##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549
   FORM 10-Q   (Mark One) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2004 or [  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to Commission File No. 000-25805 Fauquier Bankshares, Inc.  Virginia
    
    54-1288193(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 10 Courthouse SquareWarrenton, Virginia
    
    20186(Address of principal executive offices)
    
    (Zip Code)
 (540) 347-2700
(Registrants telephone number, including area code) Not Applicable
(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 [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] As of November 2, 2004, the latest practicable date for determination,
3,339,272 shares of common stock, par value $3.13 per share, of the registrant
were outstanding.




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##### 



FAUQUIER BANKSHARES, INC. INDEX PagePart I. FINANCIAL INFORMATION
    
    
    2Item 1. Financial Statements
    
    
    2Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003
    
    
    2Consolidated Statements of Income (unaudited) for the Three Months Ended September 30, 2004 and 2003
    
    
    3Consolidated Statements of Income (unaudited) for the Nine Months Ended September 30, 2004 and 2003
    
    
    4Consolidated Statements of Changes in Shareholders Equity (unaudited) for the Nine Months Ended September 30, 2004 and 2003
    
    
    5Consolidated Statements of Cash Flows (unaudited) for the Nine Months Ended September 30, 2004 and 2003
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4. Controls and Procedures
    
    
    29Part II. OTHER INFORMATION
    
    
    29Item 1. Legal Proceedings
    
    
    29Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    30Item 3. Defaults Upon Senior Securities
    
    
    30Item 4. Submission of Matters to a Vote of Security Holders
    
    
    30Item 5. Other Information
    
    
    30Item 6. Exhibits
    
    
    30SIGNATURES
    
    
    31
 1




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##### 



Part I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS 
 Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Balance Sheets Unaudited
    
    AuditedSeptember 30, 2004
    
    December 31, 2003AssetsCash and due from banks
    
    $
    18,260,895
    
    
    $
    11,808,387Interest-bearing deposits in other banks
    
    
    278,340
    
    
    
    142,042Federal funds sold
    
    
    11,672,000
    
    
    
    Securities, at fair value
    
    
    51,706,952
    
    
    
    52,386,006Loans, net of allowance for loan losses of $3,958,241
in 2004 and $3,575,002 in 2003
    
    
    322,135,300
    
    
    
    295,311,745Bank premises and equipment, net
    
    
    8,703,047
    
    
    
    7,875,424Accrued interest receivable
    
    
    1,382,384
    
    
    
    1,233,004Other assets
    
    
    10,624,732
    
    
    
    9,703,670Total assets
    
    $
    424,763,650
    
    
    $
    378,460,278LiabilitiesDeposits:Noninterest-bearing
    
    $
    84,301,628
    
    
    $
    73,128,879Interest-bearing
    
    
    288,478,683
    
    
    
    247,999,697Total deposits
    
    $
    372,780,311
    
    
    $
    321,128,576Federal funds purchased
    
    
    
    
    
    
    2,000,000Dividends payable
    
    
    
    
    
    
    430,590Federal Home Loan Bank advances
    
    
    15,000,000
    
    
    
    20,000,000Company-obligated mandatorily redeemable capital securities
    
    
    4,000,000
    
    
    
    4,000,000Other liabilities
    
    
    2,626,554
    
    
    
    2,438,327Commitments and contingent liabilities
    
    
    
    
    
    
    Total liabilities
    
    $
    394,406,865
    
    
    $
    349,997,493Shareholders EquityCommon stock, par value, $3.13; authorized 8,000,000 shares;
issued and outstanding, 2004, 3,337,752 shares; 2003, 3,312,230 shares
    
    
    10,447,164
    
    
    
    10,367,280Retained earnings
    
    
    19,841,403
    
    
    
    18,082,684Accumulated other comprehensive income(loss), net
    
    
    68,218
    
    
    
    12,821Total shareholders equity
    
    $
    30,356,785
    
    
    $
    28,462,785Total liabilities and shareholders equity
    
    $
    424,763,650
    
    
    $
    378,460,278
 See accompanying Notes to Consolidated Financial Statements. 2




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##### 



Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
For the Nine Months Ended September 30, 2004 and 2003 2004
    
    2003Interest IncomeInterest and fees on loans
    
    $
    14,721,572
    
    
    $
    12,499,056Interest and dividends on securities available for sale:Taxable interest income
    
    
    1,132,968
    
    
    
    1,185,791Interest income exempt from federal income taxes
    
    
    43,172
    
    
    
    52,501Dividends
    
    
    112,383
    
    
    
    189,098Interest on federal funds sold
    
    
    39,641
    
    
    
    48,610Interest on deposits in other banks
    
    
    18,796
    
    
    
    1,555Total interest income
    
    
    16,068,532
    
    
    
    13,976,611Interest ExpenseInterest on deposits
    
    
    2,430,544
    
    
    
    2,324,086Interest on federal funds purchased
    
    
    33,817
    
    
    
    9,908Interest on Federal Home Loan Bank advances
    
    
    592,757
    
    
    
    527,421Distribution on capital securities of subsidiary trust
    
    
    149,208
    
    
    
    146,369Total interest expense
    
    
    3,206,326
    
    
    
    3,007,784Net interest income
    
    
    12,862,206
    
    
    
    10,968,827Provision for loan losses
    
    
    539,583
    
    
    
    470,000Net interest income after
provision for loan losses
    
    
    12,322,623
    
    
    
    10,498,827Other incomeWealth management income
    
    
    969,766
    
    
    
    673,272Service charges on deposit accounts
    
    
    1,922,547
    
    
    
    1,861,059Other service charges, commissions and fees
    
    
    897,423
    
    
    
    988,407Gains on securities, available for sale
    
    
    

    
    
    
    288,334Other operating income
    
    
    33,208
    
    
    
    29,997Total other income
    
    
    3,822,944
    
    
    
    3,841,069Other ExpensesSalaries and benefits
    
    
    5,799,404
    
    
    
    4,826,460Net occupancy expense of premises
    
    
    649,489
    
    
    
    638,416Furniture and equipment
    
    
    952,108
    
    
    
    882,945Other operating expenses
    
    
    3,743,251
    
    
    
    3,368,079Total other expenses
    
    
    11,144,252
    
    
    
    9,715,900Income before income taxes
    
    
    5,001,315
    
    
    
    4,623,996Income tax expense
    
    
    1,515,312
    
    
    
    1,381,177Net Income
    
    $
    3,486,003
    
    
    $
    3,242,819Earnings per Share, basic
    
    $
    1.05
    
    
    $
    0.98Earnings per Share, assuming dilution
    
    $
    0.99
    
    
    $
    0.93Dividends per Share
    
    $
    0.41
    
    
    $
    0.35
 See accompanying Notes to Consolidated Financial Statements. 3




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##### 



Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
For the Three Months Ended September 30, 2004 and 2003 2004
    
    2003Interest IncomeInterest and fees on loans
    
    $
    5,131,571
    
    
    $
    4,394,061Interest and dividends on securities available for sale:Taxable interest income
    
    
    427,159
    
    
    
    277,409Interest income exempt from federal income taxes
    
    
    14,381
    
    
    
    14,464Dividends
    
    
    48,154
    
    
    
    67,751Interest on federal funds sold
    
    
    19,178
    
    
    
    11,871Interest on deposits in other banks
    
    
    536
    
    
    
    827Total interest income
    
    
    5,640,979
    
    
    
    4,766,383Interest ExpenseInterest on deposits
    
    
    906,465
    
    
    
    726,913Interest on federal funds purchased
    
    
    15
    
    
    
    4,527Interest on Federal Home Loan Bank advances
    
    
    185,503
    
    
    
    177,739Distribution on capital securities of subsidiary trust
    
    
    53,176
    
    
    
    47,112Total interest expense
    
    
    1,145,159
    
    
    
    956,291Net interest income
    
    
    4,495,820
    
    
    
    3,810,092Provision for loan losses
    
    
    231,250
    
    
    
    240,000Net interest income after
provision for loan losses
    
    
    4,264,570
    
    
    
    3,570,092Other incomeWealth management income
    
    
    336,445
    
    
    
    238,497Service charges on deposit accounts
    
    
    687,073
    
    
    
    608,620Other service charges, commissions and fees
    
    
    273,936
    
    
    
    345,974Gains on securities, available for sale
    
    
    
    
    
    
    288,334Other operating income
    
    
    8,891
    
    
    
    10,247Total other income
    
    
    1,306,345
    
    
    
    1,491,672Other ExpensesSalaries and benefits
    
    
    1,960,821
    
    
    
    1,655,112Net occupancy expense of premises
    
    
    221,771
    
    
    
    223,395Furniture and equipment
    
    
    342,591
    
    
    
    298,679Other operating expenses
    
    
    1,109,791
    
    
    
    1,156,938Total other expenses
    
    
    3,634,974
    
    
    
    3,334,124Income before income taxes
    
    
    1,935,941
    
    
    
    1,727,640Income tax expense
    
    
    603,956
    
    
    
    522,013Net Income
    
    $
    1,331,985
    
    
    $
    1,205,627Earnings per Share, basic
    
    $
    0.40
    
    
    $
    0.36Earnings per Share, assuming dilution
    
    $
    0.38
    
    
    $
    0.34Dividends per Share
    
    $
    0.14
    
    
    $
    0.12
 See accompanying Notes to Consolidated Financial Statements. 4




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##### 



Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders Equity
(Unaudited)
For the Nine Months Ended September 30, 2004 and 2003 AccumulatedOtherCommon
    
    Retained
    
    Comprehensive
    
    ComprehensiveStock
    
    Earnings
    
    Income (Loss)
    
    Income
    
    TotalBalance, December 31, 2002
    
    $
    10,341,726
    
    
    $
    15,419,307
    
    
    $
    670,132
    
    
    
    
    
    
    $
    26,431,165Comprehensive income:Net income
    
    
    
    
    
    
    3,242,819
    
    
    
    
    
    
    $
    3,242,819
    
    
    
    3,242,819Other comprehensive income net of tax:Unrealized holding losses on securities available
for sale, net of deferred income taxes of $376,238
    
    
    
    
    
    
    
    
    
    
    (730,344
    )
    
    
    (730,344
    )
    
    
    (730,344
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    2,512,475
    
    
    
    Cash dividends
    
    
    
    
    
    
    (1,157,540
    )
    
    
    
    
    
    
    
    
    
