Exhibit 13

Tower Bancorp, Inc.

2008 Annual Financial Report

CONTENTS

	Page
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON THE FINANCIAL STATEMENTS	1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING	2 - 3
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING	4 - 5
CONSOLIDATED FINANCIAL STATEMENTS
Balance sheets	6
Statements of income	7
Statements of changes in stockholders’ equity	8
Statements of cash flows	9 - 10
Notes to consolidated financial statements	11 - 34

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON THE FINANCIAL STATEMENTS

To the Board of Directors and

   Shareholders of Tower Bancorp, Inc.

We have audited the accompanying consolidated balance sheets of Tower Bancorp, Inc. and subsidiary as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2008.  Tower Bancorp, Inc.’s management is responsible for these financial statements.  Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Tower Bancorp, Inc. and subsidiary as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1 to the consolidated financial statements, the Corporation changed its policy for accounting for stock-based compensation in 2006.  As discussed in Note 21 to the consolidated financial statements, the Corporation changed its method of accounting for split-dollar post-retirement benefits in 2008 as required by the provisions of EITF 06-04.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Tower Bancorp, Inc. and subsidiary’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2009 expressed an adverse opinion.

/S/ SMITH ELLIOTT KEARNS & COMPANY, LLC

Chambersburg, Pennsylvania
March 13, 2009

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON INTERNAL CONTROL OVER FINANCIAL REPORTING

To the Board of Directors and

   Shareholders of Tower Bancorp, Inc.

We have audited Tower Bancorp, Inc. and subsidiary’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).  Tower Bancorp, Inc. and subsidiary’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting.  Our responsibility is to express an opinion on the Corporation’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audit also included performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinion.

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

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

A material weakness is a control deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Corporation’s annual or interim financial statements will not be prevented or detected on a timely basis.  The following material weakness has been identified and included in management’s assessment.  The Corporation did not maintain adequate risk identification and monitoring of loans.  Weaknesses include an ineffective loan review function, incomplete management information system, inadequate information to support the borrowers’ ability to service the loans, inconsistent loan documentation, and ineffective evaluation of the components of the allowance for loan losses.  These conditions result in a weakness in management’s ability to administer the loan portfolio and to determine the adequacy of the allowance for loan losses.  This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2008 financial statements, and this report does not affect our report dated March 13, 2009 on those financial statements.

In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Tower Bancorp, Inc. and subsidiary have not maintained effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets and the related consolidated statements of income, changes in stockholders’ equity and cash flows of Tower Bancorp, Inc. and subsidiary, and our report dated March 13, 2009 expressed an unqualified opinion.

/S/ SMITH ELLIOTT KEARNS & COMPANY, LLC

Chambersburg, Pennsylvania
March 13, 2009

MANAGEMENT’S REPORT ON INTERNAL CONTROL
OVER FINANCIAL REPORTING

To our Shareholders,
Tower Bancorp, Inc.
Greencastle, Pennsylvania

The management of Tower Bancorp, Inc. and its wholly-owned subsidiary (the “Corporation”) has the responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting.  Management maintains a comprehensive system of internal control to provide reasonable assurance of the proper authorization of transactions, the safeguarding of assets and the reliability of the financial records.  The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees.  Tower Bancorp, Inc. and its wholly-owned subsidiary maintain an internal auditing program, under the supervision of the Audit Committee of the Board of Directors, which independently assesses the effectiveness of the system of internal control and recommends possible improvements.

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.

Under the supervision and with the participation of the Corporation’s management, including its Chief Executive Officer and Chief Financial Officer, the Corporation has evaluated the effectiveness of its internal control over financial reporting as of December 31, 2008 using the Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the Corporation’s annual or interim financial statements will not be prevented or detected on a timely basis.  Management identified the following material weakness in internal control over financial reporting as of December 31, 2008:

The Corporation did not maintain adequate risk identification and monitoring of loans.  Weaknesses include an ineffective loan review function, incomplete management information system, inadequate information to support the borrowers’ ability to service the loans, inconsistent loan documentation, and ineffective evaluation of the components of the allowance for loan losses.  These conditions result in a weakness in management’s ability to administer the loan portfolio and to determine the adequacy of the allowance for loan losses.

As a result of the material weakness identified above, management has concluded that Tower Bancorp, Inc. and subsidiary did not maintain effective internal control over financial reporting as of December 31, 2008 based on criteria established in Internal Control — Integrated Framework issued by the COSO.

The independent registered public accounting firm of Smith Elliott Kearns & Company, LLC has issued an audit report on the Corporation’s internal control over financial reporting as of December 31, 2008.  The accounting firm’s audit report on internal control over financial reporting is included in this financial report.

/S/ Jeffrey B. Shank	/S/ Franklin T. Klink, III
Jeffrey B. Shank	Franklin T. Klink, III
President and Chief Executive Officer	Chief Financial Officer
March 13, 2009	March 13, 2009

REMEDIATION OF MATERIAL WEAKNESS

The Corporation continues to develop and implement plans to address our material weakness.  Management has taken the following steps to improve the internal controls over financial reporting.

Management has maintained a full time Loan Review Officer.  The Loan Review Officer has been reviewing the adequacy of management’s risk identification of loans for calculating the adequacy of the allowance for loan losses.  The Corporation has maintained a full time Credit Administration Officer and a full time Credit Analyst to assist in the identification and monitoring of risk within the loan portfolio.  In addition, a consulting firm was engaged to assist in reviewing the adequacy of management’s risk identification processes and ratings.  The loan policy was redrafted to better address risk identification of loans.  A consulting firm was engaged to assist with the new loan policy.  Management reviewed the management information systems, particularly the data used for loan risk assessment.  The data has been updated to reflect current risk assessments.  New procedures were implemented to strengthen the collection and filing of information to support borrower’s ability to service loans.  The Board of Directors formed a Compliance Committee to oversee the development and implementation of the actions to remediate the material weakness.  A consulting firm was engaged to assist the Compliance Committee.

TOWER BANCORP INC. AND ITS WHOLLY-OWNED SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31, 2008 and 2007

	2008			2007
	(000 omitted)
ASSETS
Cash and due from banks	$	10,757		$	16,770
Federal funds sold	0			20,081
Interest bearing deposits with banks	802			0
Investment securities available for sale	76,451			83,846
Restricted Bank stock	4,788			2,914
Loans
Commercial, financial and agricultural	27,840			30,444
Real estate — Mortgages	360,696			331,521
Real estate — Construction and land development	15,714			20,134
Consumer	14,853			17,059
	419,103			399,158
Net deferred loan fees, costs and discounts	(209		)	(679		)
Less: Allowance for loan losses	(4,597		)	(3,854		)
Total loans	414,297			394,625
Premises, equipment, furniture and fixtures	11,834			9,861
Real estate owned other than premises	2,316			2,313
Accrued interest receivable	1,855			1,861
Cash surrender value of life insurance	11,208			10,768
Deferred income taxes	3,107			0
Goodwill	16,558			16,558
Other intangible assets	1,583			1,994
Other assets	973			45
Total assets	$	556,529		$	561,636

	2008			2007
	(000 omitted)
LIABILITIES
Deposits in domestic offices
Demand, noninterest bearing	$	44,205		$	46,860
Savings	216,021			223,904
Time	161,085			169,166
Total deposits	421,311			439,930
Liabilities for other borrowed funds	59,525			37,735
Accrued interest payable	637			999
Deferred income taxes	0			1,657
Other liabilities	4,299			2,901
Total liabilities	485,772			483,222
STOCKHOLDERS’ EQUITY
Stockholders’ equity
Common Stock: no par value, authorized 5,000,000 shares, issued 2,420,481 shares	2,225			2,225
Additional paid-in capital	34,787			34,831
Retained earnings	40,278			40,696
Accumulated other comprehensive income	(2,375		)	4,558
	74,915			82,310
Less: Cost of treasury stock, 105,001 shares - 2008; 98,055 shares — 2007	(4,158		)	(3,896		)
Total stockholders’ equity	70,757			78,414
Total liabilities and stockholders’ equity	$	556,529		$	561,636

The Notes to Consolidated Financial Statements are an integral part of these statements

6

TOWER BANCORP INC. AND ITS WHOLLY-OWNED SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2008, 2007, and 2006

