LSB Bancshares, Inc.

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

(Mark One)


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

For the fiscal year ended December 31, 2005


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

For the transition period from to

Commission file number 000-11448

LSB BANCSHARES, INC.

(Exact Name of Registrant as Specified in Its Charter)


North Carolina		56-1348147

(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)

LSB BANCSHARES, INC.
ONE LSB PLAZA
LEXINGTON, NORTH CAROLINA 27292
(Address of Principal Executive Offices)
(Zip Code)

(336) 248-6500
(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:


Title of Each Class		Name of Exchange on Which Registered
None		Not Applicable

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, Par Value $5.00 Per Share
(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 o No þ

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

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 þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o

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

The aggregate market value of the voting common equity (there being no nonvoting common equity) held by nonaffiliates, computed by reference to the price at which the common equity was last sold, as of the last business day of the registrant’s most recently completed second fiscal quarter was $147,433,800.

There were 8,529,601 shares of the registrant’s common stock outstanding as of February 28, 2006.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement for the Annual Meeting of shareholders to be held on April 19, 2006 are incorporated by reference into Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K.

PART I

Item 1. Business.

REGISTRANT. LSB Bancshares Inc. (“Bancshares”) is a bank holding company incorporated on December 8, 1982 under the laws of the State of North Carolina, headquartered in Lexington, North Carolina and registered under the Federal Bank Holding Company Act of 1956, as amended (the “FBHCA”). Bancshares’ principal executive offices are located at One LSB Plaza, Lexington, North Carolina 27292. Its telephone number is (336) 248-6500.

Bancshares’ principal business is providing banking and other financial services through its banking subsidiary, Lexington State Bank (the “Bank”). Bancshares is the parent holding company of the Bank, a North Carolina chartered commercial bank. The principal assets of Bancshares are all outstanding shares of the Bank’s common stock. As part of its operations, Bancshares is not dependent upon a single customer or a few customers whose loss would have a material adverse effect on Bancshares. At December 31, 2005, Bancshares and its subsidiaries had consolidated assets of $976 million and 417 employees.

SUBSIDIARY BANK. The Bank is chartered under the laws of the State of North Carolina to engage in the business of general banking. The Bank employs 392 people. Founded in 1949, the Bank offers a wide array of services in commercial banking including accepting deposits, corporate cash management, discount brokerage, IRA plans, mortgage production, secured and unsecured loans and trust functions through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties in North Carolina. The Bank also provides banking services through automated teller machines (“ATMs”) and cash dispensers, “LSB By Net” online banking and 24-hour “LSB By Phone” banking. To the Bank’s knowledge it operates the only independent trust department in Davidson County, providing estate planning, estate and trust administration, IRA trusts, personal investment accounts and pension and profit-sharing trusts.

NON-BANK SUBSIDIARIES. The Bank has two wholly-owned non-bank subsidiaries: Peoples Finance Company of Lexington, Inc. (“Peoples Finance”) and LSB Investment Services, Inc. (“LSBIS”). Peoples Finance was founded under the laws of the State of North Carolina in 1983. The Bank acquired Peoples Finance on January 1, 1984. Peoples Finance employs 13 people and operates from four offices located in Lexington, King and Archdale, North Carolina as a finance company licensed under the laws of the State of North Carolina. As a finance company, Peoples Finance offers secured and unsecured loans to individuals up to a maximum of $10,000, as well as dealer originated loans.

LSBIS was incorporated under the laws of the State of North Carolina in 1994 and began operations on December 1, 1994. It offers a full range of uninsured, nondeposit investment products, including mutual funds, annuities, stocks and bonds and insurance services. LSBIS employs 11 people and operates from the Bank’s home office, as well as offices located in Welcome, Winston-Salem, King and Wallburg, North Carolina. LSBIS offers products through Uvest Investment Services, an independent broker-dealer, which is a member of the National Association of Securities Dealers, Inc. (“NASD”) and the Securities Investor Protection Corporation (“SIPC”). Investments are neither deposits nor obligations of the Bank, nor are they guaranteed or insured by any depository institution, the Federal Deposit Insurance Corporation (“FDIC”), or any other government agency.

COMPETITION. Commercial banking in the Bank’s service area is highly competitive. The Bank and Bancshares as its holding company face competition from national and state banks, thrift institutions, credit unions, investment banking and brokerage firms, and mortgage and finance companies in the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. The Bank’s most direct competition for deposits has historically derived from other commercial banks located in and around the counties in which it maintains banking offices. The Bank also competes for deposits with regional and super-regional banks, money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes

principally from other commercial banks, including offices of regional and super-regional banks, located in and around the counties in which it maintains banking offices. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.

GENERAL HIGHLIGHTS OF BUSINESS IN 2005.

Financial Summary. Net income for 2005 was $9,637,000 or $1.12 per diluted share, compared to $8,380,000 or $0.97 per diluted share in 2004, an increase of 15% in earnings per share. Net interest income for 2005 increased 12% compared with net interest income for 2004, reflecting an improvement in the net interest margin and growth in earning assets of Bancshares. Noninterest income decreased 2% from 2004, although the 2004 amount included a $292,000 nonrecurring gain on the sale of real estate. Excluding that gain, noninterest income would have been essentially unchanged in 2005 relative to 2004. Noninterest expense increased 6% during the same period. The provision for loan losses was $3,219,000 in 2005 compared to $3,017,000 in 2004. Nonperforming assets (including nonaccrual loans, accruing loans more than 90 days past due, renegotiated troubled debt and other real estate owned) totaled $8,087,000 at December 31, 2005, up 97% from $4,111,000 at December 31, 2004. Included in the $8.1 million was $4.4 million in other real estate owned, most of which related to the acquisition, by means of deed-in-lieu of foreclosure, of coastal condominium units by the Bank during the second quarter of 2005. The allowance for loan losses was $8,440,000 or 1.12% of loans, at the end of 2005, compared to $7,962,000, or 1.12% of loans, at the end of 2004. In 2005, return on average assets was 1.00% and return on average shareholders’ equity was 10.49%. As of December 31, 2005, assets increased 7%, deposits increased 14% and loans increased 6% compared to December 31, 2004. As of December 31, 2005, shareholders’ equity totaled $91,829,000, which represents an equity-to-asset ratio of 9.4%. For additional financial information, please review Item 6, “Selected Financial Data,” and Item 8, “Financial Statements and Supplementary Data,” which begin on page 15 and page 37 below, respectively.

Business Developments during the Last Fiscal Year. During October of 2005 the Bank opened its relocated Danbury branch. This larger full service branch allows the Bank to better serve our growing customer base in this community.

Progress continued during 2005 in many areas regarding Impact ’05, which is the Bank’s multi-year initiative to improve performance in many areas, particularly in its retail delivery system, operations, technology and service. Among other developments, the benefits of a new Bank training infrastructure were realized during the year. Additionally, the Bank’s Model Branch initiative, which is standardizing the tools and procedures in the branches, should provide branch sales and service employees with even better tools for increased sales, improved customer service and operational efficiencies. In this regard, the installation of a state-of-the-art Enterprise Relationship Management System, which will be completed in the first quarter of 2006, will become the primary sales and service platform used by all customer service employees. The implementation of a new easier-to-read statement for all deposit accounts as well as a new user-friendly retail internet banking system is providing additional features and functionality for all customers.

We also implemented an online budgeting system as a tool to facilitate our financial planning process as well as realized the benefits of the first phase of the LSB Call Center that is designed to measure our success in providing our customers with an even more responsive banking relationship. The first phase of the LSB Call Center included a new automated call distribution and reporting system which added the ability to evenly distribute deposit customer calls to customer service representatives and monitor service levels. Phase two of the LSB Call Center will include

the training of additional customer service representatives to handle loan, eBanking, credit card and other banking services. Phase two is expected to be completed by the end of 2006.

For additional information regarding the business of Bancshares and its subsidiaries during 2005, please review Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which begins on page 16 below.

REGULATION

General. As a bank holding company, Bancshares is subject to supervision, examination and regulation by the Board of Governors of the Federal Reserve System. The Bank is chartered by the State of North Carolina and as such is subject to supervision, examination and regulation by the Office of the Commissioner of Banks of the State of North Carolina (the “Banking Commission”). The Bank is also a member of the FDIC and is therefore subject to supervision and examination by that agency. In addition to federal and state banking laws and regulations, Bancshares and its subsidiaries are subject to other federal and state laws and regulations, and supervision and examination by other state and federal regulatory agencies, including the Securities and Exchange Commission (the “SEC”), the NASD and state securities regulators.

The following is a brief summary of some of the statutes, rules and regulations which directly or indirectly affect the operations and management of Bancshares and its subsidiaries. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of all applicable statutes or regulations. Any change in applicable laws or regulations may have a material adverse effect on Bancshares’ business and prospects.

Regulation of Bancshares. As mentioned above, Bancshares is a bank holding company within the meaning of the FBHCA. Under the FBHCA, Bancshares’ activities, and the activities of the companies which it controls or in which it holds more than five percent of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for its subsidiaries, or any other activity which the Federal Reserve determines to be a proper incident to the business of banking. Some of the activities that the Federal Reserve has determined by regulation to be proper incidents to the business of banking, and thus permissible for bank holding companies such as Bancshares, include (a) making or servicing loans and certain types of leases and related activities; (b) engaging in certain insurance and discount brokerage activities; (c) underwriting and dealing in government securities and certain other securities and financial instruments; (d) providing certain data processing and data transmission services; (e) acting in certain circumstances as a fiduciary or investment or financial advisor; (f) management consulting and counseling activities; (g) issuing and selling retail monetary instruments such as money orders, savings bonds and travelers’ checks and providing check printing and courier services; (h) operating trust companies and non-bank depository institutions such as savings associations; and (i) making investments in corporations or projects designed primarily to promote community welfare. Generally, a bank holding company is required to obtain prior approval from the Federal Reserve to engage in any new activity not previously approved by the Federal Reserve or to acquire more than five percent of any class of voting stock of any company or any bank which is not already majority-owned by such bank holding company.

Bancshares is also subject to the North Carolina Bank Holding Company Act of 1984 (the “NCBHCA”). As required by the NCBHCA, Bancshares, by virtue of its ownership of the Bank, has registered as a bank holding company with the Banking Commission. The NCBHCA prohibits Bancshares from acquiring or controlling certain non-bank banking institutions which have offices in North Carolina.

Regulation of the Bank. As mentioned above, the Bank is organized as a North Carolina state chartered bank subject to regulation, supervision and examination by the Federal Reserve and the Banking Commission and to regulation by the FDIC. Federal and state laws and regulations impose various requirements upon the Bank, including those related to required reserves against deposits, allowable investments, loans, mergers, consolidations,

issuance of securities, payment of dividends, establishment of branches, limitations on credit to subsidiaries and other aspects of the business of such subsidiaries. The federal and state banking agencies have broad authority and discretion in connection with their supervisory and enforcement activities and examination policies, including policies involving the classification of assets and the establishment of loan loss allowances for regulatory purposes. Such actions by these regulators prohibit member banks from engaging in unsafe or unsound banking practices. The Bank is also subject to certain reserve requirements established by the Federal Reserve Board.

Other Regulations. The operations and management of Bancshares and its subsidiaries are subject to the statutes, rules and regulations briefly summarized below.

Check Clearing for the 21st Century Act. Most banks, such as the Bank, use check-imaging technology to capture digital images of the fronts and backs of checks as they are processed through high-speed check sorters. The Check Clearing for the 21^st Century Act (the “Check 21 Act”) authorizes banks to replace the physical transportation of checks with an electronic transfer of check images.

The key feature of the Check 21 Act is the creation of a new negotiable instrument called a “substitute check.” A substitute check is a paper reproduction of an original check that meets certain content and format requirements imposed by the Check 21 Act. Under the Check 21 Act, banks will be able to create substitute checks from the original deposited paper checks and process them electronically under a uniform electronic processing system. All banks were required to accept substitute checks beginning October 28, 2004. However, no bank is required to create substitute checks and may continue to use the paper check clearing process instead. At this time the Bank is continuing to use the paper check clearing process. The Bank is continuing to position itself to take advantage of this technology in the future but does not have a conversion date at this time.

Under the Check 21 Act, substitute checks are subject to all of the consumer protections granted in the Uniform Commercial Code and certain regulations promulgated by the Federal Reserve Board. The Check 21 Act also requires banks to provide a brief notice about substitute checks to customers and establishes further warranties and indemnifications to protect consumers.

Gramm-Leach Bliley Financial Modernization Act of 1999. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “GLB Act”) modernized the federal bank regulatory framework by allowing the consolidation of banking institutions with other types of financial services firms, subject to various restrictions and requirements. In general, the GLB Act repealed most of the federal statutory barriers which separated commercial banking firms from insurance and securities firms and authorized the consolidation of such firms in a financial services holding company.

The USA PATRIOT Act. After the September 11, 2001 terrorist attacks in New York and Washington, D.C., the United States government acted in several ways to tighten control on activities perceived to be connected to money laundering and terrorist funding by enacting the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”). A series of orders were issued under the USA PATRIOT Act which identify terrorists and terrorist organizations and require the blocking of property and assets of, as well as prohibiting all transactions or dealings with, such terrorists, terrorist organizations and those that assist or sponsor them. The USA PATRIOT Act also requires each financial institution (a) to create a risk based Customer Identification Program to verify the identity of any person or entity seeking to open an account to the extent reasonable and practical; (b) to establish an anti-money laundering program; (c) to establish due diligence policies, procedures and controls with respect to its private banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (d) to avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a foreign bank that does not have a physical presence in any country. In addition, the United States Treasury Department issued regulations in cooperation with the federal banking agencies, the SEC, the Commodity Futures Trading Commission and the Department of Justice to require customer identification and verification, expand the money-laundering program

requirement to the major financial services sectors, and facilitate and permit the sharing of information between law enforcement and financial institutions, as well as among the financial institutions themselves. The United States Treasury Department also has created the Treasury USA PATRIOT Act Task Force to work with other financial regulators, the regulated community, law enforcement and consumers to continually improve the regulations.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (“SOX”) comprehensively revised the laws affecting corporate governance, accounting obligations and corporate reporting for companies with equity or debt securities registered under the Exchange Act (such as Bancshares). In particular, SOX established (a) new requirements for audit committees, including independence, expertise, and responsibilities; (b) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (c) new standards for auditors and regulation of audits; (d) increased disclosure and reporting obligations for the reporting company and their directors and executive officers; and (e) new and increased civil and criminal penalties for violations of the securities laws.

Various Consumer Protection Laws. In connection with its lending and leasing activities, Bancshares and its subsidiaries are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.

Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

AVAILABLE INFORMATION. Bancshares’ Internet address is www.lsbnc.com. Bancshares makes available, free of charge, on or through its website, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and beneficial ownership reports on Forms 3, 4 and 5 as soon as reasonably practicable after electronically filing such material with, or furnishing it to, the SEC. These filings are also accessible on the SEC’s website, www.sec.gov. In addition, Bancshares makes available on www.lsbnc.com (1) its Corporate Governance Guidelines, (ii) its Code of Business Conduct and Ethics, which applies to all directors and officers of Bancshares and its subsidiaries, (iii) its Code of Business Conduct and Ethics for CEO and Senior Financial Officers, which applies to Bancshares’ Chief Executive Officer and Chief Financial Officer and principal accounting officers, and (iv) the charters of the Executive Committee, the Stock Option and Compensation Committee, the Audit Committee and the Corporate Governance and Nominating Committee of its Board of Directors. These materials are also available free of charge in print to shareholders who request them by writing to: Monty J. Oliver, Secretary and Treasurer, One LSB Plaza, Lexington, North Carolina 27292.

Item 1A. Risk Factors.

The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect our business, financial condition, results of operations or prospects. If any of the following risks were to occur, our business, financial condition, results of operations or prospects could be materially and adversely affected.

Our operating results and financial condition would likely suffer if there is deterioration in the general economic condition of the areas in which we do business. Our primary markets are in Davidson, Forsyth, Guilford and Stokes counties in North Carolina. Because our lending and deposit-gathering activities are concentrated in these markets, we will be affected by the business activity, population, income levels, deposits and real estate activity in these markets. These markets are heavily dependent on the manufacturing industry, especially furniture manufacturing and adverse developments in this industry could have a negative affect on our financial condition and results of operations. Even though our customers’ business and financial interest may extend well beyond these market areas, adverse economic conditions that affect these market areas could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations. A significant decline in general economic conditions in North Carolina or the entire country caused by inflation, recession, unemployment or other factors which are beyond our control would also impact these local economic conditions and could have an adverse affect on our financial condition and results of operations.

Our operating results would likely suffer if management determines that there needs to be an increase in allowance for loan losses due to certain factors. Management periodically makes a determination of our allowance for loan losses based on available information, including the quality of our loan portfolio, economic conditions, the value of the underlying collateral and the level of our nonaccruing loans. If our assumptions prove to be incorrect, our allowance may not be sufficient. Increases in this allowance will result in an expense for the period. If, as a result of economic conditions or an increase in non-performing loans, management determines that an increase in our allowance for loan losses is necessary it could have an adverse affect on our results of operations.

Our financial condition, results of operations and liquidity would be adversely affected if, due to changes in economic conditions or otherwise, a material number of our borrowers or borrowers with a material amount of loans outstanding with us defaulted on their loans and the security, if any, supporting such loans proved insufficient to pay those loans, and our costs related thereto, in full. A significant source of risk for us arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most loans originated by us are secured, but some loans are unsecured depending on the nature of the loan. With secured loans, the collateral securing the repayment may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government and several other events. These changes could have a material adverse effect on our financial condition, results of operations and liquidity.

Changes in interest rates could materially adversely affect our results of operations and cash flows. Our primary source of income from operations is net interest income, which equals the difference between the interest income we generate on loans, investments and other interest-bearing assets and the interest expense we incur on deposits, borrowing and other interest-bearing liabilities. Our net interest income is affected by changes in market interest rates. These rates are highly sensitive to many factors beyond our control, including general economic conditions and the monetary and fiscal policies of various governmental and regulatory agencies.

The businesses in which we are engaged are highly competitive and our financial condition ad results of operations could be materially adversely affected by actions taken by our competitors. We face competition for banking services from national and state banks, thrift institutions, credit unions, investment banking and brokerage firms, and mortgage and finance companies in the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. Our most direct competition for deposits has historically derived from other commercial banks located in and around the North Carolina counties in which we maintain banking offices. We also compete for deposits with regional and super-regional banks, money market instruments and mutual funds. We compete for loans principally through the interest rates and loan fees we charge and the efficiency and quality of services we provide borrowers. Our competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around the North Carolina counties in which we maintain banking offices. If we are unable to continually attract and retain sufficient numbers of banking

customers we may be unable to continue our loan growth and level of deposits and our results of operations and financial condition may otherwise be negatively affected.

Changes in the various laws and regulations that govern our businesses could have a material adverse affect on our financial condition and results of operations. We are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of our operations. During 2005 we closed in on the threshold of a billion dollar bank holding company and are now subject to annual joint examinations by the state of North Carolina and the FDIC along with heightened focus during those examinations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact us and/or our ability to increase the value of our business.

Our fee revenue from LSBIS is highly dependent on the value of assets under our care and the trading volume of our customers in their brokerage accounts, which in turn could be materially adversely affected by national and local economic conditions. The fee revenue of LSBIS is largely dependent on the fair market value of assets under care and trading volumes in the brokerage business. General economic conditions and their subsequent effect on the securities markets tend to act in tandem. When general economic conditions deteriorate, consumer and corporate confidence in securities markets erodes, and LSBIS’ revenues are negatively impacted as asset values and trading volumes decrease.

We are subject to security and operational risks related to the technology we use that could result in a loss of customers, increased costs and other damages which could be material. We depend on data processing, software and communication and information exchange on a variety of platforms, networks and over the internet. Despite safeguards, we cannot be certain that all of our systems are entirely free from vulnerability to attack or other technological difficulties or failures. Any failure or interruptions or breach of security of these systems could result in failures or disruptions in our customer relationships, general ledger, deposits and servicing or loan origination systems. The occurrence of any difficulties or failures could result in a loss of customer business and have a material adverse effect on our results of operations and financial condition.

