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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934

For the year ended December 31, 2002

Commission File Number: 001-15089

Fidelity BancShares (N.C.), Inc.

(Exact name of Registrant as specified in its charter)

(919) 552-2242
(Registrant’s telephone number, including area code)

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

8.50% Capital Securities issued by FIDBANK Capital Trust I
8.50% Junior Subordinated Debentures, issued by Registrant

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

NONE

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past ninety days. Yes x No o

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o No x

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the last business day of the Registrant’s most recently completed second fiscal quarter was $24,235,000. (There is no established market, published quotes or reported prices for the Registrant’s common equity. The market value of shares held by non-affiliates has been calculated based on prices known to management of the Registrant in privately negotiated transactions.)

Common Stock - $25 Par Value, - 28,011 shares
(Number of shares outstanding, by class, as of March 24, 2003)

PART I

ITEM 1 – BUSINESS

General. Fidelity BancShares (N.C.), Inc. (“BancShares”), headquartered in Fuquay-Varina, North Carolina, was organized under the laws of Delaware on November 13, 1987 as a registered bank holding company for The Fidelity Bank (the “Bank”). BancShares operates through the Bank, which provides a variety of retail and commercial banking products and services to individuals and small to medium-sized businesses in the communities it serves. Certain statistical information with respect to BancShares’ business required by Guide 3 is contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8. Financial Statements and Supplementary Data” which appears elsewhere in this filing.

BancShares has a second wholly-owned subsidiary, FIDBANK Capital Trust I (the “Trust”), a statutory business trust created under the laws of the State of Delaware, that issued $23.0 million of 8.50% Capital Securities (the “Capital Securities”) in June 1999 maturing in 2029. The proceeds from that sale, together with the proceeds from the Trust’s sale of all its common securities to BancShares, were used to purchase an aggregate of $23.7 million in junior subordinated debentures issued by BancShares. The debentures call for interest payable quarterly at an annual rate 8.50%, with principal payable in full in 2029. Subject to certain limitations, BancShares has fully and unconditionally guaranteed the Trust’s obligations under the Capital Securities.

Members of the Holding family, including Lewis R. Holding, have been actively involved in the management of BancShares. As a result, BancShares has been managed from a long-term perspective with primary emphasis being placed on balance sheet liquidity, loan quality, and earnings stability. Consistent with its management philosophy, BancShares has emphasized a low-risk loan portfolio derived from its local markets. (See “Item 12. Security Ownership of Certain Beneficial Owners and Management.”)

All significant activities of BancShares and its subsidiaries are banking related so that BancShares operates within one industry. Neither BancShares nor its subsidiary has any foreign operations.

The Bank is a state-chartered commercial bank. Its predecessor bank, Bank of Fuquay, was organized during 1909 and merged with Bank of Biscoe during 1970, at which time the continuing bank’s name was changed to The Fidelity Bank. The Bank currently operates 62 banking offices in 47 separate central North Carolina communities, 31 of which have been opened or acquired from other institutions within the past five fiscal years. Most recently, during 1998 the Bank purchased an aggregate of $35.7 million in assets and assumed an aggregate of $75.1 million in deposit liabilities, associated with five branch offices of a related financial institution, First-Citizens Bank & Trust Company, Raleigh, North Carolina (“FCB”), and during 1999, it purchased an aggregate of $29.1 million in assets and assumed an aggregate of $99.6 million in deposit liabilities, associated with seven additional branch offices of FCB. In 2001 the bank purchased an aggregate of $5.8 million in assets and assumed an aggregate of $49.5 million in deposit liabilities associated with three branch offices of First Union National Bank. Additionally, during 1999, 2000 and 2001, the Bank opened 22 de novo branch offices.

The Bank has two wholly-owned subsidiaries, Fidelity Properties, Inc. and TFB Financial Services. TFB Financial Services, Inc. (“TFB Financial Services”), formerly Servco Service Corporation, was acquired on September 1, 1996 in the acquisition of Perpetual State Bank and provides non-deposit investment products, including mutual funds, annuities, stocks, and bonds. Fidelity Properties currently is inactive.

BancShares’ principal executive offices are located at 100 South Main Street, Fuquay-Varina, North Carolina 27526 and its telephone number is (919) 552-2242. BancShares’ internet website is www.fidelitybanknc.com.

Description of Business. The Bank is a community-oriented bank which is engaged in a general commercial and consumer banking business. Its operations are primarily retail oriented and directed towards individuals and small- to medium-sized businesses in its market area. While the Bank provides most traditional commercial and consumer banking services, its principal activities are the taking of demand and time deposits and the making of secured and unsecured loans. The Bank’s deposits are insured by the FDIC to the maximum amount permitted by law.

The Bank is focused on community-oriented banking via (i) localized lending, (ii) core deposit funding, (iii) conservative balance sheet management, and (iv) stable growth. The Bank’s franchise is well diversified, serving both large cities and small rural towns in North Carolina. By outsourcing its core data processing requirements to FCB (see “Item 13. Certain Relationships and Related Transactions”), the Bank can offer a complete array of financial services while maintaining its community banking orientation. The Bank’s focus on diverse markets and its emphasis on customer service provide it with a stable source of core funding.

The Bank’s primary source of revenue is interest income from its lending activities. Since it commenced business, the Bank has pursued a strategy of growth through internal expansion by establishing branch offices in communities in its geographic market and by acquiring smaller institutions or offices of other institutions in its existing markets or in new markets.

Competition. Commercial banking in North Carolina is highly competitive. In its market areas, the Bank competes directly with a number of local, regional and superregional banking organizations. Competition among financial institutions for loans and deposits is based, to a large extent, on interest rates charged or paid. Fees and charges for other services, office location, the quality of customer services, community reputation and continuity of personnel, and, in the case of loans to large commercial borrowers, relative lending limits, also are important competitive factors. Many of the Bank’s competitors have greater resources, broader geographic markets and higher lending limits and offer more services than the Bank, and they can better afford and make more effective use of media advertising, support services and electronic technology than can the Bank. The Bank depends on its reputation in its local community, direct customer contact, its ability to make credit and other business decisions locally, and personalized service to counter these competitive disadvantages.

In recent years, federal and state legislation has heightened the competitive environment in which all financial institutions must conduct their business, and the potential for competition among financial institutions of all types has increased significantly. Additionally, with the elimination of restrictions on interstate banking, a North Carolina commercial bank may be required to compete not only with other North Carolina financial institutions, but also with out-of-state financial institutions which may acquire North Carolina institutions and are able to provide certain financial services across state lines, thereby adding to the competitive atmosphere of the industry in general.

