Edgar Filing: FAUQUIER BANKSHARES, INC.

form10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2011

o	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _____________to_____________

Commission File No.: 000-25805

Fauquier Bankshares, Inc.

(Exact name of registrant as specified in its charter)

Virginia	54-1288193
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

10 Courthouse Square, Warrenton, Virginia	20186
(Address of principal executive offices)	(Zip Code)

(540) 347-2700

(Registrant's telephone number, including area code)

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

Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x No o

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

Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company x

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

Yes o No x

The registrant had 3,669,758 shares of common stock outstanding as of August 9, 2011.

FAUQUIER BANKSHARES, INC.

INDEX

Part I.	FINANCIAL INFORMATION
		Page
Item 1.	Financial Statements	3

	Consolidated Balance Sheets as of June 30, 2011 (unaudited) and December 31, 2010	3
	Consolidated Statements of Income (unaudited) for the Three Months Ended June 30, 2011 and 2010	4
	Consolidated Statements of Income (unaudited) for the Six Months Ended June 30, 2011 and 2010	5
	Consolidated Statements of Changes in Shareholders’ Equity (unaudited) for the Six Months Ended June 30, 2011 and 2010	6
	Consolidated Statements of Cash Flows (unaudited) for the Six Months Ended June 30, 2011 and 2010	7
	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40

Item 4.	Controls and Procedures	40

Part II.	OTHER INFORMATION

Item 1.	Legal Proceedings	40

Item 1A.	Risk Factors	40

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	40

Item 3.	Defaults Upon Senior Securities	40

Item 4.	Removed and Reserved	41

Item 5.	Other Information	41

Item 6.	Exhibits	41

SIGNATURES		42

Index

Part I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Balance Sheets

	June 30, 2011			December 31, 2010
	(Unaudited)			(Audited)
Assets
Cash and due from banks	$	5,339,543		$	5,252,361
Interest-bearing deposits in other banks		52,467,431			41,919,040
Federal funds sold		9,899			11,098
Securities available for sale, net		49,634,377			46,537,941
Restricted investments		2,970,600			3,388,300
Loans		454,424,286			466,748,799
Allowance for loan losses		(6,616,154	)		(6,307,193	)
Net loans		447,808,132			460,441,606
Bank premises and equipment, net		14,153,374			14,158,374
Accrued interest receivable		1,486,299			1,488,438
Other real estate owned, net of allowance		3,469,000			2,821,000
Bank-owned life insurance		11,408,614			11,201,800
Other assets		10,426,084			10,820,386
Total assets	$	599,173,353		$	598,040,344

Liabilities
Deposits:
Noninterest-bearing	$	75,384,154		$	67,624,847
Interest-bearing:
NOW accounts		142,668,685			143,842,999
Savings accounts and money market accounts		135,872,173			132,825,735
Time deposits		164,693,877			175,762,789
Total interest-bearing		443,234,735			452,431,523
Total deposits		518,618,889			520,056,370

Federal Home Loan Bank advances		25,000,000			25,000,000
Company-obligated mandatorily redeemable capital securities		4,124,000			4,124,000
Other liabilities		5,274,729			4,754,411
Commitments and contingencies		-			-
Total liabilities		553,017,618			553,934,781

Shareholders' Equity
Common stock, par value, $3.13; authorized 8,000,000 shares; issued and outstanding: 2011: 3,669,758 shares including 32,572 nonvested; 2010: 3,636,758 shares including 33,772 nonvested shares		11,384,392			11,277,346
Retained earnings		36,250,727			34,892,905
Accumulated other comprehensive income (loss), net		(1,479,384	)		(2,064,688	)
Total shareholders' equity		46,155,735			44,105,563

Total liabilities and shareholders' equity	$	599,173,353		$	598,040,344

See accompanying Notes to Consolidated Financial Statements

Index

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

For the Three Months Ended June 30, 2011 and 2010

	2011		2010
Interest Income
Interest and fees on loans	$	6,405,669	$	6,722,975
Interest and dividends on securities available for sale:
Taxable interest income		266,645		302,606
Interest income exempt from federal income taxes		60,125		56,542
Dividends		24,010		6,651
Interest on federal funds sold		5		8
Interest on deposits in other banks		31,543		15,990
Total interest income		6,787,997		7,104,772

Interest Expense
Interest on deposits		968,338		1,337,008
Interest on federal funds purchased		-		36
Interest on Federal Home Loan Bank advances		246,959		192,161
Distribution on capital securities of subsidiary trusts		49,639		20,503
Total interest expense		1,264,936		1,549,708

Net interest income		5,523,061		5,555,064

Provision for loan losses		308,334		375,000

Net interest income after provision for loan losses		5,214,727		5,180,064

Other Income
Trust and estate income		345,905		283,992
Brokerage income		81,207		71,846
Service charges on deposit accounts		738,974		645,489
Other service charges, commissions and income		409,895		392,862
Total other-than-temporary impairment losses on securities		-		-
Less: Portion of gain/(loss) recognized in other comprehensive income before taxes		-		-
Net other-than-temporary impairment losses on securities		-		-
Gain (loss) on sale of securities		3,240		(1,689	)
Total other income		1,579,221		1,392,500

Other Expenses
Salaries and benefits		2,651,374		2,802,936
Occupancy expense of premises		463,000		443,404
Furniture and equipment		282,794		291,122
Marketing expense		164,370		164,444
Legal, audit and consulting expense		310,190		294,721
Data processing expense		294,381		255,815
Federal Deposit Insurance Corporation expense		194,885		170,462
Loss on sale or impairment of other real estate owned		250,821		45,000
Other operating expenses		651,454		738,587
Total other expenses		5,263,269		5,206,491

Income before income taxes		1,530,679		1,366,073

Income tax expense		392,529		355,501

Net Income	$	1,138,150	$	1,010,572

Earnings per Share, basic	$	0.31	$	0.28

Earnings per Share, assuming dilution	$	0.31	$	0.28

Dividends per Share	$	0.12	$	0.20

See accompanying Notes to Consolidated Financial Statements.

Index

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

For the Six Months Ended June 30, 2011 and 2010

	2011			2010
Interest Income
Interest and fees on loans	$	12,910,861		$	13,414,252
Interest and dividends on securities available for sale:
Taxable interest income		506,753			605,261
Interest income exempt from federal income taxes		118,009			115,977
Dividends		34,700			13,467
Interest on federal funds sold		13			11
Interest on deposits in other banks		56,546			24,078
Total interest income		13,626,882			14,173,046

Interest Expense
Interest on deposits		1,975,735			2,612,032
Interest on federal funds purchased		13			36
Interest on Federal Home Loan Bank advances		491,205			465,781
Distribution on capital securities of subsidiary trusts		98,739			39,828
Total interest expense		2,565,692			3,117,677

Net interest income		11,061,190			11,055,369

Provision for loan losses		770,835			750,000

Net interest income after provision for loan losses		10,290,355			10,305,369

Other Income
Trust and estate income		647,773			531,456
Brokerage income		192,897			130,950
Service charges on deposit accounts		1,411,429			1,266,941
Other service charges, commissions and income		759,389			724,081
Total other-than-temporary impairment losses on securities		(228,306	)		(84,876	)
Less: Portion of gain/(loss) recognized in other comprehensive income before taxes		(39,179	)		390,797
Net other-than-temporary impairment losses on securities		(189,127	)		(475,673	)
Gain on sale of securities		4,253			87,418
Total other income		2,826,614			2,265,173

Other Expenses
Salaries and benefits		5,360,950			5,250,624
Occupancy expense of premises		939,140			943,306
Furniture and equipment		601,230			608,818
Marketing expense		301,886			320,862
Legal, audit and consulting expense		579,871			561,952
Data processing expense		589,740			518,805
Federal Deposit Insurance Corporation expense		392,682			353,079
Loss on sale or impairment of other real estate owned		250,821			61,139
Other operating expenses		1,377,681			1,537,918
Total other expenses		10,394,001			10,156,503

Income before income taxes		2,722,968			2,414,039

Income tax expense		663,932			599,574

Net Income	$	2,059,036		$	1,814,465

Earnings per Share, basic	$	0.56		$	0.50

Earnings per Share, assuming dilution	$	0.56		$	0.50

Dividends per Share	$	0.24		$	0.40

See accompanying Notes to Consolidated Financial Statements.

Index

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Changes in Shareholders' Equity

For the Six Months Ended June 30, 2011 and 2010

	Common Stock		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Comprehensive Income			Total
Balance, December 31, 2009	$	11,103,371	$	33,458,933		$	(1,923,462	)				$	42,638,842
Comprehensive income:
Net income				1,814,465					$	1,814,465			1,814,465
Other comprehensive income net of tax:
Unrealized holding gains on securities available for sale, net of tax of $64,998							126,172			126,172			126,172
Less: gain on sale of securities available for sale, net of tax of $29,722							(57,696	)		(57,696	)		(57,696	)
Add: reclassification adjustments for other-than-temporary impairment, net of tax of $161,729							313,944			313,944			313,944
Other comprehensive income net of tax of $197,005										382,420
Total comprehensive income									$	2,196,885
Cash dividends ($.40 per share)				(1,451,260	)								(1,451,260	)
Amortization of unearned compensation, restricted stock awards				243,554									243,554
Issuance of common stock - nonvested shares (28,847 shares)		90,291		(90,291	)								-
Issuance of common stock - vested shares (6,522 shares)		20,414		69,459									89,873
Exercise of stock options		60,140		95,950									156,090
Balance, June 30, 2010	$	11,274,216	$	34,140,810		$	(1,541,042	)				$	43,873,984

Balance, December 31, 2010	$	11,277,346	$	34,892,905		$	(2,064,688	)				$	44,105,563
Comprehensive income:
Net income				2,059,036					$	2,059,036			2,059,036
Other comprehensive income net of tax:
Interest rate swap, net of tax of $22,744							(44,151	)		(44,151	)		(44,151	)
Unrealized holding gains on securities available for sale, net of tax of $261,408							507,438			507,438			507,438
Less: gain on sale or call of securities available for sale, net of tax of $1,446							(2,807	)		(2,807	)		(2,807	)
Add: reclassification adjustments for other-than-temporary impairment, net of tax of $64,303							124,824			124,824			124,824
Other comprehensive income net of tax of $301,521										585,304
Total comprehensive income									$	2,644,340
Cash dividends ($.24 per share)				(880,742	)								(880,742	)
Amortization of unearned compensation, restricted stock awards				69,051									69,051
Issuance of common stock - nonvested shares (10,914 shares)		34,161		(34,161	)								-
Issuance of common stock - vested shares (4,752 shares)		14,874		53,080									67,954
Exercise of stock options		58,011		91,558									149,569
Balance, June 30, 2011	$	11,384,392	$	36,250,727		$	(1,479,384	)				$	46,155,735

See accompanying Notes to Consolidated Financial Statements

Index

Fauquier Bankshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

For the Six Months Ended June 30, 2011 and 2010

(Unaudited)

	2011			2010
Cash Flows from Operating Activities
Net income	$	2,059,036		$	1,814,465
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		600,017			622,495
Disposal of obsolete assets		44,708			-
Provision for loan losses		770,835			750,000
Loss on sale or impairment of other real estate		250,821			61,139
(Gain) on sale and call of securities		(4,253	)		(87,418	)
Loss on impairment of securities		189,127			475,673
Amortization of security premiums, net		51,471			26,018
Amortization of unearned compensation, net of forfeiture		69,051			243,554
Changes in assets and liabilities:
(Increase) in other assets		(130,569	)		(282,624	)
(Decrease) increase in other liabilities		472,099			(199,976	)
Net cash provided by operating activities		4,372,343			3,423,326

Cash Flows from Investing Activities
Proceeds from sale of securities available for sale		-			1,541,751
Proceeds from maturities, calls and principal payments of securities available for sale		10,005,712			5,255,068
Purchase of securities available for sale		(12,384,774	)		(11,510,884	)
Purchase of premises and equipment		(639,725	)		(1,117,841	)
Redemptions of restricted securities		417,700			-
Net decrease (increase) in loans		10,652,639			(1,124,106	)
Proceeds from sale of other real estate owned		311,179			434,636
Net cash provided by provided by (used in) investing activities		8,362,731			(6,521,376	)

Cash Flows from Financing Activities
Net increase in demand deposits, NOW accounts and savings accounts		9,631,431			35,936,505
Net (decrease) in certificates of deposit		(11,068,912	)		(9,097,606	)
Cash dividends paid on common stock		(880,742	)		(1,451,260	)
Issuance of common stock		217,523			245,963
Net cash provided by (used in) financing activities		(2,100,700	)		25,633,602

Increase in cash and cash equivalents		10,634,374			22,535,552

Cash and Cash Equivalents
Beginning		47,182,499			26,208,367

Ending	$	57,816,873		$	48,743,919

Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest	$	2,543,411		$	3,144,161

Income taxes	$	656,392		$	1,024,000

Supplemental Disclosures of Noncash Investing Activities
Unrealized gain on securities available for sale, net of tax effect	$	629,455		$	382,420
Foreclosed assets acquired in settlement of loans	$	1,210,000		$	428,000
Unrealized (loss) interest rate swap, net of taxes	$	(44,151	)	$	-

See accompanying Notes to Consolidated Financial Statements.

Index

FAUQUIER BANKSHARES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

Note 1.

General

The consolidated financial statements include the accounts of Fauquier Bankshares, Inc. (“the Company”) and its wholly-owned subsidiaries: The Fauquier Bank (“the Bank”) and Fauquier Statutory Trust II; and the Bank's wholly-owned subsidiary, Fauquier Bank Services, Inc. In consolidation, significant intercompany financial balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial positions as of June 30, 2011 and December 31, 2010 and the results of operations for the three and six months ended June 30, 2011 and 2010. The notes included herein should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s 2010 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”).