Item 1B. Unresolved Staff Comments. Not Applicable.

Item 2. Properties.

Bancshares’ principal executive offices are located at One LSB Plaza, Lexington, North Carolina 27292. This five-story office building totals 74,800 square feet and also serves as the home office of the Bank. A majority of the major staff functions are located within this office complex, which is owned by the Bank.

The Bank operates twenty-five branches, one mortgage origination office and nine off-premise ATM locations. The Bank owns fifteen of the twenty-five branches, while ten branches, the mortgage origination office and the off-premise ATM locations are leased. The Bank’s leased properties are subject to leases that expire on various dates from September 30, 2006 to February 28, 2010. The Bank operates branches at the following locations:


ARCADIA*	ARCHDALE*	CLEMMONS*
3500 Old Salisbury Road	11651-D North Main Street	2386 Lewisville-Clemmons Road
Arcadia, NC 27292	Archdale, NC 27263	Clemmons, NC 27012

CORPORATE OFFICE*	DANBURY*	HIGH POINT*
One LSB Plaza	1101 North Main Street	200 Westchester Drive
Lexington, NC 27292	Danbury, NC 27016	High Point, NC 27262

JAMESTOWN	KERNERSVILLE*	KING*
120 East Main Street	131 East Mountain Street	647 South Main Street
Jamestown, NC 27282	Kernersville, NC 27284	King, NC 27021

MIDWAY*	NATIONAL HIGHWAY*	PIEDMONT RETIREMENT CENTER
11492 Old U.S. Highway 52	724 National Highway	100 Hedrick Drive
Midway, NC 27295	Thomasville, NC 27360	Thomasville, NC 27360

RALEIGH	RANDOLPH STREET*	REYNOLDA*
805 Spring Forest Road	941 Randolph Street	2804 Fairlawn Drive
Suite 800	Thomasville, NC 27360	Winston-Salem, NC 27106
Raleigh, NC 27609

RURAL HALL*	SHERWOOD PLAZA*	SOUTH LEXINGTON*
8055 Broad Street	3384 Robinhood Road	1926 Cotton Grove Road
Winston-Salem, NC 27045	Winston-Salem, NC 27106	Lexington, NC 27292

STRATFORD ROAD*	TALBERT BOULEVARD*	TYRO*
161 South Stratford Road	285 Talbert Boulevard	4481 Highway 150 South
Winston-Salem, NC 27104	Lexington, NC 27292	Tyro, NC 27295

UPTOWN EXPRESS	WALKERTOWN*	WALLBURG*
DRIVE-THRU*	3000 Old Hollow Road	10335 North NC Highway 109
500 South Main Street	Walkertown, NC 27051	Wallburg, NC 27373
Lexington, NC 27292

WELCOME*	WEST SIDE*
6123 Old US Highway 52	60 New US Highway 64 West
Welcome, NC 27374	Lexington, NC 27292


*		ATM available at this location.

Peoples Finance operates from (a) a 1,200 square foot, one-story building located at 203 East Center Street, Lexington, North Carolina 27292, which it owns; (b) a 1,200 square foot, one-story building located at 614 South Main Street, King, North Carolina 27021, which it leases; (c) a 1,000 square foot, one-story building located at 11246 North Main Street, Suite 306, Archdale, North Carolina 27263, which it leases; and (d) an administrative office at 300 E. Center Street, Lexington, North Carolina 27292, which it leases.

LSBIS operates from (a) a 800 square foot space in the principal office of the Bank, which it leases; (b) a 100 square foot space in the building located at 10335 North N.C. Highway 109, Wallburg, North Carolina 27373, which it leases; (c) a 250 square foot space in the building located at 6123 Old U.S. Highway 52, Welcome, North Carolina 27374, which it leases; (d) a 300 square foot space in the building located at 161 South Stratford Road, Winston-Salem, North Carolina 27104, which it leases; and (e) a 100 square foot space in the building located at 647 South Main Street, King, North Carolina 27021, which it leases.

Except as described herein, Bancshares, the Bank, Peoples Finance and LSBIS own all properties free and clear of encumbrances.

Item 3. Legal Proceedings.

From time to time, Bancshares and its subsidiaries are involved in litigation arising from the ordinary course of their business. As of the date of this report, neither Bancshares nor any of its subsidiaries are involved in any material legal proceedings.

Item 4. Submission of Matters to a Vote of Security Holders.

There were no matters submitted to a vote of 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.

Bancshares’ common stock is traded on the Nasdaq National Market under the symbol LXBK. The following table shows the high, low and closing sales prices reported on the Nasdaq National Market and cash dividends declared per share for the indicated periods.


			Prices				Cash Dividends
	High		Low		Close		Declared

2005
Fourth Quarter	$	18.78	$	17.36	$	17.69	$	0.17
Third Quarter		19.23		17.40		17.40		0.17
Second Quarter		19.00		16.60		17.96		0.17
First Quarter		18.01		16.25		17.01		0.17

2004
Fourth Quarter	$	17.60	$	15.95	$	16.89	$	0.16
Third Quarter		16.96		15.97		16.56		0.16
Second Quarter		18.46		14.70		16.15		0.16
First Quarter		20.00		15.43		17.29		0.16

As of February 28, 2006, there were 2,713 record holders of Bancshares’ common stock.

The following table sets forth certain information regarding outstanding options and shares for future issuance under equity compensation plans as of December 31, 2005. Individual equity compensation arrangements are aggregated and included within this table. This table excludes any plan, contract or arrangement that provides for the issuance of options, warrants or other rights that are given to Bancshares’ shareholders on a pro rata basis and any employee

benefit plan that is intended to meet the qualification requirements of Section 401(a) of the Internal Revenue Code of 1986, as amended.

Number of Shares

Remaining Available

for Future Issuance

under Equity

Number of Shares to be

Weighted-Average

Compensation Plans

Issued Upon Exercise of

Exercise Price of

(excluding shares

Outstanding Options,

reflected in

Warrants and Rights (1)

Warrants and Rights

column (a)) (1)

Plan Category

(a)

(b)

(c)

Equity Compensation Plans Approved by Shareholders

614,961

16.9804

562,750

Equity Compensation Plans Not Approved by Shareholders

—

Total

614,961

16.9804

562,750


(1)		In connection with the approval by Bancshares’ shareholders of Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees (the “Comprehensive Benefit Plan”) at the annual meeting of shareholders in 2004, the following previously existing benefit plans were terminated (except with respect to outstanding grants): (a) the 1986 Employee Incentive Stock Option Plan; (b) the 1994 Director Stock Option Plan; (c) the 1996 Omnibus Stock Incentive Plan; (d) the Annual Incentive Plan; and (e) the Amended and Restated Deferred Compensation Plan for Directors. The Comprehensive Benefit Plan is now the only plan from which the Stock Option and Compensation Committee of Bancshares’ Board of Directors (the “Compensation Committee”) awards new grants of stock options, deferred stock and other equity-based awards to directors and employees.

The Board of Directors of Bancshares has authorized a repurchase plan for shares of its common stock in the open market or privately negotiated transactions on a time-to-time and ongoing basis, depending upon market conditions and subject to compliance with all applicable securities laws and regulations. The repurchase plan is intended to help Bancshares achieve its goal of building shareholder value and maintaining appropriate capital levels. The plan was originally announced in November 1998 with extensions approved in August 1999 and May 2004. Unless extended by Bancshares, the plan will expire on May 31, 2006. The original plan authorized 300,000 shares as have each of the extensions, for a total authorized repurchase amount of 900,000 shares.

During 2005, 2004 and 2003, 106,408, 19,800 and 0 shares, respectively, were repurchased and retired by Bancshares under this repurchase plan. The total number of shares repurchased under the plan as of December 31, 2005, was 569,989 leaving 330,011 shares available for repurchase under the plan, which as indicated above, is currently set to expire on May 31, 2006, if not extended by Bancshares prior thereto.

Item 6. Selected Financial Data.

The following table should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” and Item 8, “Financial Statements and Supplementary Data,” which begin on page 16 and page 37 below, respectively.


	Years Ended December 31
(In thousands, except per share data and ratios)	2005			2004			2003			2002			2001
SUMMARY OF OPERATIONS
Interest income	$	60,425		$	49,319		$	50,790		$	52,932		$	58,607
Interest expense		16,726			10,367			11,177			15,185			25,619


Net interest income		43,699			38,952			39,613			37,747			32,988
Provision for loan losses		3,219			3,017			5,215			2,480			1,862


Net interest income after provision for loan losses		40,480			35,935			34,398			35,267			31,126
Noninterest income		13,792			14,063			14,517			12,000			9,758
Noninterest expense		39,770			37,687			36,434			32,040			27,311


Income before income taxes		14,502			12,311			12,481			15,227			13,573
Income taxes		4,865			3,931			3,903			5,013			4,421


Net income	$	9,637		$	8,380		$	8,578		$	10,214		$	9,152


Cash dividends declared	$	5,805		$	5,490		$	5,454		$	5,080		$	4,727


SELECTED YEAR-END ASSETS AND LIABILITIES
Investment Securities	$	128,159		$	129,194		$	121,091		$	128,402		$	155,337
Loans, net of unearned income		755,398			712,185			663,446			645,548			588,364
Assets		975,795			914,988			867,906			851,793			833,327
Deposits		822,173			722,275			702,502			696,481			682,164
Shareholders’ equity		91,829			90,742			88,560			85,507			79,343

RATIOS (AVERAGES)
Net income to total assets		1.00	%		0.94	%		0.98	%		1.21	%		1.13	%
Net income to shareholders’ equity		10.49			9.26			9.66			12.28			11.84
Dividend payout		60.24			65.51			63.58			49.74			51.65
Shareholders’ equity to total assets		9.53			10.15			10.11			9.87			9.56

PER SHARE DATA
Earnings per share:
Basic	$	1.13		$	0.98		$	1.01		$	1.21		$	1.08
Diluted		1.12			0.97			1.00			1.20			1.08
Cash dividends declared		0.68			0.64			0.64			0.60			0.56
Book value at end of year		10.77			10.57			10.36			10.09			9.40

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion should be read in conjunction with Item 1A, “Risk Factors”, Item 6, “Selected Financial Data,” Item 8, “Financial Statements and Supplementary Data,” and the audit report of Turlington and Company, L.L.P., Bancshares’ independent registered public accounting firm which begin on pages 8, 15, 37 and 39 below, respectively.

Forward-looking Statements

This Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements represent expectations and beliefs of Bancshares including but not limited to Bancshares’ operations, performance, financial condition, growth or strategies. These forward-looking statements are identified by words such as “expects”, “anticipates”, “should”, or other similar statements about future events. For this purpose, any statements contained in this Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements. These forward-looking statements involve estimates, assumptions by management, risks and uncertainties that could cause actual results to differ materially from current projections depending on a variety of important factors, including without limitation: (1) the strength of the United States economy generally and the strength of the local economies in which Bancshares conducts operations may be different than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit, including the resultant effect on Bancshares’ loan portfolio and allowance for loan losses; (2) 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; (3) inflation, interest rate, market and monetary fluctuations; (4) adverse conditions in the stock market, the public debt market and other capital markets (including changes in interest rate conditions) and the impact of such conditions on Bancshares’ capital markets and capital management activities, including, without limitation, Bancshares’ private equity investment activities and brokerage activities; (5) the timely development of competitive new products and services by Bancshares and the acceptance of these products and services by new and existing customers; (6) the willingness of customers to accept third party products marketed by Bancshares; (7) the willingness of customers to substitute competitors’ products and services for Bancshares’ products and services and vice versa; (8) the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking and securities); (9) technological changes; (10) changes in consumer spending and saving habits; (11) the effect of corporate restructurings, acquisitions and/or disposition, and the failure to achieve the expected revenue growth and/or expense savings from such corporate restructurings, acquisitions and/or dispositions; (12) the growth and profitability of Bancshares’ noninterest or fee income being less than expected; (13) unanticipated regulatory or judicial proceedings; (14) the impact of changes in accounting policies by the SEC; (15) adverse changes in financial performance and/or condition of Bancshares’ borrowers which could impact repayment of such borrowers’ outstanding loans; and (16) Bancshares’ success at managing the risks involved in the foregoing. Bancshares cautions that the foregoing list of important factors is not exclusive. See also “Risk Factors” which begins on page 8 above. Bancshares does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of Bancshares.

Introduction

Bancshares is a bank holding company headquartered in Lexington, North Carolina. Its principal assets are all of the outstanding shares of common stock of its commercial bank subsidiary. Founded in 1949, the Bank operates as a North Carolina chartered commercial bank serving customers through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties in North Carolina. During October of 2005 the Bank opened its relocated Danbury branch. This larger full service branch allows the Bank to better serve its growing customer base in this community. The benefits of a new Bank training infrastructure were realized during the year. Additionally, the Bank’s Model Branch initiative, which is standardizing the tools and procedures in the branches, should provide branch sales and service employees with even better tools for increased sales, improved customer service and operational efficiencies. In this regard, the installation of a state-of-the-art Enterprise

Relationship Management System, which will be completed in the first quarter of 2006, will become the primary sales and service platform used by all customer service employees. The implementation of a new easier-to-read statement for all deposit accounts as well as a new user-friendly retail internet banking system is providing additional features and functionality for all customers. Through the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS, Bancshares provides a wide range of financial services to individuals and corporate customers.

Bancshares’ results of operations are dependent primarily on the results of operations of the Bank and thus are dependent to a significant extent on net interest income, which is the difference between the income earned on its loan and investment portfolios and its cost of funds, consisting of interest paid on deposits and borrowings. The Bank’s noninterest income has become increasingly important to its performance through fees earned by its non-bank subsidiary LSBIS. Results of operations are also affected by Bancshares’ provision for loan losses, mortgage loan sales activities, service charges and other fee income, and noninterest expense. Bancshares’ noninterest expense principally consists of compensation and employee benefits, office occupancy and equipment expense, data processing, professional fees, and advertising and business promotion expenses. Bancshares’ results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities.

The Bank (and Bancshares as its holding company) faces competition in both the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. Its most direct competition for deposits has historically derived from other commercial banks located in and around the counties in which it maintains banking offices. The Bank also competes for deposits with both regional and super-regional banks, and money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around the counties in which it maintains banking offices. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.

Critical Accounting Policies

The accounting and reporting policies of the Bank and its subsidiaries comply with generally accepted accounting principles in the United States and conform to standards within the industry. Bancshares believes that its most significant accounting policies deal with:

	•		The allowance for loan loss, as it requires the most subjective and complex judgments from senior management. Management considers several factors in determining the allowance for loan loss. These include economic conditions, advice of regulators, historical experience and factors affecting particular borrowers. Changes in the assumptions of these policies could result in a significant impact on the Bank’s financial statements. For further information, see the Asset Quality and Allowance for Loan Losses section and Note 1, “Summary of Significant Accounting Policies,” in the “Notes to Consolidated Financial Statements.”

	•		Pension and postretirement benefit plans to employees, the “Benefits Plans”. Bancshares utilizes actuarial methods required by Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions”, to account for its noncontributory defined benefit pension plan (the “Pension Plan”), which covers substantially all employees and Bancshares follows Statement of Financial Accounting Standards No. 106, “Employer’s Accounting For Postretirement Benefits

			Other Than Pensions” to account for its postretirement life and health benefits. The actuarial methods for the Benefits Plans require numerous assumptions to calculate the net periodic benefit expense and the related benefit obligation for the Benefits Plans. Inherent in these valuations are key assumptions, including the discount rate and expected long-term rate of return on plan assets. Material changes in the costs of the Benefits Plans may occur in the future due to changes in these assumptions, changes in the number of participants, changes in the level of benefits provided, changes in asset levels and changes in legislation.

			Since future pension and postretirement liabilities are calculated using an assumed discounted rate, the discount rate is a significant assumption. The discount rate is selected using various market indicators and reflects the available cost in the marketplace of settling all pension obligations. The discount rate of 6.0% for 2005 was selected based upon reviewing trends in the interest indexes of Aaa and Aa bond rates and the 30-yr Treasury rate and analysis of the duration of the Pension Plan’s liabilities.

			The expected long-term rate of return on the Pension Plan’s assets should, over time, approximate the actual long-term returns on the assets of the Pension Plan. Assumptions are developed by the Pension Plan’s investment consultant for each investment style category as to rate of return, risk, yield and correlation with other categories that serve as components of the long-term strategy. Based upon these assumptions, eligible components are tested over the desired time horizon given the acceptable tolerance for risk as determined by the Plan Sponsor. The expected long-term rate of return of 7.5% reflects assumptions as to continued execution of the current strategic asset allocation, modern portfolio theory and the Pension Plan’s investment policy.

			Please refer to Note 14, “Pension and Employee Benefit Plans,” in the “Notes to Consolidated Financial Statements” for disclosures related to Bancshares’ benefits plans, including quantitative disclosures reflecting the impact that changes in certain assumptions would have on service and interest costs and benefit obligations.

Overview

The discussion presented herein is intended to provide an overview of the financial condition, changes in financial condition and results of operations of Bancshares and its wholly-owned subsidiary, the Bank, for the years 2005, 2004 and 2003. The consolidated financial statements include the accounts and results of operations of the Bank’s wholly-owned subsidiaries, Peoples Finance and LSBIS. The intent of the discussion and analysis is to provide the reader with pertinent information about Bancshares and its subsidiaries in the areas of liquidity, capital resources, results of operation, off-balance sheet arrangements, contractual obligations, financial position, asset quality and interest sensitivity. It should be read in conjunction with the audited financial statements, notes and supplemental tables provided herein.

Results of Operations

For 2005, Bancshares reported net income of $9.637 million or $1.12 per diluted share compared to $8.380 million or $.97 per diluted share for 2004 and $8.578 million or $1.00 per diluted share for 2003. The increase in net income for the current year was the result of an improvement in the net interest margin and growth in earning assets of Bancshares. Net interest income for 2005 increased 12% compared with net interest income for 2004, reflecting an improvement in the net interest margin and growth in earning assets of Bancshares.

Net interest margin increased during 2005, ending the year at 4.91% compared to 4.75% for 2004 and 4.89% for 2003. As a result, the net interest income for 2005, on a tax equivalent basis, increased $4.660 million or 11.8% compared to a decrease in 2004 of $729,000 or 1.8%. Noninterest income declined $271,000 or 1.99% in 2005 compared to a decrease in 2004 of $454,000 or 3.1% compared to 2003. Noninterest expense for 2005 increased

$2.083 million or 5.5% compared to $1.253 million or 3.4% for 2004. The provision for loan losses in 2005 was $3.219 million, up $202,000 or 6.7% from 2004. Return on average assets for 2005 was 1.00% compared to 0.94% for 2004 and 0.98% in 2003. Return on average shareholders’ equity for 2005 was 10.49% compared to 9.26% in 2004 and 9.66% in 2003.

Balance sheet growth gained in all categories during 2005. There was an increase in loans in 2005 of $43.213 million or 6.1% compared to growth in 2004 of $48.739 million or 7.3%. Consolidated assets in 2005 increased $60.807 million or 6.7% compared to 2004, which increased $47.082 million or 5.4% over 2003. Deposit growth for 2005 was $99.898 million or 13.8% compared to a 2004 increase of $19.773 million or 2.8%.

Net Interest Income

Net interest income for the Bank represents the dollar amount by which income generated from earning assets exceeds its cost of funds. Net interest income is the primary source of revenue for the Bank. Interest-earning assets consist primarily of loans and investment securities. These assets are subject to credit risk and interest rate risk, which are discussed in detail in “Asset Quality and Allowance for Loan Losses.” Net interest income is affected by various factors, among which are the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned and paid on those assets and liabilities. Table 1 provides an analysis of average volumes, yields and rates and net interest income on a tax-equivalent basis for the three years ended December 31, 2005, 2004 and 2003. Tax-exempt income has been adjusted to a tax equivalent basis.