Employees. At December 31, 2002, the Bank employed 392 full-time employees and 22 part-time employees. The Bank is not a party to any collective bargaining agreements and considers relations with its employees to be good. BancShares does not have any separate employees.

Supervision and Regulation. BancShares is a bank holding company registered with the Federal Reserve Board (the “FRB”) under the Bank Holding Company Act of 1956, as amended (the “Act”), and is subject to supervision and examination by, and the regulations and reporting requirements of the FRB.

The Bank is a North Carolina-chartered commercial bank, and its deposits are insured by the FDIC. It is subject to supervision and examination by, and the regulations and reporting requirements of, the North Carolina Commissioner of Banks (the “Commissioner”) and the FDIC. As a result of its ownership of the Bank, BancShares also is registered with and subject to regulation by the Commissioner under the state’s bank holding company laws.

As an insured bank, the Bank is prohibited from engaging as a principal in activities that are not permitted for national banks unless (i) the FDIC determines that the activity would pose no significant risk to the appropriate deposit insurance fund, and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards. Insured institutions also are prohibited from acquiring or retaining any equity investment of a type or in an amount not permitted for national banks. The Bank is not a member of the Federal Reserve System, but is subject to reserve requirements applicable to non-member banks.

The FRB, FDIC and Commissioner all have broad powers to enforce laws and regulations applicable to BancShares and the Bank and to require corrective action of conditions affecting the safety and soundness of the Bank. Among other, these powers include cease and desist orders, the imposition of civil penalties and the removal of officers and directors.

ITEM 2 – PROPERTIES

At December 31, 2002 the Bank maintained 62 banking offices in 47 central North Carolina communities. BancShares owns the majority of the buildings and leases other facilities from third parties. Statistical information with respect to BancShares’ property and equipment is contained in this filing under “Item 8. Financial Statements and Supplementary Data.”

ITEM 3 – LEGAL PROCEEDINGS

The Bank is a party to various legal proceedings in the ordinary course of its business. However, based on information presently available, and after consultation with legal counsel, BancShares’ management believes that the ultimate outcome in such proceedings, in the aggregate, will not have any material adverse effect on BancShares’ financial condition.

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

None.

PART II

ITEM 5 – MARKET FOR BANCSHARES’ COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

There is no established trading market, published quotes or reported prices for BancShares’ common stock. All sales of the stock are in privately negotiated transactions between individual holders. On March 14, 2003, there were 125 record holders of BancShares’ common stock.

The per share cash dividends paid by BancShares during each quarterly period during 2002 and 2001 are set forth in Table XI, under Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this report. A cash dividend of $8.00 per share was declared by the Board of Directors on January 27, 2003, payable March 31, 2003, to holders of record as of March 1, 2003. BancShares’ sole source of funds for the payment of dividends to its shareholders is dividends it receives from the Bank. Payments of dividends by BancShares and the Bank are made at the discretion of their Boards of Directors and are contingent upon satisfactory earnings as well as projected future capital needs. Subject to the foregoing, it is currently management’s expectation that comparable cash dividends will continue to be paid in the future.

ITEM 6 – SELECTED FINANCIAL DATA

The following table sets forth certain selected consolidated financial information for BancShares as of and for the years ended December 31, 2002, 2001, 2000, 1999 and 1998. The data has been derived from BancShares’ audited consolidated financial statements. The consolidated financial statements as of December 31, 2002 and 2001 and for each of the years in the three year period ended December 31, 2002, and the independent auditors’ report thereon, are included elsewhere in this filing. The following should also be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere herein.

Table 1

SELECTED FINANCIAL DATA

   (1)    For each indicated period, total common dividends declared divided by net income.

   (2)    See “Supervision and Regulation – Capital Adequacy” for a more detailed description of these ratios.

   (3)    For each indicated period, net income divided by the average number of common shares outstanding. BancShares has no potentially dilutive securities.

   (4)    At the end of each indicated period, shareholders’ equity divided by the number of common shares outstanding.

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

Management’s discussion and analysis of earnings and related financial data are presented to assist in understanding the financial condition and results of operations of Fidelity BancShares (N.C.), Inc. and Subsidiaries (“BancShares”), for the years 2002, 2001, and 2000. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and related notes presented under “Item 8. Financial Statements and Supplementary Data.” BancShares is a bank holding company with two wholly owned subsidiaries – The Fidelity Bank (the “Bank”), a North Carolina-chartered bank, and FIDBANK Capital Trust I (the “Trust”) – a statutory business trust created under the laws of the State of Delaware.

Critical Accounting Policies

BancShares’ significant accounting policies are set forth in note 1 of the consolidated financial statements. Of these significant accounting policies, BancShares considers its policy regarding the allowance for loan losses to be a critical accounting policy, because it requires management’s most subjective and complex judgments. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations. BancShares has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. BancShares’ assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which is not known to management at the time of the issuance of the consolidated financial statements. For additional discussion concerning BancShares’ allowance for loan losses and related matters, see ASSET QUALITY.

Acquisitions

On February 11, 2003 the Company entered into an agreement to purchase four branches from First Citizens Bank & Trust Company, a related party (see Note 16 to the consolidated financial statements). Assets and deposits to be acquired are $30,687,000 and $116,158,000, respectively. An intangible asset of approximately $9,216,000 would result from this purchase. This purchase is subject to applicable regulatory approval. The purchase is expected to close in the second quarter of 2003.

2002 Acquisitions. BancShares made no acquisitions during 2002. There were no de novo branches opened in 2002.

2001 Acquisitions. In February 2001, BancShares acquired the deposits of three North Carolina branches of First Union National Bank (see note 2 to BancShares’ consolidated financial statements). These acquisitions were accounted for as a purchase and, therefore, the results of operations prior to the purchase are not included in BancShares’ consolidated financial statements. These acquisitions were as follows:

There were three de novo branch openings in 2001.

2000 Acquisitions. BancShares made no acquisitions during 2000. There were three de novo branch openings in 2000.

Results of Operations

Net Income. For 2002, net income of $8.2 million represented a 10.72% increase from 2001 net income of $7.4 million. BancShares experienced an increase in noninterest income during 2002 due to an increased volume of service charges. In addition, there was a decrease in noninterest expense. Noninterest expense decreased due to an impairment loss of $471,000 on the closing of 2 branch offices in 2001 compared to an impairment loss of $143,000 in 2002 from the closing of one branch. Also, in 2001, amortization of goodwill was $1,489,000 compared with $308,000 in 2002. In addition, noninterest expense was favorably impacted by a decrease in other noninterest expense due to lower consulting, legal and other professional fees in 2002.

Net income of $7.4 million in 2001 represented an 8.7% decrease from 2000 net income of $8.1 million. BancShares experienced a strong increase in noninterest income during 2001, which was hampered by an increase in noninterest expense due to increased consulting, legal, and other professional fees.