The results of operations for the three and six months ended June 30, 2011 are not necessarily indicative of the results expected for the full year.

Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU 2010-06 amends Subtopic 820-10 to clarify existing disclosures, require new disclosures, and includes conforming amendments to guidance on employers’ disclosures about postretirement benefit plan assets. ASU 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU 2010-20, “Receivables (Topic 310) – Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” The new disclosure guidance significantly expands the existing requirements and will lead to greater transparency into a company’s exposure to credit losses from lending arrangements. The extensive new disclosures of information as of the end of a reporting period became effective for both interim and annual reporting periods ending on or after December 15, 2010. Specific disclosures regarding activity that occurred before the issuance of the ASU, such as the allowance roll forward and modification disclosures, will be required for periods beginning on or after December 15, 2010. The Company has included the required disclosures in its consolidated financial statements.

In December 2010, the FASB issued ASU 2010-28, “Intangible – Goodwill and Other (Topic 350) – When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” The amendments in this ASU modify Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. The amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In December 2010, the FASB issued ASU 2010-29, “Business Combinations (Topic 805) – Disclosure of Supplementary Pro Forma Information for Business Combinations.” The guidance requires pro forma disclosure for business combinations that occurred in the current reporting period as though the acquisition date for all business combinations that occurred during the year had been as of the beginning of the annual reporting period. If comparative financial statements are presented, the pro forma information should be reported as though the acquisition date for all business combinations that occurred during the current year had been as of the beginning of the comparable prior annual reporting period. ASU 2010-29 is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Early adoption is permitted. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

The SEC issued Final Rule No. 33-9002, “Interactive Data to Improve Financial Reporting.” The rule requires companies to submit financial statements in extensible business reporting language (“XBRL”) format with their SEC filings on a phased-in schedule. Large accelerated filers and foreign large accelerated filers using accounting principles generally accepted in the United States (“ U.S. GAAP”) were required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2010. All remaining filers are required to provide interactive data reports starting with their first quarterly report for fiscal periods ending on or after June 15, 2011.

Index

In March 2011, the SEC issued Staff Accounting Bulletin (“SAB”) 114. This SAB revises or rescinds portions of the interpretive guidance included in the codification of the Staff Accounting Bulletin Series. This update is intended to make the relevant interpretive guidance consistent with current authoritative accounting guidance issued as a part of the FASB’s Codification. The principal changes involve revision or removal of accounting guidance references and other conforming changes to ensure consistency of referencing through the SAB Series. The effective date for SAB 114 is March 28, 2011. The adoption of the new guidance did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU 2011-02, “Receivables (Topic 310) – A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring.” The amendments in this ASU clarify the guidance on a creditor’s evaluation of whether it has granted a concession to a debtor. They also clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulty. The amendments in this ASU are effective for the first interim or annual period beginning on or after June 15, 2011. Early adoption is permitted. Retrospective application to the beginning of the annual period of adoption for modifications occurring on or after the beginning of the annual adoption period is required. As a result of applying these amendments, an entity may identify receivables that are newly considered to be impaired. For purposes of measuring impairment of those receivables, an entity should apply the amendments prospectively for the first interim or annual period beginning on or after June 15, 2011. The Company has adopted ASU 2011-02 and will include the required disclosures in its September 30, 2011 consolidated financial statements.

In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and (2) the collateral maintenance implementation guidance related to that criterion. The amendments in this ASU are effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Company is currently assessing the impact that ASU 2011-03 will have on its consolidated financial statements.

In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and the International Accounting Standards Board (“IASB”) to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and IFRSs. The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application. Early application is not permitted. The Company is currently assessing the impact that ASU 2011-04 will have on its consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income.” The objective of this ASU is to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The single statement of comprehensive income should include the components of net income, a total for net income, the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present all the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. The amendments do not change the items that must be reported in other comprehensive income, the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, or the calculation or reporting of earnings per share. The amendments in this ASU should be applied retrospectively. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2011. Early adoption is permitted because compliance with the amendments is already permitted. The amendments do not require transition disclosures. The Company is currently assessing the impact that ASU 2011-05 will have on its consolidated financial statements.

Index

Note 2.

Securities

The amortized cost and fair value of securities available for sale, with unrealized gains and losses follows:

	June 30, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Obligations of U.S. Government corporations and agencies	$	42,032,570	$	806,291	$	-			42,838,861
Obligations of states and political subdivisions		5,782,122		308,185		-			6,090,307
Corporate bonds		3,758,006		-		(3,434,421	)		323,585
Mutual funds		332,096		3,028		-			335,124
FHLMC preferred bank stock		9,100		37,400		-			46,500
	$	51,913,894	$	1,154,904	$	(3,434,421	)	$	49,634,377

	December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Obligations of U.S. Government corporations and agencies	$	40,020,633	$	353,292	$	(342,206	)	$	40,031,719
Obligations of states and political subdivisions		5,467,451		154,160		(2,847	)		5,618,764
Corporate bonds		3,947,133		-		(3,395,289	)		551,844
Mutual funds		326,861		-		(347	)		326,514
FHLMC preferred bank stock		9,100		-		-			9,100
	$	49,771,178	$	507,452	$	(3,740,689	)	$	46,537,941

The amortized cost and fair value of securities available for sale, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations without penalties.

	June 30, 2011
	Amortized Cost		Fair Value
Due in one year or less	$	-	$	-
Due after one year through five years		13,573,495		13,622,026
Due after five years through ten years		6,477,909		6,788,839
Due after ten years		31,521,294		28,841,888
Equity securities		341,196		381,624
	$	51,913,894	$	49,634,377

There were no impairment losses on securities during the quarters ended June 30, 2011 and June 30, 2010. For the six months ended June 30, 2011 and June 30, 2010, impairment losses on securities were $189,000 and $476,000, respectively.

There were no securities sold during the three and six month periods ended June 30, 2011. During the quarter ended June 30, 2011, five securities were called totaling a fair value of $5.5 million, resulting in a gain of $3,240. During the six months ended June 30, 2011, six securities were called totaling a fair value of $6.5 million, resulting in a gain of $4,253. During the six months ended June 30, 2010, one security, a 30 year mortgage-backed government agency with a fair value of $1.5 million, was sold at a gain of $87,418. This bond was sold because of its relatively longer-term current duration of approximately five years and its inherent extension risk of an additional two years of duration if market interest rates increase in the future. The tax expense on this gain on sale was $30,000.

The following table shows the Company securities with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2011 and December 31, 2010, respectively.

Index

	Less than 12 Months				12 Months or More					Total
June 30, 2011	Fair Value		Unrealized (Losses)		Fair Value		Unrealized (Losses)			Fair Value		Unrealized (Losses)

Obligations of U.S. Government, corporations and agencies
Obligations of states and political subdivisions
Corporate bonds		-		-		323,585		(3,434,421	)		323,585		(3,434,421	)
Subtotal, debt securities						323,585		(3,434,421	)		323,585		(3,434,421	)
Mutual funds		-		-		-		-			-		-
Total temporary impaired securities	$	-	$	-	$	323,585	$	(3,434,421	)	$	323,585	$	(3,434,421	)

	Less than 12 Months					12 Months or More					Total
December 31, 2010	Fair Value		Unrealized (Losses)			Fair Value		Unrealized (Losses)			Fair Value		Unrealized (Losses)

Obligations of U.S. Government, corporations and agencies	$	24,409,268	$	(342,206	)	$	-	$	-		$	24,409,268	$	(342,206	)
Obligations of states and political subdivisions		579,760		(2,847	)		-		-			579,760		(2,847	)
Corporate bonds		-		-			551,844		(3,395,289	)		551,844		(3,395,289	)
Subtotal, debt securities		24,989,028		(345,053	)		551,844		(3,395,289	)		25,540,872		(3,740,342	)
Mutual funds		-		-			326,514		(347	)		326,514		(347	)
Total temporary impaired securities	$	24,989,028	$	(345,053	)	$	878,358	$	(3,395,636	)	$	25,867,386	$	(3,740,689	)

The nature of securities which were temporarily impaired for a continuous 12 month period or more at June 30, 2011 consisted of four corporate bonds with a cost basis net of other-than-temporary impairment (“OTTI”) totaling $3.8 million and a temporary loss of approximately $3.4 million. The method for valuing these four corporate bonds came from Moody's Analytics. Moody’s Analytics employs a two-step discounted cash-flow valuation process. The first step is to use Monte Carlo simulations to evaluate the credit quality of the collateral pool and the structural supports. Step two is to apply a discount rate to the cash flows to calculate a value. These four corporate bonds are the “Class B” or subordinated “mezzanine” tranche of pooled trust preferred securities. The trust preferred securities are collateralized by the interest and principal payments made on trust preferred capital offerings by a geographically diversified pool of approximately 60 different financial institutions. They have an estimated maturity of 25 years. These bonds could have been called at par on the five year anniversary date of issuance, which has already passed for all four bonds. The bonds reprice every three months at a fixed rate index above the three-month London Interbank Offered Rate (“LIBOR”). These bonds have sufficient collateralization and cash flow projections to satisfy their valuation based on the cash flow portion of the OTTI test under authoritative accounting guidance as of June 30, 2011. All four bonds totaling $324,000 at fair value, are greater than 90 days past due, and are classified as nonperforming corporate bond investments in the nonperforming asset table in Note 3.

Additional information regarding each of the pooled trust preferred securities as of June 30, 2011 follows:

Cost, net of OTTI loss		Fair Value		Percent of Underlying Collateral Performing			Percent of Underlying Collateral in Deferral			Percent of Underlying Collateral in Default			Estimated incremental defaults required to break yield (1)	Current Moody's Rating		Cumulative Amount of OTTI Loss		Cumulative Other Comprehensive Loss, net of tax benefit
$	359,294	$	9,852		53.5	%		29.2	%		17.3	%	broken	Ca		$	640,706	$	230,632
	1,614,436		250,975		68.9	%		17.5	%		13.6	%	broken	Ca			385,564		899,884
	1,250,664		48,100		64.7	%		27.7	%		7.6	%	broken	Ca			749,336		793,692
	533,612		14,658		64.6	%		21.7	%		13.7	%	broken		C		466,388		342,510
$	3,758,006	$	323,585													$	2,241,994	$	2,266,718

(1)

A break in yield for a given tranche investment means that defaults and/or deferrals have reached such a level that the specific tranche would not receive all of the contractual principal and interest cash flow by its maturity, resulting in not a temporary shortfall, but an actual loss. This column represents the percentage of additional defaults among the currently performing collateral that would result in other-than-temporary loss.

Index

The Company monitors these pooled trust preferred securities in its portfolio as to additional collateral issuer defaults and deferrals, which as a general rule, indicate that additional impairment may have occurred. Due to the continued stress on banks in general, and the issuer banks in particular, as a result of overall economic conditions, the Company anticipates having to recognize additional impairment in future periods; however the extent, timing, and probability of any additional impairment cannot be reasonably estimated at this time.

The following roll forward reflects the amount related to credit losses recognized in earnings (in accordance with FASB Accounting Standards Codification (“ASC”) 320-10-35-34D:

Beginning balance as of December 31, 2010		$	2,052,867
Add:	Amount related to the credit loss for which an other-than- temporary impairment was not previously recognized		-
Add:	Increases to the amount related to the credit loss for which an other-than temporary impairment was previously recognized		189,127
Less:	Realized losses for securities sold		-
Less:	Securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the Company intends to sell the security or more likely than not will be required to to sell the security before recovery of its amortized cost basis.		-
Less:	Increases in cash flows expected to be collected that are recognized over the remaining life of the security (See FASB ASC 320-10-35-35)		-
	Ending balance as of June 30, 2011	$	2,241,994

The carrying value of securities pledged to secure deposits and for other purposes amounted to $39.6 million and $42.6 million at June 30, 2011 and December 31, 2010, respectively.

The amortized cost and fair value of restricted securities follows:

	June 30, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)		Fair Value
Restricted investments:								-
Federal Home Loan Bank stock	$	2,821,600	$	-	$	-	$	2,821,600
Federal Reserve Bank stock		99,000		-		-		99,000
Community Bankers' Bank stock		50,000		-		-		50,000
	$	2,970,600	$	-	$	-	$	2,970,600

	December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)		Fair Value
Restricted investments:								-
Federal Home Loan Bank Stock	$	3,239,300	$	-	$	-	$	3,239,300
Federal Reserve Bank Stock		99,000		-		-		99,000
Community Bankers' Bank Stock		50,000		-		-		50,000
	$	3,388,300	$	-	$	-	$	3,388,300

The Company’s restricted investments include an equity investment in the Federal Home Loan Bank of Atlanta (“FHLB”). FHLB stock is generally viewed as a long-term investment and as a restricted investment which is carried at cost because there is no market for the stock other than the FHLB or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on ultimate recoverability of the par value rather than recognizing temporary declines in value. The FHLB temporarily suspended the payment of cash dividends in 2009 and resumed the payment in 2010. The Company does not consider this investment to be other-than-temporarily impaired at June 30, 2011, and no impairment has been recognized.

Index

Note 3.

