UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

 

(Mark One)

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

For the quarterly period ended June 30, 2006

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

For the transition period from                      to                     

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)

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ   No o

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

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

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

     As of August 7, 2006, the latest practicable date for determination, 3,476,520 shares of common stock, par value $3.13 per share, of the registrant were outstanding.

 

 

FAUQUIER BANKSHARES, INC.

INDEX

						Page
Part I. FINANCIAL INFORMATION
		Item 1.		Financial Statements		2
				Consolidated Balance Sheets as of June 30, 2006 (unaudited) and December 31, 2005		2
				Consolidated Statements of Income (unaudited) for the Three Months Ended June 30, 2006 and 2005		3
				Consolidated Statements of Income (unaudited) for the Six Months Ended June 30, 2006 and 2005		4
				Consolidated Statements of Changes in Shareholders’ Equity (unaudited) for the Six Months Ended June 30, 2006 and 2005		5
				Consolidated Statements of Cash Flows (unaudited) for the Six Months Ended June 30, 2006 and 2005		6
				Notes to Consolidated Financial Statements		7
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		14
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk		30
		Item 4.		Controls and Procedures		30
Part II. OTHER INFORMATION						30
		Item 1.		Legal Proceedings		30
		Item 1A.		Risk Factors		30
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		31
		Item 3.		Defaults Upon Senior Securities		31
		Item 4.		Submission of Matters to a Vote of Security Holders		31
		Item 5.		Other Information		32
		Item 6.		Exhibits		32
SIGNATURES						32

Part I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Balance Sheets

		Unaudited				Audited
		June 30, 2006				December 31, 2005
Assets
Cash and due from banks		$	16,288,056			$	26,565,702
Interest-bearing deposits in other banks			556,535				680,013
Federal funds sold			9,000				493,000
Securities, at fair value			42,537,205				48,390,771
Loans, net of allowance for loan losses of $4,457,970 in 2006 and $4,238,143 in 2005			412,638,311				381,049,471
Bank premises and equipment, net			8,002,381				8,289,581
Accrued interest receivable			1,613,794				1,585,849
Other assets			13,632,813				14,191,023
Total assets			495,278,095				481,245,410
Liabilities
Deposits:
Noninterest-bearing			88,420,902				95,411,624
Interest-bearing			314,884,228				296,245,545
Total deposits			403,305,130				391,657,169
Federal funds purchased			17,000,000				5,000,000
Dividends payable			—				—
Federal Home Loan Bank advances			31,000,000				42,000,000
Company-obligated mandatorily redeemable capital securities			4,124,000				4,124,000
Other liabilities			2,777,157				2,885,096
Commitments and contingent liabilities			—				—
Total liabilities			458,206,287				445,666,265
Shareholders’ Equity
Common stock, par value, $3.13; authorized 8,000,000 shares; issued and outstanding, 2006, 3,475,085 shares; 2005, 3,448,786 shares			10,877,016				10,794,700
Retained earnings			27,031,130				25,440,838
Accumulated other comprehensive income (loss), net			(836,338	)			(656,393	)
Total shareholders’ equity			37,071,808				35,579,145
Total liabilities and shareholders’ equity		$	495,278,095			$	481,245,410

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
For the Three Months Ended June 30, 2006 and 2005

		2006				2005
Interest Income
Interest and fees on loans		$	6,905,346			$	5,744,799
Interest and dividends on securities available for sale:
Taxable interest income			395,485				483,732
Interest income exempt from federal income taxes			13,129				13,054
Dividends			74,847				58,768
Interest on federal funds sold			2,763				30,345
Interest on deposits in other banks			6,303				1,309
Total interest income			7,397,873				6,332,007
Interest Expense
Interest on deposits			1,846,576				1,202,909
Interest on federal funds purchased			166,650				1,456
Interest on Federal Home Loan Bank advances			394,625				218,565
Distribution on capital securities of subsidiary trust			87,018				67,812
Total interest expense			2,494,869				1,490,742
Net interest income			4,903,004				4,841,265
Provision for loan losses			180,000				208,750
Net interest income after provision for loan losses			4,723,004				4,632,515
Other Income
Wealth management income			336,334				284,667
Service charges on deposit accounts			723,513				660,395
Other service charges, commissions and income			373,063				321,976
Gain on sale of property rights			—				—
Total other income			1,432,910				1,267,038
Other Expenses
Salaries and benefits			2,321,056				2,074,304
Net occupancy expense of premises			262,648				230,248
Furniture and equipment			347,787				319,841
Other operating expenses			1,383,916				1,476,442
Loss on sale of securities			—				—
Total other expenses			4,315,407				4,100,835
Income before income taxes			1,840,507				1,798,718
Income tax expense			552,695				549,567
Net Income		$	1,287,812			$	1,249,151
Earnings per Share, basic		$	0.37			$	0.36
Earnings per Share, assuming dilution		$	0.36			$	0.35
Dividends per Share		$	0.190			$	0.16