Net income per share for 2002 was $292.34 compared to $263.71 for 2001; the increase is attributable to increased earnings, as well as decreased average shares outstanding due to the repurchase by BancShares of 15 shares of common stock.

Net income per share was $24.26 less in 2001 than the $287.97 recognized for 2000. The decrease in net income per share during 2001 was attributable to decreased earnings, slightly offset by decreased average shares outstanding due to BancShares’ repurchase of 44 shares of common stock during 2001.

Net Interest Income. The greatest portion of BancShares’ earnings is from net interest income, which is the difference between interest income on earning assets and interest paid on deposits and other interest bearing liabilities. The primary factors affecting net interest income are changes in the volume and yields/rates on earning assets and interest bearing liabilities and the ability to respond to changes in interest rates through asset/liability management. Table I sets forth the average balances on interest earning assets and interest bearing liabilities, as well as the average yields earned and average rates paid for 2002, 2001, and 2000. The average prime rate, as set by the Federal Reserve, was 4.67%, 6.91% and 9.23%, for the years ended December 31, 2002, 2001, and 2000, respectively.

In 2002, net interest income was $36.9 million compared to $36.6 million in 2001, an increase of $246,000 or 0.67%. 2001 net interest income was $68,000 or .19% greater than 2000 net interest income of $36.6 million. In 2002 and 2001 the amount of increase in net interest income was very small due to the low interest rates in 2002 and the Federal Reserve reducing interest rates eleven times in 2001. Because 60.0% of BancShares’ loans are tied to prime, the decline in interest rates has reduced interest income. The increase in net interest income in 2002 and 2001 was attributable to decreased interest expense on deposits and short-term borrowings. In 2002, interest income declined $10.4 million or 15.76% compared to that of 2001. During 2001 interest income declined $892,000 or 1.33% compared to $11.7 million or 21.1% in 2000. Interest expense decreased $10.7 million or 36.2% in year 2002. Interest expense was $18.8 million in 2002, $29.5 million in 2001 and $30.5 million in 2000. In 2002 the bank experienced higher volumes of interest bearing liabilities, but dramatic decreases in interest rates contributed to the lower interest expense. The decrease in interest expense in 2001 was also due to interest rate decreases eleven times during the year, although there were higher volumes of interest bearing liabilities. In 2000, the increase was attributable to higher volumes of interest bearing liabilities and the increasing rate environment. The rates paid on interest bearing liabilities were 2.53%, 4.03%, and 4.59% in 2002, 2001, and 2000, respectively.

Loans produced the largest component of interest income, amounting to $50.8 million in 2002, $56.1 million in 2001, and $56.4 million in 2000. This represented a decrease of $5.3 million or 9.39% in 2002 and a decrease of $369,000 or .65% in 2001. During 2002 and 2001, average loans outstanding increased $65.9 million or 10.34% and $50.2 million or 8.55%, respectively. In both years, loan growth within the existing branches and de novo branch openings contributed to the increase in average loans. Average yields on loans during 2002, 2001 and 2000 were 7.23%, 8.81%, and 9.63% respectively. The decrease in the 2002 average yield was due to a lower average prime rate during 2002 compared to 2001.

Likewise, the decrease in the 2001 average yield on loans was due to the decrease in the average prime rate during 2001 compared to 2000.

Earnings from investments and overnight funds sold provided the remainder of interest income, contributing $4.9 million in 2002, $10.1 million in 2001, and $10.6 million in 2000. Average balances and yields on these securities are shown in Table I. Average interest bearing cash balances during 2002 and 2001 were $24.4 and $34.1 million, which earned an average rate of 1.58% and 3.86%, respectively.

As noted above, total 2002 interest expense decreased 36.17% below that of 2001, which decreased 3.15% compared to 2000. The principal component of BancShares’ interest expense is interest paid on deposits, which totaled $16.6 million in 2002, $26.8 million in 2001, and $27.5 million in 2000. Average interest bearing deposit balances for 2002, 2001, and 2000, were $698.6 million, $683.2 million, and $618.6 million, respectively. This represents an increase of 2.3% in 2002 and 10.4% in 2001 over the prior years due to de novo branch openings and growth within the existing branch network. Additionally, the growth during 2001 was partially attributable to the acquisition of branches. Included in the interest expense is interest expense of $2.0 million resulting from the $23.0 million Capital Trust Securities issued by the Trust during 1999 (see note 9 to BancShares’ consolidated financial statements). These long-term obligations, which qualify as Tier 1 Capital for BancShares, bear interest at 8.50%, are callable in 2004, and mature in 2029. The average balance on the long-term obligations during both 2002 and 2001 was $23 million. The average rate paid on the obligations was 8.50% in 2002 and 2001.

BancShares’ interest rate spread was 3.65%, 3.63%, and 4.09% on a tax equivalent basis in 2002, 2001, and 2000, respectively. BancShares’ ability to maintain a favorable spread between interest income and interest expense is a major factor in generating earnings. Therefore, it is necessary for BancShares to effectively manage earning assets and interest bearing liabilities.

Provision for Loan Losses. BancShares’ provision for loan losses charged against earnings was $3.2 million, $3.0 million and $2.6 million in 2002, 2001, and 2000, respectively. The provision for loan losses increased primarily due to increased loan balances, increased bankruptcies and the impact of a declining economy as well as growth within the existing branch network. In addition, in 2002 the provision was increased due to the credit review of some large loan relationships which revealed increased delinquencies and bankruptcy filings and deterioration in credit quality and thus the credit score was changed and an increased provision was needed. Also, the credit card portfolio was reviewed through Equifax for credit scoring and it was determined that a higher reserve percentage was needed. As noted above, average loans grew $65.9 million or 10.34% in 2002 compared to $50.2 million or 8.55% in 2001. During 2002 and 2001, BancShares noted a softening in its market area, with increases in unemployment and increases in bankruptcies. In addition, many of BancShares’ loan originations occurred in new markets through de novo branches where management concluded there is greater risk that loan underwriting quality may not be up to BancShares’ standards as in existing markets. These conditions contributed to the increase in the provision for loan losses during the year. While the full impact of these changes may not be known until future periods, management concluded that additional provisions were necessary to reflect this change in economic conditions during the year.

