to eliminate employment positions of borrowers, and small businesses and other 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 conditions 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.

During 2005 the Federal Reserve has increased the Federal Funds Rate a total of 2.00%, with the rate set at 4.25% as of December 31, 2005. These increases had a positive impact on 2005 earnings and should continue to have a positive impact on the Bank’s net interest income in future periods. The positive impact from the increase in the Federal Funds Rate has been partially offset by the decrease in earnings realized on interest rate swaps utilized by the Company to convert some variable rate loans to fixed rate. These swaps were put in place during the time that the Federal Funds Rate approached 1.00% and helped to offset the decline in income experienced in 2003 and 2004 because of the reductions in the Federal Funds Rate that the Federal Reserve implemented from January 2001 to June 2003.

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

A-3

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 2006 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 4, 2006 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 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 December 2004, the FASB revised SFAS No. 123 (“SFAS No. 123 (R)”). SFAS No. 123 (R), “Share-Based Payment,” requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative to financial statement recognition. SFAS No. 123 (R) is effective for periods beginning after December 31, 2005. The Company will adopt in the first quarter of 2006. The financial statement impact of adopting this change in accounting principle is not expected to be material due to the small number of unvested shares at December 31, 2005.

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 generally accepted accounting principles. 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-25 through A-48.

Results of Operations

Summary. The Company reported earnings of $6.3 million in 2005, or $1.84 basic net earnings per share and $1.80 diluted net earnings per share, a 43% increase as compared to $4.4 million, or $1.28 basic net earnings per share and $1.26 diluted net earnings per share, for 2004. Net earnings from recurring operations for 2005 were $6.8 million, or $1.98 basic net earnings per share and $1.94 diluted net earnings per share, representing a 48% increase over net earnings from recurring operations of $4.6 million, or $1.33 basic net earnings per share and $1.31 diluted net earnings per share in 2004. Net non-recurring losses on disposition of assets in 2005 amounted to $746,000, primarily due to a $730,000 loss on sale of securities. This is an increase over net non-recurring losses on disposition of assets for the year ended December 31, 2004, which amounted to $248,000. The Company’s increase in recurring earnings for 2005 is 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.

Net earnings for 2004 represented an increase of 121% as compared to 2003 net earnings of $2.0 million. Net earnings from recurring operations for 2004 increased 106% when compared to $2.2 million, or $0.65 basic net earnings per share and $0.64 diluted net earnings per share for 2003. Net earnings for 2003 included non-recurring losses on the sale of securities of $53,000. The increase in 2004 recurring earnings was primarily attributable to a decrease in the provision for loan losses and an increase in net interest income, which were partially offset by an increase in non-interest expense.

The annualized return on average assets in 2005 was 0.90%, compared to 0.65% in 2004 and 0.30% in 2003. Excluding non-recurring gains and losses on disposition of assets, the annualized return on average assets was 0.96%, 0.67% and 0.34% in 2005, 2004 and 2003, respectively. Annualized return on average shareholders’ equity was 11.31% in 2005 compared to 8.52% in 2004 and 4.01% in 2003. Excluding non-recurring gains and losses on disposition of assets, the annualized return on average shareholders’ equity was 12.07%, 8.81% and 4.46% in 2005, 2004 and 2003, respectively.

A-4

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 $27.9 million for 2005, or 17% over net interest income of $24.0 million in 2004. The increase was attributable to an increase in interest income due to an increase in the prime rate resulting from Federal Reserve interest rate increases combined with an increase in the average outstanding balance of available for sale securities. Net interest income increased 8% in 2004 from $22.2 million in 2003.

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, 2005, 2004 and 2003. 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 34% 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.

Table 1- Average Balance Table
	December 31, 2005								December 31, 2004						December 31, 2003
(Dollars in Thousands)		Average Balance			Interest		Yield / Rate			Average Balance		Interest	Yield / Rate			Average Balance		Interest	Yield / Rate
Interest-earning assets:
Loans	$	550,545			37,234		6.76	%		547,753		29,826	5.45	%		539,559		28,700	5.32	%
Interest rate swap agreements		-			(575	)	-0.14	%		-		1,056	2.21	%		-		1,522	3.22	%
Loan fees		-			1,951		0.29	%		-		1,409	0.26	%		-		1,390	0.26	%
Total loans		550,545			38,610		7.01	%		547,753		32,291	5.90	%		539,559		31,612	5.86	%

Investments - taxable		37,487			1,597		4.26	%		35,920		1,545	4.30	%		49,082		2,186	4.45	%
Investments - nontaxable*		71,203			3,389		4.76	%		57,850		2,741	4.74	%		22,990		1,228	5.34	%
Federal funds sold		2,272			73		3.21	%		3,363		35	1.05	%		5,981		58	0.98	%
Other		6,674			238		3.57	%		5,209		141	2.70	%		8,152		174	2.14	%

Total interest-earning assets		668,181			43,907		6.57	%		650,095		36,753	5.65	%		625,764		35,258	5.63	%

Cash and due from banks		15,149								13,058						12,587
Other assets		31,324								30,601						31,008
Allowance for loan losses		(7,811	)							(9,369	)					(8,282	)

Total assets	$	706,843								684,385						661,077

Interest-bearing liabilities:
NOW accounts	$	110,852			1,468		1.32	%		106,832		1,292	1.21	%		75,757		688	0.91	%
Regular savings accounts		21,205			65		0.31	%		21,845		72	0.33	%		21,131		75	0.35	%
Money market accounts		56,858			1,112		1.96	%		51,069		535	1.05	%		58,134		556	0.96	%
Time deposits		292,807			8,923		3.05	%		300,175		7,145	2.38	%		310,991		8,157	2.62	%
FHLB borrowings		65,934			2,889		4.38	%		58,656		2,603	4.44	%		59,305		2,597	4.38	%
Demand notes payable to U.S. Treasury		702			21		3.02	%		678		8	1.14	%		710		7	0.99	%
Trust preferred securities		14,433			938		6.50	%		14,433		677	4.69	%		14,433		668	4.62	%
Other		419			13		3.00	%		192		3	1.46	%		215		1	0.47	%

Total interest-bearing liabilities		563,210			15,429		2.74	%		553,880		12,335	2.23	%		540,676		12,749	2.36	%

Demand deposits		89,275								78,221						67,690
Other liabilities		1,275								2,137						2,800
Shareholders' equity		55,989								51,978						49,971

Total liabilities and shareholder's equity	$	709,749								686,216						661,137

Net interest spread				$	28,478		3.83	%				24,418	3.43	%				22,509	3.27	%

Net yield on interest-earning assets							4.26	%					3.76	%					3.60	%

Taxable equivalent adjustment
Investment securities				$	536							460						323

Net interest income				$	27,942							23,958						22,186

*Includes U.S. government agency securities that are non-taxable for state income tax purposes of $50.7 million in 2005, $40.4 million in 2004 and $9.4 million in 2003. An effective tax rate of 6.90% was used to calculate the tax equivalent yield on these securities.

A-5

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.

Table 2 - Rate/Volume Analysis-Tax Equivalent Basis

	December 31, 2005									December 31, 2004
(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	$	180			6,139			6,319			481			198			679

Investments - taxable		67			(15	)		52			(603	)		(38	)		(641	)
Investments - nontaxable		634			14			648			1,756			(243	)		1,513
Federal funds sold		(23	)		61			38			(26	)		3			(23	)
Other		45			52			97			(73	)		40			(33	)

Total interest income		903			6,251			7,154			1,535			(40	)		1,495

Interest expense:

NOW accounts		51			125			176			329			275			604
Regular savings accounts		(2	)		(5	)		(7	)		2			(5	)		(3	)
Money market accounts		87			490			577			(71	)		50			(21	)
Time deposits		(200	)		1,978			1,778			(271	)		(741	)		(1,012	)
FHLB Borrowings		321			(35	)		286			(28	)		34			6
Demand notes payable to
U.S. Treasury		-			13			13			-			1			1
Trust Preferred Securities		24			237			261			-			9			9
Other		5			5			10			-			2			2

Total interest expense		286			2,808			3,094			(39	)		(375	)		(414	)

Net interest income	$	617			3,443			4,060			1,574			335			1,909

Net interest income on a tax equivalent basis totaled $28.5 million in 2005, increasing 17% or $4.1 million from 2004. This increase was primarily attributable to an increase in the yield on interest-earning assets partially offset by an increase in the cost of funds. The interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.83% in 2005, an increase from the 2004 net interest spread of 3.43%. The net yield on interest-earning assets in 2005 increased to 4.26% from the 2004 net interest margin of 3.76%.

Tax equivalent interest income increased $7.2 million or 19% in 2005 primarily due to an increase in the Bank’s prime lending rate from an average rate of 4.34% in 2004 to 6.19% in 2005. The increase in rates combined with a $17.4 million increase in average interest-earning assets resulted in an increase in the yield on interest-earning assets to 6.57% in 2005 as compared to 5.65% in 2004. The $18.1 million increase in average interest-earning assets was attributable primarily to a $14.9 million increase in average investment securities. Average loans in 2005 increased 1% to $550.5 million when compared to 2004. All other interest-earning assets including federal funds sold increased to $8.9 million in 2005 from $8.6 million in 2004.

Interest expense increased $3.1 million or 25% in 2005 due to an increase in the average rate paid on interest-bearing liabilities combined with a $9.3 million increase in volume of interest-bearing liabilities. The cost of funds increased to 2.74% in 2005 from 2.23% in 2004. 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 $9.3 million growth in average interest-bearing liabilities was primarily attributable to an increase in FHLB borrowings of $7.2 million to $65.9 million in 2005 from $58.7 million in 2004.

A-6

In 2004 net interest income on a tax equivalent basis increased $1.9 million or 8% to $24.4 million in 2004 from $22.5 million in 2003. The interest rate spread was 3.43% in 2004, an increase from the 2003 net interest spread of 3.27%. The net yield on interest-earning assets in 2004 increased to 3.76% from the 2003 net interest margin of 3.60%.

Provision for Loan Losses. Provision 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 Statement of Financial Accounting Standards (“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 $3.1 million, $3.3 million, and $6.7 million for the years ended December 31, 2005, 2004 and 2003, respectively. The decrease in the provision for loan losses for 2005 reflects a decrease in classified loans of $5.3 million as of December 31, 2005 when compared to December 31, 2004, netted against the effect of a 6% growth in gross loans during 2005. Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing possible loan losses

Non-Interest Income. Non-interest income for 2005 totaled $6.7 million, an increase of $676,000 or 11% from non-interest income of $6.0 million for 2004. The increases in non-interest income for 2005 are primarily due to an increase in fee income from the Bank’s Banco de la Gente branches, which were in operation for the first full year in 2005, increases in debit card fee income and an increase in mortgage banking income. Non-interest income for 2004 increased $175,000 or 3% from non-interest income of $5.8 million for 2003. The increase in non-interest income for 2004 is primarily due to an increase in service charge fee income associated with deposit growth, which were partially offset by a decrease in mortgage banking income. Excluding non-recurring gains or losses on the disposition of assets, non-interest income for 2005 increased 19% to $7.4 million as compared to $6.2 million in 2004. Non-interest income, excluding non-recurring gains or losses on the disposition of assets, totaled $6.2 million for 2003.