	2008		2007		2006
			(000 omitted)
Interest and Dividend Income
Interest and fees on loans	$	27,023	$	28,490	$	22,384
Interest and dividends on investment securities
Taxable	2,467		1,618		1,800
Federal tax exempt	1,196		1,278		1,227
Interest on federal funds sold	258		1,961		348
Interest on deposits with banks	30		16		40
Total interest income	30,974		33,363		25,799
Interest Expense
Interest on time certificates of deposit of $100,000 or more	1,248		1,561		896
Interest on other deposits	7,002		10,367		6,482
Interest on borrowed funds	2,040		2,082		2,495
Total interest expense	10,290		14,010		9,873
Net interest income	20,684		19,353		15,926
Provision for loan losses	1,375		600		360
Net interest income after provision for loan losses	19,309		18,753		15,566
Other Income
Investment services income	713		961		413
Service charges on deposit accounts	1,897		1,808		1,523
Other service charges, collection and exchange charges, commissions and fees	1,241		1,525		1,084
Investment securities gains	269		1,886		3,923
Other income	397		531		381
	4,517		6,711		7,324
Other Expenses
Salaries, wages and other employee benefits	8,581		8,188		6,949
Occupancy expense	1,132		1,058		853
Furniture and equipment expenses	2,953		2,571		2,220
Merger expense	300		0		0
Impairment expense	2,607		0		0
Other operating expenses	4,651		4,279		4,018
	20,224		16,096		14,040
Income before income taxes	3,602		9,368		8,850
Applicable income tax expense	424		2,331		2,718
Net income	$	3,178	$	7,037	$	6,132
Earnings per share:
Basic earnings per share	$	1.37	$	3.00	$	2.92
Weighted average shares outstanding	2,316,697		2,345,286		2,103,487
Diluted earnings per share	$	1.37	$	2.99	$	2.87
Weighted average shares outstanding	2,320,496		2,353,426		2,137,168

The Notes to Consolidated Financial Statements are an integral part of these statements

7

TOWER BANCORP INC.  AND ITS WHOLLY-OWNED SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Years Ended December 31, 2008, 2007, and 2006

	Common Stock		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income			Treasury Stock			Total Stockholders’ Equity
	(000 omitted)
Balance at December 31, 2005	$	2,225	$	6,760		$	31,618		$	9,557		$	(1,771	)	$	48,389
Comprehensive income:
Net income	0		0			6,132			0			0			6,132
Net unrealized gain on available for sale securities (net of tax $605)	0		0			0			1,174			0			1,174
Total comprehensive income															7,306
Cash dividends declared on common stock $(0.74 per share)	0		0			(1,602		)	0			0			(1,602		)
Merger activity	0		28,009			0			0			(72		)	27,937
Stock options granted	0		108			0			0			0			108
Stock options exercised	0		(69		)	0			0			0			(69		)
Purchase of treasury stock (10,989 shares)	0		(30		)	0			0			(813		)	(843		)
Sale of treasury stock (8,619 shares)	0		32			0			0			295			327
Balance at December 31, 2006	2,225		34,810			36,148			10,731			(2,361		)	81,553
Comprehensive income:
Net income	0		0			7,037			0			0			7,037
Net unrealized gain (loss) on available for sale securities (net of tax $3,180)	0		0			0			(6,173		)	0			(6,173		)
Total comprehensive income															864
Cash dividends declared on common stock $(1.06 per share)	0		0			(2,489		)	0			0			(2,489		)
Stock options granted	0		108			0			0			0			108
Stock options exercised	0		(71		)	0			0			0			(71		)
Purchase of treasury stock (43,122 shares)	0		0			0			0			(1,853		)	(1,853		)
Sale of treasury stock (8,345 shares)	0		(16		)	0			0			318			302
Balance at December 31, 2007	2,225		34,831			40,696			4,558			(3,896		)	78,414
Comprehensive income:
Net income	0		0			3,178			0			0			3,178
Net unrealized gain (loss) on available for sale securities (net of tax $3,572)	0		0			0			(6,933		)	0			(6,933		)
Total comprehensive income (loss)															(3,755		)
Cash dividends declared on common stock $(1.12 per share)	0		0			(2,595		)	0			0			(2,595		)
Split dollar life insurance accounting	0		0			(1,001		)	0			0			(1,001		)
Stock options granted	0		78			0			0			0			78
Stock options exercised	0		(52		)	0			0			0			(52		)
Purchase of treasury stock (14,409 shares)	0		0			0			0			(558		)	(558		)
Sale of treasury stock (7,463 shares)	0		(70		)	0			0			296			226
Balance at December 31, 2008	$	2,225	$	34,787		$	40,278		$	(2,375	)	$	(4,158	)	$	70,757

The Notes to Consolidated Financial Statements are an integral part of these statements

8

TOWER BANCORP INC. AND ITS WHOLLY-OWNED SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2008, 2007, and 2006

	2008			2007			2006
				(000 omitted)
Cash flows from operating activities:
Net income	$	3,178		$	7,037		$	6,132
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	1,067			1,267			915
Net loss on sale of property and equipment	48			8			0
Provisions for loan loss	1,375			600			360
Granting of Stock Options	78			108			108
(Gain) on sale of investment securities	(269		)	(1,886		)	(3,923		)
Provision for deferred taxes	(1,084		)	(342		)	(12		)
Impairment of investments	2,607			0			0
(Increase) decrease in:
Other assets	(1,049		)	754			(292		)
Mortgage servicing valuation	52			(301		)	0
Interest receivable	6			(20		)	(738		)
Cash surrender value of life insurance	(440		)	(85		)	(378		)
Increase (decrease) in:
Interest payable	(362		)	5			(113		)
Other liabilities	307			(61		)	151
Other net	0			0			(112		)
Net cash provided by operating activities	5,514			7,084			2,098
Cash flows from investing activities:
Net (increase) in loans	(20,800		)	(8,416		)	(19,949		)
Purchases of property and equipment	(4,027		)	(1,474		)	(2,593		)
Net decrease in interest bearing deposits with banks	(802		)	97			3,086
Maturity/sales of available for sale securities	12,427			9,260			47,407
Purchases of available for sale securities	(16,924		)	(12,391		)	(16,728		)
Sales of fixed assets	1,012			7			6
Purchase of restricted bank stock	(2,730		)	(121		)	(1,066		)
Cash acquired in acquisition	0			0			4,594
Purchase price of shares exchanged for cash	0			0			(2,935		)
Net cash provided (used) by investing activities	$	(31,844	)	$	(13,038	)	$	11,822

The Notes to Consolidated Financial Statements are an integral part of these statements

9

TOWER BANCORP INC.  AND ITS WHOLLY-OWNED SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

Years Ended December 31, 2008, 2007, and 2006

	2008			2007			2006
				(000 omitted)
Cash flows from financing activities:
Net increase (decrease) in deposits	$	(18,717	)	$	30,095		$	9,599
Borrowings (payments) on short term borrowings	38,885			(13,540		)	(18,531		)
Long-term borrowings	18,615			1,081			0
Payments on long-term borrowings	(15,609		)	(5,000		)	0
Purchase of treasury stock	(558		)	(1,853		)	(813		)
Proceeds from sale of treasury stock	296			302			226
Cash dividends paid	(2,595		)	(2,489		)	(2,017		)
Net cash provided (used) by financing activities	20,317			8,596			(11,536		)
Net increase (decrease) in cash and cash equivalents	(6,013		)	2,642			2,384
Cash and cash equivalents at beginning of year	16,770			14,128			11,744
Cash and cash equivalents at end of year	$	10,757		$	16,770		$	14,128
Supplemental disclosure of cash flows information:
Cash paid during the year for:
Interest	$	10,653		$	14,005		$	9,243
Income taxes	1,948			2,861			2,783
Supplemental schedule of noncash investing and financing activities:
Unrealized gain (loss) on securities available for sale (net of tax effects)	$	(8,654	)	$	(6,173	)	$	1,174
Impairment of investments (net of tax)	1,721			0			0
Additional paid-in capital issued in merger	0			0			28,009

The Notes to Consolidated Financial Statements are an integral part of these statements

10

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.   Summary of Significant Accounting Policies

Nature of Operations

Tower Bancorp, Inc. (the “Corporation”) is a bank holding company whose primary activity consists of owning and supervising its subsidiary, The First National Bank of Greencastle, which is engaged in providing banking and bank related services in South Central Pennsylvania, principally Franklin and Fulton Counties, and Washington County, Maryland.  Its sixteen (16) offices are located in Greencastle, Quincy, Shady Grove, Laurich, Waynesboro, Chambersburg (2), Rouzerville, McConnellsburg (2), Needmore, Fort Loudon and Mercersburg, Pennsylvania; Hancock and Hagerstown (2), Maryland.

Principles of Consolidation

The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiary, The First National Bank of Greencastle (the “Bank”).  All significant intercompany transactions and accounts have been eliminated.

FNB Mortgage Brokers, Inc. was a wholly-owned subsidiary of the Bank, and was acquired in the merger with FNB Financial Corporation in 2006.  FNB Mortgage Brokers, Inc. was dissolved by the Corporation on February 28, 2007.

First Fulton County Community Development Corporation (FFCCDC) is a wholly-owned subsidiary of the Bank, and was acquired in the merger with FNB Financial Corporation in 2006.  The purpose of FFCCDC is to serve the needs of low to moderate income individuals and small business in Fulton County under the Community Development and Regulatory Improvement Act of 1995.  FFCCDC has been inactive since it was acquired.

During 2006, the Corporation completed the merger of FNB Financial Corporation, and these operations are included subsequent to the purchase.  See Note 18 for further discussion.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles 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.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans.  In connection with the determination of the allowances for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties.

