UNITED STATESSECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549**______________**

FORM 10-K

ANNUAL REPORT PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark one)

|XXX |  | ANNUAL REPORT
      PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT
      OF **1934**
|--- |  | ----------------------------------------------------------------------------------------------------
|    |  |                                                                                                     
|    |  | For the fiscal year
      ended December 31, 2007                                                   
|    |  |                                                                                                     
|    |  | TRANSITION REPORT
      PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934
|    |  |                                                                                                     
|    |  | For the transition
      period from __________ to
    __________                                   

Commission File Number 0-24958

POTOMAC BANCSHARES, INC.(Exact Name of Registrant as Specified in
Its Charter)

|West
      Virginia                            | 55-0732247               
|---------------------------------------------- | -------------------------
|(State or Other
      Jurisdiction of          | (I.R.S.
      Employer   
|Incorporation or
      Organization)           | Identification
      No.)
|                                              
|111 East
      Washington Street               |                          
|PO Box 906,
      Charles Town WV              | 25414-0906               
|(Address of
      Principal Executive Offices) | (Zip
      Code)         

|Registrant's
      telephone number, including area code          |  | 304-725-8431 | 
|----------------------------------------------------------------- |  | ------------ | 
|                                                                  |  |              | 
|Securities
      registered pursuant to Section 12(b) of the Act: |  |             

|                    |  | Name of Each
      Exchange
|------------------- |  | ---------------------------
|Title of Each Class |  | on
      Which Registered  
|NONE                |  |                            
|                    |  |                            

Securities registered pursuant to
Section 12(g) of the Act:

Common
Stock, $1.00 Par Value(Title of Class)

---

Indicate by check mark if the registrant
is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes ___  NoXX

Indicate by check mark if the registrant
is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act.

Yes ___  NoXX

Indicate by check mark whether the
registrant: (l) 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.

YesXXNo
___

Indicate by check mark if disclosure of
delinquent filers in response to Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the best of registrant's knowledge, in
definitive proxy or information statements incorporated by reference in Part III
of this Form 10-K or any amendment to this Form 10-K. ___

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

Large Accelerated Filer
___          Accelerated Filer
___          Non-Accelerated Filer
___          Smaller Reporting
CompanyXX

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

Yes ___  NoXX

State the aggregate market value of the
voting and non-voting common equity held by nonaffiliates computed by reference
to the price at which the common equity was last sold, or the average bid and
asked price of such common equity, as of the last business day of the
registrants most recently completed second fiscal quarter.$50,054,614 as of June 30, 2007

|Indicate the number of shares outstanding of
      each of the registrant's classes of common stock, as of the latest
      practicable date.
|---------------------------------------------------------------------------------------------------------------------------------------------
|3,405,500 as of March 3,
      2008                                                                                                          

DOCUMENTS INCORPORATED BY REFERENCE

The following lists the document that
is incorporated by reference in the Form 10-K Annual Report, and the Parts and
Items of the Form 10-K into which the document is incorporated.

|                                                                 |  | Part of the
      Form 10-K into Which      | 
|---------------------------------------------------------------- |  | ------------------------------------------- | 
|Document                                                         |  | __the
      Document is Incorporated__      | 
|                                                                 |  |                                             | 
|Portions of Potomac Bancshares,
      Inc.s Proxy Statement for |  | Part III,
      Items 10, 11, 12, 13 and 14 | 
|the 2008 Annual Meeting
      of Shareholders                    |  |                                             | 

2

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Potomac Bancshares, Inc.Annual Report on Form 10-KFor the Year Ended December 31, 2007

|PART I   |        |                                                                                                                         
|-------- | ------ | ------------------------------------------------------------------------------------------------------------------------
|         |        |                                                                                                                         
|Item     | 1.     | Business                                                                                                                
|Item     | 1A.    | Risk Factors                                                                                                            
|Item     | 2.     | Properties                                                                                                              
|Item     | 3.     | Legal Proceedings                                                                                                       
|Item     | 4.     | Submission of Matters to a Vote of Security Holders                                                                     
|        
|PART II  |        |                                                                                                                         
|        
|Item     | 5.     | Market for Registrants Common Equity, Related Stockholder Matters
      and Issuer Purchases of Equity
      Securities
|Item     | 6.     | Selected
      Financial Data                                                                                           
|Item     | 7.     | Managements Discussion and Analysis of Financial Condition and
      Results of Operations                             
|Item     | 8.     | Financial
      Statements and Supplementary Data                                                                       
|Item     | 9.     | Changes In and Disagreements with Accountants on Accounting and
      Financial Disclosure                              
|Item     | 9A(T). | Controls and
      Procedures                                                                                           
|Item     | 9B.    | Other Information                                                                                                       
|        
|PART III |        |                                                                                                                         
|        
|Item     | 10.    | Directors, Executive Officers and Corporate Governance                                                                  
|Item     | 11.    | Executive
      Compensation                                                                                            
|Item     | 12.    | Security Ownership of Certain Beneficial Owners and Management and
      Related Stockholder Matters                    
|Item     | 13.    | Certain
      Relationships and Related Transactions and Director Independence                                          
|Item     | 14.    | Principal Accountant Fees and Services                                                                                  
|        
|PART IV  |        |                                                                                                                         
|        
|Item     | 15.    | Exhibits and Financial Statement Schedules                                                                              

FORWARD-LOOKING STATEMENTS

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

The risks and uncertainties that may
affect the operations, performance, development and results of the companys
business include, but are not limited to, the growth of the economy, interest
rate movements, the impact of competitive products, services and pricing,
customer business requirements, Congressional legislation and similar matters as
well as the occurrence of the events described in the Risk Factors section of
this Form 10-K. We caution readers of this report not to place undue reliance on
forward-looking statements which are subject to influence by the named risk
factors and unanticipated future events. Actual results, accordingly, may differ
materially from management expectations.

3

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PART I

Item 1. Business.

History and
Operations

The Board of Directors of Bank of
Charles Town (the "bank") caused Potomac Bancshares, Inc. ("Potomac" or the
company) to be formed on March 2, 1994, as a single-bank holding company. To
date, Potomac's only activities have involved the acquisition of the bank.
Potomac acquired all of the shares of the banks common stock on July 29, 1994.

Bank of Charles Town is a West
Virginia state-chartered bank that formed and opened for business in 1871. The
Federal Deposit Insurance Corporation insures the banks deposits. The bank
engages in general banking business primarily in Jefferson County and Berkeley
County, West Virginia. The bank also provides services to Washington County and
Frederick County, Maryland and Loudoun County, Frederick County and Clarke
County, Virginia. In 2005 the bank opened a loan production office in
Winchester, Virginia. The main office is in Charles Town, West Virginia at 111
East Washington Street, with branch offices in

- Harpers Ferry,
  West Virginia,
- Kearneysville, West Virginia,
- Martinsburg,
  West Virginia and
- Hedgesville,
  West Virginia.

The bank provides individuals,
businesses and local governments with a broad range of banking services. These
services include

- Commercial
  credit lines, equipment loans, and construction financing,
- Real estate
  loans, secondary market and adjustable rate mortgages,
- Retail loan
  products including home equity lines of credit,
- Checking and
  savings accounts for businesses and individuals and
- Certificates
  of deposit and individual retirement accounts.

Automated teller machines located at
each of the five offices and Touchline 24, an interactive voice response system
available at 1-304-728-2424, provide certain services to customers on a
twenty-four hour basis. The bank initiated the formation of an ATM network with
two banks in the community to provide customers of all three banks 17 ATM
locations in the eastern panhandle of West Virginia. Bill paying and certain
other banking services are available through the Internet. The trust and
financial services department provides financial management, investment and
trust services. BCT Investments provides financial management, investment and
brokerage services.

*Lending
Activities*. The bank offers a variety of
loans for consumer and commercial purposes. The majority of these loans are
secured.

Underwriting standards for all
lending include

- Sound credit
  analysis,
- Proper documentation according to the bank's loan
  policy standards,
- Avoidance of loan concentrations to a single
  industry or with a single class of collateral,
- Diligent
  maintenance of past due and nonaccrual loans and
- A risk grading
  system that assists us in managing deteriorating credits on a proactive basis.

The lending policies of the bank
address the importance of a diversified portfolio and of a balance between
maximum yield and minimum risk. It is the banks policy to avoid concentrations
of loans such as loans to one industry, loans to one borrower or guarantor or
loans secured by similar collateral.

4

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The bank's loan policy designates
particular loan-to-value limits for real estate loans in accordance with
recommendations in Section 304 of the Federal Deposit Insurance Corporation
Improvement Act of 1991. As stated in the loan policy, there may be certain
lending situations not subject to these loan-to-value limits and from time to
time senior management of the bank may permit exceptions to the established
limits. Any exceptions are sufficiently documented.

Loans secured by real estate are
made to individuals and businesses for

- The purchase of raw land and land
  development,
- Commercial, multi-family and other non-residential
  construction,
- Purchase of
  improved property,
- Purchase of
  owner occupied one to four family residential property,
- Lines of
  credit and
- Home equity
  loans.

Approximately 91.1% of the bank's
loans are secured by real estate. These loans had an average delinquency rate of
1.12% and a loss rate of 0.10 % during 2007. The average delinquency rate and
loss rate are based on comparisons to 2007 average total loans.

As of December 31, 2007, aggregate
dollar amounts (in thousands) in loan categories secured by real estate are as
follows:

|·Construction and land
      development  | $ | 55 042 
|----------------------------------------- | - | -------
|·Secured by farmland                      |   | 1 328  
|·Secured by 1-4 family
      residential  |   | 98 864 
|·Secured by multifamily
      residential |   | 1 749  
|·Secured by nonfarm
      nonresidential  |   | 47 726 
|                                         
|                                          | $ | 204 709

Commercial loans not secured by real estate with an aggregate balance of
$5.0 million at December 31, 2007 make up approximately 2.2% of the total loan
portfolio. The banks loan policy for commercial loans including those
commercial loans secured by real estate is to

- Grant loans on a sound and collectible
  basis,
- Invest the banks funds profitably for the benefit
  of shareholders and the protection of depositors and
- Serve the legitimate credit needs of the community
  in which the bank is located.

Average delinquency and the loss
rate for commercial loans not secured by real estate was less than 1% during
2007.

Retail loans to individuals for
personal expenditures are approximately 6.6% of the bank's total loans at
December 31, 2007. The aggregate balance of these loans was $14.7 million at
December 31, 2007. The majority of these loans are installment loans with the
remainder made as term loans.

There is some risk in every retail
loan transaction. The bank accepts moderate levels of risk while minimizing
retail loan losses through careful investigation into the character of each
borrower, determining the source of repayment before closing each loan,
collateralizing most loans, exercising care in documentation procedures,
administering an aggressive retail loan collection program, and following the
retail loan policies. Loans to individuals for personal expenditures had an
average delinquency rate of 0.06 % and a loss rate of 0.04% in 2007 (based on
comparisons to 2007 average total loans).

All other loans total $193 thousand
(0.1% of total loans) at December 31, 2007. These loans had no delinquency rate
and no average loss rate in 2007 compared to 2007 average total loans.

*Investment
Activities*. The bank's investment policy
governs its investment activities.

The policy states that excess daily
funds are to be invested in federal funds sold and securities purchased under
agreements to resell. The daily funds are used to cover deposit draw downs by
customers, to fund loan commitments and to help maintain the bank's
asset/liability mix.

5

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According to the policy, funds in
excess of those invested in federal funds sold and securities purchased under
agreements to resell are to be invested in (1) U.S. Treasury bills, notes or
bonds, (2) obligations of U.S. Government agencies or (3) obligations of the
State of West Virginia and political subdivisions thereof with a rating of not
less than AAA or fully insured bonds.

The policy governs various other
factors including maturities, the closeness of purchase price to par, amounts
that may be purchased and percentages of the various types of investments that
may be held.

*Deposit
Activities*. The bank offers
noninterest-bearing and interest-bearing checking accounts and statement savings
accounts. The bank offers automatically renewable certificates of deposit in
various terms from 91 days to five years. Individual retirement accounts in the
form of certificates of deposit are also available.

To open a deposit account, the
depositor must meet the following requirements for low risk individuals:

- Present a
  valid identification,
- Have a social
  security number,
- Must be a U.S. citizen or possess evidence of
  legal alien status, and
- Must be at least 18 years of age or share an
  account with a person at least 18 years of age.

When depositors are considered medium
or high risk (i.e. out-of-state drivers license and/or resident), additional
verification requirements apply. Management believes that the bank fully
complies with the USA Patriot Act.

Competition

As of February 29, 2008, there were
67 bank holding companies (including multi-bank and one bank holding companies)
operating in the State of West Virginia. These holding companies are
headquartered in various West Virginia cities and control banks throughout the
State of West Virginia, including banks that compete with the bank in its market
area.