Average Balances and Net Interest Income Analysis

[TABLE 1]

Fully taxable equivalent basis¹ (In thousands)


	2005								2004								2003
				Interest								Interest								Interest
	Average			Income/		Average			Average			Income/		Average			Average			Income/		Average
	Balance			Expense		Yield/Rate			Balance			Expense		Yield/Rate			Balance			Expense		Yield/Rate

Earning assets:
Loans and leases receivable²	$	752,420		$	54,568		7.25	%	$	689,034		$	44,137		6.41	%	$	664,155		$	44,837		6.75	%
Taxable securities		93,400			3,610		3.87			88,693			3,285		3.70			97,647			3,960		4.06
Tax exempt securities		30,927			1,939		6.27			31,437			2,120		6.74			31,849			2,289		7.19
Federal Home Loan Bank		5,597			220		3.93			3,996			144		3.60			3,101			114		3.68
Interest-bearing bank balances		2,107			120		5.70			2,232			32		1.43			4,349			45		1.03
Federal funds sold		16,213			521		3.21			18,741			241		1.29			23,135			253		1.09


Total earning assets		900,664			60,978		6.77			834,133			49,959		5.99			824,236			51,498		6.25
Non-earning assets:
Cash and due from banks		37,958								36,765								36,120
Premises and equipment		18,128								16,634								14,381
Other assets		15,486								12,202								11,276
Allowance for loan losses		(8,348	)							(8,157	)							(7,494	)


Total assets	$	963,888		$	60,978				$	891,577		$	49,959				$	878,519		$	51,498


Interest-bearing liabilities:
Savings and time deposits	$	666,952		$	13,120		1.97	%	$	629,425		$	7,022		1.12	%	$	635,502		$	8,048		1.27	%
Securities sold under agreements to repurchase		1,313			12		0.91			1,300			10		0.77			1,564			13		0.83
Borrowings from Federal Home Loan Bank		84,345			3,594		4.26			77,787			3,335		4.29			60,828			3,116		5.12


Total interest-bearing liabilities		752,610			16,726		2.22			708,512			10,367		1.46			697,894			11,177		1.60
Other liabilities and shareholders’ equity:
Demand deposits		113,610								87,784								86,221
Other liabilities		5,769								4,746								5,568
Shareholders’ equity		91,899								90,535								88,836


Total liabilities and shareholders’ equity	$	963,888		$	16,726				$	891,577		$	10,367				$	878,519		$	11,177


Net interest income and net interest margin³				$	44,252		4.91	%				$	39,592		4.75	%				$	40,321		4.89	%


Interest rate spread⁴							4.55	%							4.53	%							4.65	%


¹		Income related to securities exempt from federal income taxes is stated on a fully taxable-equivalent basis, assuming a federal income tax rate of 34%, and is then reduced by the non-deductible portion of interest expense.

²		The average loans and leases receivable balances include non-accruing loans. Loan fees of $1,963, $2,411 and $3,805 for 2005, 2004 and 2003, respectively, are included in interest income.

³		Net interest margin is computed by dividing net interest income by average earning assets.

⁴		Earning assets yield minus interest-bearing liability rate.

Net interest income for 2005, on a tax-equivalent basis, increased $4.660 million or 11.8% compared to an decrease of $729,000 or 1.8% for 2004. This increase was due to an improvement in the net interest margin as well as growth in earning assets.

On a tax-equivalent basis, the net interest margin for 2005 increased to 4.91% compared to 4.75% for 2004 and 4.89% for 2003. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The Federal Reserve increased interest rates eight times in 2005 after five consecutive increases in 2004 and one reduction in interest rates in 2003. With the significant increase in deposits the bank was able to fund the increased loan demand at a lower rate than in 2004 when it relied more heavily on borrowed funds. The net interest margin increased 16 basis points in 2005 after a decline of 14 basis points in 2004 and a gain of three basis points in 2003. In 2005, the average yield on earning assets increased by 78 basis points while the average rate on interest-bearing liabilities increased at a slower rate of 76 basis points. This resulted in an increase of the interest rate spread in 2005 of 2 basis points compared to a 12 basis point reduction in 2004 and a 12 basis point gain in 2003.

Average earning assets in 2005 increased $66.531 million or 8.0% compared to $9.897 million or 1.2% in 2004. Interest-bearing liabilities for 2005 increased $44.098 million or 6.2% compared to $10.618 million or 1.5% for 2004. A more detailed discussion of the volume and rate variance is provided under the sections of “Earning Assets” and “Interest-Bearing Liabilities.”

Earning Assets

Volume and rate variance analysis distinguishes between the changes in average outstanding balances of interest-earning assets and interest-bearing liabilities (volume variance) and changes in average interest rates (rate variance). A detailed analysis has been provided in Table 2 shown below. Any changes attributable to both volume and rate have been allocated proportionately.

Volume and Rate Variance Analysis
[TABLE 2]


				2005									2004
	Volume			Rate			Total			Volume			Rate			Total
Fully taxable equivalent basis¹ (In thousands)	Variance²			Variance²			Variance			Variance²			Variance²			Variance

Interest income:
Loans receivable	$	4,302		$	6,129		$	10,431		$	1,628		$	(2,328	)	$	(700	)
Taxable investment securities		174			151			325			(343	)		(332	)		(675	)
Tax exempt investment securities		(34	)		(147	)		(181	)		(29	)		(140	)		(169	)
Federal Home Loan Bank		62			14			76			33			(3	)		30
Interest-bearing bank balances		(2	)		90			88			(27	)		14			(13	)
Federal funds sold		(37	)		317			280			(53	)		41			(12	)

Total interest income		4,465			6,554			11,019			1,209			(2,748	)		(1,539	)


Interest expense:
Savings and time deposits		444			5,654			6,098			(77	)		(949	)		(1,026	)
Securities sold under agreements to repurchase		—			2			2			(2	)		(1	)		(3	)
Borrowings from Federal Home Loan Bank		282			(23	)		259			777			(558	)		219

Total interest expense		726			5,633			6,359			698			(1,508	)		(810	)


Increase (decrease) in net interest income	$	3,739		$	921		$	4,660		$	511		$	(1,240	)	$	(729	)


¹		Income related to securities exempt from federal income taxes is stated on a fully taxable-equivalent basis, assuming a federal income tax rate of 34%, and is then reduced by the non-deductible portion of interest expense.

²		The volume/rate variance for each category has been allocated on a consistent basis between rate and volume variances, based on the percentage of rate, or volume, variance to the sum of the two absolute variances.

In 2005, the average balance of the loan portfolio increased $63.386 million or 9.2% compared to an increase of $24.879 million or 3.7% in 2004. Loan growth remained strong for the majority of 2005, slowing some in the fourth quarter of the year. As shown in Table 2, both the loan portfolio’s volume and rate variance were strong for 2005. The 2005 gain in the average balance of the loan portfolio produced a positive volume variance of $4.302 million, while the increase in the average yield from the previous year resulted in a positive rate variance of $6.129 million. The total variance of loans receivable for 2005 was a positive $10.431 million. The average yield on loan receivables increased 84 basis points in 2005 compared to a decline of 34 basis points in 2004.

The average balance of the total investment securities portfolio was $124.327 million in 2005 compared to $120.130 million in 2004. Funds invested in securities stayed fairly steady throughout 2005. Investment securities held-to-maturity at December 31, 2005 were $27.427 million compared to $28.539 million at December 31, 2004. The market values of investment securities available-for-sale at December 31, 2005 were $100.732 million compared to $100.655 million December 31, 2004. The average balance of the taxable investment securities portfolio increased $4.707 million in 2005 resulting in a positive volume variance of $174,000. Yields on the portfolio increased 17 basis points in 2005 producing a positive rate variance of $151,000, resulting in a total positive variance of $325,000. The average balance of the tax-exempt securities portfolio in 2005 declined $510,000 or 1.6% from 2004 levels and yields declined 47 basis points. The decline in the average balance of this portfolio produced a negative volume variance of $34,000 while the decrease in yields produced a negative rate variance of $147,000. The result for 2005 was a total variance of negative $181,000.

On average, funds maintained with the Federal Home Loan Bank increased $1.601 million or 40.1% in 2005 producing a positive volume variance of $62,000, while an increase of 33 basis points in the average yield resulted in a positive rate variance of $14,000 and a total variance of positive $76,000.

In 2005, the average balance of overnight investments in securities purchased under resale agreements declined by $2.528 million or 13.5%. The volume variance produced by this decline was a negative $37,000. Yields on these overnight investments increased 192 basis points in 2005 producing a positive rate variance of $317,000 and a resulting total positive variance of $280,000.

Interest Sensitivity Analysis ¹

[TABLE 3]


	December 31, 2005
									Total
	1-90			91-180			181-365		Within		1-5		Over
	Day			Day			Day		One		Year		5-year
(In thousands, except ratios)	Sensitive			Sensitive			Sensitive		Year		Sensitive		Sensitive		Total

Interest-earning assets:
Loans, net of unearned income	$	326,645		$	26,868		$	51,029	$	404,542	$	161,166	$	189,690	$	755,398
U.S. government agencies obligations		3,993			2,006			7,923		13,922		62,114		17,998		94,034
Obligations of states and political subdivisions		(128	)		1,780			13		1,665		3,666		24,580		29,911
Investment in Federal Home Loan Bank		4,214			—			—		4,214		—		—		4,214
Interest-bearing bank balances		1,385			—			—		1,385		—		—		1,385
Federal funds sold		16,355			—			—		16,355		—		—		16,355

Total interest-earning assets	$	352,464		$	30,654		$	58,965	$	442,083	$	226,946	$	232,268	$	901,297


Interest-bearing liabilities:
N.O.W account deposits²	$	30,506		$	—		$	—	$	30,506	$	112,474	$	—	$	142,980
Money market deposits²		25,075			—			—		25,075		207,800		—		232,875
Regular savings deposits²		4,149			—			—		4,149		29,924		—		34,073
Time deposits		119,138			90,432			39,427		248,997		31,733		—		280,730
Securities sold under agreements to repurchase		1,657			—			—		1,657		—		—		1,657
Borrowing from Federal Home Loan Bank		10,000			10,000			5,000		25,000				28,000		53,000

Total interest-bearing liabilities	$	190,525		$	100,432		$	44,427	$	335,384	$	381,931	$	28,000	$	745,315

Interest sensitivity gap	$	161,939		$	(69,778	)	$	14,538	$	106,699
Ratio of interest-sensitive assets/ interest-sensitive liabilities		1.85			(0.31	)		1.33		1.32


¹		Interest sensitivity is computed using assets and liabilities having interest rates that can be adjusted during the period indicated.

²		Maturity of deposits without a contractual maturity date was computed using an asset/liability simulation model.

Summary of Investment Securities Portfolio
[TABLE 4]


	December 31, 2005				December 31, 2004				December 31, 2003
	Amortized		Market		Amortized		Market		Amortized		Market
(In thousands)	Cost		Value		Cost		Value		Cost		Value

U.S. government agencies obligations	$	96,040	$	94,034	$	91,685	$	91,591	$	86,020	$	87,628
Obligations of state and political subdivisions		30,039		30,088		31,640		32,697		29,929		31,596
Federal Home Loan Bank		4,214		4,214		6,009		6,009		3,500		3,500

Total securities	$	130,293	$	128,336	$	129,334	$	130,297	$	119,449	$	122,724

Investment Securities Portfolio Maturity Schedule
[TABLE 5]


	December 31, 2005
			Weighted
	Amortized		Average
(Dollars in thousands)	Cost		Yield¹

U. S. government agencies obligations:
Within one year	$	14,002		3.38	%
One to five years		82,038		3.89
Five to ten years		—		—


Total		96,040		3.82


Obligations of states and political subdivisions:
Within one year		1,769		6.97
One to five years		5,072		6.91
Five to ten years		14,876		6.30
After ten years		8,322		6.03


Total		30,039		6.37


Federal Home Loan Bank		4,214		4.60


Total securities	$	130,293		4.43


¹		Income related to securities exempt from federal income taxes is stated on a fully taxable-equivalent basis, assuming a federal income tax rate of 34%, and is then reduced by the non-deductible portion of interest expense.

Interest Bearing Liabilities

The interest-bearing liabilities average balance in 2005 increased $44.098 million or 6.2% compared to $10.618 million or 1.5% in 2004. The average rate paid on interest-bearing liabilities in 2005 increased 76 basis points compared to a decline of 14 basis points in 2004 and a decline of 65 basis points in 2003.

The majority of the interest-bearing liabilities portfolio is comprised of savings and time deposit accounts. In 2005, these average deposits increased $37.527 million or 6.0% compared to a decrease of $6.077 million or 1.0% in 2004. The average rate paid on these deposits increased 85 basis points in 2005 compared to a decrease of 15 basis points in 2004 and a decrease of 69 basis points in 2003. The increase in savings and time deposits in 2005 produced a positive volume variance of $444,000, while the increase in interest rates resulted in a positive rate variance of $5.654 million. Total variance for savings and time deposits in 2005 was a positive $6.098 million.

Average Total Deposits
[TABLE 6]


	2005					2004					2003
	Average		Average			Average		Average			Average		Average			2005			2004
(In thousands)	Balance		Rate			Balance		Rate			Balance		Rate			Change			Change

Demand deposits	$	113,610				$	87,784				$	86,221					29.4	%		1.8	%
N.O.W account deposits		143,257		0.46	%		153,875		0.39	%		154,189		0.50	%		(6.9	)		(0.2	)
Money market deposits		228,947		2.03			224,218		0.99			217,057		1.00			2.1			3.3
Regular savings deposits		36,264		0.29			37,826		0.25			36,629		0.34			(4.1	)		3.3
Time deposits		258,484		2.98			213,506		1.93			227,627		2.18			21.1			(6.2	)


Total deposits¹	$	780,562				$	717,209				$	721,723					8.8			(0.6	)


	December 31, 2005
			Over 3		Over 6
	3 Months		Through		Through		Over 12
	Or Less		6 months		12 months		Months		Total

Time deposit maturity schedule:²
Time deposits of $100,000 or more	$	72,726	$	49,941	$	10,158	$	7,205	$	140,030


1		The bank has no deposits in foreign offices.

2		The bank has no other time deposits of $100,000 or more issued by domestic offices.

Core deposit growth in 2005 was most notably in demand deposits which increased 29.4% for the year after a modest gain of 1.8% in 2004. Money market deposits grew slightly less in 2005 with an increase of 2.1% compared to a 3.3% increase in 2004. During 2005 NOW account deposits declined 6.9% and savings deposits declined 4.1% as consumers sought higher rates in CD deposits. Time deposits for 2005 increased 21.1% as interest rates rose following a decline in time deposits in 2004 of 6.2%.

Table 6, Average Total Deposits, shown above, contains the breakdown of average deposits for the years 2005, 2004 and 2003, respectively. Overall average total deposits increased $63.353 million or 8.8% in 2005 compared to 2004 and average core deposits increased $18.375 million or 3.6% in 2005. The change in average total deposits from 2005 compared to 2004 was primarily due to average time deposits increasing $44.978 million or 2.1% compared to the prior year.

Funds borrowed from the Federal Home Loan Bank averaged $84.345 million in 2005, an increase of $6.558 million or 8.4% over 2004. In general, during 2005 deposit growth outpaced loan growth toward year end resulting in the Bank being able to pay back a large portion of its overnight borrowed funds position. As shown in Table 2, Volume and Rate Variance Analysis, this resulted in a positive volume variance of only $282,000, while rates paid on these borrowings decreased 3 basis points producing a negative rate variance of $23,000. The total variance for 2005 was a positive $259,000.

Risk Management

It is the design of risk management to ensure long-range profitability performance and minimize risk, adhere to proper liquidity and maintain sound capital. To meet these objectives, the process of asset/liability management monitors the exposure to interest rate risk, balance sheet trends, pricing policies and liquidity position. Reports regarding Credit, Asset/Liability, Market, and Operational Risks are provided to the Bank’s Board of Directors.

Risk management practices include key elements such as independent checks and balances, formal authority limits, policies and procedures, and portfolio management performed by experienced personnel.

Interest Rate Risk Management

The primary purpose of managing interest rate risk is to minimize the volatility to earnings from changes in interest rates and preserve the value of Bancshares’ capital. Interest rate movements and balance sheet composition affect profitability and performance. Management’s responsibility for both liquidity and interest sensitivity reside with a designated Asset/Liability Management Committee (“ALCO”). As a part of its decision-making process, ALCO evaluates market conditions, interest rate trends and the economic environment. Based upon its view of existing and expected market conditions, ALCO adopts balance sheet strategies intended to optimize net interest income to the extent possible while minimizing the risk associated with unanticipated changes in interest rates.

Bancshares also uses simulation analysis to compute net interest income at risk under a variety of market interest rate scenarios to identify interest rate risk exposures. This simulation, which considers forecasted balance sheet changes, deposit mix, pricing impacts, and other changes in the net interest spread, provides an estimate of the annual net interest income at risk for given changes in interest rates. The results help Bancshares develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a number of assumptions and judgments. In this case, the assumptions relate primarily to loan and deposit growth and interest rates. Management believes the assumptions used in its simulations are reasonable. Nevertheless, simulation modeling provides only a sophisticated estimate, not a precise calculation of exposure to changes in interest rates.

The simulation models used to analyze Bancshares’ net interest income create various at-risk scenarios looking at increases and/or decreases in interest rates from an instantaneous movement. The models are continuously updated to incorporate management action and on-going assumptions. A 200 basis instantaneous increase or decrease in interest rates over a one-year period is a key scenario analyzed. Based on the rate sensitivity position on December 31, 2005, net interest income exposure over the next 12 months to an instantaneous increase in interest rates of 200 basis points is estimated to be approximately five percent of base net interest income which is well inside the Bank’s maximum tolerable decline of 15%. These scenarios are used as one estimate of risk, and do not necessarily represent management’s current view of future interest rates or market developments. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions, and management’s strategies, among other factors, including those presented in the Risk Factors and Forward-Looking Statements sections of this report.

Other than the impact related to the immediate change in value of balance sheet accounts, such as mortgage servicing rights, these simulation models exclude the dynamics related to how fee income and noninterest expense may be affected by actual changes in interest rates or expectations of changes. Mortgage banking revenue, which is generated from originating, selling and servicing residential mortgage loans, is highly sensitive to changes in interest rates due to the direct effect changes in interest rates have on loan demand. In general, low or declining interest rates typically lead to increased origination and sales income but potentially lower servicing-related income due to the impact of higher loan prepayments on the value of mortgage servicing assets. Conversely, high or rising interest rates typically reduce mortgage loan demand and hence origination and sales income while servicing-related income may rise due to lower prepayments. The effect on origination and sales income to total earnings is more significant than servicing related income.

Asset/Liability management includes analyzing interest sensitivity, which pertains to possible changes in the rates of certain assets and liabilities before their scheduled maturities. The ALCO process seeks to match maturities and re-pricing opportunities of interest-sensitive assets and liabilities to minimize risk of interest rate movements. Full discussion of the effects of these respective portfolios on the Bank’s performance for 2005 can be found under the headings of Earning Assets and Interest-Bearing Liabilities. The interest sensitivity gap schedule analyzing the interest rate risk as of December 31, 2005, is presented in Table 3, Interest Sensitivity Analysis. Within this analysis, projected runoff of deposits that do not have a contractual maturity date were computed using the Bank’s simulation

model. As interest sensitivity is continually changing, Table 3 reflects the Bank’s balance sheet position at one point in time and is not necessarily indicative of its position on other dates. On December 31, 2005, the one-year cumulative interest sensitivity gap was a positive $106.699 million for a ratio of interest-sensitive assets to interest-sensitive liabilities of 1.32.

Bancshares began using derivatives in the fourth quarter of 2005. The derivatives are being used in conjunction with the Bank’s sale of Indexed Certificates of Deposits (ICD’s). ICDs pay no periodic interest payments. Rather under the ICD’s interest, if any, is paid at maturity and is calculated based on the positive price movements, if any, of the Dow Jones Industrial Average^SM (DJIA) over the entire term of the ICD. The goal is to curtail the interest rate risk of the ICD to the Bank by engaging in “perfectly matched” hedges or option contracts tied to the underlying index with creditworthy hedge providers who will support the inherent performance of the ICD at maturity of the issuances.

This approach will mitigate any exposure to unintended market risk and essentially fix Bancshares’ cost of funds at inception for the term of the ICD without concern over the performance of the DJIA. Bancshares has also looked at the risk associated with any default in payment by the hedge providers. This risk is mitigated by all hedge providers having investment grade ratings. If the hedge providers fall below an investment grade rating collateral must be posted. Bancshares will also be using multiple hedge providers to spread the risk and providers are all publicly traded and have been in operation over 60 years.

