National Bancshares 10-K 2005 FY Annual report

Exhibit 13

National Bancshares Corporation
Annual Report to Security Holders
for the
fiscal year ended
December 31, 2005

(See Attached)

Dear Shareholders,

2005 was full of changes, challenges, opportunities and focus. From opening and closing offices, introducing new services, organizational changes and earnings challenges to risk management improvement, it has been a very interesting year for us. In the early part of the year, we had an opportunity to purchase a vacant banking office in the busy commercial district on the north end of Wooster. This expansion opportunity enabled us to broaden our presence in the Wooster market and complement the Cleveland Road office. Since opening the Burbank Road office in the second quarter of the year, we have been meeting our projections on deposit growth here and have seen additional deposit growth at the Cleveland Road office as well. In total, we have seen our deposits increase 63% in Wooster since opening this new office. We are excited about expanding our services in the Wooster locale and look forward to possible additional expansion in the future.

With the lease of our Marketplace office, located inside Massillon Wal-Mart, expiring in mid 2005, we elected not to renew this lease and to close this location. The office was not profitable and prospects for future growth and profitability at this site were, at best, suspect. Resources from this location were redeployed to other offices including the new Burbank Road office. We continue, however, to operate a drive-up ATM in the parking lot at this location.

We have embraced positive change in the organization, and commenced a review of product-offerings by a special staff committee. As a result of this review, our checking account products were simplified, resulting in new features and consolidation. We rolled out a new money market product with a very attractive interest rate and introduced two new mortgage loan products designed to serve first-time homebuyers and low-to-moderate income customers. Additionally, our new product line was enhanced with an Overdraft Privilege Service, for those customers that may inadvertently overdraw their checking account, and Online Bill Payment Service for customers that enjoy the convenience of Internet banking. We continue to encourage and review customer comments to be certain our product offering meets the needs of our organization’s growing customer base.

Financial results for 2005 were disappointing. Net income of $2.1 million was down $811 thousand, or 28%, below that of the previous year. The flattening of the yield curve during the past year has made it challenging to increase net interest income. Non-interest income was down due to sizable capital gains realized in 2004 and not repeated in 2005. Non-interest expenses were up reflecting expenses

associated with closing one office and opening another, as well as additional personnel costs from staff realignment. Total assets were off from the previous year-end by $1.5 million. Net loans declined by approximately $5.2 million while $7.4 million in fixed rate residential mortgage loans were sold into the secondary market. This sale assisted in controlling our interest rate exposure to changes in long-term rates.

Our long-term history of increased cash dividends continued during this past year. Cash dividends declared, in the amount of 64 cents per share, increased by 4.9% over the previous year. The market value of our stock declined by 16.9% from year-end 2004 to year-end 2005. Unfortunately, the market for financial institution stocks has not been kind this past year. Our price followed the direction of many financial stocks, pulled downward by the market as well as by declining earnings. We are optimistic that 2006 will bring increased earnings as well as an improving market for financial stocks.

In reviewing current and long-range needs of the organization, the management structure and necessary skill sets were reviewed. As a result, a consolidation and reorganization of certain management duties and responsibilities was implemented. Various job functions were streamlined to enhance the management structure of the organization. We continue our review to improve other areas of the organization as well. Developmental plans and training programs encompassing many different areas of responsibility in the company are being implemented. This investment in our staff will improve their knowledge and abilities to drive the necessary changes needed to effectively compete in an ever-changing marketplace.

Throughout this past year our organization has worked diligently to prepare for required implementation of section 404 of theSarbanes-Oxley Act. This section of the Act required all controls within the organization to be mapped and tested to be sure they were in place and working properly. We have recently completed mapping of the controls and have initiated testing. We will be utilizing these processes to improve overall risk management systems within the organization. This will assure that many areas of risk associated with our business are being monitored and measured on an ongoing basis.

As we look ahead to 2006, we are entering our 125th year of operation. Beginning as a partnership in 1881, we have grown to 14 offices serving three counties with a staff of over 150 employees. This expansion has been realized through a combination of bank and branch acquisitions and de novo branching. We are planning activities throughout the year to celebrate this very special anniversary. We look forward to seeing many of you during 2006 and hope we may have the opportunity to serve your financial needs.

Chuck Dolezal
President and Chairman

FINANCIAL HIGHLIGHTS

These financial highlights are merely excerpts of and are not a substitute for National Bancshares Corporation’s consolidated financial statements, including notes, and other detailed financial information we provide elsewhere in this document. You should read the entire document, including the Financial Review and the consolidated financial statements and notes to the consolidated financial statements.

Financial Position

					Percentage
(Year End Balances)	2005		2004		Change
Total Assets	$	306,881,008	$	308,424,929		(0.50	)%
Deposits		249,487,821		248,522,476		0.39	%
Loans — Net		191,538,419		196,724,596		(2.64	)%
Investment Securities		77,009,046		76,327,029		0.89	%
Shareholders’ Equity		34,653,425		35,319,321		(1.89	)%

Summary of Operations
Net Interest Income	$	11,946,806	$	11,965,677	(0.16	)%
Net Income		2,099,810		2,910,740	(27.86	)%
Regular Cash Dividends		1,430,072		1,363,038	4.92	%
Net Income Per Share		0.94		1.30	(27.69	)%
Cash Dividends Per Share		0.64		0.61	4.92	%
Book Value Per Share		15.51		15.81	(1.90	)%

Our Mission Statement

We are an independent community bank committed to providing products and services that will improve the financial lives of our customers through financial and operational excellence.

Our Vision Statement

We will Accomplish Our Mission By:

•  Identifying and exceeding customer service expectations by delivering quality products and financial services to the markets we serve.

•  Assisting in generating economic stability, growth and employment throughout the market area by managing and prudently investing local resources.

•  Providing an ongoing program to develop and recognize our associates as valuable assets of the organization.

About Our Cover: The cover features many of our employees who contribute their valuable time to charitable organizations throughout the communities we serve. We are proud of these employees and of those employees not pictured on the cover, for making such worthwhile efforts to help make our communities a better place!

National Bancshares Corporation is a one-bank holding company with assets of $307 million. First National Bank, its subsidiary, is headquartered in Orrville, Ohio. Serving Wayne County, southern Medina County and western Stark County through fourteen banking offices. First National Bank offers a variety of personal and commercial deposit and lending services.

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SELECTED FINANCIAL DATA

The summary financial information to follow is not a substitute for National Bancshares Corporation’s consolidated financial statements, notes to the consolidated financial statements, and other detailed financial information we provide elsewhere in this document. You should read the entire document, including the consolidated financial statements, the notes to the consolidated financial statements, and the Financial Review. We derived the following data from National Bancshares’ audited consolidated financial statements for the fiscal years ended December 31, 2001 through 2005.

	As of or For the Years Ended December 31,
	2005		2004		2003		2002		2001
Income Statement Data:
Interest Income	$	16,075,195	$	15,311,999	$	15,043,809	$	15,941,153	$	13,556,747
Interest Expense		4,128,389		3,346,322		3,740,016		4,927,774		4,954,357
Net Interest Income		11,946,806		11,965,677		11,303,793		11,013,379		8,602,390
Provision for Loan Losses		159,233		177,500		245,000		1,569,402		40,000
Net Interest Income After Provision For Loan Losses		11,787,573		11,788,177		11,058,793		9,443,977		8,562,390
Noninterest Income		1,801,200		1,895,313		1,532,020		1,458,031		1,145,238
Noninterest Expense		10,985,615		9,897,462		9,140,516		7,998,774		6,403,105
Income Before Income Taxes		2,603,158		3,786,028		3,450,297		2,903,234		3,304,523
Income Taxes		503,348		875,288		806,746		648,460		777,320
Net Income	$	2,099,810	$	2,910,740	$	2,643,551	$	2,254,774	$	2,527,203
Balance Sheet Data:
Cash and Due from Banks	$	10,985,160	$	11,756,454	$	11,506,999	$	10,010,654	$	6,935,082
Investment securities		77,009,046		76,327,029		83,793,119		70,806,397		60,843,655
Loans, net		191,538,419		196,724,596		187,056,241		190,559,663		116,880,804
Deposits		249,487,821		248,522,476		242,847,291		239,297,227		159,519,295
Borrowings		19,952,284		21,679,242		20,140,702		21,211,964		5,741,697
Shareholders’ Equity		34,653,425		35,319,321		34,804,735		33,190,050		30,922,188
Total Assets		306,881,008		308,424,929		301,249,375		296,502,555		197,763,446
Per Common Share Data:
Net Income	$	0.94	$	1.30	$	1.18	$	1.01	$	1.13
Cash Dividends		0.64		0.61		0.58		0.54		0.52
Book Value		15.51		15.81		15.58		14.85		13.93
Weighted Average Number of Shares Outstanding		2,234,488		2,234,488		2,234,488		2,228,510		2,230,013

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SELECTED FINANCIAL DATA

	As of or For the Years Ended December 31,
	2005			2004			2003			2002			2001
Selected Data:
Return on Average Equity		5.90	%		8.29	%		7.58	%		7.01	%		8.17	%
Return on Average Assets		0.70	%		0.97	%		0.90	%		0.85	%		1.27	%
Dividend Payout Percentage		68.10	%		46.83	%		49.03	%		53.40	%		45.85	%
Efficiency Ratio(1)		79.91	%		71.41	%		71.21	%		64.14	%		65.69	%
Full Time Equivalent Staff		135			136			133			122			103
Average Total Assets to Full Time Equivalent Staff	$	2,233,711		$	2,214,226		$	2,209,383		$	2,166,827		$	1,938,835
Asset Quality Ratios:
Allowance for Loan Losses to Ending Total Loans		0.98	%		0.89	%		0.85	%		0.83	%		1.12	%
Net Loan Charge-offs to Average Loans		0.01	%		0.01	%		0.13	%		0.89	%		0.06	%
Capital Ratios:
Average Equity to Average Assets		11.81	%		11.65	%		11.86	%		12.17	%		15.49	%
Leverage Ratio(2)		9.76	%		9.41	%		9.04	%		8.61	%		14.98	%
Total Risk-Based Capital Ratio(2)		14.45	%		13.73	%		13.59	%		13.58	%		22.71	%

(1)	The efficiency ratio is calculated by dividing noninterest expenses by the sum of net interest income and non-interest income.
(2)	Computed in accordance with Comptroller of the Currency and FDIC guidelines.

The following table shows quarterly results of operations for 2005 and 2004.

					Provision			Income				Basic and
					for			Before				Diluted
	Interest		Net Interest		Loan			Income		Net		Earnings
	Income		Income		Losses			Taxes		Income		Per Share
2005
First quarter	$	3,828,291	$	2,964,022	$	80,000		$	644,796	$	520,799	$	0.23
Second quarter		3,975,548		3,012,758		212,500			509,134		431,939		0.19
Third quarter		4,035,644		2,958,723		44,000			537,116		447,916		0.20
Fourth quarter		4,235,712		3,011,303		(177,267	)		912,112		699,156		0.31
2004
First quarter	$	3,776,566	$	3,005,542	$	47,500		$	1,131,312	$	829,998	$	0.37
Second quarter		3,786,272		2,925,382		85,000			861,227		656,179		0.29
Third quarter		3,813,203		2,951,300		45,000			764,954		593,893		0.27
Fourth quarter		3,935,958		3,083,453		—			1,028,535		830,670		0.37

During fourth quarter 2005, the Corporation reversed a portion of the year’s provision for loan loss by $177,267. This reversal reflects an improvement on historical loan losses and an improvement of condition regarding various specific loans.

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FINANCIAL REVIEW

This financial review is intended to assist the reader in evaluating the performance of National Bancshares Corporation for the years ended December 31, 2005, 2004 and 2003. This information should be read in conjunction with the consolidated financial statements and accompanying notes to the financial statements.

Forward Looking Statement

The Private Securities Litigation Reform Act of 1995 contains safe harbor provisions regarding forward-looking statements. Forward-looking statements can be identified by terminology such as “believes,” “expects,” “anticipates,” “estimates,” “intends,” “should,” “will,” “plans,” “potential” and similar words. Forward-looking statements are also statements that are not statements of historical fact. Forward-looking statements necessarily involve risks and uncertainties. They are merely predictive or statements of probabilities, involving known and unknown risks, uncertainties and other factors. If one or more of these risks or uncertainties occurs or if the underlying assumptions prove incorrect, actual results in 2006 and beyond could differ materially from those expressed in or implied by the forward-looking statements.

Forward-looking statements are based upon a variety of estimates and assumptions. The estimates and assumptions involve judgments about a number of things, including future economic, competitive, and financial market conditions and future business decisions. These matters are inherently subject to significant business, economic, and competitive uncertainties, all of which are difficult to predict and many of which are beyond National Bancshares Corporation’s control. Although we believe the estimates and assumptions are reasonable, actual results could vary materially from those shown. Inclusion of forward-looking information does not constitute a representation by National Bancshares or any other person that the indicated results will be achieved. You are cautioned not to place undue reliance on forward-looking information.

Financial Condition

Loans. National Bancshares’ total assets decreased by 0.5% and net loans decreased by $5.2 million or 2.6% from 2004 to 2005. Much of this decline in net loans can be attributed to the fact that the Bank sold $7.4 million in fixed rate real estate mortgage loans to secondary markets during 2005. By completing these sales to the secondary markets, the Bank reduces interest rate risk. The Bank retained the servicing of these loans which provides a source of revenue to the Company.

When examining loans collateralized by real estate, this category of loans decreased by $4.7 million. However this decline is primarily comprised of a decrease in residential loans of $6.1 million during 2005. When factoring out the aforementioned real estate mortgages sold to the secondary markets, total residential loans increased by $1.3 million. This increase is due to the hiring of a dedicated mortgage loan originator in early 2005. Offsetting a portion of this decline in loans collateralized by real estate were increases of $0.8 million in home equity loans, $0.6 million in commercial real estate loans and $0.1 million in construction loans. At the end of 2004 residential mortgage loans secured by 1-4 family real estate constituted 49% of First National Bank’s total loans, compared 47% at the end of 2005. Commercial real estate loans increased from 24% to 25% of the Bank’s total loans from year-end 2004 to 2005. Changes in our home equity product during 2004 and 2005 resulted in an increase of $0.8 million or 4% in home equity loans in 2005. This increase is the result of favorable promotions on this product during 2005. Home equity loans are now 10% of the Bank’s total loans, compared to 9% in 2004. Construction loans increased $0.1 million from 2004 to 2005. At the end of the construction period a construction loan migrates from the construction loan category to another, such as commercial real estate, if First National Bank provides permanent financing.

First National Bank’s loan policy provides that loans in any one of three broad categories of lending products may constitute up to 60% of the total loan portfolio: commercial loans, real estate loans and commercial real estate loans. Consumer loans may constitute up to 50% and non-real estate agricultural and unsecured loans may constitute up to 10% of the total loan portfolio.

When examining “Other” loans, consumer and credit card loans also increased, offset by declines in commercial and other loans. Consumer loans, which consist primarily of automobile loans, increased $0.8 million or 15% during 2005 due to an

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FINANCIAL REVIEW

interest rate promotion. Commercial loans declined by $1.2 million or 5% from 2004. This decline is due to fierce competition we are experiencing in our service areas. Other loans, which consist mostly of tax-free industrial development bond loans, decreased $0.1 million or 7% due to pay downs. The composition of the Bank’s loan portfolio in dollar amounts and in percentages at the end of each of the last five fiscal years was as follows.