Loans and Allowance for Loan Losses

Analysis of the allowance for loan losses follows:

	Six Months Ended
	June 30, 2010
Balance at 12/31/2009	$	5,481,963
Provision for loan losses		750,000
Recoveries of loans previously charged-off		66,056
Loan losses charged-off		(900,728	)
Balance at 6/30/2010	$	5,397,291

	June 30, 2010
Impaired loans for which an allowance has been provided	$	2,579,891
Impaired loans for which no allowance has been provided		509,475
	$	3,089,366
Allowance provided for impaired loans, included in the allowance for loan losses	$	1,008,100

	Six Months Ended			Three Months Ended
	June 30, 2010			June 30, 2010
Average balance in impaired loans	$	3,419,361		$	3,171,924
Interest income recognized on impaired loans	$	36,032		$	24,292

Allowance for Loan Losses and Recorded Investment in Loans Receivable

	As of December 31, 2010 and for the Period Ended June 30, 2011
	Commercial and Industrial			Commercial Real Estate		Commercial Construction		Consumer			Residential Real Estate			Home Equity Line of Credit			Unallocated		Total
Allowance for Loan Losses
Beginning balance at 12/31/2010	$	792,796		$	2,320,692	$	150,513	$	314,580		$	1,622,830		$	1,105,782		$	-	$	6,307,193
Charge-offs		-			-		-		(12,801	)		(271,911	)		(363,237	)		-		(647,949	)
Recoveries		-			157,724		-		25,469			-			2,882			-		186,075
Provision		(194,175	)		926,481		8,325		(295,960	)		37,299			(71,877	)		360,742		770,835
Ending balance at 6/30/2011	$	598,621		$	3,404,897	$	158,838	$	31,288		$	1,388,218		$	673,550		$	360,742	$	6,616,154

Ending balances individually evaluated for impairment	$	248,100		$	-	$	-	$	-		$	-		$	-				$	248,100

Ending balances collectively evaluated for impairment	$	350,521		$	3,404,897	$	158,838	$	31,288		$	1,388,218		$	673,550				$	6,007,312

Loans Receivable
Individually evaluated for impairment	$	819,646		$	605,517	$	-	$	-		$	-		$	-				$	1,425,163
Collectively evaluated for impairment		28,998,802			214,743,618		27,389,565		7,031,226			136,137,440			51,022,985					465,323,636
Ending balance at 12/31/2010	$	29,818,448		$	215,349,135	$	27,389,565	$	7,031,226		$	136,137,440		$	51,022,985				$	466,748,799

Individually evaluated for impairment	$	418,748		$	257,490	$	-	$	-		$	-		$	-				$	676,238
Collectively evaluated for impairment		27,728,131			201,957,479		29,566,531		5,817,124			139,667,398			49,011,385					453,748,048
Ending balance at 6/30/2011	$	28,146,879		$	202,214,969	$	29,566,531	$	5,817,124		$	139,667,398		$	49,011,385				$	454,424,286

Index

Credit Quality Indicators

	As of June 30, 2011
	Commercial and Industrial		Commercial Real Estate		Commercial Construction		Consumer		Residential Real Estate		Home Equity Line of Credit		Total
Grade:
Pass	$	19,734,940	$	147,886,356	$	29,566,531	$	5,733,772	$	132,572,166	$	46,122,245	$	381,546,010
Special mention		2,357,379		25,972,864		-		55,503		3,155,550		1,241,611		32,782,907
Substandard		5,806,420		28,355,749		-		27,849		3,939,682		1,647,529		39,777,229
Doubtful		248,140		70,000		-		-		-		-		318,140
Loss		-		-		-		-		-		-		-
Total	$	28,146,879	$	202,214,969	$	29,566,531	$	5,817,124	$	139,667,398	$	49,011,385	$	454,424,286

	As of December 31, 2010
	Commercial and Industrial		Commercial Real Estate		Commercial Construction		Consumer		Residential Real Estate		Home Equity Line of Credit		Total
Grade:
Pass	$	24,489,238	$	160,944,161	$	22,854,565	$	6,935,003	$	129,087,024	$	46,551,709	$	390,861,700
Special mention		3,118,443		41,077,145		4,535,000		59,602		2,834,248		1,839,000		53,463,438
Substandard		1,923,445		13,327,829		-		36,621		3,880,454		1,986,196		21,154,545
Doubtful		287,322		-		-		-		355,714		646,080		1,289,116
Loss		-		-		-		-		-		-		-
Total	$	29,818,448	$	215,349,135	$	27,389,565	$	7,031,226	$	136,137,440	$	51,022,985	$	466,748,799

Age Analysis of Past Due Loans Receivable

	As of June 30, 2011
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Financing Receivables		Carrying Amount > 90 Days and Accruing		Nonaccruals
Commercial and industrial	$	1,146,494	$	159,719	$	240,608	$	1,546,821	$	26,600,058	$	28,146,879	$	-	$	418,748
Commercial real estate		3,797,671		211,060		187,490		4,196,221		198,018,748		202,214,969		-		257,490
Commercial construction		-		-		-		-		29,566,531		29,566,531		-
Consumer		76,908		40,119		14,185		131,212		5,685,912		5,817,124		-		19,941
Residential real estate		2,861,140		226,963		844,465		3,932,568		135,734,830		139,667,398		-		1,688,003
Home equity line of credit		1,023,313		58,855		572,360		1,654,528		47,356,857		49,011,385		-		572,960
Total	$	8,905,526	$	696,716	$	1,859,108	$	11,461,350	$	442,962,936	$	454,424,286	$	-	$	2,957,142

	As of December 31, 2010
	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days		Total Past Due		Current		Total Financing Receivables		Carrying Amount > 90 Days and Accruing		Nonaccruals
Commercial and industrial	$	84,131	$	98,475	$	95,696	$	278,302	$	29,540,146	$	29,818,448	$	75,102	$	368,771
Commercial real estate		427,995		-		187,490		615,485		214,733,650		215,349,135		187,490		312,672
Commercial construction		-		-		-		-		27,389,565		27,389,565		-		-
Consumer		100,219		-		-		100,219		6,931,007		7,031,226		-		12,197
Residential real estate		1,208,344		551,353		502,119		2,261,816		133,875,624		136,137,440		-		769,000
Home equity line of credit		363,641		351,792		612,018		1,327,451		49,695,534		51,022,985		-		646,080
Total	$	2,184,330	$	1,001,620	$	1,397,323	$	4,583,273	$	462,165,526	$	466,748,799	$	262,592	$	2,108,720

Index

Impaired Loans Receivable

	June 30, 2011
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no specific allowance recorded:
Commercial and industrial	$	170,608	$	170,608	$	-	$	142,276	$	2,267
Commercial real estate		257,490		257,490		-		240,130		3,216
Commercial construction		-		-		-		-		-

With an allowance recorded:
Commercial and industrial		248,140		248,140		248,100		252,340		-
Commercial real estate		-		-		-		-		-
Commercial construction		-		-		-		-		-

Total:
Commercial and industrial		418,748		418,748		248,100		394,616		2,267
Commercial real estate		257,490		257,490		-		240,130		3,216
Commercial construction		-		-		-		-		-
Total	$	676,238	$	676,238	$	248,100	$	634,746	$	5,483

	December 31, 2010
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no specific allowance recorded:
Commercial and industrial	$	133,689	$	133,689	$	-	$	167,891	$	3,317
Commercial real estate		312,672		312,672		-		333,554		-
Commercial construction		-		-		-		-		-

With an allowance recorded:
Commercial and industrial		829,092		829,092		641,900		856,290		46,044
Commercial real estate		149,710		149,710		148,800		150,345		8,454
Commercial construction		-		-		-		-		-

Total:
Commercial and industrial		962,781		962,781		641,900		1,024,181		49,361
Commercial real estate		462,382		462,382		148,800		483,899		8,454
Commercial construction		-		-		-		-		-
Total	$	1,425,163	$	1,425,163	$	790,700	$	1,508,080	$	57,815

The average recorded investment in impaired loans for the three months ended June 30, 2011 was $716,673 and the interest income recognized on impaired loans during the three months was $5,482.

No additional funds are committed to be advanced in connection with impaired loans. The reduction in impaired loans from $1.4 million at December 31, 2010 to $676,000 at June 30, 2011 primarily reflects the reclassification of ten loans totaling approximately $1.2 million that were performing and no longer deemed to be impaired. This was partially offset by the addition of three commercial loans totaling approximately $135,000 to the impaired classification.

Under authoritative accounting guidance, the above impaired loan disclosure does not exclude any commercial non-accrual loans at June 30, 2011 and 2010. There were no loans past due 90 days or more and still accruing interest at June 30, 2011 and 2010, and $263,000 at December 31, 2010.

Index

Non-performing Assets and Loans Contractually Past Due

(In thousands)	June 30, 2011			December 31, 2010			June 30, 2010
Non-accrual loans	$	2,957		$	2,109		$	2,479
Restructured loans*		-			-			-
Other real estate owned		3,469			2,821			2,412
Other repossessed assets owned		-			21			11
Non-performing corporate bond investments, at fair value		324			552			1,636
Total non-performing assets	$	6,750		$	5,503		$	6,538

Loans past due 90 days accruing interest	$	-		$	263		$	-

Allowance for loan losses to total loans		1.46	%		1.35	%		1.15	%
Non-accrual loans to total loans		0.65	%		0.45	%		0.53	%
Allowance for loan losses to non-performing loans		223.73	%		299.10	%		217.71	%

________________

* Restructured loans on non-accrual status are included with non-accrual loans and not with restructured loans. At June 30, 2011 and December 31, 2010, there were no loans and one loan of $255,000, respectively, that were both restructured and on non-accrual status.

Authoritative accounting guidance requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. Authoritative accounting guidance also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

A loan is considered impaired when it is probable that the Bank will be unable to collect all principal and interest amounts according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, expected future cash flows, financial condition of the borrower, and the current economic conditions. A performing loan may be considered impaired if the factors above indicate a need for impairment. A loan on non-accrual status may not be impaired if it is in the process of collection or if the shortfall in payment is insignificant. A delay of less than 30 days or a shortfall of less than 5% of the required principal and interest payments generally is considered “insignificant” and would not indicate an impairment situation, if in management’s judgment the loan will be paid in full. Loans that meet the regulatory definitions of doubtful or loss generally qualify as impaired loans under authoritative accounting guidance. As is the case for all loans, charge-offs for impaired loans occur when the loan or portion of the loan is determined to be uncollectible.

Note 4.

Company-Obligated Mandatorily Redeemable Capital Securities

On September 21, 2006, the Company’s wholly-owned Connecticut statutory business trust privately issued $4.0 million face amount of the trust’s Floating Rate Capital Securities in a pooled capital securities offering (“Trust II”). Simultaneously, the trust used the proceeds of that sale to purchase $4.0 million principal amount of the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. The interest rate on the capital security resets every three months at 1.70% above the then current three month LIBOR. Interest is paid quarterly. Total capital securities at June 30, 2011 and 2010 were $4,124,000. The Trust II issuance of capital securities and the respective subordinated debentures are callable at any time after five years from the issue date. The subordinated debentures are an unsecured obligation of the Company and are junior in right of payment to all present and future senior indebtedness of the Company. The capital securities are guaranteed by the Company on a subordinated basis.

Note 5.

Derivative Instruments and Hedging Activities

U. S. GAAP requires that all derivatives be recognized in the Consolidated Financial Statements at their fair values. On the date that the derivative contract was entered into, the Company designated the derivative as a hedge of variable cash flows to be paid in conjunction with recognized liabilities, or a cash-flow hedge. For a derivative treated as a cash flow hedge, the ineffective portion of changes in fair value is reported in current period earnings. The effective portion of the cash flow hedge is recorded as an adjustment to the hedged item through other comprehensive income.

Index

The Company formally assesses, both at the hedges’ inception, and on an on-going basis, whether derivatives used in hedging transactions have been highly effective in offsetting changes in cash flows of hedged items and whether those derivatives are expected to remain highly effective in subsequent periods. The Company discontinues hedge accounting when (a) it determines that a derivative is no longer effective in offsetting changes in cash flows of a hedged item; (b) the derivative expires or is sold, terminated or exercised; (c) probability exists that the forecasted transaction will no longer occur; or (d) management determines that designating the derivative as a hedging instrument is no longer appropriate. In all cases in which hedge accounting is discontinued and a derivative remains outstanding, the Company will carry the derivative at fair value in the Consolidated Financial Statements, recognizing changes in fair value in current period income in the consolidated statement of income.

The Company follows generally accepted accounting principles, FASB ASU 815-10-50 “Disclosures about Derivative Instruments and Hedging Activities”, which includes the disclosure requirements for derivative instruments and hedging activities to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows.

The Company entered into an interest rate swap agreement on July 1, 2010. The Bank uses the interest rate swap to reduce interest rate risks and to manage interest income, specifically with regard to the interest rate expense on its Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. By entering into this agreement, the Company converts a floating rate liability priced at three month LIBOR plus 1.70% into a fixed rate liability priced at 4.91% through 2020. Interest differentials paid or received under the swap agreements are reflected as adjustments to interest income. These interest rate swap agreements are considered cash flow hedge derivative instruments that qualify for hedge accounting. The notional amounts of the interest rate swaps are not exchanged and do not represent exposure to credit loss. In the event of default by a counter party, the risk in these transactions is the cost of replacing the agreements at current market rates.

The effects of derivative instruments on the Consolidated Financial Statements for June 30, 2011 and December 31, 2010 are as follows:

(In thousands)

June 30, 2011

Derivatives designated as hedging instruments

Notional/ Contract Amount

Estimated Net Fair Value

Fair Value Balance Sheet Location

Expiration Date

Fixed Rate

Interest rate swap-10 year cash flow

4,000

(48

)

Other Liabilities

9/15/2020

3.21

	June 30, 2011
Derivatives in cash flow hedging relationships	Amount of Gain (Loss) Recognized in OCI on Derivatives, net of tax (Effective Portion)			Location of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion)	Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion)
Interest rate swap-10 year cash flow	$	(44	)	Not applicable	$	-

December 31, 2010

Derivatives designated as hedging instruments

Notional/ Contract Amount

Estimated Net Fair Value

Fair Value Balance Sheet Location

Expiration Date

Fixed Rate

Interest rate swap-10 year cash flow

4,000

Other Assets

9/15/2020

3.21

	December 31, 2010
Derivatives in cash flow hedging relationships	Amount of Gain (Loss) Recognized in OCI on Derivatives, net of tax (Effective Portion)		Location of Gain or (Loss) Recognized in Income on Derivative (Ineffective Portion)	Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion)
Interest rate swap-10 year cash flow	$	12	Not applicable	$	-

Index

Under the terms of the agreement, the Company receives interest quarterly at the rate equivalent to three month LIBOR repricing every three months on the same date as the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036 and pays interest income monthly at the fixed rate shown above.