Noninterest Income. Noninterest income, which consists primarily of service charges, commissions and fees, increased $483,000 in 2002 over 2001 and increased $2.8 million in 2001 compared to 2000. Total noninterest income was $10.4 million in 2002, $9.9 million in 2001, and $7.2 million in 2000. The increase in 2002 in noninterest income is attributable to growth in fee-earning transaction accounts, increased volume of fees charged, and improved fee collection on accounts. The primary reasons for increased service charges on deposit accounts are an overall increase in deposit accounts, fees earned on an overdraft checking product which was introduced in 2000, and increased volume of NSF fees. A loss on marketable equity securities offset some of the increase in noninterest income in 2002. The 2001 increase in noninterest income compared to 2000 is also attributable to growth in deposit accounts, a new overdraft checking product which was introduced in 2000, and increased NSF fee income as well as a gain on exchange and subsequent sale of a marketable equity security in 2001.

Noninterest Expense. Noninterest expense includes expenses attributable to personnel, occupancy, furniture and equipment, data processing, FDIC assessments, printing, supplies, legal and professional fees, postage, amortization of intangibles, and other miscellaneous operating expenses. Noninterest expense was $31.1 million in 2002, $31.9 million in 2001, and $28.4 million in 2000. Control of noninterest expense is an important aspect in managing net income. Acquisition

of branches during 2001 and 1999 should enhance future operating results of BancShares; however, earnings were reduced in 2001 and 2000 as BancShares amortized intangibles resulting from these acquisitions.

The most significant element of BancShares’ noninterest expense is personnel costs. Salaries and benefits represented 57.0%, 52.5%, and 53.7%, of total noninterest expense during 2002, 2001, and 2000, respectively. Salaries and benefits increased by $986,000 or 5.89% in 2002 and $1.5 million or 9.86% in 2001. The primary causes of these increases are the opening of three de novo branches and the acquisition of three branches in 2001, as well as the opening of three de novo branches in 2000.

Occupancy and equipment expenses increased from $4.8 million in 2000 to $5.0 million in 2001 and remained at $5.0 million in 2002. The increase of $191,000 in 2001 was attributable to acquired branches and the de novo branch openings noted above, of which there were none in 2002.

Data processing costs represent charges by vendors that perform data processing services for the Bank. Data processing fees are primarily based upon per item or per account charges. Data processing costs were $3.2 million, $3.0 million, and $2.5 million in 2002, 2001, and 2000, respectively. These increases were due to the addition of acquired and de novo branches as well as growth in the loan and deposit base in the existing branch network, as noted above. As discussed in note 16 to the consolidated financial statements, BancShares’ data processing services are provided by a related party. See RELATED PARTY TRANSACTIONS.

Amortization of intangibles during 2002 decreased $1.2 million to $308,000 compared to $1.5 million for 2001. Amortization of intangibles was $1.1 million in 2000. The increase in amortization of intangibles during 2001 was attributable to the acquisition of three branches in the first quarter of 2001. Intangibles from this acquisition amounted to $6.0 million (see notes 2 to BancShares’ consolidated financial statements). In 2002, the decrease in amortization of intangibles was related to the adoption of SFAS No. 147 (see Note 1 (o), New Accounting Standards) which resulted in BancShares discontinuing amortization of a significant portion of its intangible assets.

During 2002, BancShares analyzed the operations of one branch since its inception in 1999 and determined that the loss experience would not turn around in the near future. The Board of Directors of BancShares approved to close this branch and at June 30, 2002, BancShares has accrued disposition costs which include $103,000 for losses on fixed assets, $20,000 for lease cancellation fees, and $20,000 for costs to close the branch. During the third quarter of 2002, BancShares closed the branch with no material adjustments being made to the accrued impairment costs. During 2001, BancShares analyzed the results of operations of two branches through the first three months of 2001 taking into consideration recent economic conditions and the projected performance of these branches. BancShares concluded the carrying value of these branches were impaired and therefore recorded an impairment loss of $470,740 to reduce the carrying value of these branches to fair value.

Other miscellaneous operating expenses were $4.8 million, $5.3 million, and $4.7 million in 2002, 2001, and 2000, respectively. The decrease in 2002 was mainly the result of decreased consulting fees as well as decreased legal and professional fees in 2002 as there were no acquisitions in the current year. The increase in 2001 was the result of increases in costs across all categories of other operating expenses due to the increased customer base and account activity resulting from acquired branches, de novo branch openings and growth within the existing branch network.

Income Taxes. In 2002, 2001, and 2000, BancShares had taxable income for book purposes that resulted in income tax expense of $4.8 million, $4.3 million, and $4.6 million, respectively. The resulting effective income tax rates for the years ended December 31, 2002, 2001, and 2000 were 36.8%, 36.6%, and 36.3%, respectively.

Financial Condition

Earning and Noninterest Earning Assets. Earning assets consist of loans, investment securities, and short-term investments that earn interest. Average earning assets during 2002 were $902.2 million, an increase of $37.6 million or 4.35% over 2001’s interest earning assets of $864.6 million. During 2001, average interest earning assets increased $90.2 million or 11.64% from the 2000 average of $774.4 million. Increases during both years resulted from de novo branch openings and growth within the existing branch network. Further, in 2001, growth in average balances was partially attributable to the 2001 acquisition of branches noted above.

Average noninterest earning assets during 2002 were $82.1 million compared to $84.6 million in 2001, a decrease of 2.89%. During 2001, an increase of $5.7 million or 7.25% occurred compared to the 2000 average of $78.9 million. The 2002 decrease was primarily due to decreased intangible assets and decreased accrued interest receivable. The 2001 increase was primarily due to increases in cash, fixed assets and intangible assets resulting from the acquired branches or de novo branch openings. The average balances of noninterest earning assets are shown in Table I.

Return on average total assets for 2002 was 0.83%, compared to 0.78% and 0.95% in 2001 and 2000, respectively. The increase for 2002 was the result of increased earnings due to increased fee income and decreased amortization of intangibles. The decline for 2001 was the result of lower earnings, arising from a decreased net interest margin due to the Federal Reserve cutting rates eleven times in 2001, opening of three de novo branches, acquisition of three branches and an impairment loss on closing 2 in-store branches. Changes in the composition of average balances are shown in Table I and Table II.

Return on average equity for 2002 was 9.16%, compared to 8.99% and 11.01% in 2001 and 2000, respectively. In 2002, the increase was due to increased earnings and was offset by increased average equity. In 2001, the decline was due to decreased earnings coupled with increased average equity due to earnings and unrealized gains on securities available for sale.

Interest Bearing and Noninterest Bearing Liabilities. Interest bearing liabilities consist of deposits, short-term borrowed funds and long-term borrowed funds. Average interest bearing liabilities during 2002 were $743.4 million, an increase of 1.6% from the 2001 average of $731.7 million, which was 10.2% higher than that of 2000, $664.2 million. BancShares’ principal interest bearing liabilities are interest bearing deposits. Interest bearing deposits represented $698.7 million, $683.2 million, and $618.6 million of average interest bearing liabilities in 2002, 2001, and 2000, respectively. Short-term borrowings and long-term borrowings represent the remaining balances. The cost of total interest bearing liabilities was 2.53%, 4.03%, and 4.59% in 2002, 2001, and 2000, respectively.