	Loan Portfolio Composition at December 31,
	2005						2004						2003						2002						2001
	$			%			$			%			$			%			$			%			$			%
Type of Loan:
Collateralized by real estate:
Commercial	$	47,638,035			25	%	$	47,080,983			24	%	$	39,349,045			21	%	$	28,747,949			15	%	$	23,933,475			20	%
Residential		91,591,798			47	%		97,694,011			49	%		101,291,447			54	%		118,834,883			62	%		53,522,228			45	%
Home equity		19,044,581			10	%		18,272,212			9	%		14,008,018			7	%		12,555,738			6	%		9,426,924			8	%
Construction		6,440,000			3	%		6,326,884			3	%		5,131,685			3	%		2,065,964			1	%		4,769,337			4	%
		164,714,414			85	%		169,374,090			85	%		159,780,195			85	%		162,204,534			84	%		91,651,964			77	%
Other:
Consumer		6,205,096			3	%		5,385,953			3	%		4,828,644			3	%		4,847,264			3	%		5,224,468			5	%
Commercial		20,045,739			10	%		21,196,523			10	%		21,374,911			11	%		21,631,567			11	%		18,050,801			15	%
Credit Cards — unsecured		1,405,708			1	%		1,361,726			1	%		1,263,565			0	%		1,276,587			1	%		1,227,172			1	%
Other		1,565,995			1	%		1,675,030			1	%		1,821,016			1	%		2,570,767			1	%		2,249,271			2	%
Total Loans	$	193,936,952			100	%	$	198,993,322			100	%	$	189,068,331			100	%	$	192,530,719			100	%	$	118,403,676			100	%
Less:
Unearned and deferred income		(495,705	)					(505,428	)					(408,522	)					(366,856	)					(201,720	)
Allowance for loan losses		(1,902,828	)					(1,763,298	)					(1,603,568	)					(1,604,200	)					(1,321,152	)
Net loans	$	191,538,419					$	196,724,596					$	187,056,241					$	190,559,663					$	116,880,804
Net loans as a percent of total assets		62.41	%					63.78	%					62.09	%					64.22	%					59.10	%

At the end of 2005 total agricultural loans increased by $1.0 million, amounting to approximately $5.5 million. About $4.5 million of that amount consists of loans collateralized by farmland, which is included in the $47.6 million commercial loans secured by real estate. The remainder, $1.0 million, consists of loans for agricultural production and other loans to farmers, and that figure is included in the $20.0 million figure for commercial loans (not collateralized by real estate). Ranked by Standard Industry Classification  — or SIC — codes, the industries most represented among First National Bank’s commercial borrowers include operators of nonresidential buildings, operators of dwellings other than apartment buildings and operators of apartment buildings, in that order, accounting for approximately 6.01%, 4.12% and 2.51% of the total loans at year-end 2005, respectively.

Conventional mortgage loans secured by 1-4 family real estate are long-term assets and in many cases have a fixed interest rate. The vast majority of loans added to First National Bank’s portfolio by the acquisition of Peoples Federal were fixed-rate residential mortgage loans, but their number has declined since the merger as these fixed-rate have been refinanced elsewhere or paid off. Approximately 47% of the portfolio of conventional mortgage loans secured by 1-4 family and multifamily real estate at year-end 2005 was adjustable rate. First National Bank’s fixed-rate conventional mortgage loans are originated with loan documentation that permits their sale in the secondary market. The Bank’s policy is to classify all fixed rate mortgage loans as ’Held for Sale” or “Held for Portfolio” at the time the loans are originated. The classification will be based upon several factors such as the

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loan’s interest rate and term, the Bank’s liquidity position, the interest rate environment and general economic market conditions.

The first table to follow presents maturity information for the loan portfolio at year-end 2005, without taking into account prepayments or unscheduled principal repayments. Loans are shown as maturing based on contractual maturities. The second table shows the dollar amount of all loans due after December 31, 2005 that have pre-determined interest rates and the dollar amount of all loans due after December 31, 2005 that have floating or adjustable rates.

		Loan Portfolio Maturity at December 31, 2005
						5 years or
		0 to 1 year*		1 to 5 years		more		Total
Amount due:
Collateralized by real estate:
	Commercial	$	5,719,120	$	22,766,298	$	19,152,617	$	47,638,035
	Residential		10,276,962		34,988,303		46,326,533		91,591,798
	Home equity		—		61,817		18,982,764		19,044,581
	Construction		1,723,432		1,926,813		2,789,755		6,440,000
Consumer loans			2,430,827		3,771,846		2,423		6,205,096
Commercial			7,687,722		6,342,719		6,015,298		20,045,739
Credit cards			1,405,708		—		—		1,405,708
Other			614,547		703,271		248,177		1,565,995
Total		$	29,858,318	$	70,561,067	$	93,517,567	$	193,936,952

*  Loans due on demand and overdrafts are included in the amount due in one year or less.

		Fixed Rate		Adjustable Rate		Total
Collateralized by real estate:
	Commercial		4,597,668		43,040,367		47,638,035
	Residential		48,724,056		42,867,742		91,591,798
	Home equity		—		19,044,581		19,044,581
	Construction		535,334		5,904,666		6,440,000
Consumer loans			6,017,587		187,509		6,205,096
Commercial			4,693,533		15,352,206		20,045,739
Credit cards			1,076,924		328,784		1,405,708
Other			1,220,790		345,205		1,565,995
Total		$	66,865,892	$	127,071,060	$	193,936,952

Allowance for Loan Losses. As explained in Note 1 of the consolidated financial statements, the allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. The allowance for loan losses is the sum of components recognized and measured either: (1) according to Statement of Financial Accounting Standards (SFAS) 5, “Accounting for Contingencies,” for pools of homogenous loans, or (2) according to SFAS 114, “Accounting by Creditors for Impairment of a Loan,” for loans the Bank considers impaired based upon individual loan review. Management determines the necessary allowance balance using the Bank’s loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions,

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FINANCIAL REVIEW

and other factors. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.

Loans Analyzed Individually. Determining the loan loss allowance begins with the Bank’s assessment of credit risk for loans analyzed individually. Individual loans are assigned credit-risk grades based on the Bank’s assessment of conditions affecting a borrower’s ability to satisfy its contractual obligation under the loan agreement. The assessment process includes reviewing a borrower’s current financial information, historical payment experience, credit documentation, public information, and other information specific to each borrower. Loans reviewed individually are reviewed at least annually, or more frequently if management becomes aware of information affecting a borrower’s ability to fulfill its obligation. All loans over $200 thousand or to customers whose aggregate total loans exceed $200 thousand are reviewed individually, except for first mortgage loans on a borrower’s personal residence. Loans or customers with balances under $200 thousand may also be reviewed individually if considered necessary by the board or management. Likewise, all commercial lending relationships over $200 thousand are ranked according to risk at least annually, but a risk ranking may change at any point during the year if the credit relationship changes. In addition, a qualified independent third party performs loan reviews annually on all aggregate loan relationships of $500 thousand or greater with a sampling of loan relationships between $200 thousand and $500 thousand. Loans analyzed individually are ranked as follows –

Pass (Pass I, II and III)loans are loans that are considered satisfactory, with lower than average risk and low probability of serious financial deterioration on the borrower’s part	Watch (Pass IV)loans are loans that are performing according to the terms of the loan agreement but that nevertheless require enhanced management supervision because of factors such as an unusual payment history or a weakened financial condition on the borrower’s part
Special-Mentionloans have more than average risk, with identified potential weaknesses that deserve management’s close attention. Left uncorrected, the potential weaknesses could result in deterioration of repayment prospects. In the case of a commercial borrower for example, potential weaknesses could include adverse trends in the borrower’s operations or adverse economic or market conditions that could affect the borrower in the future	Substandardloans are inadequately protected by the current financial condition and paying capacity of the borrower or by any collateral securing the loan. Substandard loans have a well-defined weakness or weaknesses jeopardizing collection of the debt in full, with a distinct possibility of loss if the weakness or weaknesses are not corrected. Although a loan may be classified substandard even if payments are not 90 days or more past due, if payments are 90 days or more past due the loan will be classified as substandard if not adequately collateralized, if not ranked even lower
Doubtfulloans have all the weaknesses inherent in those classified as substandard, with the added characteristic that existing facts, conditions, and values make collection or liquidation in full highly questionable and improbable. The possibility of loss is extremely high, but because of factors that could work to the borrower’s advantage classification of the “doubtful” loan as “loss” is deferred	Loans classified asLossare those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. When a bank classifies an asset as “loss,” the bank is required either to establish an allowance for losses equal to 100% of that portion of the asset so classified or to charge off that amount

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FINANCIAL REVIEW

If it is probable that the Bank will be unable to collect all principal and interest due on a commercial or non-homogenous loan — and that the loan is therefore impaired — management measures the amount of impairment using the loan’s expected future cash flows (discounted at the loan’s effective interest rate), or the fair value of the underlying collateral if loan repayment is expected to come from the sale or operation of the collateral. First National Bank considers larger loans ranked doubtful or loss to be impaired. Substandard, special mention, and watch loans are not considered impaired. Impairment is evaluated in total for smaller-balance loans of similar nature — such as residential mortgage, consumer, and credit card loans — and on an individual loan basis for other loans. If a loan is impaired, a portion of the loan loss allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.

Increases in the allowance for loan losses are made by charges to the provision for loan losses. No specific provision for loan losses results if an individually reviewed loan is ranked “pass” or “watch,” but they are included in the pools of loans analyzed under SFAS 5. Loans classified special mention or substandard, and smaller-balance loans classified doubtful are assigned a provision based upon a historical migration analysis performed on classified loans. The migration analysis identifies the percentage of classified loans by category that has historically been ultimately charged-off. The migration percentages are reviewed and adjusted by management to reflect various factors such as the growth and change in mix of the loan portfolio and the regulator’s guidelines. Loans ranked loss are charged off in their entirety because at that point the unconfirmed loss that the loan loss allowance is intended to approximate is considered to be confirmed.

As of December 31, 2005, 2004, and 2003 classified assets were as follows –

			Classified assets at December 31,
			2005					2004					2003
					Percent of					Percent of					Percent of
			Amount		total loans			Amount		total loans			Amount		total loans
Classified loans:
	Special mention		$	5,421,909		2.8	%	$	6,189,953		3.1	%	$	3,126,131		1.7	%
	Substandard			4,838,160		2.5	%		3,340,416		1.7	%		3,994,474		2.1	%
	Doubtful			1,185,504		0.6	%		731,900		0.4	%		383,495		0.2	%
	Loss			—		0.0	%		—		0.0	%		—		0.0	%
		Total classified loans	$	11,445,573		5.9	%	$	10,262,269		5.2	%	$	7,504,100		4.0	%
Other classified assets				—		0.0	%		—		0.0	%		—		0.0	%
		Total classified assets	$	11,445,573		5.9	%	$	10,262,269		5.2	%	$	7,504,100		4.0	%

Pools of Homogenous Loans Analyzed under SFAS 5. The total loan loss allowance is derived both from analysis of individual impaired loans under SFAS 114 and analysis of aggregated pools of loans under SFAS 5. Smaller balance loans (such as automobile or home equity loans, for example), homogenous groups of loans (such as residential mortgage loans), and less severely classified loans reviewed individually may be analyzed on an aggregated or pooled basis under SFAS 5.

Under SFAS 5, loans are segmented into groups of loans having similar risk characteristics based on purpose, loan type, and collateral, for example residential mortgage loans, home equity loans, and consumer loans. Losses inherent in pools of loans are estimated using average historical losses over a period of years for loans of those types, but with adjustments to account for changes in loan policies, changes in underwriting or loan recovery practices, changes in prevailing economic conditions, changes in the nature or volume of the loan portfolio, and

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FINANCIAL REVIEW

changes in other internal and external factors. Loans secured by real estate — particularly residential mortgage loans — generally have less credit risk than other types of loans.

Changes in the Allowance for Loan Losses and Classified Assets. A proper loan review function is vital to establishment of an appropriate loan loss allowance. Loan officers and the Bank’s credit analysts are responsible for the assignment of risk ratings for loans reviewed individually. Each month a committee consisting of the Bank’s President, Controller, and Chief Loan Officer evaluates the loan loss allowance and reports the results of its evaluation to the Bank’s board. Finally, the Bank adjusts its loan loss allowance methodologies retrospectively as well, making adjustments in its estimates and assumptions as necessary to account for variances of estimated loan losses from actual loan loss experience. The Bank’s determination about classification of its assets and the amount of its allowances is subject to review by the Office of the Comptroller of the Currency (OCC), which may order the establishment of additional loss allowances.

First National Bank’s percentage of the allowance for loan losses to total loans was 0.89% for 2004. When compared against 2003, it increased of 4.7%. For 2005, the percentage of the allowance for loan losses to total loans was 0.98%. This represents a 10.1% increase over 2004. As is the case in both 2004 and 2005, the Bank experienced an increase in the number of loans being rated as classified. However, magnifying the increase in 2005 is the fact that total loans at the end of 2005 had declined by approximately $5.1 million for year-end 2004. The ratio of classified assets to tier 1 capital plus the allowance for loan losses increased from 26% in 2003 to 36% in 2004 and from 36% in 2004 to 37% in 2005. The continued weakness in the local economy and deterioration of financial position of some of the Bank’s commercial borrowers has led to more loans being classified.

Loan review and monitoring is vital to establishment of an appropriate loan loss allowance and to proper credit administration and risk management generally. As is typical with a community bank, management is personally familiar with the credit factors that support customers’ loans, including the financial circumstances of commercial borrowers’ organizations, the quality of real estate collateral supporting loans, and similar factors. However, in order to minimize the risks associated with our loan process, the Bank has taken a more formal and systematic approach its credit administration, loan review, and associated functions. As part of this process in both 2004 and 2005, a qualified independent third party was engaged to perform loan reviews. Management intends on continuing utilizing a third party on an annual basis to perform loan reviews.

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FINANCIAL REVIEW

Loans deemed uncollectible are charged against the allowance for loan losses. But even after a loan is charged off, the Bank nevertheless attempts recovery when possible. Recoveries of previously charged-off amounts are credited to the allowance for loan losses. Transactions in the allowance for loan losses are summarized in the table to follow.

