POTOMAC BANCSHARES INC - Quarter Report: 2005 September (Form 10-Q)

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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, 2005

Commission file number 0-24958

POTOMAC BANCSHARES, INC.

(Exact Name of Registrant as Specified in Its Charter)

West Virginia

55-0732247

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification No.)

111 East Washington Street

PO Box 906

Charles Town WV 25414

(Address of Principal Executive Offices) (Zip Code)

304-725-8431

(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 ¨

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

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

As of November 7, 2005, Potomac Bancshares, Inc. had 3,393,122 shares of common stock outstanding.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY

FORM 10-Q

September 30, 2005

INDEX


		PAGE
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements.

	Consolidated Balance Sheets as of September 30, 2005 (Unaudited) and December 31, 2004 (Audited)	3

	Consolidated Statements of Income (Unaudited) for the Three Months Ended September 30, 2005 and 2004 and for the Nine Months Ended September 30, 2005 and 2004	4

	Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) for the Nine Months Ended September 30, 2005 and 2004	5

	Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2005 and 2004	6

	Notes to Consolidated Financial Statements September 30, 2005 (Unaudited) and December 31, 2004 (Audited)	7 -11

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations.	11-15

Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	15 -16

Item 4.	Controls and Procedures.	16

Part II.	OTHER INFORMATION

Item 1.	Legal Proceedings.	16

Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.	17

Item 5.	Other Information.	17

Item 6.	Exhibits.	17

Signatures		18

FORWARD-LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 evidences Congress’ determination that the disclosure of forward-looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward-looking statements by corporate management. This Form 10Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements that involve risk and uncertainty. “Forward-looking statements” are easily identified by the use of words such as “could,” “anticipate,” “estimate,” “believe,” and similar words that refer to a future outlook. To comply with the terms of the safe harbor, the company notes that a variety of factors could cause the company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the company’s forward-looking statements.

The risks and uncertainties that may affect the operations, performance, development and results of the company’s business include, but are not limited to, the growth of the economy, interest rate movements, the impact of competitive products, services and pricing, customer business requirements, Congressional legislation and similar matters. We caution readers of this report not to place undue reliance on forward-looking statements which are subject to influence by the named risk factors and unanticipated future events. Actual results, accordingly, may differ materially from management expectations.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

POTOMAC BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(in thousands)


	(Unaudited)
	September 30 2005			December 31 2004
Assets:
Cash and due from banks	$	7 483		$	11 371
Interest-bearing deposits in financial institutions		513			794
Securities purchased under agreements to resell and federal funds sold		120			6
Securities available for sale, at fair value		46 946			47 339
Loans held for sale		125			148
Loans, net of allowance for loan losses of $2,205 and $1,966 respectively		207 089			177 039
Bank premises and equipment, net		5 957			5 787
Accrued interest receivable		1 106			913
Other assets		6 359			5 139

Total Assets	$	275 698		$	248 536

Liabilities and Stockholders’ Equity:
Liabilities:
Deposits
Noninterest-bearing deposits	$	36 105		$	34 236
Interest-bearing deposits		195 056			166 315

Total Deposits		231 161			200 551
Accrued interest payable		296			180
Securities sold under agreements to repurchase and federal funds purchased		17 587			17 577
Federal Home Loan Bank advances		1 098			6 370
Other liabilities		1 064			1 102

Total Liabilities	$	251 206		$	225 780

Stockholders’ Equity:
Common stock, $1 per share par value; 5,000,000 shares authorized; issued, 2005, 3,600,000 shares; 2004, 1,800,000 shares	$	3 600		$	1 800
Surplus		2 400			4 200
Undivided profits		20 656			18 631
Accumulated other comprehensive (loss), net		(314	)		(25	)

	$	26 342		$	24 606
Less cost of shares acquired for the treasury, 2005, 206,878 shares; 2004, 103,439 shares		1 850			1 850

Total Stockholders’ Equity	$	24 492		$	22 756

Total Liabilities and Stockholders’ Equity	$	275 698		$	248 536

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(in thousands except per share data)

(Unaudited)


	For the Three Months Ended September 30					For the Nine Months Ended September 30
	2005		2004			2005		2004
Interest and Dividend Income:
Interest and fees on loans	$	3 595	$	2 688		$	9 920	$	7 486
Interest on securities held to maturity - taxable		—		—			—		35
Interest on securities available for sale - taxable		380		402			1 115		1 163
Interest on securities available for sale – nontaxable		13		2			39		2
Interest on securities purchased under agreements to resell and federal funds sold		26		2			31		29
Other interest and dividends		39		2			72		6