Average noninterest bearing liabilities during 2002 were $151.5 million, an increase of $16.3 million or 12.1% over the 2001 average of $135.2 million. During 2001, the average noninterest bearing liabilities increased $19.7 million or 17.08% over the 2000 average of $115.5 million. Noninterest bearing demand deposits are the principal noninterest bearing liability. Increases in noninterest bearing demand deposit balances are attributable to acquired branches, de novo branch openings and expansion within the existing branch network. See Table I.

Loans. As of December 31, 2002, loans, net of the allowance for loan losses, totaled $717.3 million compared to $659.7 million and $607.5 million at year-end 2001 and 2000, respectively. The increase was attributable to normal loan growth from the existing branch network and de novo branch openings in 2001 and 2000 as well as decreased interest rates in 2002. Also in 2001, growth was due to acquired loans of $3.9 million from the acquisition of three branches in first quarter 2001. The composition of the loan portfolio for each of the years in the five year period ended December 31, 2002 is listed in Table IV. Commercial real estate secured loans have increased from the prior year. Due to the weakening economy, the Bank is seeking sounder collateral such as real estate instead of accounts receivable or equipment which is also leading to the decrease in commercial and industrial non-real estate secured loans. The Bank feels the commercial real estate as collateral has less credit risk. With the furniture and textile manufacturing in a downturn, there has been less equipment financing and more real estate secured loans. In addition, the Bank has refinanced some real estate credit from other institutions and made some non-owner occupied loans such as for hotels as they feel this is safer collateral.

Rate sensitivity and liquidity in the loan portfolio are achieved by making loans with adjustable interest rates and shorter maturities. This allows the Bank to adjust its pricing structure with changes in interest rates. At the end of 2002, 68.2% of the loan portfolio was due to mature or would be available for interest rate repricing in 2003. See Table IX.

Investments. Management’s asset/liability strategies include maintaining an investment securities portfolio with appropriate maturities to preclude the necessity of selling investment securities for purposes of liquidity. Traditionally, BancShares has maintained a larger investment portfolio than its peers.

BancShares accounts for investment securities under the provisions of Statement of Financial Accounting Standards No. 115 (“Statement 115”), “Accounting for Certain Investments in Debt and Equity Securities,” which requires that investments in debt and equity securities be classified in three categories and accounted for as follows: debt securities that BancShares has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized

cost; debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available for sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity. Securities available for sale consist of securities which may be sold in response to changes in interest rates, prepayment risk, regulatory capital requirements and liquidity needs.

At December 31, 2002, the fair value of available for sale securities exceeded the carrying value by $8.0 million. Deferred taxes related to these available for sale securities were $3.2 million, and shareholders’ equity included $4.9 million for the net unrealized gain related to these available for sale securities. At December 31, 2001, the fair value of available for sale securities exceeded the carrying value by $8.0 million. Deferred taxes related to these available for sale securities were $3.2 million, and shareholders’ equity included $4.8 million for the net unrealized gain related to these available for sale securities. BancShares does not maintain a trading account.

BancShares routinely reviews its investment securities to identify any declines in market value that are considered other than temporary. This process involves obtaining a current understanding of the overall financial condition of the issuer and the reasons for any deterioration in value, reviewing the length of time the fair value has been below cost, and considering the degree to which fair value is below cost. To the extent management concludes that declines in fair values of investment securities are other than temporary, BancShares records a charge to earnings and reduces the cost basis of the investment security. During 2002, BancShares recorded other than temporary impairment losses of $96,487 and recorded no such losses during 2001 or 2000. There can be no assurance that additional other than temporary impairment losses will not occur in future periods.

Commitments, Contingencies and Off-balance sheet risk

BancShares is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, lines of credit and standby letters of credit. These instruments involve elements of credit risk in excess of amounts recognized in the accompanying consolidated financial statements. Substantially all such instruments expire within one to three years.

BancShares’ risk of loss in the event of nonperformance by the other party to the commitment to extend credit, line of credit or standby letter of credit is represented by the contractual amount of these instruments. BancShares uses the same credit policies on the borrower in making commitments under such instruments as it does for on-balance sheet instruments. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Collateral held varies, but may include accounts receivable, inventory, real estate and time deposits with financial institutions. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

As of December 31, 2002 and 2001, outstanding financial instruments whose contract amounts represent credit risk were as follows:

BancShares does not have any special purpose entities or other similar forms of off-balance sheet financing arrangements.

BancShares’ lending is concentrated primarily in central North Carolina and the surrounding communities in which it operates. Credit has been extended to certain of BancShares’ customers through multiple lending transactions; however, there is no concentration to any single customer or industry.

BancShares and the Bank are defendants in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated operations, liquidity or financial position of BancShares or the Bank.

Asset Quality

Provision and Allowance for Loan Losses. Because BancShares’ loan portfolio represents its largest earning asset, BancShares continually monitors the quality of its loan portfolio. The Bank operates in a diversified economic environment and, in the opinion of management, is not unduly exposed to any one particular industry. BancShares’ customers are generally impacted by local and national economic conditions, as increases in unemployment levels, bankruptcy filings, and other key economic factors can directly or indirectly impact their ability to perform in accordance with the loan terms. In 2002, BancShares charged-off loans net of recoveries of $699,000. This represents a decrease of $286,000 from 2001 net charge-offs of $985,000. The 2001 net charge-offs of $985,000 were an increase of $516,000 from 2000 net charge-offs of $469,000. This increase is partially attributable to the impact of a decline in economic conditions in BancShares’ market areas. The percentage of charge-offs (net of recoveries) to average outstanding loans was 0.10% in 2002, 0.15% in 2001, and 0.08% in 2000. See Table V.

The ratio of total non-performing assets to total loans plus other real estate was 0.13% and 0.00% at December 31, 2002 and 2001, respectively. Assets classified as other real estate were $220,000 and $15,000 at December 31, 2002 and 2001, respectively.

Accrual of interest is discontinued on a loan when management believes the borrower’s financial condition is such that the collection of principal or interest is doubtful. Loans are returned to accrual status when the factors indicating doubtful collectibility cease to exist.

Management considers a loan to be impaired when, based on current information or events, it is probable that a borrower will be unable to pay all amounts due according to the contractual terms of the loan agreement. Impaired loans are valued using either the discounted expected cash flow method or the value of the collateral.

While a loan (including an impaired loan) is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding. When the future collectibility of the recorded loan balance is not in doubt, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.