The bank's market area is generally
defined as Jefferson County and Berkeley County, West Virginia. As of June 30,
2007, there were seven banks in Jefferson County with 17 banking offices. The
total deposits of these commercial banks as of June 30, 2007 were
$720
million, and the bank ranked number one in total deposits with $215 million or 29.77 % of
the total deposits in the market at that time. The bank has two branch offices
in Berkeley County at this time. Opening in July 2001 and June 2003, these
branches have 3.62 % of the market share of deposits in Berkeley County where
there are nine banks with 28 banking offices.

For most of the services that the
bank performs, there is also competition from financial institutions other than
commercial banks. For instance, credit unions, some insurance companies, and
issuers of commercial paper and money market funds actively compete for funds
and for various types of loans. In addition, personal and corporate trust and
investment counseling services are offered by insurance companies, investment
counseling firms and other business firms and individuals. Due to the geographic
location of the bank's primary market area, the existence of larger financial
institutions in Maryland, Virginia and Washington, D.C. influences the
competition in the market area. Larger regional and national corporations
continue to be increasingly visible in offering a broad range of financial
services to all types of commercial and consumer customers. The principal
competitive factors in the markets for deposits and loans are interest rates,
either paid or charged. The chartering of numerous new banks in West Virginia
and the opening of numerous federally chartered savings and loan associations
has increased competition for the bank. The 1986 legislation passed by the West
Virginia Legislature allowing statewide branch banking provided increased
opportunities for the bank, but it also increased competition for the bank in
its service area. With the beginning of reciprocal interstate banking in 1988,
bank holding companies (such as Potomac Bancshares, Inc.) also face additional
competition in efforts to acquire other subsidiaries throughout West Virginia.

In 1994, Congress passed the
Riegle-Neal Interstate Banking and Branching Efficiency Act. Under this Act,
bank holding companies are permitted to acquire banks located in states other
than the bank holding companys home state without regard to whether the
transaction is permitted under state law. Commencing on June 1, 1997, the Act
allowed national banks and state banks with different home states to merge
across state lines, unless the home state of a participating bank enacted
legislation prior to May 31, 1997, that expressly prohibits interstate mergers.
Additionally, the Act allows banks to branch across state lines, unless the
state where the new branch will be located enacted legislation restricting or
prohibitingdenovointerstate branching on or before May 31, 1997. West Virginia adopted
legislation, effective May 31, 1997, that allowed for interstate branch banking
by merger across state lines and allowed fordenovobranching and branching by
purchase and assumption on a reciprocal basis with the home state of the bank in
question. The effect of this legislation has been increased competition for West
Virginia banks, including the bank.

6

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Employees

Potomac currently has no employees.

As of February 29, 2007, the bank
had 98 full-time employees and 17 part-time employees.

Supervision and
Regulation

*Introduction*. Potomac is a bank holding company within the provisions of
the Bank Holding Company Act of 1956, is registered as such, and is subject to
supervision by the Board of Governors of the Federal Reserve System ("Board of
Governors"). The Bank Holding Company Act requires Potomac to secure the prior
approval of the Board of Governors before Potomac acquires ownership or control
of more than five percent (5%) of the voting shares or substantially all of the
assets of any institution, including another bank.

As a bank holding company, Potomac
is required to file with the Board of Governors annual reports and such
additional information as the Board of Governors may require pursuant to the
Bank Holding Company Act. The Board of Governors may also make examinations of
Potomac and its banking subsidiaries. Furthermore, under Section 106 of the 1970
Amendments to the Bank Holding Company Act and the regulations of the Board of
Governors, a bank holding company and its subsidiaries are prohibited from
engaging in certain tie-in arrangements in connection with any extension of
credit or any provision of credit, sale or lease of property or furnishing of
services.

Potomacs depository institution
subsidiaries are subject to affiliate transaction restrictions under federal law
that limit the transfer of funds by the subsidiary banks to their respective
parents and any nonbanking subsidiaries, whether in the form of loans,
extensions of credit, investments or asset purchases. Such transfers by any
subsidiary bank to its parent corporation or any nonbanking subsidiary are
limited in an amount to 10% of the institution's capital and surplus and, with
respect to such parent and all such nonbanking subsidiaries, to an aggregate of
20% of any such institution's capital and surplus.

Potomac is required to register
annually with the Commissioner of Banking of West Virginia ("Commissioner") and
to pay a registration fee to the Commissioner based on the total amount of bank
deposits in banks with respect to which it is a bank holding company. Although
legislation allows the Commissioner to prescribe the registration fee, it limits
the fee to ten dollars per million dollars of deposits rounded off to the
nearest million dollars. Potomac is also subject to regulation and supervision
by the Commissioner.

Potomac is required to secure the
approval of the West Virginia Board of Banking before acquiring ownership or
control of more than five percent of the voting shares or substantially all of
the assets of any institution, including another bank. West Virginia banking law
prohibits any West Virginia or non-West Virginia bank or bank holding company
from acquiring shares of a bank if the acquisition would cause the combined
deposits of all banks in the State of West Virginia, with respect to which it is
a bank holding company, to exceed 25% of the total deposits of all depository
institutions in the State of West Virginia.

*Depository Institution
Subsidiary*. The bank is subject to FDIC
deposit insurance assessments. As part of new regulations implementing The
Federal Deposit Insurance Reform Act of 2005 (FDIRA), assessments for FDIC
deposit insurance coverage are now assessed and collected in the quarter
following the period of insurance. On June 29, 2007 the bank was billed for the
coverage period of January 1 through March 31, 2007. This is the first time in a
number of years that the bank has had premiums assessed for deposits. For the
first three quarters of 2007 based on our Category I risk classification our
assessment rate annualizes to 1.250 basis points or .000125 times the total
deposit assessment base each quarter. This is the least risky classification and
the lowest possible assessment. An additional facet of the new legislation was a
one time assessment credit available to institutions in existence on December
31, 1996 that had paid a deposit insurance assessment prior to that date which
has completely offset the deposit assessments for the bank for the coverage
periods for the first three quarters of 2007 and will likely offset the deposit
assessment for one additional quarter and one additional partial quarter. The
FDIC set the Financing Corporation (FICO) Bank Insurance Fund (BIF) premium for
the bank at the annual rate of 1.1140 basis points or .0000285 times the total
deposits of the bank for the last invoice received dated December 28, 2007. This
is a separate premium which is not tied to the bank's risk classification. It is
possible that BIF insurance assessments will be changed, and it is also possible
that there may be a special additional assessment. A large special assessment
could have an adverse impact on Potomacs results of operations.

7

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*Capital
Requirements*. The Federal Reserve Board has
issued risk-based capital guidelines for bank holding companies, such as
Potomac. The guidelines establish a systematic analytical framework that makes
regulatory capital requirements more sensitive to differences in risk profiles
among banking organizations, takes off-balance sheet exposures into explicit
account in assessing capital adequacy, and minimizes disincentives to holding
liquid, low-risk assets. Under the guidelines and related policies, bank holding
companies must maintain capital sufficient to meet both a risk-based asset ratio
test and leverage ratio test on a consolidated basis. The risk-based ratio is
determined by allocating assets and specified off-balance sheet commitments into
four weighted categories, with higher levels of capital being required for
categories perceived as representing greater risk. The leverage ratio is
determined by relating core capital (as described below) to total assets
adjusted as specified in the guidelines. The bank is subject to substantially
similar capital requirements adopted by applicable regulatory agencies.

Generally, under the applicable
guidelines, the financial institution's capital is divided into two tiers. "Tier
1", or core capital, includes common equity, noncumulative perpetual preferred
stock (excluding auction rate issues) and minority interests in equity accounts
or consolidated subsidiaries, less goodwill. Bank holding companies, however,
may include cumulative perpetual preferred stock in their Tier 1 capital, up to
a limit of 25% of such Tier 1 capital. "Tier 2", or supplementary capital,
includes, among other things, cumulative and limited-life preferred stock,
hybrid capital instruments, mandatory convertible securities, qualifying
subordinated debt, and the allowance for loan losses, subject to certain
limitations, less required deductions. "Total capital" is the sum of Tier 1 and
Tier 2 capital.

Financial institutions are required
to maintain a risk-based ratio of 8%, of which 4% must be Tier 1 capital. The
appropriate regulatory authority may set higher capital requirements when an
institution's particular circumstances warrant.

Financial institutions that meet
certain specified criteria, including excellent asset quality, high liquidity,
low interest rate exposure and the highest regulatory rating, are required to
maintain a minimum leverage ratio of 3%. Financial institutions not meeting
these criteria are required to maintain a leverage ratio which exceeds 3% by a
cushion of at least 100 to 200 basis points, and, therefore, the ratio of Tier 1
capital to total assets should not be less than 4%.

The guidelines also provide that
financial institutions experiencing internal growth or making acquisitions will
be expected to maintain strong capital positions substantially above the minimum
supervisory levels, without significant reliance on intangible assets.
Furthermore, the Federal Reserve Board's guidelines indicate that the Federal
Reserve Board will continue to consider a "tangible Tier 1 leverage ratio" in
evaluating proposals for expansion or new activities. The tangible Tier 1
leverage is the ratio of an institution's Tier 1 capital, less all intangibles,
to total assets, less all intangibles.

Failure to meet applicable capital
guidelines could subject the financial institution to a variety of enforcement
remedies available to the federal regulatory authorities, including limitations
on the ability to pay dividends, the issuance by the regulatory authority of a
capital directive to increase capital and the termination of deposit insurance
by the FDIC, as well as to the measures described in the "Federal Deposit
Insurance Corporation Improvement Act of 1991" as applicable to undercapitalized
institutions.

The Federal Reserve Board, as well
as the FDIC, has adopted changes to their risk-based and leverage ratio
requirements that require that all intangible assets, with certain exceptions,
be deducted from Tier 1 capital. Under the Federal Reserve Board's rules, the
only types of intangible assets that may be included in (i.e., not deducted
from) a bank holding company's capital are readily marketable purchased mortgage
servicing rights ("PMSRs") and purchased credit card relationships ("PCCRs"),
provided that, in the aggregate, the total amount of PMSRs and PCCRs included in
capital does not exceed 50% of Tier 1 capital. PCCRs are subject to a separate
limit of 25% of Tier 1 capital. The amount of PMSRs and PCCRs that a bank
holding company may include in its capital is limited to the lesser of (i) 90%
of such assets' fair market value (as determined under the guidelines), or (ii)
100% of such assets' book value, each determined quarterly. Identifiable
intangible assets (i.e., intangible assets other than goodwill) other than PMSRs
and PCCRs, including core deposit intangibles, acquired on or before February
19, 1992 (the date the Federal Reserve Board issued its original proposal for
public comment), generally will not be deducted from capital for supervisory
purposes, although they will continue to be deducted for purposes of evaluating
applications filed by bank holding companies.

8

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As of December 31, 2007, Potomac had
capital in excess of all applicable requirements as shown below:

Actual
    
    Required
    
    Excess(in thousands)Tier 1 capital:Common stock
    $
    3,672Surplus
    
    3,771Retained earnings
    
    24,78732,230Less cost of shares acquired for the treasury
    
    2,701Total tier 1 capital
    $
    29,529
    
    $
    9,081
    
    $
    20,448Tier 2
      capital:Allowance for loan losses (1)
    
    2,779Total
      risk-based capital
    $
    32,308
    
    $
    18,161
    
    $
    14,147Risk-weighted assets
    $
    227,013Tier 1
      capital
    $
    29,529
    
    $
    11,818
    
    $
    17,711Average
      total assets
    $
    295,451Capital
      ratios:Tier 1 risk-based capital ratio
    
    13.01%
    
    
    4.00%
    
    
    9.01%Total risk-based capital ratio
    
    14.23%
    
    
    8.00%
    
    
    6.23%Tier 1 capital to average total assets (leverage)
    
    9.99%
    
    
    4.00%
    
    
    5.99%(1)    
      Limited to 1.25% of gross risk-weighted assets.


*Gramm-Leach-Bliley Act of 1999.*On November 4, 1999, Congress adopted the
Gramm-Leach-Bliley Act of 1999. This Act, also known as the Financial
Modernization Law, repealed a number of federal limitations on the powers of
banks and bank holding companies originally adopted in the 1930s. Under the
Act, banks, insurance companies, securities firms and other service providers
may now affiliate. In addition to broadening the powers of banks, the Act
created a new form of entity, called a financial holding company, which may
engage in any activity that is financial in nature or incidental or
complimentary to financial activities.

The Federal Reserve Board provides
the principal regulatory supervision of financial services permitted under the
Act. However, the Securities and Exchange Commission and state insurance and
securities regulators also assume substantial supervisory powers and
responsibilities.