			Year Ended December 31,
			2005			2004			2003			2002			2001
Loan loss allowance, beginning of period			$	1,763,298		$	1,603,568		$	1,604,200		$	1,321,152		$	1,343,124
Loans charged off:
	Collateralized by real estate:
		Commercial		—			—			—			—			20,007
		Residential		—			24,003			—			—			—
		Home equity		—			—			—			—			—
		Construction		—			—			—			1,475,906			—
	Consumer			7,928			24,605			9,923			21,943			21,006
	Commercial			33,608			—			237,526			23,431			38,730
	Credit cards			16,058			20,154			20,036			24,706			6,439
	Other			—			—			—			—			—
		Total loans charged off		57,594			68,762			267,485			1,545,986			86,182
Recoveries of loans previously charged off:
	Collateralized by real estate:
		Commercial		—			—			—			—			—
		Residential		326			—			—			—			1,451
		Home equity		—			—			—			—			—
		Construction		31,555			—			—			—			—
	Consumer			5,144			1,772			8,840			12,151			20,937
	Commercial			600			41,230			7,320			2,300			1,218
	Credit cards			266			7,990			5,693			652			604
	Other			—			—			—			—			—
		Total recoveries		37,891			50,992			21,853			15,103			24,210
Net loans recovered (charged off)				(19,703	)		(17,770	)		(245,632	)		(1,530,883	)		(61,972	)
Provision charged to operations				159,233			177,500			245,000			1,569,402			40,000
Allowance of acquired institution				—			—			—			244,529			—
Loan loss allowance, end of period			$	1,902,828		$	1,763,298		$	1,603,568		$	1,604,200		$	1,321,152
Loans outstanding:
	Average			197,064,000			194,032,000			187,180,000			172,159,000			110,418,000
	End of period			193,936,952			198,993,322			189,068,331			192,530,719			118,403,676
Ratio of allowance for loan losses to total loans outstanding at end of period				0.98	%		0.89	%		0.85	%		0.83	%		1.12	%
Net recoveries (charge offs) to average loans				(0.01	)%		(0.01	)%		(0.13	)%		(0.89	)%		(0.06	)%

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FINANCIAL REVIEW

The allowance for loan losses is allocated among loan categories as shown in the table to follow. Although the Bank considers inherent losses in individual loans and categories of similar loans when it establishes the loan loss allowance, the allowance is a general reserve available to absorb all credit losses in the portfolio. No part of the allowance is segregated for or dedicated to any particular asset or group of assets.

			Allocation of the Allowance for Loan Losses at December 31,
			2005				2004				2003				2002				2001
					Percent of				Percent of				Percent of				Percent of				Percent of
					loans in				loans in				loans in				loans in				loans in
					each				each				each				each				each
					category to				category to				category to				category to				category to
			Amount		total loans		Amount		total loans		Amount		total loans		Amount		total loans		Amount		total loans
Collateralized by real estate:
	Commercial		$	719,888		25%	$	372,597		24%	$	462,667		21%	$	277,776		15%	$	171,388		20%
	Residential			185,805		47%		114,364		49%		56,624		54%		258,377		62%		74,396		45%
	Home equity			8,340		10%		12,755		9%		5,592		7%		14,623		6%		13,103		8%
	Construction			—		3%		—		3%		—		3%		40,789		1%		763,783		4%
Consumer				40,201		3%		16,293		3%		7,976		3%		20,497		3%		58,732		5%
Commercial				825,709		10%		1,226,638		10%		964,121		11%		967,182		11%		177,538		15%
Credit cards				46,980		1%		20,651		1%		21,760		0%		24,956		1%		51,691		1%
Other				75,904		1%		—		1%		—		1%		—		1%		—		2%
Unallocated				—		N/A		—		N/A		84,828		N/A		—		N/A		10,521		N/A
		Total	$	1,902,828		100%	$	1,763,298		100%	$	1,603,568		100%	$	1,604,200		100%	$	1,321,152		100%

Management reviews nonperforming assets for unfavorable collectibility factors and assesses the requirement for specific reserves on those credits. Management considers any loan past due 90 days or more and any loan on non-accrual to be a nonperforming asset. Any loan 90 days or more past due that is not both adequately collateralized and in a positive cash-flow position and any loan of a borrower experiencing serious financial deterioration may be placed on non-accrual by the Chief Lending Officer. Interest received on non-accrual loans – also referred to as nonperforming loans – is recorded as a reduction of principal. The table to follow summarizes nonperforming assets and other nonperforming assets by category.

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FINANCIAL REVIEW

			Nonperforming Assets at December 31,
			2005			2004			2003			2002			2001
Collateralized by real estate:
Commercial:
	Non-accrual		$	—		$	—		$	—		$	—		$	142,803
	Past due 90 days or more			—			—			—			—			—
Residential:
	Non-accrual			598,905			394,970			567,590			171,482			103,152
	Past due 90 days or more			197,831			51,549			28,577			76,752			71,942
Home equity:
	Non-accrual			4,680			—			—			—			12,823
	Past due 90 days or more			—			—			23,172			—			—
Construction:
	Non-accrual			—			125,502			125,502			140,000			—
	Past due 90 days or more			—			—			—			—			—
Not collateralized by real estate:
Consumer:
	Non-accrual			3,854			8,041			—			4,964			—
	Past due 90 days or more			5,116			4,099			—			—			13,232
Commercial:
	Non-accrual			1,471,934			899,082			677,777			1,841,922			—
	Past due 90 days or more			35,809			—			—			252,331			58,749
Credit cards:
	Non-accrual			—			—			8,988			—			—
	Past due 90 days or more			6,355			—			—			5,690			4,012
		Total nonperforming assets		2,324,484			1,483,243			1,431,606			2,493,141			406,713
Other real estate owned				103,334			46,000			—			—			—
Total nonperforming assets			$	2,427,818		$	1,529,243		$	1,431,606		$	2,493,141		$	406,713
Loans outstanding, net			$	191,538,419		$	196,724,596		$	187,056,241		$	190,559,663		$	116,880,804
Nonperforming assets to total net loans				1.21	%		0.75	%		0.77	%		1.31	%		0.35	%
Nonperforming assets to total assets				0.76	%		0.48	%		0.48	%		0.84	%		0.21	%
Allowance for loan losses to total loans				0.98	%		0.89	%		0.85	%		0.83	%		1.12	%
Allowance for loan losses to nonperforming assets				81.86	%		118.88	%		112.01	%		64.34	%		324.84	%

Securities. To assist in local development, the Bank actively purchases bonds issued by local municipalities, school systems, and other public entities when opportunities arise. Other securities are primarily comprised of corporate bonds and notes as well as equity securities of approximately $250 thousand. Investment securities are classified either as held to maturity or as available for sale. The Bank does not hold any securities for trading purposes. If management has the intent and the Bank has the ability at the time of purchase to hold a security until maturity or on a long-term basis, the security is classified as held-to-maturity and it is reflected on the balance sheet at historical cost. Securities to be held for indefinite periods and not intended to be held to maturity or on a long-term basis are classified as available-for-sale, and they are reflected on the balance sheet at their market value. Management determines the appropriate classification at the time of purchase. At year-end 2005, 2004 and 2003 there was no single issuer of securities where the total book value of such securities exceeded 10% of shareholders’ equity except for US government and agency obligations.

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FINANCIAL REVIEW

The following table shows the amortized cost and estimated fair values of the corporation’s investment portfolio at the dated indicated.

				Gross		Gross
		Amortized		unrealized		unrealized
		Cost		gains		losses			Fair Value
December 31, 2005
Available for Sale:
U.S. Government and federal agency		$	22,397,882	$	26,624	$	(282,131	)	$	22,142,375
State and municipal			2,040,585		36,699		(1,929	)		2,075,355
Corporate bonds and notes			30,992,806		192,861		(462,748	)		30,722,919
Mortgage Backed			4,968,661		4,599		(75,230	)		4,898,030
Equity securities			240,253		13,285		(304	)		253,234
	Total available for sale		60,640,187		274,068		(822,342	)		60,091,913
Held to Maturity:
State and municipal			16,917,133		283,969		(86,082	)		17,115,020
Total Investment Securities		$	77,557,320	$	558,037	$	(908,424	)	$	77,206,933
December 31, 2004
Available for Sale:
U.S. Government and federal agency		$	17,561,943	$	227,251	$	(30,080	)	$	17,759,114
State and municipal			2,861,927		129,113		—			2,991,040
Corporate bonds and notes			37,146,122		1,157,837		(86,103	)		38,217,856
Mortgage Backed			630,679		11,196		(222	)		641,653
Equity securities			785,897		66,422		—			852,319
	Total available for sale		58,986,568		1,591,819		(116,405	)		60,461,982
Held to Maturity:
State and municipal			15,865,047		580,268		(546	)		16,444,769
Total Investment Securities		$	74,851,615	$	2,172,087	$	(116,951	)	$	76,906,751
December 31, 2003
Available for Sale:
U.S. Government and federal agency		$	24,241,317	$	730,120	$	(19,375	)	$	24,952,062
State and municipal			2,261,802		175,194		—			2,436,996
Corporate bonds and notes			34,981,032		1,924,041		(79,437	)		36,825,636
Mortgage Backed			1,804,731		317,735		—			2,122,466
Equity securities			859,940		26,013		(33,550	)		852,403
	Total available for sale		64,148,822		3,173,103		(132,362	)		67,189,563
Held to Maturity:
State and municipal			16,603,556		712,328		(15,800	)		17,300,084
Total Investment Securities		$	80,752,378	$	3,885,431	$	(148,162	)	$	84,489,647

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FINANCIAL REVIEW

The contractual maturity of investment securities at December 31, 2005 is shown below.

			December 31, 2005
			One year or			More than one			More than five			More than ten
			less			to five years			to ten years			years			Total investment securities
			Carrying Value			Carrying Value			Carrying Value			Carrying Value			Carrying Value			Market
			Average Yield			Average Yield			Average Yield			Average Yield			Average Yield			Value
Available for Sale:
U.S. Government and federal agency			$	—		$	8,807,230		$	13,335,145		$	—		$	22,142,375		$	22,142,375
							4.28	%		5.46	%					4.93	%
State and municipal				—			257,816			207,552			1,609,987			2,075,355			2,075,355
							3.00	%		4.95	%		5.23	%		4.81	%
Corporate bonds and notes				3,245,264			17,192,279			10,285,375			—			30,722,919			30,722,919
				5.47	%		5.21	%		4.82	%					5.14	%
Mortgage-backed				—			39,519			—			4,858,511			4,898,030			4,898,030
							9.35	%					5.74	%		6.14	%
		Total debt securities		3,245,264			26,296,844			23,828,072			6,468,498		$	59,838,679			59,838,679
				5.47	%		5.15	%		4.99	%		5.37	%		5.13	%
Equity securities				—			—			—			253,235			253,235			253,235
													0.00	%		0.00	%
	Total available for sale			3,245,264			26,296,844			23,828,072			6,721,733			60,091,913			60,091,913
				5.47	%		5.15	%		4.99	%		5.17	%		5.11	%
Held to Maturity:
State and municipal				439,467			2,589,674			8,534,455			5,353,537			16,917,133			17,115,020
				5.07	%		5.02	%		4.45	%		4.89	%		4.80	%
Total investment securities			$	3,684,731		$	28,886,518		$	32,362,527		$	12,075,270		$	77,009,046		$	77,206,934
				5.42	%		5.14	%		4.85	%		5.04	%		5.04	%

Federal Bank Stock. As of December 31, 2005, the Bank held 22,551 shares of $100 par value Federal Home Loan Bank of Cincinnati stock, which are restricted securities. FHLB stock represents an equity interest in the FHLB, but it does not have a readily determinable market value. The stock can be sold at its par value only, and only to the FHLB or to another member institution. Member institutions are required to maintain a minimum stock investment in the FHLB, based on total assets, total mortgages, and total mortgage-backed securities.

Deposits. Deposits increased during 2005, with growth concentrated in time deposits and interest-bearing demand accounts, offset by a decline in non-interest bearing demand and savings. First National Bank’s savings accounts include passbook and statement savings, as well as Preferred Savings accounts tiered to pay higher rates for higher balances. First National Bank does not solicit brokered deposits. Savings accounts decreased $14.5 million or 16.4% from the end of 2004 to the end of 2005. This was primarily due to customer fund movement to certificate of deposits and Money Market Demand Accounts. Noninterest bearing demand deposits, consisting of regular checking accounts, decreased $0.4 million or 0.9%. Interest-bearing demand deposits, which include Negotiable Order of Withdrawal accounts and Money Market Deposit Accounts, increased $9.2 million or 22.7% during 2005. Much of the increase in this category is attributed to improved rates in the money market demand account and the introduction of a premium money market demand account Certificates of deposit rates increased during 2005, making this an attractive investment for our customers. Customers moved funds from demand and savings accounts, in addition to new monies into certificate of deposits. Time deposits under $100,000 increased $4.6 million or 7.6% during 2005. During the same period, Time deposits of $100,000 and more increased by $2.0 million or 19.3%. The table below shows the amount of time deposits (certificates of deposit) of $100,000 or more by time remaining until maturity as of December 31, 2005.

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FINANCIAL REVIEW

		Maturity of Time Deposits
		of $100,000 or More at
		December 31, 2005
				Percent of
Time Remaining to Maturity		Amount		total
Three months or less		$	2,280,418		18.4	%
Over three through 12 months			5,919,817		47.7	%
Over one year through 3 years			3,932,866		31.7	%
Over 3 years			270,526		2.2	%
	Total	$	12,403,627		100.0	%

Deposits are the primary sources of funds for lending activities and other general business purposes. Our core deposits at year-end 2005 were approximately $171 million, consisting of demand and savings deposits. This represented 69.6% of total long-term assets, compared to 70.2% at year-end 2004. Our net non-core funding dependence ratio was 7.1% at year-end 2005 and 7.9% at year-end 2004. We use the net non-core funding dependence ratio to measure the Bank’s dependence on high-cost funding sources to support long-term assets, meaning funding sources other than core funding sources like retail customer deposits. The net non-core funding dependence ratio is calculated as non-core liabilities, such as time deposits over $100,000, repurchase agreements and Federal Home Loan Bank advances, less short-term investments, divided by total long-term investments. One of our goals is to increase the percentage of core or non-maturity deposits relative to the Bank’s long-term assets, enhancing the Bank’s liquidity and management of interest-rate risk by increasing the level of low-cost and stable funding sources for the Bank’s long-term assets.

During 2005, the Bank closed its Market Place (Massillon) office and opened the Burbank Road (Wooster) office. The May 31, 2005 closure of Market Place resulted in lost deposits of $0.4 million from the prior year. Beginning in 2006, these deposits will be accountable to our Downtown Massillon Office. As for Burbank Road, this office opened on June 30, 2005 and along with our Cleveland Road office has contributed to a $3.7 million increase of deposits in the Wooster market.

Liquidity and Capital Resources. A Bank’s liquidity risk is the risk associated with having to satisfy current and future financial obligations in a timely manner. The Bank considers core earnings, strong capital ratios, and credit quality essential for maintaining high credit ratings, which allow the Bank cost-effective access to market-based liquidity. Both short- and long-term liquidity needs are addressed by maturities and sales of unpledged investment securities, loan repayments and maturities, sales of loans that are not pledged as security for FHLB borrowings, and transactions in cash and cash equivalents, such as federal funds sold. The use of these resources, combined with access to credit, provide funds for satisfying depositor, borrower, and creditor needs. Management considers the Bank to have satisfactory liquidity, with the ability to satisfy the demands of customers and the local economy. Liquidity may be adversely affected by unexpected deposit outflows, which can be caused by higher interest rates paid by competitors. Management monitors projected liquidity needs and establishes a desirable level based in part on the Bank’s commitment to make loans as well as management’s assessment of the Bank’s ability to generate funds.