At December 31, 2002 the Bank had $724,000 of impaired loans, all of which were on nonaccrual status. At December 31, 2001, the Bank did not have any nonaccrual loans, nor did the Bank have any restructured or impaired loans. At December 31, 2002 and 2001, the bank had $424,000 and $625,000 accruing loans 90 days or more past due.

The allowance for loan losses represented 1.62% and 1.39% of loans outstanding at year end 2002 and 2001, respectively. The allowance for loan losses increased primarily due to increased loan balances, increased bankruptcies and the impact of a declining economy as well as growth within the existing branch network. In addition, in 2002 the provision was increased due to the credit review of some large loan relationships which revealed increased delinquencies and bankruptcy filings and thus the credit score was changed and an increased provision was needed. Also, the credit card portfolio was reviewed through Equifax for credit scoring and it was determined that a higher reserve percentage was needed. During 2002 and 2001, BancShares noted a softening in its market area, with increases in unemployment and increases in bankruptcies. These conditions contributed to the increase in the provision for loan losses during the year. While the full impact of these changes may not be known until future periods, management concluded that additional provisions were necessary to reflect this change in economic conditions during the year. This increased allocation contributed to the increase in the percentage of allowance for loan losses to total loans from 1.39% at December 31, 2001 to 1.62% at December 31, 2002. The Bank’s provision for loan losses charged against earnings was $3,225,000, $3,000,000, and $2,625,000, in 2002, 2001, and 2000, respectively. The increase in the provision for loan losses in 2002 and 2001 was primarily attributable to loan growth in both years, and the origination of loans in acquired branches during 2001, as well as

the impact of the matters discussed above. In addition, many of BancShares’ loan originations occurred in new markets through de novo branches where management concluded there is greater risk that loan underwriting quality may not be up to BancShares’ standards as in existing markets.

Management considers the December 31, 2002 allowance for loan losses adequate to cover probable losses inherent in the loan portfolio. Management’s periodic evaluation of the adequacy of the allowance is based on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s experience, the estimated value of any underlying collateral, current economic conditions, analysis of peer bank trends, and other risk factors. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. While management uses the best information available to make evaluations, future adjustments may be necessary if economic or other conditions differ substantially from the assumptions used.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses and losses on other real estate owned. Such agencies may require the Bank to recognize adjustments to the allowances based on the examiners’ judgements about information available to them at the time of their examinations.

Related Party Transactions

BancShares has entered into various service contracts with another bank holding company and its subsidiary (the “Corporation”). The Corporation has two significant shareholders, who are also significant shareholders of BancShares. At December 31, 2002, the first significant shareholder beneficially owned 11,155 shares, or 39.82 percent, of BancShares’ outstanding common stock. At the same date, the second significant shareholder beneficially owned 1,696 shares, or 6.05 percent, of BancShares’ outstanding common stock.

These two significant shareholders are directors and executive officers of the Corporation and at December 31, 2002, beneficially owned 2,529,519 shares, or 28.61 percent, and 1,384,121 shares, or 15.74 percent, respectively, of the Corporation’s outstanding Class A common stock, and 650,958 shares, or 38.73 percent, and 199,052 shares, or 11.81 percent, respectively, of the Corporation’s outstanding Class B common stock. The above totals include 472,855 Class A common shares, or 5.38 percent, and 104,644 Class B common shares, or 6.23 percent, that are considered to be beneficially owned by both of the shareholders and, therefore, are included in each of their totals. A subsidiary of the Corporation is FCB.

The Bank’s contract with FCB was negotiated at arms-length and was approved by BancShares’ Board of Directors. Based on its comparison in previous years of the terms of the contract with terms available to it from other providers of the services being obtained from FCB, management of the Bank believes the terms of its contract with FCB, including prices, are no less favorable to the Bank than could be obtained from an unrelated provider.

The following are expenses paid by BancShares to the Corporation:

The BancShares also has a correspondent relationship with the Corporation. Correspondent account balances with the Corporation included in cash and due from banks and overnight funds sold totaled $38,454,633 and $41,448,498 at December 31, 2002 and 2001, respectively.

BancShares is related through common ownership with Southern Bank and Trust Co. (“Southern”) in that the aforementioned two significant shareholders of BancShares and certain of their related parties are also significant shareholders of Southern. BancShares has contracted with Southern to service on its behalf $4.1 million of BancShares’ mortgage loans.

While BancShares and the Corporation intend to negotiate these arrangements at arms length, there is no guarantee that the results of operations of BancShares would not be different if these transactions were with unrelated parties.

Liquidity, Market Risk and Interest Sensitivity

Liquidity. Liquidity refers to the ability of BancShares to generate sufficient funds to meet its financial obligations and commitments at a reasonable cost. Maintaining liquidity ensures that funds will be available for reserve requirements, customer demand for loans, withdrawal of deposit balances and maturities of other deposits and liabilities. Past experience helps management anticipate cyclical demands and amounts of cash required. These obligations can be met by existing cash reserves or funds from maturing loans and investments, but in the normal course of business are met by deposit growth.

In assessing liquidity, many relevant factors are considered, including stability of deposits, quality of assets, economy of the markets served, business concentration, competition and BancShares’ overall financial condition. BancShares’ liquid assets include all investment securities (minus pledged securities), overnight funds sold, and cash and due from banks. These assets represented 17.97% of deposits at December 31, 2002, a decrease from 22.19% at December 31, 2001.

BancShares’ liquidity ratio, which is defined as cash plus short-term and marketable securities (minus pledged securities) divided by deposits and short-term liabilities, was 17.52% at December 31, 2002, compared to 21.49% at December 31, 2001. In addition, the Bank has a $121 million line of credit with the Federal Home Loan Bank to meet liquidity needs.

BancShares has traditionally maintained high levels of liquidity, characteristic of the high ratio of investment securities to total assets that it maintains. Although loans have increased in each of the recent fiscal periods, BancShares’ ability to manage its liquidity is was due to the increases in deposits to fund the loans made.

Funds received from any maturing investments that are not immediately necessary to sustain BancShares’ liquidity are invested in similar instruments or used to fund any increased loan demand. Investments scheduled to mature within the one year time frame, without consideration of marketable equity securities, represented 78.64% and 88.00% of the total investment securities portfolio at December 31, 2002 and 2001, respectively.

In addition, BancShares held marketable equity securities with fair values of $11.5 million and $11.6 million at December 31, 2002 and 2001, respectively. These investments are classified as available for sale and could be sold at management’s discretion.