Service charges on deposit accounts totaled $3.8 million during 2005, an increase of $345,000, or 10% over 2004. Service charge income increased $168,000, or 5% in 2004 compared to 2003. 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 69% to $1.1 million for the year ended December 31, 2005 as compared to $677,000 for the same period one year ago. This increase is primarily attributable to fee income from the Bank’s Banco de la Gente branches, which were in operation for the first full year in 2005.

The Company reported net losses on sale of securities of $730,000, $64,000 and $53,000 in 2005, 2004 and 2003, respectively. Losses on the sale of securities were primarily due to the sale of $20 million in callable U.S. Government Agency securities, which were reinvested in fixed term U.S. Government Agency securities in order to reduce the exposure to a decrease in interest rates in the Bank’s investment portfolio.

Mortgage banking income increased to $469,000 in 2005 from $357,000 in 2004. During 2004 mortgage banking income decreased $248,000 from the $605,000 reported in 2003. The decrease in mortgage banking income for 2004 was primarily attributable to an increase in mortgage interest rates during 2004.

Net losses on repossessed assets were $38,000 for 2005 compared to net losses on repossessed assets of $180,000 for 2004. During 2003 a net loss on repossessed assets of $747,000 was recognized.

The Company recognized a $479,000 gain on the sale of loans during 2003 as a result of the sale of the Bank’s $3.7 million credit card portfolio in 2003. There were no gains on the sale of loans recognized in 2005 and 2004.

Miscellaneous income for 2005 totaled $1.7 million, an increase of 24% from $1.4 million for 2004. The 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. During 2003, miscellaneous income increased 18% primarily due to an increase in debit card fee income.

Table 3 presents a summary of non-interest income for the years ended December 31, 2005, 2004 and 2003.

A-7

Table 3 - Non-Interest Income

(Dollars in Thousands)	2005			2004			2003
Service charges	$	3,780			3,435			3,267
Other service charges and fees		1,142			677			611
Gain (loss) on sale of securities		(730	)		(64	)		(53	)
Mortgage banking income		469			356			604
Insurance and brokerage commissions		387			430			421
Loss on foreclosed and repossessed assets		(38	)		(179	)		(747	)
Gain on sale of loans		-			-			479
Miscellaneous		1,686			1,365			1,263
Total non-interest income	$	6,696			6,020			5,845

Non-Interest Expense. Total non-interest expense amounted to $21.8 million for 2005, an increase of 9% from 2004. Non-interest expense for 2004 increased 10% to $20.1 million from non-interest expense of $18.2 million for 2003.

Salary and employee benefit expense was $12.4 million in 2005, compared to $11.5 million during 2004, an increase of $873,000 or 8%, following a $1.4 million or 14% increase in salary and employee benefit expense in 2004 over 2003. The 2005 increase in salary and employee benefits is primarily due to normal salary increases and increased incentive expense. The increase during 2004 is attributable to normal salary increases, increased incentive expense and increased employee insurance costs.

The Company recorded occupancy expenses of $3.9 million in 2005, compared to $3.7 million during 2004, an increase of $277,000 or 8%, following an increase of $282,000 or 8% in occupancy expenses in 2004 over 2003. The increase in 2005 is primarily due to an increase in furniture and equipment expense and lease expense. Increases in 2004 are attributable to an increase in repairs and maintenance expense and an increase in lease expense resulting from lease agreements for branch facilities entered into during 2003 and 2004. During 2003, the Company sold two branch locations with net book values of approximately $3.1 million and is currently leasing the facilities from the buyers. As a result of the sales, the Company deferred a gain of approximately $633,000 and is recognizing the gain over the lease term. Approximately $22,000 of the deferred gain was recognized for the years ended December 31, 2005 and 2004. During 2003 approximately $18,000 of the deferred gain was recognized. Annual rent expense related to these two locations is $237,000.

The total of all other operating expenses increased $610,000 or 12% during 2005. Other operating expense increased $170,000 or 4% in 2004 over 2003. The increase in other expense for 2005 is primarily attributable to increases of $219,000 in fraud and forgery and processing adjustments on transactional accounts, $99,000 in professional fees, $74,000 in deposit program expense and $73,000 in debit card expense.

Table 4 presents a summary of non-interest expense for the years ended December 31, 2005, 2004 and 2003.

Table 4 - Non-Interest Expense

(Dollars in Thousands)	2005		2004		2003
Salaries and wages	$	8,648		8,240		7,733
Employee benefits		3,702		3,237		2,367
Total personnel expense		12,350		11,477		10,100
Occupancy expense		3,949		3,672		3,390
Office supplies		314		314		270
FDIC deposit insurance		76		81		82
Professional services		389		290		333
Postage		264		211		217
Telephone		403		337		333
Director fees and expense		334		351		234
Marketing and public relations		656		620		541
Consulting fees		233		306		280
Taxes and licenses		218		200		443
Other operating expense		2,631		2,198		2,005
Total non-interest expense	$	21,817		20,057		18,228

A-8

Income Taxes. Total income tax expense was $3.4 million in 2005 compared with $2.2 million in 2004 and $1.1 million in 2003. The primary reason for the increase in taxes for 2005 as compared to 2004 and 2003 was the increase in pretax income. The Company’s effective tax rates were 34.81%, 33.51% and 34.50% in 2005, 2004 and 2003, 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, 2005 such unfunded commitments to extend credit were $133.4 million, while commitments in the form of standby letters of credit totaled $2.7 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, 2005, the Company’s core deposits totaled $430.4 million, or 74% 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 System on a short-term basis.

At December 31, 2005, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $40.3 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 $71.6 million at December 31, 2005. The remaining availability at FHLB was $49.3 million at December 31, 2005. The Bank also had the ability to borrow up to $26.5 million for the purchase of overnight federal funds from three correspondent financial institutions as of December 31, 2005.

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 36.81% at December 31, 2005, 34.82% at December 31, 2004 and 26.83% at December 31, 2003. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.

As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $14.3 million during 2005. Net cash used in investing activities of $49.8 million consisted primarily of a net increase in loans of $35.1 million. Net cash provided by financing activities amounted to $38.6 million, primarily from $26.3 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 to be 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, 2005.

A-9

Table 5 - Interest Sensitivity Analysis

(Dollars in Thousands)		Immediate		1-3 Months		4-12 Months		Total Within One year		Over One year & Non-sensitive		Total
Interest-earning assets:
Loans	$	427,716		17,536		8,697		453,949		112,714	$	566,663
Mortgage loans available for sale		2,248		-		-		2,248		-		2,248
Investment securities		-		1,753		-		1,753		113,405		115,158
Federal funds sold		1,347		-		-		1,347		-		1,347
Interest-bearing deposit accounts		1,480		-		-		1,480		-		1,480
Other interest-earning assets		-		-		-		-		5,506		5,506

Total interest-earning assets		432,791		19,289		8,697		460,777		231,625	$	692,402

Interest-bearing liabilities:
NOW, savings, and money market deposits		183,249		-		-		183,249		-	$	183,249
Time deposits		69,697		42,161		130,078		241,936		63,008		304,944
Other short term borrowings		1,474		-		-		1,474		-		1,474
FHLB borrowings		4,600		2,500		-		7,100		64,500		71,600
Securities sold under agreement to repurchase		981		-		-		981		-		981
Trust preferred securities		-		14,433		-		14,433		-		14,433

Total interest-bearing liabilities		260,001		59,094		130,078		449,173		127,508	$	576,681

Interest-sensitive gap	$	172,790		(39,805	)	(121,381	)	11,604		104,117	$	115,721

Cumulative interest-sensitive gap	$	172,790		132,985		11,604		11,604		115,721

Interest-earning assets as a percentage of interest-bearing liabilities		166.46	%	32.64	%	6.69	%	102.58	%

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, 2005 totaled $692.4 million, exceeding rate sensitive liabilities of $576.7 million by $115.7 million.

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, 2005, the Company had cash flow hedges with a notional amount of $70.0 million. These derivative instruments consist of two interest rate floor contracts that are used to hedge future cash flows of the first $70.0 million of certain variable rate commercial loans against the downward effects of their repricing in the event of a decreasing rate environment for a period of three years ending in July 2008 and November 2008. 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

A-10

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.

The Company settled two previously outstanding interest rate swap agreements during 2005. The first swap with a notional amount of $25.0 million and scheduled to mature in April 2006 was sold for a loss of $318,000. The second swap with a notional amount of $30.0 million and scheduled to mature in September 2006 was sold for a loss of $552,000. The losses realized upon settlement are being recognized over the original term of the agreements, and during the year ended December 31, 2005, losses of approximately $484,000 were recognized.

The Bank also utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At December 31, 2005, the Bank had $90.5 million in loans with interest rate floors; however, none of the floors were in effect pursuant to the terms of the promissory notes on these loans.

An analysis of the Company’s financial condition and growth can be made be examining the changes and trends in interest-earning assets and interest-bearing liabilities, and 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, 2005 the market value of AFS securities totaled $115.2 million, compared to $105.6 million and $79.5 million at December 31, 2004 and 2003, respectively. The increase in 2005 investment securities is attributable to additional securities purchases, which were partially offset by paydowns on mortgage-backed securities and maturities during 2005. This increase in AFS securities reflects management’s directed effort to increase investment securities as a percentage of total assets in an effort to reduce the credit risk in the balance sheet. Table 6 presents the market value of the AFS securities held at December 31, 2005, 2004 and 2003.

Table 6 - Summary of Investment Portfolio

(Dollars in Thousands)	2005		2004		2003
Obligations of United States government
agencies and corporations	$	60,243		46,570		34,517

Obligations of states and political subdivisions		21,609		20,649		14,950

Mortgage backed securities		31,004		36,543		24,920

Trust preferred securities		1,750		1,750		5,000

Equity securities		552		86		73

Total securities	$	115,158		105,598		79,460

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 $108.7 million in 2005, $93.8 million in 2004 and $72.1 million in 2003. Table 7 presents the amortized cost of AFS securities held by the Company by maturity category at December 31, 2005. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity and 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 34% for securities that are both federal and state tax exempt and an effective tax rate of 6.90% for state tax exempt securities.