While management uses available information to recognize losses on loans and foreclosed real estate, future additions to the allowances may be necessary based on changes in local economic conditions.  In addition, regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowances for losses on loans and foreclosed real estate.  Such agencies may require the Corporation to recognize additions to the allowances based on their judgments about information available to them at the time of their examination.  Because of these factors, management’s estimate of credit losses inherent in the loan portfolio and the related allowance may change in the near term.

11

Note 1.   Summary of Significant Accounting Policies (Continued)

Investment Securities

The Corporation’s investments in securities are classified in three categories and accounted for as follows:

·Trading Securities.  Securities held principally for resale in the near term are classified as trading securities and recorded at their fair values.  Unrealized gains and losses on trading securities are included in other income.

·Securities to be Held to Maturity.  Bonds and notes for which the Corporation has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts which are recognized in interest income using the interest method over the period to maturity.

·Securities Available for Sale.  Securities available for sale consist of securities not classified as trading securities nor as securities to be held to maturity.  These are securities that management intends to use as a part of its asset and liability management strategy and may be sold in response to changes in interest rates, resultant prepayment risk and other related factors.  Securities available for sale are recorded at their fair values.

Unrealized holding gains and losses, net of tax, on securities available for sale are reported as a net amount in other comprehensive income.

Gains and losses on the sale of securities available for sale are determined using the specific-identification method.

The Corporation had no trading or held to maturity securities in 2008 or 2007.

Investments include equity securities with a concentration in the financial services sector amounting to $ 18,483,000 and $ 33,861,000 at December 31, 2008 and 2007, respectively.

The Corporation’s investments are exposed to various risks, such as interest rate, market risk, currency and credit risks.  Due to the level of risk associated with certain investments and the level of uncertainty related to changes in the value of the investments, it is at least reasonably possible that changes in risks in the near term would materially affect investment assets reported in the financial statements.  In addition, recent economic uncertainty and market events have led to unprecedented volatility in currency, commodity, credit and equity markets culminating in failures of some banking and financial services firms and Government intervention to solidify others.  These recent events underscore the level of investment risk associated with the current economic environment, and accordingly the level of risk in the Corporation’s investments.

Restricted Bank Stock

The Corporation is required to maintain minimum investment balances in The Federal Reserve Bank, Federal Home Loan Bank and Atlantic Central Banker’s Bank.  These investments are carried at cost because they are not actively traded and have no readily determinable market value.

Premises, Equipment, Furniture and Fixtures and Depreciation

Premises, equipment, and furniture and fixtures are carried at cost less accumulated depreciation.  Depreciation has been provided generally on the straight-line method and is computed over the estimated useful lives of the various assets as follows:

	Years
Premises	15-40
Equipment, furniture and fixtures	3-15

Repairs and maintenance are charged to operations as incurred.  Land is not depreciated.

12

Note 1.   Summary of Significant Accounting Policies (Continued)

Foreclosed Property

Foreclosed properties includes properties for which the institution has taken physical possession in connection with loan foreclosure proceedings.  See Note 5 for further details.

At the time of foreclosure, foreclosed real estate is recorded at fair value less cost to sell, which becomes the property’s new basis.  Any write-downs based on the asset’s fair value at date of acquisition are charged to the allowance for loan losses.  If an increase in basis results, it is classified as non-interest income unless there has been a prior charge-off, in which case a recovery to the allowance for loan losses is recorded.  After foreclosure, these assets are carried as “other assets” at the new basis.  Improvements to the property are added to the basis of the assets.  Costs incurred in maintaining foreclosed real estate and subsequent adjustments to the carrying amount of the property are classified as “other expenses”.

Loans and Allowance for Loan Losses

Loans are stated at the amount of unpaid principal, reduced by unearned discount, deferred loan origination fees, and an allowance for loan losses.  Unearned discount on installment loans is recognized as income over the terms of the loans by the interest method.  Interest on other loans is calculated by using the simple interest method on daily balances of the principal amount outstanding.

The allowance for loan losses is established through a provision for loan losses charged to expense.  Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely.  The allowance is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectibility of loans and prior loan loss experience.  The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and current economic conditions that may affect the borrowers’ ability to pay.

Loan origination fees and certain direct loan origination costs are deferred and the net amount amortized as an adjustment of the related loan’s yield.  The Corporation is amortizing these amounts over the contractual life of the related loans.

Nonaccrual/Impaired Loans

The accrual of interest income on loans ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely.  Interest accrued but not collected as of the date of placement on nonaccrual status is reversed and charged against current income unless fully collateralized.  Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending on management’s assessment of the ultimate collectibility of principal.  Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote.  Interest income on such loans is recognized only to the extent of interest payments received.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  The larger commercial loans are evaluated for impairment.  Impairment is measured on a loan-by-loan basis by comparing the contractual principal and interest payments to the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.  Consumer loans such as residential mortgages and installments, comprised of smaller balance homogeneous loans, are collectively evaluated for impairment.  Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote.  Interest income on such loans is recognized only to the extent of interest payments received.

13

Note 1.   Summary of Significant Accounting Policies (Continued)

Earnings per Share of Common Stock

Earnings per share of common stock were computed based on weighted average shares outstanding.  For diluted earnings per share, net income is divided by the weighted average number of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents.  The corporation’s common stock equivalents consist of outstanding stock options.  See Note 10 for further details.

A reconciliation of the weighted average shares outstanding used to calculate basic net income per share and diluted net income per share follows.  There is no adjustment to net income to arrive at diluted net income per share.

	2008	2007	2006
Weighted average shares outstanding (basic)	2,316,697	2,345,286	2,103,487
Impact of common stock equivalents	3,799	8,140	33,681
Weighted average shares outstanding (diluted)	2,320,496	2,353,426	2,137,168

Goodwill

Goodwill represents the excess of the purchase price over the underlying fair value of merged entities.  Goodwill is accounted for under Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”, and is assessed for impairment at least annually and as triggering events occur.  In making this assessment, management relies on a number of factors including operating results, business plans, economic projections, anticipated future cash flows, and transactions and market place data.  There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment.  Changes in economic and operating conditions could result in a goodwill impairment in future periods.  Disruptions to the business such as end market conditions and protracted economic weakness, unexpected significant declines in operating results, and market capitalization declines may result in a goodwill impairment.  These types of events and the resulting analysis could result in additional charges for goodwill and other asset impairments in the future.  See Note 18 for further details.

Intangible Assets

Intangible assets include premiums from purchases of core deposit relationships acquired in the merger with FNB Financial Corporation.  The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.  Also included in intangible assets are mortgage servicing rights resulting from loans serviced for others, discussed further in Note 6.  See Note 18 for further details.

Loan Servicing

The cost of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing revenues.  Impairment of mortgage servicing rights is assessed based on the fair value of those rights.  Fair values are estimated using discounted cash flows based on a current market interest rate.  For purposes of measuring impairment, the rights are stratified based on the predominant risk characteristics of the underlying loans:  product type, investor type, interest rate, and term.

Federal Income Taxes

For financial reporting purposes, the provision for loan losses charged to operating expense is based on management’s judgment, whereas for federal income tax purposes, the amount allowable under present tax law is deducted.  Additionally, deferred compensation is charged to operating expense in the period the liability is incurred for financial reporting purposes, whereas, for federal income tax purposes, these expenses are deducted when paid.  There are also differences between the amount of depreciation, intangible amortization, and deferred compensation expensed for tax and financial reporting purposes, and an income tax effect caused by the adjustment to fair value for available for sale securities.  As a result of these timing differences, deferred income taxes are provided in the financial statements.  See Note 13 for further details.

14

Note 1.   Summary of Significant Accounting Policies (Continued)

Federal Income Taxes (Continued)

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained.  The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any.  Tax positions taken are not offset or aggregated with other positions.  Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority.  The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above would be reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits would be classified as additional income taxes in the statement of income.

At December 31, 2008 there was no liability for unrecognized tax benefits.

Cash Flows

For purposes of the Statements of Cash Flows, the Corporation has defined cash and cash equivalents as highly liquid debt instruments with maturities of three months or less.  They are included in the balance sheet caption “cash and due from banks”.  As permitted by generally accepted accounting principles, the Corporation has elected to present the net increase or decrease in deposits in banks, loans and deposits in the Statements of Cash Flows.

Fair Values of Financial Instruments

Generally accepted accounting principles (GAAP) require disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques.  Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows.  In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments.  GAAP exclude certain financial instruments and all nonfinancial instruments from its disclosure requirements.  Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the corporation.  See Note 19 for further details.

The following methods and assumptions were used by the Corporation in estimating fair values of financial instruments as disclosed herein:

Cash and Cash Equivalents.  The carrying amounts of cash and short-term instruments approximate their fair value.

Interest Bearing Deposits with Banks.  Interest bearing balances with banks having a maturity greater than one year have estimated fair values using discounted cash flows based on current market interest rates.

Securities to be Held to Maturity and Securities Available for Sale.  Fair values for investment securities are based on quoted market prices.