Total Interest and Dividend Income	$	4 053	$	3 096		$	11 177	$	8 721

Interest Expense:
Interest on deposits	$	966	$	539		$	2 332	$	1 510
Interest on securities sold under agreements to repurchase and federal funds purchased		138		60			345		151
Federal Home Loan Bank advances		36		21			157		66

Total Interest Expense	$	1 140	$	620		$	2 834	$	1 727

Net Interest Income	$	2 913	$	2 476		$	8 343	$	6 994

Provision for Loan Losses		134		131			311		264

Net Interest Income after Provision for Loan Losses	$	2 779	$	2 345		$	8 032	$	6 730

Noninterest Income:
Trust and financial services	$	272	$	211		$	746	$	610
Service charges on deposit accounts		417		389			1 169		1 114
BCT Visa/MC Fees		72		48			195		126
(Loss) on sale of securities available for sale		—		(28	)		—		(26	)
Net gain on sale of loans		64		46			146		119
Other operating income		130		138			385		372

Total Noninterest Income	$	955	$	804			2 641	$	2 315

Noninterest Expenses:
Salaries and employee benefits	$	1 132	$	1 044		$	3 242	$	2 996
Net occupancy expense of premises		124		103			348		300
Furniture and equipment expenses		248		229			714		642
Advertising and marketing		74		65			192		147
Auditing and accounting expense		45		31			151		50
Communications		38		37			112		111
Postage		38		37			105		112
ATM and check card expenses		67		51			185		143
Other operating expenses		422		372			1 150		1 036

Total Noninterest Expenses	$	2 188	$	1 969		$	6 199	$	5 537

Income before Income Tax Expense	$	1 546	$	1 180		$	4 474	$	3 508
Income Tax Expense		572		432			1 609		1 243

Net Income	$	974	$	748		$	2 865	$	2 265

Earnings Per Share, basic	$	.29	$	.22		$	.84	$	.67

Earnings Per Share, diluted	$	.29	$	.22		$	.84	$	.67

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004

(in thousands)

(Unaudited)


	Common Stock		Surplus			Undivided Profits			Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Comprehensive Income			Total
Balances, December 31, 2003	$	1 800	$	4 200		$	16 543		$	(1 708	)	$	498					$	21 333

Comprehensive income
Net income		—		—			2 265			—			—		$	2 265			2 265
Other comprehensive (loss): unrealized holding (losses) arising during the period (net of tax, $179)		—		—			—			—			(347	)		(347	)		(347	)
Reclassification for losses included in net income (net of tax, $9)		—		—			—			—			17			17			17

Total comprehensive income															$	1 935

Cash dividends ($.22 per share)		—		—			(738	)		—			—						(738	)

Purchase of common stock for the treasury		—		—			—			(142	)		—						(142	)

Balances, September 30, 2004	$	1 800	$	4 200		$	18 070		$	(1 850	)	$	168					$	22 388

Balances, December 31, 2004	$	1 800	$	4 200		$	18 631		$	(1 850	)	$	(25	)				$	22 756

Comprehensive income
Net income		—		—			2 865			—			—		$	2 865			2 865
Other comprehensive (loss): unrealized holding (losses) arising during the period (net of tax, $149)		—		—			—			—			(289	)		(289	)		(289	)

Total comprehensive income															$	2 576

Cash dividends ($.25 per share)		—		—			(840	)		—			—						(840	)

Stock split in the form of a 100% stock dividend		1 800		(1 800	)		—			—			—						—

Balances, September 30, 2005	$	3 600	$	2 400		$	20 656		$	(1 850	)	$	(314	)				$	24 492

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)


	For the Nine Months Ended
	September 2005			September 2004
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	2 865		$	2 265
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		311			264
Depreciation		499			447
Discount accretion and premium amortization on securities, net		62			78
Loss on sale of securities available for sale		—			26
Proceeds from sale of loans		8 046			6 536
Origination of loans for sale		(8 023	)		(6 466	)
Changes in assets and liabilities:
(Increase) in accrued interest receivable		(193	)		(5	)
(Increase) in other assets		(1 071	)		(173	)
Increase in accrued interest payable		116			61
Increase (decrease) in other liabilities		(38	)		61