A-11

Table 7 - Maturity Distribution and Weighted Average Yield on Investments
	One Year or Less					After One Year Through 5 Years					After 5 Years Through 10 Years					After 10 Years					Totals
(Dollars in Thousands)	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
Book value:

United States Government agencies	$	-		-			36,433		4.27	%		24,318		4.80	%		-		-		$	60,751		4.48	%

States and political subdivisions		200		7.21	%		8,341		5.08	%		9,329		4.88	%		3,878		7.04	%		21,748		5.36	%

Mortgage backed securities		-		-			432		3.74	%		12,371		3.99	%		19,063		4.53	%		31,866		4.31	%

Trust preferred securities		-		-			-		-			-		-			1,750		7.16	%		1,750		7.16	%

Equity securities		-		-			-		-			-		-			815		0.21	%		815		0.21	%

Total securities	$	200		7.21	%		45,206		4.42	%		46,018		4.60	%		25,506		4.95	%	$	116,930		4.61	%

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 County. Although the Bank 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. In management’s opinion, there are no significant concentrations of credit with particular borrowers engaged in similar activities.

The composition of the Company’s loan portfolio is presented in table 8.

Table 8 - Loan Portfolio

	2005					2004					2003					2002					2001
(Dollars in Thousands)	Amount		% of Loans			Amount		% of Loans			Amount		% of Loans			Amount		% of Loans			Amount		% of Loans
Breakdown of loan receivables:
Commercial	$	79,902		14.10	%		79,189		14.79	%		90,558		16.41	%		92,141		17.51	%		102,409		20.87	%
Real estate - mortgage		330,227		58.28	%		312,988		58.45	%		332,730		60.26	%		322,987		61.36	%		277,737		56.61	%
Real estate - construction		141,420		24.96	%		127,042		23.73	%		110,392		19.99	%		80,552		15.30	%		82,791		16.88	%
Consumer		15,115		2.66	%		16,249		3.03	%		18,446		3.34	%		30,690		5.83	%		27,671		5.64	%

Total loans	$	566,664		100.00	%		535,468		100.00	%		552,126		100.00	%		526,370		100.00	%		490,608		100.00	%

Less: Allowance for loan losses		7,425					8,049					9,722					7,248					6,091

Net loans	$	559,239					527,419					542,404					519,122					484,517

As of December 31, 2005, gross loans outstanding were $566.7 million, an increase of $31.2 million or 6% from the December 31, 2004 balance of $535.5 million. Commercial loans increased $713,000 in 2005. Real estate mortgage loans grew $17.2 million when compared to 2004 due to an increase in commercial real estate loans. Real estate construction loans increased $14.4 million in 2005 as a result of an increase in real estate development loans. Consumer loans decreased $1.1 million in 2005.

Mortgage loans held for sale were $2.2 million at December 31, 2005, a decrease of $1.5 million from the December 31, 2004 balance of $3.8 million which represented an increase of $3.2 million from the December 31, 2003 balance of $587,000

A-12

Table 9 identifies the maturities of all loans as of December 31, 2005 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 Loans
Commercial	$	70,761		8,572		569	$	79,902
Real estate - mortgage		245,454		51,624		33,149		330,227
Real estate - construction		131,110		9,373		937		141,420
Consumer		6,624		7,215		1,275		15,114

Total loans	$	453,949		76,784		35,930	$	566,663

Total fixed rate loans	$	11,316		63,882		35,930	$	111,128
Total floating rate loans		442,633		12,902		-		455,535

Total loans	$	453,949		76,784		35,930	$	566,663

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, 2005, outstanding loan commitments totaled $133.4 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.

An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by the Bank’s credit administration personnel and presented to the Bank’s Board of Directors on a monthly basis. The allowance is the total of specific reserves allocated to significant individual loans plus a general reserve. After individual loans with specific allocations have been deducted, the general reserve is calculated by applying general reserve percentages to the nine risk grades within the portfolio. Loans are categorized as one of nine risk grades based on management’s assessment of the overall credit quality of the loan, including payment history, financial position of the borrower, underlying collateral and internal credit review. The general reserve percentages are determined by management based on its evaluation of losses inherent in the various risk grades of loans. The allowance for loan losses is established through charges to expense in the form of a provision for loan losses. Loan losses and recoveries are charged and credited directly to the allowance.

An allowance for loan losses is also established, as necessary, for individual loans considered to be impaired in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114. A loan is considered 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. 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 collateral if the loan is collateral dependent. At December 31, 2005 and 2004, the recorded investment in loans that were considered to be

A-13

impaired under SFAS No. 114 was approximately $3.5 million and $5.1 million, respectively, with related allowance for loan losses of approximately $478,000 and $773,000, respectively.

The Bank’s allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses compared to a group of peer banks identified by the regulators. During their routine examinations of banks, the FDIC and the North Carolina Commissioner of Banks may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

While it is the Bank's policy to charge off in the current period loans for which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise. After review of all relevant matters affecting loan collectability, management believes that the allowance for loan losses is appropriate.

As described above, 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 County. Although the Bank 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. At December 31, 2005, approximately 5% of the Company’s portfolio was not secured by any type of collateral. Unsecured loans generally involve higher credit risk than secured loans, and in the event of customer default, the Company has a higher exposure to potential loan losses.

Net charge-offs for 2005 were $3.7 million. The ratio of net charge-offs to average total loans was 0.68% in 2005, 0.90% in 2004 and 0.79% in 2003. Charge-offs in 2004 included charges of $1.0 million and $550,000 related to loans to customers that were formerly directors of the Company. The allowance for loan losses decreased to $7.4 million or 1.31% of total loans outstanding at December 31, 2005. This decrease in the allowance for loan losses was the result of a reduction in classified loans. For December 31, 2004 and 2003, the allowance for loan losses amounted to $8.0 million, or 1.50% of total loans outstanding and $9.7 million, or 1.76% of total loans outstanding, respectively.

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, 2005 and 2004.

Table 10 - Loan Risk Grade Analysis

	Percentage of Loans						General Reserve
	By Risk Grade						Percentage
Risk Grade	2005			2004			2005			2004


Risk 1 (Excellent Quality)		14.28	%		13.44	%		0.15	%		0.15	%
Risk 2 (High Quality)		18.16	%		23.03	%		0.50	%		0.50	%
Risk 3 (Good Quality)		56.40	%		53.89	%		1.00	%		1.00	%
Risk 4 (Management Attention)		8.38	%		5.67	%		2.50	%		2.50	%
Risk 5 (Watch)		0.88	%		0.95	%		7.00	%		7.00	%
Risk 6 (Substandard)		0.42	%		0.61	%		12.00	%		12.00	%
Risk 7 (Low Substandard)		0.86	%		1.46	%		25.00	%		25.00	%
Risk 8 (Doubtful)		0.00	%		0.00	%		50.00	%		50.00	%
Risk 9 (Loss)		0.00	%		0.00	%		100.00	%		100.00	%

At December 31, 2005, there were two relationships which exceeded $1.0 million (totaling $2.7 million) in the Watch risk grade, no relationships that exceeded $1.0 million in the Substandard risk grade and two relationships which exceed $1.0 million (totaling $4.5 million) in the Low Substandard risk grade. Balances of individual relationships exceeding $1.0 million in these risk grades ranged from $1.1 million to $3.2 million. These customers continue to meet payment requirements and these relationships would not become non-performing assets unless they are unable to meet those requirements.

A-14

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)		2005		2004		2003		2002		2001
Reserve for loan losses at beginning	$	8,049		9,722		7,248		6,091		4,713

Loans charged off:
Commercial		293		1,004		1,179		3,737		842
Real estate - mortgage		2,141		3,842		2,422		158		790
Real estate - construction		1,250		4		251		-		51
Consumer		516		535		630		546		675

Total loans charged off		4,200		5,385		4,482		4,441		2,358

Recoveries of losses previously charged off:

Commercial		144		162		36		40		84
Real estate - mortgage		162		144		18		-		-
Real estate - construction		-		-		1		4		6
Consumer		160		150		157		122		101

Total recoveries		466		456		212		166		191

Net loans charged off		3,734		4,929		4,270		4,275		2,167

Provision for loan losses		3,110		3,256		6,744		5,432		3,545

Reserve for loan losses at end of year	$	7,425		8,049		9,722		7,248		6,091

Loans charged off net of recoveries, as
a percent of average loans outstanding		0.68	%	0.90	%	0.79	%	0.84	%	0.48	%

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 $5.0 million at December 31, 2005 compared to $6.0 million at December 31, 2004. Non-accrual loans were $3.5 million at December 31, 2005, a decrease of $1.6 million from non-accruals of $5.1 million at December 31, 2004. As a percentage of loans outstanding, non-accrual loans were 0.62% and 0.95% at December 31, 2005 and 2004, respectively. The Bank had loans ninety days past due and still accruing at December 31, 2005 of $946,000 as compared to $245,000 for the same period in 2004. Other real estate owned totaled $531,000 and $682,000 as of December 31, 2005 and 2004, respectively. The Bank had no repossessed assets as of December 31, 2005 and 2004.

At December 31, 2005 the Company had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $4.4 million or 0.79% of total loans. Non-performing loans for 2004 were $5.3 million, or 1.00% of total loans and $4.6 million, or 0.84% of total loans for 2003. Interest that would have been recorded on non-accrual loans for the years ended December 31, 2005, 2004 and 2003, had they performed in accordance with their original terms, amounted to approximately $507,000, $264,000 and $400,000 respectively. Interest income on impaired loans included in the results of operations for 2005, 2004, and 2003 amounted to approximately $77,000, $123,000 and $67,000, 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-15

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)	2005			2004			2003			2002			2001
Non-accrual loans	$	3,492			5,097			4,343			4,602			3,756
Loans 90 days or more past due and still accruing		946			245			271			239			655
Total non-performing loans		4,438			5,342			4,614			4,841			4,411
All other real estate owned		531			682			1,447			240			256
All other repossessed assets		-			-			206			1,538			4
Total non-performing assets	$	4,969			6,024			6,267			6,619			4,671

As a percent of total loans at year end
Non-accrual loans		0.62	%		0.95	%		0.79	%		0.87	%		0.77	%
Loans 90 days or more past due and still accruing		0.17	%		0.05	%		0.05	%		0.05	%		0.13	%
Total non-performing assets		0.88	%		1.12	%		1.14	%		1.26	%		0.95	%

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, 2005, total deposits were $582.9 million, an increase of $26.4 million or 5% increase over the December 31, 2004 balance of $556.5 million. The increase in deposits is primarily attributable to growth in core deposits, which include demand deposits, savings accounts and certificates of deposits of denominations less than $100,000, to $430.4 million at December 31, 2005 from $402.2 million at December 31, 2004. The increase in core deposits resulted primarily from an increase in the Bank’s certificates of deposits of denominations less than $100,000, due to a change in certificate of deposit pricing strategies implemented in 2005.

Time deposits in amounts of $100,000 or more totaled $152.4 million at December 31, 2005, $154.3 million and $171.6 million at December 31, 2004 and 2003, respectively. The decrease in 2005 is due to a reduction in brokered deposits that were replaced with core deposits. At December 31, 2005, brokered deposits amounted to $40.3 million as compared to $39.4 million at December 31, 2004. 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, 2005 have a weighted average rate of 3.64% with a weighted average original term of 18 months.

Table 13 is a summary of the maturity distribution of time deposits in amounts of $100,000 or more as of December 31, 2005.