15

Note 1.   Summary of Significant Accounting Policies (Continued)

Fair Values of Financial Instruments (Continued)

Loans Receivable.  For variable rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values.  Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Deposit Liabilities.  The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts).  The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date.  Fair values for fixed rate certificates of deposits and IRA’s are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected maturities on time deposits.

Federal Funds Purchased and Other Borrowed Funds.  The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within 90 days approximate their fair values.  Fair values of other borrowings are estimated using discounted cash flow analyses based on the Corporation’s current incremental borrowing rates for similar types of borrowing arrangements.

Accrued Interest.  The carrying amounts of accrued interest approximate their fair values.

Off-Balance-Sheet Instruments.  The Corporation generally does not charge commitment fees. Fees for standby letters of credit and their off-balance-sheet instruments are not significant.

Advertising

The Corporation expenses advertising costs as they are incurred.  Advertising expense for the years ended December 31, 2008, 2007, and 2006, was $ 370,594, $ 371,104, and $ 332,246, respectively.

Trust Assets

Assets held by the Corporation in a fiduciary or agency capacity are not included in the consolidated financial statements since such assets are not assets of the Corporation.  In accordance with banking industry practice, income from fiduciary activities is generally recognized on the cash basis which is not significantly different from amounts that would have been recognized on the accrual basis.

Comprehensive Income

The Corporation follows generally accepted accounting principles when reporting comprehensive income. Comprehensive income is defined as the change in equity from transactions and other events from nonowner sources.  It includes all changes in equity except those resulting from investments by stockholders and distributions to stockholders.  Comprehensive income includes net income and certain elements of “other comprehensive income” such as foreign currency transactions; accounting for futures contracts; employers accounting for pensions; and accounting for certain investments in debt and equity securities.

The Corporation has elected to report its comprehensive income in the statement of changes in stockholders’ equity.  The only element of “other comprehensive income” that the Corporation has is the unrealized gains or losses on available for sale securities.

16

Note 1.   Summary of Significant Accounting Policies (Continued)

Comprehensive Income (Continued)

The components of the change in net unrealized gains (losses) on securities are as follows:

	2008			2007			2006
	(000 Omitted)
Gross unrealized holding gains (losses) arising during the year	$	(12,843	)	$	(7,467	)	$	5,702
Reclassification adjustment for impairment losses recognized in net income	2,607			0			0
Reclassification adjustment for (gains) realized in net income	(269		)	(1,886		)	(3,923		)
Net unrealized holding gains (losses) before taxes	(10,505		)	(9,353		)	1,779
Tax effect	(3,572		)	3,180			(605		)
Net change	$	(6,933	)	$	(6,173	)	$	1,174

Fair Value Measurements

SFAS No. 157, Fair Value Measurements, defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements.  The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.  The three levels are defined as follows:

·	Level 1	inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
·	Level 2	inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
·	Level 3	inputs to the valuation methodology are unobservable and significant to the fair value measurement

In February 2008, the FASB issued Staff Position No. 157-2 (“FSP 157-2”) which delayed the effective date of SFAS 157 for certain nonfinancial assets and nonfinancial liabilities except for those items that are recognized or disclosed at fair value in the financial statements on a recurring basis.  FSP 157-2 defers the effective date of SFAS 157 for such nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years.  Thus, the Corporation has only partially applied SFAS 157.  Those items affected by FSP 157-2 include other real estate owned (“OREO”), goodwill and core deposit intangibles.

Following is a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Securities

Where quoted prices are available in an active market, securities are classified within level 1 of the valuation hierarchy.  Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities.  If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow.  Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities.  In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within level 3 of the valuation hierarchy.  Currently, all equity securities held by the holding company with a total fair value of $ 18,483,000 are considered to be Level 1 Securities.  All others held by the bank with a total fair value of $ 57,968,000 are considered to be Level 2.

17

Note 1.   Summary of Significant Accounting Policies (Continued)

Fair Value Measurements (Continued)

Loans held for sale

Loans held for sale are required to be measured at lower of cost or fair value.  Under SFAS No. 157, market value is to represent fair value.  Management obtains quotes or bids on all or part of these loans directly from the purchasing financial institutions.  Premiums received or to be received on the quotes or bids are indicative of the fact that cost is lower than fair value.  At December 31, 2008, there were no loans held for sale.

Impaired loans

SFAS No. 157 applies to loans measured for impairment using the practical expedients permitted by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent).  Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of the collateral.  At December 31, 2008 there were $ 3,653,000 in loans that the Corporation has identified as impaired (See Note 8).

Other Real Estate Owned

Certain assets such as other real estate owned (OREO) are measured at the lower of cost, or fair value less cost to sell.  Fair values are determined by appraisals or comparisons to similar properties.

The Corporation had no liabilities subject to fair value reporting requirements at December 31, 2008.  A summary of assets at December 31, 2008 measured at estimated fair value on a recurring basis is as follows:

	Level 1		Level 2		Level 3		Total Fair Value  Measurements
	(000 omitted)
Securities available for sale	$	18,483	$	57,968	$	0	$	76,751
Impaired loans	0		3,653		0		3,653
	$	18,483	$	61,621	$	0	$	80,104

Stock Option Plans

The Corporation maintains two stock-based compensation plans.  These plans provide for the granting of stock options to the Corporation’s employees and directors.  The Corporation has historically accounted for the plans using the intrinsic-value method under the recognition and measurement principles of APB Opinion No. 25 and related Interpretations.  In December 2004, the FASB issued a final FAS Statement No. 123R, “Share-Based Payment”, which requires financial statement recognition of compensation cost for stock options and other stock-based awards based on use of a fair value determination on the date of grant and expensing over the applicable vesting period.

As a result of adopting Statement 123R on January 1, 2006, the Corporation’s income before taxes and net income for the year ended December 31, 2008 are $ 20,000 and $ 13,000 less, for the year ended December 31, 2007 are $ 38,000 and $ 25,000 less and for the year ended December 31, 2006 are $ 32,000 and $ 11,000 less, respectively, than if it had continued to account for share-based compensation under APB Opinion 25.  Basic and diluted earnings per share for the year ended December 31, 2007 are $ 0.01 and $ 0.01 less, respectively, than if the Corporation had continued to account for share-based compensation under APB Opinion 25.  There is no difference for the year ended December 31, 2008.  The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model.

See Note 10 for further details concerning the Corporation’s stock option plans.

18

Note 1.   Summary of Significant Accounting Policies (Continued)

Reclassifications

Certain reclassifications have been made to the 2007 and 2006 financial statements to conform to reporting for 2008.

Note 2.   Investment Securities

The investment securities portfolio is comprised of securities classified as available for sale at December 31, 2008 and 2007, resulting in investment securities available for sale being carried at fair value.

The amortized cost and fair value of investment securities available for sale at December 31 were:

	Amortized  Cost		Gross Unrealized Gains		Gross  Unrealized Losses		Fair Value
	(000 omitted)
	2008
Mortgage-backed securities	$	13,948	$	303	$	8	$	14,243
Corporate bonds	4,272		0		1,031		3,241
Equities	23,092		1,874		6,483		18,483
Obligations of state and political subdivisions	38,738		1,874		128		40,484
	$	80,050	$	4,051	$	7,650	$	76,451
	2007
Mortgage-backed securities	$	14,929	$	260	$	12	$	15,177
Corporate bonds	1,697		7		140		1,564
Equities	27,784		8,167		2,090		33,861
Obligations of state and political subdivisions	32,529		737		22		33,244
	$	76,939	$	9,171	$	2,264	$	83,846

The fair values of investment securities available for sale at December 31, 2008, by contractual maturity, are shown below.  Contractual maturities will differ from expected maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Securities Available for Sale
	Amortized		Fair
	Cost		Value
	(000 omitted)
Due in one year or less	$	2,380	$	2,390
Due after one year through five years	7,851		7,728
Due after five years through ten years	20,426		21,195
Due after ten years	12,353		12,412
	43,010		43,725
Mortgage-backed securities	13,948		14,243
Equity securities	23,092		18,483
	$	80,050	$	76,451

19

Note 2.   Investment Securities (Continued)

Proceeds from sales and maturities of investment securities available for sale during 2008, 2007, and 2006, were $ 12,427,000, $ 9,260,000, and $ 47,407,000, respectively.  Gross realized gains and losses on those sales and maturities were $ 1,078,000 and $ 809,000 for 2008, $ 1,900,000 and $ 14,000 for 2007, and $ 4,025,315 and $ 102,297 for 2006, respectively.

Securities carried at $ 17,872,872 and $ 15,273,317 at December 31, 2008 and 2007, respectively, were pledged to secure public funds and for other purposes as required or permitted by law.