Liquidity Risk Management

Liquidity risk is the risk of being unable to fund assets with liabilities of the appropriate duration and interest rate, as well as the risk of not being able to meet unexpected cash needs. The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, other creditors and borrowers, and the requirements of ongoing operations. This objective is met by maintaining liquid assets in the form of trading securities and securities available for sale, maintaining sufficient unused borrowing capacity, growing core deposits, and the repayment of loans and the capability to sell loans. The Bank’s Funding Committee is responsible for managing these needs by taking into account the marketability of assets; the sources, stability and availability of funding; and the level of unfunded commitments. Funds are available from a number of sources. The principal sources include cash and cash equivalents, maturing investments and loans, core deposits and the securities available for sale portfolio. Correspondent relationships are also maintained with several large banks in order to have access to federal funds purchases as a secondary source of liquidity. Traditionally, the Bank has been a seller of excess investable funds in the federal funds market and uses these funds as a part of its liquidity management.

The Bank also has available lines of credit maintained with the Federal Home Loan Bank of Atlanta (“FHLB”), which can be used for funding and/or liquidity needs. This credit is collateralized by a blanket lien on qualifying loans secured by first mortgages on 1-4 family residences as well as qualified multi-family and home equity lines. At December 31, 2005, the Bank had an available line of credit with the FHLB totaling $189 million with $93 million outstanding and $53 million funded. While traditionally the FHLB is used for longer-term borrowings, it can be used for short-term liquidity needs. At year-end, overnight borrowings from the FHLB totaled $5 million. The Bank has two $10 million and a $20 million irrevocable letter of credit with the FHLB that are used in lieu of securities to pledge against public deposits.

The Bank has federal funds lines of credit facilities established with three other banks that total $40 million, as well as access to the Federal Reserve Bank of Richmond’s discount window. These lines are intended for short-term borrowings and are subject to restrictions limiting the frequency and term of advances. At December 31, 2005, there were no borrowings from these lines of credit. Another source of liquidity is the Bank’s securities available for sale portfolio. In addition, the Bank has access to retail brokered certificates of deposit, dealer and commercial customer repurchase agreements and internet certificates of deposit. The Bank can seek additional liquidity through the sale of loans.

Net cash provided by operating activities, a primary source of liquidity, was $11.516 million in 2005 compared to $16.480 million in 2004 and $8.530 million in 2003. The decrease in net cash provided by operating activities in 2005 was primarily attributable to the increase in other assets. This was in large part due to the pre-payment of yearly service contracts related to the increase in technology efficiencies due to the Impact ’05 initiatives such as the implementation of an Enterprise Relationship Management system, a new financial management reporting package and others. The increase in net cash provided by operating activities in 2004 was primarily attributable to the decrease in mortgage loans held for sale. Details of cash flows for the years 2005, 2004 and 2003 are provided in the Consolidated Statements of Cash Flows located in Item 8, which begins on page 37 below.

Off-Balance Sheet Transactions

Certain financial transactions are entered into by the Bank in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. The off-balance sheet transactions as of December 31, 2005, and December 31, 2004, were commitments to extend credit and standby letters of credit. The Bank does not have any ownership interest in any off-balance sheet subsidiaries or special purpose entities.

Commitments
[TABLE 7]


(In thousands)	2005		2004

Loan commitments	$	200,404	$	189,626
Credit card lines		20,980		18,847
Standby letters of credit		5,831		4,980

Total unused commitments	$	227,215	$	213,453

Commitments to extend credit to customers represent legally binding agreements with fixed expiration dates. These include both loan commitments and credit card lines. Since many of the commitments expire without being funded, the commitment amounts do not necessarily represent liquidity requirements.

Standby letters of credit are conditional commitments guaranteeing the performance of a customer to a third party. Those guarantees are primarily issued to customers as a part of their normal course of business. Funding for draws from standby letters of credit would be funded through normal sources of deposit growth or borrowings and would not have a material impact on liquidity.

In the normal course of business, the Bank has executed irrevocable letters of credit through the FHLB. These letters of credit are issued to secure public deposits placed with the Bank by one or more public depositors. As of December 31, 2005, the Bank has two $10 million and a $20 million irrevocable letter of credit with the FHLB that are used in lieu of securities to pledge against public deposits. As of December 31, 2004, two irrevocable letters of credit were extended, one in the amount of $10 million and one in the amount of $20 million both with terms of ten years. The securing of public deposits through the use of irrevocable letters of credit is a part of the Bank’s overall liquidity management.

Contractual Obligations

The following disclosure shows the contractual obligations that the Bank had outstanding at December 31, 2005. At December 31, 2005 the Bank had no outstanding capital lease obligations, purchase obligations, or other long-term obligations reflected on Bancshares’ balance sheet under Generally Accepted Accounting Principles.

Contractual Obligations
[TABLE 8]


	Payments due by period
			Less						More
			Than		1-3		3-5		Than
(In thousands)	Total		1 Year		Years		Years		5 Years

Long-Term Debt Obligations	$	53,000	$	25,000	$	—	$	18,000	$	10,000
Operating Lease Obligations		1,274		502		346		426		—

Total	$	54,274	$	25,502	$	346	$	18,426	$	10,000

Capital Resources and Shareholders’ Equity

Shareholders’ equity at December 31, 2005, was $91.829 million compared to $90.742 million at December 31, 2004, an increase of 1.2%. Average shareholders’ equity as a percentage of average total assets at December 31, 2005, was 9.53% compared to 10.15% at December 31, 2004.

Regulatory guidelines require minimum levels of capital based on a risk weighting of each asset category and off-balance sheet contingencies. Regulatory agencies divide capital into Tier 1 or core capital and total capital. Tier 1 capital, as defined by regulatory agencies, consists primarily of common shareholders’ equity less goodwill and certain other intangible assets. Total capital consists of Tier 1 capital plus the allowable portion of the allowance for loan losses and certain long-term debt. Additional regulatory capital measures include the Tier 1 leverage ratio. Tier 1 leverage ratio is defined as Tier 1 capital divided by average total assets less goodwill and certain other intangibles and has a regulatory minimum of 3.0%, with most institutions required to maintain a ratio of at least 4.0% to 5.0%, depending primarily upon risk profiles. In addition to the aforementioned risk-based capital requirements, the Bank is subject to a leverage capital requirement, requiring a minimum ratio of Tier 1 Capital (as defined previously) to total adjusted average assets of 3.0% to 5.0%. The Bank’s capital requirements are summarized in Table 9 below, Capital Ratios.

Capital Ratios
[TABLE 9]


						Risk-Based Capital
	Leverage Capital					Tier 1 Capital					Total Capital
(In thousands)	Amount		Percent¹			Amount		Percent²			Amount		Percent²

Actual	$	92,648		9.50	%	$	92,648		11.48	%	$	101,088		12.53	%
Required		29,259		3.00			32,272		4.00			64,545		8.00
Excess		63,389		6.50			60,376		7.48			36,543		4.53


1		Percentage of total adjusted average assets. The Federal Reserve Board’s minimum leverage ratio requirement is 3.0% to 5.0%, depending on the institutions composite rating as determined by its regulators. The Federal Reserve Board has not advised the Bank of any specific requirement applicable to it.

2		Percentage of risk-weighted assets.

The number of beneficial shareholders holding Bancshares stock totaled approximately 5,227 at December 31, 2005. At December 31, 2005, participants in Bancshares’ dividend reinvestment plan total 1,567, representing 30.0% of total beneficial shareholders, and hold a total of 1,714,377 shares.

Noninterest Income

In 2005 noninterest income declined $271,000 or 1.9% compared to a decline of $454,000 or 3.1% in 2004. The decline in noninterest income for 2005 was due to the noninterest income in 2004 including a $292,000 nonrecurring

gain on the sale of real estate. Excluding that gain, noninterest income would have been essentially unchanged compared to 2004. The decrease in fee income from service charges on deposit accounts for 2005 was $109,000 or 1.6% compared to a decrease of $56,000 or .8% for 2004. This has continued to decrease due to more customers paying their bills over the internet and not using checks as much as in the past. Gain on sale of mortgage loans for 2005 increased $24,000 or 4.5% compared to a decrease of $816,000 or 60.6% for 2004. In 2004 the decrease was due to the decline in mortgage activity due to the increase in rates. For the change in Other Operating Income see Table 10, Other Operating Income and Expenses, presented below.

Noninterest Expense

In 2005 noninterest expense increased $2.083 million or 5.5% compared to $1.253 million or 3.4% in 2004. Personnel expense in 2005, consisting of employee salaries and benefits, increased $1.2 million or 5.8% compared to a decrease of $389,000 or 1.9% in 2004. The increase in personnel expense in 2005 is largely due to the Bank paying out management incentive compensation of approximately $600,000 for 2005. The Bank did not meet its strategic goals in 2004 and therefore did not pay this management incentive compensation during 2004. The decrease in personnel expense in 2004 is attributable to reduced mortgage production incentives paid as the result of slower mortgage loan financing activities and a modest reduction in staff. The staff reductions resulted from consolidation of three offices in the Lexington community and improved efficiencies in bank operations. Full-time equivalent employees for Bancshares totaled 417 at year-end 2005 compared to 420 at year-end 2004 and 429 at year-end 2003. Occupancy expense for 2005 increased $88,000 or 4.9% compared to increases of $125,000 or 7.6% for 2004. Equipment depreciation and maintenance expense decreased $33,000 or 1.4% in 2005 compared to $227,000 or 11.0% in 2004. The increase in occupancy expense is a normal gain experienced as the result of growth.

For the changes in other operating expenses, please see Table 10, Other Operating Income and Expenses, below.

Other Operating Income and Expenses
[TABLE 10]


	Years Ended December 31						Variance
(Dollars in thousands)	2005		2004		2003		2005			2004

Other operating income:
Bankcard income	$	2,530	$	2,531	$	2,370		—	%		6.8	%
Fee income ⁽¹⁾		1,817		1,527		1,283		19.0			19.0
Investment Services commissions ⁽²⁾		984		1,297		1,499		(24.1	)		(13.5	)
Insurance commissions		243		231		227		5.2			1.8
Trust income ⁽³⁾		658		618		537		6.5			15.1
Other income ⁽⁴⁾		190		404		274		(53.0	)		47.4

	$	6,422	$	6,608	$	6,190		(2.8	)		6.8


Other operating expenses:
Advertising⁽⁵⁾	$	757	$	851	$	858		(11.0	)%		(0.8	)%
Automated services ⁽⁶⁾		2,974		2,479		2,054		20.0			20.7
Bankcard expense		1,927		1,836		1,855		5.0			(1.0	)
Legal and professional fees ⁽⁷⁾		2,092		2,052		1,442		1.9			42.3
Postage		796		764		722		4.2			5.8
Stationery, printing and supplies ⁽⁸⁾		678		901		848		(24.8	)		6.3
OREO expense ⁽⁹⁾		698		152		118		359.2			28.8
Other expenses		4,292		4,323		4,171		(0.7	)		3.6

	$	14,214	$	13,358	$	12,068		6.4			10.7


⁽¹⁾		The increase in both 2005 and 2004 is primarily due to increased use of debit card purchases which results in merchant fees collected by the Bank.

⁽²⁾		The decreases for 2005 and 2004 are due to a decreased volume of Investment Services products sold.

⁽³⁾		Assets under management in the trust department totaled $104,117,000, $103,836,000 and $96,382,000, respectively for 2005, 2004 and 2003.

⁽⁴⁾		The increase from 2003 to 2004 and the decrease from 2004 to 2005 is due to a $292,000 nonrecurring gain on the sale of real estate in 2004.

⁽⁵⁾		The decrease in advertising for 2005 is primarily due to a large deposit campaign that was run in 2004 and not in 2005 and branch opening costs in 2004 for the Jamestown opening.

⁽⁶⁾		This increase for both 2004 and 2005 is due to Impact ’05 initiatives put in place to improve the Bank’s performance in operations, retail delivery systems and technology. These include enhancements to our data processing systems and the renewal and license fee costs associated with these, an upgrade in our communication lines to the branches and contingency planning.

⁽⁷⁾		The increase during 2004 was due to $415,000 in SOX related expenses incurred. We did have a decrease in legal fees in 2005 of approximately $245,000 but this decrease was offset mainly by an increase in consulting expenses of $100,000 due to training initiatives, an increase in insurance and bonding premiums of $25,000, an increase in professional fees of $20,000, an increase in state banking assessment fees of $15,000 and an increase in CPA expenses of $27,000.

⁽⁸⁾		The decrease in 2005 is due to the outsourcing of the Bank’s supply room starting in the second quarter of 2005.

⁽⁹⁾		The increase in 2005 is due to the materials and professional fees to remediate the condominiums discussed in “Asset Quality and Allowance for Loan Losses” on page 32 of this report.

Asset Quality and Allowance for Loan Losses

Summary of Loan Portfolio
[TABLE 11]


(In thousands)	2005		2004		2003		2002		2001

Commercial, financial and agricultural	$	288,241	$	281,909	$	275,474	$	269,053	$	212,731
Real estate – construction		38,179		50,125		44,618		36,319		35,164
Real estate – mortgage		354,322		314,822		283,134		276,065		271,375
Installment loans to individuals		72,336		62,987		56,842		56,223		59,402
Lease financing		403		447		972		486		535
Other		1,917		1,895		2,406		7,402		9,157

Total loans, net of unearned income	$	755,398	$	712,185	$	663,446	$	645,548	$	588,364

The bank has no foreign loan activity.

Maturities and Sensitivities of Loans to Changes in Interest Rates


	December 31, 2005
	Commercial,
	financial		Real estate –
(In thousands)	and agricultural		construction		Total

Due in 1 year or less	$	112,458	$	38,179	$	150,637
Due after 1 year through 5 years:
Fixed interest rates		47,208		—		47,208
Floating interest rates		117,567		—		117,567
Due after 5 years:
Fixed interest rates		6,226		—		6,226
Floating interest rates		3,617		—		3,617

Total	$	287,076	$	38,179	$	325,255

At December 31, 2005, the allowance for loan losses was $8.440 million or 1.12% of loans outstanding compared to $7.962 million or 1.12% of loans outstanding at December 31, 2004, and $7.846 million or 1.18% of loans outstanding at December 31, 2003. Net charge-offs for 2005 were $2.741 million or 0.36% of average loans outstanding compared to 2004 net charge-offs of $2.901 million or 0.42% of average loans outstanding and 2003 net charge-offs of $4.653 million or 0.70% of average loans outstanding. The additional charge-offs in 2003 were due primarily to the two problem credits that were written off in the fourth quarter. Adequate provisions and allowances for loan loss reserves are based on numerous factors including growth of the loan portfolio, delinquencies, net charge-offs, nonperforming loans and collateral values. Additional information regarding the allowance for loan losses is contained in Table 12, Analysis of Allowance for Loan Losses, below.

Analysis of Allowance for Loan Losses
[TABLE 12]


	As of or for the Years Ended
							December 31
(In thousands, except ratios)	2005			2004			2003			2002			2001

Average amount of loans outstanding	$	752,420		$	689,034		$	664,155		$	607,620		$	558,821
Amount of loans outstanding		755,398			712,185			663,446			645,548			588,364
Allowance of loan losses:
Balance on January 1	$	7,962		$	7,846		$	7,284		$	6,440		$	5,959
Loans charged off:
Secured by real estate		267			45			189			—			1
Commercial and industrial		1,324			2,436			3,925			943			730
Installment		1,414			799			522			633			859
Credit Card		234			366			375			357			302

Total charge-offs		3,239			3,646			5,011			1,933			1,892

Recoveries of loans previously charged off:
Secured by real estate		66			49			10			—			15
Commercial and industrial		256			250			153			127			250
Installment		134			366			146			108			123
Credit Card		42			80			49			62			123

Total recoveries		498			745			358			297			511

Net loans charged off		2,741			2,901			4,653			1,636			1,381

Provision for loan losses		3,219			3,017			5,215			2,480			1,862

Balance on December 31	$	8,440		$	7,962		$	7,846		$	7,284		$	6,440

Ratio of net charge-offs of loans to average loans outstanding during the year		0.36	%		0.42	%		0.70	%		0.27	%		0.25	%

The provision for loan losses charged to operations in 2005 totaled $3.219 million compared to $3.017 million in 2004 and $5.215 million in 2003. At December 31, 2005, the allowance for loan losses was 1.04 times nonperforming assets compared to 1.94 and 1.34 times at December 31, 2004 and 2003, respectively. Managements’ practice is to maintain the allowance for loan losses at a level sufficient to reflect the estimated probable incurred losses in the loan portfolio. Based on analysis of the current loan portfolio and levels of current problem assets and potential problem loans, management believes the allowance for loan losses to be adequate. In management’s judgment, the allocation of the allowance for loan losses for 2005, reflected in Table 14 below, Allocation of Allowance for Loan Losses, accurately reflects the inherent risks associated with each of the various lending categories.

Nonperforming Assets
[TABLE 13]


	December 31
(Dollars in thousands)	2005			2004			2003			2002			2001

Nonaccrual loans:
Secured by real estate	$	680		$	388		$	1,262		$	—		$	747
Commercial and industrial		234			297			492			272			188
Installment		15			—			—			—			—
Restructured loans		856			582			1,135			2,260			324
Other real estate acquired through foreclosed properties		4,391			1,531			1,742			2,111			880
Accruing loans which are contractually past due 90 days or more		1,911			1,313			1,184			2,354			2,412

Total nonperforming assets	$	8,087		$	4,111		$	5,815		$	6,997		$	4,551

Nonperforming assets to:
Loans outstanding at end of year		0.49	%		0.58	%		0.88	%		1.08	%		0.77	%
Total assets at end of year		0.38			0.45			0.67			0.82			0.55


	Year Ended December 31
	2005		2004		2003		2002		2001

Loss of interest income associated with nonperforming loans at December 31:
Interest income that would have been recorded in accordance with original terms	$	57	$	57	$	114	$	82	$	96
Less interest income actually recorded		—		—		—		—		18

Loss of interest income	$	57	$	57	$	114	$	82	$	78

Allocation of Allowance for Loan Losses
[TABLE 14]


	2005					2004					2003					2002					2001
			% Of					% Of					% Of					% Of					% Of
			Total					Total					Total					Total					Total
(Dollars in thousands)	Amount		Loans			Amount		Loans			Amount		Loans			Amount		Loans			Amount		Loans

Commercial, financial and agricultural	$	2,404		38.1	%	$	2,268		39.6	%	$	2,235		41.5	%	$	2,075		41.7	%	$	1,823		36.2	%
Real estate – construction		911		5.0			859		7.0			847		6.7			787		5.6			695		6.0
Real estate – mortgage		3,377		46.9			3,186		44.2			3,140		42.7			2,915		42.8			2,578		46.1
Installment loans to individuals		1,417		9.6			1,337		8.8			1,318		8.6			1,224		8.7			1,081		10.1
Lease financing		57		0.1			54		0.1			53		0.1			49		0.1			44		0.0
Other		156		0.3			147		0.3			145		0.4			134		1.1			119		1.6
Unallocated		118		0.0			111		0.0			108		0.0			100		0.0			100		0.0

Total	$	8,440		100.0	%	$	7,962		100.0	%	$	7,846		100.0	%	$	7,284		100.0	%	$	6,440		100.0	%

The allowance for loan losses has been allocated only on an approximate basis. The entire amount of the allowance is available to absorb losses occurring in any category. The allocation is not necessarily indicative of future losses.

Total nonperforming assets at December 31, 2005 were $8.087 million compared to $4.111 million at December 31, 2004 and $5.815 million at December 31, 2003 (see Table 13 above, Nonperforming Assets, for the breakdown).

Nonperforming assets are defined as nonaccrual loans, restructured loans, other real estate acquired through foreclosed properties and accruing loans ninety days or more past due. The accrual of interest is generally discontinued on all loans that become ninety days past due as to principal or interest unless collection of both principal and interest is assured by way of collateralization, guarantees or other security and the loan is considered to be in the process of collection.