Table 13 - Maturities of Time Deposits over $100,000

(Dollars in Thousands)		2005
Three months or less	$	33,040
Over three months through six months		28,730
Over six months through twelve months		38,760
Over twelve months		51,881
Total	$	152,411

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, 2005, FHLB borrowings totaled $71.6 million compared to $59.0 million at December 31, 2004 and $58.0 million at December 31, 2003. Average FHLB borrowings for 2005 were $65.9 million, compared to average balances of $58.7 million for 2004 and $59.3 million for 2003. The maximum amount of outstanding FHLB borrowings was $77.6 million in 2005, and $70.7 in 2004 and $75.1 in 2003. The FHLB advances outstanding at December 31, 2005 had both fixed and adjustable interest rates ranging from 3.28% to 6.49%. Currently $7.1 million of the FHLB advances outstanding have contractual maturities prior to December 31, 2006. The FHLB has the option to convert $52.0 million of the total advances to a floating rate and, if converted, the Bank may repay advances without prepayment of a prepayment fee. The Company also has an additional $10.0 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.

A-16

Demand notes payable to the U. S. Treasury, which represent treasury tax and loan payments received from customers, amounted to approximately $1.5 million, $1.2 million and $443,000 at December 31, 2005, 2004 and 2003, respectively.

Securities sold under agreements to repurchase amounted to $981,000 as of December 31, 2005. The Company had no securities sold under agreements to repurchase as of December 21, 2004 and 2003.

The Company had no federal funds purchased as of December 31, 2005, 2004 or 2003.

Junior Subordinated Debentures (related to Trust Preferred Securities). In December 2001 the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust I (“PEBK Trust”), which issued $14.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures that qualify as Tier 1 capital under Federal Reserve Board guidelines. All of the common securities of PEBK Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust to purchase $14.4 million of junior subordinated debentures of the Company, which pay a floating rate equal to prime plus 50 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of PEBK Trust. PEBK Trust is not included in the consolidated financial statements at December 31, 2005, 2004 or 2003.

The trust preferred securities accrue and pay quarterly distributions based on the liquidation value of $50,000 per capital security at a floating rate of prime plus 50 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust 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.

The trust preferred securities are mandatorily redeemable upon maturity of the debentures on December 31, 2031, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust, in whole or in part, on or after December 31, 2006. 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, 2005 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.

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		Total
Contractual Cash Obligations
Long-term borrowings*	$	2,500		2,500		17,000		45,000	$	67,000
Junior subordinated debentures		-		-		-		14,433		14,433
Operating lease obligations		985		1,935		1,447		4,232		8,599

Total	$	3,485		4,435		18,447		63,665	$	90,032

Other Commitments
Commitments to extend credit	$	46,450		23,217		9,472		54,270	$	133,409
Standby letters of credit
and financial guarantees written		2,607		85		-		-		2,692

Total	$	49,057		23,302		9,472		54,270	$	136,101

*Excludes $4.6 million adjustable rate credit due to the FHLB, which matured in February 2006.

A-17

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-10 and in Notes 1, 10, 11 and 16 to the Consolidated Financial Statements.

Capital Resources. Shareholders’ equity at December 31, 2005 was $54.4 million compared to $50.9 million at December 31, 2004 and $48.6 million at December 31, 2003. At December 31, 2005 and 2004, unrealized gains and losses, net of taxes, amounted to losses of $1.4 million and $121,000, respectively. For the year ended December 31, 2003, unrealized gains and losses, net of taxes, amounted to a gain of $588,000. 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 7.92%, 7.59% and 7.56% for 2005, 2004 and 2003. The return on average shareholders’ equity was 11.31% at December 31, 2005 as compared to 8.52% and 4.01% as of December 31, 2004 and December 31, 2003, respectively. Total cash dividends paid during 2005 amounted to $1.4 million. Cash dividends totaling $1.3 million were paid during 2004 and 2003.

In November 2004, the Company’s Board of Directors authorized the repurchase of up to $3.0 million in common shares of the Company’s outstanding common stock effective through the end of November 2005. During 2005, the Company repurchased a total of 15,000 shares at a total price of $315,000. During 2004, the Company repurchased a total of 15,100 shares at a total price of $291,000.

In November 2005, 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 effective through the end of November 2006. No shares have been repurchased under the current plan.

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, 2005, 2004 and 2003 includes $14.0 million in trust preferred securities. The Company’s Tier 1 capital ratio was 11.02%, 10.97% and 10.50% at December 31, 2005, 2004 and 2003, 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 12.19%, 12.22% and 11.75% at December 31, 2005, 2004 and 2003, 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 total average assets of 4.0% or greater. The Company’s Tier 1 leverage capital ratio was 9.84%, 9.50% and 9.37% at December 31, 2005, 2004 and 2003, respectively.

The Bank’s Tier 1 risk-based capital ratio was 10.46%, 10.35% and 9.87% at December 31, 2005, 2004 and 2003, respectively. The total risk-based capital ratio for the Bank was 11.64%, 11.60% and 11.13% at December 31, 2005, 2004 and December 31, 2003, respectively. The Bank’s Tier 1 leverage capital ratio was 9.33%, 8.95% and 8.80% at December 31, 2005, 2004 and 2003 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, 2005, 2004 and 2003.

The capital treatment of trust preferred securities has been reviewed recently by the Federal Reserve Bank. The Federal Reserve Bank’s proposal for capital treatment of trust preferred securities, released May 4, 2004, would continue to permit the inclusion of trust preferred securities in Tier 1 capital of bank holding companies. Further discussions of FIN 46 are included under “Recent Accounting Pronouncements” in Note 1 of the Notes to Consolidated Financial Statements.

A-18

The Company’s key equity ratios as of December 31, 2005, 2004 and 2003 are presented in Table 15.

Table 15 - Equity Ratios

	2005		2004		2003
Return on average assets	0.90	%	0.65	%	0.30	%
Return on average equity	11.31	%	8.52	%	4.01	%
Dividend payout ratio	22.34	%	28.37	%	62.56	%
Average equity to average assets	7.92	%	7.59	%	7.56	%

Quarterly Financial Data. The Company’s consolidated quarterly operating results for the years ended December 31, 2005 and 2004 are presented in table 16.

Table 16 - Quarterly Financial Data

	2005								2004
(Dollars in thousands, except per share amounts)	First		Second		Third		Fourth		First		Second		Third		Fourth

Total interest income	$	9,581		10,349		11,352		12,089		8,936		8,847		9,135		9,374
Total interest expense		3,346		3,686		3,978		4,418		3,066		3,002		3,103		3,164

Net interest income		6,235		6,663		7,374		7,671		5,870		5,845		6,032		6,210

Provision for loan losses		690		723		930		767		859		868		931		598
Other income		1,638		1,842		1,795		1,421		1,500		1,531		1,549		1,440
Other expense		5,259		5,301		5,388		5,869		4,720		4,873		4,990		5,474

Income before income taxes		1,924		2,481		2,851		2,456		1,791		1,635		1,660		1,578
Income taxes		647		873		1,010		851		613		547		552		521

Net earnings	$	1,277		1,608		1,841		1,605		1,178		1,088		1,108		1,057

Basic earnings per share	$	0.37		0.47		0.53		0.47		0.34		0.31		0.32		0.31
Diluted earnings per share	$	0.36		0.46		0.52		0.46		0.34		0.31		0.32		0.30

A-19

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 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, 2005, 2004 and 2003, 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, 2005. 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, 2005. As of December 31, 2005, 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		2006		2007		2008		2009 & 2010		Thereafter			Total		Fair Value
Fixed rate	$	19,131		16,117		14,695		31,070		30,114		$	111,128	$	111,049
Average interest rate		7.93	%	7.28	%	6.80	%	6.83	%	6.92	%
Variable rate	$	169,488		66,448		38,876		74,198		106,526		$	455,535	$	455,498
Average interest rate		7.82	%	7.97	%	8.05	%	7.89	%	7.65	%
												$	566,663	$	566,547
Investment Securities		.
Interest bearing cash	$	-		-		-		-		1,480		$	1,480	$	1,480
Average interest rate		-		-		-		-		3.64	%
Federal funds sold	$	1,347		-		-		-		-		$	1,347	$	1,347
Average interest rate		3.80	%	-		-		-		-
Securities available for sale	$	1,535		5,485		16,725		25,708		65,705		$	115,158	$	115,158
Average interest rate		4.41	%	4.57	%	4.29	%	4.18	%	3.88	%
Nonmarketable equity securities	$	-		-		-		-		3,735		$	3,735	$	5,506
Average interest rate		-		-		-		-		3.97	%

Debt Obligations
Deposits	$	230,683		101,307		46,232		37,888		166,744		$	582,854	$	583,312
Average interest rate		3.36	%	4.10	%	4.05	%	3.77	%	1.05	%
Advances from FHLB	$	47,100		7,500		-		17,000		-		$	71,600	$	71,843
Average interest rate		3.62	%	3.99	%	-		5.35	%	-
Demand notes payable to U.S. Treasury	$	1,474		-		-		-		-		$	1,474	$	1,474
Average interest rate		3.79	%	-		-		-		-
Securities sold under agreement to repurchase	$	981		-		-		-		-		$	981	$	981
Average interest rate		3.14	%	-		-		-		-
Junior subordinated debentures	$	-		-		-		-		14,433		$	14,433	$	14,433
Average interest rate		-		-		-		-		7.11	%

Derivative Instruments (notional amount)
Interest rate floor contracts	$	-		-		70,000		-		-		$	70,000	$	176
Average interest rate		-		-		6.63	%	-		-

A-20

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 Income
Hypothetical rate change (ramp over 12 months)		Amount	% Change
+2%	$	33,409	7.68	%
+1%	$	32,216	3.83	%
0%	$	31,028	0.00	%
-1%	$	29,952	-3.47	%
-2%	$	29,052	-6.37	%

	Estimated Resulting Theoretical Market Value of Equity
Hypothetical rate change (immediate shock)	Amount		% Change
+2%	$	48,424		-8.63	%
+1%	$	50,588		-4.54	%
0%	$	52,995		0.00	%
-1%	$	55,686		5.08	%
-2%	$	58,725		10.81	%

A-21

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 National 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 6, 2006, the Company had 702 shareholders of record, not including the number of persons or entities whose stock is held in nominee or street name through various brokerage firms or banks. The market price for the Company’s common stock was $23.82 on March 6, 2006.

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 Data
2005		Low Bid	High Bid	Cash Dividend Per Share
First Quarter	$	17.75	22.27	0.10

Second Quarter	$	17.25	22.00	0.10

Third Quarter	$	18.16	22.27	0.10

Fourth Quarter	$	19.47	24.00	0.11


2004		Low Bid	High Bid	Cash Dividend Per Share
First Quarter	$	15.84	18.25	0.09

Second Quarter	$	16.09	17.95	0.09

Third Quarter	$	16.54	18.09	0.09

Fourth Quarter	$	16.39	18.18	0.09

A-22

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.