The net interest expense on the interest rate swap was $29,431 for quarter ended June 30, 2011 and $58,502 for the six months ended June 30, 2011.

Note 6.

Earnings Per Share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of dilutive potential common stock.

	Three Months Ended				Three Months Ended
	June 30, 2011				June 30, 2010
	Shares		Per Share Amount		Shares		Per Share Amount
Basic earnings per share		3,669,758	$	0.31		3,631,411	$	0.28
Effect of dilutive securities, stock-based awards		16,501				16,943
		3,686,259	$	0.31		3,648,354	$	0.28

	Six Months Ended				Six Months Ended
	June 30, 2011				June 30, 2010
	Shares		Per Share Amount		Shares		Per Share Amount
Basic earnings per share		3,662,596	$	0.56		3,617,173	$	0.50
Effect of dilutive securities, stock-based awards		15,338				17,549
		3,677,934	$	0.56		3,634,722	$	0.50

There were no options with a strike price above the Company’s common stock closing sales price of $12.19 and $15.49 on June 30, 2011 and 2010, respectively, that were excluded from the earnings per share calculation.

Note 7.

Stock Based Compensation

Stock Incentive Plan

On May 19, 2009, the shareholders of the Company approved the Company’s Stock Incentive Plan (the “Plan”), which superseded and replaced the Omnibus Stock Ownership and Long Term Incentive Plan.

Under the Plan, stock options, stock appreciation rights, non-vested and/or restricted shares, and long-term performance unit awards may be granted to directors and certain employees for purchase of the Company’s common stock. The effective date of the Plan is March 19, 2009, the date the Company’s Board approved the Plan, and it has a termination date of December 31, 2019. The Company’s Board may terminate, suspend or modify the Plan within certain restrictions. The Plan authorizes for issuance 350,000 shares of the Company’s common stock. The Plan requires that options be granted at an exercise price equal to at least 100% of the fair market value of the common stock on the date of the grant; however, for those individuals who own more than 10% of the stock of the Company and are awarded an incentive stock option, the option price must be at least 110% of the fair market value on the date of grant. Such options are generally not exercisable until three years from the date of issuance and generally require continuous employment during the period prior to exercise. The options will expire in no more than ten years after the date of grant. The stock options, stock appreciation rights, restricted shares, and long-term performance unit awards for certain employees are generally subject to vesting requirements and are subject to forfeiture if vesting and other contractual provision requirements are not met.

The Company previously has issued stock options to non-employee directors under its Non-employee Director Stock Option Plan, which expired in 1999. Under that plan, each non-employee director of the Company or its subsidiary received an option grant covering 2,240 shares of Company common stock on April 1 of each year during the five-year term of the plan. The first grant under the plan was made on May 1, 1995. The exercise price of awards was fixed at the fair market value of the shares on the date the option was granted. During the term of the plan, options for a total of 120,960 shares of common stock were granted. Effective January 1, 2000, the Omnibus Stock Ownership and Long-Term Incentive Plan for employees was amended and restated to include non-employee directors. The Company did not grant stock options during the six months ended June 30, 2011 or June 30, 2010.

Index

Restricted Shares

The restricted shares are accounted for using the fair market value of the Company’s common stock on the date the restricted shares were awarded. The restricted shares issued to certain officers are subject to a vesting period, whereby, the restrictions on the shares lapse on the third year anniversary of the date the restricted shares were awarded. Compensation expense for these shares is accrued over the three year period.

The Company has granted awards of non-vested shares to certain officers and vested shares (effective March 31, 2010) to non-employee directors under the above-described incentive plans: 9,714 shares and 9,784 shares of unvested restricted stock to executive officers and 4,752 shares and 5,553 shares of vested restricted stock to non-employee directors on February 17, 2011 and March 5, 2010, respectively. Compensation expense for these non-vested shares amounted to $33,000 and $38,000, net of forfeiture, for the three months ended June 30, 2011 and 2010, respectively. For the six months ended June 30, 2011 and 2010, compensation expense for these non-vested shares, net of forfeiture, amounted to $69,000 and $74,000, respectively. During the quarter ended March 31, 2010, the restricted shares previously issued to non-employee directors were no longer subject to a vesting period, and the previously deferred compensation expense on these shares, totaling an additional compensation expense of $169,000, was fully recognized during the first quarter of 2010. Beginning in 2011, compensation expense for the non-employee director shares will be recognized at the date the shares are granted. In the quarter ended June 30, 2011, there was no compensation expense for non-employee director shares.

The Company granted 9,714 and 9,784 of performance-based stock rights to certain officers on February 17, 2011 and March 5, 2010, respectively, under the above-described plans.

The performance-based stock rights are accounted for using the fair market value of the Company’s common stock on the date the restricted shares were awarded, and adjusted as the market value of the stock changes. The performance-based stock rights shares issued to executive officers are subject to a vesting period, whereby, the restrictions on the shares lapse on the third year anniversary of the date the restricted shares were awarded. The award for 2010 is subject to the Company reaching a predetermined return on average equity ratio for the final year of the vesting period. The award for 2011 is subject to the Company reaching a predetermined three year performance average on the return on average equity ratio as compared to predetermined peer group of banks. Compensation expense for performance-based stock rights amounted to $14,000 and $40,000 in the quarters ended June 30, 2011, and 2010, respectively. Compensation expense for performance-based stock rights amounted to $63,000 and $68,000 in the six months ended June 30, 2011, and 2010, respectively.

A summary of the status of options granted under the Plans is presented below:

	Six Months Ended June 30, 2011
	Number of Shares			Weighted Average Exercise Price		Average Intrinsic Value (1)

Outstanding at January 1, 2011		42,266		$	10.84
Granted		-
Exercised		(18,534	)		8.07
Forfeited		-
Outstanding at June 30, 2011		23,732		$	13.00

Exercisable at end of quarter		23,732				$	(19,223	)
Weighted-average fair value per option of options granted during the year		-

(1) The aggregate intrinsic value of stock options in the table above reflects the pre-tax intrinsic value (the amount by which the June 30, 2011 market value of the underlying stock option exceeded the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on June 30, 2011. This amount changes based on the changes in the market value of the Company’s common stock.

The total intrinsic value of options exercised during the six months ended June 30, 2011 and 2010 was $97,303 and $153,851, respectively.

Index

A summary of the status of the Company’s non-vested restricted shares granted under the above-described plans is presented below:

	Six Months Ended June 30, 2011
	Shares			Weighted Average Grant Date Fair Value

Nonvested at January 1, 2011		33,772		$	13.61

Granted		14,466			14.30
Vested		(15,666	)		16.67
Forfeited		-			-
Nonvested at June 30, 2011		32,572		$	12.44

As of June 30, 2011, there was $220,094 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. This type of deferred compensation cost is recognized over a period of three years.

A summary of the status of the Company’s non-vested performance-based stock rights is presented below:

	Six Months Ended June 30, 2011
	Performance Based Stock Rights		Weighted Average Fair Value

Nonvested at January 1,		22,858	$	11.65

Granted		9,714		14.30
Vested		-		-
Forfeited		-		-
June		32,572	$	12.44

The Company also maintains a Director Deferred Compensation Plan (“Deferred Compensation Plan"). This plan provides that any non-employee director of the Company or the Bank may elect to defer receipt of all or any portion of his or her compensation as a director. A participating director may elect to have amounts deferred under the Deferred Compensation Plan held in a deferred cash account, which is credited on a quarterly basis with interest equal to the highest rate offered by the Bank at the end of the preceding quarter. Alternatively, a participant may elect to have a deferred stock account in which deferred amounts are treated as if invested in the Company’s common stock at the fair market value on the date of deferral. The value of a stock account will increase and decrease based upon the fair market value of an equivalent number of shares of common stock. In addition, the deferred amounts deemed invested in common stock will be credited with dividends on an equivalent number of shares. Amounts considered invested in the Company’s common stock are paid, at the election of the director, either in cash or in whole shares of the common stock and cash in lieu of fractional shares. Directors may elect to receive amounts contributed to their respective accounts in one or up to five installments.

The Company has a nonqualified deferred compensation program for a former key employee’s retirement, in which the contribution expense is solely funded by the Company. The retirement benefit to be provided is variable based upon the performance of underlying life insurance policy assets. Deferred compensation expense amounted to $474 and $1,383 for the quarters ended June 30, 2011 and 2010, and $1,185 and $2,766 for the six months ending June 30, 2011 and 2010, respectively.

Concurrent with the establishment of the Deferred Compensation Plan, the Company purchased life insurance policies on this employee with the Company named as owner and beneficiary. These life insurance policies are intended to be utilized as a source of funding the Deferred Compensation Plan. The Company has recorded in other assets of $1,128,827 and $1,112,442 representing cash surrender value of these policies at June 30, 2011, and December 31, 2010, respectively.

Index

Note 8.

Employee Benefit Plan

On December 20, 2007, the Company’s Board of Directors approved the termination of the defined benefit pension plan effective on December 31, 2009, and effective January 1, 2010 replaced the defined benefit pension plan with an enhanced 401(k) plan. On August 16, 2010, the Company received a favorable determination letter dated August 12, 2010 from the Internal Revenue Service for the December 31, 2010 termination date. Between January 1, 2010 and December 10, 2010, the Company distributed $7,203,754 of pension benefits, of which $7,086,067 was distributed between November 30, 2010 and December 10, 2010, and represented the final distribution upon the plan’s termination. On February 1, 2011, the Company filed a Post-Distribution Certification for Standard Termination with the Pension Benefit Guaranty Corporation.

The Company has a defined contribution retirement plan under Internal Revenue Code (“Code”) Section 401(k) covering employees who have completed 3 months of service and who are at least 18 years of age. Under the plan, a participant may contribute an amount up to 100% of their covered compensation for the year, not to exceed the dollar limit set by law (Code Section 402(g)). The Company will make an annual matching contribution equal to 100% on the first 1% of compensation deferred and 50% on the next 5% of compensation deferred, for a maximum match of 3.5% of compensation. Beginning in 2010, the Company began making an additional safe harbor contribution equal to 6% of compensation to all eligible participants. The Company’s 401(k) expenses for the quarters ended June 30, 2011 and 2010 were $164,000, and $150,000, respectively. The Company’s 401(k) expenses for the six months ended June 30, 2011 and 2010 were $327,000, and $300,000, respectively.

Note 9.

Fair Value Measurement

The Company adopted ASC 820 “Fair Value Measurement and Disclosures” (previously Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements”) on January 1, 2008 to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. ASC 820 clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:

Level 1 –

Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 –

Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 –

Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that considers observable market data (Level 2).

Interest rate swap: Cash flow interest rate swap is classified within Level 2 with fair values determined by quoted market prices and mathematical models using current and historical data.

Index

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2011 and December 31, 2010 by levels within the valuation hierarchy:

			Fair Value Measurements Using
(In thousands)	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Obervable Inputs (Level 2)		Signicant Unobservable Inputs (Level 3)
Assets at June 30, 2011
Available-for-sale securities:
Obligations of U.S. Government corporations and agencies	$	42,839	$	-	$	42,839	$	-
Obligations of states and political subdivisions		6,090		-		6,090		-
Corporate bonds		324		-		-		324
Mutual funds		335		335		-		-
FHLMC preferred stock		46		-		46		-
Total available-for sale securities		49,634		335		48,975		324

Interest rate swap		-		-		-
Total assets at fair value		49,634		335		48,975		324

Liabilities at June 30, 2011
Interest rate swap		48		-		48		-
Total liabilities at fair value	$	48	$	-	$	48	$	-

Assets at December 31, 2010
Available-for-sale securities:
Obligations of U.S. Government corporations and agencies	$	40,032	$	-	$	40,032	$	-
Obligations of states and political subdivisions		5,619		-		5,619		-
Corporate bonds		552		-		-		552
Mutual funds		326		326		-		-
FHLMC preferred stock		9		-		9		-
Total available-for sale securities		46,538		326		45,660		552

Interest rate swap		19		-		19
Total assets at fair value		46,557		326		45,679		552

Liabilities at December 31, 2010

Interest rate swap

Total liabilities at fair value

Change in Level 3 Fair Value

The changes in Level 3 assets measured at estimated fair value on a recurring basis during the six months ended June 30, 2011 and year ended December 31, 2010 were as follows:

	Total Gains (Losses) Realized / Unrealized
(In thousands)	Balance January 1 2011		Included in Earnings			Included in Other Comprehensive Income			Transfers in and/or out of Level 3 and 2		Balance June 30, 2011
Available for sale securities	$	552	$	(189	)	$	(39	)	$	-	$	324

	Total Gains (Losses) Realized / Unrealized
(In thousands)	Balance January 1 2010		Included in Earnings			Included in Other Comprehensive Income		Transfers in and/or out of Level 3 and 2		Balance December 31, 2010
Available for sale securities	$	1,912	$	(1,394	)	$	34	$	-	$	552

Certain assets are measured at fair value on a nonrecurring basis in accordance with accounting principles generally accepted in the United States. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

Index

The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned (OREO): Foreclosed assets are adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair market value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company considers the OREO as nonrecurring Level 2. When a current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company considers the OREO as nonrecurring Level 3.

Management believes that the fair value component in its valuation follows the provisions of ASC 820.

The following table summarizes the Company’s financial assets that were measured at fair value on a nonrecurring basis during the period.