Net cash provided by operating activities	$	2 574		$	3 094

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from maturity of securities held to maturity	$	—		$	6 000
Proceeds from maturity of securities available for sale		9 000			1 000
Proceeds from sale of securities available for sale		300			8 974
Proceeds from call of securities available for sale		—			5 000
Purchase of securities available for sale		(9 407	)		(24 019	)
Net (increase) in loans		(30 361	)		(25 002	)
Purchases of bank premises and equipment		(669	)		(724	)

Net cash (used in) investing activities	$	(31 137	)	$	(28 771	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in noninterest-bearing deposits	$	1 869		$	7 462
Net increase in interest-bearing deposits		28 741			17 755
Net proceeds of securities sold under agreements to repurchase and federal funds sold		10			451
Net (repayment) of Federal Home Loan Bank advances		(5 272	)		(257	)
Purchase of treasury shares		—			(142	)
Cash dividends		(840	)		(738	)

Net cash provided by financing activities	$	24 508		$	24 531

Decrease in cash and cash equivalents	$	(4 055	)	$	(1 146	)

CASH AND CASH EQUIVALENTS
Beginning		12 171			13 024

Ending	$	8 116		$	11 878

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest	$	2 718		$	1 666

Income taxes	$	1 519		$	1 176

SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES
Unrealized (loss) on securities available for sale	$	(438	)	$	(500	)

See Notes to Consolidated Financial Statements.

POTOMAC BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005 (UNAUDITED) AND DECEMBER 31, 2004

In the opinion of management, the accompanying financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of September 30, 2005, and December 31, 2004, the results of operations for the three months and nine months ended September 30, 2005 and 2004, and cash flows and statements of changes in stockholders’ equity for the nine months ended September 30, 2005 and 2004. The statements should be read in conjunction with Notes to Consolidated Financial Statements included in the Potomac Bancshares, Inc. annual report for the year ended December 31, 2004. The results of operations for the three month and nine month periods ended September 30, 2005 and 2004, are not necessarily indicative of the results to be expected for the full year.

The consolidated financial statements of Potomac Bancshares, Inc. (the company) and its wholly-owned subsidiary, Bank of Charles Town (the bank), include the accounts of both companies. All material intercompany balances and transactions have been eliminated in consolidation.

Certain reclassifications have been made to prior period amounts to conform to the current year presentation.

The 2003 Stock Incentive Plan was approved by stockholders on May 13, 2003 which authorized up to 180,000 shares of common stock to be used in the granting of incentive options to employees and directors. This is the first stock incentive plan adopted by the company. Under the plan, the option price cannot be less than the fair market value of the stock on the date granted. An option’s maximum term is ten years from the date of grant. The company granted 44,982 options in the first quarter of 2005 and 35,988 options in the first quarter of 2004. No options were granted in 2003. Options granted under the plan may be subject to a graded vesting schedule.

The company accounts for the plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based compensation cost is reflected in net income, as all options granted under the plan have an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates 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.


	For the Nine Months Ended
	September 30 2005			September 30 2004
	(dollars in thousands, except per share amounts)
Net income, as reported	$	2 865		$	2 265
Total stock-based compensation expense determined under fair value based method for all awards		(49	)		(30	)

Pro forma net income	$	2 816		$	2 235

Earnings per share:
Basic – as reported	$	0.84		$	.67

Basic – pro forma	$	0.83		$	.66

Diluted – as reported	$	0.84		$	.67

Diluted – pro forma	$	0.83		$	.66

3.	On January 11, 2005 the Board of Directors of Potomac Bancshares, Inc. declared a stock split in the form of a 100% stock dividend payable on March 15, 2005. Shares issued increased from 1,800,000 to 3,600,000. All per share information has been restated for the stock split.

