BANK OF THE JAMES FINANCIAL GROUP INC - Quarter Report: 2007 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2007

BANK OF THE JAMES FINANCIAL GROUP, INC.

(Name of Registrant as Specified in Its Charter)

(434) 846-2000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section13 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.    x  Yes    ¨  No

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. (Check one):

Large Accelerated Filer  ¨    Accelerated Filer  ¨    Non-Accelerated Filer  x

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

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 2,558,578 shares of Common Stock, par value $2.14 per share, were outstanding at November 14, 2007.

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PART I – FINANCIAL INFORMATION

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

As of September 30, 2007 and December 31, 2006

(dollar amounts in thousands, except per share amounts)

See accompanying notes to these consolidated financial statements

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Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statement of Operations

For the Three and Nine Months Ended September 30, 2007 and 2006

(dollar amounts in thousands, except per share amounts) (unaudited)

See accompanying notes to these consolidated financial statements

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Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

For the Nine months Ended September 30, 2007 and 2006

(dollar amount in thousands, except per share amounts) (unaudited)

See accompanying notes to these consolidated financial statements

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Note 1 – Basis of Presentation

The unaudited consolidated financial statements have been prepared by Bank of the James Financial Group, Inc. (“Financial” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission. In management’s opinion the accompanying financial statements, which unless otherwise noted are unaudited, reflect all adjustments, consisting solely of normal recurring accruals, necessary for a fair presentation of the financial information as of and for the three and nine month periods ended September 30, 2007, in conformity with accounting principles generally accepted in the United States of America. Additional information concerning the organization and business of Financial, accounting policies followed, and other related information are contained in Financial’s Annual Report on Form 10-KSB for the year ended December 31, 2006. These financial statements should be read in conjunction with the audited consolidated financial statements and footnotes for the year ended December 31, 2006 included in Financial’s Annual Report on Form 10-KSB. Results for the three and nine month periods ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.

Financial’s critical accounting policy relates to the evaluation of the allowance for loan losses which is based on management’s opinion of an amount that is adequate to absorb loss in the existing portfolio of Bank of the James (the “Bank”), Financial’s wholly-owned subsidiary. The allowance for loan loss is established through a provision for loan loss based on available information including the composition of the loan portfolio, historical loan loss (to the extent available due to limited history), specific impaired loans, availability and quality of collateral, age of the various portfolios, changes in local economic conditions, and loan performance and quality of the portfolio. Different assumptions used in evaluating the adequacy of the Bank’s allowance for loan loss could result in material changes in Financial’s financial condition and results of operations. The Bank’s policies with respect to the methodology for determining the allowance for loan loss involve a higher degree of complexity and require management to make subjective judgments that often require assumptions or estimates about uncertain matters. These critical policies and their assumptions are periodically reviewed with the Board of Directors.

Note 2 – Use of Estimates

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Note 3 – Earnings Per Share

For the quarters ended September 30, 2007 and 2006, basic earnings per share has been computed based upon the weighted average common shares outstanding of 2,557,396 and 2,218,685, respectively. All earnings per share amounts have been adjusted to reflect the 10% stock declared by Financial in May 2007 and paid in July 2007 as well as all prior stock dividends.

Currently, only the option shares granted to officers and employees of Financial pursuant to the Amended and Restated Stock Option Plan of Financial are considered dilutive under the provisions of Statement of Financial Accounting Standards No. 128, “Earnings Per Share.” The following is a summary of the earnings per share calculation for the three and nine months ended September 30, 2007 and 2006.

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Note 4 – Stock Based Compensation

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment” (SFAS 123R). SFAS 123R requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant and eliminates the choice to account for employee stock options under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). The Company adopted SFAS 123R effective January 1, 2006 using the modified prospective method and as such, results for prior periods have not been restated. Prior to January 1, 2006, no compensation expense was recognized by the Company for stock option grants as all such grants had an exercise price not less than fair market value on the date of grant. The Company has not issued any restricted stock.

As a result of adopting SFAS 123R on January 1, 2006, the amount of stock-based compensation included within the non-interest expense category for the nine months ended September 30, 2007 and 2006 is $9,000 and 78,000, respectively.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for the three month period ended September 30, 2007: dividend yield of 0%, expected volatility of 40%, a risk-free interest rate of 4.75%, and expected lives of 7 years.