BancShares’ consolidated statements of cash flows disclose the principal sources and uses of cash from operating, investing, and financing activities for 2002, 2001, and 2000. In 2002, BancShares’ operating activities provided cash flows of $13.1 million. Net income of $8.2 million, adjusted for non-cash operating activities, provided the majority of cash generated from operations. Investing activities, including lending, used $31.0 million of BancShares’ cash flow. Loans originated, net, of principal collected, used $61.2 million. Securities purchases used $211.4 million, and expenditures for premises and equipment utilized $2.1 million of BancShares’ cash flow. The cash outflows from these investing activities were offset by $243.0 million of cash received from investment maturities. Net additional cash inflows of $22.5 million resulted from financing activities, principally from deposit inflows of $27.9 million.

In 2001, BancShares’ operating activities provided cash flows of $14.5 million. Net income of $7.4 million, adjusted for non-cash operating activities, provided the majority of cash generated from operations. Investing activities,

including lending, provided $1.1 million of BancShares’ cash flow. Loans originated, net of principal collected, used $51.7 million. Securities purchases used $131.7 million, and expenditures for premises and equipment utilized $2.0 million of BancShares’ cash flow. The cash outflows from these investing activities were offset by $148 million of cash received from investment maturities and $38.7 million of cash received in branch acquisitions. Net additional cash inflows of $18.9 million resulted from financing activities, principally from deposit inflows of $19.4 million.

In 2000, BancShares’ operating activities provided cash flows of $14.3 million. Net income of $8.1 million, adjusted for non-cash operating activities, provided the majority of cash generated from operations. Investing activities, including lending, used $76.5 million of BancShares’ cash flow. Loans originated, net of principal collected, used $64.3 million. Securities purchases, net of maturities, used $7.7 million, and expenditures for premises and equipment utilized $4.4 million of BancShares’ cash flow. Net additional cash inflows of $59.0 million resulted from financing activities, principally from deposit inflows of $56.5 million.

The Bank has no brokered funds. Jumbo certificates of deposit (“CD’s”) are considered to include all CD’s of $100,000 or more. The Bank does not and has never aggressively bid on these deposits, and it does not seek nor does it accept deposits from outside of its general trade area. Almost all of the Bank’s jumbo CD customers have other relationships with the Bank, including savings, demand and other time deposits and, in some cases, loans. At December 31, 2002 and 2001, jumbo CD’s represented 11.27% and 11.52% of total deposits, respectively.

In the opinion of management, BancShares has the ability to generate sufficient amounts of cash to cover normal funding requirements and any additional needs which may arise, within realistic limitations, during the next twelve months, and management is not aware of any known demands, commitments or uncertainties that will affect liquidity in a material way.

BancShares has obligations under existing contractual obligations that will require payments in future periods. The following table presents aggregated information about such payments to be made in future periods. Transaction deposit accounts with indeterminate maturities have been classified as having payments due in less than one year.

As of December 31, 2002

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

BancShares’ market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. Management seeks to manage this risk through the use of shorter term maturities. The composition and size of the investment portfolio is managed so as to reduce the interest rate risk in the deposit and loan portfolios while at the same time maximizing the yield generated by the portfolio.

The table below presents in tabular form the contractual balances and the estimated fair value of financial instruments at their expected maturity dates as of December 31, 2002. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment

as of December 31, 2002. For core deposits without contractual maturity (i.e. interest bearing checking, savings and money market accounts), the table presents principal cash flows as maturing in 2003 since they are subject to immediate repricing.

   (1)    Marketable equity securities with a book value of approximately $3,468,000 and a fair value of approximately $11,513,000 have been excluded from this table.

Interest Sensitivity. Deregulation of interest rates and short-term, interest earning deposits which are more volatile, has created a need for shorter maturities of interest earning assets. As a result, an increasing percentage of commercial, installment, and mortgage loans are being made with variable rates or shorter maturities to increase liquidity and interest rate sensitivity.

The difference between interest sensitive asset and interest sensitive liability repricing within time periods is referred to as the interest rate sensitivity gap. Gaps are identified as either positive (interest sensitive assets in excess of interest sensitive liabilities) or negative (interest sensitive liabilities in excess of interest sensitive assets).

As of December 31, 2002, BancShares had a positive one year cumulative gap position of 23.51% and a positive total cumulative gap position of 17.62%. BancShares has interest earning assets of $654.0 million maturing or repricing within one year and interest bearing liabilities of $437.6 million repricing within one year. BancShares experienced growth in loans offset by a decrease in investments with maturities of one year or less and a decrease in deposits and short-term borrowings with maturities of one year or less. A positive gap position implies that interest earning assets (loans and investments) will reprice at a faster rate than interest bearing liabilities (deposits). In a falling rate environment, this position will generally have a negative effect on earnings, while in a rising rate environment this position will generally have a positive effect on earnings.

Inflation. The effect of inflation on financial institutions differs from the impact on other types of businesses. Since assets and liabilities of banks are primarily monetary in nature, they are more affected by changes in interest rates than by the rate of inflation.

Inflation generates increased credit demands and fluctuations in interest rates. Although credit demand and interest rates are not directly tied to inflation, each can significantly impact net interest income. As in any business and industry, expenses such as salaries, equipment, occupancy, and other operating expenses are also subject to upward pressures created by inflation.

Since the rate of inflation has been relatively stable during the last several years, the impact of inflation of the earnings presented in this report is insignificant.

Capital Resources

Shareholders’ Equity and Capital Adequacy. Sufficient levels of capital are necessary to sustain growth and absorb losses. To this end, the Federal Reserve, which regulates BancShares, and the FDIC, which regulates the Bank, have established risk based capital (“RBC”) adequacy guidelines.

As of December 31, 2002, BancShares’ Leverage Capital Ratio (as defined herein) was 9.46%, as compared to 8.99% and 9.72%, respectively, at year-end 2001 and 2000. Within RBC calculations, BancShares’ assets, including commitments to lend and other off-balance sheet items, are weighted according to Federal regulatory guidelines for the risk considered inherent in the assets. BancShares’ Tier 1 Capital Ratio (as defined herein) as of December 31, 2002 was 12.52% compared to ratios of 12.19% and 11.87% for 2001 and 2000, respectively. The calculation of Total Capital Ratio (as defined herein) allows, in BancShares’ circumstances, the inclusion of BancShares’ allowance for loan losses in capital, but only to a maximum of 1.25% of risk weighted assets. As of December 31, 2002, BancShares’ Total Capital Ratio was 14.26%. The Total Capital Ratios for 2001 and 2000 were 13.95% and 13.29%, respectively.