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
For the Six Months Ended June 30, 2006 and 2005

		2006				2005
Interest Income
Interest and fees on loans		$	13,328,784			$	11,074,630
Interest and dividends on securities available for sale:
Taxable interest income			813,322				990,477
Interest income exempt from federal income taxes			26,252				26,136
Dividends			121,995				85,499
Interest on federal funds sold			17,405				37,496
Interest on deposits in other banks			11,278				2,830
Total interest income			14,319,036				12,217,068
Interest Expense
Interest on deposits			3,417,674				2,242,295
Interest on federal funds purchased			204,450				26,886
Interest on Federal Home Loan Bank advances			882,437				422,103
Distribution on capital securities of subsidiary trust			172,723				129,600
Total interest expense			4,677,284				2,820,884
Net interest income			9,641,752				9,396,184
Provision for loan losses			300,000				333,750
Net interest income after provision for loan losses			9,341,752				9,062,434
Other Income
Wealth management income			663,881				602,368
Service charges on deposit accounts			1,359,452				1,301,520
Other service charges, commissions and income			725,405				625,562
Gain on sale of property rights			250,000				—
Total other income			2,998,738				2,529,450
Other Expenses
Salaries and benefits			4,504,823				4,132,226
Net occupancy expense of premises			503,801				463,318
Furniture and equipment			679,506				637,128
Other operating expenses			2,732,368				2,687,654
Loss on sale of securities			82,564				—
Total other expenses			8,503,062				7,920,326
Income before income taxes			3,837,428				3,671,558
Income tax expense			1,152,004				1,112,139
Net Income		$	2,685,424			$	2,559,419
Earnings per Share, basic		$	0.77			$	0.74
Earnings per Share, assuming dilution		$	0.75			$	0.72
Dividends per Share		$	0.365			$	0.31

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders’ Equity
(Unaudited)
For the Six Months Ended June 30, 2006 and 2005

										Accumulated
										Other
		Common				Retained				Comprehensive				Comprehensive
		Stock				Earnings				Income (Loss)				Income				Total
Balance, December 31, 2004		$	10,618,775			$	21,320,223			$	(47,934	)						$	31,891,064
Comprehensive income:
Net income							2,559,419				—			$	2,559,419				2,559,419
Other comprehensive income net of tax:
Unrealized holding losses on securities available for sale, net of deferred income taxes of $137,241			—				—				(266,410	)			(266,410	)			(266,410	)
Total comprehensive income			—				—				—			$	2,293,009				—
Cash dividends ($.31 per share)			—				(1,065,592	)			—								(1,065,592	)
Restricted Stock Forfeiture			(3,506	)			(24,494	)											(28,000	)
Net issuance of restricted stock, stock incentive plan (10,045 shares)			31,441				218,077				—								249,518
Unearned compensation on restricted stock							(249,518	)											(249,518	)
Amortization of unearned compensation, restricted stock awards							157,790												157,790
Issuance of common stock			8,811				62,736				—								71,547
Exercise of stock options			115,213				193,057				—								308,270
Balance, June 30, 2005		$	10,770,734			$	23,171,698			$	(314,344	)						$	33,628,088
Balance, December 31, 2005		$	10,794,700			$	25,440,838			$	(656,393	)						$	35,579,146
Comprehensive income:
Net income							2,685,424				—			$	2,685,424				2,685,424
Other comprehensive income net of tax:
Unrealized holding losses on securities available for sale, net of deferred income taxes of $293,600			—				—				(179,945	)			(179,945	)			(179,945	)
Total comprehensive income			—				—				—			$	2,505,479				—
Cash dividends ($.365 per share)			—				(1,268,073	)			—								(1,268,073	)
Net issuance of restricted stock, stock incentive plan (10,347 shares)			32,386				228,772				—								261,158
Unearned compensation on restricted stock							(261,158	)											(261,158	)
Amortization of unearned compensation, restricted stock awards							102,879												102,879
Issuance of common stock			10,993				75,688				—								86,680
Exercise of stock options			38,937				26,760				—								65,697
Balance, June 30, 2006		$	10,877,016			$	27,031,131			$	(836,338	)						$	37,071,808

Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
For the Six Months Ended June 30, 2006 and 2005

		2006				2005
Cash Flows from Operating Activities
Net income		$	2,685,424			$	2,559,419
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			604,154				591,207
Provision for loan losses			300,000				333,750
Amortization of security premiums, net			14,830				30,175
Amortization of unearned compensation			102,879				157,790
Changes in assets and liabilities:
Decrease (Increase) in other assets			622,964				(427,128	)
(Decrease) Increase in other liabilities			(107,939	)			(719,674	)
Net cash provided by operating activities			4,222,312				2,525,539
Cash Flows from Investing Activities
Proceeds from sale of securities available for sale			3,024,745				—
Proceeds from maturities, calls and principal payments of securities available for sale			2,150,247				7,712,216
Purchase of securities available for sale			—				(258,199	)
Purchase of premises and equipment			(316,954	)			(453,605	)
Proceeds (Purchase) of other investment			391,100				(461,300	)
Net Decrease (Increase) in loans			(31,888,840	)			(14,869,394	)
Net cash (used in) investing activities			(26,639,702	)			(8,330,282	)
Cash Flows from Financing Activities
Net (Decrease) Increase in demand deposits, NOW accounts and savings accounts			(15,411,318	)			(8,587,708	)
Net (Decrease) Increase in certificates of deposit			27,059,281				18,830,478
Federal Home Loan Bank advances			—				8,000,000
Federal Home Loan Bank principal repayments			(11,000,000	)			(5,000,000	)
Purchase (Repayment) of Federal Funds			12,000,000				5,000,000
Cash dividends paid on common stock			(1,268,073	)			(1,574,479	)
Issuance of common stock			152,376				379,817
Acquisition of common stock			—				(28,000	)
Net cash provided by (used in) financing activities			11,532,266				17,020,108
Increase (Decrease) in cash and cash equivalents			(10,885,124	)			11,215,365
Cash and Cash Equivalents
Beginning			27,738,715				9,166,574
Ending		$	16,853,591			$	20,381,939
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest		$	3,251,617			$	2,693,981
Income taxes		$	808,000			$	1,290,000
Supplemental Disclosures of Noncash Investing Activities
Unrealized gain (loss) on securities available for sale, net		$	272,644			$	(403,652	)

See accompanying Notes to Consolidated Financial Statements.

Fauquier Bankshares, Inc. and Subsidiaries
Notes to Consolidated Financial Statements

1.   General

The consolidated statements include the accounts of Fauquier Bankshares, Inc. (the Company) and its wholly-owned subsidiary, The Fauquier Bank (the Bank), 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, 2006 and December 31, 2005 and the results of operations and cash flows for the six months ended June 30, 2006 and 2005.

The results of operations for the six months ended June 30, 2006 and 2005 are not necessarily indicative of the results expected for the full year.

2.   Securities

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

						Gross				Gross
		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				(Losses)				Value
		June 30, 2006
Obligations of U.S. Government corporations and agencies		$	33,535,551			$	1,368			$	(1,169,125	)		$	32,367,794
Obligations of states and political subdivisions			962,375				47,222				—				1,009,597
Corporate Bonds			6,000,000								(86,250	)			5,913,750
Mutual Funds			273,537				—				(15,393	)			258,144
FHLMC Preferred Bank Stock			441,000				—				(45,000	)			396,000
Restricted investments:
Federal Home Loan Bank Stock			2,357,000				—				—				2,357,000
Federal Reserve Bank Stock			72,000				—				—				72,000
Community Bankers’ Bank Stock			50,000				—				—				50,000
The Bankers Bank Stock			112,920				—				—				112,920
		$	43,804,383			$	48,590			$	(1,315,768	)		$	42,537,205