During 2006, the Company took into consideration guidance under SFAS 123R and SEC Staff Accounting Bulletin No. 107 (SAB 107) when reviewing and updating assumptions.

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Stock option plan activity for the nine months ended September 30, 2007 is summarized below:

Stock Option Disclosure 2007

The total approximate value of in-the-money options exercised during the first nine months ended September 30, 2007 was $251,268. As of September 30, 2007 there was approximately $5,752 of total unrecognized compensation expense related to non vested option awards which will be recognized over the remaining service period.

Note 5 – Stock Dividend

On May 15, 2007, the Board of Directors of the Company declared a 10% stock dividend. The stock dividend was paid on July 24, 2007 to shareholders of record June 19, 2007. Following the stock dividend, the number of outstanding shares increased from 2,323,852 to 2,566,266. The dividend required a reclassification of retained earnings effective May 15, 2007 in the amount of $4,008,000. Of this amount, $491,000 was reclassified as common stock and $3,517,000 was reclassified as additional paid-in-capital. The reclassification did not change total stockholders’ equity.

Note 6 – Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements but may change current practice for some entities. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The Company does not expect the implementation of SFAS 157 to have a material impact on its consolidated financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective of this statement is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The fair value option established by this statement permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument and is irrevocable. SFAS 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company is in the process of evaluating the impact SFAS 159 may have on its consolidated financial statements.

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains statements that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and the Private Securities Litigation Reform Act of 1995. The words “believe,” “estimate,” “expect,” “intend,” “anticipate,” “plan” and similar expressions and variations thereof identify certain of such forward-looking statements which speak only as of the dates on which they were made. Bank of the James Financial Group, Inc. undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Readers are cautioned that any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results may differ materially from those indicated in the forward-looking statements as a result of various factors. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which we operate); competition for our customers from other providers of financial services; government legislation and regulation (which changes from time to time and over which we have no control); changes in the value of real estate securing loans made by the Bank; changes in interest rates; and material unforeseen changes in the liquidity, results of operations, or financial condition of our customers. Other risks, uncertainties and factors could cause our actual results to differ materially from those projected in any forward-looking statements we make.

GENERAL

Critical Accounting Policies

Bank of the James Financial Group, Inc.’s (“Financial”) 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 ratios 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 estimating risk. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

The allowance for loan losses is management’s estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and are reasonably estimable and (ii) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses on impaired loans 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. Guidelines for determining allowances for loan losses are also provided in the SEC Staff Accounting Bulletin No. 102 – “Selected Loan Loss Allowance Methodology and Documentation Issues” and the Federal Financial Institutions Examination Council’s interagency guidance, “Interagency Policy Statement on the Allowance for Loan and Lease Losses” (the “FFIEC Policy Statement”). See “Management Discussion and Analysis Results of Operations – Allowance for Loan Losses and Loan Loss Reserve” below for further discussion of the allowance for loan losses.

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Overview

Financial is a bank holding company with its headquarters in Lynchburg, Virginia. Financial was incorporated at the direction of Bank of the James (the “Bank”) on October 3, 2003 to serve as a bank holding company of the Bank. Financial had no business until January 1, 2004 when it acquired the common stock of the Bank through a statutory share exchange on a one-for-one basis. In addition to the Bank, Financial wholly-owns BOTJ Investment Group, Inc. (“Investment Group”) through which we offer brokerage, fixed and variable annuity products, and related services to the public through a third party broker-dealer. These two businesses are our only subsidiaries and primary assets. Financial conducts its business through the following three business segments: community banking through the Bank, mortgage origination through the Mortgage Division of the Bank, and securities brokerage services through Investment Group.

Financial declared a 25% stock dividend on January 17, 2006 which was paid on March 10, 2006. Financial declared a 10% stock dividend on May 15, 2007 which was paid on July 24, 2007.

The Bank is a Virginia banking corporation headquartered in Lynchburg, Virginia. The Bank was incorporated under the laws of the Commonwealth of Virginia as a state chartered bank in 1998 and began banking operations in July 1999. The Bank was organized to engage in general retail and commercial banking business. The Bank is a community-oriented financial institution that provides varied banking services to individuals, small and medium-sized businesses, and professional concerns in the Central Virginia, Region 2000 area, which encompasses the following seven jurisdictions in Central Virginia: the Town of Altavista, Amherst County, Appomattox County, the City of Bedford, Bedford County, Campbell County, and the City of Lynchburg. The Bank strives to provide its customers with products comparable to statewide regional banks located in its market area, while maintaining the prompt response time and level of service of a community bank. Management believes this operating strategy has particular appeal in the Bank’s market area.