	Carrying Value at June 30, 2011
(In thousands)	Balance as of June 30, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Observable Inputs (Level 3)
Assets:
Impaired loans, net	$	428	$	-	$	187	$	241
Other real estate owned, net		3,469		-		3,469		-

	Carrying Value at December 31, 2010
(In thousands)	Balance as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Observable Inputs (Level 3)
Assets:
Impaired loans, net	$	634	$	-	$	438	$	196
Other real estate owned, net		2,821		-		2,821		-

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instruments. ASC 820 (previously SFAS No. 107 “Disclosures about Fair Value of Financial Instruments”) excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

Index

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and cash equivalents

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

Securities

For securities and marketable equity securities held for investment purposes, fair values are based on quoted market prices or dealer quotes. For other securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair values are based on quoted market prices for similar securities. See Note 2 “Securities” of the Notes to Consolidated Financial Statements for further discussion on determining fair value for pooled trust preferred securities.

Loans Receivable

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans (e.g., one-to-four family residential), credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. Fair values for other loans (i.e., commercial real estate and investment property mortgage loans, commercial and industrial loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Life Insurance

The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value. This redemption value is based on existing market conditions and therefore represents the fair value of the contract.

Deposit Liabilities

The fair values disclosed for demand deposits (i.e., interest and non-interest bearing checking, statement savings and money market accounts) are, by definition, equal to the amount payable at the reporting date (that is, their carrying amounts). Fair values of fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected monthly maturities on time deposits.

Federal Funds Purchased

The carrying amounts of the Company’s federal funds purchased are approximate fair value.

Borrowed Funds

The fair values of the Company’s FHLB advances and other borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance-Sheet Financial Instruments

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.

At June 30, 2011 and December 31, 2010, the fair value of loan commitments and standby letters of credit were deemed immaterial.

Index

The estimated fair values of the Company's financial instruments are as follows:

	June 30, 2011				December 31, 2010
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
(In Thousands)
Financial assets:
Cash and short-term
investments	$	57,807	$	57,807	$	47,171	$	47,171
Federal funds sold		10		10		11		11
Securities		49,634		49,634		46,538		46,538
Restricted Investments		2,971		2,971		3,388		3,388
Loans, net		447,808		471,967		460,442		479,009
Accrued interest receivable		1,486		1,486		1,488		1,488
BOLI		11,409		11,409		11,202		11,202
Interest rate swap		-		-		19		19
Total financial assets	$	571,125	$	595,284	$	570,259	$	588,826

Financial liabilities:
Deposits	$	518,619	$	522,401	$	520,056	$	524,324
FHLB advances		25,000		26,205		25,000		26,247
Company obligated mandatorily redeemable capital securities		4,124		4,514		4,124		4,696
Accrued interest payable		487		487		464		464
Interest rate swap		48		48		-		-
Total financial lialilities	$	548,278	$	553,655	$	549,644	$	555,731

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

Note 10.

Subsequent Events

In accordance with ASC 855-10/SFAS 165, the Company evaluates subsequent events that have occurred after the balance sheet date, but before the financial statements are issued. There are two types of subsequent events: (1) recognized, or those that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements, and (2) non-recognized, or those that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.

Based on the evaluation, the Company did not identify any recognized or non-recognized subsequent events that would have required adjustment to, or disclosure in, the financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

In addition to the historical information contained herein, this report contains forward-looking statements. Forward-looking statements are based on certain assumptions and describe future plans, strategies, and expectations of the Company and the Bank, and are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” “may,” “will” or similar expressions. Although we believe our plans, intentions and expectations reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions, or expectations will be achieved. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain, and actual results could differ materially from those contemplated. Factors that could have a material adverse effect on our operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the Bank’s loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in our market area, our plans to expand our branch network and increase our market share, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements in this report and you should not place undue reliance on such statements, which reflect our position as of the date of this report.

Index

For additional discussion of risk factors that may cause our actual future results to differ materially from the results indicated within forward-looking statements, please see "Risk Factors" in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

GENERAL

Fauquier Bankshares, Inc. (“the Company”) was incorporated under the laws of the Commonwealth of Virginia on January 13, 1984. The Company is a registered bank holding company and owns all of the voting shares of The Fauquier Bank (“the Bank”). The Company engages in its business through the Bank, a Virginia state-chartered bank that commenced operations in 1902. The Company has no significant operations other than owning the stock of the Bank. The Company had issued and outstanding 3,669,758 shares of common stock, par value $3.13 per share, held by approximately 409 holders of record on June 30, 2011. The Bank has ten full service branch offices located in the Virginia communities of Old Town-Warrenton, Warrenton, Catlett, The Plains, Sudley Road-Manassas, Old Town-Manassas, New Baltimore, Bealeton, Bristow and Haymarket. The executive offices of the Company and the main office of the Bank are located at 10 Courthouse Square, Warrenton, Virginia 20186.

The Bank’s general market area principally includes Fauquier County, western Prince William County, and neighboring communities and is located approximately fifty (50) miles southwest of Washington, D.C.

The Bank provides a range of consumer and commercial banking services to individuals, businesses and industries. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (“FDIC”). The basic services offered by the Bank include: non-interest-bearing demand deposit accounts, money market deposit accounts, NOW accounts, time deposits, safe deposit services, credit cards, cash management, direct deposits, notary services, night depository, prepaid debit cards, cashier’s checks, domestic collections, savings bonds, automated teller services, drive-in tellers, internet banking, telephone banking, and banking by mail. In addition, the Bank makes secured and unsecured commercial and real estate loans, issues stand-by letters of credit and grants available credit for installment, unsecured and secured personal loans, residential mortgages and home equity loans, as well as automobile and other types of consumer financing. The Bank provides automated teller machine (“ATM”) cards, as a part of the Maestro, Accel-Exchange and Plus ATM networks, thereby permitting customers to utilize the convenience of larger ATM networks. The Bank also is a member of the Certificate of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep Service (“IND”), to provide customers multi-million dollar FDIC insurance on CD investments and deposit sweeps through the transfer and/or exchange with other FDIC insured institutions. CDARS and IND are registered service marks of Promontory Interfinancial Network, LLC.

The Bank operates a Wealth Management Services (“WMS” or “Wealth Management”) division that began with the granting of trust powers to the Bank in 1919. The WMS division provides personalized services that include investment management, trust, estate settlement, retirement, insurance, and brokerage services.

The Bank, through its subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company, Bankers Title Shenandoah, LLC, a title insurance company, and Infinex Investments, Inc., a full service broker/dealer. Bankers Insurance and Bankers Title Shenandoah are owned by a consortium of Virginia community banks, and Infinex is owned by banks and banking associations in various states.

The revenues of the Bank are primarily derived from interest on, and fees received in connection with, real estate and other loans, and from interest and dividends from investment and mortgage-backed securities, and short-term investments. The principal sources of funds for the Bank’s lending activities are its deposits, repayment of loans, the sale and maturity of investment securities, and borrowings from the Federal Home Loan Bank (“FHLB”) of Atlanta. Additional revenues are derived from fees for deposit-related and WMS-related services. The Bank’s principal expenses are the interest paid on deposits and operating and general administrative expenses.

Index

As is the case with banking institutions generally, the Bank’s operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System (“Federal Reserve”). As a Virginia-chartered bank and a member of the Federal Reserve, the Bank is supervised and examined by the Federal Reserve and the Virginia State Corporation Commission. Interest rates on competing investments and general market rates of interest influence deposit flows and costs of funds. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Bank faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans. Please see "Risk Factors" in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

As of June 30, 2011, the Company had total consolidated assets of $599.2 million, total loans net of allowance for loan losses of $447.8 million, total consolidated deposits of $518.6 million, and total consolidated shareholders’ equity of $46.2 million.

CRITICAL ACCOUNTING POLICIES

GENERAL. The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of the Company’s transactions would be the same, the timing of events that would impact the Company’s transactions could change.

ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on three basic principles of accounting: (i) Accounting Standards Codification (“ASC”) 450 “Contingencies” (previously Statement of Financial Accounting Standards (“SFAS”) No. 5, "Accounting for Contingencies") which requires that losses be accrued when they are probable of occurring and estimable, (ii) ASC 310 “Receivables” (previously SFAS No. 114, "Accounting by Creditors for Impairment of a Loan") which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance and (iii) Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues,” which requires adequate documentation to support the allowance for loan losses estimate.

The Company’s allowance for loan losses has two basic components: the specific allowance and the general allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans identified as impaired. The specific allowance uses various techniques to arrive at an estimate of loss. First, analysis of the borrower’s overall financial condition, resources and payment record, the prospects for support from financial guarantors, and the fair market value of collateral are used to estimate the probability and severity of inherent losses. Then the migration of historical default rates and loss severities, internal risk ratings, industry and market conditions and trends, and other environmental factors are considered. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not identified as impaired. The general allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical and peer group delinquency and credit loss experience, together with analyses that reflect current trends and conditions. The Company also considers trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The general allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future. The general allowance also captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in the specific allowances.

Specifically, the Company uses both external and internal qualitative factors when determining the non-loan-specific allowances. The external factors utilized include: unemployment in the Company’s defined market area of Fauquier County, Prince William County, and the City of Manassas (“market area”), as well as state and national unemployment trends; new residential construction permits for the market area; bankruptcy statistics for the Virginia Eastern District and trends for the United States; and foreclosure statistics for the market area and the state. Quarterly, these external qualitative factors as well as relevant anecdotal information are evaluated from data compiled from local periodicals such as The Washington Post, The Fauquier Times Democrat, and The Bull Run Observer, which cover the Company’s market area. Additionally, data is gathered from the Federal Reserve Beige Book for the Richmond Federal Reserve District, Global Insight’s monthly economic review, the George Mason School of Public Policy Center for Regional Analysis, and daily economic updates from various other sources. Internal Bank data utilized includes: loans past due aging statistics, nonperforming loan trends, trends in collateral values, loan concentrations, loan review status downgrade trends, and lender turnover and experience trends. Both external and internal data is analyzed on a rolling six quarter basis to determine risk profiles for each qualitative factor. Ratings are assigned through a defined matrix to calculate the allowance consistent with authoritative accounting literature. A narrative summary of the reserve allowance is produced quarterly and reported directly to the Company’s Board of Directors. The Company’s application of these qualitative factors to the allowance for loan losses has been consistent over the reporting period.

Index

The Company employs an independent outsourced loan review function, which annually substantiates and/or adjusts internally generated risk ratings. This independent review is reported directly to the Company’s Board of Directors’ audit committee, and the results of this review are factored into the calculation of the allowance for loan losses.

EXECUTIVE OVERVIEW

This discussion is intended to focus on certain financial information regarding the Company and the Bank and may not contain all the information that is important to the reader. The purpose of this discussion is to provide the reader with a more thorough understanding of our financial statements. As such, this discussion should be read carefully in conjunction with the consolidated financial statements and accompanying notes contained elsewhere in this report.

The Bank is the primary independent community bank in its immediate market area as measured by deposit market share. It seeks to be the primary financial service provider for its market area by providing the right mix of consistently high quality customer service, efficient technological support, value-added products, and a strong commitment to the community. The Company and the Bank’s primary operating businesses are in commercial and retail lending, deposit accounts and core deposits, and assets under WMS management.

Net income of $1.14 million for the second quarter of 2011 was a 12.6% increase from the net income for the second quarter of 2010 of $1.01 million. Net income of $2.06 million for the first six months of 2011 was a 13.5% increase from the net income for the first six months of 2010 of $1.81 million. Loans, net of reserve, totaling $447.8 million at June 30, 2011, decreased 2.7% when compared with December 31, 2010, and decreased 3.2% when compared with June 30, 2010. Deposits, totaling $518.6 million at June 30, 2011, decreased 0.3% compared with year-end 2010, and increased 5.2% when compared with June 30, 2010. Assets under WMS management, totaling $322.7 million in market value at June 30, 2011, increased 10.2% from June 30, 2010.

Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, competition for loans and deposits, and many other factors, as well as the overall volume of interest-earning assets. These factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management’s current projections, net interest income may increase in 2011 and beyond as average interest-earning assets increase, but this may be offset in part or in whole by a possible contraction in the Bank’s net interest margin resulting from competitive market conditions and/or a flat or inverted yield curve. A steeper yield curve is projected to result in an increase in net interest income, while a flatter or inverted yield curve is projected to result in a decrease in net interest income.

The Bank’s non-performing assets totaled $6.7 million or 1.13% of total assets at June 30, 2011, as compared with $5.5 million or 0.92% of total assets at December 31, 2010, and $6.5 million or 1.12% of total assets at June 30, 2010. Nonaccrual loans totaled $3.0 million or 0.65% of total loans at June 30, 2011 compared with $2.1 million or 0.45% of total loans at December 31, 2010, and $2.5 million or 0.53% of total loans at June 30, 2010. The provision for loan losses was $771,000 for the first six months of 2011 compared with $750,000 for the first six months of 2010. Loan charge-offs, net of recoveries, totaled $462,000 or 0.10% of total average loans for the first six months of 2011, compared with $835,000 or 0.18% of total average loans for the first six months of 2010. Total allowance for loan losses was $6.6 million or 1.46% of total loans at June 30, 2011 compared with $6.3 million or 1.35% of loans at December 31, 2010 and $5.4 million or 1.15% of loans at June 30, 2010.

COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED JUNE 30, 2011 AND JUNE 30, 2010

NET INCOME

Net income of $1.14 million for the second quarter of 2011 was a 12.6% increase from the net income for the second quarter of 2010 of $1.01 million. Earnings per share on a fully diluted basis were $0.31 for the second quarter of 2011 compared to $0.28 for the second quarter of 2010. Profitability as measured by return on average assets increased from 0.69% in the second quarter of 2010 to 0.77% for the same period in 2011. Profitability as measured by return on average equity increased from 9.28% to 9.99% over the same respective quarters in 2010 and 2011. The increase in net income and the corresponding profitability measures was primarily due to a $93,000 increase in service charges on deposits, and a $67,000 decrease in the provision for losses. These were partially offset by a $32,000 decrease in net interest income in the second quarter of 2011 compared with the second quarter of 2010.