The most liquid assets are cash and cash equivalents, which at year-end 2005 consisted of $11.0 million in cash and due from banks and $8.8 million in Federal funds sold. At year-end 2004 cash and cash equivalents consisted of $11.8 million in cash and due from banks and $6.1 million in Federal funds sold. Federal funds sold are overnight investments with correspondent banks, an investment and liquidity tool that are used to maximize earning assets. Investment securities classified as available for sale that are not pledged are another source of liquidity. In addition to the net non-core funding dependence ratio, we also consider the Bank’s loans-to-deposits ratio to assess liquidity, seeking to cap the ratio of loans to deposits at 90%. The ratio of total loans to deposits at year-end 2005 was 77.7%. At the end of 2005 the fair value of securities available for sale was approximately $60.1 million, while the total carrying value of securities pledged was approximately $24.7 million, representing securities pledged to secure public deposits and repurchase agreements.

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FINANCIAL REVIEW

Operating activities provided net cash of $3.3 million in 2005, $3.2 million in 2004, and $3.3 million in 2003, generated principally from net income in those years. During 2004 the Bank adopted a formal “Loans Available for Sale Policy”, and it continues in existence today. In accordance with the policy, during 2005, the Bank reported the $7 million in origination and proceeds from sales of mortgage loans held for sale as operating activities. Investing activities consist primarily of loan originations and repayments, along with investment securities purchases, sales, and maturities. In 2003 it also reflects proceeds from the sale of mortgage loans of $5.4 million. In 2003 investing activities used cash of $9.5 million as investment purchases exceeded investment maturities, repayments and sales and proceeds from sale of loans by approximately $7.0 million. As interest rates increased in 2004 new loan origination activity for residential mortgages declined, but originations in other categories remained strong. Investing activities used cash of $2.8 million in 2004 as investment purchases and loan originations less repayments, exceeded the proceeds from maturities of interest-bearing deposits with other banks, investment maturities, repayments and sales by $2.6 million. With increasing interest rates in 2005, net cash from investing activities was $0.8 million, with the proceeds from investment maturities, repayments and sales exceeding purchases and loan originations less repayments by $2.1 million. Loan originations by category in the last three years were as follows –

		2005		2004		2003
Collateralized by real estate:
	Commercial	$	15,163,415	$	11,228,923	$	11,406,806
	Residential		18,242,996		21,340,723		40,472,446
	Home equity		2,847,510		2,349,374		2,288,240
	Construction		6,779,521		2,412,419		2,567,017
Consumer			4,499,803		3,734,831		3,447,668
Commercial			9,105,734		8,643,897		9,478,041
Credit cards			236,400		389,700		504,700
Other			578,675		333,052		317,891
	Total	$	57,454,054	$	50,432,919	$	70,482,809

Financing activities include the solicitation and repayment of customer deposits, borrowings and repayments, treasury stock activity, and the payment of dividends. The Bank had $17 million of borrowings outstanding with the Federal Home Loan Bank (FHLB) of Cincinnati at the end of 2005, maturing in 2010 and 2011. We assumed $19.4 million in FHLB advances when we acquired Peoples Financial Corporation in April 2002. First National Bank has approximately $58 million available in short-term funding arrangements with its correspondent banks and the FHLB. Additional information concerning FHLB borrowings and bank obligations under repurchase agreements is contained in Notes 7 and 8 of the consolidated financial statements of National Bancshares.

The outstanding balances and related information about short-term borrowings, which consists almost entirely of securities sold under agreements to repurchase are summarized as follows –

	Year Ended December 31,
	2005			2004			2003
Balance at year end	$	2,359,521		$	3,888,235		$	2,786,848
Average balance outstanding		4,100,383			3,140,013			2,845,520
Maximum month-end balance		8,918,122			4,847,337			3,385,869
Weighted-average rate at year end		2.54	%		0.69	%		0.10	%
Weighted-average rate during the year		1.72	%		0.36	%		0.13	%

National Bancshares and the Bank are subject to federal regulations imposing minimum capital requirements. We monitor total risk-based, tier I risk-based, and tier I leverage capital ratios to assure compliance with regulatory capital requirements. At December 31, 2005 both National Bancshares and the Bank exceeded minimum risk-based and leverage capital ratio requirements. The Bank’s ratio of total capital to risk-based assets was 13.62% on December 31, 2005. The minimum required ratio is 8%. Additional information concerning capital ratios at year-end 2005 and 2004 is contained in Note 12 of the consolidated financial statements.

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FINANCIAL REVIEW

Contractual Obligations. As discussed in the notes to National Bancshares’ consolidated financial statements, we have obligations to make payments under contracts, including borrowings. At December 31, 2005, the aggregate contractual obligations are –

		Payment due by period
				Less than						More than
Contractual Obligations		Total		1 year		1 - 3 years		3 - 5 years		5 years
Time Deposits		$	78,271,968	$	49,122,067	$	27,572,691	$	1,577,210	$	—
Long-term obligations			17,000,000		—		—		11,000,000		6,000,000
Information system contract obligations			2,535,000		780,000		1,560,000		195,000		—
Operating lease obligations			92,524		36,624		31,200		24,700		—
	Total	$	97,899,492	$	49,938,691	$	29,163,891	$	12,796,910	$	6,000,000

Off-Balance Sheet and Contingent Liabilities. Some financial instruments, such as loan commitments, credit lines, and letters of credit are issued to satisfy customers’ financing needs. Ordinarily having fixed expiration dates, these are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are satisfied. Off-balance-sheet risk in the form of potential credit loss exists up to the face amount of these instruments, although we do not expect material losses. We use the same credit policies to make these commitments that we use to make loans, including obtaining collateral at exercise of the commitment. Funding commitments by expiration period were as follows at year-end 2005 –

		Expiration of Funding Commitments
		One year		Over one
		and less		year		Total
Unused loan commitments		$	24,989,698	$	26,165,602	$	51,155,300
Letters of credit			499,400		—		499,400
	Total	$	25,489,098	$	26,165,602	$	51,654,700

Of the unused loan commitments, approximately $7.3 million pertain to fixed-rate commitments and approximately $43.9 million pertain to variable-rate commitments. Rates on fixed rate unused loan commitments range from 4.75% to 19.80%. Because our experience demonstrates that a large percentage of funding commitments expire unused or only partially used, we believe that the total funding commitments shown in the table above do not necessarily represent actual future cash requirements.

The Bank is required by reserve regulations of the Federal Reserve Board to maintain cash on hand or on deposit with the Federal Reserve Bank. Reserve requirements vary according to the amount of a Bank’s transaction accounts, checking accounts principally. Reserve balances do not earn interest. First National Bank was required to have cash on hand or on deposit with the Federal Reserve Bank of $3.6 million at year-end 2005 and $3.9 million at year-end 2004.

The Bank occasionally sells loans it originates, particularly conventional fixed-rate residential mortgage loans. These loans are not sold with recourse. The Bank has retained mortgage-servicing rights on approximately $10.4 million of residential mortgage loans sold.

Shareholders’ Equity. The 1.9% decrease in shareholders’ equity from year-end 2004 to year-end 2005 is attributable to decreased accumulated other comprehensive income, which resulted from the decline in the market value of investments available for sale caused by the increase in short-term and intermediate interest rates. Accumulated other comprehensive income represents the unrealized appreciation or depreciation (net of taxes) in the market value of debt and equity investments available for sale. Because of interest rate volatility, accumulated other comprehensive income could materially fluctuate for each interim and year-end period, depending on economic and interest rate conditions.

Because National Bancshares is dependent on the Bank for earnings and funds necessary to pay dividends, the ability of National Bancshares to pay dividends to its shareholders is subject to bank

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FINANCIAL REVIEW

regulatory restrictions. According to the National Bank Act and Office of the Comptroller of the Currency (OCC) Rule 5.64, a national bank may never pay a cash dividend without advance OCC approval if the amount of the dividend exceeds retained net income for the year and for the two preceding years (after any required transfers to surplus). In December 2005, the Bank paid a dividend to National Bancshares in the amount of $2.0 million. At December 31, 2005, the Bank could, without prior approval, declare additional dividends of $4.1 million.

Interest-Rate Sensitivity. Like other financial institutions, the Bank is subject to interest rate risk, which management considers to be the Bank’s most significant market risk. Interest rate sensitivity, or interest rate risk, relates to the effect of changing interest rates on net interest income. Interest-earning assets with interest rates tied to the prime rate for example, or that mature in relatively short time periods, are considered interest-rate sensitive. Interest-bearing liabilities with interest rates that can be re-priced in a discretionary manner, or that mature in relatively short periods of time, are also considered interest-rate sensitive. The differences between interest-sensitive assets and interest-sensitive liabilities over various time horizons are commonly referred to as sensitivity gaps. As interest rates change, a sensitivity gap will have either a favorable effect or an adverse effect on net interest income. A negative gap — with liabilities repricing more rapidly than assets — generally has a favorable effect when interest rates are falling, and an adverse effect when rates are rising. A positive gap — with assets repricing more rapidly than liabilities — generally has the opposite effect: an adverse effect when rates are falling and a favorable effect when rates are rising. National Bancshares and the Bank do not own any trading assets and are not subject to foreign currency exchange or commodity price risk.

Interest rate risk in total is a product of risks such as repricing risk, option risk, and basis risk. Repricing risk results from differences in the maturity, or repricing, of asset and liability portfolios. Most residential mortgage and consumer loans give consumers the right to prepay with little or no prepayment penalty, and because of competitive pressures commercial lenders might choose not to enforce prepayment penalties on commercial loans. First National Bank’s fixed-rate conventional mortgage loans are originated with loan documentation that permits their sale to the secondary market and the Bank’s policy is classify these loans as “Held for Sale” or “Held in Portfolio” at the time the loans are originated based on such factors as the Bank’s liquidity position, interest rate environment and general economic conditions. A loan prepayment right is, like the right of a depositor to early withdrawal without penalty, a form of embedded option giving the customer the opportunity to benefit when market interest rates change, ordinarily at a Bank’s expense in the form of higher costs or lower revenue. Although residential mortgage loans tend to have lower credit risk than other forms of lending, they tend also to have higher option risk and interest rate risk because of this prepayment feature and their long-term nature. Option risk in the form of prepayments also affects the value of mortgage-backed securities. Basis risk refers to the potential for changes in the underlying relationship between market rates and indices, which can result in a narrowing of the profit spread on an earning asset or liability. Basis risk also exists in administered rate liabilities, such as NOW accounts, savings accounts, and money market accounts, whose historical pricing relationships to market rates may change due to the level or directional change in market interest rates.

Management’s goal is to manage interest rate risk by maintaining the one-year ratio of interest-earning assets to interest-bearing liabilities within a range between 50% and 150%. At year-end 2005 the Bank had a negative one-year cumulative gap of -20% of total assets, and a ratio of interest-earning assets to interest-bearing liabilities of 65%. This compares to a negative one-year cumulative gap of -20% of total assets, and a ratio of interest-earning assets to interest-bearing liabilities of 64% at year-end 2004. In 2003, the one-year cumulative gap was -30% of total assets, and a ratio of interest-earning assets to interest-bearing liabilities of 50%. At year-end 2005 long-term interest-earning assets represent 19% of total earning assets, compared to 22% at year-end 2004. This has reduced our exposure to interest rate risk. Management has taken actions to shorten the maturities of the Bank’s assets and lengthen the maturities of the

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FINANCIAL REVIEW

Bank’s liabilities, including offering attractive rates on variable rate loans and offering certificate of deposit specials maturing in longer than twelve months.

The following table shows the maturities or repricing of the Bank’s earning assets and liabilities at year-end 2005 based upon the contractual maturity or contractual repricing dates of loans and the contractual maturities of time deposits. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less.

			Maturing or Repricing Periods
			Within			4 - 12			1 - 5			Over 5
			3 months			months			years			years			Total
Interest-earning assets:
Federal funds sold			$	8,780,000		$	—		$	—		$	—		$	8,780,000
Investment securities				3,793,268			13,376,044			32,434,201			27,405,533			77,009,046
Federal bank stock				—			—			—			2,987,050			2,987,050
Loans held for sale				—			—			—			—			—
Loans collateralized by real estate:
	Commercial (1)			8,842,497			7,986,281			30,252,826			556,431			47,638,035
	Residential (1)			8,941,825			17,824,064			42,437,916			22,387,993			91,591,798
	Home equity (1)			19,008,680			35,901			—			—			19,044,581
	Construction (1)			3,917,944			422,523			1,689,506			410,027			6,440,000
Consumer loans (1)				739,235			1,765,753			3,700,108			—			6,205,096
Commercial (1)				14,350,782			2,563,029			3,131,928			—			20,045,739
Credit cards (1)				345,373			1,060,335			—			—			1,405,708
Other (1)				423,966			299,225			652,797			190,007			1,565,995
		Total interest-earning assets	$	69,143,570		$	45,333,155		$	114,299,282		$	53,937,041		$	282,713,048
Interest-bearing liabilities:
	Interest-bearing demand		$	32,283,940		$	—		$	—		$	—		$	32,283,940
	Money market			17,739,977			—			—			—			17,739,977
	Savings			74,048,596			—			—			—			74,048,596
	Time			11,991,697			37,121,673			29,158,598			—			78,271,968
	Repurchase agreements			2,359,521			—			—			—			2,359,521
	Other borrowings			592,763			—			11,000,000			6,000,000			17,592,763
		Total interest-bearing liabilities	$	139,016,494		$	37,121,673		$	40,158,598		$	6,000,000		$	222,296,765
Interest-sensitivity gap			$	(69,872,925	)	$	8,211,482		$	74,140,684		$	47,937,041		$	60,416,281
Cumulative interest sensitivity gap			$	(69,872,925	)	$	(61,661,443	)	$	12,479,241		$	60,416,281
Cumulative interest sensitivity gap as a percent of total equity				-201.63	%		-177.94	%		36.01	%		174.34	%
Cumulative interest sensitivity gap as a percent of total assets				-22.77	%		-20.09	%		4.07	%		19.69	%

(1)	For purposes of the gap analysis, loans are not reduced by the allowance for loan losses.
(2)	Federal Home Loan Bank advances included in other borrowings are convertible variable rate instruments that could reprice in earlier periods should market rates rise.

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FINANCIAL REVIEW

One way to minimize interest rate risk is to maintain a balanced or matched interest-rate sensitivity position. However, matched funding does not always maximize profits. To increase net interest income, the Bank selectively mismatches asset and liability repricing to take advantage of short-term interest rate movements. The magnitude of the mismatch depends on management’s assessment of the risks presented by forecasted interest rate movements.

Interest rates change daily on federal funds purchased and sold. Federal funds are therefore the most sensitive to the market and have the most stable fair values. Loans and deposits tied to indices such as the prime rate or federal discount rate are also market sensitive, with stable fair values. The least sensitive instruments include long-term, fixed-rate loans and securities, which have the least stable fair value. Management of maturity distributions of assets and liabilities between these extremes is as important as the balances maintained. Management of maturity distributions involves matching interest rate maturities as well as principal maturities, which can influence net interest income significantly. In periods of rapidly changing interest rates, a negative or positive gap can cause major fluctuations in net interest income and earnings. Managing asset and liability sensitivities to enhance growth regardless of changes in market conditions is one of the objectives of the bank’s asset/liability management strategy.