    
    (1,157,540
    )Acquisition of 21,010 shares of common stock
    
    
    (65,761
    )
    
    
    (288,725
    )
    
    
    
    
    
    
    
    
    
    
    (354,486
    )Exercise of stock options
    
    
    87,465
    
    
    
    133,925
    
    
    
    
    
    
    
    
    
    
    
    221,390Balance, September 30, 2003
    
    $
    10,363,430
    
    
    $
    17,349,786
    
    
    $
    (60,212
    )
    
    
    
    
    
    $
    27,653,004Balance, December 31, 2003
    
    $
    10,367,280
    
    
    $
    18,082,684
    
    
    $
    12,821
    
    
    
    

    
    
    $
    28,462,785Comprehensive income:Net income
    
    
    
    
    
    
    3,486,003
    
    
    
    
    
    
    $
    3,486,003
    
    
    
    3,486,003Other comprehensive income net of tax:Unrealized holding gain on securities available
for sale, net of deferred income taxes of $28,538
    
    
    
    
    
    
    
    
    
    
    55,397
    
    
    
    55,397
    
    
    
    55,397Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    3,541,400
    
    
    
    Cash dividends
    
    
    
    
    
    
    (1,363,017
    )
    
    
    
    
    
    
    
    
    
    
    (1,363,017
    )Acquisition of 30,570 shares of common stock
    
    
    (95,684
    )
    
    
    (601,147
    )
    
    
    
    
    
    
    
    
    
    
    (696,831
    )Net issuance of restricted stock, less amortization
    
    
    39,304
    
    
    
    26,126
    
    
    
    
    
    
    
    
    
    
    
    65,430Issuance of common stock
    
    
    4,839
    
    
    
    28,601
    
    
    
    
    
    
    
    
    
    
    
    33,440Exercise of stock options
    
    
    131,425
    
    
    
    182,153
    
    
    
    
    
    
    
    
    
    
    
    313,578Balance, September 30, 2004
    
    $
    10,447,164
    
    
    $
    19,841,403
    
    
    $
    68,218
    
    
    
    
    
    
    $
    30,356,785
 See accompanying Notes to Consolidated Financial Statements. 5




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##### 



Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
For the Nine Months Ended September 30, 2004 and 2003 2004
    
    2003Cash Flows from Operating ActivitiesNet income
    
    $
    3,486,003
    
    
    $
    3,242,819Adjustments to reconcile net income to net
cash provided by operating activities:Depreciation and amortization
    
    
    798,695
    
    
    
    764,464Provision for loan losses
    
    
    539,583
    
    
    
    470,000(Gain) on sale of premises and equipment
    
    
    (5,910
    )
    
    
    (Gain) on sale of securities available for sale
    
    
    
    
    
    
    (288,334
    )Amortization of security premiums and (accretion) of
discounts, net
    
    
    217,925
    
    
    
    683,159Changes in assets and liabilities:(Increase) in other assets
    
    
    (1,098,980
    )
    
    
    (466,506
    )Increase in other liabilities
    
    
    188,227
    
    
    
    418,349Net cash provided by operating activities
    
    
    4,125,543
    
    
    
    4,823,951Cash Flows from Investing ActivitiesProceeds from maturities, calls and principal
payments of securities available for sale
    
    
    14,202,716
    
    
    
    35,571,185Purchase of securities available for sale
    
    
    (13,657,652
    )
    
    
    (36,310,976
    )Proceeds from sale of premises and equipment
    
    
    5,910
    
    
    
    Proceeds from sale of securities available for sale
    
    
    
    
    
    
    10,322,980Purchase of premises and equipment
    
    
    (1,626,318
    )
    
    
    (2,245,250
    )Purchase of Bank Owned Life Insurance
    
    
    
    
    
    
    (5,000,000
    )Net (increase) in loans
    
    
    (27,363,138
    )
    
    
    (62,879,433
    )Net cash (used in) investing activities
    
    
    (28,438,482
    )
    
    
    (60,541,494
    )Cash Flows from Financing ActivitiesNet increase in demand deposits, NOW accounts
and savings accounts
    
    
    52,063,292
    
    
    
    32,656,424Net increase (decrease) in certificates of deposit
    
    
    (411,557
    )
    
    
    10,820,720Proceeds from Federal Home Loan Bank advances
    
    
    9,000,000
    
    
    
    Repayment of Federal Home Loan Bank advances
    
    
    (14,000,000
    )
    
    
    Proceeds from Federal Funds Purchased
    
    
    
    
    
    
    8,600,000Repayment of Federal Funds Purchased
    
    
    (2,000,000
    )
    
    
    Cash dividends paid
    
    
    (1,793,607
    )
    
    
    (1,123,667
    )Issuance of common stock
    
    
    412,448
    
    
    
    221,390Acquisition of common stock
    
    
    (696,831
    )
    
    
    (354,486
    )Net cash provided by financing activities
    
    
    42,573,745
    
    
    
    50,820,381Increase (decrease) in cash and cash
equivalents
    
    
    18,260,806
    
    
    
    (4,897,162
    )Cash and Cash EquivalentsBeginning
    
    
    11,950,429
    
    
    
    24,937,080Ending
    
    $
    30,211,235
    
    
    $
    20,039,918Supplemental Disclosures of Cash Flow InformationCash payments for:Interest
    
    $
    3,170,282
    
    
    $
    3,040,512Income taxes
    
    $
    1,572,000
    
    
    $
    1,116,000Supplemental Disclosures of Noncash Investing ActivitiesUnrealized gain (loss) on securities available for sale, net
    
    $
    83,935
    
    
    $
    (1,106,582
    )
 See accompanying Notes to Consolidated Financial Statements. 6




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##### 



FAUQUIER BANKSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements  1.
    
    GeneralThe consolidated statements include the accounts of Fauquier Bankshares, Inc. (Bankshares) and its wholly-owned subsidiary
The Fauquier Bank (TFB), of which Fauquier Bank Services, Inc. is its sole subsidiary. 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 September 30, 2004 and December 31, 2003, and the
results of operations and cash flows for the nine months ended September 30, 2004 and 2003.
The results of operations for the nine and three months ended September 30, 2004 and 2003 are not necessarily indicative of the
results expected for the full year.2.
    
    SecuritiesThe amortized cost of securities available for sale, with unrealized gains and losses follows: Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    (Losses)
    
    ValueSeptember 30, 2004Obligations of U.S. Government corporations
and agencies
    
    $
    42,213,251
    
    
    $
    256,965
    
    
    $
    (130,423
    )
    
    $
    42,339,793Obligations of states and political
subdivisions
    
    
    1,161,417
    
    
    
    66,624
    
    
    
    
    
    
    
    1,228,041Corporate Bonds
    
    
    6,000,000
    
    
    
    7,500
    
    
    
    (45,000
    )
    
    
    5,962,500Other
    
    
    255,110
    
    
    
    
    
    
    
    (1,805
    )
    
    
    253,305Restricted investments:Federal Home
Loan Bank stock
    
    
    1,262,200
    
    
    
    
    
    
    
    
    
    
    
    1,262,200Federal Reserve Bank
stock
    
    
    72,000
    
    
    
    
    
    
    
    
    
    
    
    72,000Bankers Bank Stock
    
    
    102,113
    
    
    
    
    
    
    
    
    
    
    
    102,113Community
Bankers Bank stock
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    50,000FHLMC
Preferred Bank stock
    
    
    487,500
    
    
    
    
    
    
    
    (50,500
    )
    
    
    437,000$
    51,603,591
    
    
    $
    331,089
    
    
    $
    (227,728
    )
    
    $
    51,706,952
 7




---



##### 



Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    (Losses)
    
    ValueDecember 31, 2003Obligations
of U.S. Government corporations
and agencies
    
    $
    46,592,397
    
    
    $
    254,827
    
    
    $
    (208,599
    )
    
    $
    46,638,625Obligations of states and political
subdivisions
    
    
    1,164,580
    
    
    
    72,001
    
    
    
    
    
    
    
    1,236,581Corporate Bonds
    
    
    3,000,000
    
    
    
    
    
    
    
    (71,200
    )
    
    
    2,928,800Restricted investments:Federal Home Loan
Bank stock
    
    
    1,000,000
    
    
    
    
    
    
    
    
    
    
    
    1,000,000Federal Reserve Bank
stock
    
    
    72,000
    
    
    
    
    
    
    
    
    
    
    
    72,000Community Bankers
Bank stock
    
    
    50,000
    
    
    
    
    
    
    
    
    
    
    
    50,000FHLMC Preferred
Bank stock
    
    
    487,500
    
    
    
    
    
    
    
    (27,500
    )
    
    
    460,000$
    52,366,477
    
    
    $
    326,828
    
    
    $
    (307,299
    )
    
    $
    52,386,006
  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. September 30, 2004Amortized
    
    FairCost
    
    ValueDue in one year or less
    
    $
    219,681
    
    
    $
    219,999Due after one year through five years
    
    
    15,386,427
    
    
    
    15,400,465Due after five years through ten years
    
    
    4,540,872
    
    
    
    4,512,354Due after ten years
    
    
    29,227,687
    
    
    
    29,397,516Equity securities
    
    
    2,228,924
    
    
    
    2,176,618$
    51,603,591
    
    
    $
    51,706,952
   8




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##### 



The following table shows Bankshares 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 September 30, 2004. Less Than 12 Months
    
    12 Months or More
    
    TotalUnrealized
    
    
    
    
    
    Unrealized
    
    
    
    
    
    UnrealizedDescription of Securities
    
    Fair Value
    
    (Losses)
    
    Fair Value
    
    (Losses)
    
    Fair Value
    
    (Losses)Obligations of U.S. government
corporations and agencies
    
    $
    13,407,107
    
    
    $
    (111,325
    )
    
    $
    3,146,534
    
    
    $
    (19,098
    )
    
    $
    16,553,641
    
    
    $
    (130,423
    )Corporate bonds
    
    
    1,995,000
    
    
    
    (5,000
    )
    
    
    856,250
    
    
    
    (40,000
    )
    
    
    2,851,250
    
    
    
    (45,000
    )Subtotal, debt securities
    
    
    15,402,107
    
    
    
    (116,325
    )
    
    
    4,002,784
    
    
    
    (59,098
    )
    
    
    19,404,891
    
    
    
    (175,423
    )Preferred Stock
    
    
    487,500
    
    
    
    (50,500
    )
    
    
    
    
    
    
    
    
    