John W. Lineberger, Jr.

President, Lincoln Bonded Warehouse Company (commercial warehousing and distribution facility)

Gary E. Matthews

President and Director, Matthews Construction Company, Inc.

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 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

Executive Vice President and Assistant Corporate Treasurer

A. Joseph Lampron

Executive Vice President, Chief Financial Officer and Corporate Treasurer

A-23

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 consolidated balance sheets of Peoples Bancorp of North Carolina, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of earnings, changes in shareholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Peoples Bancorp of North Carolina, Inc. as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

/s/ Porter Keadle Moore, LLP

Atlanta, Georgia

March 4, 2006

Certified Public Accountants

Suite 1800 * 235 Peachtree Street NE * Atlanta, Georgia 30303 * Phone 404-588-4200 * Fax 404-588-4222 * www.pkm.com

A-24

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

December 31, 2005 and 2004

Assets	2005			2004


Cash and due from banks, including reserve requirements	$	18,468,999			15,067,871
of $5,229,000 and $4,643,000
Federal funds sold		1,347,000			1,723,000
Cash and cash equivalents		19,815,999			16,790,871

Investment securities available for sale		115,158,184			105,598,106
Other investments		5,810,749			5,396,959
Total securities		120,968,933			110,995,065

Mortgage loans held for sale		2,247,900			3,783,175

Loans		566,663,416			535,467,733
Less allowance for loan losses		(7,424,782	)		(8,048,627	)
Net loans		559,238,634			527,419,106

Premises and equipment, net		12,662,153			12,742,730
Cash surrender value of life insurance		6,311,757			6,034,188
Accrued interest receivable and other assets		9,034,239			8,582,937
Total assets	$	730,279,615			686,348,072

Liabilities and Shareholders' Equity

Deposits:
Non-interest bearing demand	$	94,660,721			78,024,194
NOW, MMDA & savings		183,248,699			193,917,507
Time, $100,000 or more		152,410,976			154,300,926
Other time		152,533,265			130,279,446
Total deposits		582,853,661			556,522,073

Demand notes payable to U.S. Treasury		1,473,693			1,184,392
Securities sold under agreement to repurchase		981,050			-
FHLB borrowings		71,600,000			59,000,000
Junior subordinated debentures		14,433,000			14,433,000
Accrued interest payable and other liabilities		4,585,217			4,270,755
Total liabilities		675,926,621			635,410,220

Shareholders' equity:

Preferred stock, no par value; authorized
5,000,000 shares; no shares issued
and outstanding		-			-
Common stock, no par value; authorized
20,000,000 shares; issued and
outstanding 3,440,805 shares in 2005
and 3,135,074 shares in 2004		41,096,500			35,040,390
Retained earnings		14,656,160			16,018,206
Accumulated other comprehensive income (loss)		(1,399,666	)		(120,744	)
Total shareholders' equity		54,352,994			50,937,852

Total liabilities and shareholders' equity	$	730,279,615			686,348,072

See accompanying notes to consolidated financial statements.

A-25

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Statements of Earnings

For the Years Ended December 31, 2005, 2004 and 2003

	2005			2004			2003


Interest income:
Interest and fees on loans	$	38,609,667			32,290,835			31,612,448
Interest on federal funds sold		72,578			35,236			58,384
Interest on investment securities:
U.S. Government agencies		3,584,755			2,903,865			2,244,375
States and political subdivisions		735,892			660,227			577,339
Other		367,875			402,080			441,958
Total interest income		43,370,767			36,292,243			34,934,504

Interest expense:
NOW, MMDA & savings deposits		2,644,413			1,899,249			1,318,820
Time deposits		8,923,488			7,145,486			8,157,388
FHLB borrowings		2,888,785			2,602,866			2,597,043
Junior subordinated debentures		938,145			676,547			667,526
Other		33,790			10,518			7,891
Total interest expense		15,428,621			12,334,666			12,748,668

Net interest income		27,942,146			23,957,577			22,185,836

Provision for loans losses		3,110,000			3,256,000			6,743,900

Net interest income after provision for loan losses		24,832,146			20,701,577			15,441,936

Other income:
Service charges		3,779,933			3,434,544			3,266,949
Other service charges and fees		1,141,879			677,191			610,591
Loss on sale of securities		(729,727	)		(63,688	)		(52,855	)
Mortgage banking income		469,109			356,782			604,568
Insurance and brokerage commissions		386,662			429,788			420,762
Loss on sale of repossessed assets		(37,811	)		(179,886	)		(746,543	)
Gain on sale of loans		-			-			478,759
Miscellaneous		1,686,334			1,365,397			1,262,883
Total other income		6,696,379			6,020,128			5,845,114

Other expense:
Salaries and employee benefits		12,350,119			11,477,495			10,099,811
Occupancy		3,948,694			3,672,051			3,389,857
Other		5,517,832			4,907,923			4,738,253
Total other expenses		21,816,645			20,057,469			18,227,921

Earnings before income taxes		9,711,880			6,664,236			3,059,129

Income taxes		3,380,900			2,233,300			1,055,538

Net earnings	$	6,330,980			4,430,936			2,003,591

Basic earnings per share	$	1.84			1.28			0.58
Diluted earnings per share	$	1.80			1.26			0.58
Cash dividends declared per share	$	0.41			0.36			0.36


See accompanying notes to consolidated financial statements.

A-26

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Changes in Shareholders' Equity

For the Years Ended December 31, 2005, 2004 and 2003

								Accumulated
									Other
	Common Stock					Retained			Comprehensive
	Shares			Amount		Earnings			Income (Loss)		Total


Balance, December 31, 2002	3,133,547		$	35,097,773		12,094,363			1,412,597		48,604,733

Cash dividends declared	-			-		(1,253,430	)		-		(1,253,430	)

Exercise of stock options	1,655			23,737		-			-		23,737

Net earnings	-			-		2,003,591			-		2,003,591

Change in accumulated other
comprehensive income (loss), net of tax	-			-		-			(824,735	)	(824,735	)

Balance, December 31, 2003	3,135,202			35,121,510		12,844,524			587,862		48,553,896

Cash dividends declared	-			-		(1,257,254	)		-		(1,257,254	)

Repurchase and retirement of common
stock	(15,100	)		(290,826	)	-			-		(290,826	)

Exercise of stock options	14,972			209,706		-			-		209,706

Net earnings	-			-		4,430,936			-		4,430,936

Change in accumulated other
comprehensive income (loss), net of tax	-			-		-			(708,606	)	(708,606	)

Balance, December 31, 2004	3,135,074			35,040,390		16,018,206			(120,744	)	50,937,852

10% 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 common
stock	(15,000	)		(314,750	)	-			-		(314,750	)

Exercise of stock options	7,185			96,773		-			-		96,773

Net earnings	-			-		6,330,980			-		6,330,980

Change in accumulated other
comprehensive 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	)	54,352,994


See accompanying notes to consolidated financial statements.

A-27

PEOPLES BANCORP OF NORTH CAROLINA, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

For the Years Ended December 31, 2005, 2004 and 2003

		2005		2004		2003


Net earnings	$	6,330,980		4,430,936		2,003,591

Other comprehensive income (loss):
Unrealized holding gains (losses) on securities
available for sale		(3,045,565	)	30,988		(419,147	)
Reclassification adjustment for losses on
sales of securities available for sale included
in net earnings		729,727		63,688		52,855
Unrealized holding losses on derivative
financial instruments qualifying as cash flow
hedges		(283,493	)	(702,000	)	(284,000	)
Reclassification adjustment for losses (gains) on
derivative financial instruments qualifying as
cash flow hedges included in net earnings		483,715		(553,375	)	(700,626	)

Total other comprehensive income (loss),
before income taxes		(2,115,616	)	(1,160,699	)	(1,350,918	)

Income tax expense (benefit) related to other
comprehensive income:

Unrealized holding gains (losses) on securities
available for sale		(1,186,248	)	12,070		(163,258	)
Reclassification adjustment for losses on
sales of securities available for sale included
in net earnings		284,229		24,806		20,587
Unrealized holding losses on derivative
financial instruments qualifying as cash flow
hedges		(123,082	)	(273,429	)	(110,618	)
Reclassification adjustment for losses (gains) on
derivative financial instruments qualifying as
cash flow hedges included in net earnings		188,407		(215,540	)	(272,894	)

Total income tax expense (benefit) related to
other comprehensive income		(836,694	)	(452,093	)	(526,183	)

Total other comprehensive income (loss),
net of tax		(1,278,922	)	(708,606	)	(824,735	)

Total comprehensive income	$	5,052,058		3,722,330		1,178,856

See accompanying notes to consolidated financial statements.

A-28

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2005, 2004 and 2003

	2005			2004			2003

Cash flows from operating activities:
Net earnings	$	6,330,980			4,430,936			2,003,591
Adjustments to reconcile net earnings to
net cash provided by operating activities:
Depreciation, amortization and accretion		1,643,459			1,563,245			1,963,995
Provision for loan losses		3,110,000			3,256,000			6,743,900
Deferred income taxes		332,806			341,441			(1,526,062	)
Loss on sale of investment securities		729,727			63,688			52,855
Recognition of gain (loss) on sale of
derivative instruments		483,715			(553,375	)		(700,626	)
Gain on sale of loans		-			-			(478,759	)
Amortization of deferred gain on sale of premises		(21,984	)		(22,412	)		-
Loss (gain) on sale of repossessed assets		(2,189	)		15,412			262,840
Writedown of other real estate and repossessions		40,000			164,474			483,703
Change in:
Mortgage loans held for sale		1,535,275			(3,195,680	)		4,477,140
Cash surrender value of life insurance		(277,569	)		(988,739	)		(216,741	)
Other assets		462,686			(3,442,472	)		377,900
Other liabilities		651,204			1,470,823			(4,582	)

Net cash provided by operating activities		15,018,110			3,103,341			13,439,154

Cash flows from investing activities:
Purchases of investment securities available for sale		(49,431,813	)		(48,667,610	)		(55,439,455	)
Proceeds from calls and maturities of investment securities
available for sale		9,655,995			19,413,975			27,158,675
Proceeds from sales of investment securities available
for sale		27,768,392			2,986,313			19,896,324
Purchases of other investments		(5,367,790	)		(4,822,500	)		(925,000	)
Proceeds from sale of other investments		4,239,000			3,642,514			953,600
Net change in loans		(35,062,738	)		12,578,820			(31,533,937	)
Proceeds from sale of loans		-			-			4,207,206
Purchases of premises and equipment		(1,373,019	)		(1,502,346	)		(1,913,876	)
Proceeds from sale of premises and equipment		1,750			-			-
Proceeds from sale of repossessed assets		246,218			2,153,103			1,502,891
Purchases of derivative financial instruments		(364,000	)		-			-
Proceeds from (payment on) settlement of
derivative financial instruments		(870,000	)		-			1,254,000

Net cash used by investing activities		(50,558,005	)		(14,217,731	)		(34,839,572	)

Cash flows from financing activities:
Net change in deposits		26,331,588			6,719,841			34,063,277
Net change in demand notes payable to U.S. Treasury		289,301			741,008			(1,156,616	)
Net change in securities sold under agreement to repurchase		981,050			-			-
Proceeds from FHLB borrowings		162,300,000			95,850,000			46,650,000
Repayments of FHLB borrowings		(149,700,000	)		(94,850,000	)		(51,721,429	)
Proceeds from exercise of stock options		96,773			209,706			23,737
Common stock repurchased		(314,750	)		(290,826	)		-
Cash paid in lieu of fractional shares		(4,700	)		-			-
Cash dividends paid		(1,414,239	)		(1,257,254	)		(1,253,430	)

Net cash provided by financing activities		38,565,023			7,122,475			26,605,539

Net change in cash and cash equivalent		3,025,128			(3,991,915	)		5,205,121

Cash and cash equivalents at beginning of period		16,790,871			20,782,786			15,577,665

Cash and cash equivalents at end of period	$	19,815,999			16,790,871			20,782,786

A-29

PEOPLES BANCORP OF NORTH CAROLINA, INC.