						Gross				Gross
		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				(Losses)				Value
		December 31, 2005
Obligations of U.S. Government corporations and agencies		$	38,731,324			$	10,072			$	(943,127	)		$	37,798,269
Obligations of states and political subdivisions			962,013				57,516				—				1,019,529
Corporate Bonds			6,000,000				—				(98,750	)			5,901,250
Mutual Funds			267,947				—				(7,144	)			260,803
FHLMC Preferred Bank Stock			441,000				—				(13,100	)			427,900
Restricted investments:
Federal Home Loan Bank Stock			2,748,100				—				—				2,748,100
Federal Reserve Bank Stock			72,000				—				—				72,000
Community Bankers’ Bank Stock			50,000				—				—				50,000
The Bankers Bank Stock			112,920				—				—				112,920
		$	49,385,304			$	67,588			$	(1,062,121	)		$	48,390,771

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, 2006
		Amortized				Fair
		Cost				Value
Due in one year or less		$	—			$	—
Due after one year through five years			17,937,593				17,374,440
Due after five years through ten years			2,218,144				2,145,976
Due after ten years			20,342,189				19,770,725
Equity Securities			3,306,457				3,246,064
		$	43,804,383			$	42,537,205

The following table shows the Company’s investments with gross unrealized losses and their fair value, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2006:

		Less than 12 Months								12 Months or More								Total
Description of Securities		Fair Value				Unrealized (Losses)				Fair Value				Unrealized (Losses)				Fair Value				Unrealized (Losses)
Obligations of U.S. Government corporations and agencies		$	2,847,333			$	(76,802	)		$	29,253,744			$	(1,092,323	)		$	32,101,077			$	(1,169,125	)
Corporate Bonds			—				—				5,913,750				(86,250	)			5,913,750				(86,250	)
Subtotal, debt securities			2,847,333				(76,802	)			35,167,494				(1,178,573	)			38,014,827				(1,255,375	)
Preferred Stock			—				—				441,000				(45,000	)			441,000				(45,000	)
Mutual Fund			—				—				273,537				(15,393	)			273,537				(15,393	)
Total temporary impaired securities		$	2,847,333			$	(76,802	)		$	35,882,031			$	(1,238,966	)		$	38,729,364			$	(1,315,768	)

The nature of the securities which are temporarily impaired for a continuous 12 months or more can be segmented into three groups. The first group consists of Federal Agency bonds totaling $14.9 million with a temporary loss of approximately $496,000. The bonds within this group have Aaa/AAA ratings from Moody’s and Standard & Poors. These bonds have estimated maturity dates of 24 months to 39 months. The Company has the ability to hold these bonds to maturity.

The second group consists of Federal agency mortgage-backed securities totaling $15.3 million with a temporary loss of approximately $596,000. The securities within this group have Aaa/AAA ratings from Moody’s and Standard & Poors. The estimated maturity dates range from 18 months to 335 months, and return principal on a monthly basis representing the repayment and prepayment of the underlying mortgages. The Company has the ability to hold these securities to maturity.

The third group consists of corporate bonds, rated A2 by Moody’s, totaling $6 million with a temporary loss of approximately $86,250. These bonds have an estimated maturity of 27 years, but can be called at par on the five year anniversary. If not called, the bonds reprice every three months at a fixed index above LIBOR. The Company has the ability to hold these bonds to maturity.

The carrying value of securities pledged to secure deposits and for other purposes amounted to $16,030,481 and $18,317,369 at June 30, 2006 and December 31, 2005, respectively.

3.		Loans
		A summary of the balances of loans follows:

		June 30,				December 31,
		2006				2005
		(Thousands)
Real estate loans:
Construction		$	31,686			$	27,302
Secured by farmland			638				535
Secured by 1 - to - 4 family residential			161,797				153,997
Other real estate loans			134,905				120,416
Commercial and industrial loans (not secured by real estate)			42,624				35,497
Consumer installment loans			34,238				38,677
All other loans			11,734				9,386
Total loans		$	417,622			$	385,810
Unearned income			(526	)			(523	)
Allowance for loan losses			4,458				4,238
Net loans		$	412,638			$	381,049

Analysis of the allowance for loan losses follows:

		Six Months				Six Months				Twelve Months
		Ended				Ended				Ended
		June, 30				June, 30				December 31,
		2006				2005				2005
Balance at beginning of period		$	4,238,143			$	4,060,321			$	4,060,321
Provision charged to operating expense			300,000				333,750				472,917
Recoveries added to the allowance			48,347				32,920				53,331
Loan losses charged to the allowance			(128,520	)			(138,060	)			(348,426	)
Balance at end of period		$	4,457,970			$	4,288,931			$	4,238,143

Nonperforming assets consist of the following:

		June 30,				December 31,
		2006				2005
		(Thousands)
Nonaccrual loans		$	1,706			$	13
Restructured loans			—				—
Total nonperforming loans			1,706				13
Foreclosed property			67				182
Total nonperforming assets		$	1,773			$	195

Total loans past due 90 days or more and still accruing interest totaled $0 on June 30, 2006 and $679,000 on December 31, 2005.