The Bank was organized in part as a response to the loss of many of the Central Virginia, Region 2000 area’s local financial institutions through mergers with larger, non-local banks and bank holding companies. The organizers perceived that local customers who once relied on experienced personal attention were being forced to use 800 numbers, computerized menus, and persons in other localities who were not familiar with their needs.

The Bank opened for business on July 22, 1999 to fill this void left in the Region 2000 market. The Bank’s organizers recognized that an opportunity existed to create a banking institution designed exclusively for a market that expected personalized service. The idea was to build a financial institution staffed with experienced professionals who would place a high value on knowing their customers and serving their distinctive banking needs.

The Bank was capitalized by more than 2,400 shareholders that wanted a new local bank. These investors provided the initial customer base and are integral to the success of the Bank. Management believes that the key to the Bank’s success lies in providing Bank customers with personalized service while providing products and services that meet their banking needs.

The Bank’s principal office is located at 828 Main Street, Lynchburg, Virginia 24504 and its telephone number is (434) 846-2000. The Bank also maintains a website at www.bankofthejames.com.

Investment Group was incorporated under the laws of the Commonwealth of Virginia in 2006. Effective April 4, 2006, Investment Group began providing securities brokerage services to Bank customers and others. Investment Group provides the Services through an agreement with Community Bankers’ Securities, LLC (“CB Securities”), a registered broker-dealer. Under

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this agreement, CB Securities will operate service centers in one or more branches of the Bank. As of the date hereof, Investment Group’s only center is located in the Church Street office. All centers will be staffed by a dual employee of Investment Group and CB Securities. Investment Group receives commissions on transactions generated and in some cases ongoing management fees such as mutual fund 12b-1 fees. As of the date hereof, Investment Group has been conducting business for approximately nineteen months and its financial impact on the consolidated financials of the Company has been immaterial. In addition, Investment Group has purchased 4.96% of CBS Holdings, LLC for $10,000. CBS Holdings has an option to purchase CB Securities.

Our operating results depend primarily upon the Bank’s net interest income, which is determined by the difference between (i) interest and dividend income on earning assets, which consist primarily of loans, investment securities and other investments and (ii) interest expense on interest-bearing liabilities, which consist principally of deposits and other borrowings. The Bank’s net income also is affected by its provision for loan losses, as well as the level of its non-interest income, including loan fees and service charges, and its non-interest expenses, including salaries and employee benefits, occupancy expense, data processing expenses, Federal Deposit Insurance Corporation premiums, expense (both direct and indirect) in complying with the Sarbanes-Oxley Act of 2002, miscellaneous other expenses, franchise taxes, and income taxes.

The Bank intends to enhance its profitability by increasing its market share in the Region 2000 area, providing additional services to its customers, and controlling costs.

The Bank currently serves its customers through the following seven full service offices: the main office located at 828 Main Street in Lynchburg (opened October 2004) (the “Main Street Office”), a branch located at 615 Church Street in Lynchburg (opened July 1999), a branch located at 5204 Fort Avenue in Lynchburg (the “Fort Avenue Branch”) (opened November 2000), a branch located on South Amherst Highway in Amherst County (the “Madison Heights Branch”) (opened June 2002), a branch located at 17000 Forest Road in Forest (the “Forest Branch”) (opened February 2005), a branch located at 4935 Boonsboro Road, Suites C and D in Lynchburg (the “Boonsboro Branch”) (opened April 2006), and a branch located at 164 South Main Street, Amherst, Virginia (the “Amherst Branch”) (opened January 2007). In addition, the Bank, through its mortgage division, originates residential mortgage loans through two offices—one located at the Forest Branch and the other located at 14662 Moneta Rd., Suite A in Moneta (opened July 2005).

The Bank continuously evaluates areas located within Region 2000 to identify additional viable branch locations. Based on this ongoing evaluation, the Bank may acquire one or more additional suitable sites.

Subject to regulatory approval, the Bank anticipates opening additional branches during the next two fiscal years. Although numerous factors could influence the Bank’s expansion plans, the following discussion provides a general overview of the additional branch locations that the Bank currently is considering.