Index

NET INTEREST INCOME AND EXPENSE

Net interest income decreased $32,000 or 0.6% to $5.52 million for the quarter ended June 30, 2011 from $5.56 million for the quarter ended June 30, 2010. The decrease in net interest income was due primarily to the decline in loan balances, reduced yields on earning assets, and an increase in expense on capital securities from the second quarter of 2010 to the second quarter of 2011. These were partially offset by reduced rates on deposits and wholesale funding over the same period. The Company’s net interest margin decreased from 4.16% in the second quarter of 2010 to 4.06% in the second quarter of 2011.

Total interest income decreased $317,000 or 4.5% to $6.79 million for the second quarter of 2011 from $7.10 million for the second quarter of 2010. This decrease was primarily due to a 32 basis point decline in the yield on earning assets and reduced loan balances from second quarter 2010 to second quarter 2011. This was partially offset by an increase in balances of investment securities and deposits in other banks.

The average yield on loans was 5.66% for the second quarter of 2011, down from 5.82% in the second quarter of 2010. Average loan balances decreased $8.9 million or 1.9% from $469.1 million during the second quarter of 2010 to $460.2 million during the second quarter of 2011. The decrease in loans outstanding and yield resulted in a $317,000 or 4.7% decline in interest and fee income from loans for the second quarter of 2011 compared with the same period in 2010.

Average investment security balances increased $10.1 million from $42.2 million in the second quarter of 2010 to $52.3 million in the second quarter of 2011. The tax-equivalent average yield on investments decreased from 3.74% for the second quarter of 2010 to 2.92% for the second quarter of 2011 resulting in a decrease in interest and dividend income on security investments of $15,000 or 4.1%, from $366,000 for the second quarter of 2010 to $351,000 for the second quarter of 2011. This decrease was primarily due to reduced yields on mortgage backed securities in the Bank’s investment portfolio. Interest income on deposits in other banks increased $16,000 from second quarter 2010 to second quarter 2011 resulting from higher earning balances at the Federal Reserve.

Total interest expense decreased $285,000 or 18.4% from $1.55 million for the second quarter of 2010 to $1.26 million for the second quarter of 2011 primarily due to the decline in time deposit and wholesale funding balances.

Interest paid on deposits decreased $369,000 or 27.6% from $1.34 million for the second quarter of 2010 to $968,000 for the second quarter of 2011. Average balances on time deposits declined $31.2 million or 15.8% from $197.7 million to $166.5 million while the average rate decreased from 1.97% to 1.67% in the second quarter of 2010 to the second quarter of 2011, resulting in $282,000 less of interest expense. Average savings accounts increased $4.7 million or 9.4% from the second quarter of 2010 to the second quarter of 2011 while the rate declined from 0.47% to 0.26%, resulting in $23,000 less in interest expense. Average money market account balances increased $9.9 million from second quarter 2010 to second quarter 2011, while their average rate decreased from 0.75% to 0.48% over the same period, resulting in a decrease of $32,000 of interest expense for the second quarter of 2011. Average NOW deposit balances increased $37.3 million from the second quarter of 2010 to the second quarter of 2011, while the average rate decreased from 0.69% to 0.43%, resulting in a decrease of $32,000 in NOW interest expense for the second quarter of 2011.

Interest expense on capital securities increased $29,000 from the second quarter of 2010 to the second quarter of 2011 due to the interest rate swap on the Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. The swap converts a floating rate liability to a fixed rate of 4.91% through 2020, and reduces interest rate risk exposure. From the second quarter of 2010 to the second quarter of 2011, interest expense on FHLB of Atlanta advances increased $55,000 due to $85,000 gain on the prepayment of FHLB advances, which was recognized as a reduction to FHLB interest expense, taken during the second quarter of 2010. The average rate on total interest-bearing liabilities decreased from 1.33% in the second quarter of 2010 to 1.08% for the second quarter of 2011.

Index

The following table sets forth information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields and rates paid for the periods indicated. These yields and costs are derived by dividing income or expense by the average daily balances of assets and liabilities, respectively, for the periods presented.

Average Balances, Income and Expense, and Average Yields and Rates

	Three Months Ended June 30, 2011								Three Months Ended June 30, 2010
(In thousands)	Average			Income/		Average			Average			Income/		Average
Assets	Balances			Expense		Rate			Balances			Expense		Rate
Loans
Taxable	$	444,085		$	6,252		5.65	%	$	451,954		$	6,561		5.82	%
Tax-exempt (1)		13,788			233		6.85	%		14,032			246		7.03	%
Nonaccrual (2)		2,275			-		-			3,099			-		-
Total Loans		460,148			6,485		5.66	%		469,085			6,807		5.82	%

Securities
Taxable		46,297			291		2.51	%		36,626			309		3.38	%
Tax-exempt (1)		6,024			91		6.05	%		5,631			86		6.09	%
Total securities		52,321			382		2.92	%		42,257			395		3.74	%

Deposits in banks		44,255			32		0.29	%		35,388			16		0.18	%
Federal funds sold		10			-		0.22	%		8			-		0.38	%
Total earning assets		556,734			6,899		4.97	%		546,738			7,218		5.29	%

Less: Reserve for loan losses		(6,831	)							(5,526	)
Cash and due from banks		5,471								6,317
Bank premises and equipment, net		14,257								14,536
Other real estate owned		3,360								2,354
Other assets		23,136								22,211
Total Assets	$	596,127							$	586,630

Liabilities and Shareholders' Equity
Deposits
Demand deposits	$	76,391							$	68,406

Interest-bearing deposits
NOW accounts		144,306			153		0.43	%		106,912			185		0.69	%
Money market accounts		73,968			88		0.48	%		64,082			120		0.75	%
Savings accounts		54,864			36		0.26	%		50,160			59		0.47	%
Time deposits		166,506			691		1.67	%		197,742			973		1.97	%
Total interest-bearing deposits		439,644			968		0.88	%		418,896			1,337		1.28	%


Federal funds purchased		-			-		-			55			-		0.26	%
Federal Home Loan Bank advances		25,000			247		3.91	%		46,044			192		1.67	%
Capital securities of subsidiary trust		4,124			50		4.83	%		4,124			21		1.99	%
Total interest-bearing liabilities		468,768			1,265		1.08	%		469,119			1,550		1.33	%

Other liabilities		5,261								5,442
Shareholders' equity		45,707								43,663
Total Liabilities & Shareholders' Equity	$	596,127							$	586,630

Net interest spread				$	5,634		3.89	%				$	5,668		3.97	%

Interest expense as a percent of average earning assets							0.91	%							1.14	%
Net interest margin							4.06	%							4.16	%

______________________

(1)

Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.

(2)

Nonaccrual loans are included in the average balance of total loans and total earning assets.

RATE/VOLUME ANALYSIS

The following table sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); and changes in rates (change in rate multiplied by old volume). Changes in rate-volume, which cannot be separately identified, are allocated proportionately between changes in rate and changes in volume.

Index

Rate / Volume Variance

	Three Months Ended June 30, 2011 Compared to Three Months Ended June 30, 2010
(In thousands)	Change			Due to Volume			Due to Rate
Interest Income
Loans; taxable	$	(309	)	$	(114	)		(195	)
Loans; tax-exempt (1)		(13	)		(4	)		(9	)
Securities; taxable		(18	)		82			(100	)
Securities; tax-exempt (1)		5			6			(1	)
Deposits in banks		16			4			12
Federal funds sold		-			-			-
Total Interest Income		(319	)		(26	)		(293	)

Interest Expense
NOW accounts		(31	)		65			(96	)
Money market accounts		(33	)		19			(52	)
Savings accounts		(23	)		6			(29	)
Time deposits		(282	)		(154	)		(128	)
Federal funds purchased and securities sold under agreements to repurchase		-			-			-
Federal Home Loan Bank advances		55			(88	)		143
Capital securities of subsidiary trust		29			-			29
Total Interest Expense		(285	)		(152	)		(133	)
Net Interest Income	$	(34	)	$	126		$	(160	)

___________________

(1) Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.

PROVISION FOR LOAN LOSSES, ALLOWANCE FOR LOAN LOSSES, AND ASSET QUALITY

The provision for loan losses was $308,000 for the second quarter of 2011, compared with $375,000 for the second quarter of 2010. The amount of the provision for loan loss was based upon management’s continual evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the loan portfolio, trends in the Bank’s delinquent and non-performing loans, estimated values of collateral, and the impact of economic conditions on borrowers. Greater weight is given to the loss history by loan category, prolonged changes in portfolio delinquency trends by loan category, and changes in economic trends. There can be no assurances, however, that future losses will not exceed estimated amounts, or that increased amounts of provisions for loan losses will not be required in future periods.

OTHER INCOME

Total other income increased by $187,000 from $1.39 million for the second quarter of 2010 to $1.58 million in the second quarter of 2011. Non-interest income is derived primarily from recurring non-interest fee income, which consists primarily of fiduciary trust and other Wealth Management fees, brokerage fees, service charges on deposit accounts, debit card interchange income and other fee income. The increase was due to increases of $62,000 and $93,000 in trust and estate income, and service charges on deposit accounts, respectively.

Trust and estate income increased $62,000 or 21.8% from the second quarter of 2010 to the second quarter of 2011, as assets under management increased from year to year, primarily due to the growth in new customer relationships and the increase in overall stock market valuations.

Brokerage service revenues increased $9,000 or 13.0% from the second quarter of 2010 to the second quarter of 2011 due to the growth in new customer relationships and increased brokerage transactions.

Service charges on deposit accounts increased $93,000 or 14.5% to $739,000 for the second quarter of 2011 compared to one year earlier. The change is primarily due to an increase in numbers of deposit customers generating increased deposit activity.

Other service charges, commissions and fees increased $17,000 or 4.3% from $393,000 in second quarter 2010 to $410,000 in the second quarter of 2011. Included in other service charges, commissions, and income is debit card interchange income which totaled $288,000 for the second quarter of 2011. Also included is Bank Owned Life Insurance (“BOLI”) income, which was $104,000 during the second quarter of 2011, compared with $103,000 one year earlier. Total BOLI was $11.4 million in cash value at June 30, 2011, compared with $11.0 million one year earlier.

Index

The future impact of the Federal Reserve’s debit-card interchange rule issued on June 29, 2011 cannot be determined at this time.

OTHER EXPENSE

Total other expense increased $57,000 or 1.1% during the second quarter of 2011 compared with the second quarter of 2010.

Salaries and employees’ benefits decreased $152,000 or 5.4 %, due to a $202,000 decrease in pension expense, partially offset by a $35,000 increase in salaries. The Bank’s pension plan was terminated in 2009 and disbursed during 2010, requiring $202,000 to accrue in 2010 for coverage of pension liabilities through the December 2010 disbursement date. Active full-time equivalent personnel totaled 161 at June 30, 2011 compared with 164 at June 30, 2010, due to an increase in position vacancies.

The Bank expects personnel costs, consisting primarily of salary and benefits, to continue to be its largest other expense. As such, the most important factor with regard to potential changes in other expenses is the expansion of staff. The cost of any additional staff expansion, however, would be expected to be offset by the increased revenue generated by the additional services that the new staff would enable the Bank to perform. For the remainder of 2011, the Company plans to add no new positions, and will fill three currently vacant positions.

Occupancy expense increased $20,000 or 4.4%, while furniture and equipment expense decreased $8,000 or 2.9%, from second quarter 2010 to second quarter 2011. The increase in occupancy expense was due primarily to increased real estate taxes.

Marketing expense was $164,000 for both the second quarter of 2010 and the second quarter of 2011. The majority of marketing expense is related to the direct mail program for transaction deposit accounts.

Legal, accounting and consulting expense increased $15,000 or 5.2% in the second quarter of 2011 compared with the second quarter of 2010.

FDIC deposit insurance expense increased 14.3% from $170,000 for the second quarter of 2010 to $195,000 for the second quarter of 2011. Future FDIC assessment expense is difficult to project, and will be largely dependent on the relative health of the U.S. banking industry.

The loss on impairment or sale of other real estate owned (“OREO”) increased $206,000 from the second quarter 2010 to the second quarter 2011. The increase was comprised of a $101,000 loss on sale of a residential property and an additional $150,000 write-down of a commercial property.

Data processing expense increased $39,000 or 15.1% for the second quarter of 2011 compared with the same time period in 2010 due to the growth in customer accounts and transactions processed. The Bank outsources much of its data processing to a third-party vendor.

Other operating expenses decreased $87,000 or 11.8% in the second quarter of 2011 compared with the second quarter of 2010. The decline primarily was due to lower deposit account-related charge-offs, as well as decreased supplies and postage expense related to the outsourcing of statement production and mailing.

INCOME TAXES

Income tax expense was $393,000 for the quarter ended June 30, 2011 compared with $356,000 for the quarter ended June 30, 2010. The effective tax rates were 25.6% and 26.0% for the second quarter of 2011 and 2010, respectively. The effective tax rate differed from the statutory federal income tax rate of 34% due to the Bank’s investment in tax-exempt loans and securities, income from the BOLI purchases, and community development tax credits.

COMPARISON OF OPERATING RESULTS FOR THE SIX MONTHS ENDED JUNE 30, 2011 AND JUNE 30, 2010

NET INCOME

Net income of $2.06 million for the first six months of 2011 was a $245,000 or 13.5% increase from the net income for the first six months of 2010 of $1.81 million. Earnings per share on a fully diluted basis were $0.56 for the first six months of 2011 compared to $0.50 for the first six months of 2010. Profitability as measured by return on average assets increased from 0.64% for the six months of 2010 to 0.70% for the same period in 2011. Profitability as measured by return on average equity increased from 8.22% to 9.19% over the same respective six month periods in 2010 and 2011. The increase in net income and the corresponding profitability measures was primarily due to a $287,000 decrease on the loss on the impairment of the Bank’s investment in pooled trust preferred corporate bonds, as well as increases in trust and estate income, brokerage income, and service charges on deposits. These were partially offset by an increase in $237,000 increase in operating expenses in the first six months of 2011 compared with the first six months of 2010.