The majority of the increase in the nonperforming assets during 2005 resulted from defaults on loans by one of the Bank’s long-term customers during the second quarter of 2005. The Bank made loans to this customer in connection

with a condominium project the customer was developing in Georgetown, South Carolina. The loans were secured by the residential condominium units in the building being developed by the customer. During the second quarter of 2005, the Bank acquired 18 residential condominium units by means of a deed-in-lieu of foreclosure. These 18 units, together with two others owned by third parties, are located on the second and third floors of a three-story building. The ground floor of the building has been developed into retail condominium units by another third party.

At the time of the Bank’s acquisition of the 18 condominium units, the defaulted loans had a $3.4 million principal balance due. After evaluating its potential net realizable value of these condominium units, the Bank took an immediate $400,000 charge against earnings and booked the remaining $3 million balance in other real estate owned.

After acquiring the condominium units, the Bank learned that many of the units had been damaged by water intrusion problems resulting from construction and design defects and storm damage. As a result, the Bank engaged experts to analyze and remediate the mold damage in several of its’ condominium units and the Bank believes the remediation is substantially complete within the 18 units it owns. The Bank has incurred expenses of approximately $680,000 as of December 31, 2005 ($800,000 as of February 28, 2006) in connection with its investigation and remediation related to these condominiums. Based on a report from one of its experts, the Bank believes the owner of the ground floor has not satisfactorily addressed the problems on the ground floor and this failure, if not addressed, could result in additional damage to the Bank’s units. The Bank continues to evaluate its alternatives, which include, but may not be limited to, seeking to immediately sell the Bank’s 18 condominium units individually or as a group or to take control of the entire project. At present, the Bank cannot predict which alternative it will elect nor can it determine with any accuracy the additional costs and expenses it will incur in connection with this project nor the potential amount it will realize upon its disposition of the project or the timeframe within which such disposition may occur.

Credit Risk Management

As a part of Credit Administration, management regularly reviews and grades its loan portfolio for purposes of determining asset quality and the need to make additional provisions for loan losses. The review process is performed both internally and externally, through the employment of independent credit review professionals. As part of the 2005 external credit review, a sampling was conducted of new small-business loans and commercial loans with loan amounts of $250,000 or more made since the last review. Samplings of existing commercial loans were also made pertaining to watch list credits, marginal credits, randomly selected loans by size, church loans, and loans by specific loan officers. Total internal and external loan review activity represented 51% of the average commercial loan portfolio.

The allowance for loan losses represents management’s estimate of an adequate amount to provide for the risk of future losses inherent in the loan portfolio. In its on-going analysis of the allowance for loan losses and its adequacy, management considers historic loan loss experience, economic risks associated with each of the lending categories, amount of past due and nonperforming loans, underlying collateral values securing loans, credit concentrations and other factors which might affect potential credit losses. The Bank is also subject to regulatory examinations and determinations as to the adequacy of its allowance for loan losses, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by the regulatory agencies.

There are, however, additional risks of future losses that cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy and factors affecting particular borrowers, management’s judgment as to the adequacy of the allowance for loan losses is necessarily approximate and imprecise. In its oversight of the credit review process, management has not identified any undue economic risks associated with the various lending categories, nor any significant credit concentrations within these categories.

With the exception of one credit discussed below, loans classified for regulatory purposes as loss, doubtful, substandard or special mention that have not been disclosed in Table 13, Nonperforming Assets, do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms. A borrower of the Bank, in the furniture industry, is currently in voluntary liquidation and as a result management has serious doubts following the completion of liquidation, the borrower will be able to comply with the loan repayment terms.

Income Taxes

Financial statement Note 10 provides a reconciliation between the amount of taxes computed using the statutory tax rate and the actual tax expense. The expense for income tax is recorded based on amounts payable, current and deferred. In 2005, the income tax expense was $4.865 million compared to $3.931 million in 2004 and $3.903 million in 2003. The effective tax rate for 2005 was 33.6% compared to 31.9% for 2004 and 31.3% for 2003. In 2003, Bancshares purchased an investment tax credit partnership interest through SunTrust Bank of Atlanta, Georgia. The partnership holds four projects within the State of North Carolina that qualify for North Carolina State historic and low-income housing tax credits. The purchase price of the partnership interest was $540,000 and is expected to yield $1.000 million in North Carolina tax credits over the years 2003 to 2009. Tax credit amounts were $185,000 for 2005 compared to $187,000 for 2004 and $131,000 for 2003.

Inflation

For financial institutions, the effects of inflation and governmental programs to control it tend to vary from non-bank companies. The impact is more likely to be felt by banking institutions in interest rates associated with earning assets and interest-bearing liabilities. Reduced inflation tends to improve interest margins associated with interest-bearing assets and liabilities. There has been no material effect from inflation on Bancshares’ revenues, income from continuing operations, or financial statements for Bancshares’ last three fiscal years.

Broad-ranged economic conditions such as inflation, and governmental efforts to spur economic growth, are difficult for individual companies to respond to effectively. Consistent long-term management is the key to dealing with such conditions. The objective of management in such times is to remain positioned for growth when the economy rebounds. Management seeks to do this through its long-range budget and profit-planning process.

Accounting and Regulatory Issues

In March 2004, the FASB issued Emerging Issues Task Force Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF Issue No. 03-1”), which provides new guidance for assessing impairment losses on debt and equity investments and includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF Issue No. 03-1; however, the disclosure requirements remain effective and have been adopted by Bancshares in these financial statements. Bancshares adopted the currently effective provisions of EITF Issue No. 03-1 with no resulting material effect on its financial position or operating results.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”), which is a revision of SFAS 123 and supersedes APB Opinion No. 25. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. In addition, compensation cost for the unvested portion of previously granted awards that remain outstanding on the effective date of SFAS 123R shall be recognized on or after the effective date, as the related services are rendered, based on the awards’ grant-date fair value as previously calculated for the pro-forma disclosure under SFAS 123. SFAS 123R is effective for all stock-

based awards granted on or after January 1, 2006 and the Bank has implemented SFAS 123R as of January 1, 2006 and will report it starting in the first quarter of 2006.

At the April 13, 2005 FASB Board meeting, the Board authorized the final drafting of certain amendments to Statement on Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”) regarding beneficial interests and servicing rights. On August 11, 2005 the Board issued three exposure drafts — “Accounting for Transfers of Financial Assets, Accounting for Servicing of Financial Assets and Accounting for Certain Hybrid Financial Instruments” — as proposed amendments to SFAS No. 140. Management is currently monitoring and evaluating the potential impact of these various amendments, including the proposed one-time irrevocable election to move servicing rights from a LOCOM (lower of cost or fair market value) to a fair value accounting basis, which management intends to adopt.

At the June 29, 2005 FASB Board meeting, the Board agreed to issue FSP FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which will replace the guidance previously set forth in EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. This FSP effectively eliminates the accounting guidance provided in EITF 03-1 in favor of existing impairment recognition guidance under SFAS No. 115, SAB No. 59, APB No. 18, and EITF Topic D-44. The FSP is for periods beginning after September 15, 2005, but its adoption is not expected to have a material impact on our consolidated financial statements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.

Bancshares’ market risk arises primarily from the interest rate risk inherent in its lending and deposit-taking activities. The structure of Bancshares’ loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. Bancshares does not maintain a trading account nor is it subject to currency exchange risk or commodity price risk. Responsibility for monitoring interest rate risk rests with the ALCO Committee, which is appointed by Bancshares’ Board of Directors. The ALCO Committee meets on a regular basis to review interest rate risk exposure and liquidity positions. Balance sheet management and funding strategies are reviewed to ensure that any potential impact on earnings and liquidity, resulting from a fluctuation in interest rates, is within acceptable standards.

Additional information called for by Item 7A is set forth in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which begins on page 16 above.

Item 8. Financial Statements and Supplementary Data.

The following financial statements and notes related thereto should be read in conjunction with Item 6, “Selected Financial Data,” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” which begin on page 15 and 16, respectively.

Statement of Management Responsibility

The management of Bancshares and subsidiaries is responsible for the preparation of the financial statements, related financial data and other information in this annual report on Form 10-K. The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s estimates and judgment where appropriate. Other information in the annual report is consistent with that contained in the financial statements. In fulfilling its responsibility for the integrity and fairness of these statements and information, management relies on the accounting system and related internal controls that are designed to provide reasonable assurances that transactions are authorized and recorded in accordance with established procedures, assets are safeguarded, and proper and reliable records are maintained.

Bancshares maintains a professional staff of internal auditors who independently assess the effectiveness of the internal controls and recommend possible improvements thereto. The Audit Committee is appointed by the Board of Directors to assist the Board in monitoring: the integrity of the financial statements of Bancshares; the independent auditor’s qualifications and independence; the performance of Bancshares’ internal audit function and independent auditors; and the compliance by Bancshares with legal and regulatory requirements. The independent auditors, internal auditors and banking regulators have direct access to the Audit Committee with or without management present.

The financial statements have been audited by Turlington and Company, L.L.P., independent auditors, who render an independent, professional opinion on management’s financial statements and internal control over financial reporting. Their report expresses an opinion as to, among other things, the fairness of the financial position and results of operations of LSB Bancshares, Inc. and subsidiaries based on their audit conducted in accordance with auditing standards generally accepted in the United States of America.

Please also review our assessment on internal control over financial reporting included in Item 9A, “Controls and Procedures,” which begins on page 66 below.

LSB BANCSHARES, INC.
January 31, 2006

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders
LSB Bancshares, Inc.
Lexington, North Carolina

We have audited the accompanying consolidated balance sheets of LSB Bancshares, Inc. and subsidiaries (the “Corporation”) as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. We also have audited management’s assessment, included in Item 9A below, entitled “Controls and Procedures,” that the Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Corporation’s internal control over financial reporting 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A corporation’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A corporation’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the corporation; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the corporation are being made only in accordance with authorizations of management and directors of the corporation; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the corporation’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of LSB Bancshares, Inc. and subsidiaries as of December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, management’s assessment that LSB Bancshares, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005 is fairly stated, in all material respects, based on criteria established

Consolidated Balance Sheets


	December 31
(In thousands, except for shares)	2005			2004

ASSETS
Cash and Due from Banks (Note 2)	$	45,600		$	35,407
Interest-Bearing Bank Balances		1,385			2,115
Federal Funds Sold		16,355			14,246
Investment Securities (Note 3):
Held to Maturity, Market Value $27,603 and $29,642		27,427			28,539
Available for Sale		100,732			100,655
Loans (Notes 4 and 11)		755,398			712,185
Less, Allowance for Loan Losses (Note 4)		(8,440	)		(7,962	)

Net Loans		746,958			704,223
Premises and Equipment (Note 5)		19,358			17,390
Other Assets		17,980			12,413

Total Assets	$	975,795		$	914,988


LIABILITIES
Deposits:
Demand	$	131,515		$	88,805
Savings, N.O.W. and Money Market Accounts		409,928			417,584
Certificates of Deposit of less than $100,000 (Note 6)		140,700			118,569
Certificates of Deposit of $100,000 or more (Note 6)		140,030			97,317

Total Deposits		822,173			722,275
Securities Sold Under Agreements to Repurchase (Note 6)		1,657			1,536
Borrowings from the Federal Home Loan Bank (Note 7)		53,000			95,000
Other Liabilities		7,136			5,435

Total Liabilities		883,966			824,246


SHAREHOLDERS’ EQUITY
Preferred Stock, Par Value $.01 Per Share:
Authorized 10,000,000 Shares; none issued		—			—
Common Stock, Par Value $5 Per Share:
Authorized 50,000,000 Shares; Issued 8,524,033 in 2005 and 8,590,184 Shares in 2004		42,620			42,951
Paid-In Capital		9,430			10,482
Directors’ Deferred Plan		(1,334	)		(1,197	)
Retained Earnings		42,424			38,592
Accumulated Other Comprehensive Loss		(1,311	)		(86	)

Total Shareholders’ Equity		91,829			90,742

Total Liabilities and Shareholders’ Equity	$	975,795		$	914,988

Commitments and Contingencies Note 8

Notes to consolidated financial statements are an integral part hereof.

Consolidated Statements of Income


	Years Ended December 31
(In thousands, except for shares and per share amounts)	2005		2004		2003

INTEREST INCOME
Interest and Fees on Loans	$	54,568	$	44,137	$	44,837
Interest on Investment Securities:
Taxable		3,610		3,285		3,960
Tax Exempt		1,386		1,480		1,581
Interest-Bearing Bank Balances		340		176		159
Federal Funds Sold		521		241		253

Total Interest Income		60,425		49,319		50,790


INTEREST EXPENSE
Deposits		13,120		7,022		8,048
Securities Sold Under Agreements to Repurchase and Federal Funds Purchased		12		10		13
Borrowings from the Federal Home Loan Bank		3,594		3,335		3,116

Total Interest Expense		16,726		10,367		11,177

Net Interest Income		43,699		38,952		39,613
Provision for Loan Losses (Note 4)		3,219		3,017		5,215

Net Interest Income after Provision for Loan Losses		40,480		35,935		34,398


NONINTEREST INCOME
Service Charge on Deposit Accounts		6,816		6,925		6,981
Gains on Sales of Mortgages		554		530		1,346
Other Operating Income (Note 9)		6,422		6,608		6,190

Total Noninterest Income		13,792		14,063		14,517


NONINTEREST EXPENSE
Personnel Expense		21,426		20,254		20,643
Occupancy Expense		1,867		1,779		1,654
Equipment Depreciation and Maintenance		2,263		2,296		2,069
Other Operating Expense (Note 9)		14,214		13,358		12,068

Total Noninterest Expense		39,770		37,687		36,434

Income Before Income Taxes		14,502		12,311		12,481
Income Taxes (Note 10)		4,865		3,931		3,903

Net Income	$	9,637	$	8,380	$	8,578


Earnings Per Share:
Basic	$	1.13	$	0.98	$	1.01
Diluted	$	1.12	$	0.97	$	1.00

Weighted Average Shares Outstanding:
Basic		8,547,282		8,576,109		8,515,711
Diluted		8,587,537		8,620,713		8,587,787

Notes to consolidated financial statements are an integral part hereof.

Consolidated Statements
Of Changes in Shareholders’ Equity


																Accumulated
										Directors’						Other			Total
	Common Stock						Paid-In			Deferred			Retained			Comprehensive			Shareholders’
(In thousands, except for shares)	Shares			Amount			Capital			Plan			Earnings			Income(loss)			Equity

Balances at December 31, 2002		8,472,518		$	42,363		$	9,729		$	(995	)	$	32,578		$	1,832		$	85,507
Net Income														8,578						8,578
Change in unrealized gain on securities available for sale, net of deferred income taxes																	(823	)		(823	)

Comprehensive income																				7,755
Cash dividends declared on common stock														(5,454	)					(5,454	)
Common stock issued for stock options exercised		76,424			382			476												858
Common stock acquired											(106	)								(106	)

Balances at December 31, 2003		8,548,942		$	42,745		$	10,205		$	(1,101	)	$	35,702		$	1,009		$	88,560
Net Income														8,380						8,380
Change in unrealized gain on securities available for sale, net of deferred income taxes																	(1,095	)		(1,095	)

Comprehensive income																				7,285
Cash dividends declared on common stock														(5,490	)					(5,490	)
Common stock issued for stock options exercised		61,042			305			479												784
Common stock acquired		(19,800	)		(99	)		(202	)		(96	)								(397	)

Balances at December 31, 2004		8,590,184		$	42,951		$	10,482		$	(1,197	)	$	38,592		$	(86	)	$	90,742
Net Income														9,637						9,637
Change in unrealized gain on securities available for sale, net of deferred income taxes																	(1,225	)		(1,225	)

Comprehensive income																				8,412
Cash dividends declared on common stock														(5,805	)					(5,805	)
Common stock issued for stock options exercised		40,257			201			283												484
Common stock acquired		(106,408	)		(532	)		(1,335	)		(137	)								(2,004	)

Balances at December 31, 2005		8,524,033		$	42,620		$	9,430		$	(1,334	)	$	42,424		$	(1,311	)	$	91,829

Notes to consolidated financial statements are an integral part hereof.

Consolidated Statements of Cash Flows


	Years Ended December 31
(In thousands)	2005			2004			2003

CASH FLOW FROM OPERATING ACTIVITIES
Net Income	$	9,637		$	8,380		$	8,578
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,011			2,065			1,832
Securities premium amortization and discount accretion, net		116			120			78
(Increase) decrease in loans held for sale		(382	)		2,275			(6,673	)
Deferred income taxes		75			111			(230	)
Increase in income taxes payable		27			61			61
(Increase) decrease in income earned but not received		(1,121	)		(83	)		387
Increase (decrease) in interest accrued but not paid		659			250			(252	)
Net (increase) decrease in other assets		(3,754	)		91			(177	)
Net increase (decrease) in other liabilities		1,015			162			(249	)
Provision for loan losses		3,219			3,017			5,215
(Gain) loss on sale of premises and equipment		14			31			(40	)

Net cash provided by operating activities		11,516			16,480			8,530

CASH FLOW FROM INVESTING ACTIVITIES
Purchase of securities held to maturity		(4,052	)		(4,180	)		(280	)
Proceeds from maturities of securities held to maturity		5,154			4,713			15,232
Purchases of securities available for sale		(22,411	)		(59,896	)		(51,824	)
Proceeds from maturities of securities available for sale		20,235			49,357			42,765
Net increase in loans made to customers		(45,571	)		(53,916	)		(15,877	)
Purchases of premises and equipment		(4,029	)		(4,622	)		(3,318	)
Proceeds from sale of premises and equipment		36			87			65
Net (increase) decrease in federal funds sold		(2,109	)		11,640			(12,502	)

Net cash used for investing activities		(52,747	)		(56,817	)		(25,739	)

CASH FLOW FROM FINANCING ACTIVITIES
Net increase in demand deposits, N.O.W., money market and savings accounts		35,054			12,479			13,317
Net increase (decrease) in time deposits		64,844			7,294			(7,296	)
Net increase (decrease) in securities sold under agreements to repurchase		121			(496	)		503
Proceeds from long-term debt		98,000			152,000			22,000
Payments on long-term debt		(140,000	)		(127,000	)		(15,000	)
Dividends paid		(5,805	)		(5,490	)		(5,454	)
Proceeds from issuance of common stock		484			784			858
Common stock acquired		(2,004	)		(397	)		(106	)

Net cash provided by financing activities		50,694			39,174			8,822

Increase (decrease) in cash and cash equivalents		9,463			(1,163	)		(8,387	)
Cash and cash equivalents at the beginning of the years		37,522			38,685			47,072

Cash and cash equivalents at the end of the years	$	46,985		$	37,522		$	38,685

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the years for:
Interest	$	16,068		$	10,117		$	11,428
Income taxes		5,000			3,878			4,541
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Transfer of loans to other real estate owned	$	4,435		$	2,115		$	1,844
Unrealized gain on securities available for sale:
Change in securities available for sale		(1,993	)		(1,782	)		(1,339	)
Change in deferred income taxes		768			687			516
Change in shareholders’ equity		(1,225	)		(1,095	)		(823	)

Notes to consolidated financial statements are an integral part hereof.

Notes To Consolidated Financial Statements

As of or for the Years Ended December 31, 2005, 2004 and 2003

Note 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Policies

The accounting and financial reporting policies of Bancshares and its subsidiaries conform to accounting principles generally accepted in the United States of America and prevailing industry practices. The following is a description of significant accounting policies.

Nature of Operations

Bancshares is a bank holding company organized under the laws of the State of North Carolina and registered under the FBHCA. Bancshares conducts its domestic financial services business through its wholly owned subsidiary the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS. Bancshares serves customers primarily in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake Counties, North Carolina.

Consolidation

The consolidated financial statements include the accounts of Bancshares and its direct and indirect wholly-owned subsidiaries, after eliminating inter-company balances and transactions. Securities and other property held in a fiduciary or agency capacity are not included in the consolidated balance sheets since these are not assets or liabilities of Bancshares. Certain prior year amounts have been reclassified to conform to current year presentation.

Use Of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents

Bancshares considers cash and due from banks and interest-bearing bank balances as cash and cash equivalents for purposes of the consolidated statements of cash flows. Due from bank balances and interest-bearing bank balances are maintained in other financial institutions.