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The Bank estimates that the cost of improvements, furniture, fixtures, and equipment necessary to upfit these properties will be between $900,000 and $1,500,000 per location.

Although the Bank cannot predict with certainty the financial impact of each new branch, management generally anticipates that each new branch will become profitable within 12 to 18 months of operation.

Except as set forth herein, the Bank does not expect to purchase any significant property or equipment in the upcoming 12 months. Future branch openings are subject to regulatory approval.

OFF-BALANCE SHEET ARRANGEMENTS

The Bank is a party to various financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amount recognized in the balance sheets and could impact the overall liquidity and capital resources to the extent customers accept and or use these commitments.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. A summary of the Bank’s commitments is as follows (dollar amounts in thousands):

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Because many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on the Bank’s credit evaluation of the customer.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. Collateral is required in instances that the Bank deems necessary.

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SUMMARY OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion represents management’s discussion and analysis of the financial condition and results of operations of Financial as of September 30, 2007 and December 31, 2006 and for the three and nine months ended September 30, 2007 and 2006. It should be read in conjunction with the financial statements included elsewhere herein.

The comparison of the financial condition and operating results between September 30, 2007 and December 31, 2006, as applicable, should be read in the context of the length of time for which the Bank has been operating.

All financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.

Financial Condition

September 30, 2007 as Compared to December 31, 2006

Total assets were $261,745,000 on September 30, 2007 compared with $232,709,000 at December 31, 2006. The increase in total assets is due in part to an increase in deposits. Deposits increased in the first two quarters of 2007 in part due to an increase in rates (as a result of the competitive pressures of the market) that the Bank offers on its deposit products and the Bank’s reputation for service. Deposits increased in the third quarter due in large part to the Bank’s sales efforts throughout Region 2000. New deposits at the recently opened Boonsboro Branch and Amherst Branch as well as the continued growth of our Fort Avenue Branch and Main Street Office contributed to this increase in deposits.

Total deposits grew from $201,789,000 for the year ended December 31, 2006 to $223,330,000 on September 30, 2007, an increase of 10.68%. In addition, the Bank’s effort to increase non-FDIC insured sweep accounts (repurchase agreements) resulted in an increase in the balance in these accounts to $12,796,000 on September 30, 2007 from $8,450,000 on December 31, 2006.

Loans, net of unearned income and allowance, increased to $215,287,000 on September 30, 2007 from $187,469,000 on December 31, 2006. Total loans increased to $217,457,000 on September 30, 2007 from $189,560,000 on December 31, 2006. The following summarizes the position of the Bank’s loan portfolio as of the dates indicated by dollar amount and percentages (dollar amounts in thousands):

Non-accrual loans increased to $1,016,000 on September 30, 2007 from $646,000 on December 31, 2006. Management has provided for the anticipated losses on these loans in the loan loss reserve and does not anticipate that they will have a material impact on the financial condition of the Bank. Early in the quarter ended September 30, 2007, the Bank sold an other real estate owned (OREO) property for a net of $477,000 (which resulted in a loss of $58,000). At the end of the three months ended September 30,

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2007, the market value of other real estate owned, which consisted of two single family residences purchased after default by the borrower, was $500,000. The Bank currently is trying to sell these properties. The Bank anticipates that any losses on the sale of these properties will not have a material impact on the Bank’s financial condition.

Cash and cash equivalents decreased to $6,717,000 on September 30, 2007 from $9,876,000 on December 31, 2006. Cash and cash equivalents consist of cash due from correspondents, cash in vault, and overnight borrowings (including federal funds sold). The decrease was due in large part to the Bank’s liquidation of federal funds sold needed to fund loans. In addition, this decrease is due in part to routine fluctuations in deposits, including fluctuations in transactional accounts and professional settlement accounts, both of which are subject to fluctuations, and will contribute to variations in cash and cash equivalents.

Securities held-to-maturity decreased to $6,494,000 on September 30, 2007 from $7,494,000 on December 31, 2006, which resulted from the call of a security prior to maturity. Securities available-for-sale increased to $23,278,000 on September 30, 2007 from $18,698,000 on December 31, 2006. This increase resulted from the investment of surplus cash in fixed income securities.