Index

NET INTEREST INCOME AND EXPENSE

Net interest income increased $6,000 or 0.1% to $11.06 million for the six months ended June 30, 2011 compared with the six months ended June 30, 2010. The increase in net interest income was due primarily to the reduced cost of deposits due to the change in the deposit mix resulting in more transaction accounts and less time deposits. This was mostly offset by the decline in loan balances and reduced yields on earning assets over the same period. The Company’s net interest margin decreased from 4.24% in the six months ended June 30, 2010 to 4.09% in the first six months of 2011.

Total interest income decreased $546,000 or 3.9% to $13.63 million for the six months ended June 30, 2011 from $14.17 million for the six months ended June 30, 2010. This decrease was primarily due to a 39 basis point decline in the yield on earning assets and reduced loan balances from six months ended June 30, 2010 to six months ended June 30, 2011. This was partially offset by an increase in balances of investment securities and deposits in other banks.

The average yield on loans was 5.71% for the six months ended June 30, 2011, down from 5.85% in the six months ended June 30, 2010. Average loan balances decreased $6.4 million or 1.4% from $468.1 million during the first six months of 2010 to $461.7 million during the first six months of 2011. The decrease in loans outstanding and yield resulted in a $503,000 or 3.8% decline in interest and fee income from loans for the six months ended June 30, 2011 compared with the same period in 2010.

Average investment security balances increased $10.0 million from $41.8 million for the first six months of 2010 to $51.8 million during the first six months of 2011. The tax-equivalent average yield on investments decreased from 3.80% for the six months ended June 30, 2010 to 2.78% for the six months ended June 30, 2011 resulting in a decrease in interest and dividend income on security investments of $75,000 or 10.2%, from $734,000 for the six months ended June 30, 2010 to $659,000 for the six months ended June 30, 2011. This decrease was primarily due to reduced yields on mortgage backed securities in the Bank’s investment portfolio. Interest income on deposits in other banks increased $32,000 from the first six months of 2010 to the first six months of 2011 resulting from higher earning balances at the Federal Reserve.

Total interest expense decreased $552,000 or 17.7% from $3.12 million for the first six months of 2010 to $2.57 million for the first six months of 2011 primarily due to the decline in time deposit balances and rates.

Interest paid on deposits decreased $636,000 or 24.4% from $2.61 million for the six months ended June 30, 2010 to $1.98 million for the six months ended June 30, 2011. Average balances on time deposits declined $28.8 million or 14.5% from $198.7 million to $169.9 million while the average rate decreased from 1.98% to 1.69% from the six months ended June 30, 2010 to the six months ended June 30, 2011, resulting in $526,000 less of interest expense. Average savings accounts increased $5.8 million or 11.7% from the first six months of 2010 to the first six months of 2011 while the rate declined from 0.48% to 0.26%, resulting in $46,000 less in interest expense. Average money market account balances increased $15.9 million from the first six months of 2010 to the six months ended June 30, 2011, while their average rate decreased from 0.75% to 0.46% over the same period, resulting in a decrease of $52,000 of interest expense during the first six months of 2011. Average NOW deposit balances increased $41.2 million from the six months ended June 30, 2010 to the six months ended June 30, 2011, while the average rate decreased from 0.65% to 0.44%, resulting in a decrease of $12,000 in NOW interest expense for the six months ended June 30, 2011.

Interest expense on capital securities increased $59,000 from the six months ended June 30, 2010 to the six months ended June 30, 2011 due to the interest rate swap on the Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. The swap converts a floating rate liability to a fixed rate of 4.91% through 2020, and reduces interest rate risk exposure. From the six months ended June 30, 2010 to the six months ended June 30, 2011, interest expense on FHLB of Atlanta advances increased $25,000 due to increase in the average rate on the FHLB advances from 1.96% to 3.91% due to the extension of their weighted average maturity, which reduces the potential risk of reduced net interest income due to rising interest rates. The average rate on total interest-bearing liabilities decreased from 1.36% in the first six months of 2010 to 1.09% for the first six months of 2011.

Index

Average Balances, Income and Expense, and Average Yields and Rates

	Six Months Ended June 30, 2011								Six Months Ended June 30, 2010
(In thousands)	Average			Income/		Average			Average			Income/		Average
Assets	Balances			Expense		Rate			Balances			Expense		Rate
Loans
Taxable	$	444,766		$	12,581		5.70	%	$	450,630		$	13,090		5.86	%
Tax-exempt (1)		14,814			501		6.82	%		14,079			491		7.06	%
Nonaccrual (2)		2,107			-		-			3,413			-		-
Total Loans		461,687			13,082		5.71	%		468,122			13,581		5.85	%

Securities
Taxable		45,916			541		2.36	%		36,124			619		3.43	%
Tax-exempt (1)		5,934			179		6.03	%		5,698			176		6.17	%
Total securities		51,850			720		2.78	%		41,822			795		3.80	%

Deposits in banks		43,003			57		0.27	%		26,335			24		0.18	%
Federal funds sold		10			-		0.25	%		9			-		0.26	%
Total earning assets		556,550			13,859		5.02	%		536,288			14,400		5.41	%

Less: Reserve for loan losses		(6,633	)							(5,509	)
Cash and due from banks		5,373								6,025
Bank premises and equipment, net		14,199								14,509
Other real estate owned		3,236								2,409
Other assets		23,310								22,361
Total Assets	$	596,035							$	576,083

Liabilities and Shareholders' Equity
Deposits
Demand deposits	$	73,807							$	66,077

Interest-bearing deposits
NOW accounts		140,087			306		0.44	%		98,932			318		0.65	%
Money market accounts		77,593			178		0.46	%		61,719			230		0.75	%
Savings accounts		55,194			72		0.26	%		49,410			118		0.48	%
Time deposits		169,886			1,420		1.69	%		198,652			1,946		1.98	%
Total interest-bearing deposits		442,760			1,976		0.90	%		408,713			2,612		1.29	%


Federal funds purchased		4			-		0.68	%		28			-		0.26	%
Federal Home Loan Bank advances		25,000			491		3.91	%		48,011			466		1.96	%
Capital securities of subsidiary trust		4,124			99		4.83	%		4,124			40		1.95	%
Total interest-bearing liabilities		471,888			2,566		1.09	%		460,876			3,118		1.36	%

Other liabilities		5,178								4,605
Shareholders' equity		45,162								44,525
Total Liabilities & Shareholders' Equity	$	596,035							$	576,083

Net interest spread				$	11,293		3.93	%				$	11,282		4.05	%

Interest expense as a percent of average earning assets							0.93	%							1.17	%
Net interest margin							4.09	%							4.24	%

______________________

(1) Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.

(2) Nonaccrual loans are included in the average balance of total loans and total earning assets.

RATE/VOLUME ANALYSIS

Index

Rate / Volume Variance

	Six Months Ended June 30, 2011 Compared to Six Months Ended June 30, 2010
				Due to			Due to
(In thousands)	Change			Volume			Rate
Interest Income
Loans; taxable	$	(509	)	$	(170	)		(339	)
Loans; tax-exempt (1)		9			26			(17	)
Securities; taxable		(77	)		168			(245	)
Securities; tax-exempt (1)		3			7			(4	)
Deposits in banks		32			15			17
Federal funds sold		-			-			-
Total Interest Income		(542	)		46			(588	)

Interest Expense
NOW accounts		(12	)		132			(144	)
Money market accounts		(52	)		59			(111	)
Savings accounts		(46	)		14			(60	)
Time deposits		(526	)		(282	)		(244	)
Federal funds purchased and securities sold under agreements to repurchase		-			-			-
Federal Home Loan Bank advances		25			(223	)		248
Capital securities of subsidiary trust		59			-			59
Total Interest Expense		(552	)		(300	)		(252	)
Net Interest Income	$	10		$	346		$	(336	)

___________________

(1) Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.

PROVISION FOR LOAN LOSSES, ALLOWANCE FOR LOAN LOSSES, AND ASSET QUALITY

The provision for loan losses was $771,000 for the six months ended June 30, 2011, compared with $750,000 for the six months ended June 30, 2010. The amount of the provision for loan loss was based upon management’s continual evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the loan portfolio, trends in the Bank’s delinquent and non-performing loans, estimated values of collateral, and the impact of economic conditions on borrowers. Greater weight is given to the loss history by loan category, prolonged changes in portfolio delinquency trends by loan category, and changes in economic trends. There can be no assurances, however, that future losses will not exceed estimated amounts, or that increased amounts of provisions for loan losses will not be required in future periods.

OTHER INCOME

Total other income increased by $561,000 or 24.8% from $2.27 million for the six months ended June 30, 2010 to $2.83 million in the six months ended June 30, 2011. The increase in other income was primarily due to a $287,000 decline in impairment losses on the Bank’s investment in pooled trust preferred corporate bonds. Also contributing to the increase in other income was a $144,000 increase in service charges on deposit accounts, and trust and estate income increasing $116,000.

Trust and estate income increased $116,000 or 21.9% from the first six months of 2010 to the first six months of 2011, as assets under management increased from year to year, primarily due to the growth in new customer relationships and the increase in overall stock market valuations.

Brokerage service revenues increased $62,000 or 47.3% from the first six months of 2010 to the first six months of 2011 due to the growth in new customer relationships and increased brokerage transactions.

Service charges on deposit accounts increased $144,000 or 11.4% to $1.41 million for the first six months of 2011 compared to one year earlier. The change is primarily due to an increase in numbers of deposit customers generating increased deposit activity.

Other service charges, commissions and fees increased $35,000 or 4.9% from $724,000 for the six months ended June 30, 2010 to $759,000 for the six months ended June 30, 2011. Included in other service charges, commissions, and income is debit card interchange income which totaled $523,000 for the six months ended June 30, 2011. Also included is BOLI income, which was $207,000 during the first six months of 2011, compared with $204,000 one year earlier.

Index

OTHER EXPENSE

Total other expense increased $237,000 or 2.3% during the six months ended June 30, 2011 compared with the six months ended June 30, 2010.

Salaries and employees’ benefits increased $110,000 or 2.1%, due to the $174,000 increase in incentive compensation and an $119,000 increase in salaries, partially offset by a $206,000 decrease in pension expense. Cash based incentives are based upon the Company exceeding predetermined goals established by the Company’s board of directors.

Occupancy expense decreased $4,000 or 0.4%, while furniture and equipment expense decreased $8,000 or 1.2%, from the first six months of 2010 to the first six months of 2011.

Marketing expense decreased $19,000 or 5.9% from $321,000 for the first six months of 2010 to $302,000 for the first six months of 2011. This primarily reflected the marketing expense of the grand opening of the Haymarket office and relocation of the Warrenton-View Tree office that occurred during the first quarter of 2010.

Legal, accounting and consulting expense increased $18,000 or 3.2% in the six months ended June 30, 2011 compared with the six months ended June 30, 2010. Increased accounting expenses were about offset by reduced management consulting fees.

FDIC deposit insurance expense increased $40,000 or 11.2% from $353,000 for the first six months of 2010 to $393,000 for the first six months of 2011 due to increased deposit balances.

The loss on impairment or sale of OREO increased $190,000 from the six months ended June 30, 2010 compared with the same period in 2011, due to a $101,000 loss on sale of a residential properties and an additional $150,000 write-down of a commercial property.

Data processing expense increased $71,000 or 13.7% for the first six months of 2011 compared with the same time period in 2010 due to increased transaction activity processing.

Other operating expenses decreased $160,000 or 10.4% in the six months ended June 30, 2011 compared with the six months ended June 30, 2010. The decline was primarily due to lower deposit account-related charge-offs, as well as decreased supplies and postage expense related to the outsourcing of statement production and mailing.

INCOME TAXES

Income tax expense was $664,000 for the six months ended June 30, 2011 compared with $600,000 for the six months ended June 30, 2010. The effective tax rates were 24.4% and 24.8% for the first six months of 2011 and 2010, respectively.

COMPARISON OF FINANCIAL CONDITION AT JUNE 30, 2011 AND DECEMBER 31, 2010

Total assets were $599.2 million at June 30, 2011 compared with $598.0 million at December 31, 2010, an increase of 0.2% or $1.1 million. Balance sheet categories reflecting significant changes included interest-bearing deposits in other banks, securities, and total loans, and deposits. Each of these categories is discussed below.

INTEREST-BEARING DEPOSITS IN OTHER BANKS. Interest-bearing deposits in other banks were $52.5 million at June 30, 2011, reflecting an increase of $10.5 million from December 31, 2010. The increase in interest-bearing deposits in other banks was primarily due to the deployment of funds from loan repayments into interest-bearing deposits in other banks.

INVESTMENT SECURITIES. Total investment securities were $49.6 million at June 30, 2011, reflecting an increase of $3.1 million from $46.5 million at December 31, 2010. The increase is due to purchases, primarily government backed mortgage pools that are used to collateralize public deposits in excess of FDIC deposit insurance.

LOANS. Total net loan balance after allowance for loan losses was $447.8 million at June 30, 2011, which represents a decrease of $12.6 million or 2.7% from $460.4 million at December 31, 2010.

OTHER REAL ESTATE OWNED. Other real estate owned increased by $648,000 from December 31, 2010 to $3.5 million at June 30, 2011 due to the addition of a residential real estate foreclosed property that was partially offset by the sale of another, and a $150,000 valuation write down of a commercial property.