Consolidated Statements of Cash Flows, continued

For the Years ended December 31, 2005, 2004 and 2003


		2005		2004		2003


Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	15,189,559		11,833,234		12,975,587
Income taxes	$	2,245,000		2,483,394		2,093,000

Noncash investing and financing activities:
Change in unrealized gain (loss) on investment securities
available for sale, net	$	(1,413,819	)	57,800		(223,621	)
Change in unrealized gain (loss) on derivative financial
instruments, net	$	134,897		(766,406	)	(601,114	)
Transfer of loans to other real estate and repossessions	$	133,210		1,362,138		3,382,633
Financed portion of sale of other real estate	$	-		2,212,142		1,258,500
Financed portion of sale of premises and equipment	$	-		-		3,729,932
Reclassification of a security from other investments
to securities available for sale	$	715,000		-		-


See accompanying notes to consolidated financial statements.

A-30

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 Federal Reserve Bank, 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 and Iredell 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, 2005 and 2004, 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-31

Other Investments

Other investments include equity securities with no readily determinable fair value. These investments are carried at cost.

Mortgage Loan Held for Sale

Mortgage loans held for sale are carried at the lower of aggregate cost or market value. At December 31, 2005 and 2004, the cost of mortgage loans held for sale approximates the market value.

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. Loan origination fees and direct origination costs of loans are recognized at the time the loan is recorded on the books. Because the loan origination fee approximates the cost to originate most loans, the effect on net income is immaterial.

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 is established through a provision for loan losses charged to earnings. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely. The allowance represents an amount, which, in management’s judgment, will be adequate to absorb probable losses on existing loans that may become uncollectible.

Management’s judgment in determining the adequacy of the allowance is based on evaluations of the collectability of loans. These evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, current economic conditions that may affect the borrower’s ability to pay, overall portfolio quality, and review of specific problem loans. In determining the adequacy of the allowance for loan losses, management uses a loan grading system that rates individual loans into nine risk classifications. These risk categories are assigned allocations of loss based on management’s estimate of potential loss, which is generally based on an analysis of historical loss experience, current economic conditions, performance trends, and discounted collateral deficiencies. The combination of these results is compared monthly to the recorded allowance for loan losses and material differences are adjusted by increasing or decreasing the provision for loan losses. Management uses an independent external loan reviewer to challenge and corroborate the loan grading system and provide additional analysis in determining the adequacy of the allowance for loan losses and the future provisions for estimated losses.

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different than those of management.

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 represent the unamortized cost of purchased and originated contractual rights to service mortgages for others in exchange for a servicing fee. Mortgage servicing rights are amortized over the period of estimated net servicing income and are periodically adjusted for actual prepayments of the underlying mortgage loans. The Company amortized approximately $56,000, $88,000, and $338,000 during 2005, 2004 and 2003, respectively. No new servicing assets were recognized during 2005, 2004 and 2003.

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 $18.1 million, $22.6 million and $29.7 million at December 31, 2005, 2004 and 2003, respectively.

A-32

The Company originates certain fixed rate mortgage loans and commits these loans for sale. The commitments to originate fixed rate mortgage loans and the commitments to sell these loans to a third party are both derivative contracts. The fair value of these derivative contracts is immaterial and have no effect on the recorded amounts in the financial statements.

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 years
Furniture 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.

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.

A-33

Accumulated Other Comprehensive Income

At December 31, 2005, accumulated other comprehensive income consisted of net unrealized losses on securities available for sale of $1.1 million and net unrealized losses on derivatives of $318,000. At December 31, 2004, accumulated other comprehensive income (loss) consisted of net unrealized gains on securities available for sale of $332,000 and net unrealized losses on derivatives of $453,000.

Stock-Based Compensation

The Company’s stock-based compensation plan is accounted for under Accounting Principles Board Opinion No. 25 and related interpretations. No compensation expense has been recognized related to the grant of the incentive stock options. Had compensation cost been determined based upon the fair value of the options at the grant dates, the Company’s net earnings and net earnings per share would have been reduced to the proforma amounts indicated below.

			2005	2004	2003

Net earnings	As reported	$	6,330,980	4,430,936	2,003,591
	Effect of grants		(143,747)	(312,444)	-
	Effect of forfeitures		5,253	14,092	-

	Proforma	$	6,192,486	4,132,584	2,003,591

Basic earnings per share	As reported	$	1.84	1.28	0.58
	Proforma	$	1.79	1.19	0.58

Diluted earnings per share	As reported	$	1.80	1.26	0.58
	Proforma	$	1.76	1.18	0.58

The weighted average fair value of options at grant date in 2004 was $4.27. The fair value of each option is estimated on the date of grant using the Black-Scholes options-pricing model with the following weighted average assumptions used for grants in 2004 - dividend yield of 2.14%; risk free interest rate of 4.22%; expected volatility of 0.153; and an expected life of 10 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. For the year ended December 31, 2003 net earnings per share equaled diluted earnings per share, as the potential common shares outstanding during the period had no effect on the computation.

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, 2005, 2004 and 2003 are as follows:

For the year ended December 31, 2005:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per share	$	6,330,980	3,449,873	$	1.84
Effect of dilutive securities:
Stock options		-	60,655
Diluted earnings per share	$	6,330,980	3,510,528	$	1.80

For the year ended December 31, 2004:		Net Earnings	Common Shares		Per Share Amount

Basic earnings per share	$	4,430,936	3,459,379	$	1.28
Effect of dilutive securities:
Stock options		-	47,604
Diluted earnings per share	$	4,430,936	3,506,983	$	1.26

A-34

For the year ended December 31, 2003:		Net Earnings	Common Shares		Per Share Amount
Basic earnings per share	$	2,003,591	3,447,056	$	0.58
Effect of dilutive securities:
Stock options		-	29,703
Diluted earnings per share	$	2,003,591	3,476,759	$	0.58

On February 17, 2005, the Board of Directors of the Company authorized a 10% stock dividend and a $0.10 per share cash divided. As a result of the stock divided, each shareholder received one new share of stock for every ten 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 divided. The cash dividend was paid based on the number of shares held by shareholders as adjusted by the stock dividend. The stock and cash dividends were paid on March 16, 2005 to shareholders of record on March 3, 2005. All previously reported per share amounts have been restated to reflect this stock dividend.

Recent Accounting Pronouncements

In December 2004, the FASB revised SFAS No. 123 (“SFAS No. 123 (R)”). SFAS No. 123 (R), “Share-Based Payment,” requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. Pro forma disclosure is no longer an alternative to financial statement recognition. SFAS No. 123 (R) is effective as of the beginning of fiscal years beginning after June 15, 2005. The Company will adopt in the first quarter of 2006. The financial statement impact of adopting this change in accounting principle is not expected to be material due to the small number of unvested shares at December 31, 2005.

(2) Investment Securities

Investment securities available for sale at December 31, 2005 and 2004 are as follows:

		December 31, 2005
			Gross	Gross
		Amortized	Unrealized	Unrealized	Estimated Fair
		Cost	Gains	Losses	Value
Mortgage-backed securities	$	31,865,547	-	861,583	31,003,964
U.S. government agencies		60,751,179	83,410	591,506	60,243,083
State and political subdivisions		21,748,079	268,720	407,307	21,609,492
Trust preferred securities		1,750,000	-	-	1,750,000
Equity securities		814,995	-	263,350	551,645

Total	$	116,929,800	352,130	2,123,746	115,158,184

		December 31, 2004
			Gross	Gross
		Amortized	Unrealized	Unrealized	Estimated Fair
		Cost	Gains	Losses	Value

Mortgage-backed securities	$	36,492,826	188,816	138,443	36,543,199
U.S. government agencies		46,498,958	170,574	99,195	46,570,337
State and political subdivisions		20,212,105	546,905	110,189	20,648,821
Trust preferred securities		1,750,000	-	-	1,750,000
Equity securities		99,995	-	14,246	85,749

Total	$	105,053,884	906,295	362,073	105,598,106

The current fair value and associated unrealized losses on investments in debt securities with unrealized losses at December 31, 2005 are summarized in the table below, with the length of time the individual securities have been in a continuous loss position.

A-35

		December 31, 2005
		Less than 12 Months		12 Months or More		Total
			Unrealized		Unrealized		Unrealized
		Fair Value	Losses	Fair Value	Losses	Fair Value	Losses

Mortgage-backed securities	$	19,267,931	436,110	11,725,154	425,473	30,993,085	861,583
U.S. government agencies		27,541,468	313,598	11,221,262	277,908	38,762,730	591,506
State and political subdivisions		5,986,444	106,833	6,546,483	300,474	12,532,927	407,307
Equity securities		479,050	235,950	72,595	27,400	551,645	263,350


Total	$	53,274,893	1,092,491	29,565,494	1,031,255	82,840,387	2,123,746

		December 31, 2004
		Less than 12 Months		12 Months or More		Total
			Unrealized		Unrealized		Unrealized
		Fair Value	Losses	Fair Value	Losses	Fair Value	Losses

Mortgage-backed securities	$	9,706,756	100,854	2,625,755	37,589	12,332,511	138,443
U.S. government agencies		14,910,156	85,488	2,986,293	13,707	17,896,449	99,195
State and political subdivisions		7,118,463	110,189	-	-	7,118,463	110,189
Equity securities		-	-	85,749	14,246	85,749	14,246

Total	$	31,735,375	296,531	5,697,797	65,542	37,433,172	362,073

At December 31, 2005, unrealized losses in the investment securities portfolio related to debt securities totaled $1.9 million. The unrealized losses on these debt securities arose due to changing interest rates and are considered to be temporary. From the December 31, 2005 tables above, 34 out of 66 securities issued by state and political subdivisions contained unrealized losses and 67 out of 70 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 amortized cost and estimated fair value of investment securities available for sale at December 31, 2005, 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.