As of December 31, 2002, the Bank’s Leverage Capital Ratio (as defined above) was 8.74%, which, along with 8.30% and 9.17% as of December 31, 2001 and 2000, respectively, represents a well-capitalized institution under FDIC standards (one whose ratio exceeds 5%). The Bank’s Tier 1 Capital ratio (as defined above) as of December 31, 2002 was 11.52%, which, along with 11.30% and 11.26% as of December 31, 2001 and 2000, respectively, represents a well-capitalized institution under FDIC standards (one whose ratio exceeds 6%). As of December 31, 2002, the Bank’s Total Capital Ratio (as defined above) was 12.78%. The Total Capital ratios for 2001 and 2000 were 12.55% and 12.31%, respectively. Total Capital Ratio in all three years represented well-capitalized institutions under FDIC standards (the ratio exceeds 10%).

These ratios will improve if BancShares’ capital increases at a rate proportionately faster than liabilities. Management is aware that growth must be controlled. BancShares’ recent expansion plans discussed elsewhere herein may appear to be contrary to this policy but management is also aware that the process of expanding market share by normal business processes can be very difficult and expensive. Management believes that improvement in its overall market share within an existing trade area is valuable in the long run and should be pursued by BancShares, when it can be done prudently.

BancShares’ primary source of new capital is earnings. In 2002, equity capital increased through retention of earnings by $7.3 million, compared to $6.5 and $7.2 million in 2001 and 2000, respectively. At December 31, 2002, shareholders’ equity totaled $92.3 million, compared to $85.0 million in 2001. Shareholders’ equity at December 31, 2002 and 2001 included, as discussed above, $4.9 million and $4.8 million, respectively, of net unrealized securities gains on available for sale securities.

The ratio of average shareholders’ equity to average total assets was 9.08% in 2002, 8.67% in 2001, and 8.62% in 2000.

Retention of sufficient earnings to maintain an adequate capital position that provides BancShares with expansion capabilities is an important factor in determining dividends. During 2002, BancShares paid $896,000 in dividends, versus $898,000 and $900,000 in 2001 and 2000, respectively. As a percentage of net income, dividends were 10.95% in 2002, 12.13% in 2001, and 11.11% in 2000. The decrease in dividends paid in 2002 compared to 2001 and 2001 compared to 2000 is attributable to a decrease in the number of shares outstanding each year.

Accounting and Other Matters

In June 1998, the Financial Accounting Standard Board (the “FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. This statement, as amended by SFAS No. 137 and SFAS No. 138, is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. Earlier application of all provisions of this statement is encouraged. BancShares adopted this statement on January 1, 2001, with no material effect on its consolidated financial statements.

In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141 (Statement 141), “Business Combinations,” and Statement of Financial Accounting Standards No. 142 (Statement 142), “Goodwill and Other Intangible Assets.” Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Statement 141 also specifies criteria which must be met for intangible assets acquired in a purchase method business combination to be recognized and reported apart from goodwill. Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that identifiable intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.”

In August 2001, the FASB issued Statement of Financial Accounting Standards No. 143 (Statement 143), “Accounting for Asset Retirement Obligations,” which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement cost. This standard requires BancShares to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development and or normal use of the assets. BancShares also is to record a corresponding increase to the carrying amount of the related long-lived asset and to depreciate that cost over the life of the asset. The liability is changed at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the initial fair value measurement. This statement is effective for fiscal years beginning after June 15, 2002. The Company does not expect adoption of this statement to have a material effect on its consolidated financial statements.

In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144 (Statement 144), “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This standard provides guidance on differentiating between long-lived assets to be held and used, long-lived assets to be disposed of other than by sale and long-lived assets to be disposed of by sale. Statement 144 supersedes FASB Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” Statement 144 also supersedes Accounting Principals Board Opinion No. 30, “Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” This statement is effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 had no material impact on BancShares’ consolidated financial statements.

In October 2002, the FASB issued Statement of Financial Accounting Standards No. 147 (Statement 147), “Acquisitions of Certain Financial Institutions,” which brings all business combinations involving financial institutions, except mutuals, into the scope of Statement 141, Business Combinations. Statement 147 requires that all acquisitions of financial institutions that meet the definition of a business, including acquisitions of part of a financial institution that meet the definition of a business, must be accounted for in accordance with Statement 141 and the related intangibles accounted for in accordance with Statement 142, Goodwill and Other Intangible Assets. Statement 147 removes such acquisitions from the scope of Statement 72, which was adopted in February 1983 to address financial institutions’ acquisitions during a period when many of such acquisitions involved “troubled” institutions. Statement 147 also amends Statement 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” to include in its scope long-term customer-relationship intangible assets of financial institutions. Statement 147 was generally effective immediately upon issuance and provides guidance with respect to amortization and impairment of intangibles recognized in connection with acquisitions previously within the scope of Statement 72. BancShares adopted Statement 147 during the fourth quarter of 2002, but effective January 1, 2002. BancShares restated its previously issued 2002 interim consolidated financial statements (including separate quarterly

results) to remove the effects of amortization of intangibles previously recorded under Statement 72 in the first three quarters of the 2002 fiscal year. (See Notes 1(k) and 6 to the consolidated financial statements).

In December 2002, the Financial Accounting Standard Board (the “FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” an amendment of FASB Statement No. 123, “Accounting for Stock- Based Compensation.” Statement No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This Statement is effective for fiscal years ending after December 15, 2002 and for interim periods beginning after December 15, 2002 with early application encouraged. BancShares does not expect to be impacted by this Statement, as there currently are no stock options.

In November 2002, the Financial Accounting Standards Board issued Financial Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which addresses the disclosure to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. FIN 45 requires the guarantor to recognize a liability for the non-contingent component of the guarantee, such as the obligation to stand ready to perform in the event that specified triggering events or conditions occur. The initial measurement of this liability is the fair value of the guarantee at inception. The recognition of the liability is required even if it is not probable that payments will be required under the guarantee or if the guarantee was issued with a premium payment or as part of a transaction with multiple elements. The disclosure requirements are effective for interim and annual financial statements ending after December 15, 2002. The initial recognition and measurement provisions are effective for all guarantees within the scope of FIN 45 issued or modified after December 31, 2002. BancShares issues standby letters of credit whereby BancShares guarantees performance if a specified triggering event or condition occurs. The guarantees generally mature within one year and may be automatically renewed depending on the terms of the guarantee and credit worthiness of the customer. See note 13. The adoption of recognition provisions is not expected to be material to BancShares financial statements.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (FIN 46). FIN 46 addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. FIN 46 applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interest entities obtained after January 31, 2003. The application of FIN 46 is not expected to have an impact on BancShares’ consolidated financial statements.

Management is not aware of any other trends, events, uncertainties, or current recommendations by regulatory authorities that will have or that are reasonably likely to have a material effect on BancShares’ liquidity, capital resources or other operations.

Statistical Information

The following tables contain certain additional information regarding BancShares’ business operations.

Table I.
Average Balance Sheet Items and Net Interest Differential
Average Balances and Average Rates Earned and Paid