The Act addresses a variety of other
matters, including customer privacy issues. The obtaining of certain types of
information by false or fraudulent pretenses is a crime. Banks and other
financial institutions must notify their customers about their policies on
sharing information with certain third parties. In some instances, customers may
refuse to permit their information to be shared. The Act also requires
disclosures of certain automatic teller machine fees and contains certain
amendments to the federal Community Reinvestment Act.

*Permitted Non-Banking
Activities*. Under the Gramm-Leach-Bliley
Act, bank holding companies may become financial holding companies and engage in
certain non-banking activities. Potomac has not yet filed to become a financial
holding company and presently does not engage in, nor does it have any immediate
plans to engage in, any such non-banking activities.

A notice of proposed non-banking
activities must be furnished to the Federal Reserve and the Banking Board before
Potomac engages in such activities, and an application must be made to the
Federal Reserve and Banking Board concerning acquisitions by Potomac of
corporations engaging in those activities. In addition, the Federal Reserve may,
by order issued on a case-by-case basis, approve additional non-banking
activities.

*The Bank*. The bank is a state-chartered bank that is not a member of
the Federal Reserve System and is subject to regulation and supervision by the
FDIC and the Commissioner.

*Compliance with Environmental
Laws*. The costs and effects of compliance
with federal, state and local environmental laws will not have a material effect
or impact on Potomac or the bank.

9

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*International Money Laundering
Abatement and Anti-Terrorist Financing Act of 2001 (USA Patriot
Act)*. TheInternational Money Laundering Abatement and Anti-Terrorist Financing Act
of 2001 (the Patriot Act) was adopted in response to the September 11, 2001
terrorist attacks. The Patriot Act provides law enforcement with greater powers
to investigate terrorism and prevent future terrorist acts. Among the
broad-reaching provisions contained in the Patriot Act are several designed to
deter terrorists ability to launder money in the United States and provide law
enforcement with additional powers to investigate how terrorists and terrorist
organizations are financed. The Patriot Act creates additional requirements for
banks, which were already subject to similar regulations. The Patriot Act
authorizes the Secretary of the Treasury to require financial institutions to
take certain special measures when the Secretary suspects that certain
transactions or accounts are related to money laundering. These special measures
may be ordered when the Secretary suspects that a jurisdiction outside of the
United States, a financial institution operating outside of the United States, a
class of transactions involving a jurisdiction outside of the United States or
certain types of accounts are of primary money laundering concern. The special
measures include the following: (a) require financial institutions to keep
records and report on the transactions or accounts at issue; (b) require
financial institutions to obtain and retain information related to the
beneficial ownership of any account opened or maintained by foreign persons; (c)
require financial institutions to identify each customer who is permitted to use
a payable-through or correspondent account and obtain certain information from
each customer permitted to use the account; and (d) prohibit or impose
conditions on the opening or maintaining of correspondent or payable-through
accounts.

*Sarbanes-Oxley Act of 2002.*On July 30, 2002, the Senate and the House
of Representatives of the United States enacted the Sarbanes-Oxley Act of 2002,
a law that addresses, among other issues, corporate governance, auditing and
accounting, executive compensation, and enhanced and timely disclosure of
corporate information.

Effective August 29, 2002, as
directed by Section 302(a) of Sarbanes-Oxley, Potomacs chief executive officer
and chief financial officer are each required to certify that Potomacs
Quarterly and Annual Reports do not contain any untrue statement of a material
fact. The rules have several requirements, including having these officers
certify that: they are responsible for establishing, maintaining and regularly
evaluating the effectiveness of Potomacs internal controls; they have made
certain disclosures to Potomacs auditors and the audit committee of the Board
of Directors about Potomacs internal controls; and they have included
information in Potomacs Quarterly and Annual Reports about their evaluation and
whether there have been significant changes in Potomacs internal controls or in
other factors that could significantly affect internal controls subsequent to
the evaluation. Effective in 2008, Section 404 of Sarbanes-Oxley will become
applicable to Potomac.

*Available Information.*The company files annual, quarterly and
current reports, proxy statements and other information with the SEC. The
companys SEC filings are filed electronically and are available to the public
through the Internet at the SECs website at http://www.sec.gov. In addition,
any document filed by the company with the SEC can be read and copied at the
SECs public reference facilities at 100 F Street, NE, Washington, DC 20549.
Copies of documents can be obtained at prescribed rates by writing to the Public
Reference Section of the SEC at 100 F Street, NE, Washington, DC 20549. The
public may obtain information on the operation of the Public Reference Room by
calling the SEC at 1-800-SEC-0330. Copies of documents can also be obtained free
of charge by any shareholder by writing to Gayle Marshall Johnson, Sr. Vice
President and Chief Financial Officer, Potomac Bancshares, Inc., PO Box 906,
Charles Town, WV 25414.

10

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Item 1A. Risk Factors.

Due to Increased Competition, the
Company May Not Be Able to Attract and Retain Banking Customers At Current
Levels.

If, due to competition from
competitors in the companys market area of Jefferson and Berkeley Counties,
West Virginia, the company is unable to attract new and retain current
customers, loan and deposit growth could decrease causing the companys results
of operations and financial condition to be negatively impacted. The company
faces competition from the following:

- local,
  regional and national banks;
- savings and
  loans;
- internet
  banks;
- credit unions;
- insurance
  companies;
- finance
  companies; and
- brokerage
  firms serving the companys market areas.

Because
of the banks geographic location, the existence of larger financial
institutions in Maryland, Virginia and Washington, DC influences the competition
in the banks market area.

The Companys Lending Limit May
Prevent It from Making Large Loans.

In the future, the
company may not be able to attract larger volume customers because the size of
loans that the company can offer to potential customers is less than the size of
the loans that many of the companys larger competitors can offer. Accordingly,
the company may lose customers seeking large loans to regional and national
banks. We anticipate that our lending limit will continue to increase
proportionately with the companys growth in earnings; however, the company may
not be able to successfully attract or maintain larger customers.

It should
also be noted that the company may choose with its larger volume customers to
participate or syndicate that portion of a loan that exceeds its legal
lending limit. This may be done from time to time to retain that customers
primary relationship within the bank.

Certain Loans That the Bank Makes
Are Riskier than Loans for Real Estate Lending.

The bank makes loans
that involve a greater degree of risk than loans involving residential real
estate lending. Commercial business loans may involve greater risks than other
types of lending although the banks commercial loans are generally real estate
secured. Only a small portion of the banks commercial loans are secured by
collateral other than real estate. Consumer loans may involve greater risk
because adverse changes in borrowers incomes and employment after funding of
the loans may impact their abilities to repay the loans.

The Company Is Subject to Interest
Rate Risk.

Aside from credit risk,
the most significant risk resulting from the companys normal course of
business, extending loans and accepting deposits, is interest rate risk. If
market interest rate fluctuations cause the companys cost of funds to increase
faster than the yield of its interest-earning assets, then its net interest
income will be reduced. The companys results of operations depend to a large
extent on the level of net interest income, which is the difference between
income from interest-earning assets, such as loans and investment securities,
and interest expense on interest-bearing liabilities, such as deposits and
borrowings. Interest rates are highly sensitive to many factors that are beyond
the companys control, including general economic conditions and the policies of
various governmental and regulatory authorities.

The Company May Not Be Able to
Retain Key Members of Management.

The departure of one or
more of the companys officers or other key personnel could adversely affect the
companys operations and financial position. The companys management makes most
decisions that involve the companys operations. The key personnel have all been
with the company since 2001. They include Robert F. Baronner, Jr., David W.
Irvin and Gayle Marshall Johnson.

11

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An Economic Slowdown in the
Companys Market Area Could Hurt Our Business.

Because we focus our
business in Jefferson and Berkeley Counties, West Virginia, an economic slowdown
in these areas could hurt our business. An economic slowdown could have the
following consequences:

- Loan
  delinquencies may increase;
- Problem assets and foreclosures may increase;
- Demand for the products and services of the
  company may decline; and
- Collateral (including real estate) for loans made
  by the company may decline in value, in turn reducing customers borrowing
  power and making existing loans less secure.

The
housing market in Jefferson and Berkeley counties in West Virginia has shown a
sharp decline. The results have included each of the situations described above.
However, management has taken a proactive approach to marketing foreclosed and
repossessed properties. The losses on resale of these properties have not been
material to date.

The Company and the Bank are
Extensively Regulated.

The operations of the company are
subject to extensive regulation by federal, state and local governmental
authorities and are subject to various laws and judicial and administrative
decisions imposing requirements and restrictions on them. Policies adopted or
required by these governmental authorities can affect the companys business
operations and the availability, growth and distribution of the companys
investments, borrowings and deposits. Proposals to change the laws governing
financial institutions are frequently raised in Congress and before bank
regulatory authorities. Changes in applicable laws or policies could materially
affect the companys business, and the likelihood of any major changes in the
future and their effects are impossible to determine.

The Companys Allowance for Loan
Losses May Not Be Sufficient.

In the future, the company could
experience negative credit quality trends that could lead to a deterioration of
asset quality. Such deterioration could require the company to incur loan
charge-offs in the future and incur additional loan loss provision, both of
which would have the effect of decreasing earnings. The company maintains an
allowance for possible loan losses, which is a reserve established through a
provision for possible loan losses charged to expense that represents
managements best estimate of probable losses that may be incurred within the
existing portfolio of loans. Any increases in the allowance for possible loan
losses will result in a decrease in net income and, possibly, capital, and may
have a material adverse effect on the companys financial condition and results
of operation.

Management is constantly monitoring
credit quality and any changes that may be tied to current economic conditions.
As a result of deteriorating economic conditions bank management has increased
the allowance for loan losses. The increase is based on the review of existing
loans and managements analysis of the credit quality of the existing loans.
Management takes a conservative approach to the quality of loans in the
portfolio and feels that the bank is adequately reserved for the current market
and loan portfolio conditions.

A Shareholder May Have Difficulty
Selling Shares.

Because a very limited public market
exists for the holding companys common stock, a shareholder may have difficulty
selling his or her shares in the secondary market. We cannot predict when, if
ever, we could meet the listing qualifications of the NASDAQ Stock Markets
National Market Tier or any exchange. We cannot assure you that there will be a
more active public market for the shares in the near future.

Shares of the Companys Common Stock
Are Not FDIC Insured.

Neither the Federal Deposit
Insurance Corporation nor any other governmental agency insures the shares of
the companys common stock. Therefore, the value of your shares in the company
will be based on their market value and may decline.

12

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Customers May Default on the
Repayment of Loans.

The banks customers may default on
the repayment of loans, which may negatively impact the companys earnings due
to loss of principal and interest income. Increased operating expenses may
result from the allocation of management time and resources to the collection
and work-out of these loans. Collection efforts may or may not be successful
causing the company to write off these loans or repossess the collateral
securing these loans which may or may not exceed the balance of these
loans.

The Companys Controls and
Procedures May Fail or Be Circumvented.

Management regularly reviews and
updates the companys internal controls, disclosure controls and procedures, and
corporate governance policies and procedures. Any system of controls, no matter
how well designed and operated, is based in part on certain assumptions and can
provide only reasonable, not absolute, assurances that the objectives of the
system are met. Any failure or circumvention of the companys controls and
procedures or failure to comply with regulations related to controls and
procedures could have a material adverse effect on the companys business,
results of operations and financial conditions.

Item 2. Properties.

Potomac currently has no property.

The bank owns the land and buildings
of the main office and the branch office facilities in Harpers Ferry,
Kearneysville, and Hedgesville. The bank owns the branch office facility in
Martinsburg and the land that was leased through February 2008 was purchased by
the bank on February 29, 2008 as previously planned. The bank also owns a lot at
the corner of Route 340 and Washington Street in Bolivar that may be used for
future expansion or may be sold.

The main office property is located
at 111 East Washington Street, Charles Town, West Virginia. This property
consists of two separate two story buildings located side by side with adjoining
corridors. During 2000, the construction of the newer of these two buildings was
completed. The first floor of the new building houses the Trust and Financial
Services Division. The second floor of the new building houses certain
administrative and loan offices. Both of these floors open into the older bank
premises. The older building, constructed in 1967, was renovated at the same
time the new building was constructed. The renovation includes all new lighting,
new ceilings, new floor and wall coverings as well as some minor structural
changes for more efficient operations. In July of 2006, the bank completed the
purchase of a property adjacent to the main office for future expansion. In
March 2008, construction should begin for an addition to the main office
facilities and be completed in early 2009.

In October 2005 to provide
additional office and storage areas, the bank leased space in Burr Industrial
Park in Kearneysville, West Virginia. The leased space houses the Finance
Department and provides record storage facilities for the bank.