Investment Securities

Management determines the appropriate classification of investment securities at the time of purchase. Securities that may be sold in response to or in anticipation of changes in interest rates or other factors are classified as available for sale and carried at market value. The unrealized gains and losses on these securities are reported net of applicable taxes as a separate component of shareholders’ equity. Securities that Bancshares has the positive intent and ability to hold to maturity are carried at amortized cost. Bancshares does not have any securities held for trading. Interest income on securities, including amortization of premiums and accretion of discounts, is recognized using the interest method. Gains and losses on the sale of securities are recognized on a specific identification basis.

Loans

Loans are generally carried at the principal amount outstanding, net of deferred loan fees and certain direct origination costs on originated loans and unamortized discounts and premiums on purchased loans. Mortgage loans held for sale are carried at the lower of cost or market value, as determined by outstanding commitments from investors. Loan origination fees are capitalized and recognized as an adjustment of the yield of the related loan. Discounts and premiums on any purchased residential real estate loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Discounts and premiums on any purchased consumer loans are recognized over the expected lives of the loans using methods that approximate the interest method. Interest is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments of principal and interest as they become due.

Allowance for Loan Losses

The allowance for loan losses is that amount which is considered adequate to provide for potential losses in the portfolio. Management’s evaluation of the adequacy of the allowance is based on several factors, including an analysis of the loss experience in relation to outstanding amounts, a review of impaired loans, regular examinations and appraisals of the portfolio and current conditions.

Foreclosed Real Estate

Foreclosed real estate only includes formally foreclosed property. At the time of foreclosure, foreclosed real estate is recorded at the lower of the Bank’s cost or the asset’s fair value less costs to sell, which becomes the property’s new basis. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, these assets are carried at the lower of their new cost basis or fair value less cost to sell. Costs incurred in maintaining foreclosed real estate and subsequent write-downs to reflect declines in the fair value of the property are charged to operations.

Premises and Equipment

Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation is computed by use of the straight-line method, using the following estimated lives: buildings, 20 to 40 years; equipment, 3 to 10 years; and vaults, 10 to 40 years. Leasehold improvements are amortized by use of the straight-line method over the lesser of the estimated useful lives of the improvements or the terms of the respective leases.

Income Taxes

The provision for income taxes is based on income and expenses and assets and liabilities for financial statement purposes. Deferred income taxes are computed under the provisions of Statement of Financial Accounting Standards Number 109, “Accounting for Income Taxes”.

Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income by the sum of the weighted average number of common shares outstanding for the period plus the number of additional dilutive common shares that would have been outstanding if potentially dilutive options had been exercised. All references to shares outstanding have been adjusted to give effect to stock splits that may have occurred during the periods.

Stock-Based Compensation

Bancshares accounts for its stock-based compensation plans using the accounting prescribed by Accounting Principles Board Opinion Number 25, “Accounting for Stock Issued to Employees.” In October 1995, Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), was issued and encourages, but does not require, adoption of a fair value method of accounting for employee stock-based compensation plans. In December 2002, the FASB Issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an Amendment of FASB Statement No. 123” (“SFAS 148”). As permitted by SFAS 123 and SFAS 148, Bancshares has elected to disclose the pro forma net income and earnings per share as if the fair value method had been applied in measuring compensation cost.

Bancshares had stock based compensation plans at December 31, 2005 accounted for under Accounting Principles Board Opinion Number 25, under which no compensation cost has been recognized. Had compensation cost for these plans been determined consistent with SFAS 123 and SFAS 148, Bancshares’ net income and earnings per share would have been reduced to the following pro forma amounts (In thousands, except per share amounts):


	Years Ended December 31
	2005		2004		2003

Net income, as reported	$	9,637	$	8,380	$	8,578
Less, total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		388		326		283
Pro forma net income	$	9,249	$	8,054	$	8,295


	Years Ended December 31
	2005		2004		2003

Earnings Per Share:
Basic – as reported	$	1.13	$	0.98	$	1.01
Basic – pro forma		1.08		0.94		0.97
Diluted – as reported		1.12		0.97		1.00
Diluted – pro forma		1.08		0.93		0.97

To determine the above pro forma amounts, the fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:


	Years Ended December 31
	2005			2004			2003

Dividend yield		3.78	%		3.67	%		3.50	%
Risk-free interest rate		4.25	%		3.63	%		3.25	%
Expected stock volatility		21.01	%		25.17	%		36.13	%
Expected years until exercise		7.26			6.82			7.33

Due to the pending adoption of SFAS No. 123(R), effective April 11, 2005, the Stock Option and Compensation Committee of the Board of Directors of Bancshares (the “Compensation Committee”) voted to immediately vest certain unvested and underwater options held by current employees and executive officers. The Bank will adopt SFAS No. 123(R) on January 1, 2006.

The early vesting of these options was made to reduce compensation expense that otherwise would have been recorded in future periods once Bancshares implements SFAS 123(R) on January 1, 2006. As a result of this accelerated vesting, Bancshares expects to reduce its future aggregate compensation expense related to the options subject to the vesting by a total of approximately $227,000, based on estimated value calculations using Black-Scholes valuation methodology.

Accounting for Derivatives

The Bank accounts and reports for derivative instruments in accordance with Statement of Financial Accounting Standard No. 133 “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS 133”). SFAS 133 requires recognition of all derivatives as either assets or liabilities in the balance sheet and requires measurement of those instruments at fair value through adjustments to accumulated other comprehensive income and/or current earnings, as appropriate. As of the date of this report the Bank only used fair value hedging. For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged liability are recorded in current period net income. If a derivative has ceased to be highly effective, hedge accounting is discontinued prospectively.

Note 2 — REGULATORY RESTRICTIONS

Bancshares and the Bank are subject to certain requirements imposed by state and federal banking statutes and regulations.

The Bank is required to maintain a certain weekly average clearing account balance with the Federal Reserve Bank of Richmond. The required weekly average clearing account balance for the years ended December 31, 2005 and 2004 was $56,000,000 and $91,000,000, respectively. The amount is negotiated by the Bank with the Federal Reserve Bank of Richmond.

Certain regulatory requirements restrict the lending of funds by and between Bancshares and the Bank and the amount of dividends which can be paid to Bancshares by the Bank. On December 31, 2005, the Bank had available retained earnings of $69,837,000 for the payment of dividends without obtaining prior regulatory approval.

The Bank is a member of the FHLB. Member institutions are required to maintain an investment in the common stock of the FHLB based on the member’s outstanding loan amount with the FHLB. Member institutions must also maintain adequate collateral in qualifying 1-4 family residential loans and other loans that meet the guidelines of the FHLB. At December 31, 2005, the Bank owned $4,213,500 of FHLB common stock.

Bancshares and the Bank are subject to certain regulatory capital requirements administered by federal and state banking agencies. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, Bancshares and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Failure to meet minimum capital requirements can result in certain mandatory and possible discretionary actions by regulators that, if undertaken, could have a direct material effect on Bancshares’ financial statements.

At December 31, 2005, the most recent notifications from regulatory authorities categorized Bancshares and the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes has changed Bancshares’ or the Bank’s well capitalized

status. Management believes that Bancshares and the Bank meet all capital adequacy requirements to which they are subject.

The Bank’s capital amounts and ratios approximate Bancshares’ capital amounts and ratios, which are summarized as follows (Dollars in thousands):


											Minimum Ratios
											For
											Capital			To Be
	Capital Amount				Ratio						Adequacy			Well
	2005		2004		2005			2004			Purposes			Capitalized*

Total capital to risk-weighted assets	$	101,088	$	98,279		12.53	%		13.08	%		8.00	%		10.00	%
Tier I capital to risk-weighted assets		92,648		90,317		11.48			12.02			4.00			6.00
Tier I capital to average assets		92,648		90,317		9.50			9.91			3.00			5.00


*		under Prompt Corrective Action provisions

Note 3 — INVESTMENT SECURITIES

The valuations of investment securities as of December 31, 2005 and 2004 were as follows (In thousands):


	2005 – Securities Held to Maturity
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value

State, county and municipal securities	$	27,427	$	505	$	329	$	27,603


	2005 – Securities Available for Sale
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains			Losses		Value

U.S. government agency obligations	$	96,040	$	45		$	2,051	$	94,034
State, county and municipal securities		2,612		—			128		2,484
Equity securities		4,214		—			—		4,214

Total	$	102,866	$	45		$	2,179	$	100,732


	2004 – Securities Held to Maturity
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value

State, county and municipal securities	$	28,539	$	1,121	$	18	$	29,642


	2004 – Securities Available for Sale
	Amortized		Unrealized		Unrealized		Market
	Cost		Gains		Losses		Value

U.S. government agency obligations	$	91,685	$	593	$	687	$	91,591
State, county and municipal securities		3,101		36		82		3,055
Equity securities		6,009		—		—		6,009

Total	$	100,795	$	629	$	769	$	100,655

The following is a schedule of securities in a loss position as of December 31, 2005 (In thousands):


	Less than 1 Year				1 Year or More				Total
	Market		Unrealized		Market		Unrealized		Market		Unrealized
	Value		Loss		Value		Loss		Value		Loss

U.S. government agency obligations	$	28,668	$	409	$	56,269	$	1,643	$	84,937	$	2,052
State, county and municipal securities		9,375		330		2,236		127		11,611		457

Total securities	$	38,043	$	739	$	58,505	$	1,770	$	96,548	$	2,509

The following is a maturity schedule of investment securities at December 31, 2005 by contractual maturity (In thousands):


	Securities Held				Securities Available
	to Maturity				for Sale
	Amortized		Market		Amortized		Market
	Cost		Value		Cost		Value

Debt securities:
Due in one year or less	$	2,172	$	2,189	$	14,002	$	13,897
Due after one year through five years		3,530		3,585		83,743		81,748
Due after five years through ten years		13,825		13,969		485		464
Due after ten years		7,900		7,860		422		409

Total debt securities		27,427		27,603		98,652		96,518
Equity securities		—		—		4,214		4,214

Total securities	$	27,427	$	27,603	$	102,866	$	100,732

The Bank owned stock in FHLB with book and market values of $4,213,500 and $6,009,000 at December 31, 2005 and 2004, respectively. The stock is included in equity securities and classified as available for sale.

A recap of the sales and maturities of held to maturity securities follows (In thousands):


	Years Ended December 31
	2005		2004		2003

Proceeds from sales and maturities	$	5,154	$	4,713	$	15,232
Gross realized gains		—		—		—
Gross realized losses		—		—		—

A recap of the sales and maturities of available for sale securities follows (In thousands):


	Years Ended December 31
	2005		2004		2003

Proceeds from sales and maturities	$	20,235	$	49,357	$	42,765
Gross realized gains		—		—		—
Gross realized losses		—		—		—

Investment securities with amortized costs of $92,705,000 and $84,470,000 and market values of $91,101,000 and $85,028,000 as of December 31, 2005 and 2004, respectively, were pledged to secure public deposits and for other purposes.

Note 4 — LOANS AND ALLOWANCE FOR LOAN LOSSES

Loans are summarized as follows (In thousands):


	December 31
	2005		2004

Commercial, financial, and agricultural	$	288,240	$	281,909
Real estate-construction		38,179		50,125
Real estate-mortgage		354,322		314,822
Installment loans to individuals		72,336		62,987
Lease financing		403		447
Other		1,918		1,895

Total loans, net of unearned income	$	755,398	$	712,185

Nonperforming assets are summarized as follows (In thousands):


	December 31
	2005		2004

Nonaccrual loans	$	929	$	685
Restructured loans		856		582
Loans past due 90 days or more		1,911		1,313

Total nonperforming loans		3,696		2,580
Foreclosed real estate		4,391		1,531

Total nonperforming assets	$	8,087	$	4,111

Impaired loans and related information are summarized in the following tables (In thousands):


	December 31
	2005		2004		2003

Loans specifically identified as impaired	$	8,937	$	3,484	$	6,435


Allowance for loan losses associated with impaired loans	$	1,101	$	939	$	1,091


	Years Ended December 31
	2005		2004		2003

Average balances of impaired loans for the years	$	6,887	$	6,415	$	8,663


Interest income recorded for impaired loans	$	453	$	261	$	441

An analysis of the changes in the allowance for loan losses follows (In thousands):


	Years Ended December 31
	2005			2004			2003

Balances at beginning of years	$	7,962		$	7,846		$	7,284
Provision for loan losses		3,219			3,017			5,215
Recoveries of amounts previously charged off		498			745			358
Loans charged off		(3,239	)		(3,646	)		(5,011	)

Balances at end of years	$	8,440		$	7,962		$	7,846

Bancshares’ policy for impaired loan accounting subjects all loans to impairment recognition except for large groups of smaller balance homogeneous loans such as credit card, residential mortgage and consumer loans. Bancshares generally considers loans 90 days or more past due and all nonaccrual loans to be impaired.

At December 31, 2005, Bancshares had no significant commitments to loan additional funds to the borrowers of impaired loans.

Note 5 — PREMISES AND EQUIPMENT

The following is a summary of premises and equipment (In thousands):


	December 31
	2005		2004

Land	$	4,388	$	4,254
Building		11,816		10,334
Equipment		18,968		16,724
Leasehold improvements		1,061		1,087

		36,233		32,399
Less, accumulated depreciation		16,875		15,009

Total	$	19,358	$	17,390

Note 6 — TIME DEPOSITS AND SHORT-TERM BORROWED FUNDS

The scheduled maturities of time deposits at December 31, 2005, were as follows (In thousands):


Year	Amount

2006	$	248,997
2007		21,750
2008		9,958
2009		25

	$	280,730

Short-term borrowed funds outstanding consisted of securities sold under agreements to repurchase. These short-term borrowings by the Bank are collateralized by U.S. Treasury and other U.S. Government agency obligations with amortized cost of $5,017,000 and market value of $4,910,000 at December 31, 2005. The securities collateralizing the short-term borrowings have been delivered to a third party custodian for safekeeping. The following table presents certain information for securities sold under agreements to repurchase (In thousands):


	2005			2004			2003
Balance at December 31	$	1,657		$	1,536		$	2,032


Average daily balance outstanding during the year	$	1,308		$	1,300		$	1,564


Avearage interest rate paid during the year		0.89	%		0.71	%		0.83	%

Note 7 — BORROWINGS

The Bank has established a secured credit availability with the FHLB totaling approximately $189,321,000 at year-end. At December 31, 2005 and 2004, the outstanding balances under this arrangement were $53,000,000 and $95,000,000, respectively. For 2005 and 2004, the effective interest rates incurred were 4.75% and 3.90%, respectively. Maturities are as follows (In thousands):


Year	Amount

2006	$	25,000
2007		—
2008		—
2009		—
2010		18,000
Thereafter		10,000

	$	53,000

Borrowings under this line of credit are secured by the Bank’s stock in the FHLB and a blanket floating lien on certain qualifying 1-4 family mortgage loans as well as other qualifying loans.

The bank has obtained two $10,000,000 and a $20,000,000 irrevocable letter of credit, which will expire on May 10, 2006, August 11, 2010 and September 3, 2014, respectively. These letters of credit were issued by the FHLB in favor of the State of North Carolina to secure public deposits.

Note 8 — COMMITMENTS AND CONTINGENT LIABILITIES

In the normal course of business, the Bank is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit, both of which involve elements of credit and interest rate risk not reflected in the Consolidated Balance Sheets. The Bank uses the same credit policies in making commitments and issuing standby letters of credit as it does for on-balance sheet instruments. The Bank’s exposure to credit loss in the event of nonperformance by the party to whom commitments and standby letters of credit have been extended is represented by the contractual amount of the financial instrument.

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 may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon or fully utilized, the total commitment amounts do not necessarily represent future cash requirements. Collateral, if deemed necessary, is determined on a case-by-case basis and is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties. Unfunded commitments to extend credit totaled $221,384,000 at December 31, 2005. The Bank determines the fair value of these commitments using an estimation of the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. However, the Bank does not charge a fee on a commitment to extend credit; therefore, the carrying amount and estimated fair value of such commitments were zero at December 31, 2005 and 2004.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Standby letters of credit generally have fixed expiration dates and may require payment of a fee. The credit risk involved is essentially the same as that involved in extending loan commitments to customers. The Bank’s policy for obtaining collateral, and the nature of such collateral, is essentially the same as that involved in making commitments to extend credit. Standby letters of credit totaled $5,831,000 at December 31, 2005. The Bank determines the fair value of standby letters of credit by using an estimation of fees currently charged to enter into similar agreements, taking into consideration the remaining terms of the agreements and the present creditworthiness of the counterparties. At December 31, 2005 and 2004, the Bank had standby letters of credit with estimated fair values of $24,000 and $24,000, respectively.

The following table summarizes outstanding unfunded commitments at December 31, 2005 and 2004 (In thousands):


(In thousands)	2005		2004

Loan commitments	$	200,404	$	189,626
Credit card lines		20,980		18,847
Standby letters of credit		5,831		4,980


Total unused commitments	$	227,215	$	213,453

The Bank and Peoples Finance together grant commercial, installment and mortgage loans to customers throughout their service area. The Bank and Peoples Finance have a diversified loan portfolio with no specific concentration of credit risk. The Bank does have a concentration of credit risk by maintaining cash balances with other banks, which are $34,373,000 in excess of Federal Deposit Insurance limits and has federal funds sold of $16,355,000 at December 31, 2005.

Neither Bancshares nor any of its subsidiaries are involved in any material pending legal proceedings.

Note 9 — SUPPLEMENTARY INCOME STATEMENT INFORMATION

The following is an analysis of items in other operating income and other operating expenses as shown on the Consolidated Statements of Income (In thousands):


	Years Ended December 31
	2005		2004		2003

Other operating income:
Bankcard income	$	2,530	$	2,531	$	2,370
Fee income		1,817		1,527		1,283
Investment Services commissions		984		1,297		1,499
Insurance commissions		243		231		227
Trust income		658		618		537
Other income		190		404		274

	$	6,422	$	6,608	$	6,190


Other operating expenses:
Advertising	$	757	$	851	$	858
Automated services		2,974		2,479		2,054
Bankcard expense		1,927		1,836		1,855
Legal and professional fees		2,092		2,052		1,442
Postage		796		764		722
Stationery, printing and supplies		678		901		848
OREO expense		698		152		118
Other expenses		4,292		4,323		4,171

	$	14,214	$	13,358	$	12,068

Note 10 — INCOME TAXES

The components of income tax expense (benefits) are as follows (In thousands):


	Years Ended December 31
	2005			2004			2003

Current	$	4,790		$	3,820		$	4,133

Deferred:
Allowance for loan losses		(185	)		(44	)		(217	)
Depreciation		173			84			(25	)
Pension		70			(11	)		3
Deferred compensation		30			(70	)		(71	)
Deferred income		(33	)		112			95
Other		20			40			(15	)

Subtotal		75			111			(230	)

Total	$	4,865		$	3,931		$	3,903

A reconciliation of the federal statutory tax rate to the effective tax rate follows:


	Years Ended December 31
	2005			2004			2003

Federal statutory tax rate		34.2	%		34.0	%		34.0	%
Tax exempt interest income		(3.5	)		(4.2	)		(4.6	)
Nonqualified options exercised		(0.1	)		(0.3	)		(0.5	)
Disallowed interest expense		0.4			0.3			0.3
State taxes, net of federal tax benefit		1.9			2.0			2.0
Other		0.7			0.1			0.1

Effective tax rate		33.6	%		31.9	%		31.3	%

The components of the net deferred tax asset follow (In thousands):


	December 31
	2005			2004
Unrealized loss on securities available for sale	$	823		$	54
Allowance for loan losses		3,254			3,069
Depreciation		(570	)		(396	)
Pension		(470	)		(400	)
Deferred compensation		474			504
Deferred income		(1,204	)		(1,237	)
Other		(13	)		7

Subtotal		2,294			1,601
Valuation allowance		—			—

Total	$	2,294		$	1,601

During 2003, the Bank purchased an investment tax credit partnership interest for $540,000. The partnership is expected to yield $1,000,000 in tax credits over the years 2003 to 2009. Bancshares accounts for tax credits using the flow-through method, thereby reducing income tax expense in the year in which the credits are received. Tax credit amounts were $185,000 for 2005, $187,000 for 2004 and $131,000 for 2003.