    
    487,500
    
    
    
    (50,500
    )Mutual Fund
    
    
    255,110
    
    
    
    (1,805
    )
    
    
    
    
    
    
    
    
    
    
    255,110
    
    
    
    (1,805
    )Total temporary impaired securities
    
    $
    16,144,717
    
    
    $
    (168,630
    )
    
    $
    4,002,784
    
    
    $
    (59,098
    )
    
    $
    20,147,501
    
    
    $
    (227,728
    )
  The nature of the securities which are temporarily impaired can be segmented into four groups. The first group consists of two
Federal Agency securities totaling 7.0 million with a temporary loss of $54,424. The securities within this group
have maturity dates of 27 months and 44 months. The security with the 44 month maturity has a call date at par of
three months. Bankshares has the ability to hold these bonds to their call date or their maturity.The second group consists of one Federal agency mortgage-backed security and four Federal agency collateralized
mortgage obligation securities totaling $9.6 million with a temporary loss of $75,999. The securities within this group
have estimated maturity dates ranging from 3 months to 74 months, and return principal on a monthly basis representing the repayment
and prepayment of the underllying mortgages. Bankshares has the ability to hold these bonds to their maturity.The third group consists of two corporate bonds, rated A2 by Moodys, totaling $3.0 million with a temporary loss of $45,000.
This bond has a remaining maturity of approximately 29 years, but can be called at par on its five year anniversary. If not called,
the bond prices, every three months at a fixed index above LIBOR. Bankshares has the ability to hold this bond to its maturity.The final security is preferred stock with Freddie Mac totaling $487,500 with a temporary loss of 50,500. Bankshares has
the ability to hold this stock.3.
    
    LoansA summary of the balances of loans follows: September 30,
    
    December 31,2004
    
    2003(Thousands)Real estate loans:Construction
    
    $
    26,792
    
    
    $
    21,243Secured by farmland
    
    
    1,060
    
    
    
    1,329Secured by 1-4 family residential
    
    
    131,490
    
    
    
    119,116Other real estate loans
    
    
    94,159
    
    
    
    81,884Commercial and industrial loans (except those secured by real estate)
    
    
    22,558
    
    
    
    21,070Consumer installment loans
    
    
    41,891
    
    
    
    41,429All other loans
    
    
    8,522
    
    
    
    13,033Total loans
    
    $
    326,472
    
    
    $
    299,104Less: Unearned income
    
    
    378
    
    
    
    217Allowance for loan losses
    
    
    3,958
    
    
    
    3,575Net loans
    
    $
    322,136
    
    
    $
    295,312
   9




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##### 



Analysis of the allowance for loan losses follows: Nine Months
    
    Nine Months
    
    Twelve MonthsEnding
    
    Ending
    
    EndingSeptember 30,
    
    September 30,
    
    December 31,2004
    
    2003
    
    2003Balance at beginning of period
    
    $
    3,575,002
    
    
    $
    2,909,607
    
    
    $
    2,909,607Provision charged to operating expense
    
    
    539,583
    
    
    
    470,000
    
    
    
    784,000Recoveries added to the allowance
    
    
    29,546
    
    
    
    141,573
    
    
    
    160,089Loan losses charged to the allowance
    
    
    (185,890
    )
    
    
    (183,093
    )
    
    
    (278,694
    )Balance at end of period
    
    $
    3,958,241
    
    
    $
    3,338,087
    
    
    $
    3,575,002
  Nonperforming assets consist of the following: June 30,
    
    December 31,2004
    
    2003(Thousands)Nonaccrual loans
    
    $
    1,026
    
    
    $
    967Restructured loans
    
    
    
    
    
    
    Total non-performing loans
    
    
    1,026
    
    
    
    967Foreclosed property
    
    
    143
    
    
    
    Total non-performing assets
    
    $
    1,169
    
    
    $
    967
  Total loans past due 90 days or more and still accruing interest totaled $49,000 on June 30, 2004 and
$840,000 on December 31, 2003, respectively. 4.  Company-Obligated Mandatorily Redeemable Capital Securities of Subsidiary Trust  On March 26, 2002, Bankshares 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 Bankshares 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
Bankshares and are junior in right of payment to all present and future senior indebtedness of Bankshares. The Capital Securities
are guaranteed by Bankshares on a subordinated basis.  The Capital Securities are presented in the consolidated balance sheets of Bankshares under the caption Company-Obligated
Mandatorily Redeemable Capital Securities. Bankshares 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. 10




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##### 



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 diluted potential common stock. Dilutive potential common stock
had no effect on income available to common shareholders. Three Months
    
    Nine Months
    
    Nine MonthsEnding
    
    Ending
    
    EndingSeptember 30, 2004
    
    September 30, 2004
    
    September 30, 2003Per Share
    
    
    
    
    
    Per Share
    
    
    
    
    
    Per ShareShares
    
    Amount
    
    Shares
    
    Amount
    
    Shares
    
    AmountBasic earnings per share
    
    
    3,326,773
    
    
    $
    0.40
    
    
    
    3,318,458
    
    
    $
    1.05
    
    
    
    3,307,114
    
    
    $
    0.98Effect of dilutive securities, stock options
    
    
    177,211
    
    
    
    
    
    
    
    189,582
    
    
    
    
    
    
    
    168,495Diluted earnings per share
    
    
    3,503,984
    
    
    $
    0.38
    
    
    
    3,508,040
    
    
    $
    0.99
    
    
    
    3,475,609
    
    
    $
    0.93
  6.
    
    Stock-Based CompensationAt September 30, 2004, Bankshares has a stock-based compensation plan. Bankshares accounts for the plan under the recognition and measurement principles of APB Opinion 25, Accounting for Stock Issued to Employees,and
related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date
of the grant. The following table illustrates the effect on net income and earnings per share for Bankshares had the fair value recognition provisions of FASB Statement No. 12, Accounting for Stock-Based Compensation, been
applied to stock-based compensation. September 30,
    
    September 30,2004
    
    2003Net income , as reported
    
    $
    3,486,003
    
    
    $
    3,242,819Deduct: total stock-based employee compensation
expense determined based on fair value
method of awards, net of tax
    
    
    (48,752
    )
    
    
    (111,275
    )Pro forma net income
    
    $
    3,437,251
    
    
    $
    3,131,544Earnings per share:Basic - as reported
    
    $
    1.05
    
    
    $
    0.98Basic - pro forma
    
    $
    1.04
    
    
    $
    0.95Diluted - as reported
    
    $
    0.99
    
    
    $
    0.93Diluted - pro forma
    
    $
    0.98
    
    
    $
    0.90
 11




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##### 



7.
    
    Employee Benefit PlanThe following table provides a reconciliation of the changes in the defined benefit plans obligations for the
periods ending September 30, 2004 and 2003. Nine Months EndedSeptember 30,2004
    
    2003Service cost
    
    $
    341,877
    
    
    $
    278,811Interest cost
    
    
    304,269
    
    
    
    270,327Expected return on plan assets
    
    
    (294,861
    )
    
    
    (232,332
    )Amortization of transition obligation/(asset)
    
    
    (14,235
    )
    
    
    (14,235
    )Amortization of prior service cost
    
    
    5,826
    
    
    
    5,826Recognized net actuarial (gain)/loss
    
    
    29,517
    
    
    
    38,124Net periodic benefit cost
    
    $
    372,393
    
    
    $
    346,521
  Bankshares previously disclosed in its financial statements for the year ended December 31, 2003, that it expected to contribute $68,000 to its pension plan in 2004. As of September 30, 2004, contributions totaling $412,000
have been made. Bankshares presently anticipates no additional contributions to fund its pension plan in 2004. 12




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##### 



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION 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
management, and are generally identifiable by use of the words believe,
expect, intend, anticipate, estimate, project, may, will or
similar expressions. Although we believe our plans, intentions and
expectations reflected in these forward-looking statements are reasonable, we
can give no assurance that these plans, intentions, or expectations will be
achieved. Our ability to predict results or the actual effect of future plans
or strategies is inherently uncertain, and actual results could differ
materially from those contemplated. Factors that could have a material adverse
effect on our operations and future prospects include, but are not limited to,
changes in: interest rates, general economic conditions, the
legislative/regulatory climate, monetary and fiscal policies of the U.S.
Government, including the policies of the U.S. Treasury and the Board of
Governors of the Federal Reserve System, the quality or composition of The
Fauquier Banks (TFB) 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. (Bankshares) was incorporated under the laws of the
Commonwealth of Virginia on January 13, 1984. Bankshares is a registered bank
holding company and owns all of the voting shares of TFB, a Virginia
state-chartered bank that commenced operations in 1902. Bankshares engages in
its business through TFB, and has no significant operations other than owning
the stock of TFB. Bankshares had issued and outstanding 3,337,752 shares of
common stock, par value $3.13 per share, held by approximately 391 holders of
record on September 30, 2004. TFB 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 branch in Bealeton opened during May 2004. The
executive offices of Bankshares and the main office of TFB are located at 10
Courthouse Square, Warrenton, Virginia 20186. TFB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. TFB provides a range of consumer and commercial banking services to individuals
and businesses. The deposits of TFB are insured up to applicable limits by the
Bank Insurance Fund of the Federal Deposit Insurance Fund (the FDIC). The
basic services offered by TFB 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, TFB 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. TFB 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. TFB operates a Wealth Management Services (WMS) division that began with the
granting of trust powers to TFB in 1919. The WMS division provides personalized
services that include investment management, trust, estate settlement,
retirement, insurance, and brokerage services. TFB, through its subsidiary
Fauquier Bank Services, Inc., has equity ownership interests in Bankers
Insurance, LLC, a
Virginia independent insurance company, and Bankers Investments Group, LLC, a
full service broker/dealer. Bankers Insurance consists of a consortium of 56
Virginia community bank owners and Bankers Investments Group is owned by 30
Virginia community banks. 13




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##### 



The revenues of TFB are primarily derived from interest and fees received 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 TFB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 TFB are the interest paid on deposits and
borrowings, and operating and general administrative expenses. As is the case with banking institutions generally, TFB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, TFB 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. TFB faces strong competition in the
attraction of deposits (its primary source of lendable funds) and in the
origination of loans. CRITICAL ACCOUNTING POLICIES GENERAL.Bankshares 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 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) 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 and (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. Our allowance for loan losses has three basic components: the specific
allowance, 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 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. 14