Management attempts to maintain consistent growth in net interest income and net income while managing interest rate risk within board-approved policy limits. Evaluating the Bank’s exposure to changes in interest rates is the responsibility of the Asset/ Liability Management Committee, a committee of Bank officers meeting monthly and reporting directly to the board. The Asset/ Liability Management Committee assesses both the adequacy of the management process used to control interest rate risk and the quantitative level of exposure, monitoring and managing interest rate risk to control the effect of changing interest rates on net interest income and net income. Evaluating the quantitative level of interest rate risk exposure requires assessment of existing and potential effects of changes in interest rates on the Bank’s financial condition, including capital adequacy, earnings, liquidity, and asset quality. The Asset/ Liability Management Committee also monitors the Bank’s liquidity levels. Interest rate risk exposure is reviewed in monthly meetings of the Asset/ Liability Committee. Risk is mitigated by matching maturities or repricing opportunities.

Gap analysis has limitations because it cannot measure the effect of interest rate movements and competitive pressures on the repricing and maturity characteristics of interest-earning assets and interest-bearing liabilities. The static gap analysis is based on assumptions concerning such matters as when assets and liabilities will reprice in a changing interest rate environment. The model assumes that certain assets and liabilities of similar maturity or repricing opportunities will react the same to changes in interest rates. However, certain assets and liabilities indicated as maturing or repricing within a stated period might actually mature or reprice at different times and at different volumes from those estimated. Actual results can differ significantly from simulated results if, for example, market conditions and management strategies vary from the assumptions used in the analysis. The actual prepayments and withdrawals experienced by the Bank after a change in interest rates could deviate significantly from those assumed in calculating the data shown in the table. Adjustable-rate loans, for example, commonly have provisions limiting changes in interest rates each time the interest rate changes and on a cumulative basis over the life of the loan. Also, the renewal or repricing of some assets and liabilities can be discretionary and subject to competitive and other pressures. The ability of borrowers to service their debt could diminish after an interest rate increase. Therefore, the gap table above does not and cannot necessarily indicate the actual future impact of general interest movements on net interest income.

Management also uses an earnings simulation model to assess interest rate sensitivity, which estimates the effect on net interest income and net income assuming various interest rate changes – or “rate shocks” – such as changes of plus or minus 100 basis points or plus 200 basis points. At year-end 2005 the earnings simulation model predicts a minor increase in net income assuming interest rates increase, and moderate decrease if rates decrease. Being in a liability-sensitive position

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FINANCIAL REVIEW

would dictate an earnings decrease if rates rise. However, the model incorporates numerous assumptions, including relative levels of market interest rates, loan prepayments, reactions of depositors to changes in interest rates, and control over the timing and amount of interest rate changes on various deposit products, such as savings accounts. Factoring in competitive issues and liquidity levels, rate changes on certain deposit products may lag interest rate changes in the market. The Bank’s goal is to limit earnings at risk to 15% of projected net income over a one year time period assuming a plus or minus shift of 100 basis points in interest rates. The table to follow shows the predicted effect on net income over one year under the earnings simulation model assuming interest rate changes of plus or minus 100 and plus 200 basis points. The earnings simulation model’s predictions of the effect of rate changes on net income must not be relied upon as being indicative of actual results. Further, it does not necessarily contemplate all actions we might undertake in response to interest rate changes. Management continues to seek non-interest income opportunities and seeks to control expenses in an effort to offset these possible fluctuations in net income.

	Effect of a Change in
	Interest Rates on Net Income
	Over a 12-Month Period
(Dollars in thousands)	2005				2004
+ 200 basis points	$	234	10.6	%	$	42		1.4	%
+ 100 basis points	$	17	0.8	%	$	5		0.2	%
- 100 basis points	$	63	2.8	%	$	(18	)	(0.6	)%

First National Bank also has longer-term interest rate risk exposure, which may not be appropriately measured by earnings sensitivity analysis. Longer-term interest rate risk exposure can be measured using an “economic value of equity” sensitivity analysis. The economic value of equity sensitivity analysis involves discounting cash flows on the balance sheet to present value assuming various interest rate levels. The discounted present value of all cash flows represents the bank’s economic value of equity. The analysis requires modifying the expected cash flows in each interest rate scenario, which affects the discounted present value. In 2004 the Bank established limits for economic value of equity and began performing this sensitivity analysis. The Bank’s goal is to limit a decline in economic value of equity to no more than 10% and 16% for interest rate changes of 100 and 200 basis points, respectively. At year-end 2005, the analysis showed the Bank was within established limits at 0.4% and -3.8% for interest rate changes of plus 100 and 200 basis points, and - -3.6% for an interest rate change of minus 100 basis points.

Results of Operations

First National Bank derives substantially all of its income from banking and bank-related services, including interest earnings on residential real estate, commercial real estate, commercial, and consumer loans and investment securities along with fee income from deposit services. National Bancshares Corporation’s business consists almost exclusively of acting as holding company for the bank. First National Bank’s business is not complex: the Bank gathers deposits and it makes loans, principally in Wayne, Stark, Medina and Holmes Counties, Ohio.

Net income increased 10.1% from 2003 to 2004, and decreased 27.9% from 2004 to 2005. The principal difference between 2003 and 2004 was lower interest rates, increased non-interest income and increased non-interest expenses. However, during 2005, in addition to decreased non-interest income and increased non-interest expenses, we experienced higher interest rates as the Federal Reserve Board increased rates. Additionally, due to the lack of growth and increased competition in the region of Ohio we serve, and in order to attract and maintain new deposits and loans, the Bank needed to provide more competitive products/services and pricing on our product/service offering. Additionally during 2005, the Bank continued to make significant organizational changes, including changes made at the senior management level. As with prior reorganizations, this was to position the Bank for future growth and expansion.

Interest and fees on loans increased $1.1 million or 10.3% in 2005 as average yields increased from 5.72% in 2004 to 6.21% in 2005, and the average loan balance increased $3.0 million. Interest and fees on loans increased $265 thousand or 2.4% in 2004 from 2003 due to higher average loan volume as average yields declined from 5.79% to 5.72%. Interest on Federal funds sold decreased by 12.3%

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FINANCIAL REVIEW

from 2003 to 2004. This is due to the decreased volume of Federal funds sold, but was partially offset by an increase in interest rates. When comparing 2004 to 2005, the income increased by 222.1%, due to larger availability of funds to invest in Federal funds and increased interest rates. Interest on taxable investment securities increased 0.8% in 2004 from 2003 and decreased 15.1% in 2005 from 2004. The increase in 2004 is due to increased volume partially offset by a decline in yield, while in 2005 we experienced a decrease in average volume and yield. Interest on nontaxable obligations of states and political subdivisions declined in both 2004 and 2005. While average yields declined during 2004 and 2005, the average volume of nontaxable obligations increased during 2004 and declined in 2005. The decline of interest rates to historically low levels in 2003 and 2004 affected the Bank’s interest expense on deposits, which declined from 2003 to 2004. However, as a result of the interest rate increases during 2005, increased competition for deposits and the result of a shift in mix of interest bearing versus non-interest bearing deposits, the Bank experienced 27.1% increase on interest expense on deposits. Net interest income increased 5.9% in 2004 from 2003 and decreased by 0.2% in 2005 from 2004. The net yield on interest-earning assets improved to 4.55% in 2005 compared to 4.47% in 2004.

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FINANCIAL REVIEW

Average Balances, Interest Rates and Yields. The average balances of our interest-earning assets and interest-bearing liabilities, interest earned on assets and interest cost of liabilities for the periods indicated, and the average yields earned and rates paid are presented in the table to follow. Yields are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented. Average balances are daily averages.

		Year Ended December 31,
		2005							2004								2003
		Daily							Daily								Daily
		Average				Average			Average					Average			Average				Average
(Dollars in Thousands)		Balance		Interest		Yield/cost (3)			Balance		Interest			Yield/cost (3)			Balance		Interest		Yield/cost (3)
Assets
Interest earning assets:
Investment securities:
	Taxable	$	54,089	$	2,727		5.06	%	$	59,265	$	3,186			5.56	%	$	55,445	$	3,124		5.94	%
	Nontaxable		19,545		1,307		6.71	%		19,807		1,401			7.13	%		19,742		1,421		7.26	%
	(tax equivalent basis)
Federal Funds Sold			6,823		242		3.55	%		4,983		75			1.51	%		8,233		86		1.04	%
Interest bearing deposits			—		—		0.00	%		437		27			6.18	%		998		62		6.21	%
Net loans (including nonaccrual loans)			197,064		12,243		6.21	%		194,032		11,099			5.72	%		187,180		10,834		5.79	%
Total interest-earning assets			277,521		16,520		5.81	%		278,524		15,788			5.67	%		271,598		15,527		5.72	%
All other assets			24,030							22,611								22,250
Total assets		$	301,551						$	301,135							$	293,848
Liabilities and Shareholder’s Equity
Interest-bearing liabilities:
	Interest-bearing checking	$	42,683		421		0.99	%	$	37,743		114			0.30	%	$	35,072		207		0.59	%
	Savings		80,746		614		0.76	%		89,428		650			0.73	%		84,620		844		1.00	%
	Time, $100,000 and over		10,420		312		2.99	%		11,991		282			2.35	%		11,286		362		3.21	%
	Time, other		63,034		1,799		2.85	%		64,427		1,427	��		2.21	%		70,699		1,603		2.27	%
Other funds purchased			22,072		983		4.45	%		20,737		873			4.21	%		20,342		724		3.56	%
Total interest-bearing liabilities			218,955		4,128		1.89	%		224,326		3,346			1.49	%		222,019		3,740		1.68	%
Demand deposits			44,655							38,749								33,807
Other liabilities			2,321							2,966								3,165
Shareholders’ equity			35,620							35,094								34,857
Total Liabilities and Shareholders’ Equity		$	301,551						$	301,135							$	293,848
Net interest income (tax equivalent basis)				$	12,391						$	12,442							$	11,787
Interest rate spread(1)							3.92	%							4.18	%						4.04	%
Net yield on interest-earning assets(2)							4.55	%							4.47	%						4.34	%
Ratio of average interest-earning assets to average interest-bearing liabilities							126.75	%							124.16	%						122.33	%

(1)	Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(2)	Net yield on interest-earning assets represents net interest income as a percentage of average interest-earning assets.
(3)	Average yields are computed using annualized interest income and expense for the periods.

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FINANCIAL REVIEW

Rate/ Volume Analysis. Changes in interest income and interest expense attributable to (1) changes in volume (changes in average volume multiplied by prior year rate), and (2) changes in rates (changes in rate multiplied by prior year average volume) are shown in the table to follow. Increases and decreases due to both rate and volume have been allocated proportionally to the change due to volume and the change due to rate.

			Changes in net interest									Changes in net interest
			income for the year ended									income for the year ended
			December 31, 2005									December 31, 2004
			2005 versus 2004 Increase									2004 versus 2003 Increase
			(Decrease) Due to Changes In									(Decrease) Due to Changes In
									Net									Net
(Dollars in thousands)			Volume			Rate			Change			Volume			Rate			Change
Interest Income
Investment securities:
	Taxable		$	(268	)	$	(191	)	$	(459	)	$	215		$	(153	)	$	62
	Non taxable			(18	)		(76	)		(94	)		5			(25	)		(20	)
	(tax equivalent basis)*
Federal funds sold				36			131			167			(34	)		23			(11	)
Interest bearing deposits				(27	)		—			(27	)		(35	)		—			(35	)
Loans (including nonaccrual loans)				176			968			1,144			397			(132	)		265
		Total interest income (tax equivalent basis)	$	(101	)	$	832		$	731		$	548		$	(287	)	$	261
Interest Expense
Deposits
	Interest bearing checking		$	17		$	290		$	307		$	16		$	(109	)	$	(93	)
	Savings			(65	)		28			(37	)		48			(242	)		(194	)
	Time, $100,000 and over			(40	)		70			30			23			(103	)		(80	)
	Time, other			(31	)		403			372			(142	)		(34	)		(176	)
Other funds purchased				58			52			110			14			135			149
		Total interest expense	$	(61	)	$	843		$	782		$	(41	)	$	(353	)	$	(394	)
Change in net interest income (tax equivalent basis)*			$	(40	)	$	(11	)	$	(51	)	$	589		$	66		$	655

*  Tax equivalence based on highest statutory tax rates of 34%.

Noninterest income grew in 2004 from 2003 and declined slightly in 2005 from 2004. Occasional sales of investment securities and loans contribute to noninterest income, but in First National Bank’s case the largest consistent contributors to noninterest income are fees charged on checking accounts and “other” noninterest income, which includes safety deposit box rents and other miscellaneous fees and collections. During 2004, the Bank benefited from gains on the sale of investments. In 2005, this did not occur to the extent experienced in 2004. When excluding gains on the sale of investments from 2004 and 2005, non-interest income increased by 15.7%, due to the implementation of overdraft protection service.

Noninterest expenses are the cost of doing business. This includes salaries and employee benefits, data processing fees, dues, subscriptions and fees, occupancy and depreciation, maintenance expenses and miscellaneous other expenses. Noninterest expenses grew by 8.3% in 2004 compared to 2003, attributable to higher salary and employee benefits, data processing fees, and dues, subscriptions and fees. During 2004, the Bank hired additional lending and support staff. Data processing expenses increased as

24

FINANCIAL REVIEW

the amount of transactions associated to deposit and loans customers increased. Additionally, dues, subscriptions and fees increased as expenses associated with consulting services for the Bank’s implementation of Sarbanes-Oxley were incurred, as well as expenses for a bank-wide sales training initiative. In 2005, noninterest expenses grew by 11.0% when compared to 2004. This increase is attributable to higher salary and employee benefits, data processing fees, occupancy fees, dues, subscriptions and fees, maintenance and repair expenses, marketing expenses and other expenses. The increase in salaries and employee benefits is primarily attributed to severance pay associated with the 2005 senior management reorganization. Data processing fees increased due to the volume of transactions processed during the year, particularly with deposits. Occupancy fees increased due to the required accrual of additional real estate tax provisions. Dues, subscriptions and fees increased as a result of consulting fees incurred to continue the implementation of Sarbanes-Oxley. Maintenance and repairs increased as the result of a variety of repairs that were made to many of the Bank’s branches. These repairs were necessary for customer and staff safety, as well as to maintain a customer friendly atmosphere at each affected branch. Regarding marketing expenses, these expenses increased as the Bank made a concerted effort to promote existing and new products and to create increased Bank identity in the markets we serve. Other expense increased due to increases in charge offs and director fees and pension. Charge offs increased due to the implementation of the overdraft protection service provided to our customers. And the director pension increased due to a reduction in the assumed discount rate for this benefit. Our efficiency ratio for 2003 was 71.2%, increasing to 71.4% in 2004 and to 79.9% in 2005. The efficiency ratio is essentially a measurement of how much it costs to produce an additional dollar of net income. A bank can manage interest rate changes but it cannot control them. A bank can, however, exercise some control over its noninterest expenses. Although there isn’t universal agreement about how an efficiency ratio should be calculated, with slight variations from one user to the next, we calculate our efficiency ratio simply by dividing noninterest expenses by the sum of net interest income and non-interest income. An efficiency ratio of 79.9% means it costs about 80 cents to produce an additional dollar of net income. Achieving the optimal efficiency ratio (the lower the better) requires careful control of noninterest expenses, but perhaps even more importantly it requires active capitalization on the banking franchise those noninterest expenses support, including robust loan growth and accumulation of low-cost deposits.