Note 11 — RELATED PARTY TRANSACTIONS

The Bank had loans outstanding to executive officers, directors and their affiliated companies. An analysis of the activity with respect to such aggregate loans to related parties is as follows (In thousands):


	Amount

Balance at December 31, 2004	$	7,731
New loans during the year		10,675
Repayments during the year		(10,021	)

Balance at December 31, 2005	$	8,385

Note 12 — INTANGIBLE ASSETS

The following tables summarize information about intangible assets which are included in Other Assets on the Consolidated Balance Sheets (In thousands):


	Years Ended December 31
	2005			2004			2003

Mortgage servicing rights:
Balances at beginning of years	$	280		$	280		$	276
Mortgage servicing rights originated		110			181			261
Amortization of rights		(153	)		(181	)		(257	)

Balances at end of years	$	237		$	280		$	280


Total loans services at end of years	$	83,108		$	90,892		$	91,757


Deposit premium:
Balance at beginning of years	$	19		$	68		$	117
Amortization		(19	)		(49	)		(49	)

Balances at end of years	$	—		$	19		$	68


Goodwill:
Balance at beginning of years	$	490		$	490		$	490
Impairment		—			—			—

Balances at end of years	$	490		$	490		$	490

The summary of estimated amortization expense for existing intangibles, excluding goodwill, for the five years subsequent to 2005 follows (In thousands):


Year	Amount

2006	$	121
2007		74
2008		38
2009		4
2010		—
Thereafter		—

	$	237

Note 13 — FAIR VALUE OF FINANCIAL INSTRUMENTS

Statement of Financial Accounting Standards Number 107, “Disclosures about Fair Value of Financial Instruments,” requires that Bancshares disclose estimated fair values for its financial instruments. Fair value estimates, methods and assumptions are set forth below for Bancshares’ financial instruments.

Cash and Short-Term Investments

For cash and short-term investments, including federal funds sold, the carrying amount is a reasonable estimate of fair value.

Investment Securities

For securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loans Receivable

The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Deposit Liabilities

The fair value of demand deposits, savings accounts and certain money market deposits is the amount payable on demand at December 31, 2005. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. The estimated fair values of Bancshares’ financial instruments are as follows (In thousands):


	December 31
	2005					2004
	Carrying			Estimated		Carrying			Estimated
	Amount			Fair Value		Amount			Fair Value

Financial assets:
Cash and short term investments	$	63,340		$	63,340	$	51,768		$	51,768
Investment securities		130,293			128,335		129,194			130,297
Loans		755,398			755,699		712,185			733,864
Less allowance for loan losses		(8,440	)		—		(7,962	)		—

Net loans		746,958			755,699		704,223			733,864
Financial liabilities:
Deposits		822,173			817,192		722,275			718,942
Securities sold under agreements to repurchase		1,657			1,657		1,536			1,536
Borrowings from Federal Home Loan Bank		53,000			50,094		95,000			93,743

Note 14 — PENSION AND EMPLOYEE BENEFIT PLANS

The Bank and its subsidiaries have a noncontributory defined benefit pension plan, which covers substantially all employees. The benefits are based on years of service and the average of the highest five consecutive years of compensation paid during the ten years preceding retirement. Contributions are made on an annual basis, with the total amount of such contributions being between the minimum required for funding standard account purposes and the maximum deductible for federal income tax purposes.

The Bank and its subsidiaries have a plan to provide some health care benefits and life insurance for employees for the period between early retirement and normal retirement. Only those employees who retire after age 55 and have completed 10 years of service will be eligible for these benefits. The benefits are provided through a self-insured plan administered by an insurance company. The Bank is responsible for paying claims as they occur during the year. Statement of Financial Accounting Standards Number 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” requires the accrual of nonpension benefits as employees render service. The liability for postretirement benefits is unfunded.

The following tables set forth the changes in the projected benefit obligations and the fair value of plan assets for the Bank’s defined benefit pension plan and postretirement benefits provided for certain retired employees and the amounts recognized in the consolidated financial statements at December 31 (In thousands):


	Pension Benefits						Postretirement Benefits
	2005			2004			2005			2004

Change in Benefit Obligation

Benefit obligation, beginning of year	$	13,054		$	11,498		$	961		$	813
Service cost		839			773			52			53
Interest cost		797			725			51			55
Actuarial gain (loss)		425			283			(90	)		80
Participants’ contributions		—			—			10			10
Benefits paid to participants		(290	)		(225	)		(42	)		(50	)

Benefit obligation at end of year	$	14,825		$	13,054		$	942		$	961


Change in Plan Assets
Fair value, beginning of year	$	9,977		$	8,489		$	—		$	—
Actual return on plan assets		352			556			—			—
Participants’ contributions		—			—			10			10
Actual employer contributions		1,400			1,157			32			40
Benefits paid to participants		(290	)		(225	)		(42	)		(50	)

Fair value, end of year	$	11,439		$	9,977		$	—		$	—


Accrued(Prepaid) Benefit Cost
Funded status	$	3,384		$	3,077		$	942		$	961
Unrecognized net actuarial gain		(4,549	)		(3,903	)		(228	)		(326	)
Unrecognized prior service cost		(668	)		(734	)		—			—
Unrecognized transition asset		—			—			(82	)		(92	)

Net amount recognized in consolidated financial statements	$	(1,833	)	$	(1,560	)	$	632		$	543


	Pension Benefits									Postretirement Benefits
	Year Ended December 31,									Year Ended December 31,
	2005			2004			2003			2005		2004		2003

Net Periodic Benefit Cost
Service cost	$	839		$	773		$	608		$	52	$	53	$	31
Interest cost		797			725			663			52		55		50
Expected return on plan assets		(774	)		(664	)		(553	)		—		—		—
Amortization of prior service cost		66			66			65			—		—		—
Transition Obligation		—			—			—			10		10		10
Net actuarial loss		199			191			1			8		14		10

Net periodic benefit cost	$	1,127		$	1,091		$	784		$	122	$	132	$	101

The following table sets forth the projected benefits payments for each of the next five fiscal years and in the aggregate for the five fiscal years thereafter (In thousands):


	Pension		Post retirement
	Benefits		Benefits

Estimated Benefits Payments for the Fiscal Year Ending:
December 31, 2006	$	439	$	59
December 31, 2007		475		72
December 31, 2008		531		75
December 31, 2009		574		83
December 31, 2010		692		74
December 31, 2011 – 2015		4,676		463


	Pension Benefits
	December 31
(Amounts in thousands)	2005			2004

Asset Allocation
Cash equivalent		5.6	%		8.3	%
Fixed income securities		37.5			38.0
Mutual Funds		4.1			8.1
Equity securities		52.3			45.2
Accrued income		0.5			0.4

Total		100.0	%		100.0	%


Accumulated benefit obligation	$	11,441		$	9,758


	2005			2004

Benefit Obligation Assumptions
Discount rate		6.00	%		6.25	%
Expected long-term rate return on assets		7.50			7.50
Rate of increase in compensation levels		5.50			5.50
Rate of increase in maximum benefits levels		5.00			5.00

Bancshares expects to contribute $1,100,000 to its pension plan in 2006.

The pension plan’s investments are managed by the Trust Department of the Bank (the “Trust Department”). The Trust Department acts under the direction of the Trust Committee of the Board of Directors for the Bank (the “Trust Committee”). The Trust Committee approves the investment strategy and asset allocation guidelines for the plan, which is currently 40% in fixed income securities and cash equivalents and 60% in equity securities.

The fixed income portion consists primarily of individual debt securities from U.S. Government, Government Agencies and corporate debt securities rated A or better at the time of purchase by a nationally recognized rating service. High yield and foreign debt securities may be held in the portfolio, and are acquired through mutual funds. The equity portion consists of individual stocks and mutual funds. Equity securities are selected from a list of high quality companies meeting specific characteristics. Mutual funds are selected that have acceptable ratings from nationally recognized fund analytic companies.

The current diversification criteria allows for no more than 20% of the portfolio holdings in any one issuer with the exception of government, government agency, or insured fixed income instruments.

The plan’s sponsor uses an expected annual rate of return on plan assets of 7.50% in determining the plan’s Net Periodic Pension Cost under Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions.” This assumption is a long-term assumption, and the plan sponsor believes it is consistent with and within the reasonable range of the expected nominal returns for any portfolio with similar investment strategies.


	Postretirement Benefits
	December 31
(Amounts in thousands)	2005			2004

Assumed Health Care Cost Trend Rates
Health care cost trend assumed for next year		8.00	%		9.00	%
Ultimate trend rate		5.00	%		5.00	%
Year that the rate reaches the ultimate trend rate		2009			2009
Benefit Obligation Discount Rate Assumption		6.00	%		6.25	%

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects (In thousands):


	1 Percentage		1 Percentage
	Point		Point
	Increase		Decrease

Effect on total of service and interest cost	$	15	$	(12	)

Effect on postretirement benefit obligation	$	324	$	(269	)

Bancshares expects to pay $59,000 to cover claims under the postretirement plan in 2006.

The Bank and its subsidiaries have a defined contribution retirement plan covering substantially all employees with one year of service. Participating employees may contribute a percentage of their compensation to the plan, with the Bank and its subsidiaries matching a portion of the employee contribution. The Bank’s matching contribution is invested in Bancshares common stock. Bancshares’ stock held by the plan as of December 31, 2005 and 2004 was 153,142 and 136,443 shares, respectively. Total expense under the plan was $294,000, $271,000 and $302,000 for 2005, 2004, and 2003, respectively.

Note 15 — LEASES

The Bank is obligated under several lease agreements, which expire in 2006 through 2010. The leased property is for land and building use. Rental payments under these leases amounted to $505,000, $504,000 and $461,000 for the years ended December 31, 2005, 2004, and 2003, respectively.

A summary of noncancelable lease commitments for the Bank follows (In thousands):


Year	Amount

2006	$	482
2007		336
2008		273
2009		115
2010		38

	$	1,244

Note 16 — CAPITAL STOCK

Preferred Stock

The Board of Directors may issue Bancshares preferred stock in one or more classes or series. The Board of Directors has the authority, without the need for shareholder approval, to determine and vary the voting rights, designations, preferences, qualifications, privileges, limitations, options, conversion rights and other special rights of each series of preferred stock, including, but not limited to, dividend rates and manner of payment, preferential amounts payable upon voluntary or involuntary liquidation, voting rights, conversion rights, redemption prices, terms and conditions, and sinking fund and stock purchase prices, terms and conditions.

Common Stock

The common stock represents voting shares, and dividends on the common stock are paid at the discretion of the Board of Directors.

During 2005, 2004, and 2003, Bancshares repurchased common stock in the amounts of 106,408, 19,800 and 0 shares, respectively, under a repurchase plan authorized by the Board of Directors for up to 900,000 shares of common stock. As of December 31, 2005, Bancshares had repurchased a total of 569,989 shares under the plan. Consequently, Bancshares may repurchase an additional 330,011 shares under the plan, which expires May 31, 2006.

Rights

On February 10, 1998, the Board of Directors of Bancshares declared a dividend distribution of one right (each, a “Right”) for (a) each outstanding share of Bancshares’ common stock at the close of business on March 10, 1998, and (b) each share of Bancshares’ common stock issued after March 10, 1998, until the earliest of the following dates (the “Distribution Date”): (i) 10 business days after a public announcement that a person or group acquired, or has obtained the right to acquire, 20% or more of Bancshares’ outstanding shares of common stock (the “Stock Acquisition Date”); (ii) 10 business days after the beginning of a tender offer or exchange offer that would, if consummated, result in a person or group acquiring 20% or more of Bancshares’ outstanding shares of common stock; or (iii) 10 business days after the Board of Directors declares that a person or entity is an “Adverse Person,” which is generally defined as a person or entity who owns Bancshares’ common stock for purposes deemed by the board to be detrimental to the best interests of Bancshares. A Right entitles its registered holder to purchase from Bancshares 0.01 of a share of common stock at a purchase price per full share of $100.00, subject to adjustment; provided, however, that all Rights that are, or were, beneficially owned by any person, group or entity who is a party to any event listed under (b)(i) or (b)(ii) in the immediately preceding sentence or who the Board of Directors declares to be an Adverse Person will be null and void.

The description and terms of the Rights are more particularly set forth in a Rights Agreement dated as of February 10, 1998, by and between Bancshares and Wachovia Bank, N.A., as rights agent (the “Rights Agreement”). Generally, Rights holders may exercise their Rights upon the occurrence of either of the following events (the “Trigger Dates”): (a) the board determines that a person or entity is an Adverse Person or (b) a person or group becomes the beneficial owner of 25% or more of Bancshares’ common stock after the Distribution Date. After the Trigger Dates, Rights holders may exercise their Rights by (a) purchasing shares of Bancshares’ common stock in an amount equal to two times the exercise price of the Right or (b) at the board’s discretion, receiving shares of Bancshares’ common stock that equal the difference between the exercise price of the Right and the value of the consideration that a Rights holder would pay under section (a) of this sentence. For example, if on the Trigger Dates, the exercise price of each Right is $100.00 per full share of Bancshares’ common stock, a Rights holder would have the right to (a) purchase $200.00 of Bancshares’ common Stock for $100.00 or (b) at the board’s discretion, receive $100.00 of Bancshares’ common Stock without the payment of any exercise price. In addition, at any time after the Stock Acquisition Date, if Bancshares is acquired in a merger or other business combination transaction or if 50% or

more of Bancshares’ assets are sold or transferred, each Rights holder will have the right to purchase shares of the acquiring company’s common stock in an amount equal to two times the exercise price of the Right.

The Rights will expire on December 31, 2007 (subject to extension by the Board of Directors), and may be redeemed by Bancshares at a price of $0.01 at any time prior to the acquisition by a person or group of 20% or more of Bancshares’ common stock.

Stock-Based Compensation

Prior to the approval of the Comprehensive Benefit Plan, Bancshares’ Amended and Restated Deferred Compensation Plan for Directors (the “Deferral Plan”) allowed directors to defer part of the compensation they receive from Bancshares for their services as directors. After Bancshares’ shareholders approved the Comprehensive Benefit Plan on April 21, 2004, the Deferral Plan was terminated (except with respect to outstanding grants). The Comprehensive Benefit Plan authorizes the directors to defer part of the compensation they receive for their services as Bancshares directors. If a director elects to defer part of his or her compensation, Bancshares creates a bookkeeping account for the director and credits this account with a certain number of shares of Bancshares’ common stock, which is adjusted periodically to reflect the payment and reinvestment of dividends on the common stock. Directors have only an unsecured contractual commitment of Bancshares to pay the deferred amounts due under the Deferral Plan and the Comprehensive Benefit Plan. However, Bancshares maintains a “grantor” trust in connection with shares to be issued under its previous and current deferred compensation plans. This trust has purchased, and intends to continue to purchase, shares on the open market in an amount necessary to provide to directors future benefits that accrue under these plans (although the assets of the trust are subject to the claims of Bancshares’ general creditors in the event of Bancshares’ insolvency). The following table summarizes the common stock held in the trust, which is presented as a reduction of Shareholders’ Equity:


	December 31
	2005		2004		2003

Shares of common stock owned		81,718		74,183		69,295


Cost of common stock owned	$	1,333,701	$	1,197,490	$	1,100,665

Bancshares administers the following stock-based compensation plans to the extent that there are outstanding awards to plan participants: (a) the 1986 Employee Incentive Stock Option Plan; (b) the 1994 Director Stock Option Plan; and (c) the 1996 Omnibus Stock Incentive Plan (collectively, the “Previous Benefit Plans”). After shareholders approved the Comprehensive Benefit Plan, the Previous Benefit Plans were terminated (except with respect to outstanding grants). The Comprehensive Benefit Plan gives the Compensation Committee the authority to issue 750,000 shares of common stock and an indeterminate amount of plan interests to plan participants in the form of stock options, restricted stock, restricted stock units, performance units and other stock-based awards. The Compensation Committee has the authority pursuant to the Comprehensive Benefit Plan to grant options, with such durations and vesting schedules as the Compensation Committee deems appropriate (provided, however, that such durations may not exceed ten years).

The following table summarizes information about outstanding and exercisable stock options at December 31, 2005:


		Weighted				Weighted				Weighted
	Range of	Average				Average				Average
	Exercise	Remaining		Number		Exercise		Number		Exercise
	Prices	Life		Outstanding		Prices		Exercisable		Prices

$	11.063 - 13.550		3.50		87,062	$	13.298		75,062	$	13.268
	14.250 - 15.063		3.83		50,025		14.958		50,025		14.958
	15.200 - 15.200		1.39		37,499		15.200		37,499		15.200
	16.570 - 16.570		1.29		8,125		16.570		8,125		16.570
	17.110 - 17.110		8.97		96,250		17.110		82,384		17.110
	17.240 - 17.240		6.41		73,750		17.240		44,250		17.240
	17.650 - 17.650		9.20		91,000		17.650		14,000		17.650
	18.000 - 18.000		7.94		76,250		18.000		55,000		18.000
	20.000 - 20.000		3.36		48,750		20.000		48,750		20.000
	20.750 - 20.750		2.44		46,250		20.750		46,250		20.750

					614,961				461,345

A summary of the status of Bancshares’ stock-based compensation plans as of December 31, 2005 and 2004 and changes during the years then ended is presented below:


	2005					2004
				Weighted					Weighted
				Average					Average
				Exercise					Exercise
	Shares			Price		Shares			Price

Options outstanding at beginning of years		581,364		$	16		577,734		$	16
Granted		91,000			18		96,250			17
Exercised		(40,257	)		12		(61,042	)		13
Cancelled		(17,146	)		12		(31,578	)		18

Options outstanding at end of years		614,961			17		581,364			16


Options exercisable at end of years		461,345			17		362,114			16

Note 17 – QUARTERLY FINANCIAL DATA

Quarterly financial data for 2005 and 2004 is summarized below (in thousands, except per share data). The sum of the quarterly earnings per share amounts may not equal the annual earnings per share amounts due primarily to changes in the number of shares outstanding from quarter to quarter.


	2005								2004
	4th Qtr.		3rd Qtr.		2nd Qtr.		1st Qtr.		4th Qtr.		3rd Qtr.		2nd Qtr.		1st Qtr.

Interest income	$	16,002	$	15,780	$	14,961	$	13,682	$	12,958	$	12,403	$	12,067	$	11,891
Interest expense		4,913		4,574		3,910		3,329		2,875		2,615		2,420		2,457

Net interest income		11,089		11,206		11,051		10,353		10,083		9,788		9,647		9,434
Provision for loan losses		905		715		1,060		539		621		1,104		781		511

Net interest income after provision for loan losses		10,184		10,491		9,991		9,814		9,462		8,684		8,866		8,923
Noninterest income		3,651		3,398		3,481		3,262		3,278		3,540		3,889		3,356
Noninterest expense		10,112		10,087		9,808		9,763		9,461		9,654		9,468		9,104

Income before income taxes		3,723		3,802		3,664		3,313		3,279		2,570		3,287		3,175
Income taxes		1,248		1,302		1,234		1,081		1,065		793		1,051		1,022

Net income	$	2,475	$	2,500	$	2,430	$	2,232	$	2,214	$	1,777	$	2,236	$	2,153

Earnings per share:
Basic	$	0.29	$	0.29	$	0.28	$	0.26	$	0.26	$	0.21	$	0.26	$	0.25
Diluted		0.29		0.29		0.28		0.26		0.26		0.21		0.26		0.25

Note 18 — LSB BANCSHARES, INC. (PARENT COMPANY)

The condensed balance sheets for Bancshares as of December 31, 2005 and 2004, and the related condensed statements of income and cash flows for the years ended December 31, 2005, 2004 and 2003, are as follows (in thousands):

CONDENSED BALANCE SHEETS


	December 31
	2005		2004

Assets:
Cash	$	153	$	1,656
Investment in wholly-owned subsidiary		93,799		89,683
Other assets		637		744

Total assets	$	94,589	$	92,083

Liabilities and Shareholders’ equity:
Other liabilities	$	1,448	$	1,255
Shareholders’ equity		93,141		90,828

Total liabilities and Shareholders’ equity	$	94,589	$	92,083

CONDENSED STATEMENTS OF INCOME


	Years Ended December 31
	2005		2004		2003

Dividends from subsidiary	$	5,805	$	5,490	$	5,454
Other operating expense		283		207		251

Income before equity in earnings of subsidiary		5,522		5,283		5,203
Equity in earnings of subsidiary		4,115		3,097		3,375

Net income	$	9,637	$	8,380	$	8,578

CONDENSED STATEMENTS OF CASH FLOWS


	Years Ended December 31
	2005			2004			2003

CASH FLOW FROM OPERATING ACTIVITIES:
Net income	$	9,637		$	8,380		$	8,578
Adjustments to reconcile net income to net cash provided by operating activities:
Change in investment in wholly-owned subsidiary		(4,115	)		(3,097	)		(3,375	)

Net cash provided by operating activities		5,522			5,283			5,203

CASH FLOW FROM INVESTING ACTIVITIES:
(Increase) decrease in other assets		107			(7	)		7

CASH FLOW FROM FINANCING ACTIVITIES:
Sale of capital stock		484			784			858
Dividends paid		(5,805	)		(5,490	)		(5,454	)
Common stock acquired		(2,004	)		(397	)		(106	)
Increase in other liabilities		193			155			91

Net cash used for financing activities		(7,132	)		(4,948	)		(4,611	)

Increase (decrease) in cash		(1,503	)		328			599
Cash at beginning of years		1,656			1,328			729

Cash at end of years	$	153		$	1,656		$	1,328

Note 19 – Derivatives

The following table reflects risk management derivative financial instruments for the year ended December 31, 2005:

Average

Notional

Unrealized

Years

(Dollars in thousands)

Amount

Losses (a)

Maturity

Fair value liability hedges:

Interest rate options


(a)		Represents the fair value of derivative financial instruments.