---



##### 



The formula 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 formula allowance is used for the remaining pool of larger balance,
non-homogeneous loans which were not allocated a specific allowance upon their
review. The formula 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.
We also consider 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 formula 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 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 either the formula or specific
allowances. In addition, an unallocated reserve is maintained to recognize the
imprecision in estimating and measuring inherent losses on individual loans or
pools of loans. EXECUTIVE OVERVIEW This discussion is intended to focus on certain financial information regarding
Bankshares and TFB 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, TFB has become the
primary independent community bank in its immediate geographic market. TFB
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 $1.33 million for the quarter ending September 30, 2004 was a
10.5% increase from the September 2003 quarter net income of $1.21 million. Net
income for the nine months ended September 30, 2004 was $3.49 million compared
with $3.24 million for the nine months ended September 30, 2003. The rate of
period-over-period growth in Bankshares net income would have been even higher
without the disproportionate impact on net income of the gain on sale of
securities in 2003. During the quarter ended September 30, 2003, TFB sold $10
million of available-for-sale government agency and corporate securities, whose
weighted-average remaining maturity was approximately one year, for a gain on
sale of $288,000, which adjusted for applicable taxes contributed $190,000 to
net income. The net income results were consistent with managements internal projections.
Bankshares and TFB experienced growth across all of the primary operating
businesses, with growth in commercial and retail lending, deposit accounts and
core deposits, and assets under WMS management. During the first quarter of
2003, TFB modified its loan pricing strategies and expanded its loan product
offerings in an effort to increase lending activity without sacrificing the
existing credit quality standards. The result of this effort has been a 16.7%
increase in net loan outstandings from September 30, 2003 to September 30,
2004. Total deposits increased 17.5% from September 30, 2003 to September 30,
2004, with TFB gaining local market customers dissatisfied with the service and
pricing resulting from the consolidation of other local community banks into
larger, out-of-market financial institutions. WMS assets under management grew
by $42.5 million to $235.7 million, or 22.0%, from September 30, 2003 to
September 30, 2004, with WMS revenue increasing from $673,000 to $970,000 or
44.0% for the respective nine month periods, as management focused more people,
marketing, and other resources toward the WMS business. Management continued the expansion of its branch network into southern Fauquier
County with a new branch which opened in Bealeton, Virginia during May of 2004.
Additionally, TFB looks to add to its branch network in western Prince William
County, as well as Fauquier County. TFB is 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. 15




---



##### 



COMPARISION OF OPERATING RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2004
AND SEPTEMBER 30, 2003 NET INCOME.Net income for the three months ended
September 30, 2004 was $1.33 million or $0.38 per diluted share compared with
$1.21 million or $0.34 per diluted share for the three months ended September
30, 2003. The $126,000 or 10.5% increase in net income for the quarter was
fundamentally in-line with management expectations. The rate of
period-over-period growth in Bankshares net income would have been even higher
without the disproportionate impact on net income of the gain on sale of
securities in 2003. During the quarter ended September 30, 2003, TFB sold $10
million of available-for-sale government agency and corporate securities, whose
weighted-average remaining maturity was approximately one year, for a gain on
sale of $288,000, which adjusted for applicable taxes contributed $190,000 to
net income. NET INTEREST INCOME.Net interest income increased $686,000 or 18.0% to $4.50
million for the three months ended September 30, 2004 compared with $3.81
million for the three months ended September 30, 2003. 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 September 2004 quarter was 4.61%
compared with 4.63% for the same quarter one year earlier. Average interest-earning assets grew 17.8% to $387.2 million for the third
quarter of 2004 compared with $328.7 million for the third quarter of 2003. The
yield on average interest-earning assets was 5.78% for both respective
quarters. Total interest income increased $875,000 or 18.3% to $5.64 million
for the three months ended September 30, 2004, compared with $4.77 million for
the three months ended September 30, 2003, as a result of the growth in
interest-earning assets. Interest and dividends on investment securities
increased $130,000 or 36.2%. Investment securities averaged $52.1 million for
the third quarter of 2004 compared with $61.3 million for the same quarter one
year earlier. The yield on investment securities was 3.82% on a tax-equivalent
basis for the third quarter of 2004, compared with 2.39% for the third quarter
of 2003. Interest and fees on loans increased $738,000 or 16.8% to $5.13
million for the September 2004 quarter compared with the same quarter one year
earlier. Average loans outstanding totaled $329.3 million and earned 6.17% on a
tax-equivalent basis for the quarter ended September 30, 2004, compared with
$262.0 million and 6.67%, respectively, for the quarter ended September 30,
2003. Total interest expense increased $189,000 or 19.8% to $1.15 million for the
three months ended September 30, 2004 from $0.96 million for the three months
ended September 30, 2003. Average interest-bearing liabilities grew 17.5% to
$306.2 million for the third quarter of 2004 compared with $260.6 million for
the third quarter of 2003, while the average cost on interest-bearing
liabilities increased to 1.48% from 1.45% 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 growth in the high
balance, premium interest rate NOW account product first offered in March 2004.
Average certificates of deposit balances for the third quarter of 2004 were
$78.2 million at an average cost of 2.55%, compared with $80.8 million at an
average cost of 2.59% for the same quarter one year earlier. Interest-bearing
NOW account deposits averaged $91.8 million at an average cost of 0.95% for the
September 2004 quarter, compared with $56.2 million at an average cost of 0.20%
for the September 2003 quarter. Both the growth in average balances and the
increase in the average cost were attributable to the high balance, premium
interest rate NOW accounts. Interest-bearing money market deposits averaged
$73.7 million at an average cost of 0.80% for the quarter ended September 30,
2004, compared with $61.9 million at an average cost of 0.82% for the same
quarter one year earlier. Savings account deposits averaged $40.9 million at
an average cost of 0.35% for the September 2004 quarter, compared with $41.1
million at an average cost of 0.40% for the September 2003 quarter. Average
FHLB of Atlanta advances were $17.6 million at an average cost of 4.14% for the
third quarter of 2004, and $15.0 million at an average cost of 4.64% one year
earlier. 16




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##### 



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 2004 and
beyond as average interest-earning assets increase, but this may be offset in
part or in whole by a possible contraction in TFBs net interest margin
resulting from competitive market conditions. Additionally, TFB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
decrease if market interest rates fall. The specific nature of TFB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 TFBs deposit base
structure. During the third quarter of 2004, demand deposits, NOW accounts, and
savings deposits averaged 22%, 25%, and 11% of total average deposits,
respectively, while the more interest-rate sensitive time certificates of
deposit averaged 21% of total average deposits. 17




---



##### 



The following table sets forth information relating to Bankshares average
balance sheet and reflects the average yield on assets and the average
annualized cost of liabilities for the three month periods ended September 30,
2004 and 2003. 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 Ending September 30, 2004
    
    Three Months Ending September 30, 2003Average
    
    Income/
    
    Average
    
    Average
    
    Income/
    
    AverageBalances
    
    Expense
    
    Rate
    
    Balances
    
    Expense
    
    RateASSETS:LoansTaxable
    
    $
    320,795
    
    
    $
    5,041
    
    
    
    6.17
    %
    
    $
    252,565
    
    
    $
    4,283
    
    
    
    6.66
    %Tax-exempt (1)
    
    
    7,509
    
    
    
    137
    
    
    
    7.13
    %
    
    
    8,493
    
    
    
    168
    
    
    
    7.75
    %Nonaccrual
    
    
    971
    
    
    
    0
    
    
    
    
    
    
    
    949
    
    
    
    0Total Loans
    
    
    329,275
    
    
    
    5,178
    
    
    
    6.17
    %
    
    
    262,007
    
    
    
    4,451
    
    
    
    6.67
    %SecuritiesTaxable
    
    
    50,841
    
    
    
    475
    
    
    
    3.74
    %
    
    
    59,849
    
    
    
    345
    
    
    
    2.30
    %Tax-exempt (1)
    
    
    1,211
    
    
    
    22
    
    
    
    7.19
    %
    
    
    1,410
    
    
    
    22
    
    
    
    6.22
    %Total securities
    
    
    52,052
    
    
    
    497
    
    
    
    3.82
    %
    
    

    61,259
    
    
    
    367
    
    
    
    2.39
    %Deposits in banks
    
    
    261
    
    
    
    
    
    
    
    0.81
    %
    
    
    299
    
    
    
    1
    
    
    
    1.10
    %Federal funds sold
    
    
    5,561
    
    
    
    19
    
    
    
    1.35
    %
    
    
    5,089
    
    
    
    12
    
    
    
    0.91
    %Total earning assets
    
    
    387,149
    
    
    
    5,694
    
    
    
    5.78
    %
    
    
    328,653
    
    
    
    4,831
    
    
    
    5.78
    %Less: Reserve for loan losses
    
    
    (3,839
    )
    
    
    
    
    
    
    
    
    
    
    (3,160
    )Cash and due from banks
    
    
    17,041
    
    
    
    
    
    
    
    
    
    
    
    14,842Bank premises and equipment, net
    
    
    8,782
    
    
    
    
    
    
    
    
    
    
    
    7,941Other assets
    
    
    11,596
    
    
    
    
    
    
    
    
    
    
    
    10,208Total Assets
    
    $
    420,731
    
    
    
    
    
    
    
    
    
    
    $
    358,483LIABILITIES AND SHAREHOLDERS EQUITY:DepositsDemand deposits
    
    $
    82,410
    
    
    
    
    
    
    
    
    
    
    $
    67,668Interest-bearing depositsNOW accounts
    
    
    91,836
    
    
    
    219
    
    
    
    0.95
    %
    
    
    56,247
    
    
    
    29
    
    
    
    0.20
    %Money market accounts
    
    
    73,662
    
    
    
    149
    
    
    
    0.80
    %
    
    
    61,912
    
    
    
    128
    
    
    
    0.82
    %Savings accounts
    
    
    40,939
    
    
    
    36
    
    
    
    0.35
    %
    
    
    41,115
    
    
    
    42
    
    
    
    0.40
    %Time deposits
    
    
    78,180
    
    
    
    503
    
    
    
    2.55
    %
    
    
    80,829
    
    
    
    528
    
    
    
    2.59
    %Total interest-bearing deposits
    
    
    284,617
    
    
    
    907
    
    
    
    1.26
    %
    
    
    240,103
    
    
    $
    727
    
    
    
    1.20
    %Federal funds purchased and
securities sold under
agreements to repurchase
    