The following table summarizes the Bank’s holdings for both securities held-to-maturity and securities available-for-sale as of September 30, 2007 and December 31, 2006 (amounts in thousands):

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The following table shows the gross unrealized losses and fair value of the Bank’s investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at the date indicated:

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and may do so more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of Financial to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

At September 30, 2007, the Company does not consider the unrealized losses as other-than-temporary losses due to the nature of the securities involved. The securities consist of 20 bonds. Nineteen of these bonds are S&P rated AAA and one corporate bond is S&P rated A. Of these bonds 15 are indirectly backed by the U.S. Government, four are municipal bank-qualified issues, and one is issued by a publicly traded United States corporation. For these reasons, management believes the default risk to be minimal. As management has the ability to hold securities until maturity, or for the foreseeable future if classified as available-for-sale, no declines are deemed to be other than temporary

At September 30, 2007, Financial had liquid assets of approximately $29,995,000 in the form of cash and available-for-sale investments. Management believes that liquid assets were adequate at September 30, 2007. Management anticipates that additional liquidity will be provided by the growth in deposit accounts and loan repayments at the Bank. In addition, the Bank has the ability to purchase federal funds on the open market and borrow from the Federal Reserve Bank’s discount window, if necessary.

Management is not aware of any trends, events or uncertainties that are reasonably likely to have a material negative impact on Financial’s short-term or long-term liquidity.

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At September 30, 2007, the Bank had a leverage ratio of 9.20%, a Tier 1 capital to average total assets ratio of 11.07% and a total risk-based capital ratio of 12.10%. As of September 30, 2007 and December 31, 2006 the Bank’s regulatory capital levels exceeded those established for well-capitalized institutions. The following table sets forth the minimum capital requirements and the Bank’s capital position as of September 30, 2007 and December 31, 2006 (dollar amounts in thousands):

The increase in each of the above ratios was due in large part to the increase in capital resulting from the receipt of proceeds from the stock offering that closed in December 2006.

The capital ratios for the Company on a consolidated basis are comparable to the capital ratios of the Bank set forth above.

Results of Operations

Comparison of the Three and Nine Months Ended September 30, 2007 and 2006

Earnings Summary

Net income for the three and nine months ended September 30, 2007 was $581,000 and $1,477,000, respectively, compared to a net income of $416,000 and $1,200,000 for the same periods in 2006. Net income increased in large part due to an increase in non-interest income and an increase in total earning assets.

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Basic earnings per common share for the three and nine months ended September 30, 2007 were $0.23 and $0.58, respectively, compared with $0.19 and $0.54 for the same periods in 2006. Fully diluted earnings per common share for the three and nine months ended September 30, 2007 were $0.22 and $0.55 compared with $0.18 and $0.51 for the same period in 2006. All earnings per share amounts have been adjusted to reflect 10% stock dividend paid by Financial on July 24, 2007, as well as all prior stock dividends. Although Financial’s net income increased, earnings per share were diluted by the increased number of shares outstanding resulting from the stock offer that concluded at the end of December, 2006.

These operating results represent an annualized return on stockholders’ equity of 10.01% and 8.75% for the three months and nine months ended September 30, 2007 compared with 10.55% and 10.51% for the same periods in 2006. The decreases in the annualized return on stockholders’ equity were due in large part to increase in equity resulting from the proceeds of the stock offering that closed in December 2006. The annualized return on average assets for the three and nine months ended September 30, 2007 was 0.91% and 0.81%, respectively, compared with 0.78% and 0.79% for the same periods in 2006.

Interest Income; Interest Expense; and Net Interest Income

Interest income increased to $4,581,000 and $12,972,000 for the three and nine months ended September 30, 2007 from $3,786,000 and $10,675,000 for the same periods in 2006, an increase of 21.00% and 21.52%, respectively. These increases were due to an increase in interest earning assets, including loans and investment securities.

Interest expense increased to $2,049,000 and $5,733,000 for the three and nine months ended September 30, 2007 from $1,521,000 and $4,049,000, respectively, for the same periods in 2006, an increase of 34.71% and 41.59%, respectively. These increases in interest expense were primarily due to both an increase in the aggregate balance in interest bearing deposit accounts and a shift in the mix of the Bank’s deposits from transactional accounts to higher yielding certificates of deposit. In addition, interest expense increased in part because many customers reinvest the proceeds of maturing certificates of deposit at the prevailing higher interest rates.