The Harpers Ferry branch office is
located at 1366 W. Washington Street, Bolivar, West Virginia. The office is a
one story brick building constructed in 1975 and renovated in 2005. There is
another building on this property that existed at the time of the bank's
purchase. This separate building is rented to an outside party by the bank.

The branch facility at 5480 Charles
Town Road, Kearneysville, West Virginia was erected in 1985. This one story
brick building opened for business in April of 1985. During 1993, an addition
was constructed, doubling the size of this facility. Renovation of these
facilities was completed in 2006.

The branch facility at 119 Cowardly
Lion Drive, Hedgesville, West Virginia was erected in 2003. This one story brick
building opened for business in June of 2003.

The branch office at 9738 Tuscarora
Pike in Martinsburg, West Virginia (which opened for business July 2001) is
located in a building owned by the bank. The construction of the one story brick
facility was started in 2004 and completed in January 2005. The amended lease
for this property expired and the bank purchased the land on February 29, 2008.

The bank is leasing offices in
Winchester, Virginia, to house a loan production office that opened in late
2005.

There are no encumbrances on any of
these properties. In the opinion of management, these properties are adequately
covered by insurance.

13

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Item 3. Legal Proceedings.

Currently Potomac is involved in no
legal proceedings.

The bank is involved in various
legal proceedings arising in the normal course of business, and in the opinion
of the bank, the ultimate resolution of these proceedings will not have a
material effect on the financial position or operations of the bank.

Item 4. Submission of Matters to a Vote
of Security Holders.

Not Applicable.

PART II

Item 5. Market for Registrants Common
Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The following information reflects
comparative per share data for the periods indicated for Potomac common stock
for (a) trading values and (b) dividends. This information has been restated,
where applicable, to reflect a 2% stock dividend declared on March 14, 2006 and
a 100% stock dividend declared on February 8, 2005. As of March 3, 2008, there
were approximately 1,100 shareholders.

Trading of Potomac Bancshares, Inc.
common stock is not extensive and cannot be described as a public trading
market. Potomac Bancshares, Inc. is on the OTC Bulletin Board Market. To gather
information about Potomac in this market use Potomacs symbol PTBS.OB. Scott and
Stringfellow, Inc., Koonce Securities Inc. and Ferris, Baker Watts, Inc. are
market makers for Potomacs stock. Market makers are firms that maintain a firm
bid and ask price for a given number of shares at a given point in time in a
given security by standing ready to buy or sell at publicly quoted prices.
Information about sales of Potomacs stock is available on the Internet through
many of the stock information services using Potomacs symbol. Shares of Potomac
common stock are occasionally bought and sold by private individuals, firms or
corporations, and, in most instances, Potomac does not have knowledge of the
purchase price or the terms of the purchase. The trading values for 2006 and
2007 are based on information available through the Internet.No attempt was made by Potomac to verify or determine the
accuracy of the representations made to Potomac or gathered on the Internet.

Price Range
    
    Cash DividendsHigh
    
    Low
    
    Paid per Share2006
    
    First Quarter
    $
    17.25
    
    $
    16.50
    
    $
    .0900Second
      Quarter
    
    17.25
    
    
    15.05
    
    
    .0925Third Quarter
    
    16.85
    
    
    15.35
    
    
    .0950Fourth
      Quarter
    
    16.00
    
    
    15.40
    
    
    .09752007
    
    First Quarter
    $
    15.99
    
    $
    15.15
    
    $
    .1000Second
      Quarter
    
    15.99
    
    
    15.20
    
    
    .1025Third Quarter
    
    15.70
    
    
    14.55
    
    
    .1050Fourth
      Quarter
    
    15.45
    
    
    12.05
    
    
    .1075


The primary source of funds for
dividends paid by Potomac is the dividend income received from the bank. The
bank's ability to pay dividends is subject to restrictions under federal and
state law, and under certain cases, approval by the FDIC and the Commissioner
could be required. Management of Potomac anticipates that the dividends paid by
Potomac will likely be similar to those paid in the past, but dividends will
only be paid when and as declared by the board of directors.

Performance Graph

The following graph compares the
yearly percentage change in Potomacs cumulative total shareholder return on
common stock for the five-year period ending December 31, 2007, with the
cumulative total return of the Bank Holding Companies Index (SIC Code 6712) and
the Hemscott Index. Shareholders may obtain a copy of the index by calling
Hemscott, Inc. at telephone number (301) 760-2609. There is no assurance that
Potomacs stock performance will continue in the future with the same or similar
trends as depicted in the graph.

14

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The graph shall not be deemed
incorporated by reference by any general statement into any filing under the
Securities Act of 1933 or the Securities Exchange Act of 1934, except to the
extent that Potomac specifically incorporates this graph by reference, and shall
not otherwise be filed under such Acts.

COMPARE 5-YEAR CUMULATIVE TOTAL RETURN AMONG POTOMAC BANCSHARES,
INC., BANK HOLDING COMPANIES INDEXAND HEMSCOTT INDEX



ASSUMES $100 WAS INVESTED ON JANUARY 1,
2003 AND ASSUMES DIVIDENDS WERE REINVESTED THROUGH FISCAL YEAR ENDING
DECEMBER 31, 2007

ISSUER PURCHASES OF EQUITY SECURITIES

|                               |  |                 |  |                   |  | (c) Total
      Number |  |                         
|------------------------------ |  | --------------- |  | ----------------- |  | ---------------------- |  | ------------------------
|                               |  |                 |  |                   |  | of
      Shares        |  |                         
|                               |  | (a)
      Total |  |                   |  | Purchased
      as     |  | (d) Maximum
      Number
|                               |  | Number
      of |  | (b)
      Average |  | Part of
      Publicly |  | of Shares that
      May
|                               |  | Shares          |  | Price
      Paid  |  | Announced              |  | Yet be
      Purchased  
|Period                         |  | Purchased       |  | Per Share         |  | Programs               |  | Under the
      Program 
|October 1 through October 31   |  | NONE            |  | --                |  | --                     |  | 105 478                 
|                              
|November 1 through November 30 |  | NONE            |  | --                |  | --                     |  | 105 478                 
|                              
|December 1 through December 31 |  | 4 500           |  | 12.50             |  | 266 191                |  | 100 978                 

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

15

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|Item 6.
      Selected Financial Data.           |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|------------------------------------------------ |  | -------------------------------------------- | --------- | ---- | - | --------- |  | ---- | --------- | ---- | - | --------- |  | - | ---------
|                                                
|                                                 |  | 2007                                         |           | 2006 |   | 2005      |  | 2004 |           | 2003
|                                                 |  | (Dollars in Thousands Except Per Share Data)
|Summary of Operations                            |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|                                                
|Interest income                                  |  | $                                            | 19 691    |      | $ | 19 099    |  | $    | 15 424    |      | $ | 12 008    |  | $ | 10 786   
|Interest expense                                 |  |                                              | 8 161     |      |   | 6 932     |  |      | 4 135     |      |   | 2 409     |  |   | 2 235    
|Net interest income                              |  |                                              | 11 530    |      |   | 12 167    |  |      | 11 289    |      |   | 9 599     |  |   | 8 551    
|Provision for loan losses                        |  |                                              | 678       |      |   | 331       |  |      | 330       |      |   | 289       |  |   | 147      
|Net interest income after provision              |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|for
      loan losses                            |  |                                              | 10 852    |      |   | 11 836    |  |      | 10 959    |      |   | 9 310     |  |   | 8 404    
|Noninterest income                               |  |                                              | 4 364     |      |   | 3 766     |  |      | 3 185     |      |   | 3 158     |  |   | 2 844    
|Noninterest expense                              |  |                                              | 9 688     |      |   | 9 261     |  |      | 8 460     |      |   | 7 668     |  |   | 7 142    
|Income before income taxes                       |  |                                              | 5 528     |      |   | 6 341     |  |      | 5 684     |      |   | 4 800     |  |   | 4 106    
|Income tax expense                               |  |                                              | 1 998     |      |   | 2 306     |  |      | 2 020     |      |   | 1 710     |  |   | 1 432    
|                                                
|Net income                                       |  | $                                            | 3 530     |      | $ | 4 035     |  | $    | 3 664     |      | $ | 3 090     |  | $ | 2 674    
|                                                
|Per Share Data **                                |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|                                                
|Net income, basic                                |  | $                                            | 1.03      |      | $ | 1.17      |  | $    | 1.06      |      | $ | .89       |  | $ | .75      
|Net income, diluted                              |  |                                              | 1.03      |      |   | 1.16      |  |      | 1.05      |      |   | .89       |  |   | .75      
|Cash dividends declared                          |  |                                              | .42       |      |   | .38       |  |      | .33       |      |   | .29       |  |   | .26      
|Book value at period end                         |  |                                              | 8.52      |      |   | 7.78      |  |      | 7.23      |      |   | 6.58      |  |   | 6.15     
|Weighted-average shares outstanding,
      basic |  |                                              | 3 423 239 |      |   | 3 454 961 |  |      | 3 460 984 |      |   | 3 463 373 |  |   | 3 570 143
|Weighted-average shares outstanding, diluted     |  |                                              | 3 430 764 |      |   | 3 467 918 |  |      | 3 477 538 |      |   | 3 465 895 |  |   | 3 570 143
|                                                
|Average Balance Sheet Summary                    |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|                                                
|Assets                                           |  | $                                            | 297 716   |      | $ | 289 303   |  | $    | 264 314   |      | $ | 226 052   |  | $ | 197 052  
|Loans                                            |  |                                              | 226 773   |      |   | 220 895   |  |      | 196 478   |      |   | 155 546   |  |   | 125 407  
|Securities                                       |  |                                              | 42 040    |      |   | 48 891    |  |      | 47 183    |      |   | 46 701    |  |   | 47 087   
|Deposits                                         |  |                                              | 254 908   |      |   | 243 833   |  |      | 217 307   |      |   | 190 153   |  |   | 163 328  
|Stockholders equity                             |  |                                              | 28 207    |      |   | 26 632    |  |      | 23 822    |      |   | 22 045    |  |   | 21 274   
|                                                
|Performance Ratios                               |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|                                                
|Return on average assets                         |  |                                              | 1.19%     |      |   | 1.39%     |  |      | 1.39%     |      |   | 1.37%     |  |   | 1.36%    
|Return on average equity                         |  |                                              | 12.51%    |      |   | 15.15%    |  |      | 15.38%    |      |   | 14.02%    |  |   | 12.57%   
|Dividend payout ratio                            |  |                                              | 40.78%    |      |   | 32.48%    |  |      | 31.13%    |      |   | 32.58%    |  |   | 34.67%   
|                                                
|Capital Ratios                                   |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|                                                
|Leverage ratio                                   |  |                                              | 9.99%     |      |   | 9.34%     |  |      | 9.18%     |      |   | 9.45%     |  |   | 10.20%   
|Risk-based capital ratios                        |  |                                              |           |      |   |           |  |      |           |      |   |           |  |   |          
|Tier 1 capital                                   |  |                                              | 13.01%    |      |   | 12.71%    |  |      | 12.68%    |      |   | 13.29%    |  |   | 14.67%   
|Total
      capital                              |  |                                              | 14.23%    |      |   | 13.82%    |  |      | 13.76%    |      |   | 14.44%    |  |   | 15.89%   

|** |  | All figures have been restated to
      reflect a 2% stock dividend declared on March 14, 2006, a 100% stock
      dividend declared on February 8, 2005 and a 200% stock dividend declared
      on February 3, 2003.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

16

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Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations.