    
    3
    
    
    
    0
    
    
    
    1.84
    %
    
    
    1,520
    
    
    
    5
    
    
    
    1.17
    %Federal Home Loan Bank advances
    
    
    17,554
    
    
    
    186
    
    
    
    4.14
    %
    
    
    15,000
    
    
    
    178
    
    
    
    4.64
    %Capital Securities of Subsidiary Trust
    
    
    4,000
    
    
    
    53
    
    
    
    5.20
    %
    
    
    4,000
    
    
    
    47
    
    
    
    4.61
    %Total interest-bearing liabilities
    
    
    306,174
    
    
    
    1,146
    
    
    
    1.48
    %
    
    
    260,623
    
    
    $
    957
    
    
    
    1.45
    %Other liabilities
    
    
    2,573
    
    
    
    
    
    
    
    
    
    
    
    2,703Shareholders equity
    
    
    29,572
    
    
    
    
    
    
    
    
    
    
    
    27,490Total Liabilities & Shareholders
Equity
    
    $
    420,731
    
    
    
    
    
    
    
    
    
    
    $
    358,483Net interest spread
    
    
    
    
    
    $
    4,548
    
    
    
    
    
    
    
    
    
    
    $
    3,874Interest expense as a percent of
average earning assets
    
    
    
    
    
    
    
    
    
    
    1.17
    %
    
    
    
    
    
    
    
    
    
    
    1.15
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    4.61
    %
    
    
    
    
    
    
    
    
    
    
    4.63
    %
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%. The
amount of the tax equivalent adjustment for the three month periods ending September 30, 2004 and 2003 is $54,000 and
$65,000, respectively. 18




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##### 



RATE/VOLUME ANALYSIS The following
table sets forth certain information regarding changes
in interest income and interest expense of Bankshares
 for the three month periods ended September 30, 2004
and 2003. 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 Ending September 30, 2004 Compared toThree Months Ending September 30, 2003Due to
    
    Due toChange
    
    Volume
    
    RateLoans; taxable
    
    $
    758
    
    
    $
    1,042
    
    
    $
    (284
    )Loans; tax-exempt (1)
    
    
    (31
    )
    
    
    (18
    )
    
    
    (13
    )Securities; taxable
    
    
    130
    
    
    
    (41
    )
    
    
    171Securities; tax-exempt (1)
    
    
    0
    
    
    
    (1
    )
    
    
    1Deposits in banks
    
    
    (1
    )
    
    
    
    
    
    
    (1
    )Federal funds sold
    
    
    7
    
    
    
    1
    
    
    
    6Total Interest Income
    
    
    863
    
    
    
    983
    
    
    
    (120
    )INTEREST EXPENSENOW accounts
    
    
    190
    
    
    
    27
    
    
    
    163Money market accounts
    
    
    21
    
    
    
    24
    
    
    
    (3
    )Savings accounts
    
    
    (6
    )
    
    
    
    
    
    
    (6
    )Time deposits
    
    
    (25
    )
    
    
    (17
    )
    
    
    (8
    )Federal funds purchased and securities
sold under agreements to repurchase
    
    
    (5
    )
    
    
    5
    
    
    
    Federal Home Loan Bank Advances
    
    
    8
    
    
    
    
    
    
    
    Capital Securities of Subsidiary Trust
    
    
    6
    
    
    
    
    
    
    
    6Total Interest Expense
    
    
    189
    
    
    
    39
    
    
    
    152Net Interest Income
    
    $
    674
    
    
    $
    944
    
    
    $
    (272
    )
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34% The monitoring and management of net interest income is the responsibility of
TFBs Asset and Liability Management Committee (ALCO). ALCO meets no less
than once a month, and is comprised of TFBs senior management. PROVISION FOR LOAN LOSSES.The provision for loan losses was $231,000 and
$240,000 for the three months ended September 30, 2004 and 2003, respectively.
The respective amounts of the provision for loan losses were determined based
upon managements continual evaluation of the adequacy of the allowance for
loan losses, which encompasses the overall risk characteristics of the loan
portfolio, trends in TFBs delinquent and non-performing loans, estimated
values of collateral, and the impact of economic conditions on borrowers.
There can be no assurances, however, that future losses will not exceed
estimated amounts, or that additional provisions for loan losses will not be
required in future periods. Please refer to the section entitled Critical
Accounting Policies: Allowance for Loan Losses above for an explanation of the
allowance methodology. 19




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##### 



TOTAL OTHER INCOME.Total other income decreased by $185,000 or 12.4% from
$1.49 million for the three months ended September 30, 2003 to $1.31 million
for the three months ended September 30, 2004. This decrease stemmed primarily
from the absence of gains on sales of securities during the September 2004
quarter compared with a gain on sale of securities of $288,000 during the
September 2003 quarter. Management is not projecting any sales of securities
for the remainder of 2004. Wealth management income increased $98,000 to $336,000 for the September 2004
quarter compared with $238,000 for the same quarter one year earlier.
Management seeks to increase the level of its future fee income from WMS
through the increase of its market share within its marketplace. While WMS fees
grew 41.0% for the quarter ended September 30, 2004 compared with the quarter
ended September 30, 2003, WMS fees are not projected to continue to grow at
this pace, but are projected to stabilize during the remainder of 2004 and
2005, and show more moderate growth over the longer term. Service charges on deposit accounts increased $78,000, or 12.9% to $687,000 for
the quarter ended September 30, 2004, compared with $609,000 for the same
quarter one year earlier. Management had projected deposits on service charges
to increase essentially in proportion to the growth in transaction account
deposits, which grew approximately 17.5% from September 30, 2003 to September
30, 2004. This has not been the case during the first nine months of 2004. The
variation from expectations was primarily due to the increase in the average
retail customers transaction deposit balances, which in turn lowered the
number of overdrafts resulting in lower associated fees. Management has
reduced its expectations with regard to the level of growth on deposit account
service charges over the next twelve months. Additionally, the impact of Check
21 legislation on deposit account service charges during the remainder of 2004
is difficult to predict. Signed by President Bush on October 28, 2003 and
effective October 28, 2004, the Check Clearing for the 21st Century Act (Check
21) is designed to facilitate check truncation by authorizing substitute
checks, to foster innovation in the check collection system without mandating
receipt of checks in electronic form, and to improve the overall efficiency of
the nations payments system. Over the long term, Check 21 may reduce service
charges on transaction deposit accounts, but may also reduce related
operational expenses. Income on other service charges, commission and fees decreased $72,000 or 20.8%
to $274,000 for the quarter ended September 30, 2004 compared with $346,000 one
year earlier due to TFBs sale its portfolio of merchant card customers. The
result of this sale was the reduction of service charge income of approximately
$90,000 per quarter, offset by an approximate $90,000 per quarter reduction in
merchant card operating expenses. TOTAL OTHER EXPENSES.Total other expenses increased 9.0% or $301,000 to $3.63
million for the three months ended September 30, 2004, compared with $3.33
million for the three months ended September 30, 2003, which was in-line with
managements internal projections. Salary and benefit expenses increased
$306,000, or 18.5% from the September 2003 quarter to the September 2004
quarter. The primary cause for the growth in salary and benefit expense was the
increase of full-time equivalent employees from 128 at September 30, 2003 to
139 at September 30, 2004, as well as increases in the defined-benefit pension
plan and medical insurance expense, and customary annual salary increases. The
growth in full-time equivalent employees primarily reflects the opening of the
Bealeton branch and the growth in lending operations. Net occupancy expenses
were virtually the same for the September 2003 and September 2004 quarters.
Furniture and equipment expenses increased $44,000 or 14.7% over the same time
period, reflecting the increase in computer software depreciation and related
maintenance contracts. Other operating expenses decreased $47,000 or 4.1%. The
decline in other operating expenses primarily reflects the approximate $90,000
per quarter reduction in merchant card operating expenses previously discussed
in TOTAL OTHER INCOME. In addition, TFB completed the renegotiation of its
contract with its data processing service provider effective July 2004. This
renegotiated contract is projected to reduce TFBs operating expenses by
approximately $250,000 annually for the next five years. These decreases in
other operating expenses were partially offset by an increase in legal fees
that can be primarily attributed to meeting the requirements of the
Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Management expects the costs
associated with Sarbanes-Oxley compliance to increase in 2005 in connection
with implementing the requirements of Section 404 regarding Managements Report
on Internal Controls. 20