Index

DEPOSITS. For the six months ended June 30, 2011, total deposits decreased by $1.4 million or 0.3% when compared with total deposits at December 31, 2010. Non-interest-bearing deposits increased by $7.8 million and interest-bearing deposits decreased by $9.2 million. Included in interest-bearing deposits at June 30, 2011 and December 31, 2010 were $36.7 million and $39.3 million, respectively, of brokered deposits as defined by the Federal Reserve. Of the $36.7 million in brokered deposits, $25.9 million represent deposits of Bank customers, exchanged through the CDARS’ network. With the CDARS’ program, funds are placed into certificate of deposits issued by other banks in the network, in increments of less than $250,000, to ensure both principal and interest are eligible for complete FDIC coverage. These deposits are exchanged with other member banks on a dollar-for-dollar basis, bringing the full amount of our customers deposits back to the bank and making these funds fully available for lending in our community. The increase in the Bank’s non-interest-bearing deposits and the decrease in interest-bearing deposits during the first six months of 2011 were the result of many factors difficult to segregate and quantify, and equally difficult to use as factors for future projections. The economy, local competition, retail customer preferences, changes in seasonal cash flows by both commercial and retail customers, changes in business cash management practices by Bank customers, the relative pricing from wholesale funding sources, and the Bank’s funding needs all contributed to the change in deposit balances. The Bank projects to increase its transaction accounts and other deposits in 2011 and beyond through the expansion of its branch network, as well as by offering value-added NOW and demand deposit products, and selective rate premiums on its interest-bearing deposits.

ASSET QUALITY

Non-performing assets, in most cases, consist of loans that are 90 days or more past due and for which the accrual of interest has been discontinued. Management evaluates all loans that are 90 days or more past due, as well as borrowers that have suffered financial distress, to determine if they should be placed on non-accrual status. Factors considered by management include the net realizable value of collateral, if any, and other resources of the borrower that may be available to satisfy the delinquency.

Loans are placed on non-accrual status when they have been specifically determined to be impaired or when principal or interest is delinquent for 90 days or more, unless the loans are well secured and in the process of collection. Any unpaid interest previously accrued on such loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other non-accrual loans is recognized only to the extent of interest payments received.

Non-performing assets totaled $6.7 million or 1.13% of total assets at June 30, 2011, compared with $5.5 million or 0.92% of total assets at December 31, 2010, and $6.5 million, or 1.12% of total assets at June 30, 2010. Included in non-performing assets at June 30, 2011 were $324,000 of non-performing pooled trust preferred bonds at market value, $3.5 million of other real estate owned and $3.0 million of non-accrual loans. Non-accrual loans as a percentage of total loans were 0.65% at June 30, 2011, as compared with 0.45% and 0.53% at December 31, 2010 and June 30, 2010, respectfully.

There were no loans past due 90 days or more and still accruing interest at June 30, 2011 and June 30, 2010, and $263,000 on December 31, 2010. For additional information regarding non-performing assets and potential loan problems, see “Loans and Allowance for Loan Losses” in Note 3 of the Notes to Consolidated Financial Statements contained herein.

At June 30, 2011, no concentration of loans to commercial borrowers engaged in similar activities exceeded 10% of total loans. The largest industry concentration at June 30, 2011 was approximately 5.5% of loans to the hospitality industry (hotels, motels, inns, etc.). For more information regarding the Bank’s concentration of loans collateralized by real estate, please refer to the discussion under "Risk Factors" in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 entitled "The Company has a high concentration of loans secured by both residential and commercial real estate and a downturn in either or both markets, for any reason, may continue to increase the Company’s credit losses, which would negatively affect our financial results."

Based on regulatory guidelines, the Bank is required to monitor the commercial investment real estate loan portfolio for: (a) concentrations above 100% of Tier 1 capital and loan loss reserve for construction and land loans and (b) 300% for permanent investor real estate loans. As of June 30, 2011, construction and land loans were $29.6 million or 52.5% of the concentration limit. Commercial investor real estate loans, including construction and land loans, were $118.9 million or 211.3% of the concentration level.

CONTRACTUAL OBLIGATIONS

As of June 30, 2011, there have been no other material changes outside the ordinary course of business to the contractual obligations disclosed in “Management’s Discussion and Analysis” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

Index

OFF-BALANCE SHEET ARRANGEMENTS

As of June 30, 2011, there have been no material changes to the off-balance sheet arrangements disclosed in “Management’s Discussion and Analysis” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

CAPITAL

The Company and the Bank are subject to various regulatory capital requirements administered by banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and discretionary actions by regulators that could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of Total and Tier 1 Capital (as defined in the regulations) to risk-weighted assets (as defined in the regulations), and of Tier 1 Capital to average assets (as defined in the regulations). Management believes, as of June 30, 2011, that the Company and the Bank more than satisfy all capital adequacy requirements to which they are subject.

At June 30, 2011 and December 31, 2010, the Company exceeded its regulatory capital ratios, as set forth in the following table:

Risk Based Capital Ratios

	June 30, 2011			December 31, 2010

Tier 1 Capital:
Shareholders' Equity	$	46,156		$	44,106
Plus: Unrealized loss on securities available for sale/FAS 158, net		1,504			2,134
Less: Acumulated net gain on cash flow hedge and retirement obligations		25			69
Plus: Company-obligated madatorily redeemable capital securities		4,000			4,000
Less: Disallowed deferred tax assets					-
Total Tier 1 Capital		51,635			50,171

Tier 2 Capital:
Allowable Allowance for Loan Losses		5,475			5,558

Total Capital:		57,110			55,729

Risk Weighted Assets:	$	436,921		$	443,923

Regulatory Capital Ratios:
Leverage Ratio		8.66	%		8.22	%
Tier 1 to Risk Weighted Assets		11.82	%		11.30	%
Total Capital to Risk Weighted Assets		13.07	%		12.55	%

CAPITAL RESOURCES AND LIQUIDITY

Shareholders’ equity totaled $46.2 million at June 30, 2011 compared with $44.1 million at December 31, 2010 and $43.9 million at June 30, 2010. The amount of equity reflects management’s desire to increase shareholders’ return on equity while maintaining a strong capital base. On January 10, 2011, the Board authorized the Company to repurchase up to 109,103 shares (3% of common stock outstanding on January 1, 2011) beginning January 1, 2011 and continuing until the next Board reset. No shares were repurchased during the six month period ended June 30, 2011.

Accumulated other comprehensive income/loss decreased to an unrealized loss net of tax benefit of $1.5 million at June 30, 2011 compared with $2.1 million at December 31, 2010. The decline in the magnitude of the accumulated other comprehensive loss was primarily attributable to decline in market interest rates, as well as the realization of an other-than-temporary loss of $189,000 on pooled trust preferred investment securities held available for sale.

Index

As discussed in “Company-obligated Mandatorily Redeemable Capital Securities” in Note 4 of the Notes to Consolidated Financial Statements contained herein, during 2006, the Company established a subsidiary trust that issued $4.0 million of capital securities as part of a separate pooled trust preferred security offering with other financial institutions. Under applicable regulatory guidelines, the capital securities are treated as Tier 1 capital for purposes of the Federal Reserve’s capital guidelines for bank holding companies, as long as the capital securities and all other cumulative preferred securities of the Company together do not exceed 25% of Tier 1 capital. As discussed above under “Capital,” banking regulations have established minimum capital requirements for financial institutions, including risk-based capital ratios and leverage ratios. As of June 30, 2011, the appropriate regulatory authorities have categorized the Company and the Bank as “well capitalized.”

The primary sources of funds are deposits, repayment of loans, maturities of investments, funds provided from operations, federal funds lines of credit with the Federal Reserve and other banks, and advances from the FHLB of Atlanta. While scheduled repayments of loans and maturities of investment securities are predictable sources of funds, deposit flows and loan repayments are greatly influenced by the general level of interest rates, economic conditions and competition. The Bank uses its sources of funds to fund existing and future loan commitments, to fund maturing certificates of deposit and demand deposit withdrawals, to invest in other interest-earning assets, to maintain liquidity, and to meet operating expenses. Management monitors projected liquidity needs and determines the desirable funding level based in part on the Bank’s commitments to make loans and management’s assessment of the Bank’s ability to generate funds. Management is not aware of any market or institutional trends, events or uncertainties that are expected to have a material effect on the liquidity, capital resources or operations of the Company or the Bank. Nor is management aware of any current recommendations by regulatory authorities that would have a material effect on liquidity, capital resources or operations. The Bank’s internal sources of such liquidity are deposits, loan and investment repayments, and securities available for sale. The Bank’s primary external sources of liquidity are federal funds lines of credit with the Federal Reserve Bank and other banks and advances from the FHLB of Atlanta.

Cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold totaled $57.8 million at June 30, 2011 compared with $47.2 million at December 31, 2010. These assets provide a primary source of liquidity for the Bank. In addition, management has designated the entire investment portfolio as available of sale, of which approximately $9.4 million was unpledged and readily salable at June 30, 2011. Furthermore, the Bank has an available line of credit with the FHLB of Atlanta with a borrowing limit of approximately $113.8 million at June 30, 2011 to provide additional sources of liquidity, as well as available federal funds purchased lines of credit with the Federal Reserve and various other commercial banks totaling approximately $58.2 million. At June 30, 2011, $25 million of the FHLB of Atlanta line of credit and no federal funds purchased lines of credit were in use.

The following table sets forth information relating to the Company’s sources of liquidity and the outstanding commitments for use of liquidity at June 30, 2011 and December 31, 2010. The liquidity coverage ratio is derived by dividing the total sources of liquidity by the outstanding commitments for use of liquidity.

Liquidity Sources and Uses

	June 30, 2011							December 31, 2010
(In thousands)	Total		In Use		Available			Total		In Use		Available
Sources:
Federal funds borrowing lines of credit	$	58,184	$	-	$	58,184		$	59,157	$	-	$	59,157
Federal Home Loan Bank advances		113,833		25,000		88,833			118,655		25,000		93,655
Federal funds sold and interest-bearing deposits in other banks, excluding requirements						36,688			26,339				26,339
Securities, available for sale and unpledged at fair value						9,374							3,297
Total short-term funding sources					$	193,079						$	182,448

Uses:
Unfunded loan commitments and lending lines of credit					$	64,247						$	66,215
Letters of credit						4,128							4,412
Total potential short-term funding uses					$	68,375						$	70,627

Ratio of short-term funding sources to potential short-term funding uses						282.4	%						258.3	%

IMPACT OF INFLATION AND CHANGING PRICES

The consolidated financial statements and the accompanying notes presented elsewhere in this document have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of the Company and the Bank are monetary in nature. The impact of inflation is reflected in the increased cost of operations. As a result, interest rates have a greater impact on our performance than inflation does. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

Index

CHANGES IN ACCOUNTING PRINCIPLES

For information regarding recent accounting pronouncements and their effect on the Company, see “Recent Accounting Pronouncements” in Note 1 of the Notes to Consolidated Financial Statements contained herein.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

An important component of both earnings performance and liquidity is management of interest rate sensitivity. Interest rate sensitivity reflects the potential effect on net interest income and economic value of equity from a change in market interest rates. The Bank is subject to interest rate sensitivity to the degree that its interest-earning assets mature or reprice at different time intervals than its interest-bearing liabilities. However, the Bank is not subject to the other major categories of market risk such as foreign currency exchange rate risk or commodity price risk. The Bank uses a number of tools to manage its interest rate risk, including simulating net interest income under various scenarios, monitoring the present value change in equity under the same scenarios, and monitoring the difference or gap between rate sensitive assets and rate sensitive liabilities over various time periods. Management believes that rate risk is best measured by simulation modeling.

There have been no material changes to the quantitative and qualitative disclosures made in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to provide assurance that the information required to be disclosed in the reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the Securities and Exchange Commission. An evaluation of the effectiveness of the design and operations of the Company’s disclosure controls and procedures at the end of the period covered by this report was carried out under the supervision and with the participation of the management of Fauquier Bankshares, Inc., including the Chief Executive Officer and the Chief Financial Officer. Based on such an evaluation, the Chief Executive Officer and the Chief Financial Officer concluded the Company’s disclosure controls and procedures were effective as of the end of such period.

The company regularly assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations. There have not been any significant changes in the Company’s internal control over financial reporting or in other factors that have materially affected or are reasonably likely to materially affect, such controls during the quarter ended June 30, 2011.

PART II, OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

There is no pending or threatened legal proceedings to which the Company or the Bank is a party or to which the property of either the Company or the Bank is subject to that, in the opinion of management, may materially impact the financial condition of either the Company or the Bank.

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors faced by the Company from those disclosed in Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On January 10, 2011, the Board authorized the Company to repurchase up to 109,103 shares (3% of common stock outstanding on January 1, 2011) beginning January 1, 2011 and continuing until the next Board reset. No shares were repurchased during the six month period ended June 30, 2011.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

Index

ITEM 4. (REMOVED AND RESERVED)

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS

Exhibit	Exhibit
Number	Description

3.1	Articles of Incorporation of Fauquier Bankshares, Inc., as amended, incorporated by reference to Exhibit 3.1 to Form 10-K filed March 15, 2010.

3.2	By-laws of Fauquier Bankshares, Inc., as amended and restated, incorporated by reference to Exhibit 3.2 to Form 10-Q filed August 9, 2010.

31.1	Certification of CEO pursuant to Rule 13a-14(a).

31.2	Certification of CFO pursuant to Rule 13a-14(a).

32.1	Certification of CEO pursuant to 18 U.S.C. Section 1350.

32.2	Certification of CFO pursuant to 18 U.S.C. Section 1350.

Index

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

FAUQUIER BANKSHARES, INC.

(Registrant)

/s/ Randy K. Ferrell

Randy K. Ferrell

President & Chief Executive Officer

Dated: August 9, 2011

/s/ Eric P. Graap

Eric P. Graap

Executive Vice President & Chief Financial Officer

Dated: August 9, 2011