4.	The amortized cost and fair value of securities available for sale as of September 30, 2005 and December 31, 2004 (in thousands) are as follows:


	September 30, 2005
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Obligations of U. S. Government agencies	$	45 948	$	72	$	(544	)	$	45 476
State and municipal obligations		1 474		2		(6	)		1 470

	$	47 422	$	74	$	(550	)	$	46 946

	December 31, 2004
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Obligations of U. S. Government agencies	$	46 069	$	238	$	(283	)	$	46 024
State and municipal obligations		1 307		8		—			1 315

	$	47 376	$	246	$	(283	)	$	47 339

The primary purpose of the investment portfolio is to generate income and meet liquidity needs of the company through readily saleable financial instruments. The portfolio is made up of fixed rate bonds, whose prices move inversely with rates. At the end of any accounting period, the investment portfolio has unrealized gains and losses. The company monitors the portfolio which is subject to liquidity needs, market rate changes and credit risk changes to see if adjustments are needed. The primary concern in a loss situation is the credit quality of the business behind the instrument. The primary cause of impairments is the decline in the prices of the bonds as rates have risen. There are approximately 31 accounts in the consolidated portfolio that have losses. These securities have not suffered credit deterioration and the company has the ability and intent to hold these issues to maturity; therefore, the gross unrealized losses are considered temporary as of September 30, 2005.

The following table summarizes the fair value and gross unrealized losses for securities aggregated by investment category and length of time that individual securities have been in a continuous gross unrealized loss position as of September 30, 2005 and December 31, 2004 (in thousands).


	September 30, 2005
	Less than 12 months					More than 12 months					Total
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
Obligations of U.S. Government agencies	$	15 365	$	(160	)	$	19 091	$	(384	)	$	34 456	$	(544	)
State and municipal obligations		1 273		(6	)		—		—			1 273		(6	)

Total	$	16 638	$	(166	)	$	19 091	$	(384	)	$	35 729	$	(550	)


	December 31, 2004
	Less than 12 months					More than 12 months					Total
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
Obligations of U.S. Government agencies	$	28 750	$	(241	)	$	2 470	$	(42	)	$	31 220	$	(283	)

5.	The loan portfolio, stated at face amount, is composed of the following:


	September 30 2005		December 31 2004
	(in thousands)
Mortgage loans on real estate:
Construction, land development and other land	$	42 197	$	28 929
Secured by farmland		2 659		3 986
Secured by 1-4 family residential		94 146		79 800
Other real estate		46 856		42 759
Commercial and industrial loans (except those secured by real estate)		6 754		5 949
Consumer loans		16 285		17 346
All other loans		397		236

Total loans	$	209 294	$	179 005
Less: allowance for loan losses		2 205		1 966

	$	207 089	$	177 039

6.	The following is a summary of transactions (in thousands) in the allowance for loan losses:


	September 30 2005			September 30 2004
Balance at beginning of period	$	1 966		$	1 724
Provision charged to operating expense		311			264
Recoveries added to the allowance		77			87
Loan losses charged to the allowance		(149	)		(127	)

Balance at end of period	$	2 205		$	1 948

7.	There were no impaired or nonaccrual loans at September 30, 2005 and at December 31, 2004.

8.	Components of net periodic benefit cost for the pension and postretirement benefit plans are shown below:


	Pension Benefits						Postretirement Benefits
	Nine Months Ended						Nine Months Ended
	Sept 30 2005			Sept 30 2004			Sept 30 2005			Sept 30 2004
	(in thousands)						(in thousands)
Components of Net Periodic Benefit Cost
Service cost	$	179		$	120		$	4		$	4
Interest cost		194			233			23			24
Expected return on plan assets		(237	)		(234	)		—			—
Amortization of net (gain) loss		—			—			(2	)		—
Amortization of net obligation at transition		(15	)		(15	)		13			13
Recognized net actuarial loss		—			25			—			—

Net periodic benefit cost	$	121		$	129		$	38		$	41

Employer Contribution

Through the nine months ended September 30, 2005, the company has contributed $347,758 to the pension plan, which is the entire contribution for 2005. The company has made payments of $19,250 for the postretirement benefits plan for the first nine months of 2005 and anticipates remaining payments for 2005 to total $5,775.

9.	Weighted Average Number of Shares Outstanding and Earnings Per Share

The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock. Potential diluted common stock had no effect on earnings per share available to shareholders.


	Nine Months Ended September 30, 2005			Nine Months Ended September 30, 2004
	Average Shares	Per Share Amount		Average Shares	Per Share Amount
Basic earnings per share	3 393 122	$	.84	3 396 250	$	.67
Effect of dilutive securities: Stock options	15 399			1 866
Diluted earnings per share	3 408 521	$	.84	3 398 116	$	.67

Shares outstanding have been restated to reflect the 100% stock dividend discussed in Note 3.