Restricted bank stock includes:

	2007		2007
	(000 omitted)
Federal Reserve Bank stock	$	1,025	$	133
Federal Home Loan Bank stock	3,683		2,701
Atlantic Central Bankers Bank	80		80
	$	4,788	$	2,914

The following table shows the Corporation’s gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2008 and 2007:

					2008
					(000 omitted)
	Less than 12 Months				12 Months or Greater				Total
Description	Fair Value		Unrealized  Losses		Fair  Value		Unrealized  Losses		Fair  Value		Unrealized  Losses
Mortgage-backed securities	$	2,049	$	8	$	9	$	1	$	2,058	$	9
Corporate bonds	2,475		342		766		689		3,241		1,031
Equities	6,227		2,208		4,489		4,275		10,916		6,483
Obligations of state and political subdivisions	6,028		127		0		0		6,028		127
Total	$	16,779	$	2,685	$	5,464	$	4,965	$	22,243	$	7,650

					2007
					(000 omitted)
	Less than 12 Months				12 Months or Greater				Total
Description	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Mortgage-backed securities	$	190	$	1	$	941	$	11	$	1,131	$	12
Corporate bonds	854		108		458		32		1,312		140
Equities	7,988		1,647		2,215		443		10,203		2,090
Obligations of state and political subdivisions	1,236		0		6,041		22		7,277		22
Total	$	10,268	$	1,756	$	9,655	$	508	$	19,923	$	2,264

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, but management’s intent is to hold all investments until maturity unless market, economic or specific investment concerns warrant a sale of securities.  Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

20

Note 2.Investment Securities (Continued)

At December 31, 2008, nine (9) mortgage-backed securities, five (5) corporate bonds, ninety-one (91) equities, and eighteen (18) obligations of state and political subdivisions had unrealized losses.  During 2008, the Corporation incurred impairment expense for fifteen (15) of the equity securities in financial institutions.  The total unrealized loss written off as other-than-temporarily impaired was $ 2,607,000.  Management has determined that no other declines are considered other than temporary.

At December 31, 2007, five (5) mortgage-backed securities, three (3) corporate bonds, sixty (60) equities, and fifteen (15) obligations of state and political subdivisions had unrealized losses.  Management has determined that no declines are deemed to be other than temporary at December 31, 2008.

Note 3.Allowance for Loan Losses

Activity in the allowance for loan losses is summarized as follows:

	2008		2007		2006
	(000 omitted)
Balance at beginning of period	$	3,854	$	3,610	$	2,129
Recoveries	84		80		45
Provision for possible loan losses charged to income	1,375		600		360
Additions for acquired credit risk	0		0		1,163
Total	5,313		4,290		3,697
Losses	716		436		87
Balance at end of period	$	4,597	$	3,854	$	3,610

Note 4.Premises, Equipment, Furniture and Fixtures

	Cost		Accumulated Depreciation		Depreciated Cost
			(000 omitted)
			2008
Premises (including land $1,910)	$	14,319	$	4,719	$	9,600
Equipment, furniture and fixtures	8,270		6,036		2,234
Totals, December 31, 2008	$	22,589	$	10,755	$	11,834
			2007
Premises (including land $1,626)	$	12,674	$	4,504	$	8,170
Equipment, furniture and fixtures	7,238		5,547		1,691
Totals, December 31, 2007	$	19,912	$	10,051	$	9,861

Depreciation expense amounted to $ 965,411 in 2008, $ 837,005 in 2007, and $ 667,381 in 2006.

Note 5.Real Estate Owned Other Than Premises

Included in real estate owned other than premises are certain properties which are located adjacent to the main office, as well as in Chambersburg.  The Corporation intends to hold these properties for future expansion purposes in order to protect its competitive position, and are renting certain of these properties until such time as the Corporation decides they are needed.  The depreciated cost of these properties was $ 1,985,000 and $ 2,288,000 at December 31, 2008 and 2007, respectively.

Also included in real estate owned other than premises at December 31, 2008 and 2007 is foreclosed property of $ 331,005 and $ 25,000, respectively.

21

Note 6.Loans

Related Party Loans

The Corporation’s subsidiary has granted loans to the officers and directors of the Corporation and its subsidiary and to their associates.  Related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectibility.  The aggregate dollar amount of these loans and the related activity for 2008 and 2007 was as follows:

	2008			2007
Beginning balance	$	4,247,174		$	4,527,038
New loans	2,048,000			1,096,500
Repayments	(3,148,346		)	(1,376,363		)
Ending balance	$	3,146,828		$	4,247,175

Outstanding loans to bank employees totaled $ 4,765,693 and $ 3,141,609 at December 31, 2008 and 2007, respectively.

Loan Maturities

The following table shows the maturities and sensitivities of loans to changes in interest rates based upon contractual maturities and terms as of December 31, 2008.

	Due within one year		Due over 1 but within 5 years		Due over 5 years		Nonaccruing loans		Total
	(000 omitted)
Loans at predetermined interest rates	$	18,253	$	44,036	$	60,592	$	100	$	122,981
Loans at floating or adjustable interest rates	38,512		38,987		214,098		4,316		295,913
Total (1)	$	56,765	$	83,023	$	274,690	$	4,416	$	418,894

(1) These amounts have not been reduced by the allowance for possible loan losses.

Loans Serviced for Others

During 2005, the Corporation began participation in the Federal Home Loan Bank of Pittsburgh’s (FHLB) Mortgage Partnership Finance Program.  Under this program, certain loans are sold to FHLB, but the Corporation retains the servicing rights to these loans.  The outstanding balance of loans sold to FHLB was $ 30,136,800 and $ 27,783,800 at December 31, 2008 and 2007, respectively.

22

Note 7.Financial Instruments With Off-Balance-Sheet Risk

The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers and to reduce its own exposure to fluctuations in interest rates.  These financial instruments include commitments to extend credit and standby letters of credit.  Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.  The contract amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments.

The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments.  The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on balance sheet instruments.

	Contract or Notional Amount
	2008		2007
	(000 omitted)
Financial instruments whose contract amounts represent credit risk at December 31:
Commitments to extend credit	$	23,519	$	45,949
Standby letters of credit and financial guarantees written	3,143		3,209
	$	26,662	$	49,158

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the customer.  Collateral held varies, but may include accounts receivable, inventory, real estate, equipment, and income-producing commercial properties.

Standby letters of credit and financial guarantees written are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.  The Corporation holds collateral supporting those commitments when deemed necessary by management.

Note 8.Nonaccrual/Impaired Loans

Loans 90 days or more past due (still accruing interest) were as follows at December 31:

	(000 omitted)
	2008		2007		2006
Commercial loans	$	75	$	0	$	0
Real estate mortgages	155		993		336
Consumer loans	29		8		57
Total	$	259	$	1,001	$	393

23

Note 8.Nonaccrual/Impaired Loans (Continued)

The following table shows the principal balances of nonaccrual loans as of December 31:

	(000 omitted)
	2008		2007		2006
Nonaccrual loans	$	4,416	$	4,397	$	688
Interest income that would have been accrued at original contract rates	$	268	$	229	$	51
Amount recognized as interest income	31		73		29
Foregone revenue	$	237	$	156	$	22

The following table reflects impairment of loans recognized in conformity with generally accepted accounting principles.

	2008		2007
	(000 Omitted)
Recorded investment at December 31	$	3,653	$	7,059
Average recorded investment during the year	3,995		7,408
Allowance for loan losses related to impaired loans at December 31	86		940
Interest income recognized for cash payments received during the year	282		290

Note 9.Employee Benefit Plans

The Corporation maintains a profit-sharing plan for those employees who meet the eligibility requirements set forth in the plan.  Contributions to the plan are based on Corporation performance and are at the discretion of the Corporation’s Board of Directors.  Substantially all of the Corporation’s employees are covered by the plan and the contributions charged to operations were $ 412,000, $ 352,100, and $ 240,000, for 2008, 2007, and 2006, respectively.

As a result of the merger with FNB Financial Corporation in 2006, the Corporation acquired a 401(k) plan which covered all employees of the former FNB Financial Corporation who had attained the age of 20 and completed six months of full-time service.  The plan provided for the Corporation to match employee contributions to a maximum of 5% of annual compensation.  The Corporation also had the option to make additional discretionary contributions to the plan based upon the Corporation’s performance and subject to approval by the Board of Directors.  The Corporation’s total expense for this plan was $ 83,528 for the year ended December 31, 2006.  This plan was terminated as of December 31, 2006.  All employees covered under this plan were moved to the Corporation’s profit sharing plan effective on that date.

The Corporation maintains a deferred compensation plan for certain key executives and directors, which provides supplemental retirement and life insurance benefits.  The plan is partially funded by life insurance on the participants, which lists the bank as beneficiary.  The estimated present value of future benefits to be paid, which are included in other liabilities, amounted to $ 681,004 and $ 718,390 at December 31, 2008 and 2007, respectively.  Annual expense of $ 68,555, $ 73,446, and $ 76,008 was charged to operations for 2008, 2007, and 2006, respectively.

As a result of the merger in 2006 with FNB Financial Corporation, the Corporation acquired three supplemental retirement benefit plans for directors and executive officers.  These plans are funded with single premium life insurance on the plan participants.  The cash value of the life insurance policies is an unrestricted asset of the Corporation.  The estimated present value of future benefits to be paid totaled $ 508,439 and $ 493,726 at December 31, 2008 and 2007, respectively, which is included in other liabilities.  Total annual expense for these plans amounted to $ 41,327, $ 34,159, and $ 123,149 for 2008, 2007, and 2006, respectively.