The fundamental source of the Bank’s revenue is net interest income, which is determined by the difference between (i) interest and dividend income on interest earning assets, which consist primarily of loans, investment securities and other investments, and (ii) interest expense on interest-bearing liabilities, which consist principally of deposits and other borrowings. Net interest income for the three and nine months ended September 30, 2007 was $2,532,000 and $7,239,000 respectively, compared with $2,265,000 and $6,626,000 for the same period in 2006. The growth in net interest income for the three and nine months ended September 30, 2007 as compared with the comparable three and nine months in 2006 was due to the increase in average interest-earning assets, which was the result of growth in the loan portfolio funded by the growth in deposits. The net interest margin decreased to 4.17% and 4.20% for the three and nine months ended September 30, 2007, respectively, from 4.51% and 4.62% in the same periods a year ago. During the first two quarters of 2007, the Bank increased the rates that it pays on deposit accounts in response to competition and this contributed to the decrease in the net interest margin. The increased rates remained in effect until the end of the third quarter when, in response to rate cuts by the Federal Open Market Committee, the Bank lowered the rates that it pays on transactional deposit accounts.

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Financial’s net interest margin analysis and average balance sheets are shown in Schedule I on page 18.

Non-Interest Income

Non-interest income, which is comprised primarily of fees and charges on transactional deposit accounts, mortgage loan origination fees, commissions on sales of investment products (since April, 2006), and the Bank’s ownership interest in a title insurance agency, increased to $654,000 and $1,985,000 for the three and nine month periods ended September 30, 2007, respectively, from $649,000 and $1,637,000 for the comparable periods in 2006. This 0.77% and 21.26% increase was due in large part to income generated by Investment Group, which began operations in the second quarter of 2006, as well as income generated by the Bank’s Mortgage Division. We anticipate that Investment Group will continue to contribute additional non-interest income in the remainder of 2007.

The Bank, through Bank of the James Mortgage, a Division of Bank of the James (the “Mortgage Division”) originates both conforming and non-conforming consumer residential mortgage loans in the Region 2000 area. As part of the Bank’s overall risk management strategy, all of the loans originated and closed by the Mortgage Division are presold to major national mortgage banking or financial institutions. The Mortgage Division assumes no credit or interest rate risk on these mortgages. In July, 2005, the Mortgage Division opened its second mortgage origination office. This office is located in Moneta and was opened to serve the Smith Mountain Lake market. The Bank anticipates that this office will contribute additional non-interest income during 2007.

Non-Interest Expense

Non-interest expense for the three and nine months ended September 30, 2007 increased to $2,188,000 and $6,621,000, respectively, from $2,087,000 and $5,918,000 for the comparable periods in 2006. These increases of 4.84% and 11.88%, respectively, in non-interest expense can be attributed to increased occupancy expenses, along with an increase in compensation expense related to an increase in the number of employees necessary to accommodate the Bank’s growth and expansion.

Total personnel expense increased to $1,160,000 and $3,551,000 for the three and nine month periods ended September 30, 2007, from $1,124,000 and $3,049,000 for the comparable periods in 2006. Compensation for some employees of the Mortgage Division and Investment Group is commission-based and therefore subject to fluctuation. The Bank also had increases in occupancy expense, credit expense, depreciation expense, data processing fees, and other operating expenses, all of which are related to the growth of the Bank.

Allowance for Loan Losses

The provision for loan losses is charged to earnings to bring the total allowance to a level deemed appropriate by management and is based upon many factors, including calculations of specific impairment of certain loans, general economic conditions, actual and expected credit losses, loan performance measures, historical trends and specific conditions of the individual borrower. Based on the application of the loan loss calculation, the Bank provided $59,000 and $304,000 to the allowance for loan loss for the three and nine months ended September 30, 2007, respectively, compared to a provisions of $184,000 and $489,000 for the comparable periods in 2006. Management believes that the current allowance for loan loss of $2,170,000 (or 1.00% of total loans) at September 30, 2007 is adequate.

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The following sets forth the reconciliation of the allowance for loan loss (dollar amounts in thousands):

Income Taxes

For the three and nine months September 30, 2007, Financial had an income tax expense of $300,000 and $764,000.

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Schedule I

Net Interest Margin Analysis

Average Balance Sheets

For the Quarters Ended September 30, 2007 and 2006

(dollar amounts in thousands)