10.	Recent Accounting Pronouncements

In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement No. 154, (“SFAS No. 154”) “Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement”. The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The company does not anticipate this revision will have a material effect on its financial statements.

On December 16, 2004, FASB issued Statement No. 123R (revised 2004), “Share-Based Payment,” (FAS 123R) that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. FAS 123R eliminates the ability to account for share-based compensation transactions using the intrinsic method and requires that such transactions be accounted for using a fair-value-based method and recognized as expense in the consolidated statement of income. The effective date of FAS 123R (as amended by the SEC) is for annual periods beginning after June 15, 2005. The provisions of FAS 123R are not anticipated to have a material effect on the company’s results of operations.

In March 2005, the SEC issued Staff Accounting Bulleting No. 107 (SAB 107). SAB 107 expresses the views of the SEC staff regarding the interaction of FAS 123R and certain SEC rules and regulations and provides the SEC staff’s view regarding the valuation of share-based payment arrangements for public companies. SAB 107 is not anticipated to have a material effect on the company’s results of operations.

In November 2003, the Emerging Issues Task Force (“EITF”) published Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The Task Force discussed the meaning of other-than-temporary impairment and its application to certain investments carried at cost. The Task Force requested that the FASB staff consider other impairment models within U.S. Generally Accepted Accounting Principles (“GAAP”) when developing its views. The Task Force also requested that the scope of the impairment issue be expanded to include equity investments and investments subject to FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and that the issue be addressed by the Task Force as a separate EITF issue. At the EITF meeting, the Task Force reached a consensus on one issue that certain quantitative and qualitative disclosures should be required for securities accounted for under Statement 115 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The Board ratified the consensus on that one issue. In September 2004, the Financial Accounting Standards Board (“FASB”) directed the FASB staff to issue two proposed FASB Staff Positions (“FSP”): Proposed FSP EITF Issue 03-1-a, which provides guidance for the application of paragraph 16 of EITF Issue 03-1 to debt securities that are impaired because of interest rate and/or sector spread increases and Proposed FSP EITF Issue 03-1-b, which delays the effective date of Issue 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases. In June 2005, the FASB reached a decision whereby they declined to provide additional guidance on the meaning of other-than-temporary impairment. The Board directed the FASB staff to issue EITF 03-1a as final and to draft a new FSP that will replace EITF 03-01. The final FSP (retitled FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”) would be effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. The company does not anticipate this revision will have a material effect on its financial statements.

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

CRITICAL ACCOUNTING POLICIES

General

The company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is 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 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.

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 two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimatable and (ii) SFAS 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.

Our allowance for loan losses has two basic components: the formula allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a historical loss view as an indicator of future losses and, as a result, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The unallocated allowance 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 formula allowance.

FINANCIAL OVERVIEW

Total assets have increased $27 million or 11% from the December 2004 total of $248.5 million to $275.7 million at September 30, 2005. An increase in loans of $30 million during this time period combined with a decrease in cash and due from banks makes up the majority of the change on the asset side of the balance sheet.

Total deposits have increased $30.6 million or 15% at September 30, 2005 compared to December 31, 2004. The increase in noninterest-bearing deposits is 5% at September 30, 2005 compared to December 31, 2004. Interest-bearing deposits have increased 17% during this time period. During the third quarter of 2005, we acquired $3.4 million in brokered certificates of deposit. This is the first time the bank has had brokered deposits of any kind. These deposits have a five year maturity and were acquired to fund several large loans with equivalent maturities.

The September 30, 2005 annualized return on average assets is 1.46% compared to 1.37% at December 31, 2004. At September 30, 2005 the annualized return on average equity is 16.2% compared to 14.02% at December 31, 2004. The leverage capital (equity to assets) ratio is 9.21% at September 30, 2005 compared to 9.45% at December 31, 2004.

The following table is an analysis of the company’s allowance for loan losses with amounts shown in thousands. Net charge-offs for the company have been very low when compared with the size of the total loan portfolio. Management monitors the loan portfolio on a continual basis with procedures that allow for problem loans and potential problem loans to be highlighted and watched. Written reports are prepared on a quarterly basis for all loans and information on commercial loans graded below a certain level are reported to the Board of Directors on a monthly basis. Based on experience, these loan policies and the bank’s grading and review system, management believes the loan loss allowance is adequate.