4.		Company-Obligated Mandatorily Redeemable Capital Securities of Subsidiary Trust
		On March 26, 2002, the Company’s wholly-owned Connecticut statutory business trust privately issued $4 million face amount of the trust’s Floating Rate Capital Securities (“Capital Securities”) in a pooled capital securities offering. Simultaneously, the trust used the proceeds of that sale to purchase $4 million principal amount of the Company’s Floating Rate Junior Subordinated Deferrable Interest Debentures due 2032 (“Subordinated Debentures”). Both the Capital Securities and the 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.
		The Capital Securities are presented in the consolidated balance sheets of the Company under the caption “Company-obligated mandatorily redeemable capital securities.” The Company records distributions payable on the Capital Securities as an Interest Expense in its consolidated statements of income. The cost of issuance of the Capital Securities was approximately $128,000. This cost is being amortized over a five year period from the issue date.

5.		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. Dilutive potential common stock had no effect on income available to common shareholders.

		Three Months Ended								Six Months Ended								Six Months Ended
		June 30, 2006								June 30, 2006								June 30, 2005
						Per Share								Per Share								Per Share
		Shares				Amount				Shares				Amount				Shares				Amount
Basic earnings per share			3,475,064			$	0.37				3,466,540			$	0.77				3,421,009			$	0.74
Effect of dilutive securities, stock options			112,986								112,686								128,854
Diluted earnings per share			3,588,050			$	0.36				3,579,226			$	0.75				3,549,863			$	0.72

6.

Stock-Based Compensation

		At June 30, 2006, the Company has a stock-based compensation plan. Effective January 1, 2006, the Company adopted the provisions of FASB Statement No. 123(R), Share-Based Payment, which requires that the Company recognize expense related to the fair value of stock-based compensation awards in net income. Prior to January 1, 2006, the Company accounted for its stock-based compensation under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Accordingly, stock compensation expense was not recognized in net income, as all stock options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. However, prior years’ financial statements included pro forma disclosures of the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation.
		The following table illustrates the effect on net income and earnings per share for the Company had the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, been applied to stock-based compensation for six months ended June 30, 2006 and 2005.

		June 30,				June 30,
		2006				2005
Net Income, as reported		$	2,685,424			$	2,559,419
Deduct: Total stock-based employee compensation expense determined based on fair value method of awards, net of tax			—				—
Pro forma net income		$	2,685,424			$	2,559,419
Earnings per share:
Basic — as reported		$	0.77			$	0.74
Basic — pro forma			0.77				0.74
Diluted — as reported			0.75				0.72
Diluted — pro forma			0.75				0.72

7.

Employee Benefit Plan

The following table provides a reconciliation of the changes in the defined benefit pension plan’s obligations for the six months ended June 30, 2006 and 2005.

		Six Months Ended
		June 30,
		2006				2005
Service cost		$	346,254			$	287,240
Interest cost			187,994				170,240
Expected return on plan assets			(197,920	)			(150,858	)
Amortization of transition obligation/(asset)			(9,490	)			(9,490	)
Amortization of prior service cost			3,884				3,884
Recognized net actuarial loss			30,478				31,156
Net periodic benefit cost		$	361,200			$	332,172

The Company previously disclosed in its financial statements for the year ended December 31, 2005, that it expected to contribute $790,709 to its pension plan in 2006. As of June 30, 2006, contributions totaling $424,456 have been made. This contribution fully funds the pension plan for 2006. The Company presently anticipates no additional contributions.

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

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 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 and the shape of the interest rate yield curve, 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 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.

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”), a Virginia state-chartered bank that commenced operations in 1902. The Company engages in its business through the Bank, and has no significant operations other than owning the stock of the Bank. The Company had issued and outstanding 3,475,085 shares of common stock, par value $3.13 per share, held by approximately 445 holders of record on June 30, 2006.