These derivatives were all issued in the fourth quarter of 2005 with a maturity of five years therefore the total notional amount will mature in five years.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

Not applicable.

Item 9A. Controls and Procedures.

As of the end of the period covered by this report, Bancshares has evaluated, under the supervision and with the participation of Bancshares’ management, including Bancshares’ Chief Executive Officer and Chief Financial Officer, the effectiveness of Bancshares’ disclosure controls and procedures (as defined in Rule 13A-15(e) promulgated under the Exchange Act). Based upon that evaluation, Bancshares’ Chief Executive Officer and Chief Financial Officer have concluded that Bancshares’ disclosure controls and procedures are effective to ensure that information required to be disclosed by Bancshares in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within time periods specified in the rules and forms of the SEC.

Bancshares’ management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13A-15(f) promulgated under the Exchange Act). Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Bancshares’ management assessed the effectiveness of Bancshares’ internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.

Based on this assessment, Bancshares’ management believes that, as of December 31, 2005, Bancshares’ internal control over financial reporting is effective.

Bancshares’ independent auditor, Turlington and Company L.L.P., has issued an audit report on management’s assessment of Bancshares’ internal control over financial reporting. This Report of Independent Registered Public Accounting Firm begins on page 39 in Item 8 above.

During the quarter ended December 31, 2005, there have been no changes in Bancshares’ internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, Bancshares’ internal control over financial reporting.

Item 9B. Other Information.

Not Applicable.

PART III

Item 10. Directors and Executive Officers of the Registrant.

The information called for by Item 10 with respect to directors is set forth in Bancshares’ Proxy Statement for its 2006 Annual Meeting of Shareholders (the “Proxy Statement”) under the caption, “Proposal 1: Election of Directors” and is hereby incorporated by reference, except for information with respect to Sue H. Hunter, Roberts E. Timberlake and Lloyd G. Walter, who are retiring from the Board of Directors as of April 19, 2006 in accordance with the directors’ retirement policy set forth in Bancshares’ Bylaws and Bancshares’ Governance Guidelines, which were adopted by the Board of Directors on December 21, 2004.

Sue H. Hunter, age 70, has been a director of Bancshares since 1999. She is currently President and Co-Owner of the Thomasville Emporium, Inc., Vice President of the Side Street Café; and Co-Owner of 2 Couples, LLC.

Roberts E. Timberlake, age 69, has been a director of Bancshares since 1979. He is an artist/designer and Chairman, President and CEO of Bob Timberlake, Inc.

Lloyd G. Walter, Jr., age 71, has been a director of Bancshares since 1997. He is an architect and sole proprietor doing business as LGW Consulting. He is the former CEO and founding principal of Walter, Robbs, Callahan & Pierce Architects, P.A.

The information called for by Item 10 with respect to executive officers is set forth in the Proxy Statement under the captions, “Governance of Bancshares: Executive Officers of Bancshares” and “Executive Compensation: Employment Continuity Agreements” and is hereby incorporated by reference.

The information called for by Item 10 with respect to (a) the identification of the members of Bancshares’ Audit Committee; (b) the presence of an audit committee financial expert; and (c) changes to procedures by which Bancshares’ shareholders may recommend nominees to Bancshares’ Board of Directors is set forth in the Proxy Statement under the captions, (a) “Governance of Bancshares: Current Members of the Board;” (b) “Governance of Bancshares: Board Committees: Audit Committee;” and (c) “Shareholder Proposals,” respectively, and is hereby incorporated by reference.

The information called for by Item 10 with respect to matters related to Section 16 of the Exchange Act is set forth in the Proxy Statement under the caption, “Management’s Ownership of Common Stock: Section 16(a) Beneficial Ownership Reporting Compliance” and is hereby incorporated by reference.

The information called for by Item 10 with respect to codes of ethics is set forth in the Proxy Statement under the caption, “Code of Business Conduct and Ethics” and is hereby incorporated by reference.

Item 11. Executive Compensation.

The information called for by Item 11 with respect to executive compensation is set forth in the Proxy Statement under the captions, “Governance of Bancshares: Certain Relationships and Related Transactions,” “Governance of Bancshares: Compensation Committee Interlocks and Insider Participation,” “Executive Compensation” and “Stock Performance Graph” and is hereby incorporated by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.

The information called for by Item 12 with respect to securities authorized for issuance under equity compensation plans is set forth in the Proxy Statement under the caption, “Executive Compensation: Equity Compensation Plan Information” and is hereby incorporated by reference. The information called for by Item 12 with respect to security ownership of executive officers, directors, and nominees for director is set forth in the Proxy Statement under the caption, “Management’s Ownership of Common Stock,” and is hereby incorporated by reference.

Item 13. Certain Relationships and Related Transactions.

The information called for by Item 13 with respect to transactions with management and others, certain business relationships and indebtedness of management is set forth in the Proxy Statement under the caption, “Governance of Bancshares: Certain Relationships and Related Transactions” and is hereby incorporated by reference.

Item 14. Principal Accounting Fees and Services.

The information called for by Item 14 with respect to principal accounting fees and services is set forth in the Proxy Statement under the caption, “Proposal 2: Ratification of Appointment of Turlington and Company, L.L.P. as Bancshares’ Independent Auditors for 2006” and is hereby incorporated by reference.

PART IV

Item 15. Exhibits, Financial Statement Schedules.

(a)

The following documents are filed (or, with respect to Exhibit 32, furnished) as part of this report:

(1)

Financial Statements:


	Page
Independent Accountants’ Audit Report		39
Consolidated Balance Sheets, December 31, 2005 and 2004		41
Consolidated Statements of Income for years ended December 31, 2005, 2004 and 2003		42
Consolidated Statements of Changes in Shareholders’ Equity for years ended December 31, 2005, 2004 and 2003		43
Consolidated Statements of Cash Flows for years ended December 31, 2005, 2004 and 2003		44
Notes to Consolidated Financial Statements		45

	(2)		Financial Statement Schedules: None

	(3)		Exhibits


3.1		Articles of Incorporation of Bancshares, as amended, which are incorporated by reference to Exhibit 4.1 of Bancshares’ Registration Statement on Form S-8 filed with the Securities and Exchange Commission (the “SEC”) on May 16, 2001 (SEC File No. 333-61046).

3.2		Amended and Restated Bylaws of Bancshares, which are incorporated by reference to Exhibit 3.2 of Bancshares’ Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 filed with the SEC on November 4, 2004 (SEC File No. 000-11448).

4.1		Specimen certificate of common stock, $5.00 par value, which is incorporated by reference to Exhibit 4 of Bancshares’ Registration Statement on Form S-1 (SEC File No. 2-99312).

4.2		Rights Agreement dated as of February 10, 1998 by and between Bancshares and Wachovia Bank, N.A., as Rights Agent, which is incorporated by reference to Exhibit 1 of Bancshares’ Registration Statement on Form 8-A filed with the SEC on March 6, 1998 (SEC File No. 000-11448).

10.1*		1994 Director Stock Option Plan of Bancshares, which is incorporated by reference to Exhibit 4 of Bancshares’ Registration Statement on Form S-8 filed with the SEC on July 15, 1994 (SEC File No. 33-81664).

10.2*		1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 1995 filed with the SEC on March 28, 1996 (SEC File No. 000-11448).

10.3*		Amendment Number 1 to 1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 4.5 of Bancshares’ Registration Statement on Form S-8 filed with the SEC on May 16, 2001 (SEC File No. 333-61046).

10.4*		Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees,


		which is incorporated by reference to Appendix VI of Bancshares’ 2003 Proxy Statement filed with the SEC on March 16, 2004 (SEC File No. 000-11448).

10.5*		Form of Stock Option Award Agreement for a Director adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2004 (SEC File No. 000-11448).

10.6*		Form of Incentive Stock Option Award Agreement for an Employee adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2004 (SEC File No. 000-11448).

10.7*		Form of Director Fee Deferral Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 29, 2004 (SEC File No. 000-11448).

10.8*		Employment Continuity Agreement effective as of December 24, 1997 between Bancshares and Nicholas A. Daves, which is incorporated by reference to Exhibit 10.8 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).

10.9*		Employment Continuity Agreement effective as of June 9, 1998 between Bancshares and Suzanne J. Bullotta, which is incorporated by reference to Exhibit 10.16 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 1998 filed with the SEC on March 25, 1999 (SEC File No. 000-11448).

10.10*		Employment Continuity Agreement effective as of October 15, 2001 between Bancshares and M. Jack Smith, which is incorporated by reference to Exhibit 10.10 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).

10.11*		Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Robert F. Lowe, which is incorporated by reference to Exhibit 10.7 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.12*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Monty J. Oliver and H. Franklin Sherron, Jr. with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.8 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.13*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Kathy V. Richardson and Pamela J. Varela with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.9 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.14*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Robert E. Lineback, Jr. and Philip G. Gibson with a Schedule setting forth the material details in which such documents differ from the document a copy of


		which is filed, which is incorporated by reference to Exhibit 10.10 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.15*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Ronald E. Coleman, D. Gerald Sink, Robin A. Huneycutt and Ronald W. Sink with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.11 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.16*		Employment Continuity Agreement effective as of August 16, 2004 between Bancshares and David P. Barksdale, which is incorporated by reference to Exhibit 10.16 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).

10.17*		Employment Continuity Agreement effective as of December 22, 2004 between Bancshares and Andrew G. McDowell, which is incorporated by reference to Exhibit 10.17 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).

10.18*		Restated Form of Director Fee Deferral Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 99.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.19*		Form of Stock Appreciation Rights Award Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 99.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.20*		Bancshares’ Management Incentive Plan, which is incorporated by reference to Exhibit 99.3 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.21*		2006 Director Compensation Schedule of Bancshares and Lexington State Bank, which is incorporated by reference to Exhibit 99.4 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.22*		April 11, 2005 Amendment to Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).

10.23*		Form of Amendment to the applicable Grant Agreements under the 1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).

10.24*		Form of Amendment to the Incentive Stock Option Award Agreement for an Employee adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.3 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).

21+		List of Subsidiaries at December 31, 2005.

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.


		LSB BANCSHARES, INC.

		By:		/s/ Robert F. Lowe

		Name:		Robert F. Lowe
		Title:		Chairman of the Board, President and Chief Executive Officer
		Date:		February 21, 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/ Robert F. Lowe Robert F. Lowe	Director, Chairman, President and Chief Executive Officer (Principal Executive Officer)	February 21, 2006
/s/ Monty J. Oliver Monty J. Oliver	Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer)	February 21, 2006
/s/ Michael S. Albert Michael S. Albert	Director	February 21, 2006
/s/ Walter A. Hill, Sr. Walter A. Hill, Sr.	Director	February 21, 2006
/s/ Robert B. Smith, Jr. Robert B. Smith, Jr.	Director	February 21, 2006
/s/ John W. Thomas III John W. Thomas III	Director	February 21, 2006
/s/ Robert C. Clark Robert C. Clark	Director	February 21, 2006
/s/ Leonard H. Beck Leonard H. Beck	Director	February 21, 2006
/s/ Samuel R. Harris, MD Samuel R. Harris, MD	Director	February 21, 2006
/s/ David A. Smith David A. Smith	Director	February 21, 2006

EXHIBIT INDEX


Exhibit
No.		Description
3.1		Articles of Incorporation of Bancshares, as amended, which are incorporated by reference to Exhibit 4.1 of Bancshares’ Registration Statement on Form S-8 filed with the Securities and Exchange Commission (the “SEC”) on May 16, 2001 (SEC File No. 333-61046).

3.2		Amended and Restated Bylaws of Bancshares, which are incorporated by reference to Exhibit 3.2 of Bancshares’ Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 filed with the SEC on November 4, 2004 (SEC File No. 000-11448).

4.1		Specimen certificate of common stock, $5.00 par value, which is incorporated by reference to Exhibit 4 of Bancshares’ Registration Statement on Form S-1 (SEC File No. 2-99312).

4.2		Rights Agreement dated as of February 10, 1998 by and between Bancshares and Wachovia Bank, N.A., as Rights Agent, which is incorporated by reference to Exhibit 1 of Bancshares’ Registration Statement on Form 8-A filed with the SEC on March 6, 1998 (SEC File No. 000-11448).

10.1*		1994 Director Stock Option Plan of Bancshares, which is incorporated by reference to Exhibit 4 of Bancshares’ Registration Statement on Form S-8 filed with the SEC on July 15, 1994 (SEC File No. 33-81664).

10.2*		1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 1995 filed with the SEC on March 28, 1996 (SEC File No. 000-11448).

10.3*		Amendment Number 1 to 1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 4.5 of Bancshares’ Registration Statement on Form S-8 filed with the SEC on May 16, 2001 (SEC File No. 333-61046).

10.4*		Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Appendix VI of Bancshares’ 2003 Proxy Statement filed with the SEC on March 16, 2004 (SEC File No. 000-11448).

10.5*		Form of Stock Option Award Agreement for a Director adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2004 (SEC File No. 000-11448).

10.6*		Form of Incentive Stock Option Award Agreement for an Employee adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2004 (SEC File No. 000-11448).

10.7*		Form of Director Fee Deferral Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 29, 2004 (SEC File No. 000-11448).

10.8*		Employment Continuity Agreement effective as of December 24, 1997 between Bancshares and Nicholas A. Daves, which is incorporated by reference to Exhibit 10.8


Exhibit
No.		Description
		of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).

10.9*		Employment Continuity Agreement effective as of June 9, 1998 between Bancshares and Suzanne J. Bullotta, which is incorporated by reference to Exhibit 10.16 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 1998 filed with the SEC on March 25, 1999 (SEC File No. 000-11448).

10.10*		Employment Continuity Agreement effective as of October 15, 2001 between Bancshares and M. Jack Smith, which is incorporated by reference to Exhibit 10.10 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).

10.11*		Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Robert F. Lowe, which is incorporated by reference to Exhibit 10.7 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.12*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Monty J. Oliver and H. Franklin Sherron, Jr. with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.8 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.13*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Kathy V. Richardson and Pamela J. Varela with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.9 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.14*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Robert E. Lineback, Jr. and Philip G. Gibson with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.10 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.15*		Form of Employment Continuity Agreement effective as of January 1, 2004 between Bancshares and Ronald E. Coleman, D. Gerald Sink, Robin A. Huneycutt and Ronald W. Sink with a Schedule setting forth the material details in which such documents differ from the document a copy of which is filed, which is incorporated by reference to Exhibit 10.11 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2003 filed with the SEC on March 15, 2004 (SEC File No. 000-11448).

10.16*		Employment Continuity Agreement effective as of August 16, 2004 between Bancshares and David P. Barksdale, which is incorporated by reference to Exhibit 10.16 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).

10.17*		Employment Continuity Agreement effective as of December 22, 2004 between Bancshares and Andrew G. McDowell, which is incorporated by reference to Exhibit 10.17 of Bancshares’ Annual Report on Form 10-K for the year ended December 31, 2004 filed with the SEC on March 11, 2005 (SEC File No. 000-11448).


Exhibit
No.		Description
10.18*		Restated Form of Director Fee Deferral Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 99.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.19*		Form of Stock Appreciation Rights Award Agreement adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 99.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.20*		Bancshares’ Management Incentive Plan, which is incorporated by reference to Exhibit 99.3 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.21*		2006 Director Compensation Schedule of Bancshares and Lexington State Bank, which is incorporated by reference to Exhibit 99.4 of Bancshares’ Current Report on Form 8-K filed with the SEC on December 23, 2005 (SEC File No. 000-11448).

10.22*		April 11, 2005 Amendment to Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.1 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).

10.23*		Form of Amendment to the applicable Grant Agreements under the 1996 Omnibus Stock Incentive Plan, which is incorporated by reference to Exhibit 10.2 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).

10.24*		Form of Amendment to the Incentive Stock Option Award Agreement for an Employee adopted under Bancshares’ Comprehensive Equity Compensation Plan for Directors and Employees, which is incorporated by reference to Exhibit 10.3 of Bancshares’ Current Report on Form 8-K filed with the SEC on April 15, 2005 (SEC File No. 000-11448).

21+		List of Subsidiaries at December 31, 2005.

23+		Consent of Turlington and Company, L.L.P.

31.1+		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2+		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32+		Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


*		Indicates a management contract or compensatory plan, contract or arrangement.

+		Indicates the exhibit is being filed herewith.


	Total				Total Shares		Maximum Number
	Number of		Average		Purchased Pursuant		of Shares that may
	Shares		Price Paid		to Publicly		yet be Purchased
Month	Purchased		Per Share		Announced Plan		Under the Plan

October 1 – October 31		1,868	$	17.55		1,868		331,956
November 1 – November 30		1,344	$	17.51		1,344		330,612
December 1 – December 31		601	$	17.52		601		330,011

Total Fourth Quarter		3,813	$	17.53		3,813


		Page
	PART I

Item 1	Business		4
Item 1A	Risk Factors		8
Item 1B	Unresolved Staff Comments		10
Item 2	Properties		10
Item 3	Legal Proceedings		12
Item 4	Submission of Matters to a Vote of Security Holders		12

	PART II

Item 5	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		12
Item 6	Selected Financial Data		15
Item 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
Item 7A	Quantitative and Qualitative Disclosures About Market Risk		37
Item 8	Financial Statements and Supplementary Data		37
Item 9	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure		66
Item 9A	Controls and Procedures		66
Item 9B	Other Information		67

	PART III

Item 10	Directors and Executive Officers of the Registrant		67
Item 11	Executive Compensation		67
Item 12	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		68
Item 13	Certain Relationships and Related Transactions		68
Item 14	Principal Accountant Fees and Services		68

	PART IV

Item 15	Exhibits, Financial Statement Schedules		69
EX-21
EX-23
EX-31.1
EX-31.2
EX-32

1.		I have reviewed this annual report on Form 10-K of LSB Bancshares, Inc.;

2.		Based on my knowledge, this annual 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 annual 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 annual 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)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

	(a)		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 annual report is being prepared;

	(b)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	(c)		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

	(d)		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

	(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 controls over financial reporting.



	/s/ Robert F. Lowe
	Robert F. Lowe
	Chairman, President and Chief Executive Officer



	/s/ Monty J. Oliver
	Monty J. Oliver
	Chief Financial Officer, Secretary and Treasurer


/s/ Robert F. Lowe		/s/ Monty J. Oliver

Robert F. Lowe,		Monty J. Oliver,
Chief Executive Officer		Chief Financial Officer