	September 30, 2005			September 30, 2004
Balance at beginning of period	$	1 966		$	1 724
Charge-offs:
Commercial, financial and agricultural		1			—
Real estate – construction		—			—
Real estate – mortgage		—			3
Consumer		148			124

Total charge-offs		149			127

Recoveries:
Commercial, financial and agricultural		—			—
Real estate – construction		—			—
Real estate – mortgage		—			—
Consumer		77			87

Total recoveries		77			87

Net charge-offs		72			40
Additions charged to operations		311			264

Balance at end of period	$	2 205		$	1 948

Ratio of net charge-offs during the period to average loans outstanding during the period		.037	%		.026	%

Loans are placed on nonaccrual status when principal or interest is delinquent for 90 days or more. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. Following is a table showing the risk elements in the loan portfolio with amounts in thousands.


	September 30, 2005			September 30, 2004
Nonaccrual loans	$	—		$	—
Restructured loans		—			—
Foreclosed properties		—			—

Total nonperforming assets	$	—		$	—

Loans past due 90 days accruing interest	$	—		$	40

Allowance for loan losses to period end loans		1.05	%		1.18	%

Nonperforming assets to period end loans and foreclosed properties		—			—

At September 30, 2005, other potential problem loans (excluding impaired loans) totalled $1.5 million. Loans are viewed as potential problem loans according to the ability of such borrowers to comply with current repayment terms. These loans are subject to constant management attention, and their status is reviewed on a regular basis. A portion of the allowance for loan losses is specifically allocated for these loans as a group at a rate that reflects the potential problems these loans may present.

The comparison of the income statements for the three months ended September 30, 2005 and 2004 and for the nine months ended September 30, 2005 and 2004 shows similar differences between 2005 and 2004. Some of the details are highlighted below.

•

Net income in 2005 is 26.5% greater than 2004 net income.

•

At September 30, 2005 total interest and dividend income is up 28.2% compared to September 30, 2004 due to loan growth and some increase in interest rates.

•

The income on the securities portfolio for the nine months ended September 30, 2005 is about the same as for the same time period in 2004.

•

Interest expense continues to increase. At the end of March 31, 2005 interest expense was 45% above 2004 expense for the same time period. At the end of June, 2005 it is 60% above 2004 expense at June 30. At the end of the 2005 September quarter interest expense is 64% above 2004 expense for the same period. The increase in expense is a combination of growth in deposits and higher interest rates being paid to retain deposits and attract additional deposit growth.

•

Net interest income through September 30, 2005 is 19% greater than at September 30, 2004. This percentage was 20% at the period ended June 30, 2005 compared to the prior year.

•

Net interest margin at September 30, 2005 is 4.60%, down slightly from the December 31, 2004 figure of 4.66%. During the first nine months of 2005, the overall average rate on loans has increased to 6.91% compared to 6.68% at December 31, 2004. During this same period the overall average rate being paid on deposits also increased to 1.73% compared to 1.31% at December 31, 2004.

Noninterest income increased 14% for the nine months ended September 30, 2005 compared to September 30, 2004. Some significant income items are listed here.

•

Trust and financial services income increased 22% at September 30, 2005 compared to September 30, 2004 due in large part to accrual of estate fees and to the continued contribution from BCT Investments.

•

Service charges on deposit accounts have increased only 5% in 2005 over 2004 and are still slightly under budget at September 30, 2005. The majority of these fees are overdraft related and may be under budget due to slower deposit growth than anticipated by the budget.

•

Credit and debit card fees have increased 55% at September 30, 2005 compared to the same time in 2004 due to the growth in the deposit account base and concentrated sale of cards by bank personnel.

•

Net gain on sale of loans has increased 23% at September 30, 2005 compared to the same time in 2004. However, loan managers have noticed a slowdown in business during the third quarter.

•

Other noninterest income has increased 3% as of September 30, 2005 compared to September 30, 2004. There are no significant increases or decreases in the accounts making up this category.

Noninterest expense increased 12% for the nine months ended September 30, 2005 compared to the same period in 2004. This was the same percentage of increase that we disclosed for the six months ended June 30, 2005 compared to June of 2004, so costs are being contained. Some details of this increase are listed below.

•

Salaries and employee benefits for the first nine months of 2005 are 8% more than for the first nine months of 2004 due to annual salary increases, some increase in staffing and related costs. (This percentage has also been maintained through the third quarter as it was during the first and second quarters.)