		Amortized Cost	Estimated Fair Value

Due within one year	$	200,172	201,026
Due from one to five years		44,773,905	44,213,108
Due from five to ten years		33,646,742	33,398,366
Due after ten years		5,628,439	5,790,075
Mortgage-backed securities		31,865,547	31,003,964
Equity securities		814,995	551,645

Total	$	116,929,800	115,158,184

Proceeds from sales of securities available for sale during 2005, 2004 and 2003 were $27.8 million, $3.0 million and $19.9 million, respectively. Gross losses of $730,000, $64,000 and $53,000 for 2005, 2004 and 2003, respectively, were realized on those sales.

Securities with a carrying value of approximately $25.7 million and $23.7 million at December 31, 2005 and 2004, respectively, were pledged to secure public deposits and for other purposes as required by law.

A-36

(3) Loans

Major classifications of loans at December 31, 2005 and 2004 are summarized as follows:

		2005	2004

Commercial	$	79,902,157	79,189,073
Real estate - mortgage		330,226,315	312,988,293
Real estate - construction		141,420,338	127,041,980
Consumer		15,114,606	16,248,387

Total loans		566,663,416	535,467,733

Less allowance for loan losses		7,424,782	8,048,627

Total net loans	$	559,238,634	527,419,106

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 County. 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, 2005 and 2004, the recorded investment in loans that were considered to be impaired was approximately $3.5 million and $5.1 million, respectively. In addition, the Company had approximately $946,000 and $245,000 in loans past due more than ninety days and still accruing interest at December 31, 2005 and 2004, respectively. The related allowance for loan losses on impaired loans was approximately $478,000 and $773,000 at December 31, 2005 and 2004, respectively. The average recorded investment in impaired loans for the twelve months ended December 31, 2005 and 2004 was approximately $6.2 million and $5.3 million, respectively. For the years ended December 31, 2005, 2004 and 2003, the Company recognized approximately $77,000, $123,000 and $67,000, respectively, of interest income on impaired loans.

Changes in the allowance for loan losses were as follows:

		2005	2004	2003

Balance at beginning of year	$	8,048,627	9,722,267	7,247,906
Amounts charged off		(4,199,650)	(5,385,199)	(4,481,548)
Recoveries on amounts previously charged off		465,805	455,559	212,009
Provision for loan losses		3,110,000	3,256,000	6,743,900

Balance at end of year	$	7,424,782	8,048,627	9,722,267

(4) Premises and Equipment

Major classifications of premises and equipment are summarized as follows:

		2005	2004

Land	$	2,187,254	2,170,514
Buildings and improvements		10,405,684	10,138,526
Furniture and equipment		12,743,224	11,679,698

Total premises and equipment		25,336,162	23,988,738

Less accumulated depreciation		12,674,009	11,246,008

Total net premises and equipment	$	12,662,153	12,742,730

Depreciation expense was approximately $1.5 million for the year ended December 31, 2005 and $1.3 million for the years ended December 31, 2004 and 2003.

A-37

During 2003, the Company sold two branch locations with net book values of approximately $3,115,000 and is currently leasing the facilities from the buyer. As a result of the sales, the Company deferred a gain of approximately $633,000 and is recognizing the gain over the lease term. For the periods ended December 31, 2005 and 2004, the Company recognized approximately $22,000 of the deferred gain and for the period ended December 31, 2003 approximately $18,000 of the deferred gain was recognized.

(5) Time Deposits

At December 31, 2005, the scheduled maturities of time deposits are as follows:

2006	$	241,930,881
2007		46,248,980
2008		6,666,780
2009		7,034,324
2010 and thereafter		3,063,276

Total	$	304,944,241

At December 31, 2005 and 2004, the Company has approximately $40.3 million and $39.4 million, respectively, in time deposits purchased through third party brokers. The weighted average rate of brokered deposits as of December 31, 2005 and 2004 was 3.64% and 2.38%, respectively.

(6) Federal Home Loan Bank Advances

The Bank has advances from the Federal Home Loan Bank of Atlanta (“FHLB”) with monthly interest payments at various maturity dates and interest rates ranging from 3.28% to 6.49% at December 31, 2005. 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, 2005, the carrying value of loans pledged as collateral totaled approximately $200.9 million.

Advances from the FHLB outstanding at December 31, 2005 consist of the following:

Maturity Date	Call Date	Rate	Rate Type		Amount

February 5, 2006	N/A	4.440%	Daily Rate	$	4,600,000

March 30, 2010	March 30, 2001 and every three
	months thereafter	6.020%	Convertible		5,000,000

March 30, 2010	September 30, 2000 and every three
	months thereafter	5.880%	Convertible		5,000,000

May 24, 2010	May 24, 2001 and every three
	months thereafter	6.490%	Convertible		2,000,000

January 10, 2011	January 10, 2002 and every three
	months thereafter	4.200%	Convertible		5,000,000

May 2, 2011	May 2, 2002 and every three
	months thereafter	4.055%	Convertible		30,000,000

January 26, 2006	N/A	3.280%	Adjustable		2,500,000

January 25, 2007	N/A	4.220%	Adjustable		2,500,000

June 24, 2015	June 24, 2010	3.710%	Convertible		5,000,000

June 24, 2010	June 24, 2006	3.879%	Convertible		5,000,000

July 23, 2012	July 23, 2007	3.870%	Convertible		5,000,000

				$	71,600,000

A-38

The FHLB has the option to convert $52.0 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 $10.0 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, 2005 and 2004, the Bank owned FHLB stock amounting to $4.6 million and $4.0 million, respectively.

(7) Junior Subordinated Debentures

In December 2001, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust I (“PEBK Trust”), which issued $14 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures that qualify as Tier I capital under Federal Reserve Board guidelines. All of the common securities of PEBK Trust are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust to purchase $14.4 million of junior subordinated debentures of the Company, which pay interest at a floating rate equal to prime plus 50 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used for general purposes, primarily to provide capital to the Bank. The debentures represent the sole asset of PEBK Trust. As discussed in note 1, PEBK Trust was deconsolidated by the Company under FIN 46 (Revised).

(8) Income Taxes

The provision for income taxes in summarized as follows:

		2005	2004	2003
Current	$	3,048,094	1,891,859	2,581,600
Deferred		332,806	341,441	(1,526,062)
Total	$	3,380,900	2,233,300	1,055,538

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:

		2005	2004	2003
Pre-tax income at statutory rates (34%)	$	3,302,039	2,265,840	1,040,104
Differences:
Tax exempt interest income		(263,555)	(243,346)	(216,431)
Nondeductible interest and other expense		30,511	21,588	18,668
Cash surrender value of life insurance		(73,973)	(65,871)	(73,692)
State taxes, net of federal benefits		363,264	236,544	270,493
Other, net		22,614	18,545	16,396
Total	$	3,380,900	2,233,300	1,055,538

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, 2005 and 2004.

A-39

		2005	2004
Deferred tax assets:
Allowance for loan losses	$	2,862,550	3,103,068
Amortizable intangible assets		141,010	173,548
Accrued retirement expense		533,155	454,446
Income from non-accrual loans		9,639	23,309
Deferred gain on sale of premises		220,876	228,932
Unrealized loss on cash flow hedges		223,684	289,009
Unrealized loss on available for sale securities		690,044	-
Other		33,578	28,965
Total gross deferred tax assets		4,714,536	4,301,277

Deferred tax liabilities:
Unrealized gains on available for sale securities		-	211,974
Deferred loan fees		1,135,448	1,060,798
Premises and equipment		545,570	477,285
Deferred income from servicing rights		87,330	108,920
Total gross deferred tax liabilities		1,768,348	1,858,977
Net deferred tax asset	$	2,946,188	2,442,300

(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 be 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 2005:

Beginning balance	$	8,404,828
New loans		2,229,878
Repayments		3,413,977

Ending balance	$	7,220,729

During 2005, an individual formerly considered a related party resigned as a director of the Company and as a result approximately $160,000 in loans to this individual and his affiliates have been removed from the beginning balance of the summary of related party loan activity.

At December 31, 2005 and 2004, the Company had deposit relationships with related parties of approximately $8.9 million and $13.1 million, respectively.

The Company also enters into contracts from time to time with certain directors for the construction of bank facilities. At December 31, 2005 and 2004, the Company had no outstanding construction contracts with these directors. During the year ended December 31, 2005, 2004 and 2003, total costs for construction, remodeling and repair for bank facilities paid to directors were approximately $0, $44,000 and $531,000, 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, 2005 are as follows:

Year
2006	$	984,858
2007		983,386
2008		952,257
2009		793,700
2010		652,643
Thereafter		4,232,256

Total minimum obligation	$	8,599,100

A-40

Total rent expense was approximately $956,000, $873,000 and $789,000 for 2005, 2004 and 2003, 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 Amount
		2005	2004
Financial instruments whose contract amount represent credit risk:

Commitments to extend credit	$	133,409,227	123,093,680

Standby letters of credit and financial guarantees written	$	2,692,192	3,278,326

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 $136.1 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.

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 trade 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.

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 $26.5 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, 2005, the Company had cash flow hedges with a notional amount of $70.0 million. These derivative instruments consist of two interest rate floor contracts that are used to hedge future cash flows of the first $70.0 million of certain variable rate loans against the downward effects of their repricing in the event of a

A-41

decreasing rate environment for a period of three years ending in July 2008 and November 2008. 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.

(12) Employer 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 $360,000, $363,000 and $306,000 for the years of 2005, 2004 and 2003, 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 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 2002, 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, less the Company’s cost of funds, 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 $245,000, $223,000 and $264,000 during 2005, 2004 and 2003, 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, $47,000 and $16,000, for the years ended December 31, 2005, 2004 and 2003, respectively. The following table sets forth the accumulated postretirement benefit obligation as of December 31, 2005 and 2004, which represents the liability for accrued postretirement benefit costs:

		2005	2004

Accumulated postretirement benefit obligation	$	244,304	215,985
Unrecognized gain (loss)		(80,495)	(49,038)

Net liability recognized	$	163,809	166,947

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 354,046 shares were reserved for possible issuance under this Plan. All rights must be granted or awarded within ten years from the effective date.

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 vest 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-42

	2005					2004				2003

					Weighted				Weighted				Weighted
					Average				Average				Average
					Option Price				Option Price				Option Price
		Shares			Per Share		Shares		Per Share		Shares		Per Share
Outstanding, beginning of period		202,401		$	13.39		216,726		13.26		218,545		13.25
Granted during the period		-		$	-		4,400		17.22		-		-
Forfeited during the period		(1,194	)	$	12.82		(2,260	)	13.19		-		-
Exercised during the period		(7,464	)	$	12.97		(16,465	)	12.73		(1,819	)	13.04

Outstanding, end of period		193,743		$	13.41		202,401		13.39		216,726		13.26

Number of shares exercisable		190,809		$	13.35		173,609		13.37		140,035		13.17

Options outstanding at December 31, 2005 are exercisable at option prices ranging from $11.53 to $17.44, as presented in the table above. Such options have a weighted average remaining contractual life of approximately seven years.