Critical Accounting Policies

National Bancshares’ consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America – GAAP – and follow general practices within the industry in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments based on information available as of the date of the consolidated financial statements, affecting the amounts reported in the financial statements and accompanying notes. Certain policies necessarily require greater reliance on the use of estimates, assumptions, and judgments. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the consolidated financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management, including the use of internal cash-flow modeling techniques. National Bancshares’ most significant accounting policies are presented in Note 1 of the consolidated financial statements. Management considers the allowance for loan losses, valuation of securities and goodwill and other intangible assets to be the most subjective and the most susceptible to change as circumstances and economic conditions change.

Allowance for Loan Losses. An allowance for loan losses recorded under generally accepted

25

FINANCIAL REVIEW

accounting principles is an institution’s best estimate within a range of the probable amount of loans that — based on current information and events — the institution will be unable to collect. The amount of the allowance is a product of management’s judgment and it is inevitably imprecise. Estimating the allowance requires significant judgment and the use of estimates related to many factors, including the amount and timing of future cash flows on problem loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which are susceptible to significant change. Although management believes that the allowance for loan losses was adequate at December 31, 2005, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy and employment could result in increased levels of non-performing assets and charge-offs, increased loan loss provisions, and reductions in income. Additionally, as an integral part of the examination process bank regulatory agencies periodically review a bank’s loan loss allowance. The Office of the Comptroller of the Currency (OCC) could require the recognition of additions to the loan loss allowance based on the OCC’s judgment of information available to it at the time of its examination of First National Bank.

Valuation of Securities. The portfolio of available-for-sale securities is reported at fair value. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Available-for-sale and held-to-maturity securities are reviewed quarterly for possible other-than-temporary impairment. The review includes an analysis of the facts and circumstances of each individual investment, such as the length of time the fair value has been below cost, the expectation for that security’s performance, the credit worthiness of the issuer, and the bank’s ability to hold the security to maturity. A decline in value that is considered to be other-than-temporary would be recorded as a loss within noninterest income in the consolidated statements of income.

Goodwill and Other Intangible Assets. Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified. Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank and branch acquisitions. They are initially measured at fair value and then are amortized on a straight line or accelerated method over their estimated useful lives, which is 7 to 10 years.

New Accounting Pronouncements

Effect of Newly Issued But Not Yet Effective Accounting Standards: Statement of Financial Accounting Standards Board (SFAS) No 123, Revised, requires companies to record compensation cost for stock options provided to employees in return for employment service. The cost is measured at fair value of the options when granted, and this cost is expensed over the employment service period, which is normally the vesting period of the options. This will apply to awards granted or modified in fiscal years beginning in 2006.

Currently, National Bancshares does not offer this type of compensation to employees, thus there will be no affect of this pronouncement.

26

CONSOLIDATED BALANCE SHEETS

December 31, 2005 and 2004

			2005			2004
ASSETS
Cash and due from banks			$	10,985,160		$	11,756,454
Federal funds sold				8,780,000			6,070,000
		Total cash and cash equivalents		19,765,160			17,826,454
Securities available for sale				60,091,913			60,461,982
Securities held to maturity (fair value: 2005 – $17,115,020; 2004 – $16,444,769)				16,917,133			15,865,047
Federal bank stock				2,987,050			2,877,850
Loans held for sale				—			57,000
Loans, net of allowance for loan losses: 2005 – $1,902,828; 2004 – $1,763,298				191,538,419			196,724,596
Premises and equipment, net				5,201,211			4,366,780
Other real estate owned				103,334			46,000
Goodwill				4,722,775			4,722,775
Identified intangible assets				1,136,613			1,386,577
Accrued interest receivable				1,621,306			1,615,798
Cash surrender value of life insurance				2,415,910			2,337,779
Other assets				380,184			136,291
			$	306,881,008		$	308,424,929
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits
	Noninterest-bearing		$	47,143,340		$	47,569,690
	Interest-bearing			202,344,481			200,952,786
		Total deposits		249,487,821			248,522,476
Repurchase agreements				2,359,521			3,888,235
Federal Reserve note account				592,763			791,007
Federal Home Loan Bank advances				17,000,000			17,000,000
Accrued expenses and other liabilities				2,787,478			2,903,890
		Total liabilities		272,227,583			273,105,608
Shareholders’ equity Common stock, no par value; 6,000,000 shares authorized; 2,289,528 shares issued				11,447,640			11,447,640
	Additional paid-in capital			4,689,800			4,689,800
	Retained earnings			20,067,339			19,397,601
	Treasury stock, at cost (55,040 shares)			(1,189,493	)		(1,189,493	)
	Accumulated other comprehensive income (loss)			(361,861	)		973,773
		Total shareholders’ equity		34,653,425			35,319,321
			$	306,881,008		$	308,424,929

See accompanying notes to consolidated financial statements.

27

CONSOLIDATED STATEMENTS OF INCOME

Years ended December 31, 2005, 2004 and 2003

				2005		2004		2003
Interest and dividend income
	Loans, including fees			$	12,243,402	$	11,098,476	$	10,833,688
	Federal funds sold				242,047		75,138		85,635
	Securities:
		Taxable			2,727,098		3,213,539		3,186,618
		Nontaxable			862,648		924,846		937,868
			Total interest and dividend income		16,075,195		15,311,999		15,043,809
Interest expense
	Deposits				3,145,320		2,473,832		3,016,172
	Short-term borrowings				87,712		15,037		6,996
	Federal Home Loan Bank advances				895,357		857,453		716,848
			Total interest expense		4,128,389		3,346,322		3,740,016
Net interest income					11,946,806		11,965,677		11,303,793
Provision for loan losses					159,233		177,500		245,000
Net interest income after provision for loan losses					11,787,573		11,788,177		11,058,793
Noninterest income
	Checking account fees				970,329		790,928		752,833
	Gain on sale of loans				43,548		67,379		115,982
	Gain on sale of other real estate owned				19,603		—		—
	Deposit and miscellaneous service fees				197,825		153,646		149,425
	Securities gains, net				109,035		432,915		72,290
	Other				460,860		450,445		441,490
			Total noninterest income		1,801,200		1,895,313		1,532,020
Noninterest expense
	Salaries and employee benefits				5,764,959		5,351,230		4,844,909
	Data processing				1,036,874		970,492		794,932
	Net occupancy				458,758		410,276		404,489
	Dues, subscriptions and fees				387,958		262,079		213,721
	Maintenance and repairs				382,250		262,777		267,261
	Franchise tax				372,388		355,469		321,824
	Depreciation – furniture and fixtures				330,996		363,391		353,601
	Marketing				301,154		181,526		199,242
	Amortization of intangibles				249,964		267,509		275,647
	Stationary, printing and office supplies				197,280		214,327		251,275
	Other				1,503,034		1,258,386		1,213,615
			Total noninterest expense		10,985,615		9,897,462		9,140,516
Income before income taxes					2,603,158		3,786,028		3,450,297
Income tax expense					503,348		875,288		806,746
Net income				$	2,099,810	$	2,910,740	$	2,643,551
Weighted average common shares outstanding					2,234,488		2,234,488		2,234,488
Basic and diluted earnings per common share				$	0.94	$	1.30	$	1.18

See accompanying notes to consolidated financial statements.

28

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Years ended December 31, 2005, 2004 and 2003

													Accumulated
					Additional								Other			Total
			Common		Paid-In		Retained			Treasury			Comprehensive			Shareholders’
			Stock		Capital		Earnings			Stock			Income (Loss)			Equity
Balance at January 1, 2003			$	11,447,640	$	4,689,800	$	16,502,352		$	(1,189,493	)	$	1,739,751		$	33,190,050
Comprehensive income:
	Net income							2,643,551									2,643,551
	Other comprehensive income													267,138			267,138
		Total comprehensive income															2,910,689
Cash dividends declared ($.58 per share)								(1,296,004	)								(1,296,004	)
Balance at December 31, 2003				11,447,640		4,689,800		17,849,899			(1,189,493	)		2,006,889			34,804,735
Comprehensive income:
	Net income							2,910,740									2,910,740
	Other comprehensive income (loss)													(1,033,116	)		(1,033,116	)
		Total comprehensive income															1,877,624
Cash dividends declared ($.61 per share)								(1,363,038	)								(1,363,038	)
Balance at December 31, 2004				11,447,640		4,689,800		19,397,601			(1,189,493	)		973,773			35,319,321
Comprehensive income:
	Net income							2,099,810									2,099,810
	Other comprehensive income (loss)													(1,335,634	)		(1,335,634	)
		Total comprehensive income															764,177
Cash dividends declared ($.64 per share)								(1,430,072	)								(1,430,072	)
Balance at December 31, 2005			$	11,447,640	$	4,689,800	$	20,067,339		$	(1,189,493	)	$	(361,861	)	$	34,653,425

See accompanying notes to consolidated financial statements.

29

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31, 2005, 2004 and 2003

			2005			2004			2003
Cash flows from operating activities
	Net income		$	2,099,810		$	2,910,740		$	2,643,551
	Adjustments to reconcile net income to net cash from operating activities
		Provision for loan losses		159,233			177,500			245,000
		Deferred income taxes		(239,499	)		(126,348	)		(154,585	)
		Depreciation, amortization and accretion		1,025,207			810,553			514,317
		Earnings on Bank owned life insurance		(78,131	)		(80,132	)		(88,611	)
		Federal Home Loan Bank stock dividend		(109,200	)		(106,500	)		(81,900	)
		Origination of mortgage loans held for sale		(7,397,614	)		(3,030,007	)		—
		Proceeds from sales of mortgage loans held for sale		7,421,122			3,014,578			—
		Gain on sale of loans		(43,548	)		(67,379	)		(115,982	)
		Net security gains		(109,035	)		(432,915	)		(72,290	)
		Net gain on sale of other real estate owned		(19,603	)		—			—
		Change in other assets and liabilities		621,032			108,268			383,274
		Net cash from operating activities		3,329,774			3,178,358			3,272,774
Cash flows from investing activities
	Net change in interest-bearing deposits with other banks			—			999,048			(1,863	)
	Securities held to maturity
		Proceeds from maturities and repayments		1,002,995			2,752,943			2,412,599
		Purchases		(2,034,579	)		(2,076,438	)		(636,911	)
	Securities available for sale
		Proceeds from maturities and repayments		7,717,705			14,335,787			8,442,092
		Proceeds from sales		18,664,328			4,615,918			2,071,143
		Purchases		(28,094,375	)		(13,322,070	)		(24,668,182	)
	Capital expenditures			(1,332,783	)		(179,559	)		(461,306	)
	Proceeds from sale of loans			—			—			5,432,154
	Proceeds from sale of other real estate owned			65,603			—			—
	Net change in loans to customers			4,811,723			(9,891,855	)		(2,057,750	)
		Net cash from investing activities		800,617			(2,766,226	)		(9,468,024	)
Cash flow from financing activities
	Net change in deposits			965,345			5,675,185			3,550,064
	Net change in short-term borrowings			(1,726,958	)		1,572,831			(899,810	)
	Dividends paid			(1,430,072	)		(1,340,693	)		(1,273,659	)
		Net cash from financing activities		(2,191,685	)		5,907,323			1,376,595
Net change in cash and cash equivalents				1,938,706			6,319,455			(4,818,655	)
Beginning cash and cash equivalents				17,826,454			11,506,999			16,325,654
Ending cash and cash equivalents			$	19,765,160		$	17,826,454		$	11,506,999
Supplemental cash flow information:
	Interest paid		$	3,869,119		$	3,356,077		$	3,817,233
	Income taxes paid			795,000			1,035,000			940,000
Supplemental non-cash disclosures:
	Transfer from loans to other real estate owned		$	103,334		$	46,000		$	—

See accompanying notes to consolidated financial statements.

30

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 1 – SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES

Nature of Operations and Principles of Consolidation: The consolidated financial statements include National Bancshares Corporation and its wholly-owned subsidiary, First National Bank, Orrville, Ohio (Bank), together referred to as “the Corporation.” The Bank has a minority interest in First Kropf Title, LLC. The Bank’s investment in First Kropf Title, LLC is immaterial to the consolidated financial statements. Intercompany transactions and balances are eliminated in consolidation.

The Corporation provides financial services through its main and branch offices in Orrville, Ohio, and branch offices in surrounding communities in Wayne, Medina and Stark counties. Its primary deposit products are checking, savings, and term certificate accounts, and its primary lending products are commercial and residential mortgage, commercial and consumer installment loans. Most loans are secured by specific items of collateral including business assets, consumer assets and real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Real estate loans are secured by both residential and commercial real estate. Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.

Segments: As noted above, the Corporation provides a broad range of financial services to individuals and companies in northern Ohio. While the Corporation’s chief decision makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Corporation-wide basis. Accordingly, all of the Corporation’s banking operations are considered by management to be aggregated in one reportable operating segment.

Use of Estimates: To prepare financial statements in conformity with U. S. generally accepted accounting principles, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ. The allowance for loan losses, fair values of financial instruments and carrying value of intangible assets are particularly subject to change.

Cash Flows: Cash and cash equivalents include cash, deposits with other banks with original maturities under 90 days, and federal funds sold. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits with other banks, repurchase agreements and other short-term borrowings.

Securities: Securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity. Securities are classified as available for sale when they might be sold before maturity. Equity securities with readily determinable fair values are classified as available for sale. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax.

Federal bank stock in the consolidated financial statements consists of Federal Reserve Bank and Federal Home Loan Bank stock. These securities are carried at cost.

Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method.

Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the Corporation’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value.

(Continued)

31

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 1 – SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)

Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings.

Mortgage loans held for sale are generally sold with servicing rights retained. The carrying value of mortgage loans sold is reduced by the cost allocated to the servicing right. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.

Loans: Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoffs are reported at the principal balance outstanding, net of unearned and deferred income and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

Interest income on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is well secured and in process of collection. Consumer and credit card loans are typically charged off no later than 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off.

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors.

A loan is impaired when full payment under the loan terms is not expected. Commercial and commercial real estate loans are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.

Servicing Rights: Servicing rights represent the allocated value of retained servicing rights on loans sold. Servicing assets are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the assets. Any impairment is reported as a valuation allowance. At December 31, 2005 and 2004, the servicing asset of the Corporation totaled $84,580 and $25,288, respectively, and is included with other assets in the Consolidated Balance Sheets.

(Continued)

32

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 1 – SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)

Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal; or a fixed amount per loan and are recorded as income when earned. The amortization of mortgage servicing rights is netted against loan servicing fee income.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed.

Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 7 to 39 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 7 years.

Bank Owned Life Insurance: The Corporation has purchased life insurance policies on its directors. Life insurance is recorded at its cash surrender value, or the amount that can be realized.

Goodwill and Other Intangible Assets: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified.

Other intangible assets consist of core deposit and acquired customer relationship intangible assets arising from whole bank and branch acquisitions. They are initially measured at fair value and then are amortized on a straight line or accelerated method over their estimated useful lives, which is 7 to 10 years.

The Corporation also has intangible assets associated with a prior branch acquisition, including unidentified intangibles of approximately $115,000 and $144,000 at year-end 2005 and 2004. Management does not believe that this purchase constituted a business combination and therefore is continuing to amortize the unidentified intangible asset.