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##### 



TFB expects salary and benefits to continue to be its largest other expense. As
such, the most important factor with regard to potential changes in other
expenses is the expansion of staff. The cost of any additional staff expansion,
however, would be expected to be offset by the increased revenue generated by
the additional services that the new staff would enable TFB to provide. For the
remainder of 2004, TFB does not project to materially increase staff from its
current levels. COMPARISION OF OPERATING RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004
AND SEPTEMBER 30, 2003 NET INCOME.Net income for the nine months ended
September 30, 2004 was $3.49 million or $0.99 per diluted share compared with
$3.24 million or $0.93 per diluted share for the nine months ended September
30, 2003. The $243,000 or 7.5% increase in net income for the nine month
period was fundamentally in-line with management expectations. The rate of
period-over-period growth in Bankshares net income would have been even higher
without the disproportionate impact on net income of the gain on sale of
securities in 2003. NET INTEREST INCOME.Net interest income increased $1.89 million or 17.3% to
$12.86 million for the nine months ended September 30, 2004 compared with
$10.97 million for the nine months ended September 30, 2003. The increase in
net interest income resulted from increased interest and fee income on loans as
a result of the growth in loans outstanding. The net interest margin, computed
on a tax equivalent basis, for the September 2004 nine month period was 4.59%
compared with 4.73% for the same nine month period one year earlier. The
decrease in the net interest margin can be attributed primarily to the
continuation of the low shorter-term interest rate environment, and the
corresponding reduction in the average rate on earning assets, which declined
on a tax equivalent basis to 5.73% for the nine month period ended September
30, 2004, from 6.02% for the nine month period ended September 30, 2003, and
outpaced the decline in interest-bearing liabilities by 0.15%. Average interest-earning assets grew 19.9% to $374.0 million for the first nine
months of 2004 compared with $312.0 million for the first nine months of 2003.
Total interest income increased $2.09 million or 15.0% to $16.07 million for
the nine months ended September 30, 2004, compared with $13.98 million for the
nine months ended September 30, 2003, as a result of the growth in
interest-earning assets. Investment securities income decreased $139,000 or
9.7%. Investment securities averaged $50.2 million for the first nine months
of 2004 compared with $64.9 million for the same nine month period one year
earlier. The yield on investment securities was 3.48% on a tax-equivalent
basis for the first nine months of 2004, compared with 2.99% for the first nine
months of 2003. Interest and fees on loans increased $2.22 million or 17.9% to
$14.72 million for the September 2004 nine month period compared with the same
nine month period one year earlier. Average loans outstanding totaled $315.8
million and earned 6.20% on a tax-equivalent basis for the nine month period
ended September 30, 2004, compared with $240.9 million and 6.96%, respectively,
for the nine month period ended September 30, 2003. Total interest expense increased $199,000 or 6.6% to $3.21 million for the nine
months ended September 30, 2004 from $3.01 million for the nine months ended
September 30, 2003. Average interest-bearing liabilities grew 18.7% to $296.3
million for the first nine months of 2004 compared with $249.7 million for the
first nine months of 2003, while the average cost on interest-bearing
liabilities decreased to 1.44% from 1.60% for the same respective time periods.
The decrease in total interest expense and the average cost of
interest-bearing liabilities was due to the continuation of the low
shorter-term interest rate environment into 2004. Average certificates of
deposit balances for the first nine months of 2004 were $77.9 million at an
average cost of 2.51%, compared with $78.0 million at an average cost of 2.72%
for the same nine month period one year earlier. Interest-bearing NOW account
deposits averaged $78.4 million at an average cost of 0.73% for the nine month
period through September 30, 2004, compared with $51.5 million at an average
cost of 0.21% for the same period one year earlier. Interest-bearing money
market deposits averaged $70.3 million at an average cost of 0.81% for the nine
months ended September 30, 2004, compared with $60.1 million at an average cost
of 1.11% for the same period one year earlier. Savings account deposits
averaged $40.6 million at an average cost of 0.36% for the nine months ended
September
30, 2004, compared with $40.3 million at an average cost of 0.52% for the nine
months ended September 30, 2003. Average FHLB of Atlanta advances were $21.7
million at an average cost of 3.59% for the first nine months of 2004, and
$15.0 million at an average cost of 4.64% for the same period one year earlier. 21




---



##### 



The following table sets forth information relating to Bankshares average
balance sheet and reflects the average yield on assets and the average
annualized cost of liabilities for the nine month periods ended September 30,
2004 and 2003. 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) Nine Months Ending September 30, 2004
    
    Nine Months Ending September 30, 2003Average
    
    Income/
    
    Average
    
    Average
    
    Income/
    
    AverageBalances
    
    Expense
    
    Rate
    
    Balances
    
    Expense
    
    RateASSETS:LoansTaxable
    
    $
    306,797
    
    
    $
    14,431
    
    
    
    6.20
    %
    
    $
    231,600
    
    
    $
    12,161
    
    
    
    6.95
    %Tax-exempt (1)
    
    
    8,074
    
    
    
    441
    
    
    
    7.18
    %
    
    
    8,399
    
    
    
    513
    
    
    
    8.05
    %Nonaccrual
    
    
    965
    
    
    
    
    
    
    
    
    
    
    
    938
    
    
    
    Total Loans
    
    
    315,836
    
    
    
    14,872
    
    
    
    6.20
    %
    
    
    240,937
    
    
    
    12,674
    
    
    
    6.96
    %SecuritiesTaxable
    
    
    48,968
    
    
    
    1,245
    
    
    
    3.39
    %
    
    
    63,277
    
    
    
    1,375
    
    
    
    2.90
    %Tax-exempt (1)
    
    
    1,223
    
    
    
    65
    
    
    
    7.13
    %
    
    
    1,595
    
    
    
    80
    
    
    
    6.65
    %Total securities
    
    
    50,191
    
    
    
    1,310
    
    
    
    3.48
    %
    
    
    64,872
    
    
    
    1,455
    
    
    
    2.99
    %Deposits in banks
    
    
    2,908
    
    
    
    18
    
    
    
    0.86
    %
    
    
    189
    
    
    
    2
    
    
    
    1.10
    %Federal funds sold
    
    
    5,038
    
    
    
    40
    
    
    
    1.03
    %
    
    
    6,010
    
    
    
    49
    
    
    
    1.07
    %Total earning assets
    
    
    373,973
    
    
    
    16,240
    
    
    
    5.73
    %
    
    
    312,008
    
    
    
    14,180
    
    
    
    6.02
    %Less: Reserve for loan losses
    
    
    (3,743
    )
    
    
    
    
    
    
    
    
    
    
    (3,060
    )Cash and due from banks
    
    
    17,989
    
    
    
    
    
    
    
    
    
    
    
    16,238Bank premises and equipment, net
    
    
    8,264
    
    
    
    
    
    
    
    
    
    
    
    7,326Other assets
    
    
    10,132
    
    
    
    
    
    
    
    
    
    
    
    8,572Total Assets
    
    $
    406,615
    
    
    
    
    
    
    
    
    
    
    $
    341,084LIABILITIES AND SHAREHOLDERS EQUITY:DepositsDemand deposits
    
    $
    78,930
    
    
    
    
    
    
    
    
    
    
    $
    61,846Interest-bearing depositsNOW accounts
    
    
    78,351
    
    
    
    430
    
    
    
    0.73
    %
    
    
    51,486
    
    
    
    82
    
    
    
    0.21
    %Money market accounts
    
    
    70,331
    
    
    
    426
    
    
    
    0.81
    %
    
    
    60,126
    
    
    
    500
    
    
    
    1.11
    %Savings accounts
    
    
    40,619
    
    
    
    109
    
    
    
    0.36
    %
    
    
    40,346
    
    
    
    156
    
    
    
    0.52
    %Time deposits
    
    
    77,853
    
    
    
    1,466
    
    
    
    2.51
    %
    
    
    77,976
    
    
    
    1,586
    
    
    
    2.72
    %Total interest-bearing deposits
    
    
    267,154
    
    
    
    2,431
    
    
    
    1.21
    %
    
    
    229,934
    
    
    
    2,324
    
    
    
    1.21
    %Federal funds purchased and securities
sold under agreements to repurchase
    
    
    3,484
    
    
    
    34
    
    
    
    1.29
    %
    
    
    739
    
    
    
    10
    
    
    
    1.32
    %Federal Home Loan Bank advances
    
    
    21,673
    
    
    
    593
    
    
    
    3.59
    %
    
    
    15,000
    
    
    
    527
    
    
    
    4.64
    %Capital Securities of Subsidiary Trust
    
    
    4,000
    
    
    
    149
    
    
    
    4.90
    %
    
    
    4,000
    
    
    
    146
    
    
    
    4.83
    %Total interest-bearing liabilities
    
    
    296,311
    
    
    
    3,207
    
    
    
    1.44
    %
    
    
    249,673
    
    
    
    3,007
    
    
    
    1.60
    %Other liabilitiesShareholders equityTotal Liabilities & Shareholders Equity
    
    $
    406,615
    
    
    
    
    
    
    
    
    
    
    $
    311,519Net interest spread
    
    
    
    
    
    $
    13,033
    
    
    
    
    
    
    
    
    
    
    $
    11,173Interest expense as a percent of average
earning assets
    
    
    
    
    
    
    
    
    
    
    1.14
    %
    
    
    
    
    
    
    
    
    
    
    1.28
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    4.59
    %
    
    
    
    
    
    
    
    
    
    
    4.73
    %
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.
The
amount of the tax equivalent adjustment for the nine month periods ending September 30, 2004 and 2003 is
$172,000 and
$201,000, respectively. 22




---



##### 



RATE/VOLUME ANALYSIS The following table sets forth certain information regarding changes in
interest income and interest expense of Bankshares for the nine month periods
ended September 30, 2004 and 2003. 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) Nine Months Ending September 30, 2004 Compared toNine Months Ending September 30, 2003Due to
    
    Due toChange
    
    Volume
    
    RateLoans; taxable
    
    $
    2,270
    
    
    $
    3,400
    
    
    $
    (1,130
    )Loans; tax-exempt (1)
    
    
    (72
    )
    
    
    (19
    )
    
    
    (53
    )Securities; taxable
    
    
    (130
    )
    
    
    (514
    )
    
    
    384Securities; tax-exempt (1)
    
    
    (15
    )
    
    
    (22
    )
    
    
    7Deposits in banks
    
    
    16
    
    
    
    16
    
    
    
    Federal funds sold
    
    
    (9
    )
    
    
    (7
    )
    
    
    (2
    )Total Interest Income
    
    
    2,060
    
    
    
    2,854
    
    
    
    (794
    )INTEREST EXPENSENOW accounts
    
    
    348
    
    
    
    61
    
    
    
    287Money market accounts
    
    
    (74
    )
    
    
    125
    
    
    
    (199
    )Savings accounts
    
    
    (47
    )
    
    
    1
    
    
    
    (48
    )Time deposits
    
    
    (120
    )
    
    
    (2
    )
    
    
    (118
    )Federal funds purchased and securities
sold under agreements to repurchase
    
    
    24
    
    
    
    24
    
    
    
    Federal Home Loan Bank Advances
    
    
    66
    
    
    
    134
    
    
    
    (68
    )Capital Securities of Subsidiary Trust
    
    
    3
    
    
    
    
    
    
    
    3Total Interest Expense
    
    
    200
    
    
    
    343
    
    
    
    (143
    )Net Interest Income
    
    $
    1,860
    
    
    $
    2,511
    
    
    $
    (651
    )
  (1)
    
    Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%. 23




---



##### 



PROVISION FOR LOAN LOSSES.The provision for loan losses was $540,000 and
$470,000 for the nine months ended September 30, 2004 and 2003, respectively.
Please refer to the section entitled Critical Accounting Policies: Allowance
for Loan Losses above for an explanation of the allowance methodology.
TOTAL OTHER INCOME.Total other income decreased by $18,000 or 0.5% from $3.84
million for the nine months ended September 30, 2003 to $3.82 million for the
nine months ended September 30, 2004.
This decrease stemmed from the absence of gains on sales of securities during
the first nine months of 2004 compared with a gain on sale of securities of
$288,000 during the first nine months of 2003. Revenues within TFBs Wealth
Management Services division increased $296,000 or 44.0% for the first nine
months of 2004 compared with the same period one year earlier. Service charges
on deposit accounts increased
$61,000, or 3.3% to $1.92 million for the nine months ended September 30, 2004,
compared with $1.86 million for the same nine months one year earlier. Other
service charges, commissions and fees decreased $91,000 or 9.2% for the first
nine months of 2004 compared with the first nine months of 2003. The reason
for these year to date variances from the prior year are the same factors
discussed in the section entitled COMPARISION OF OPERATING RESULTS FOR THE
THREE MONTHS ENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003: Total Other
Income. TOTAL OTHER EXPENSES.Total other expenses increased 14.7% or $1.43 million to
$11.14 million for the nine months ended September 30, 2004, compared with
$9.72 million for the nine months ended September 30, 2003, which was in-line
with managements internal projections. Salary and benefit expenses increased
$973,000 or 20.2% from the nine months ended September 30, 2003 to the nine
months ended September 30, 2004. The primary causes of the growth in salary and
benefit expense were the increase of full-time equivalent employees from 119 at
the beginning of 2003 to 139 at September 30, 2004, increases in the
defined-benefit pension plan and medical insurance expense, and customary
annual salary increases. Occupancy and furniture and equipment expenses also
increased over the same period by $11,000 or 1.7%, and $69,000 or 7.8%,
respectively. Other operating expenses increased $375,000 or 11.1%. The growth
in other operating expenses primarily reflects increases in director
compensation, loan fees, non-loan charge-offs, and outsourced data processing
fees, partially offset by the reduction in merchant card operating expenses.
Please refer to the section entitled COMPARISION OF OPERATING RESULTS FOR THE
THREE MONTHS ENDED SEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003: Total Other
Expensesabove for discussion on merchant card operating expenses. COMPARISON OF SEPTEMBER 30, 2004 AND DECEMBER 31, 2003 FINANCIAL
CONDITION Assets totaled $424.7 million at September 30, 2004, an increase of
12.2% or $46.2 million from $378.5 million at December 31, 2003. Balance sheet
categories reflecting significant changes include cash and due from banks,
loans, federal funds sold and federal funds purchased, and deposits. Each of
these categories is discussed below.
CASH AND DUE FROM BANKS.At September 30,
2004, cash and due from banks totaled $18.3 million, reflecting an increase of
$6.5 million from $11.8 million at December 31, 2003. The increase in cash and
due from banks was the result of temporarily increasing TFBs deposits with the
Federal Reserve Bank of Richmond in order to satisfy reserve requirements. LOANS.Net loans were $322.1 million at September 30, 2004, which is an
increase of $26.8 million or 9.1% from $295.3 million at December 31, 2003.
The growth in total loans is primarily attributable to an increase of $12.4
million in mortgage loans collateralized by 1-to-4 family residential real
estate, an increase of $12.3 million in mortgage loans collateralized by
commercial real estate, and an increase of $5.5 million in construction loans.
TFBs loans are made primarily to customers located within TFBs primary market
area. During 2003 and continuing for the first nine months of 2004, TFB
modified its loan pricing strategies and expanded its loan product offerings in
an effort to increase lending activity without sacrificing existing credit
quality standards. This change in strategy was the primary reason for the
increase in loans outstanding. Management will continue to utilize the same
pricing strategies for the remainder of 2004, but does not project to originate
the same level of 1-4 family residential real estate loans in 2004 as it did in
2003, primarily due to competitive pressures and market interest rates. FEDERAL FUNDS SOLD and FEDERAL FUNDS PURCHASED.Federal funds sold were $11.7
million at September 30, 2004, compared to federal funds purchased of $2.0
million at December 31, 2003. 24




---



##### 



DEPOSITS. At September 30, 2004, total deposits were $372.8 million,
reflecting an increase of $38.2 million or 11.9% from $321.1 million at
December 31, 2003. The growth was attributable to growth in
noninterest-bearing deposits, which increased $13.8 million, and growth in
interest-bearing deposits, which increased $24.4 million. Several factors may
have contributed to the increase in deposits. One factor was TFB gaining
in-market customers who were dissatisfied with the service and pricing
resulting from the consolidation of other local community banks into larger,
out-of-market financial institutions. Another factor may have been the
increase in tax refunds flowing into bank deposits. A third factor was gaining
deposits from new customers at the newly-opened Bealeton branch. TFB expects to
increase its deposits in 2004 and beyond through the continued expansion of its
branch network, as well as by offering value-added demand deposit products, and
selective rate premiums on interest-bearing deposits. ASSET QUALITY Non-performing assets, in most cases, consist of loans that
are 90 days or more past due and for which the accrual of interest has been
discontinued. Management evaluates all loans that are 90 days or more past
due, as well as loans that have suffered financial distress, to determine if
they should be placed on non-accrual status. Factors considered by management
include the estimated value of collateral, if any, and other resources of the
borrower that may be available to satisfy the delinquency.

 Non-performing
assets totaled $1.17 million or 0.36% of total loans at September 30, 2004, as
compared with $967,000, or 0.33% of total loans at December 31, 2003, and $1.10
million, or 0.39% of total loans at September 30, 2003. The provision for loan
losses was $540,000 for the first nine months of 2004 compared with $470,000
for the first nine months of 2003. The 14.8% increase in the provision for loan
losses from September 30, 2003 to 2004 was largely in response to the growth in
new loan originations during the last 12 months, and, to a lesser extent, the
continued uncertainty existing in the economic and geopolitical environment.


Loans that are 90 days past due and accruing interest totaled $20,000 and
$840,000 at September 30, 2004 and December 31, 2003, respectively. No loss is
anticipated on these loans based on the value of the underlying collateral and
other factors. There are no loans, other than those disclosed above as either non-performing
or impaired, where known information about the borrower has caused management
to have serious doubts about the borrowers ability to repay the loan. There
are also no other interest-bearing assets that would be subject to disclosure
as either non-performing or impaired if such interest-bearing assets were
loans. The largest concentrations of loans to borrowers engaged in similar
activities are $22.4 million for hotel/motel/inn loans, $19.2 million for land
development loans, and $9.8 million for child care facility loans. These three
loan concentrations represent 6.9%, 5.9%, and 3.0% of total loans respectively. CONTRACTUAL OBLIGATIONS During July 2004, TFB completed the renegotiation and signed a five year
contract with its data processing service provider, which is projected to
reduce TFBs operating expenses by approximately $250,000 annually for the next
five years. Aside from this, as of September 30, 2004, there have been no
material changes outside the ordinary course of business to the contractual
obligations disclosed in Managements Discussion and Analysis in Bankshares
Annual Report on Form 10-K for the year ended December 31, 2003. OFF-BALANCE SHEET ARRANGEMENTS As of September 30, 2004, there have been no material changes to the
off-balance sheet arrangements disclosed in Managements Discussion and
Analysis in Bankshares Annual Report on Form 10-K for the year ended December
31, 2003. 25




---



##### 



CAPITAL RESOURCES Total shareholders equity was $30.4 million at September 30, 2004 compared to
$28.5 million at December 31, 2003, an increase of $1.89 million, or 6.7%.
Bankshares shareholders equity was reduced $697,000 due to the repurchase of
30,570 shares of common stock at an average cost of $22.54 during the first
nine months of 2004. In addition, 41,989 shares of Bankshares common stock
were newly issued at an average price of $6.71 through Bankshares stock option
plans during the first nine months of 2004. During July 2004, Bankshares instituted a voluntary dividend reinvestment plan
(DRIP) through which shareholders may purchase shares of common stock through
the automatic reinvestment of their dividends. Additionally through the DRIP,
shareholders are also given the opportunity to purchase additional shares of
common stock up to specified dollar amount limits. The DRIP may either buy
existing shares in the open market, or issue newly outstanding shares in order
to fulfill its reinvestment needs. Bankshares currently has registered 250,000
shares of common stock for issuance under the DRIP. For the quarter ending
September 30, 2004, Bankshares issued 1,546 newly outstanding shares through
the DRIP at an average price of $21.63 for a total addition to shareholders
equity of $33,000. Banking regulations have established minimum capital requirements for financial
institutions, including risk-based capital ratios and leveraged ratios. Under
these guidelines, the $4.0 million of capital securities issued by Bankshares
subsidiary trust are treated as Tier 1 capital for purposes of the Federal
Reserves capital guidelines for bank holding companies, as long as the capital
securities and all other cumulative preferred securities of Bankshares together
do not exceed 25% of Tier 1 capital. Bankshares and TFB exceed their minimum
regulatory capital ratios. The following table sets forth the regulatory
capital ratio calculation for Bankshares: REGULATORY CAPITAL RATIOS
(in Thousands) September 30,
    
    December 31,2004
    
    2003Tier 1 Capital:Shareholders Equity
    
    $
    30,357
    
    
    $
    28,463Unrealized loss (gain) on securities
available for sale
    
    
    (143
    )
    
    
    (41
    )Less: Intangible assets, net
    
    
    (64
    )
    
    
    (83
    )Plus: Company-obligated madatorily
redeemable capital securities
    
    
    4,000
    
    
    
    4,000Total Tier 1 Capital
    
    
    34,150
    
    
    
    32,339Tier 2 Capital:Allowable Allowance for Loan Losses
    
    
    3,910
    
    
    
    3,511Total Capital:
    
    $
    38,060
    
    
    $
    35,850Risk Weighted Assets:
    
    $
    312,837
    
    
    $
    280,916Regulatory Capital Ratios:Leverage Ratio
    
    
    8.12
    %
    
    
    8.58
    %Tier 1 to Risk Weighted Assets
    
    
    10.92
    %
    
    
    11.51
    %Total Capital to Risk Weighted Assets
    
    
    12.17
    %
    
    
    12.76
    %
 26




---



##### 



LIQUIDITY The primary sources of funds are deposits, repayment of loans, maturities of
investments, funds provided from operations and advances from the FHLB of
Atlanta. While scheduled repayments of loans and maturities of investment
securities are predictable sources of funds, deposit flows and loan repayments
are greatly influenced by the general level of interest rates, economic
conditions and competition. TFB uses its sources of funds to fund existing and
future loan commitments, to fund maturing certificates of deposit and demand
deposit withdrawals, to invest in other interest-earning assets, to maintain
liquidity, and to meet operating expenses. Management monitors projected
liquidity needs and determines the desirable funding level based in part on
TFBs commitments to make loans and managements assessment of TFBs ability to
generate funds. Cash and amounts due from depository institutions, interest-bearing deposits in
other banks, and federal funds sold totaled $30.2 million at September 30, 2004
compared with $12.0 million at December 31, 2003. These assets provide the
primary source of liquidity for TFB. In addition, management has designated the
entire investment portfolio as available of sale, of which approximately $39.6
million is unpledged and readily salable. Futhermore, TFB has an available
line of credit with the FHLB of Atlanta with a borrowing limit of approximately
$127.4 million at September 30, 2004 to provide additional sources of
liquidity, as well as federal funds borrowing lines of credit with various
commercial banks totaling approximately $37.8 million. At September 30, 2004,
$15.0 million of the FHLB of Atlanta line of credit was in use. The following table sets forth information relating to Bankshares sources of
liquidity and the outstanding commitments for use of liquidity at September 30,
2004 and December 31, 2003. The liquidity coverage ratio is derived by dividing
the total sources of liquidity by the outstanding commitments for use of
liquidity. LIQUIDITY SOURCES AND USES
(In Thousands) September 30, 2004
    