•

Occupancy and furniture and equipment expense has increased 13% in 2005 compared to 2004. As the bank continues to grow so does the space and equipment needed to respond to the growth. Facilities have been remodeled, several additional office spaces have been leased and, as has been the case for a number of years, the bank’s continual attention to staying on the cutting edge of technology comes at considerable cost.

•

Advertising and marketing expenses have increased 31% in 2005 compared to 2004 due to continual efforts to grow the bank’s customer base by keeping Bank of Charles Town in the public “eye” as well as to keep customers informed. These efforts include media advertising and statement stuffers about the bank’s services and information to enable our customers to be educated consumers by making them aware of the increasing fraudulent schemes and scams in the market place today.

•

Auditing and accounting expenses have increased over 202% in 2005 compared to 2004 primarily due to compliance efforts related to the Sarbanes-Oxley Act of 2002. We have temporarily outsourced our internal audit function so that our internal auditor can concentrate on the Sarbanes-Oxley compliance issues. In addition to our internal auditor, we have engaged an additional accounting firm to aid in documentation and testing in this regard. With the delay in the required compliance of Sarbanes-Oxley, this expense will be less than originally budgeted for 2005.

•

ATM and check card expenses have increased 29% in the first nine months of 2005 compared to the same time period in 2004 due to growth in the deposit account base and concentrated sales efforts of the bank staff to market this product.

•

Other noninterest expenses have increased 11% at September 30, 2005 compared to September 30, 2004. Through June of 2005 this percentage was 12%. Significant increases in this category include the following.

•

Outsourcing of a portion of the trust review function shows an increase in expense of 114% in 2005 compared to 2004 because we did not start this service until May of 2004.

•

Directors and committee fees have increased in 2005 compared to 2004 because (1) 2005 is first full year for two directors who came on the board in March 2004; (2) there has been one special board meeting in 2005; and (3) the financial expert and other audit committee members are being paid increased committee fees with the additional time requirements as a result of the Sarbanes-Oxley Act.

•

Printing, stationery and supplies expense is 38% greater in 2005 than in 2004 because of continually growing customer base and required additional statements, statement stuffers and other similar items.

•

Home equity closing costs are up in 2005 compared to 2004 due to increased loans being made.

•

Online banking expense has decreased in 2005 compared to 2004 due to the pay off of the maintenance agreement of the previous vendor for our online banking product.

LIQUIDITY

Liquid assets of the company include cash and due from banks, securities purchased under agreements to resell, federal funds sold, securities available for sale, and loans and investments maturing within one year. The company’s statement of cash flows details this liquidity since January 1, 2005.

Operating Activities. The company’s net income provides cash from the bank’s operating activities. The net income figure is adjusted for certain noncash transactions, such as depreciation expense, that reduce net income but do not require a cash outlay. Through September 30, 2005 net income as adjusted has provided cash of $2.6 million. Interest income earned on loans and investments is the company’s major income source.

Investing Activities. Customer deposits and company borrowings provide the funds used to invest in loans and securities investments. In addition, the principal portion of loan payments and payoffs and funds from maturing investments provide cash flow. Purchases of bank premises and equipment are an investing activity. The net amount of cash used in investing activities through September 30, 2005 is $31.1 million.

Financing Activities. Customer deposits and company borrowings provide the financing for the investing activities as stated above. If the company has an excess of funds on any given day, the bank will sell these funds to make additional interest income to fund activities. Likewise, if the company has a shortage of funds on any given day it will purchase funds and pay interest for the use of these funds. Financing activities also include payment of dividends, purchase of shares of the company’s common stock for the treasury and repayment of any borrowed or purchased funds. The net amount of cash provided by financing activities in 2005 through September 30 is $24.5 million.

The company has additional funding sources in the Federal Home Loan Bank, The Bankers Bank and Mercantile-Safe Deposit and Trust Company. Liquidity of the company is adequate to meet present and future financial obligations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to changes in interest rates, exchange rates and equity prices. The company’s market risk is composed primarily of interest rate risk. The company’s Asset and Liability Management Committee (ALCO) is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and limit exposure to this risk. The Board of Directors reviews and approves the guidelines established by ALCO.