Long-term Assets: These assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.

Repurchase Agreements: Substantially all repurchase agreement liabilities represent amounts advanced by various customers. Securities are pledged to cover these liabilities, which are not covered by federal deposit insurance.

Benefit Plans: Retirement plan expense is the amount of required matching contributions plus any discretionary contributions to the Corporation’s 401(k) plan as determined by Board decision. Director retirement plan expense allocates the benefits over the estimated years of service.

Income Taxes: Income tax expense is the total of the current-year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

Loan Commitments and Related Financial Instruments: Financial instruments include credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer-financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

Earnings Per Common Share: Earnings per common share is net income divided by the weighted average number of shares outstanding during the period. There are no potentially dilutive instruments.

(Continued)

33

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 1 – SUMMARY OF SIGNIFICANT
ACCOUNTING POLICIES (Continued)

Comprehensive Income: Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale, which is also recognized as a separate component of equity.

Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.

Restrictions on Cash: Cash on hand or on deposit with the Federal Reserve Bank of $3,633,000 and $3,881,000 was required to meet regulatory reserve and clearing requirements at year-end 2005 and 2004. These balances do not earn interest.

Dividend Restriction: Banking regulations require maintaining certain capital levels and limit the dividends paid by the Bank to the holding company or by the holding company to shareholders. Dividends paid by the Bank to the holding company are the primary source of funds for dividends by the holding company to its shareholders. These restrictions pose no practical limit on the Bank or holding company to pay dividends at historical levels.

Fair Value of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

Reclassifications: Certain items in the prior year financial statements were reclassified to conform to the current presentation.

NOTE 2 – SECURITIES

The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income were as follows:

					Gross		Gross
					Unrealized		Unrealized
			Fair Value		Gains		Losses
2005
	U.S. Government and federal agency		$	22,142,375	$	26,624	$	(282,131	)
	State and municipal			2,075,355		36,699		(1,929	)
	Corporate bond and notes			30,722,919		192,861		(462,748	)
	Mortgage backed			4,898,030		4,599		(75,230	)
		Total debt securities		59,838,679		260,783		(822,038	)
	Equity securities			253,234		13,285		(304	)
		Total	$	60,091,913	$	274,068	$	(822,342	)
2004
	U.S. Government and federal agency		$	17,759,114	$	227,251	$	(30,080	)
	State and municipal			2,991,040		129,113		—
	Corporate bond and notes			38,217,856		1,157,837		(86,103	)
	Mortgage backed			641,653		11,196		(222	)
		Total debt securities		59,609,663		1,525,397		(116,405	)
	Equity securities			852,319		66,422		—
		Total	$	60,461,982	$	1,591,819	$	(116,405	)

(Continued)

34

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 2 – SECURITIES (Continued)

The carrying amount, unrecognized gains and losses, and fair value of securities held to maturity were as follows:

				Gross		Gross
		Carrying		Unrecognized		Unrecognized
		Amount		Gains		Losses			Fair Value
2005
	State and municipal	$	16,917,133	$	283,969	$	(86,082	)	$	17,115,020
2004
	State and municipal	$	15,865,047	$	580,268	$	(546	)	$	16,444,769

Sales of available for sale securities were as follows:

	2005		2004		2003
Proceeds	$	18,664,328	$	4,615,918	$	2,071,143
Gross gains		355,169		459,992		234,331
Gross losses		254,268		27,077		162,041
Gross gains from calls		8,134		—		—

The tax provision related to these net realized gains was $37,072, $147,191 and $24,579, respectively.

The fair value of debt securities and carrying amount, if different, at year-end 2005 by contractual maturity were as follows:

		Available for Sale		Held to Maturity
				Carrying
		Fair Value		Amount		Fair Value
Due in one year or less		$	3,245,264	$	439,467	$	442,829
Due from one to five years			26,296,844		2,589,674		2,646,447
Due from five to ten years			23,828,072		8,534,455		8,541,947
Due after ten years			6,468,498		5,353,537		5,483,797
	Total	$	59,838,679	$	16,917,133	$	17,115,020

(Continued)

35

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 2 – SECURITIES (Continued)

Securities with unrealized losses at year-end 2005 and 2004, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows:

	Less than 12 Months					12 Months or More					Total
			Unrealized					Unrealized					Unrealized
Description of Securities	Fair Value		Loss			Fair Value		Loss			Fair Value		Loss
2005
Available for sale:
U. S. government and federal agency	$	14,248,615	$	(161,125	)	$	3,870,640	$	(121,006	)	$	18,119,255	$	(282,131	)
State and municipal		257,816		(1,929	)		—		—			257,816		(1,929	)
Corporate bonds and notes		17,490,220		(342,931	)		4,091,557		(119,817	)		21,581,777		(462,748	)
Mortgage backed		4,503,875		(75,230	)		—		—			4,503,875		(75,230	)
Equity Securities		216,546		(304	)		—		—			216,546		(304	)
Total temporarily impaired	$	36,717,072	$	(581,519	)	$	7,962,197	$	(240,823	)	$	44,679,269	$	(822,342	)
Held to maturity:
State and municipal	$	6,505,193	$	(82,865	)	$	312,918	$	(3,217	)	$	6,818,111	$	(86,082	)
2004
Available for sale:
U. S. government and federal agency	$	4,980,313	$	(30,080	)	$	—	$	—		$	4,980,313	$	(30,080	)
Corporate bonds and notes		9,094,417		(77,876	)		494,063		(8,227	)		9,588,480		(86,103	)
Mortgage backed		82,007		(222	)		—		—			82,007		(222	)
Total temporarily impaired	$	14,156,737	$	(108,178	)	$	494,063	$	(8,227	)	$	14,650,800	$	(116,405	)
Held to maturity:
State and municipal	$	315,051	$	(546	)	$	—	$	—		$	315,051	$	(546	)

Unrealized losses have not been recognized into income because the securities are of high credit quality, management has the intent and ability to hold for the foreseeable future, and the decline in fair value is largely due to increases in market interest rates or normally expected market pricing fluctuations. The fair value of debt securities is expected to recover as the securities approach their maturity date and/or market rates decline.

Securities pledged at year-end 2005 and 2004 had carrying values of $24,730,999 and $27,280,918, and were pledged to secure public deposits and repurchase agreements.

(Continued)

36

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 3 – LOANS

Loans at year-end were as follows:

			2005			2004
Collateralized by real estate:
	Commercial		$	47,638,035		$	47,080,983
	Residential			91,591,798			97,694,011
	Home equity			19,044,581			18,272,212
	Construction			6,440,000			6,326,884
				164,714,414			169,374,090
Other:
	Consumer			6,205,096			5,385,953
	Commercial			20,045,739			21,196,523
	Credit cards			1,405,708			1,361,726
	Other			1,565,995			1,675,030
				193,936,952			198,993,322
	Unearned and deferred income			(495,705	)		(505,428	)
	Allowance for loan losses			(1,902,828	)		(1,763,298	)
		Total	$	191,538,419		$	196,724,596

Activity in the allowance for loan losses for the year was as follows:

	2005			2004			2003
Beginning balance	$	1,763,298		$	1,603,568		$	1,604,200
Provision for loan losses		159,233			177,500			245,000
Loans charged-off		(57,594	)		(68,762	)		(267,485	)
Recoveries		37,891			50,992			21,853
Ending balance	$	1,902,828		$	1,763,298		$	1,603,568

Impaired loans were as follows:

	2005		2004
Year-end loans with no allocated allowance for loan losses	$	—	$	125,502
Year-end loans with allocated allowance for loan losses		1,177,688		597,615
Amount of the allowance for loan losses allocated		273,438		256,060

	2005		2004		2003
Average of impaired loans during the year	$	366,164	$	395,646	$	837,670
Interest income recognized during impairment		—		190		362
Cash-basis interest income recognized		—		190		362

Loans past due over 90 days and still accruing interest at year-end 2005 and 2004 were $245,111 and $55,648. Nonaccrual loans for the same periods were $2,079,373 and $1,427,595. Non-performing loans consist primarily of residential real estate, commercial and consumer loans.

(Continued)

37

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 4 – PREMISES AND EQUIPMENT

Year-end premises and equipment were as follows:

	2005			2004
Land	$	1,666,971		$	1,114,306
Buildings		5,687,712			5,448,017
Furniture, fixtures and equipment		4,731,095			4,598,765
		12,085,778			11,161,088
Less: Accumulated depreciation		(6,884,567	)		(6,794,308	)
	$	5,201,211		$	4,366,780

Depreciation included in noninterest expense was $498,351, $549,797 and $540,541 in 2005, 2004 and 2003.

Rent expense under operating leases included in occupancy was $55,539, $62,337 and $63,322 for the years ended December 31, 2005, 2004 and 2003. Future lease commitments are not material.

NOTE 5 – INTANGIBLE ASSETS

During 2002, the Corporation acquired Peoples Financial Corporation and merged that Company’s banking operations into the Bank. Identified intangible assets totaling $1,791,376 were recognized and have useful lives of 7 to 10 years. Goodwill of $4,722,775 was realized from this transaction.

Acquired intangible assets were as follows as of year-end:

			2005				2004
			Gross				Gross
			Carrying		Accumulated		Carrying		Accumulated
			Amount		Amortization		Amount		Amortization
Amortized intangible assets:
	Core deposit intangibles		$	1,063,104	$	457,466	$	1,063,104	$	340,857
	Customer relationship intangibles			728,266		312,114		728,266		208,076
	Branch acquisition intangible			759,338		644,515		759,338		615,198
		Total	$	2,550,708	$	1,414,095	$	2,550,708	$	1,164,131

Aggregate amortization expense was $249,964, $267,509 and $275,647 for 2005, 2004 and 2003.

Estimated amortization expense for each of the next five years:

2006	$	245,978
2007		237,008
2008		231,360
2009		224,928
2010		90,032

(Continued)

38

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 6 – DEPOSITS

Year-end deposits were as follows:

	2005		2004
Demand, noninterest-bearing	$	47,143,340	$	47,569,690
Demand, interest-bearing		50,023,917		40,775,013
Savings		74,048,596		88,543,284
Time, $100,000 and over		12,403,627		10,395,125
Time, other		65,868,341		61,239,364
	$	249,487,821	$	248,522,476

A summary of time deposits at year-end 2005 by maturity follows:

2006	$	49,122,067
2007		20,403,215
2008		7,169,476
2009		1,396,075
2010 and thereafter		181,135
	$	78,271,968

NOTE 7 – FEDERAL HOME LOAN BANK ADVANCES

At year-end, advances from the Federal Home Loan Bank were as follows:

		2005		2004
Maturity in 2010, fixed rate at 6.26%, convertible to variable rate if 3-month LIBOR is at or above predetermined conversion rate level		$	1,000,000	$	1,000,000
Maturities in 2010 and 2011, fixed rate at 4.60% to 5.79%, convertible to variable if 1-month LIBOR is at or above fixed rate			16,000,000		16,000,000
	Total	$	17,000,000	$	17,000,000

Each advance is payable at its maturity date; advances may be paid prior to maturity subject to a prepayment penalty. As collateral for the advances, the Bank has approximately $81,478,000 and $89,742,000 of first mortgage loans available under a blanket lien arrangement at year-end 2005 and 2004.

Required principal payments are:

	Rate
2010	5.00 to 6.26%	$	11,000,000
2011	4.60 to 5.12%		6,000,000
		$	17,000,000

(Continued)

39

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 8 – REPURCHASE AGREEMENTS

Repurchase agreements generally mature within thirty days from the transaction date. Information concerning repurchase agreements is summarized as follows:

	2005			2004
Average balance during the year	$	4,100,383		$	3,140,013
Average interest rate during the year		1.88	%		0.36	%
Maximum month-end balance during the year		8,918,122			4,847,337
Weighted average rate at year-end		2.54	%		0.69	%

NOTE 9 – BENEFIT PLANS

The Corporation has a 401(k) retirement plan that covers substantially all employees. The plan allows employees to contribute up to a predetermined amount, subject to certain limitations, with the Corporation matching 50% of contributions up to 6% of an employee’s pay. Discretionary contributions may also be made to the plan. Total matching and discretionary contributions made by the Corporation during 2005, 2004 and 2003 amounted to $108,901, $148,398 and $137,656.

The Corporation has an Employee Stock Purchase Incentive Plan for full-time and most part-time employees. Under the Plan, each employee is entitled to receive a cash payment equal to 20% of the purchase price of Corporation common stock acquired by the employee on the open market, up to a maximum of 100 shares per calendar year. Expense recognized in 2005, 2004 and 2003 amounted to $4,624, $7,943 and $4,755.

The Corporation has a director retirement and death benefit plan for the benefit of all members of the Board of Directors. The plan is designed to provide an annual retirement benefit to be paid to each director upon retirement from the Board and attaining age 70. The retirement benefit provided to each director is an annual benefit equal to $1,000 for each year of service on the Board from and after August 24, 1994. In addition, each director has the option of deferring any portion of directors’ fees to a maximum of $5,000 per month until retirement. Interest credited to participant accounts associated with the deferrals was $39,459, $29,736 and $25,231 in 2005, 2004 and 2003. The deferred directors fee liability was $481,945 at December 31, 2005 and $401,933 at December 31, 2004. Expense recognized in 2005, 2004 and 2003 for the director retirement and death benefit plan was $138,080, $55,916 and $48,898. The liability related to the plan was $456,485 at December 31, 2005 and $328,405 at December 31, 2004.

NOTE 10 – INCOME TAXES

The components of deferred taxes were as follows:

			2005		2004
Deferred tax assets:
	Bad debts		$	486,832	$	439,392
	Deferred loan fees			168,540		169,132
	Core deposit intangibles			28,372		35,616
	Deferred compensation			319,066		248,315
	Investment in financial stock fund			—		2,591
	Non-accrual loan interest income			46,586		—
	Unrealized security losses, net			186,413		—
	Other			261		37
		Total		1,236,070		895,083

(Continued)

40

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 10 – INCOME TAXES (Continued)

			2005			2004
Deferred tax liabilities:
	Securities accretion			47,255			51,227
	Depreciation			224,735			246,889
	Federal Home Loan Bank stock dividends			463,658			426,530
	Prepaid expenses			21,100			32,069
	Mortgage servicing rights			28,757			8,598
	Partnership income			1,659			—
	Purchase accounting adjustments			539,450			646,226
	Unrealized securities gains, net			—			501,640
		Total		1,326,614			1,913,179
Net deferred tax (liability)			$	(90,544	)	$	(1,018,096	)

Federal income tax laws provided that the 2002 acquired entity could claim additional bad debt deductions through 1987, totaling $1.9 million. Accounting standards do not require a deferred tax liability to be recorded on this amount, which liability otherwise would total $646,000 at December 31, 2005. If the Bank were liquidated or otherwise ceases to be a bank or if tax laws were to change, this amount would be expensed.