24

Note 9.Employee Benefit Plans (Continued)

The Corporation has a supplemental group term retirement plan which covers certain officers of the Corporation.  This plan is funded with single premium life insurance on the plan participants.  The cash surrender value of the policies is an unrestricted asset of the Corporation.  The estimated present value of the future benefits to be paid totaled $ 234,288 and $ 186,295 at December 31, 2008 and 2007, respectively.  Total annual expense for this plan was $ 47,993, $ 78,455, and $ 66,225, for 2008, 2007, and 2006, respectively.

The Corporation maintains an employee stock ownership plan (ESOP) that generally covers all employees who have completed one year of service and attained the age of twenty.  Contributions to the plan are determined annually by the Board of Directors as a percentage of the participants’ total compensation.  Compensation for the plan is defined as compensation paid including salary reduction under Sections 125 and 401(k) of the IRS Code but excluding nontaxable fringe benefits and any compensation over $ 200,000.  The payments of benefits to participants are made at death, disability, termination or retirement.  Contributions to the plan for all employees charged to operations amounted to $ 257,500, $ 220,654, and $ 144,000, for 2008, 2007, and 2006, respectively.  All shares held in the plan are considered issued and outstanding for earnings per share calculations and all dividends earned on ESOP shares are charged against retained earnings, the same as other outstanding shares.  Total allocated shares of the plan were 107,997 and 99,507 at December 31, 2008 and 2007, respectively.

During 2008, the Corporation recorded its liability for post-retirement costs of insurance of bank owned life insurance policies in accordance with EITF 06-04.  The estimated present value of the cost of post retirement insurance totaled $ 1,108,927.  Total annual expense for this insurance was $ 107,934 for 2008.  See Note 21 for further discussion.

Note 10.Stock Option Plans

In 1996 the Corporation implemented two nonqualified stock option plans, which are described below.  The compensation cost that has been charged against income for those plans was $ 75,659, $ 104,235, and $ 108,615, for 2008, 2007, and 2006, respectively.

The first plan is for select key employees.  This plan granted options for up to 1,500, 1,603, and 1,488 shares at a purchase price of $ 1.00 per share for the years ended December 31, 2008, 2007, and 2006, respectively.  These options can be exercised only by the key employees during his/her lifetime.

The second plan is for outside directors.  This plan granted options to purchase 5,000, 4,326, and 4,062 shares for each director at $ 41.10, $ 44.75, and $ 47.75 per share for the years ended December 31, 2008, 2007, and 2006, respectively, which was based on the market value of the stock at the grant date.  Options are vested one year following the grant date and expire upon the earlier of 120 months following the date of the grant or one year following the date on which a director ceases to serve in such a capacity for the corporation.  At December 31, 2008 the range of exercise prices was from $ 20.13 to $ 47.75 per share.  At December 31, 2008, there were 87,432 shares that can still be granted under these plans.

A summary of the status of the Corporation’s two fixed stock option plans as of December 31 is as follows:

	2008				2007				2006
Fixed Options	Shares		Weighted Average Exercise Price Per Share		Shares		Weighted Average Exercise Price Per Share		Shares		Weighted Average Exercise Price Per Share
Outstanding at beginning of year	34,858		$	34	32,674		$	32	30,006		$	29
Granted	6,500		32		5,929		33		5,550		35
Exercised	7,463		20		3,745		10		2,882		7
Forfeited/expired	3,187		41		0		0		0		0
Outstanding at end of year	30,708		$	37	34,858		$	34	32,674		$	32
Options exercisable at year end	25,708				30,532				28,612
Weighted average fair value of options per share granted during the year	$	12.06			$	18.19			$	19.57

25

Note 10.Stock Option Plans (Continued)

Outstanding options at December 31, 2008 consist of the following:

	Shares Outstanding	Shares Exercisable (Vested)	Remaining Contractual Life	Exercise Price
	2,040	2,040	1 year	$	32.13
	1,950	1,950	2 years	24.37
	2,577	2,577	3 years	20.13
	2,160	2,160	4 years	24.25
	2,436	2,436	5 years	30.00
	3,870	3,870	6 years	38.75
	3,405	3,405	7 years	43.75
	3,385	3,385	8 years	47.75
	3,685	3,685	9 years	44.75
	5,000	0	10 years	41.10
	200	200	Life	1.00
Total/Average	30,708	25,708	6 years	$	36.52

The total intrinsic value of options exercised under both plans in 2008, 2007, and 2006 was $ 130,000, $ 129,000 and $ 110,620, respectively.  The aggregate intrinsic value of outstanding stock options was $10,000, $ 289,000 and $ 424,056 at December 31, 2008, 2007 and 2006, respectively.

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions.

	2008		2007		2006
Dividend yield	2.45	%	2.20	%	3.01	%
Expected life – Director	8		8		8
Expected life – Officer	0.25		0.25		0.25
Expected volatility	8.43	%	13.72	%	19.79	%
Risk-free interest rate – Director	3.54	%	4.68	%	4.43	%
Risk-free interest rate – Officer	3.22	%	5.09	%	4.30	%

Note 11.Deposits

Included in savings deposits at December 31 are NOW and Money Market Account balances totaling $ 175,169,000 and $ 183,246,000 for 2008 and 2007, respectively.

Time deposits of $ 100,000 and over aggregated $ 32,629,000 and $ 33,013,000 at December 31, 2008 and 2007, respectively.  At December 31, 2008 and 2007 the scheduled maturities of time deposits of $ 100,000 and over are as follows:

	2008		2007
	(000 omitted)
Maturity
Three months or less	$	7,299	$	7,149
Over three months through twelve months	13,541		18,228
Over twelve months	11,789		7,636
	$	32,629	$	33,013

26

Note 11.Deposits (Continued)

At December 31, 2008 scheduled maturities of all time deposits are as follows:

	(000 omitted)
2009	$	109,202
2010	16,251
2011	24,924
2012	3,117
2013	7,591
	$	161,085

The aggregate amount of demand deposits reclassified as loan balances were $ 94,753 and $ 93,583 at December 31, 2008 and 2007, respectively.

The Corporation accepts deposits of the officers, directors, and employees on the same terms including interest rates, as those prevailing at the time for comparable transactions with unrelated persons.  The aggregate dollar amount of deposits of officers, directors and employees totaled $ 4,517,187 and $ 3,809,880 at December 31, 2008 and 2007, respectively.

Note 12.Liabilities for Other Borrowed Funds

The total amount available under lines of credit at other area banks at December 31, 2008 and 2007 was $ 9,900,000 and $ 18,900,000, respectively.  Of this amount, $ 8,670,000 and $ 10,655,000 were outstanding at December 31, 2008 and 2007, respectively.  Interest on these lines ranged from 2.25% to 6.75% for 2008 and 2007.

In addition, $ 271,993 and $ 340,988 of the balance of liabilities for other borrowed funds at December 31, 2008 and 2007, respectively, represents the balance of the Treasury Tax and Loan Investment Program.  The Corporation elected to enter into this program in accordance with federal regulations.  This program permits the Corporation to borrow these Treasury Tax and Loan funds by executing an open-ended interest bearing note to the Federal Reserve Bank.  Interest is payable monthly and is computed at 1/4% below the Federal Funds interest rate.  The note is secured by U.S. Government obligations with a par value of $ 243,743 and $ 316,120 at December 31, 2008 and 2007, respectively.

The Corporation also had the following borrowings from the Federal Home Loan Bank:

	2008					2007
Loan Type	Interest Rate		Balance			Interest Rate		Balance			Maturity
Variable	0.59	%	$	18,873,000		N/A		$	0		02/28/12
Fixed rate	3.95		10,000,000			N/A		0			02/08/18
Fixed rate	4.45		1,500,000			4.45	%	1,500,000			08/05/25
Fixed rate	6.64		104,108			6.64		112,713			07/17/17
Convertible	6.23		2,250,000			6.23		2,250,000			08/30/10
Convertible	5.83		2,000,000			5.83		2,000,000			08/10/10
Convertible	5.975		500,000			5.975		500,000			07/21/10
Convertible	5.25		5,000,000			5.25		5,000,000			04/06/11
Convertible	6.54		500,000			6.54		500,000			07/12/10
Convertible	N/A		0			5.395		5,000,000			09/15/08
Convertible	3.99		5,000,000			3.99		5,000,000			11/27/12
Convertible	4.13		5,000,000			4.13		5,000,000			05/07/18
			50,727,108					26,862,713
Purchase accounting fair value adjustment			(144,509		)			(123,360		)
			$	50,582,599				$	26,739,353

27

Note 12.Liabilities for Other Borrowed Funds (Continued)

Total maximum borrowing capacity from Federal Home Loan Bank at December 31, 2008 was $ 229,514,000.  Collateral for borrowings consists of certain securities and the Corporation’s 1-4 family mortgage loans totaling approximately $ 231 million at December 31, 2008.