The Bank has eight full service branch offices located in the Virginia communities of Warrenton, Catlett, The Plains, New Baltimore, Sudley Road-Manassas, Old Town-Manassas and Bealeton. The executive offices of the Company and the main office of the Bank are located at 10 Courthouse Square, Warrenton, Virginia 20186. During the March 2005 quarter, the Bank signed a lease for its ninth full service branch in Haymarket, Virginia, scheduled to open in 2007. 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 and businesses. The deposits of the Bank are insured up to applicable limits by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (the “FDIC”). The basic services offered by the Bank include: demand deposit accounts, savings and money market deposit accounts, NOW accounts, time deposits, safe deposit services, credit cards, cash management, automated clearing house services (“ACH”) including direct deposits, notary services, night depository, traveler’s checks, cashier’s checks, domestic collections, savings bonds, automated teller services, drive-in tellers, internet banking, banking by telephone, 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 Star and Plus ATM networks, thereby permitting customers to utilize the convenience of larger ATM networks.

The Bank operates a Wealth Management Services (“WMS”) 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 Investments Group, LLC, a full service broker/dealer; and Bankers Title Shenandoah, LLC, a title insurance company. Bankers Insurance consists of a consortium of 60 Virginia community bank owners; Bankers Investments Group is owned by 32 Virginia community banks; and Bankers Title Shenandoah is owned by 10 Virginia community banks.

The revenues of the Bank are derived primarily from interest and fees earned on real estate and other loans; interest and dividends from investment and mortgage-backed securities; and fees on deposit products and WMS services. 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 and other banks. The principal expenses of the Bank are the interest paid on deposits and borrowings, and operating and general administrative expenses. 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 (“SCC”). 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.

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 financial statements 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) 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) 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) U.S. Securities and Exchange Commission 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. 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 allocated a specific allowance upon their review. 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 allowance.

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.

Through the merger and consolidation of other area banks, the Bank has become the primary independent community bank in its immediate geographic market. The Bank continually seeks to be the principal financial service provider for its market area by providing high quality customer service, efficient technological support, value-added products, and a strong commitment to the community.

Net income of $1.29 million for the quarter ended June 30, 2006 was a 3.1% increase from the June 2005 quarter net income of $1.25 million. Net income was $2.69 million for the six month period ended June 30, 2006, a 4.9% increase above the net income of $2.56 million for the six month period ended June 2005. The net income results were consistent with management’s internal projections. The Company and the Bank have continued to experience growth across all of the primary operating businesses; specifically, commercial and retail lending, retail deposits, and assets under WMS management. Net loan outstandings increased 17.1% from June 30, 2005 to June 30, 2006. Total deposits increased 4.8% from June 30, 2005 to June 30, 2006. WMS assets under management grew from approximately $266.4 million at June 30, 2005 to $294.7 million at June 30, 2006, an increase of 10.5%.

Management continues the expansion of its branch network into western Prince William County, having signed a lease for a full service branch in Haymarket, Virginia, scheduled to open in 2007. The Bank seeks to further add to its branch network in western Prince William County, as well as in Fauquier County, looking toward these new retail markets for growth in deposits and WMS income. Management also seeks to increase the level of its fee income from deposits and WMS through the increase of its market share within its current marketplace. Beginning in April 2006, the Bank introduced a new line of “Free Checking” products in order to better serve the growing population in its marketplace. Each checking account is designed to meet many of the specific individual needs of the customer. All of our new checking accounts offer free ATM access virtually anywhere in the United States and in most foreign countries, where the Bank will pay the customers’ ATM fees charged by other institutions, up to 4 times a month.

COMPARISION OF OPERATING RESULTS FOR THE THREE MONTHS ENDED JUNE 30, 2006 AND JUNE 30, 2005

NET INCOME. Net income for the three months ended June 30, 2006 was $1.29 million or $0.36 per diluted share compared with $1.25 million or $0.35 per diluted share for the three months ended June 30, 2005. The growth in net income was primarily due to a $166,000 or 13.1% increase in total other income and a $62,000 or 1.3% increase in net interest income; primarily offset by a $215,000 or 5.2% increase in other operating expenses.