AVERAGE BALANCES, INCOME/EXPENSE AND
AVERAGE YIELD/RATE

This schedule is a comparison of
interest earning assets and interest-bearing liabilities showing average yields
or rates derived from average balances and actual income and expenses. Income
and rates on tax exempt loans and securities are computed on a tax equivalent
basis using a federal tax rate of 34%. Loans placed on nonaccrual status are
reflected in the balances.

|                                        |  | 2007                 |         | 2006                 |  | 2005                
|--------------------------------------- |  | -------------------- | ------- | -------------------- |  | --------------------
|                                        |  | Average              |         | Income/              |  | Average             
|                                        |  | Balances             |         | Expense              |  | Yield/Rate          
|                                        |  | (in
      thousands) |         | (in
      thousands) |  | (in
      thousands)
|ASSETS                                  |  |                      |         |                      |  |                     
|Loans                                   |  |                      |         |                      |  |                     
|Taxable                                 |  | $                    | 225 876 |                      |  | $                   
|Tax exempt                              |  |                      | 897     |                      |  |                     
|Total loans                             |  |                      | 226 773 |                      |  |                     
|Taxable
      securities                |  |                      | 40 112  |                      |  |                     
|Nontaxable securities                   |  |                      | 1 928   |                      |  |                     
|Securities
      purchased under        |  |                      |         |                      |  |                     
|agreements to resell and                |  |                      |         |                      |  |                     
|federal funds sold                      |  |                      | 8 226   |                      |  |                     
|Other earning assets                    |  |                      | 4 616   |                      |  |                     
|Total earning assets                    |  |                      | 281 655 |                      |  | $                   
|                                       
|Allowance for loan losses               |  |                      | (2 433  | )                    |  |                     
|Cash and due
      from banks           |  |                      | 5 140   |                      |  |                     
|Premises and equipment, net             |  |                      | 6 342   |                      |  |                     
|Other
      assets                      |  |                      | 7 012   |                      |  |                     
|Total assets                            |  | $                    | 297 716 |                      |  |                     
|                                       
|LIABILITIES AND                         |  |                      |         |                      |  |                     
|STOCKHOLDERS EQUITY                    |  |                      |         |                      |  |                     
|Deposits                                |  |                      |         |                      |  |                     
|Savings and interest-                   |  |                      |         |                      |  |                     
|bearing demand deposits                 |  | $                    | 119 142 |                      |  | $                   
|Time deposits                           |  |                      | 106 778 |                      |  |                     
|Total interest-                         |  |                      |         |                      |  |                     
|bearing deposits                        |  |                      | 225 920 |                      |  |                     
|                                       
|Securities sold under agreements        |  |                      |         |                      |  |                     
|to repurchase and federal               |  |                      |         |                      |  |                     
|funds purchased                         |  |                      | 10 959  |                      |  |                     
|Advances from
      FHLB                |  |                      | 416     |                      |  |                     
|Total interest                          |  |                      |         |                      |  |                     
|bearing liabilities                     |  |                      | 237 295 |                      |  | $                   
|                                       
|Noninterest-bearing demand              |  |                      |         |                      |  |                     
|deposits                                |  |                      | 28 988  |                      |  |                     
|Other
      liabilities                 |  |                      | 3 226   |                      |  |                     
|Stockholders equity                    |  |                      | 28 207  |                      |  |                     
|Total liabilities and                   |  |                      |         |                      |  |                     
|stockholders equity                    |  | $                    | 297 716 |                      |  |                     
|                                       
|Net interest income                     |  |                      |         |                      |  | $                   
|                                       
|Net interest spread                     |  |                      |         |                      |  |                     
|Interest
      expense as a             |  |                      |         |                      |  |                     
|percent of average earning
      assets |  |                      |         |                      |  |                     
|                                       
|Net interest margin                     |  |                      |         |                      |  |                     

17

---

MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CRITICAL ACCOUNTING
POLICIES

GENERAL

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

ALLOWANCE FOR LOAN LOSSES

The
allowance for loan losses is an estimate of the losses that may be sustained in
our loan portfolio. The allowance is based on two basic principles of
accounting: (i) SFAS 5, Accounting for Contingencies, which requires that
estimated losses be accrued when they are probable of occurring and (ii) SFAS
114, Accounting by Creditors for Impairment of a Loan, which requires that
losses be accrued based on the differences between the value of collateral,
present value of future cash flows or values that are observable in the
secondary market and the loan balance.

The
allowance consists of specific, general and unallocated components. The specific
component relates to loans that are classified as doubtful or substandard. For
such loans that are also classified as impaired, an allowance is established
when the discounted cash flows (or collateral value or observable market price)
of the impaired loan is lower than the carrying value of that loan. The general
component covers non-classified loans and is based on historical loss experience
adjusted for qualitative factors. An unallocated component is maintained to
cover uncertainties that could affect managements estimate of probable losses.
The unallocated component of the allowance reflects that margin of imprecision
inherent in the underlying assumptions used in the methodologies for estimating
specific and general losses in the portfolio.

GENERAL

Although earnings were not as robust
as the past several years, our capital did increase and we paid continually
increasing dividends. The review of the company results of operations and
financial position over the past five years as shown in the Selected
Consolidated Financial Data schedule shows 2007 has been a year of change.
Managements wishes to grow the company by increasing loans and deposits and
increasing earnings on a regular basis did not completely come to fruition in
2007, although there was some growth in loans and deposits. Increasing capital
also provides the basis for continued expansion of the company including the
ability to keep pace with the technology of our ever changing world. Maintaining
the technology advantage is one of the most costly yet most necessary goals of
doing business after costs of real estate and human resources.

The continuing increase of
regulation in the banking industry and the associated costs continue to be a
major concern of management. The cost of initial compliance with Sarbanes-Oxley
Act of 2002 has been spread out over several years now, with the delay of the
banks complete implementation date to December 31, 2008. Compliance costs add
additional pressure for management to find ways to increase income.

The major
source of income for the company is interest income earned on loans and
investments and, is, of course, dependent on market conditions, so in addition
to increasing income in these areas, management has concentrated on finding
additional types of noninterest income. During 2007 and more particularly at the
end of 2007 rates decreased. The decrease in rates helps on the interest expense
side but decreases income. The bank continues to derive a generous amount of
income from the overdraft protection plan introduced about five years ago and
although there has been some concern that future regulation may diminish
earnings on this product, which would have an adverse affect on the earnings of
the company, this has not materialized to date.

18

---

The
company continues to benefit from tax exempt loan income, tax exempt income of
bank owned life insurance policies and tax exempt municipal securities in the
investment portfolio and, in fact, increased holdings of life insurance and
securities in 2007. These items reduce the income tax expense for the company as
well as produce income.

The company continues to seek ways
to reduce expenses in addition to ways to increase income while benefiting from
processes introduced in the past five years for that purpose including (1)
utilization of personnel to full potential by growing the company as much as
possible without increasing personnel, (2) continuing the reclassification of
deposits to allow a lower balance requirement at the Federal Reserve allowing
funds to be used for other purposes such as making loans, (3) increasing service
charges as appropriate and (4) the outsourcing of official checks which has been
a generous income producer as the bank earns interest on the outstanding
balances of the official checks.

The bank has been monitoring its
efficiency through the calculation of the efficiency ratio each month. This
ratio is the comparison of the banks noninterest expenses (overhead) with net
interest income plus noninterest income. A decrease in noninterest expenses or
an increase in net interest income and/or noninterest income will cause the
ratio to decrease. During 2007 the ratio fluctuated in both directions within a
few percentage points. In the beginning of 2007 rates were up slightly due to
increases in late 2006 by the Federal Reserve board. However, as economic
conditions worsened the Federal Reserve reversed ground and began to decrease
rates at the end of 2007. As a result of these changes our net interest income
has decreased. Overhead costs increased due to expenses related to repossessed
property and some inflation related increases.

Management is unaware of any trends,
events or uncertainties that would have a material effect on liquidity, capital
resources or operations. There are no current recommendations by regulatory
authorities that, if they were to be implemented, would have a material effect
on the company.

The following table sets forth
selected quarterly results (with dollars in thousands) of the company for 2007
and 2006.

|                                  |  | 2007               |        | 2006              
|--------------------------------- |  | ------------------ | ------ | ------------------
|                                  |  | Three Months Ended |        | Three Months Ended
|                                  |  |                    | Dec 31 |                   
|Interest income                   |  |                    | $      | 4 821             
|Interest
      expense            |  |                    |        | 1 968             
|Net interest income               |  |                    |        | 2 853             
|Provision for
      loan losses   |  |                    |        | 578               
|Net interest income after         |  |                    |        |                   
|provision for loan losses         |  |                    |        | 2 275             
|Noninterest
      income          |  |                    |        | 1 142             
|Noninterest expense               |  |                    |        | 2 549             
|Income before
      income taxes  |  |                    |        | 868               
|Income tax expense                |  |                    |        | 324               
|                                  | 
|Net income                        |  |                    | $      | 544               
|                                  | 
|Earnings per share, basic         |  |                    | $      | .16               
|Earnings per
      share, diluted |  |                    | $      | .16               

NET INTEREST INCOME

As
expected, the economy continued to weaken during 2007. The effect was a decrease
of 3% in the loan portfolio and a 5% decrease in net interest income during 2007
compared to 2006. Income on securities and other interest and dividends showed
slight increases in 2007.

The loan
portfolio grew 9% during 2006 as compared to 2005. Net interest income showed an
8% increase over the 2005 results. The growth in 2006 was mainly due to a period
of increased interest rates that leveled off at year end.

Interest
expense increased 18% in 2007 compared to 2006. This increase is significantly
less than the 2005 to 2006 increase. The reasons for this include less borrowing
by the bank and decreases in interest rates enacted by the Federal Reserve in
the last quarter of 2007.

19

---

The last
quarter of 2007 ended much like the same period in 2006. Economic indicators
suggest the economy is continuing to weaken. All indications are that the
Federal Reserve will continue to decrease rates throughout most of 2008.
Management is optimistic that the low interest rates will entice some loan
growth. In addition, cost of funds should continue to be reasonable as interest
rates are expected to decrease and then gradually level off throughout
2008.

VOLUME AND RATE ANALYSIS

This schedule analyzes the change in
net interest income attributable to changes in volume of the various portfolios
and changes in interest rates. The change due to both rate and volume variances
has been allocated between rate and volume based on the percentage relationship
of such variances to each other.

|                                 |  | 2007 Compared to 2006 |       | 2006 Compared to 2005
|-------------------------------- |  | --------------------- | ----- | ---------------------
|                                 |  | (in thousands)        |       | (in thousands)       
|                                 |  | Change in             |       |                      
|                                 |  | Income/               |       | Volume               
|                                 |  | Expense               |       | Effect               
|INTEREST INCOME                  |  |                       |       |                      
|Taxable loans                    |  | $                     | 330   |                      
|Tax exempt loans                 |  |                       | (31   | )                    
|Taxable securities               |  |                       | (201  | )                    
|Nontaxable securities            |  |                       | 25    |                      
|Securities purchased under       |  |                       |       |                      
|agreements to resell             |  |                       |       |                      
|and federal funds sold           |  |                       | 370   |                      
|Other earning assets             |  |                       | 97    |                      
|TOTAL                            |  | $                     | 590   |                      
|                                
|INTEREST EXPENSE                 |  |                       |       |                      
|Savings and interest-bearing     |  |                       |       |                      
|demand deposits                  |  | $                     | (39   | )                    
|Time deposits                    |  |                       | 1 552 |                      
|Securities sold under agreements |  |                       |       |                      
|to repurchase and federal        |  |                       |       |                      
|funds purchased                  |  |                       | (123  | )                    
|Federal Home Loan Bank           |  |                       |       |                      
|advances                         |  |                       | (161  | )                    
|TOTAL                            |  | $                     | 1 229 |                      
|                                
|NET INTEREST INCOME              |  | $                     | (639  | )                    

NONINTEREST INCOME AND
EXPENSE

As in prior years, fees generated
through the banks overdraft protection plan available for customers continue to
be a major contributor to the banks noninterest income. These fees are included
in the service charges on deposit accounts category which totaled $2.1 million
in 2007, $1.7 million in 2006 and $1.6 million in 2005. Trust and financial
services is the next largest contributor to the 2007 noninterest income figure.
However, growth slowed to 1.3% in 2007 compared to 8.6% in 2006. Trust income
was boosted in the past several years by the accrual of fees for settlement of
two significantly large estates. These fees are totally accrued and the estates
are closed. Estate settlement fees are one area of income that is not
particularly consistent from year to year. The financial services area is also
continuing to benefit from the growth of BCT Investments that offers brokerage
and other financial services.

The growth of the bank customer base
continues to have a positive affect on various components of noninterest income
in addition to the overdraft protection plan mentioned above. It provides for
increases in other service charges such as stop payments, sales of cashiers
checks and money orders, wire transfer fees, debit, ATM and charge card
transaction fees.

20

---

Fees on sales of loans in the
secondary market are a source of noninterest income that varies with the market
conditions. Our income from this source was $197 thousand in 2007, $117 thousand
in 2006 and $187 thousand in 2005.

During the fourth quarter of 2005,
the companys net income was negatively affected by the one time sale of
approximately $14 million in Federal agency securities that had an average
coupon yield of 2.6%. The gross loss on this sale was $369 thousand with an
after tax net income effect of $243 thousand. The proceeds of this sale were
reinvested in Federal agency securities with an average coupon yield of 4.9%
which going forward, has favorably impacted income. However, a number of
securities purchased during this transaction had call features. With the
lowering of interest rates in late 2007, these securities with the higher rates
are being called so they can be reissued at lower rates. We anticipate lower
income on our securities portfolio at least through most of 2008.

Salaries and employee benefits of
$5.3 million are about 54% of the total noninterest expense for 2007. This
percentage is similar to 2006 and 2005. Even though the bank has grown during
the past few years, full utilization of personnel has allowed the bank to hold
down salaries and benefit costs by holding down the increase in personnel.
During 2008, salaries and employee benefits are expected to increase for the
most part due to annual salary and wage increases, including merit increases,
rather than any extensive increase in personnel and due to increased group
health insurance expenses.