Note 13.Income Taxes

The Corporation and its subsidiary, the Bank, file income tax returns in the U. S. federal jurisdiction and the states of Pennsylvania and Maryland.  With few exceptions, the Corporation is no longer subject to U. S. federal, state and local income tax examination by tax authorities for years prior to 2005.

The Corporation adopted the provisions of FIN 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007 with no impact on the financial statements.

Included in the balance sheet at December 31, 2008 are tax positions related to loan charge-offs for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility.  Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate but would accelerate the payment of cash to the taxing authority to an earlier period.

The components of income tax expense are summarized as follows:

	2008			2007			2006
	(000 omitted)
Current year provision:
Federal	$	1,569		$	2,693		$	2,405
State	(61		)	(20		)	326
Deferred income taxes (benefit)	(1,084		)	(342		)	(13		)
	$	424		$	2,331		$	2,718

Federal income taxes were computed after reducing pretax accounting income for non-taxable income in the amount of $ 1,085,359, $ 1,435,976, and $ 1,466,777, for 2008, 2007, and 2006, respectively.

A reconciliation of the effective applicable income tax rate to the federal statutory rate is as follows:

	2008		2007		2006
Federal income tax rate	34.0	%	34.0	%	34.0	%
Increase resulting from:
State taxes, net of federal tax benefit	.5		.3		3.6
Reduction resulting from:
Nontaxable income and investment impairment	22.7		9.4		6.9
Effective income tax rate	11.8	%	24.9	%	30.7	%

28

Note 13.Income Taxes (Continued)

Deferred tax assets have been provided for deductible temporary differences related to the allowance for loan loss, deferred compensation, unrealized losses on securities available for sale, and interest on nonaccrual loans.  Deferred tax liabilities have been provided for taxable temporary differences related to depreciation.  The net deferred taxes included in the accompanying balance sheets at December 31 are as follows:

	2008			2007
Deferred Tax Assets
Bad debts	$	1,563		$	1,268
Deferred compensation	404			408
Stock options	36			25
Unrealized loss/impairment on investment securities	1,851			0
	3,854			1,701
Deferred Tax Liabilities
Depreciation	(296		)	(185		)
Unrealized gain on investment securities	0			(2,715		)
Purchase accounting fair value adjustments	(451		)	(458		)
	(747		)	(3,358		)
Net deferred tax asset (liability)	$	3,107		$	(1,657	)

The Corporation has not recorded a valuation allowance for the deferred tax assets as management feels that it is more likely than not that they will be ultimately realized.

29

Note 14.Tower Bancorp Inc. (Parent Company Only) Financial Information

The following are the condensed balance sheets, statements of income, and statements of cash flows for the parent company:

Balance Sheets
December 31

	2008			2007
	(000 omitted)
Assets
Cash	$	18		$	6
Securities available for sale	18,483			33,861
Investment in subsidiaries	62,786			62,655
Other assets	2,540			189
Total assets	$	83,827		$	96,711
Liabilities
Other liabilities	$	0		$	3,942
Notes payable – subsidiary	4,400			3,700
Notes payable – other	8,670			10,655
Total liabilities	13,070			18,297
Stockholders’ Equity
Common stock, no par value; authorized 5,000,000 shares, issued 2,420,481 shares	2,225			2,225
Additional paid-in capital	34,787			34,831
Retained earnings	40,278			40,696
Accumulated other comprehensive income	(2,375		)	4,558
	74,915			82,310
Less: Cost of Treasury stock, 105,001 shares – 2008; 98,055 shares – 2007	(4,158		)	(3,896		)
Total stockholders’ equity	70,757			78,414
Total liabilities and stockholders’ equity	$	83,827		$	96,711

Statements of Income
Years Ended December 31

	2008			2007		2006
	(000 omitted)
Income
Dividends	$	654		$	640	$	594
Net gain on sale of securities	257			1,900		3,995
Cash dividends from wholly-owned subsidiary	3,943			2,489		2,016
	4,854			5,029		6,605
Expenses
Interest	617			993		795
Taxes	(1,328		)	392		1,154
Postage and printing	71			61		70
Management fees	180			120		120
Professional fees	159			288		510
Merger expenses	300			0		0
Impairment expenses	2,607			0		0
Other expenses	(81		)	4		28
	2,687			1,858		2,677
Income before equity in undistributed income	2,167			3,171		3,928
Equity in undistributed income of subsidiary	1,011			3,866		2,204
Net Income	$	3,178		$	7,037	$	6,132

30

Note 14.Tower Bancorp Inc. (Parent Company Only) Financial Information (Continued)

Statements of Cash Flows
Years Ended December 31

	2008			2007			2006
	(000 omitted)
Cash flows operating activities:
Net income	$	3,178		$	7,037		$	6,132
Adjustments to reconcile net income to cash provided by operating activities:
Net gain on sale of investment securities	(257		)	(1,900		)	(3,995		)
Granting stock options	78			108			109
Equity in undistributed income of subsidiaries	(1,011		)	(3,866		)	(2,203		)
Impairment of investments	1,721			0			0
Increase in other assets	(138		)	(85		)	(48		)
Increase (decrease) in other liabilities	(1,690		)	(158		)	670
Net cash provided by operating activities	1,881			1,136			664
Cash flows from investing activities:
Purchase of investment securities	(456		)	(3,200		)	(11,903		)
Cash paid in merger	0			0			(2,370		)
Sales of investment securities	2,799			5,000			11,377
Net cash provided (used) by investing activities	2,343			1,800			(2,896		)
Cash flows from financing activities:
Purchase of treasury stock	(557		)	(1,853		)	(813		)
Proceeds from sale of treasury stock	226			302			226
Dividends paid	(2,596		)	(2,489		)	(2,017		)
Net proceeds from short-term borrowings	(1,285		)	1,110			4,815
Net cash provided (used) by financing activities	(4,212		)	(2,930		)	2,211
Net increase (decrease) in cash	12			6			(21		)
Cash, beginning	6			0			21
Cash, ending	$	18		$	6		$	0

Note 15.Compensating Balance Arrangements

Included in cash and due from banks are required deposit balances at the Federal Reserve of $ 615,000 at December 31, 2008 and 2007 and required deposit balances at Equifax of $ 49,381 and $ 54,745 at December 31, 2008 and 2007, respectively.  These are maintained to cover processing costs and service charges.

Note 16.Concentration of Credit Risk

The Corporation grants agribusiness, commercial and residential loans to customers throughout the Cumberland Valley area; Franklin and Fulton Counties, Pennsylvania; and Washington County, Maryland.  The Corporation maintains a diversified loan portfolio and evaluates each customer’s credit-worthiness on a case-by-case basis.  At December 31, 2008 and 2007, respectively, 63% and 63% of the Corporation’s loan portfolio is concentrated in mortgages secured by 1-4 family properties, and 6% and 7% is concentrated in commercial and industrial loans.  The amount of collateral obtained, if deemed necessary by the Corporation upon the extension of credit, is based on management’s credit evaluation of the customer.  Collateral held varies, but generally includes equipment and real estate.

The Corporation maintains deposit balances at several correspondent banks, which provide check collection and item processing services to the bank.  The balances with these correspondent banks, at times, exceed federally insured limits, which management considers to be a normal business risk.

31

Note 17.Commitments and Contingencies

The Corporation leased its facilities in Mercersburg under a noncancellable operating lease that expired June 30, 2008.  Total annual rent expense charged to operations was $ 14,800, $ 39,300, and $ 22,200 for 2008, 2007, and 2006, respectively.

The Corporation leased its facilities in Chambersburg under a noncancellable lease that expired in September 2007.  Total rent expense charged to operations under the noncancellable lease was $ 7,200 for 2007 and $ 9,600 for 2006.

During 2007, the Corporation entered into an agreement to lease other Chambersburg facilities under a noncancellable operating lease. Under the terms, the lease began in July 2008 and will expire in July 2018 with the option to renew for two additional five-year periods with subsequent rental amounts subject to a Rental Escalation Article.  In addition to monthly rent payments, the Corporation will pay its proportionate share of any ad valorem and real estate taxes levied or assessed on the property.  The rent expense charged was $ 20,877 and $ 0 for 2008 and 2007, respectively.

During 2005, the Corporation entered into a lease for its facilities in Hagerstown at Eastern Boulevard under a noncancellable operating lease that expires in 2020.  Beginning June 1, 2006, the lease will be subjected to a CPI increase not to exceed 5% per year.  Total annual rent expense charged to operations was $ 104,952, $ 102,200 and $ 96,000 for 2008, 2007 and 2006, respectively.

The Corporation leases a site for an Automatic Teller Machine under a noncancellable operating lease that expires in 2013 with the right to negotiate an extended lease of two additional five year terms.  Total rent expense charged to operations was $ 10,800 for 2008, 2007, and 2006.

In May 2008, the Corporation entered into a lease agreement for its Call Center facility in Shady Grove under a non-cancellable operating lease that expires on April 30, 2009.  The lease can be renewed for five consecutive one year periods, subject to a CPI increase at the time of renewal.  Total rent charged to operations under this lease was $ 10,777 for 2008.