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 5,365 book value shares under the Stock Benefits Plan. Nine directors were awarded book value shares on September 28, 1999. The book value of the common stock on September 28, 1999 was $11.45 and has been adjusted to reflect a 10% stock dividend on April 24, 2000 and a 10% stock dividend on March 16, 2005. The book value shares awarded vest 20% annually, with the first 20% vesting on September 28, 2000 and the final 20% vesting on September 28, 2004. One director was awarded 5,365 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, 2002 was $13.95. These book value shares vest at a rate of 25% annually with the first 25% having vested on May 3, 2002, and the final 25% vesting on May 3, 2005. Four directors were awarded 5,365 book value shares on May 6, 2004. The book value of the common stock on May 6, 2004 was $15.68. 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 $102,000, $92,000 and $47,000 associated with the benefits of this plan in the years ended December 31, 2005, 2004 and 2003, respectively.

A summary of book value shares activity under the Stock Benefits Plan for the years ended December 31, 2005, 2004 and 2003 is presented below.

	2005					2004					2003

				Weighted					Weighted					Weighted
				Average					Average					Average
				Price of					Price of					Price of
				Book Value					Book Value					Book Value
	Shares			Shares		Shares			Shares		Shares			Shares
Outstanding, beginning of period		70,819		$	11.88		53,114			10.67		59,015			10.64
Granted during the period		-		$	-		23,606			14.25		-			-
Forfeited during the period		-		$	-		(1,180	)		10.41		(5,902	)		10.41
Exercised during the period		(11,802	)	$	10.41		(4,721	)		10.41		-			-

Outstanding, end of period		59,017		$	12.18		70,819			11.88		53,114			10.67

Number of shares exercisable		40,127		$	11.20		45,733			10.63		40,717			10.58

(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.

A-43

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

As of December 31, 2005, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain 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:

					To Be Well
					Capitalized Under
			For Capital		Prompt Corrective
	Actual		Adequacy Purposes		Action Provisions

	Amount	Ratio	Amount	Ratio	Amount	Ratio
	(dollars in thousands)

As of December 31, 2005:

Total Capital (to Risk-Weighted Assets)
Consolidated	$ 76,993	12.19%	50,514	8.00%	N/A	N/A
Bank	$ 73,265	11.64%	50,360	8.00%	62,951	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$ 69,568	11.02%	25,257	4.00%	N/A	N/A
Bank	$ 65,840	10.46%	25,180	4.00%	37,770	6.00%
Tier 1 Capital (to Average Assets)
Consolidated	$ 69,568	9.84%	28,273	4.00%	N/A	N/A
Bank	$ 65,840	9.33%	28,217	4.00%	35,272	5.00%

As of December 31, 2004:

Total Capital (to Risk-Weighted Assets)
Consolidated	$ 72,410	12.22%	47,407	8.00%	N/A	N/A
Bank	$ 68,503	11.60%	47,240	8.00%	59,050	10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated	$ 65,021	10.97%	23,704	4.00%	N/A	N/A
Bank	$ 61,114	10.35%	23,620	4.00%	35,430	6.00%
Tier 1 Capital (to Average Assets)
Consolidated	$ 65,021	9.50%	27,374	4.00%	N/A	N/A
Bank	$ 61,114	8.95%	27,328	4.00%	34,161	5.00%

(14) Shareholders’ Equity

A-44

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, 2005, this amount was approximately $14.7 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:

		2005	2004	2003

Advertising	$	656,184	619,731	540,970

(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 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 and Mortgage Loans Held for Sale

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. Mortgage loans held for sale are valued based on the current price at which these loans could be sold into the secondary market.

Cash Surrender Value of Life Insurance

For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value.

Mortgage Servicing Rights

Fair value of mortgage servicing rights is determined by estimating the present value of the future net servicing income, on a disaggregated basis, using anticipated prepayment assumptions.

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.

A-45

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.

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.

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, 2005 and 2004 are as follows:

		2005		2004
		Carrying Amount	Estimated Fair Value	Carrying Amount	Estimated Fair Value
		(dollars in thousands)

Assets:
Cash and cash equivalents	$	19,816	19,816	16,791	16,791
Investment securities available for sale	$	115,158	115,158	105,598	105,598
Other investments	$	5,811	5,811	5,397	5,397
Mortgage loans held for sale	$	2,248	2,248	3,783	3,783
Loans, net	$	559,239	559,122	527,419	525,818
Cash surrender value of life insurance	$	6,312	6,312	6,034	6,034
Mortgage servicing rights	$	227	227	283	283
Derivative instruments	$	176	176	-	-

Liabilities:
Deposits and demand notes payable	$	584,327	584,786	557,706	556,993
FHLB advances	$	71,600	71,804	59,000	61,637
Junior subordinated debentures	$	14,433	14,433	14,433	14,433
Derivative instruments	$	-	-	742	742

A-46

(17) Peoples Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial Statements

Balance Sheets

December 31, 2005 and 2004

Assets			2005		2004

Cash			$	519,089		517,652
Interest-bearing time deposit				2,000,000		2,000,000
Investment in subsidiaries				65,057,096		61,463,299
Investment securities available for sale				451,651		-
Other investments				349,994		1,050,749
Other assets				683,493		613,727

Total assets			$	69,061,323		65,645,427

Liabilities and Shareholders' Equity

Accrued expenses			$	275,329		274,575
Junior subordinated debentures				14,433,000		14,433,000
Shareholders' equity				54,352,994		50,937,852

Total liabilities and shareholders' equity			$	69,061,323		65,645,427




Statements of Earnings

For the Years Ended December 31, 2005, 2004 and 2003

Revenues:		2005		2004		2003

Dividends from subsidiaries	$	2,375,042		1,962,551		3,948,455
Interest and dividend income		83,632		63,875		43,684

Total revenues		2,458,674		2,026,426		3,992,139

Expenses:

Interest		938,145		676,547		667,526
Other operating expenses		289,691		280,002		211,788

Total expenses		1,227,836		956,549		879,314

Earnings before income tax benefit and equity in
undistributed earnings of subsidiaries		1,230,838		1,069,877		3,112,825

Income tax benefit		379,500		296,700		277,200

Earnings before undistributed earnings in subsidiaries		1,610,338		1,366,577		3,390,025

Equity in undistributed earnings in subsidiaries		4,720,642		3,064,359		-

Dividends paid in excess in earnings		-		-		(1,386,434	)

Net earnings	$	6,330,980		4,430,936		2,003,591

A-47

Statements of Cash Flows

For the Years Ended December 31, 2005, 2004 and 2003

	2005			2004			2003
Cash flows from operating activities:

Net earnings	$	6,330,980			4,430,936			2,003,591
Adjustments to reconcile net earnings to net
cash provided by operating activities:
Amortization		17,742			17,742			17,742
Book value shares accrual		21,818			66,933			47,078
Equity in undistributed earnings of subsidiaries		(4,720,642	)		(3,064,359	)		1,386,434
Deferred income tax benefit		(8,412	)		(25,806	)		(19,173	)
Change in:
Accrued income		17,930			(9,033	)		-
Accrued expense		(21,063	)		-			7,814

Net cash provided by operating activities		1,638,353			1,416,413			3,443,486

Cash flows from investing activities:

Net change in interest-bearing time deposit		-			-			(2,000,000	)
Purchases of investment securities available for sale		-			(250,000	)		-

Net cash used by investing activities		-			(250,000	)		(2,000,000	)

Cash flows from financing activities:

Cash dividends paid		(1,414,239	)		(1,257,254	)		(1,253,430	)
Cash paid in lieu of fractional shares		(4,700	)		-			-
Common stock repurchased		(314,750	)		(290,826	)		-
Proceeds from exercise of stock options		96,773			209,706			23,737

Net cash provided (used) by financing activities		(1,636,916	)		(1,338,374	)		(1,229,693	)

Net change in cash		1,437			(171,961	)		213,793

Cash at beginning of year		517,652			689,613			475,820

Cash at end of year	$	519,089			517,652			689,613

A-48

EX-23.(A) 4 ex23_a.htm CONSENT FOR FORM S-3 FILED 8/10/2000 Consent for Form S-3 filed 8/10/2000

EXHIBIT (23)(a)

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We have issued our report dated March 4, 2006, accompanying the consolidated financial statements incorporated by reference in the Annual Report of Peoples Bancorp of North Carolina, Inc. on Form 10-K for the year ended December 31, 2005. We hereby consent to the incorporation by reference of said report in the Registration Statement of Peoples Bancorp of North Carolina, Inc. on Form S-3 (File No. 333-43426, effective August 10, 2000).

/s/ PORTER KEADLE MOORE, LLP

Atlanta, Georgia

March 24, 2006

EX-23.(B) 5 ex23_b.htm CONSENT FOR FORM S-8 FILED 9/28/2000 Consent for Form S-8 filed 9/28/2000

EXHIBIT (23)(b)

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

/s/ PORTER KEADLE MOORE, LLP

Atlanta, Georgia

March 24, 2006

EX-31.(A) 6 ex31_a.htm CERTIFICATION OF CEO - SECTION 302 Certification of CEO - Section 302

EXHIBIT (31)(a)

CERTIFICATIONS

I, Tony W. Wolfe, certify that:

1.	I have reviewed this annual report on Form 10-K of Peoples Bancorp of North Carolina Inc.;

2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.	Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.	The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

5.	The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)	all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

March 24, 2006		/s/ Tony W. Wolfe
Date		Tony W. Wolfe
		President and Chief Executive Officer
		(Principal Executive Officer)

EX-31.(B) 7 ex31_b.htm CERTIFICATION OF CFO - SECTION 302 Certification of CFO - Section 302

EXHIBIT (31)(b)

CERTIFICATIONS

I, A. Joseph Lampron, certify that:

1.	I have reviewed this annual report on Form 10-K of Peoples Bancorp of North Carolina Inc.;

2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.	Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.	The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

b)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation ; and

5.	The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)	all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b)	any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

March 24, 2006		/s/ A. Joseph Lampron
Date		A. Joseph Lampron
		Executive Vice President and Chief Financial Officer
		(Principal Financial and Principal Accounting Officer)

EX-32 8 ex32.htm CERTIFICATION - SECTION 1350/906 Certification - Section 1350/906

EXHIBIT (32)

CERTIFICATION PURSUANT TO

18 U.S.C. § 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Peoples Bancorp of North Carolina, Inc. (the “Company”) on Form 10-K for the period ending December 31, 2005, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), each of the undersigned certifies, pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best knowledge of the undersigned:

(1)		The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities
		Exchange Act of 1934; and

(2)		The information contained in the Report fairly presents, in all material respects, the financial
		condition and results of operations of the Company.

Dated: March 24, 2006		/s/ Tony W. Wolfe
		Tony W. Wolfe
		Chief Executive Officer


Dated: March 24, 2006		/s/ A. Joseph Lampron
		A. Joseph Lampron
		Chief Financial Officer