Expenses related to premises and
furniture and equipment have remained relatively stable showing modest increases
of between 3% and 4% in 2007 compared to 2006.

The other noninterest expense
category is the total of approximately 60 separate expense accounts. None of the
account balances in this category exceed 1% of gross income of the bank for any
of the three years presented. Increases are due to the growth in the banks
customer base and some inflationary increases.

21

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INTEREST RATE
SENSITIVITY

The table below shows the
opportunities the company will have to reprice interest earning assets and
interest-bearing liabilities as of December 31, 2007 (in thousands).

|                                    |  | Mature or Reprice
|----------------------------------- |  | -----------------
|                                    |  |                  
|                                    |  |                  
|                                    |  | Within           
|                                    |  | Three Months     
|Interest Earning Assets:            |  |                  
|Loans                               |  | $                
|Securities                          |  |                  
|Securities purchased under          |  |                  
|agreements to resell and            |  |                  
|federal funds sold                  |  |                  
|Other earning assets                |  |                  
|Total                               |  | $                
|                                   
|Interest-Bearing Liabilities:       |  |                  
|Time deposits                       |  |                  
|$100,000 and over                   |  | $                
|Other time deposits                 |  |                  
|Gold and Platinum accounts          |  |                  
|(NOW accounts)                      |  |                  
|Savings accounts                    |  |                  
|Securities sold under agreements to |  |                  
|repurchase and federal funds        |  |                  
|purchased                           |  |                  
|Federal Home Loan Bank advances     |  |                  
|Total                               |  | $                
|                                   
|Rate Sensitivity Gap                |  | $                
|                                   
|Cumulative Gap                      |  | $                

The matching of the maturities or
repricing opportunities of interest earning assets and interest-bearing
liabilities may be analyzed by examining the extent to which these assets and
liabilities are interest rate sensitive and by monitoring an institutions
interest rate sensitivity gap. An asset or liability is interest rate sensitive
within a specific time period if it will mature or reprice within that period.
The interest rate sensitivity gap is the difference between the amount of
interest earning assets that will mature or reprice within a specific time
period and the amount of interest-bearing liabilities that will mature or
reprice within the same time period.

A gap is considered negative when
the amount of liabilities maturing or repricing in a specific period exceeds the
amount of assets maturing or repricing in the same period. An even match between
assets and liabilities in each time frame is the safest position especially in
times of rapidly rising or declining rates. During other times, the even match
is not as critical. The advantages or disadvantages of positive and negative
gaps depend totally on the direction in which interest rates are moving. An
asset sensitive institutions net interest margin and net interest income
generally will be impacted favorably by rising interest rates, while that of a
liability sensitive institution generally will be impacted favorably by
declining interest rates.

During the first twelve months shown
in the schedule above, the company is liability sensitive, and after that time
period the company is asset sensitive. During January, February and March of
2008, $16.1 million more liabilities may reprice or will mature than assets.
During April through December of 2008, $12.3 million more liabilities may
reprice or will mature than assets. The total effect for 2007 is that $28.4
million more liabilities may reprice or mature than assets. Over the year this
is minimal sensitivity in comparison to the total of all assets and liabilities
repricing and maturing. During the 2008 time period the company should be only
slightly impacted by either rising or falling interest rates.

22

---

LOAN PORTFOLIO

Loans at December 31 (in thousands)
for each of the five years in the period ended 2007.

| |                                        |  | 2007 |             | 2006 |   | 2005        |  | 2004 |             | 2003
| | -------------------------------------- |  | ---- | ----------- | ---- | - | ----------- |  | ---- | ----------- | ----
| | Commercial, financial and agricultural |  | $    | 4
      987 |      | $ | 4
      247 |  | $    | 6
      046 |     
| | Mortgage loans
      on real estate:   |  |      |             |      |   |             |  |      |             |     
| | Construction and land development      |  |      | 55 042      |      |   | 53 801      |  |      | 41 174      |     
| | Secured by farm land                   |  |      | 1 328       |      |   | 1 557       |  |      | 2 381       |     
| | Secured by 1-4 family residential      |  |      | 98 864      |      |   | 103 983     |  |      | 98 408      |     
| | Secured by multifamily residential     |  |      | 1 749       |      |   | 3 733       |  |      | 3 486       |     
| | Secured by nonfarm nonresidential      |  |      | 47 726      |      |   | 46 367      |  |      | 43 019      |     
| | Consumer
      loans                   |  |      | 14 718      |      |   | 16 089      |  |      | 15 549      |     
| | All other loans                        |  |      | 193         |      |   | 292         |  |      | 372         |     
| |                                        |  | $    | 224 607     |      | $ | 230 069     |  | $    | 210 435     |     

The continued decline in the housing
market had a negative effect on the banks loan portfolio in 2007. Despite an
optimistic outlook at the end of 2006, the housing market did not rally as many
had predicted. For the first time in many years the loan portfolio decreased in
value. The loan staff is expecting another challenging year in 2008. Economic
indicators suggest that interest rates will continue to decline throughout 2008.
The hope is that 2009 will bring a stronger economy and an upswing in the
housing market.

There were no categories of loans
that exceeded 10% of outstanding loans at December 31, 2007 that were not
disclosed in the table above.

REMAINING MATURITIES (in thousands) OF
SELECTED LOANS

| |                                                        |  | Commercial,   |              |                   
| | ------------------------------------------------------ |  | ------------- | ------------ | ------------------
| |                                                        |  | Financial and |              | Real
      Estate-
| | At December 31, 2007                                   |  |               | Agricultural |                   
| | Loans maturing within one year                         |  | $             | 1
      428  |                   
| | Variable rate
      loans due after one year           |  |               | 517          |                   
| | Fixed rate loans due after one year through five years |  |               | 2
      944  |                   
| | Fixed rate
      loans due after five years            |  |               | 98           |                   
| | Total maturities                                       |  | $             | 4 987        |                   

23

---

ALLOWANCE FOR LOAN LOSSES

The table shown below is an analysis
of the companys allowance for loan losses. Historically, net charge-offs (loans
charged off as uncollectible less any amounts recovered on these loans) for the
company have been very low when compared with the size of the total loan
portfolio. Management continually monitors the loan portfolio with procedures
that allow for problem loans and potentially problem loans to be highlighted and
watched. Based on experience, the loan policies and the current monitoring
program, management believes the allowance for loan losses is adequate. Due to
the policies and procedures in place, management has increased the allowance to
cover the increased risks in the portfolio resulting from the current housing
market conditions and the economic slowdown.

| |                                                  |  | 2007           |             | 2006 |   | 2005        |  | 2004 |             | 2003
| | ------------------------------------------------ |  | -------------- | ----------- | ---- | - | ----------- |  | ---- | ----------- | ----
| |                                                  |  | (in thousands)
| | Balance
      at beginning of period             |  | $              | 2
      423 |      | $ | 2
      161 |  | $    | 1
      966 |     
| | Charge-offs:                                     |  |                |             |      |   |             |  |      |             |     
| | Commercial, financial and agricultural           |  |                | 14          |      |   | -
      -   |  |      | 30          |     
| | Real estate  construction                       |  |                | 32          |      |   | - -         |  |      | - -         |     
| | Real estate  mortgage                           |  |                | 206         |      |   | -
      -   |  |      | -
      -   |     
| | Consumer                                         |  |                | 252         |      |   | 207         |  |      | 218         |     
| | Total
      charge-offs                          |  |                | 504         |      |   | 207         |  |      | 248         |     
| | Recoveries:                                      |  |                |             |      |   |             |  |      |             |     
| | Commercial, financial and agricultural           |  |                | 30          |      |   | -
      -   |  |      | -
      -   |     
| | Real estate  construction                       |  |                | - -         |      |   | - -         |  |      | - -         |     
| | Real estate  mortgage                           |  |                | -
      -   |      |   | -
      -   |  |      | -
      -   |     
| | Consumer                                         |  |                | 152         |      |   | 138         |  |      | 113         |     
| | Total recoveries                                 |  |                | 182         |      |   | 138         |  |      | 113         |     
| | Net charge-offs                                  |  |                | 322         |      |   | 69          |  |      | 135         |     
| | Additions charged to operations                  |  |                | 678         |      |   | 331         |  |      | 330         |     
| |                                                 
| | Balance
      at end of period                   |  | $              | 2 779       |      | $ | 2 423       |  | $    | 2 161       |     
| | Ratio of net
      charge-offs during the period |  |                |             |      |   |             |  |      |             |     
| | to average loans outstanding during              |  |                |             |      |   |             |  |      |             |     
| | the
      period                                 |  |                | 0.14%       |      |   | 0.03%       |  |      | 0.07%       |     

ALLOCATION OF ALLOWANCE FOR LOAN LOSSES

The following table shows an
allocation of the allowance among loan categories based upon analysis of the
loan portfolios composition, historical loan loss experience, and other
factors, and the ratio of the related outstanding loan balances to total loans.

|                        |  | 2007       |       | 2006        |        | 2005       |  | 2004        |       | 2003      
|----------------------- |  | ---------- | ----- | ----------- | ------ | ---------- |  | ----------- | ----- | ----------
|                        |  | Allowance  |       | % Loans in  |        | Allowance  |  | % Loans in  |       | Allowance 
|                        |  | (in        |       | Category to |        | (in        |  | Category to |       | (in       
|                        |  | thousands) |       | Total Loans |        | thousands) |  | Total Loans |       | thousands)
|Commercial,             |  |            |       |             |        |            |  |             |       |           
|financial
      and     |  |            |       |             |        |            |  |             |       |           
|agricultural            |  | $          | 35    |             | 2.22   | %          |  | $           | 71    |           
|Mortgage loans on       |  |            |       |             |        |            |  |             |       |           
|real
      estate:      |  |            |       |             |        |            |  |             |       |           
|Construction            |  |            |       |             |        |            |  |             |       |           
|and land                |  |            |       |             |        |            |  |             |       |           
|development             |  |            | 1 025 |             | 24.50  | %          |  |             | 820   |           
|Secured
      by farm   |  |            |       |             |        |            |  |             |       |           
|land                    |  |            | 9     |             | .59    | %          |  |             | 12    |           
|Secured
      by 1-4    |  |            |       |             |        |            |  |             |       |           
|family                  |  |            |       |             |        |            |  |             |       |           
|residential             |  |            | 924   |             | 44.02  | %          |  |             | 753   |           
|Secured
      by multi- |  |            |       |             |        |            |  |             |       |           
|family                  |  |            |       |             |        |            |  |             |       |           
|residential             |  |            | 13    |             | .78    | %          |  |             | 27    |           
|Secured by nonfarm      |  |            |       |             |        |            |  |             |       |           
|nonresidential          |  |            | 661   |             | 21.25  | %          |  |             | 478   |           
|Consumer loans          |  |            | 111   |             | 6.55   | %          |  |             | 248   |           
|All other loans         |  |            | 1     |             | .09    | %          |  |             | 1     |           
|Unallocated             |  |            | - -   |             | - -    |            |  |             | 13    |           
|                       
|                        |  | $          | 2 779 |             | 100.00 | %          |  | $           | 2 423 |           

24

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RISK ELEMENTS IN THE LOAN PORTFOLIO

| |                              |  | 2007                 |             | 2006 |   | 2005  |  | 2004 |       | 2003
| | ---------------------------- |  | -------------------- | ----------- | ---- | - | ----- |  | ---- | ----- | ----
| |                              |  | (in
      thousands)
| | Nonaccrual loans             |  | $                    | 1
      584 |      | $ | 144   |  | $    | 122   |     
| | Restructured
      loans     |  |                      | - -         |      |   | - -   |  |      | - -   |     
| | Foreclosed properties        |  |                      | 430         |      |   | - -   |  |      | - -   |     
| | Total nonperforming assets   |  | $                    | 2 014       |      | $ | 144   |  | $    | 122   |     
| |                             
| | Loans
      past due 90 days |  |                      |             |      |   |       |  |      |       |     
| | accruing interest            |  | $                    | 21          |      | $ | - -   |  | $    | 65    |     
| |                             
| | Allowance for loan losses    |  |                      |             |      |   |       |  |      |       |     
| | to period end loans          |  |                      | 1.24%       |      |   | 1.05% |  |      | 1.03% |     
| |                             
| | Nonperforming assets to      |  |                      |             |      |   |       |  |      |       |     
| | period end loans and         |  |                      |             |      |   |       |  |      |       |     
| | foreclosed properties        |  |                      | .89%        |      |   | .06%  |  |      | .06%  |     

Loans are placed on nonaccrual
status when a loan is specifically determined to be impaired or when principal
or interest is delinquent for 90 days or more. Interest income generally is not
recognized on specific impaired loans unless the likelihood of further loss is
remote. Interest income on other nonaccrual loans is recognized only to the
extent of interest payments received.