An operating lease was entered into during 2008 to lease a temporary branch facility in Hancock, Maryland while the Corporation upgrades its existing building.  The terms of the lease call for monthly payments of rent and taxes, in addition to relocation fees, initial fees, and terminated fees.  The lease is continued month-to-month, as needed by the Corporation, at $ 1,483 per month.

Following is a schedule, by years, of future minimum rentals under the lease agreements as of December 31, 2008 based on current lease terms:

Year Ending
2009	$	161,000
2010	154,000
2011	154,000
2012	154,000
2013	150,000
Thereafter	874,000
	$	1,647,000

Total rent expense paid under operating leases was $ 175,456, $ 175,718 and $ 151,960 for 2008, 2007 and 2006, respectively.

The Corporation is an occasional party to legal actions arising in the ordinary course of its business.  In the opinion of management, Tower has adequate legal defenses and/or insurance coverage respecting any and each of these actions and does not believe that they will materially affect the Corporation’s operations or financial condition.

32

Note 17.Commitments and Contingencies (Continued)

On November 12, 2008, Tower Bancorp, Inc. (“Tower”) and Graystone Financial Corp. (“Graystone”) reached a definitive agreement to form a partnership of their financial institutions, The First National Bank of Greencastle and Graystone Bank, respectively, whose combined assets will become over $ 1.2 billion with offices headquartered in Harrisburg, Pennsylvania.  As part of the transaction, Tower will exchange 0.42 shares of Tower common stock for each outstanding share of Graystone.  In addition, the definitive agreement provides that the Tower shareholders will receive a special cash dividend of $ 1.12 per share prior to the effective date of the transaction.  This special dividend was approved on March 11, 2009, and is payable on March 31, 2009 to shareholders of record on march 20, 2009.  It is conditioned on final regulatory approvals of the merger prior to payment.  The transaction has received shareholder approval on March 4, 2009 and is subject to regulatory approval, and is expected to close in the second quarter of 2009.

Pursuant to the agreement the  resulting holding company shall be named Tower Bancorp, Inc. with 20 members of the Board of Directors, ten each designated by Tower and Graystone, respectively.  The agreement also provides that Kermit G. Hicks shall serve as Chairman of the Board of the resulting holding company.

Note 18.Intangible Assets

On June 1, 2006, Tower completed the merger of FNB Financial Corporation (“FNB”).  Prior to completion of the Merger, The First National Bank of McConnellsburg, FNB’s sole banking subsidiary, was a nationally-chartered commercial bank.  Immediately after the merger, The First National Bank of McConnellsburg became a wholly-owned subsidiary of Tower.  The First National Bank of McConnellsburg merged with and into First National Bank of Greencastle on August 26, 2006.

In the merger, FNB shareholders received either 0.8663 shares of Tower common stock for each share of FNB common stock or $ 39.00 in cash for each share held, depending on shareholder elections and subject to the allocation provisions of the Merger Agreement.  Tower acquired all of the outstanding shares of FNB’s common stock.  In connection with the Merger, Tower paid to the former shareholders of FNB in the aggregate, $ 2,363 million in cash and issued to the former shareholders of FNB, in the aggregate, 640,381 shares of Tower’s common stock.

This transaction resulted in intangible assets and goodwill as follows:

	As of December 31, 2008				As of December 31, 2007
	Gross Carrying Amount		Accumulated Amortization		Gross Carrying Amount		Accumulated Amortization
	(000 omitted)				(000 omitted)
Amortized intangible assets
Core deposit relationships	$	2,343	$	1,008	$	2,343	$	649

Amortization expense amounted to $ 358,560 and $ 401,161 for 2008 and 2007, respectively, and is included in other operating expenses.  The estimated amortization expense for the next five years is as follows:

	(000 omitted)
2009	$	316
2010	273
2011	231
2012	188
2013	146

33

Note 18.Intangible Assets (Continued)

Goodwill

The changes in the carrying amount of goodwill for the years ended December 31, 2008 and 2007 are as follows:

	2008		2007
	(000 Omitted)
Beginning balance	$	16,558	$	16,535
Other adjustments	0		23
Ending balance	$	16,558	$	16,558

As of December 31, 2008, the Corporation considers the goodwill acquired in the merger with FNB to not be impaired.

Mortgage Servicing Rights

During 2007, the Corporation recorded the value of mortgage servicing rights.  The balance of this valuation was $ 248,487 and $ 300,572 as of December 31, 2008 and 2007 respectively.  This asset is being amortized over the life of the related loans.

Note 19.Fair Value of Financial Instruments

The estimated fair values of the Corporation’s financial instruments were as follows at December 31:

	2008				2007
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
FINANCIAL ASSETS
Cash and due from banks	$	10,757	$	10,757	$	16,770	$	16,770
Federal funds sold	0		0		20,081		20,081
Interest bearing deposits with banks	802		802		0		0
Securities available for sale	76,451		76,451		83,846		83,846
Loans receivable	419,103		402,377		399,158		402,423
Cash surrender value of life insurance	11,208		11,208		10,768		10,768
Accrued interest receivable	1,855		1,855		1,861		1,861
Restricted bank stock	4,788		4,788		2,914		2,914
FINANCIAL LIABILITIES
Time certificates	161,085		162,279		169,166		169,628
Other deposits	260,226		260,226		270,764		270,764
Other borrowed funds	59,525		60,823		37,735		38,115
Accrued interest payable	637		637		999		999

Note 20.Regulatory Matters

Dividends paid by Tower Bancorp Inc. are generally provided from the subsidiary bank’s dividends to Tower.  The Federal Reserve Board, which regulates bank holding companies, establishes guidelines which indicate that cash dividends should be covered by current year earnings and the debt to equity ratio of the holding company must be below thirty percent.  The Bank, as a national bank, is subject to the dividend restrictions set forth by the Comptroller of the Currency.  Under such restrictions, the Bank may not, without prior approval of the Comptroller of the Currency, declare dividends in excess of the sum of the current year’s earnings (as defined) plus retained earnings (as defined) from the prior two years.  Dividends that the Bank could declare without approval of the Comptroller of the Currency, amounted to approximately $ 8,493,662 and $ 7,686,266 at December 31, 2008 and 2007, respectively.

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Note 20.Regulatory Matters (Continued)

The Corporation is also subject to various regulatory capital requirements administered by federal banking agencies.  Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the corporation’s financial statements.  Under capital adequacy guidelines, the corporation is required to maintain minimum capital ratios.  The “leverage ratio”, compares capital to adjusted total balance sheet assets while risk-based ratios compare capital to risk-weighted assets and off-balance sheet activity in order to make capital levels more sensitive to risk profiles of individual banks.  A comparison of Tower Bancorp’s capital ratios to regulatory minimums at December 31 is as follows:

	Actual				For Capital Adequacy Purposes				To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of December 31, 2008
Total capital (to risk weighted assets)	$	56,769	15.02	%	$	30,244	8.00	%	$	37,804	10.00	%
Tier I capital (to risk weighted assets)	52,172		13.80	%	15,122		4.00	%	30,244		6.00	%
Tier I capital (to average assets)	52,172		9.74	%	21,429		4.00	%	26,786		5.00	%
As of December 31, 2007
Total capital (to risk weighted assets)	$	20,654	16.74	%	$	29,571	8.00	%	$	36,964	10.00	%
Tier I capital (to risk weighted assets)	18,987		14.95	%	14,786		4.00	%	22,178		6.00	%
Tier I capital (to average assets)	18,987		10.03	%	22,053		4.00	%	27,567		5.00	%

As of December 31, 2008 the most recent notification from the Office of the Comptroller of the Currency categorized the financial institution as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, the Corporation must maintain minimum total risk, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the above table.  There are no conditions or events since that notification that management believes have changed the financial institution’s category.

On August 27, 2008, the First National Bank of Greencastle entered into a Memorandum of Understanding (“MOU”) with the Comptroller of the Currency (“OCC”).  The MOU relates primarily to the Bank’s lending function and allowance for loan losses.  The Board of Directors and management are committed to addressing and resolving the issues presented in the MOU.

Note 21.Effects of Recently Issued Accounting Standards

In September 2006, the Emerging Issues Task Force of the Financial Accounting Standards Board (EITF) issued EITF 06-04.  This pronouncement affects the recording of post-retirement costs of insurance of bank owned life insurance policies in instances where the Bank has promised a continuation of life insurance coverage to persons post retirement.  EITF 06-04 requires that a liability equal to the present value of the cost of post retirement insurance be recorded during the insured employee’s term of service.  The terms of this pronouncement require the initial recording of this liability, with a corresponding adjustment to retained earnings to reflect the implementation of the pronouncement.  On January 1, 2008, the Corporation recorded a $ 1,001,000 liability and a corresponding decrease in retained earnings.  For periods after January 1, 2008, the Corporation will record an appropriate liability and corresponding effects on current income for the applicable periods.  A net expense of $ 107,934 was recorded for the year ended December 31, 2008 as a result of this pronouncement.

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