NET INTEREST INCOME. Net interest income increased $62,000 or 1.3% to $4.90 million for the three months ended June 30, 2006 compared with $4.84 million for the three months ended June 30, 2005. The increase in net interest income resulted from increased interest and fee income on loans as a result of the increase in volume of loans outstanding. The net interest margin, computed on a tax equivalent basis, for the June 2006 quarter was 4.34%, compared with 4.72% for the same quarter one year earlier. The primary reasons for the decrease in the net interest margin are the impact of the flattening yield curve coupled with competitive pressures on the pricing of interest-earning assets and interest-bearing liabilities. Average interest-earning assets grew 10.1% to $451.3 million for the second quarter of 2006 compared with $409.8 million for the second quarter of 2005. The yield on average interest-earning assets was 6.55% for the June 2006 quarter compared with 6.18% for the June 2005 quarter. Total interest income increased $1.07 million or 16.8% to $7.40 million for the three months ended June 30, 2006, compared with $6.33 million for the three months ended June 30, 2005, as a result of the growth in the volume of interest-earning assets and in the average rate of interest earned. Interest and dividends on investment securities decreased $72,000 or 13.0%. During the first quarter of 2006, the Bank sold $2.95 million of lower yielding investment securities and utilized the proceeds from the sale to retire high cost borrowed funds. Investment securities averaged $43.3 million for the second quarter of 2006 compared with $54.0 million for the same quarter one year earlier. The yield on investment securities was 4.52% on a tax equivalent basis for the second quarter of 2006, compared with 4.17% for the second quarter of 2005. Interest and fees on loans increased $1.16 million or 20.2% to $6.91 million for the June 2006 quarter compared with the same quarter one year earlier. Average loans outstanding totaled $406.9 million and earned 6.77% on a tax-equivalent basis for the quarter ended June 30, 2006, compared with $351.2 million and 6.53%, respectively, for the quarter ended June 30, 2005.

Total interest expense increased $1.00 million or 67.4% to $2.49 million for the three months ended June 30, 2006 from $1.49 million for the three months ended June 30, 2005. Average interest-bearing liabilities grew 9.4% to $356.1 million for the second quarter of 2006 compared with $325.6 million for the second quarter of 2005, while the average cost on interest-bearing liabilities increased to 2.80% from 1.83% for the same respective time periods. The increase in total interest expense and the average cost of interest-bearing liabilities is primarily due to the overall increase in short-term interest rates, as well as significantly increased balances in higher cost funding sources such as the premium interest rate money market account, time deposits, federal funds purchased and FHLB of Atlanta borrowings. The average balance for the premium interest rate money market account was $50.5 million with an average cost of 3.88% for the three months ended June 30, 2006 compared with $1.6 million with an average cost of 3.00% for the June 2005 quarter. Average time deposit balances for the second quarter of 2006 were $115.3 million at an average cost of 3.88%, compared with $95.0 million at an average cost of 3.08% for the same quarter one year earlier. Interest-bearing NOW account deposits averaged $66.6 million at an average cost of 0.47% for the June 2006 quarter, compared with $103.9 million at an average cost of 0.95% for the June 2005 quarter. Other interest-bearing money market deposits averaged $38.6 million at an average cost of 1.38% for the quarter ended June 30, 2006, compared with $57.1 million at an average cost of 1.26% for the same quarter one year earlier. Savings account deposits averaged $38.6 million at an average cost of 0.34% for the June 2006 quarter, compared with $43.1 million at an average cost of 0.33% for the June 2005 quarter. Federal funds purchased averaged $12.1 million at a cost of 5.46% for the June 2006 quarter compared with $220,000 at a cost of 2.66% for the June 2005 quarter. Average FHLB of Atlanta advances were $30.2 million at an average cost of 5.17% for the second quarter of 2006, and $20.5 million at an average cost of 4.22% one year earlier.

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, 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 2006 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. Additionally, the Bank’s balance sheet is positioned for a stable or rising interest rate environment. This means that net interest income is projected to increase if market interest rates rise, and to decrease if market interest rates fall, assuming no change in the shape of the interest rate 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 specific nature of the Bank’s variability in net interest income due to changes in interest rates, also known as interest rate risk, is to a large degree the result of the Bank’s deposit base structure. During the second quarter of 2006, demand deposits, NOW accounts, and savings deposits averaged 22.6%, 16.7%, and 9.7% of total average deposits, respectively, while the more interest-rate sensitive money market accounts, premium money market accounts and certificates of deposit averaged 9.6%, 12.6% and 28.8% of total average deposits, respectively.