At December 31, 2007, other
potential problem loans totaled $4.2 million. Loans are viewed as potential
problem loans according to the ability of such borrowers to comply with current
repayment terms. These loans are subject to constant management attention, and
their status is reviewed on a regular basis.

SECURITIES
PORTFOLIO

In accordance with Financial
Accounting Standards Board Statement No. 115, Accounting for Certain
Investments in Debt and Equity Securities, the company records securities being
held to maturity at amortized cost and securities available for sale at fair
value. The effect of unrealized gains and losses, net of tax effects, is
recognized in stockholders equity.

The schedule below summarizes the
book value of the portfolio by maturity classifications and shows the weighted
average yield in each group.

|                                               |  | 2007           |        | Weighted |      | 2006           |  | Weighted |        | 2005           |      | Weighted
|---------------------------------------------- |  | -------------- | ------ | -------- | ---- | -------------- |  | -------- | ------ | -------------- | ---- | --------
|                                               |  | Carrying Value |        | Average  |      | Carrying Value |  | Average  |        | Carrying Value |      | Average 
|                                               |  | (in thousands) |        | Yield    |      | (in thousands) |  | Yield    |        | (in thousands) |      | Yield   
|Securities available for sale                  |  |                |        |          |      |                |  |          |        |                |      |         
|Obligations of U.S. Government
      agencies: |  |                |        |          |      |                |  |          |        |                |      |         
|Maturing within one year                       |  | $              | 10 501 |          | 4.38 | %              |  | $        | 14 169 |                | 4.05 | %       
|Maturing after one year but                    |  |                |        |          |      |                |  |          |        |                |      |         
|within five years                              |  |                | 26 200 |          | 5.00 | %              |  |          | 26 819 |                | 4.86 | %       
|Municipal obligations:                         |  |                |        |          |      |                |  |          |        |                |      |         
|Maturing within one year                       |  |                | - -    |          | - -  |                |  |          | 170    |                | 2.53 | %       
|Maturing after on year but                     |  |                |        |          |      |                |  |          |        |                |      |         
|within five years                              |  |                | 1 029  |          | 3.71 | %              |  |          | 466    |                | 3.59 | %       
|Maturing after five years                      |  |                | 1 842  |          | 3.87 | %              |  |          | 1 082  |                | 3.97 | %       
|Total securities available for sale            |  | $              | 39 572 |          |      |                |  | $        | 42 706 |                |      |         

25

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DEPOSITS

Deposits increased .63% in 2007.
Periodically we have continued to depend on alternative methods of funding. We
have seen additional deposit growth through our Berkeley County branch offices
and anticipate continued growth in those areas. We are a relatively new face in
the Berkeley County neighborhood and Berkeley County residents are still
learning about us and continue to respond in a positive manner. As of June 2006,
the bank had 3.4% of the market share of deposits in Berkeley County and as of
June 2007, we had approximately 3.6% of that market. Jefferson County deposit
market share is at 30%. We have a total market share in both counties of
approximately 14.5% at June 30, 2007.

Schedule of Average Deposits and
Average Rates Paid

|                                       |  | Year Ended December
      3    
|-------------------------------------- |  | -------------------------------
|                                       |  | (average balances in thousands)
|                                       |  | 2007                           
|                                       |  | Average                        
|                                       |  | Balance                        
|Noninterest-bearing demand deposits    |  | $                              
|                                      
|Interest-bearing
      demand deposits |  |                                
|Savings deposits                       |  |                                
|Time
      deposits                    |  |                                
|                                      
|Total
      interest-bearing deposits  |  |                                
|                                      
|Total deposits                         |  | $                              

At December 31, 2007 time deposits
of $100 thousand or more were 11.13 % of total deposits compared with 8.98% at
December 31, 2006. Maturities of time deposits of $100 thousand or more (in
thousands) at December 31, 2007 are as follows:

| | Within
      three months                   | $ | 8 682 
| | ------------------------------------------- | - | ------
| | Over three through six
      months         |   | 6 079 
| | Over
      six months through twelve months |   | 5 060 
| | Over twelve
      months                    |   | 8 383 
| |                                            
| | Total                                       | $ | 28 204

ANALYSIS OF
CAPITAL

The adequacy of the companys
capital is reviewed by management on an ongoing basis in terms of the size,
composition, and quality of the companys asset and liability levels, and
consistency with regulatory requirements and industry standards. Management
seeks to maintain a capital structure that will assure an adequate level of
capital to support anticipated asset growth and absorb potential
losses.

The Federal Reserve, the Comptroller
of the Currency and the Federal Deposit Insurance Corporation have adopted
capital guidelines to supplement the existing definitions of capital for
regulatory purposes and to establish minimum capital standards. Specifically,
the guidelines categorize assets and off-balance sheet items into four
risk-weighted categories. The minimum ratio of qualifying total capital to
risk-weighted assets is 8.0%, of which at least 4.0% must be Tier 1 capital,
composed of common equity, retained earnings and a limited amount of perpetual
preferred stock, less certain goodwill items. The company had a ratio of total
capital to risk-weighted assets of 14.23% and a ratio of Tier 1 capital to
risk-weighted assets of 13.01% at December 31, 2007. These two ratios have
increased due to the growth in capital. Both ratios exceed the capital
requirements adopted by the federal regulatory agencies.

26

---

| |                                               |  | (In
      thousands) |         |     
| | --------------------------------------------- |  | -------------------- | ------- | ----
| |                                               |  | 2007                 |         | 2006
| | Tier 1
      capital:                         |  |                      |         |     
| | Common stock                                  |  | $                    | 3 672   |     
| | Surplus                                       |  |                      | 3 771   |     
| | Retained earnings                             |  |                      | 24 787  |     
| |                                               |  |                      | 32 230  |     
| | Less cost of shares acquired for the treasury |  |                      | 2 701   |     
| |                                              
| | Total tier 1 capital                          |  | $                    | 29 529  |     
| | Tier 2
      capital:                         |  |                      |         |     
| | Allowance for loan losses (1)                 |  |                      | 2 779   |     
| |                                              
| | Total risk-based capital                      |  | $                    | 32 308  |     
| |                                              
| | Risk-weighted assets                          |  | $                    | 227 013 |     
| |                                              
| | Capital ratios:                               |  |                      |         |     
| | Tier 1 risk-based capital ratio               |  |                      | 13.01%  |     
| | Total risk-based capital ratio                |  |                      | 14.23%  |     
| | Leverage ratio                                |  |                      | 9.99%   |     

| | (1) |  | Limited to 1.25% of gross
      risk-weighted assets.
| | --- |  | -----------------------------------------------------

LIQUIDITY

Liquidity represents an
institutions ability to meet present and future financial obligations through
either the sale or maturity of existing assets or the acquisition of additional
funds through liability management. This could also be termed the management of
the cash flows of an organization. Liquid assets include cash and due from
banks, interest-bearing deposits in financial institutions, securities purchased
under agreements to resell, federal funds sold, securities available for sale,
and loans and investments maturing within one year. The companys liquidity
during 2007 is detailed in the statement of cash flows included in the financial
statements.

Operating
Activities. The companys net income usually
provides cash from the banks operating activities. The net income figure is
adjusted for certain noncash transactions such as depreciation expense that
reduces net income but does not require a cash outlay. During 2007 net income as
adjusted has used cash of $5.2 million. This is due to the loans held for sale
to BlueRidge Bank (In Organization) that we have disbursed but will not sell for
several months. Typically our loans held for sale turn around in three or four
days. Interest income earned on loans and investment securities is the companys
major income source.

Investing
Activities. Customer deposits and company
borrowings provide the funds used to invest in loans and investment securities.
In addition, the principal portion of loan payments, loan payoffs and maturity
of investment securities provide cash flow. Purchases of bank premises and
equipment are an investing activity. As mentioned in the deposit discussion
above, we have taken advantage of our borrowing capabilities for additional
funding since deposit growth is not always sufficient to cover our needs. The
net amount of cash provided by investing activities in 2007 is $8.0 million.

Financing
Activities. Customer deposits and company
borrowings provide the financing for the investing activities as stated above.
If the company has an excess of funds on any given day, the bank will sell these
funds to make additional interest income to fund activities. Likewise, if the
company has a shortage of funds on any given day it will purchase funds and pay
interest for the use of these funds. Financing activities also include payment
of dividends to shareholders, purchase of shares of the companys common stock
for the treasury and repayment of any borrowed or purchased funds. The net
amount of cash provided by financing activities in 2007 is $1.4 million.

At December 31, 2007, cash and due
from banks, interest-bearing deposits in financial institutions, securities
purchased under agreements to resell, federal funds sold and loans and
securities maturing within one year were $60.4 million.

27

---

Borrowing capabilities provide
additional liquidity. The subsidiary bank maintains a federal funds line of $7
million with one financial institution and a federal funds line of $4 million
with a second financial institution. The subsidiary bank is also a member of the
Federal Home Loan Bank of Pittsburgh and has short and/or long-term borrowing
capabilities of approximately $139 million. In June 2001, the subsidiary bank
borrowed $2.5 million amortized over seven years from the Federal Home Loan
Bank. The subsidiary bank has a Repo Plus account with the FHLB with a current
credit line of $20 million that can be renewed on an annual basis.

*Financial Instruments With
Off-Balance-Sheet Risk.*The company is a
party to financial instruments with off-balance-sheet risk in the normal course
of business to meet the financing needs of its customers. Those financial
instruments include commitments to extend credit and standby letters of credit.
Those instruments involve, to varying degrees, elements of credit and interest
rate risk in excess of the amount recognized in the balance sheet. The contract
or notional amounts of those instruments reflect the extent of involvement the
company has in particular classes of financial instruments.

The companys exposure to credit
loss in the event of nonperformance by the other party to the financial
instruments for commitments to extend credit and standby letters of credit is
represented by the contractual notional amount of those instruments. The company
uses the same credit policies in making commitments and conditional obligations
as it does for on-balance-sheet instruments.

A summary of the contract or
notional amount of the companys exposure to off-balance-sheet risk as of
December 31, 2007 and 2006 is as follows (in thousands):

2007
    
    2006Financial instruments whose contractamounts represent
      credit risk:Commitments to extend credit
    
    $
    53 389
    
    $
    60 683Standby
      letters of credit
    
    
    3 294
    
    
    4 750


Commitments to extend credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract. Commitments generally have fixed
expiration dates or other termination clauses and may require payment of a fee.
Since many of the commitments are expected to expire without being drawn upon,
the total commitment amounts do not necessarily represent future cash
requirements. The company evaluates each customers credit worthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
the company upon extension of credit, is based on managements credit evaluation
of the counterparty. Collateral held varies but may include accounts receivable,
inventory, property and equipment, and income-producing commercial properties.

Unfunded commitments under
commercial lines of credit are commitments for possible future extensions of
credit to existing customers. The majority of these lines of credit is
collateralized and usually contains a specified maturity date and may not be
drawn upon to the extent to which the company is committed.

Standby letters of credit are
conditional commitments issued by the company to guarantee the performance of a
customer to a third party. Those guarantees are primarily issued to support
public and private borrowing arrangements, including commercial paper, bond
financing, and similar transactions. The credit risk involved in issuing letters
of credit is essentially the same as that involved in extending loan facilities
to customers. The company generally holds collateral supporting those
commitments if deemed necessary.

At December 31, 2007, the company
had $603 thousand in rate lock commitments to originate mortgage
loans.

*Short-Term Borrowings.*At December 31, 2007, short-term borrowings
consist of securities sold under agreements to repurchase that are secured
transactions with customers. These borrowings generally mature the day following
the day sold. The total of short-term borrowings was $12.5 million on December
31, 2007 and $10.5 million on December 31, 2006. The short-term borrowings at
December 31, 2006 were securities sold under agreements to repurchase that were
secured transactions with customers and federal funds purchased.

28

---

The table below presents selected
information on these short-term borrowings (in thousands):

| |                                                        |  | December 31
| | ------------------------------------------------------ |  | -----------
| |                                                        |  | 2007       
| | Balance outstanding at year end                        |  | $          
| | Maximum balance
      at any month-end during the year |  | $          
| | Average balance for the year                           |  | $          
| | Weighted average
      rate for the year               |  |            
| | Weighted average rate at year end                      |  |            
| | Estimated fair
      value                             |  | $          

*Contractual Obligations.*The table below presents the contractual
obligations of the company as of December 31, 2007:

Payments (in thousands) Due By
      PeriodOver
      1
    
    Over
      3Less
    
    Year
    
    Yearsthan
      1
    
    through
    
    throughTotal
    
    Year
    
    3 Years
    
    5 YearsLong-Term Debt Obligations
    
    $
    212
    
    $
    212
    
    $
    - -
    
    $
    - -Lease Obligations for Real Estate
    
    $
    114
    
    $
    51
    
    $
    63
    
    $
    - -Lease Obligations for Equipment
    
    $
    77
    
    $
    33
    
    $
    44
    
    $
    - -


29

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Item 8. Financial Statements and
Supplementary Data.