The components of income tax expense are as follows:

		2005			2004			2003
Currently payable		$	742,847		$	1,001,636		$	961,331
Deferred			(239,499	)		(126,348	)		(154,585	)
	Total	$	503,348		$	875,288		$	806,746

The following is a reconciliation of income tax at the federal statutory rate to the effective rate of tax on the financial statements:

	Years Ended December 31,
	2005						2004						2003
	Rate			Amount			Rate			Amount			Rate			Amount
Tax at federal statutory rate		34	%	$	885,074			34	%	$	1,287,250			34	%	$	1,173,101
Tax-exempt income		(11	)		(294,635	)		(9	)		(319,108	)		(10	)		(331,423	)
Other		(3	)		(87,091	)		(2	)		(92,854	)		(1	)		(34,932	)
Income tax expense		20	%	$	503,348			23	%	$	875,288			23	%	$	806,746

(Continued)

41

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 11 – RELATED PARTY TRANSACTIONS

Loans to principal officers, directors, and their affiliates in 2005 were as follows:

Beginning balance	$	4,359,337
New loans		847,094
Repayments		(1,477,139	)
Ending balance	$	3,729,292

Unused commitments to these related parties totaled $6,158,000 and $2,965,000 at year-end 2005 and 2004. Related party deposits totaled $5,732,000 and $5,479,000 at year-end 2005 and 2004.

The Corporation has minority ownership in a title agency affiliated with a Director resulting in fee income to the Corporation of $31,122, $30,172 and $55,898 for 2005, 2004 and 2003, respectively.

NOTE 12 – REGULATORY MATTERS

The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.

Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions, asset growth and expansion are limited and capital restoration plans are required. At year-end 2005 and 2004, the most recent regulatory notifications categorized the Corporation and the Bank as well capitalized under the regulatory framework for prompt corrective action. Management is not aware of any matters after December 31, 2005 that would cause its capital category to change.

Actual and required capital amounts and ratios are presented below at year-end.

												To Be Well
							For Capital					Capitalized Under
							Adequacy					Prompt Corrective
		Actual					Purposes					Action Provisions
		Amount		Ratio			Amount		Ratio			Amount		Ratio
		(Dollars in thousands)
2005
Total capital to risk-weighted assets
	Consolidated	$	31,051		14.45	%	$	17,187		8.00	%	$	21,483		N/A
	Bank		29,261		13.62			17,184		8.00			21,480		10.00	%
Tier 1 capital to risk-weighted assets
	Consolidated		29,148		13.57			8,593		4.00			12,890		N/A
	Bank		27,358		12.74			8,592		4.00			12,888		6.00
Tier 1 capital to average assets
	Consolidated		29,148		9.76			11,943		4.00			14,929		N/A
	Bank		27,358		9.16			11,941		4.00			14,927		5.00

(Continued)

42

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 12 – REGULATORY MATTERS (Continued)

												To Be Well
							For Capital					Capitalized Under
							Adequacy					Prompt Corrective
		Actual					Purposes					Action Provisions
		Amount		Ratio			Amount		Ratio			Amount		Ratio
		(Dollars in thousands)
2004
Total capital to risk-weighted assets
	Consolidated	$	30,029		13.73	%	$	17,496		8.00	%	$	21,870		N/A
	Bank		28,776		13.19			17,452		8.00			21,815		10.00	%
Tier 1 capital to risk-weighted assets
	Consolidated		28,236		12.91			8,748		4.00			13,122		N/A
	Bank		27,001		12.38			8,726		4.00			13,089		6.00
Tier 1 capital to average assets
	Consolidated		28,236		9.41			12,008		4.00			15,010		N/A
	Bank		27,001		9.01			11,984		4.00			14,981		5.00

Dividend Restrictions — The Company’s principal source of funds for dividend payment is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above. During 2006 the Bank could, without prior approval, declare dividends of approximately $1,517,000 plus any 2006 net profits retained to the date of the dividend declaration.

NOTE 13 — LOAN COMMITMENTS AND RELATED ACTIVITIES

Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customer financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met. These agreements usually have fixed expiration dates. Commitments may expire without being used. Off-balance-sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment.

Financial instruments with off-balance-sheet risk were as follows at year-end:

	2005		2004
Unused lines of credit	$	51,155,300	$	46,062,900
Letters of credit		499,400		436,000

Of the above unused lines of credit for 2005, approximately $7,258,000 pertains to fixed-rate commitments and variable-rate commitments account for approximately $43,897,000. At year-end 2004, approximately $4,854,000 of total commitments were fixed-rate and $41,209,000 were variable rate. Rates on fixed rate unused lines of credit ranged from 4.75% to 19.80% at December 31, 2005 and 4.75% to 19.80% at December 31, 2004.

(Continued)

43

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 14 – FAIR VALUES OF FINANCIAL INSTRUMENTS

Carrying amount and estimated fair values of financial instruments were as follows at year-end:

		2005						2004
		Carrying			Fair			Carrying			Fair
		Amount			Value			Amount			Value
Financial assets
	Cash and cash equivalents	$	19,765,160		$	19,765,000		$	17,826,454		$	17,826,000
	Securities available for sale		60,091,913			60,092,000			60,461,982			60,462,000
	Securities held to maturity		16,917,133			17,115,000			15,865,047			16,445,000
	Federal bank stock		2,987,050			2,987,000			2,877,850			2,878,000
	Loans, net		191,538,419			191,599,000			196,724,596			197,410,000
	Loans held for sale		—			—			57,000			57,000
	Accrued interest receivable		1,621,306			1,621,000			1,615,798			1,616,000
Financial liabilities
	Deposit		(249,487,821	)		(248,655,000	)		(248,522,476	)		(248,184,000	)
	Short-term borrowings		(2,952,284	)		(2,952,000	)		(4,679,242	)		(4,679,000	)
	Federal Home Loan Bank advances		(17,000,000	)		(17,531,000	)		(17,000,000	)		(18,153,000	)
	Accrued interest payable		(704,306	)		(704,000	)		(445,036	)		(445,000	)

The methods and assumptions used to estimate fair value are described as follows.

Carrying amount is the estimated fair value for cash and cash equivalents, short-term borrowings, Federal bank stock, accrued interest receivable and payable, demand and savings deposits, short-term debt, and variable rate loans or deposits that reprice frequently and fully. Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the security and information about the issuer. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values. Fair value of loans held for sale is based on market quotes. Fair value of debt is based on current rates for similar financing. The fair value of off-balance-sheet items, based on the current fees or cost that would be charged to enter into or terminate such arrangements, is not material.

NOTE 15 – OTHER COMPREHENSIVE INCOME (LOSS)

Other comprehensive income (loss) components and related taxes were as follows.

	2005			2004			2003
Unrealized holding gains (loss) on available-for-sale securities	$	(1,914,653	)	$	(1,132,412	)	$	477,045
Reclassification adjustment for gains later recognized in income		(109,035	)		(432,915	)		(72,290	)
Net unrealized gains (loss)		(2,023,688	)		(1,565,327	)		404,755
Tax effect		688,054			532,211			(137,617	)
Other comprehensive income (loss)	$	(1,335,634	)	$	(1,033,116	)	$	267,138

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 16 – PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION

Condensed financial statements for National Bancshares Corporation (parent only) are as follows:

BALANCE SHEETS

			December 31,
			2005		2004
Assets
	Cash		$	2,118,481	$	1,023,529
	Investment in Bank subsidiary			32,855,390		34,057,410
	Securities available for sale			36,689		608,233
	Other assets			383		—
		Total assets	$	35,010,943	$	35,689,172
Liabilities and shareholders’ equity
	Dividends payable		$	357,518	$	357,518
	Other liabilities			—		12,333
	Shareholders’ equity			34,653,425		35,319,321
		Total liabilities and shareholders’ equity	$	35,010,943	$	35,689,172

STATEMENTS OF INCOME

			Years ended December 31,
			2005			2004			2003
Income
	Dividends from Bank subsidiary		$	2,000,000		$	1,500,000		$	—
	Other dividends			—			24,046			25,210
	Securities gains (loss), net			(768	)		19,909			110,607
		Total income		1,999,232			1,543,955			135,817
Expenses
	Miscellaneous expense			(16,119	)		(33,965	)		(30,049	)
Undistributed equity in net income of Bank subsidiary				116,697			1,400,750			2,537,783
	Net income		$	2,099,810		$	2,910,740		$	2,643,551

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005, 2004 and 2003

NOTE 16 – PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION (Continued)

STATEMENTS OF CASH FLOWS

				Years ended December 31,
				2005			2004			2003
Cash flows from operating activities
	Net income			$	2,099,810		$	2,910,740		$	2,643,551
	Adjustments to reconcile net income to net cash from operating activities:
		Equity in undistributed net income of Bank subsidiary			(116,697	)		(1,400,750	)		(2,537,783	)
		Net security (gains) loss			768			(19,909	)		(110,607	)
		Change in other assets and liabilities			(4,003	)		(899	)		—
			Net cash from operating activities		1,979,878			1,489,182			(4,839	)
Cash flows from investing activities
	Sales of securities				537,982			93,953			1,459,269
	Return of capital on investment security				7,164			—			—
		Net cash from investing activities			545,146			93,953			1,459,269
Cash flows from financing activities
	Dividends paid				(1,430,072	)		(1,340,693	)		(1,273,659	)
		Net cash from financing activities			(1,430,072	)		(1,340,693	)		(1,273,659	)
Net increase (decrease) in cash					1,094,952			242,442			180,771
Cash, beginning of year					1,023,529			781,087			600,316
Cash, end of year				$	2,118,481		$	1,023,529		$	781,087

NOTE 17 — QUARTERLY FINANCIAL DATA (UNAUDITED)

		Interest		Net Interest		Net		Basic and Diluted
		Income		Income		Income		Earnings per share
2005
	First quarter	$	3,828,291	$	2,964,022	$	520,799	$	0.23
	Second quarter		3,975,548		3,012,758		431,939		0.19
	Third quarter		4,035,644		2,958,723		447,916		0.20
	Fourth quarter		4,235,712		3,011,303		699,156		0.31
2004
	First quarter	$	3,776,566	$	3,005,542	$	829,998	$	0.37
	Second quarter		3,786,272		2,925,382		656,179		0.29
	Third quarter		3,813,203		2,951,300		593,893		0.27
	Fourth quarter		3,935,958		3,083,453		830,670		0.37

During fourth quarter 2005, the Corporation reversed a portion of the year’s provision for loan loss by $177,267. This reversal reflects an improvement on historical loan losses and an improvement of condition regarding various specific loans.

(Continued)

46

REPORT OF INDEPENDENT REGISTERED

PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders

National Bancshares Corporation

Orrville, Ohio

We have audited the accompanying consolidated balance sheets of National Bancshares Corporation as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National Bancshares Corporation as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005 in conformity with U.S. generally accepted accounting principles.

Crowe Chizek and Company LLC

Cleveland, Ohio

January 27, 2006

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PRICE RANGE OF COMMON STOCK

National Bancshares common stock is traded on the OTC Bulletin Board under the symbol “NBOH.” The OTC Bulletin Board is a regulated quotation service that displays real-time quotes, last-sale prices, and volume information in over-the-counter equity securities. A summary of the high and low prices of and cash dividends paid on National Bancshares common stock in 2004 and 2005 follows. This information does not reflect retail mark-up, markdown or commissions, and does not necessarily represent actual transactions.

2005	High		Low		Dividends Per Share
First Quarter	$	29.50	$	27.30		.16
Second Quarter		28.50		25.05		.16
Third Quarter		27.45		24.35		.16
Fourth Quarter		24.50		22.25		.16

2004	High		Low		Dividends Per Share
First Quarter	$	24.60	$	23.80		.15
Second Quarter		26.40		24.25		.15
Third Quarter		26.40		24.07		.15
Fourth Quarter		28.00		24.80		.16

SHAREHOLDER INFORMATION

Corporate Office

National Bancshares Corporation

112 West Market Street, PO Box 57

Orrville, OH 44667

Stock Trading Information
The shares of common stock of National Bancshares Corporation are traded on the OTC Bulletin Board. The ticker symbol for National Bancshares Corporation is “NBOH.”

The Corporation had 945 shareholders of

Record as of December 31, 2005.

Form 10-K

A copy of the Corporation’s 2005 Annual Report on Form 10-K as filed with the SEC will be furnished free of charge to www.fnborrville.com shareholders upon written request to the company.

Shareholder Assistance

National Bancshares Corporation

Shareholder Services Department

330-682-1030 x119

egerber@fnborrville.com

Transfer Agent

Registrar and Transfer Company

10 Commerce Drive

Cranford, NJ 07016

1-800-368-5948

info@rtco.com www.rtco.com

National Bancshares Corporation has a Dividend Reinvestment Plan and a Dividend Direct Deposit Plan available at no cost. Please contact Registrar and Transfer Company for enrollment.

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51

OFFICERS

National Bancshares Corporation

Charles J. Dolezal
President

Kenneth R. VanSickle
Senior Vice President, Secretary

Marc Valentin, CPA
Vice President, Treasurer

First National Bank

Charles J. Dolezal
President

CONTROL
Marc Valentin, CPA
Vice President & Controller

Angela Smith
Assistant Controller

Suzanne Hudson
Accounting Officer

OPERATIONS
Jim Huntsberger, CPA
Vice President, Asset/ Liability
Management and Operations, Cashier

Jan Zacharias
Operations Officer

HUMAN RESOURCES
Jackie S. Samsa
Assistant Vice President,
Manager of Human Resources

INTERNAL AUDIT
Jonna E. Ritchie
Auditor

RISK MANAGEMENT
Tammy L. Starkey
Vice President,
Risk Management


Ron Armentrout
Assistant Vice President,
Security Officer, CRA Officer


Michelle Kieffaber
Loan Officer, Compliance Officer


Jerry Schmidt
Administrative Officer,
Process Improvement

LENDING
Kenneth R. VanSickle
Senior Vice President,
Chief Loan Officer

Kathy J. Barnes
Assistant Vice President,
Commercial Lending

Mindy Bowman
Loan Officer

Scott M. Holmes
Assistant Vice President,
Mortgage and Consumer
Loan Manager

Patricia Massaro
Loan Officer

Steve L. Riddick
Vice President,
Commercial Banking

Darrell L. Smucker
Vice President,
Commercial Banking


SALES & BUSINESS
DEVELOPMENT
Paul G. Kubiak
Vice President,
Sales & Marketing

Harold D. Berkey
Vice President,
Customer Services

Jennifer Shankleton
Director of Marketing
& Development

John D. Shultz, Jr.
Vice President,
Commercial Banking
Downtown Massillon Office

OFFICE ADMINISTRATION
Paul Bayus
Assistant Vice President,
Manager Lodi Office

Karen Haueter
Assistant Vice President,
Manager Smithville and
Midway Offices

Dean Karhan
Assistant Vice President,
Manager Cleveland Road Office

James Kuschmeader
Assistant Vice President,
Manager Seville Office

Susan Kutz
Administrative Officer,
Manager West High Office

Betty Lyon
Assistant Vice President,
Manager Dalton Office

Zachery Lawrence
Assistant Vice President,
Manager Mt. Eaton Office

Matt Miller
Assistant Vice President,
Manager Burbank Road Office

Valerie Stein
Assistant Vice President,
Manager Kidron Office

Cindy Wagner
Assistant Vice President,
Manager Downtown Massillon Office

Sue Weygandt
Assistant Vice President,
Manager Mayflower Office

Amberly Wolf
Administrative Officer,
Manager Main Office Lobby

52