    December 31, 2003Total
    
    In Use
    
    Available
    
    Total
    
    In Use
    
    AvailableSources:Federal funds borrowing lines of credit
    
    $
    37,800
    
    
    $
    
    
    
    $
    37,800
    
    
    $
    33,077
    
    
    $
    2,000
    
    
    $
    31,077Federal Home Loan Bank advances
    
    
    127,391
    
    
    
    15,000
    
    
    
    112,391
    
    
    
    60,540
    
    
    
    20,000
    
    
    
    40,540Federal Reserve discount window
    
    
    431
    
    
    
    
    
    
    
    431
    
    
    
    702
    
    
    
    
    
    
    
    702Federal funds sold
    
    
    
    
    
    
    
    
    
    
    11,672
    
    
    
    
    
    
    
    
    
    
    
    Securities, available for sale and
unpledged
at fair value
    
    
    
    
    
    
    
    
    
    
    39,610
    
    
    
    
    
    
    
    
    
    
    
    40,655Total short-term funding sources
    
    
    
    
    
    
    
    
    
    $
    201,904
    
    
    
    
    
    
    
    
    
    
    $
    112,974Uses:Unfunded loan commitments and
lending lines of credit
    
    
    
    
    
    
    
    
    
    $
    69,755
    
    
    
    
    
    
    
    
    
    
    $
    70,158Letters of credit
    
    
    
    
    
    
    
    
    
    
    10,776
    
    
    
    
    
    
    
    
    
    
    
    6,192Total potential short-term funding uses
    
    
    
    
    
    
    
    
    
    $
    80,531
    
    
    
    
    
    
    
    
    
    
    $
    76,350Ratio of short-term funding sources to
potential short-term funding uses
    
    
    
    
    
    
    
    
    
    
    250.7
    %
    
    
    
    
    
    
    
    
    
    
    148.0
    %
 27




---



##### 



Management is not aware of any market or institutional trends, events or
uncertainties that are expected to have a material effect on the liquidity,
capital resources or operations of Bankshares or TFB. Nor is management aware
of any current recommendations by regulatory authorities that would have a
material effect on liquidity, capital resources or operations. TFBs internal
sources of such liquidity are deposits, loan and investment repayments, and
securities available for sale. TFBs primary external source of liquidity is
advances from the FHLB of Atlanta. RECENT ACCOUNTING PRONOUNCEMENTS On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105,
Application of Accounting Principles to Loan Commitments(SAB 105). SAB 105
clarifies existing accounting practices relating to the valuation of issued
loan commitments, including interest rate lock commitments (IRLC), subject to
SFAS No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions:
When a Loan Commitment is included in the Scope of Statement 133.Furthermore,
SAB 105 disallows the inclusion of the values of a servicing component and
other internally developed intangible assets in the initial and subsequent IRLC
valuation. The provisions of SAB 105 were effective for loan commitments
entered into after March 31, 2004. Bankshares has adopted the provisions of SAB
105. Since the provisions of SAB 105 affect only the timing of the recognition
of mortgage banking income, management does not anticipate that this guidance
will have a material adverse effect on either Bankshares consolidated
financial position or consolidated results of operations. Emerging Issues Task Force Issue No. (EITF) 03-1 The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investmentswas
issued and became effective March 31, 2004. The EITF 03-1 provides guidance
for determining the meaning of other than-temporarily impaired and its
application to certain debt and equity securities within the scope of Statement
of Financial Accounting Standards No. 115 Accounting for Certain Investments
in Debt and Equity Securities(SFAS No. 115) and investments accounted for
under the cost method. The guidance requires that investments which have
declined in value due to credit concerns or solely due to changes in interest
rates must be recorded as other-than-temporarily impaired unless Bankshares can
assert and demonstrate its intention to hold the security for a period of time
sufficient to allow for a recovery of fair value up to or beyond the cost of
the investment which might mean maturity. This issue also requires disclosures
assessing the ability and intent to hold investments in instances in which an
investor determines that an investment with a fair value less than cost is not
other-than-temporarily impaired On September 30, 2004, the Financial Accounting Standards Board (FASB)
decided to delay the effective date for the measurement and recognition
guidance contained in Issue 03-1. This delay does not suspend the requirement
to recognize other-than-temporary impairments as required by existing
authoritative literature. The disclosure guidance in Issue 03-1 was not
delayed. Please refer to Notes to Consolidated Financial Statements:
Securities for discussion on Issue 03-1 as it pertains to TFBs investment
portfolio. EITF No. 03-16, Accounting for Investments in Limited Liability Companieswas
ratified by FASB and is effective for reporting periods beginning after June
15, 2004.APB Opinion No. 18, The Equity Method of Accounting Investments in
Common Stock,prescribes the accounting for investments in common stock of
corporations that are not consolidated. AICPA Accounting Interpretation 2,
Investments in Partnerships Ventures,of Opinion 18, indicates that many of
the provisions of the Opinion would be appropriate in accounting for
partnerships. In EITF Abstracts,Topic No. D-46, Accounting for Limited
Partnership Investments,the SEC staff clarified its view that investments of
more than 3% to 5% are considered to be more than minor and, therefore, should
be accounted for using the equity method. Limited liability companies (LLCs)
have characteristics of both corporations and partnerships, but are dissimilar
from both in certain respects. Due to those similarities and differences,
diversity in practice exists with respect to accounting for non-controlling
investments in LLCs. The consensus reached was that an LLC should be viewed as
similar to a corporation or similar to a partnership for purposes of
determining whether
a non-controlling investment should be accounted for using the cost method or
the equity method of accounting. 28




---



##### 



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have
been no material changes to the quantitative and qualitative disclosures made
in Bankshares Annual Report on Form 10-K for the year ended December 31, 2003. 
 ITEM 4. CONTROLS AND PROCEDURES As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers such as
Bankshares that file periodic reports under the Exchange Act of 1934 are
required to include in those reports certain information concerning the
issuers controls and procedures for complying with the disclosure requirements
of the federal securities laws. These disclosure controls and procedures
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by an issuer in the reports it files or
submits under the Exchange Act, is communicated to the issuers management,
including its principal executive officer or officers and principal financial
officer or officers, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure. We have established disclosure controls and procedures to ensure that material
information related to Bankshares is made known to our principal executive
officer and principal financial officer on a regular basis, in particular
during the periods in which our quarterly and annual reports are being
prepared. These disclosure controls and procedures consist principally of
communications between and among the chief executive officer and the chief
financial officer, and the other executive officers of Bankshares and its
subsidiaries to identify any new transactions, events, trends, contingencies or
other matters that may be material to Bankshares operations. The chief
executive officer and chief financial officer evaluated the effectiveness of
these disclosure controls and procedures as of the end of the period covered by
this report and, based on their evaluation, concluded that our disclosure
controls and procedures were operating effectively. Because of the inherent limitations in all control systems, no evaluation of
controls can provide absolute assurance that Bankshares disclosure controls
and procedures will detect or uncover every situation involving the failure of
persons within the organization to disclose material information otherwise
required to be set forth in Bankshares periodic reports. Bankshares management is also responsible for establishing and maintaining
adequate internal controls over financial reporting and control of Bankshares
assets to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. There were no changes
in Bankshares internal control over financial reporting or control of assets
during the quarter ended September 30, 2004 that have materially affected, or
are reasonably likely to materially affect, Bankshares internal control over
financial reporting or control of assets. 
 Part II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS There are no pending or
threatened legal proceedings to which Bankshares or TFB is a party or to which
the property of either Bankshares or TFB is subject that, in the opinion of
management, may materially impact the financial condition of either company. 29




---



##### 



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS In September 1998, Bankshares announced an open market buyback program for
its common stock. Initially, the plan authorized Bankshares to repurchase up to
73,672 shares of its common stock through December 31, 1999. Each year, the
Board resets the amount of shares authorized to be repurchased during the year
under the buyback program. On May 20, 2004, the Board authorized Bankshares to
repurchase up to 264,325 shares (8% of the shares of common stock outstanding
on January 1, 2003) beginning January 1, 2003 and continuing until the next
Board reset. Bankshares has repurchased 51,580 shares under the current
program from January 1, 2003 through September 30, 2004. No shares were
repurchased during the quarter ended September 30, 2004. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES None 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 
 ITEM 5. OTHER INFORMATION None 
 ITEM 6. EXHIBITS 3.1 Articles of Incorporation of Fauquier Bankshares, Inc., as amended,
incorporated by reference to Exhibit 3(i) to registration statement on
Form 10 filed April 16, 1999 3.2 Bylaws of Fauquier Bankshares, Inc., incorporated by
reference to Exhibit 3(ii) to registration statement on Form 10 filed
April 16, 1999 Certain instruments relating to capital securities not being registered
have been omitted in accordance with Item 601(b)(4)(iii) of Regulation S-K.
The registrant will furnish a copy of any such instrument to the Securities and
Exchange Commission upon its request.


11 Refer to Part I, Item 1, Footnote 5 to
the Consolidated Financial Statements.  31.1
    
    Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)31.2
    
    Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)32.1
    
    Certification Pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer32.2
    
    Certification Pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer 30




---



##### 



SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. FAUQUIER BANKSHARES, INC.(Registrant)Date: November 12, 2004
    
    /s/ Randy K. FerrellRandy K. FerrellPresident and Chief Executive Officer(principal executive officer)Date: November 12, 2004
    
    /s/ Eric P. GraapEric P. GraapSenior Vice President and Chief Financial Officer(principal financial and accounting officer)
 31