Interest rate risk is monitored through the use of three complementary modeling tools: static gap analysis, earnings simulation modeling and economic value simulation (net present value estimation). Each of these models measures changes in a variety of interest rate scenarios. While each of the interest rate risk measures has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the company, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. Static gap which measures aggregate repricing values is less utilized since it does not effectively measure the investment options risk impact on the company and is not addressed here. But earnings simulation and economic value models which more effectively measure the cash flow impacts are utilized by management on a regular basis and are explained below.

Earnings Simulation Analysis

Management uses simulation analysis to measure the sensitivity of net income to change in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analysis such as the static gap analysis.

Assumptions used in this model, including loan and deposit growth rates, are derived from seasonal trends, economic forecasts and management’s outlook, as are the assumptions used to project yields and rates for new loans and deposits. Maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in like instruments. Mortgage loans and mortgage backed securities prepayment assumptions are based on industry estimates of repayment speeds for portfolios with similar coupon ranges and seasoning. Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and are accounted for in the different rate scenarios.

The most likely scenario represents the rate environment as management forecasts it to occur. From this base, rate shocks in 100 basis point increments are applied to see the impact on the company’s earnings. The following table represents the interest rate sensitivity on net income (fully tax equivalent basis) for the company using different rate scenarios as of June 30, 2005:


Change in Yield Curve	% Change in Net Income
+ 200 basis points	+6.8	%
+ 100 basis points	+3.5	%
Most likely	0
- 100 basis points	- 3.6	%
- 200 basis points	- 7.6	%

Economic Value Simulation

Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in economic value of equity over different rate environments is an indication of the longer term repricing risk in the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation.

The following chart reflects the change in net market value over different rate environments as of June 30, 2005:


Change in Yield Curve	Change in Economic Value of Equity
	(dollars in thousands)
+ 200 basis points	$	-2,924
+ 100 basis points		- 1,486
Most likely		0
- 100 basis points		+1,068
- 200 basis points		+1,436

There have been no significant changes during the third quarter of 2005 in the above described quantitative and qualitative disclosures using information as of June 30, 2005.

Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the date of this quarterly report. Based on that evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

There are no material legal proceedings to which the Registrant or its subsidiary, directors or officers is a party or by which they, or any of them, are threatened. All legal proceedings presently pending or threatened against Potomac Bancshares, Inc. and its subsidiary involve routine litigation incidental to the business of the company or the subsidiary and are either not material in respect to the amount in controversy or fully covered by insurance.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

ISSUER PURCHASES OF EQUITY SECURITIES


Period	(a) Total Number of Shares Purchased	(b) Average Price Paid Per Share	(c) Total Number of Shares Purchased as Part of Publicly Announced Programs	(d) Maximum Number of Shares that May Yet be Purchased Under the Program
January 1 through January 31	NONE	—	—	—

February 1 through February 28	NONE	—	—	—

March 1 through March 31	NONE	—	—	—

April 1 through April 30	NONE	—	—	—

May 1 through May 31	NONE	—	—	—

June 1 through June 30	NONE	—	—	—

July 1 through July 31	NONE	—	—	—

August 1 through August 31	NONE	—	—	—

September 1 through September 30	NONE	—	—	—

On February 12, 2002, the company’s Board of Directors originally authorized the repurchase program. The program authorized the repurchase of up to 10% of the company’s stock over the next twelve months. The stock may be purchased in the open market and/or in privately negotiated transactions as management and the board of directors determine prudent. The program has been extended on annual basis.


Item 5. Other Information

(b)

There have been no changes to the procedures by which security holders may recommend nominees to the registrant’s board of directors since the registrant last provided disclosure in response to Item 7(d)(2)(ii)(G) of Schedule 14A.

Item 6. Exhibits


31.1		Certification Under Exchange Act Rule 13a-14, Chief Executive Officer (and Section 302 of Sarbanes-Oxley Act of 2002)

31.2		Certification Under Exchange Act Rule 13a-14, Chief Financial Officer (and Section 302 of Sarbanes-Oxley Act of 2002)

32		Certification Pursuant to 18 U.S.C. Section 1350, Chief Executive Officer and Chief Financial Officer (pursuant to Section 906 of Sarbanes-Oxley Act of 2002)

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		POTOMAC BANCSHARES, INC.

Date November 10, 2005		/s/ Robert F. Baronner, Jr.
		Robert F. Baronner, Jr.
		President & CEO

Date November 10, 2005		/s/ Gayle Marshall Johnson
		Gayle Marshall Johnson
		Sr.Vice President and Chief Financial Officer