The following table sets forth information relating to the Company’s average balance sheet and reflects the average yield on assets and the average annualized cost of liabilities for the three-month periods ended June 30, 2006 and 2005. These yields and costs are derived by annualizing the income or expense for the periods presented, and dividing the product of the annualizaton by the respective average daily balances of assets and liabilities for the periods presented.

AVERAGE BALANCES, INCOME AND EXPENSES, AND AVERAGE YIELDS AND RATES
(In Thousands)

		Three Months Ended June 30, 2006												Three Months Ended June 30, 2005
		Average				Income/				Average				Average				Income/				Average
		Balances				Expense				Rate				Balances				Expense				Rate
ASSETS:
Loans
Taxable		$	397,433			$	6,806				6.78	%		$	343,860			$	5,659				6.52	%
Tax-exempt (1)			8,390				151				7.10	%			7,167				130				7.16	%
Nonaccrual			1,114				—								177				—
Total Loans			406,937				6,957				6.77	%			351,204				5,789				6.53	%
Securities
Taxable			42,322				470				4.45	%			52,953				542				4.10	%
Tax-exempt (1)			1,016				20				7.75	%			1,018				20				7.77	%
Total securities			43,338				490				4.52	%			53,971				562				4.17	%
Deposits in banks			622				6				4.01	%			263				2				1.97	%
Federal funds sold			397				3				2.75	%			4,321				30				2.78	%
Total earning assets			451,294				7,456				6.55	%			409,759				6,383				6.18	%
Less: Reserve for loan losses			(4,369	)											(4,232	)
Cash and due from banks			16,368												17,263
Bank premises and equipment, net			8,136												8,426
Other assets			14,823												15,366
Total Assets		$	486,252											$	446,582
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Deposits
Demand deposits		$	90,285											$	86,020
Interest-bearing deposits
NOW accounts			66,620				85				0.47	%			103,930				246				0.95	%
Money market accounts			38,634				133				1.38	%			57,095				179				1.26	%
Premium money market accounts			50,522				489				3.88	%			1,574				12				3.00	%
Savings accounts			38,612				33				0.34	%			43,138				36				0.33	%
Time deposits			115,328				1,114				3.88	%			95,010				731				3.08	%
Total interest-bearing deposits			309,716				1,854				2.39	%			300,747				1,204				1.60	%
Federal funds purchased and securities sold under agreements to repurchase			12,071				167				5.46	%			220				1				2.66	%
Federal Home Loan Bank advances			30,176				395				5.17	%			20,473				219				4.22	%
Capital Securities of Subsidiary Trust			4,124				87				8.35	%			4,124				68				6.51	%
Total interest-bearing liabilities			356,087				2,503				2.80	%			325,564				1,492				1.83	%
Other liabilities			2,656												1,859
Shareholders’ equity			37,224												33,139
Total Liabilities & Shareholders’ Equity		$	486,252											$	446,582
Net interest spread						$	4,953				3.75	%						$	4,891				4.35	%
Interest expense as a percent of average earning assets											2.21	%											1.46	%
Net interest margin											4.34	%											4.72	%

RATE/VOLUME ANALYSIS

The following table sets forth certain information regarding changes in interest income and interest expense of the Company for the three-month periods ended June 30, 2006 and 2005. 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 the prior period rate); and changes in rate (change in rate multiplied by the prior period volume). Changes which cannot be separately identified are allocated proportionately between changes in volume and changes in rate.

RATE / VOLUME VARIANCE
(In Thousands)

		Three Months Ended June 30,
		2006 Compared to
		Three Months Ended June 30, 2005
						Due to				Due to
		Change				Volume				Rate
INTEREST INCOME
Loans; taxable		$	1,147			$	890			$	257
Loans; tax-exempt (1)			21				22				(1	)
Securities; taxable			(72	)			(105	)			33
Securities; tax-exempt (1)			—				—				—
Deposits in banks			5				2				3
Federal funds sold			(27	)			(27	)			—
Total Interest Income			1,074				782				292
INTEREST EXPENSE
NOW accounts			(168	)			(59	)			(109	)
Money market accounts			(46	)			(57	)			11
Premium money market accounts			477				391				86
Savings accounts			(3	)			(4	)			1
Time deposits			384				178				206
Federal funds purchased and securities sold under agreements to repurchase			165				98				67
Federal Home Loan Bank Advances			176				112				64
Capital Securities of Subsidiary Trust			19				—				19
Total Interest Expense			1,004				659				345
Net Interest Income		$	70			$	123			$	(53	)