Report of Independent Registered
Public Accounting Firm

To the Stockholders and Board of
Directors Potomac Bancshares, Inc.Charles
Town, West Virginia

We have audited the consolidated
balance sheets of Potomac Bancshares, Inc. and Subsidiary as of December 31,
2007 and 2006, and the related consolidated statements of income, changes in
stockholders equity and cash flows for the years ended December 31, 2007, 2006
and 2005. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United
States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provided a reasonable basis for our opinion.

In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects,
the financial position of Potomac Bancshares, Inc. and Subsidiary as of December
31, 2007 and 2006, and the results of their operations and their cash flows for
the years ended December 31, 2007, 2006 and 2005, in conformity with U.S.
generally accepted accounting principles.

We were not engaged to examine
managements assertion about the effectiveness of Potomac Bancshares, Inc. andSubsidiarys internal control over financial
reporting as of December 31, 2007 included in the accompanying Managements
Report on Internal Control over Financial Reporting and, accordingly, we do not
express an opinion thereon.

Winchester, Virginia March 24, 2008

30

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POTOMAC BANCSHARES, INC. AND
SUBSIDIARY CONSOLIDATED BALANCE SHEETSDecember 31, 2007 and 2006 (in thousands, except share
data)

|                                                                 |  | 2007 |         | 2006
|---------------------------------------------------------------- |  | ---- | ------- | ----
|ASSETS                                                           |  |      |         |     
|                                                                 |  |      |         |     
|Cash and due from banks                                          |  | $    | 5 938   |     
|Interest-bearing deposits in other financial
      institutions  |  |      | 93      |     
|Securities purchased under agreements to resell                  |  |      |         |     
|and
      federal funds sold                                     |  |      | 5 120   |     
|Securities available for sale, at fair value                     |  |      | 39 572  |     
|Loans held for sale                                              |  |      | 8 133   |     
|Loans, net of allowance for loan losses of $2,779                |  |      |         |     
|in
      2007 and $2,423 in 2006                                 |  |      | 221 828 |     
|Premises and equipment, net                                      |  |      | 6 237   |     
|Other real estate owned                                          |  |      | 430     |     
|Accrued interest receivable                                      |  |      | 1 366   |     
|Other assets                                                     |  |      | 9 507   |     
|                                                                
|Total Assets                                                     |  | $    | 298 224 |     
|                                                                
|                                                                
|LIABILITIES AND STOCKHOLDERS EQUITY                             |  |      |         |     
|                                                                
|LIABILITIES                                                      |  |      |         |     
|Deposits                                                         |  |      |         |     
|Noninterest-bearing                                              |  | $    | 27 994  |     
|Interest-bearing                                                 |  |      | 225 380 |     
|Total Deposits                                                   |  | $    | 253 374 |     
|Securities sold under agreements to repurchase and
      federal |  |      |         |     
|funds purchased                                                  |  |      | 12 537  |     
|Federal Home Loan Bank advances                                  |  |      | 212     |     
|Accrued interest payable                                         |  |      | 757     |     
|Other liabilities                                                |  |      | 2 329   |     
|Commitments and contingent liabilities                           |  |      | - -     |     
|Total Liabilities                                                |  | $    | 269 209 |     
|                                                                
|STOCKHOLDERS EQUITY                                             |  |      |         |     
|Common stock, $1 per share par value; 5,000,000 shares           |  |      |         |     
|authorized; 3,671,691 shares issued                              |  | $    | 3 672   |     
|Surplus                                                          |  |      | 3 771   |     
|Undivided profits                                                |  |      | 24 787  |     
|Accumulated other comprehensive
      (loss)                     |  |      | (514    | )   
|                                                                 |  | $    | 31 716  |     
|Less cost of shares acquired for the treasury,
      2007,       |  |      |         |     
|266,191
      shares; 2006, 238,108 shares                       |  |      | 2 701   |     
|Total Stockholders
      Equity                                 |  | $    | 29 015  |     
|                                                                
|Total
      Liabilities and Stockholders Equity                 |  | $    | 298 224 |     

See Notes to Consolidated Financial
Statements.

31

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POTOMAC BANCSHARES, INC. AND
SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOMEYears Ended December 31, 2007,
2006 and 2005 (in thousands, except per share data)

|                                                                 |  | 2007 |        | 2006 |   | 2005  
|---------------------------------------------------------------- |  | ---- | ------ | ---- | - | ------
|Interest and Dividend Income:                                    |  |      |        |      |   |       
|Interest and fees on loans                                       |  | $    | 17 093 |      | $ | 16 712
|Interest on securities available for sale - taxable              |  |      | 1 894  |      |   | 2 095 
|Interest on securities available for sale -
      nontaxable     |  |      | 74     |      |   | 57    
|Interest on securities purchased under agreements                |  |      |        |      |   |       
|to
      resell and federal funds sold                           |  |      | 435    |      |   | 65    
|Other interest and dividends                                     |  |      | 195    |      |   | 170   
|Total Interest and Dividend Income                               |  | $    | 19 691 |      | $ | 19 099
|                                                                
|Interest Expense:                                                |  |      |        |      |   |       
|Interest on deposits                                             |  | $    | 7 696  |      | $ | 6 183 
|Interest on securities sold under agreements to
      repurchase |  |      |        |      |   |       
|and federal funds purchased                                      |  |      | 441    |      |   | 564   
|Federal Home Loan Bank advances                                  |  |      | 24     |      |   | 185   
|Total Interest Expense                                           |  | $    | 8 161  |      | $ | 6 932 
|                                                                
|Net Interest Income                                              |  | $    | 11 530 |      | $ | 12 167
|                                                                
|Provision for Loan Losses                                        |  |      | 678    |      |   | 331   
|                                                                
|Net Interest Income after Provision                              |  |      |        |      |   |       
|for Loan Losses                                                  |  | $    | 10 852 |      | $ | 11 836
|                                                                
|Noninterest Income:                                              |  |      |        |      |   |       
|Trust and financial services                                     |  | $    | 1 085  |      | $ | 1 071 
|Service charges on deposit accounts                              |  |      | 2 102  |      |   | 1 724 
|Visa/MC Fees                                                     |  |      | 453    |      |   | 364   
|Net gain on sale of loans                                        |  |      | 197    |      |   | 117   
|Gain (loss) on sale or call of securities available for sale     |  |      | 1      |      |   | - -   
|Other operating income                                           |  |      | 526    |      |   | 490   
|Total Noninterest Income                                         |  | $    | 4 364  |      | $ | 3 766 
|                                                                
|Noninterest Expenses:                                            |  |      |        |      |   |       
|Salaries and employee benefits                                   |  | $    | 5 252  |      | $ | 5 104 
|Net occupancy expense of premises                                |  |      | 563    |      |   | 546   
|Furniture and equipment expenses                                 |  |      | 925    |      |   | 890   
|Advertising and marketing                                        |  |      | 246    |      |   | 297   
|ATM and check card expense                                       |  |      | 328    |      |   | 319   
|Other operating expenses                                         |  |      | 2 374  |      |   | 2 105 
|Total Noninterest Expenses                                       |  | $    | 9 688  |      | $ | 9 261 
|Income Before Income Tax Expense                                 |  | $    | 5 528  |      | $ | 6 341 
|Income Tax
      Expense                                         |  |      | 1 998  |      |   | 2 306 
|                                                                
|Net Income                                                       |  | $    | 3 530  |      | $ | 4 035 
|                                                                
|Earnings Per Share, basic                                        |  | $    | 1.03   |      | $ | 1.17  
|Earnings Per
      Share, diluted                                |  | $    | 1.03   |      | $ | 1.16  

See Notes to Consolidated Financial
Statements.

32

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POTOMAC BANCSHARES, INC. AND
SUBSIDIARYCONSOLIDATED STATEMENTS OF
CHANGES IN STOCKHOLDERS EQUITY Years Ended December 31, 2007, 2006 and 2005
(in thousands, except per share data)

|                                  |  |        |       |         |   |           |   |          |   | Accumulated   |   |               |   |       
|--------------------------------- |  | ------ | ----- | ------- | - | --------- | - | -------- | - | ------------- | - | ------------- | - | ------
|                                  |  |        |       |         |   |           |   |          |   | Other         |   |               |   |       
|                                  |  | Common |       |         |   | Undivided |   | Treasury |   | Comprehensive |   | Comprehensive |   |       
|                                  |  | Stock  |       | Surplus |   | Profits   |   | Stock    |   | Income (Loss) |   | Income        |   | Total 
|Balances, December 31, 2004       |  | $      | 1 800 |         | $ | 4 200     |   |          | $ | 18 631        |   |               | $ | (1 850
|                                 
|Comprehensive income              |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Net income  2005                 |  |        | - -   |         |   | - -       |   |          |   | 3 664         |   |               |   | - -   
|Other comprehensive (loss):       |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Unrealized holding (losses)       |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|arising during the period         |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|(net of tax, $255)                |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | - -   
|Reclassification for losses       |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|included in net income            |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|(net of tax, $125)                |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | - -   
|Total other comprehensive (loss)  |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Total comprehensive income        |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Stock split in the form of a      |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|100% stock dividend               |  |        | 1 800 |         |   | (1 800    | ) |          |   | - -           |   |               |   | - -   
|Cash
      dividends  2005       |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|($.33 per share)                  |  |        | - -   |         |   | - -       |   |          |   | (1 137        | ) |               |   | - -   
|Balances,
      December 31, 2005 |  | $      | 3 600 |         | $ | 2 400     |   |          | $ | 21 158        |   |               | $ | (1 850
|                                 
|Comprehensive income              |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Net income  2006                 |  |        | - -   |         |   | - -       |   |          |   | 4 035         |   |               |   | - -   
|Other comprehensive income:       |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Unrealized holding gains          |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|arising during the period         |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|(net of tax, $63)                 |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | - -   
|Total comprehensive income        |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Adjustment to initially apply     |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|FASB Statement No. 158,           |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|in regard to pension and          |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|other postretirement              |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|benefits (net of tax, $441)       |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | - -   
|2%
      stock dividend           |  |        | 72    |         |   | 1 149     |   |          |   | (1 221        | ) |               |   | - -   
|Purchase of treasury shares:      |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|27,093 shares                     |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | (429  
|Stock-based compensation expense  |  |        | - -   |         |   | 112       |   |          |   | - -           |   |               |   | - -   
|Cash dividends  2006             |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|($.38 per share)                  |  |        | - -   |         |   | - -       |   |          |   | (1 295        | ) |               |   | - -   
|Balances, December 31, 2006       |  | $      | 3 672 |         | $ | 3 661     |   |          | $ | 22 677        |   |               | $ | (2 279
|                                 
|Comprehensive income              |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Net income  2007                 |  |        | - -   |         |   | - -       |   |          |   | 3 530         |   |               |   | - -   
|Other comprehensive income:       |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Unrealized holding gains          |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|arising during the period         |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|(net of tax, $159)                |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | - -   
|Change in benefit obligations     |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|and plan assets for pension       |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|and other postretirement          |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|benefits (net of tax, $97)        |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | - -   
|Total other comprehensive income  |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Total comprehensive income        |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|Purchase of treasury shares:      |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|28,083 shares                     |  |        | - -   |         |   | - -       |   |          |   | - -           |   |               |   | (422  
|Stock-based compensation expense  |  |        | - -   |         |   | 110       |   |          |   | - -           |   |               |   | - -   
|Cash dividends  2007             |  |        |       |         |   |           |   |          |   |               |   |               |   |       
|($.42 per share)                  |  |        | - -   |         |   | - -       |   |          |   | (1 420        | ) |               |   | - -   
|Balances, December 31, 2007       |  | $      | 3 672 |         | $ | 3 771     |   |          | $ | 24 787        |   |               | $ | (2 701

See Notes to Consolidated Financial
Statements.

33

---

POTOMAC BANCSHARES, INC. AND
SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWSYears Ended December 31, 2007, 2006 and 2005 (in
thousands)

|                                                                      |  | 2007 |         | 2006 |  | 2005
|--------------------------------------------------------------------- |  | ---- | ------- | ---- |  | ----
|CASH FLOWS FROM OPERATING ACTIVITIES                                  |  |      |         |      |  |     
|Net income                                                            |  | $    | 3 530   |      |  | $   
|Adjustments to reconcile net income to net
      cash                 |  |      |         |      |  |     
|provided by (used in) operating activities:                           |  |      |         |      |  |     
|Provision for loan losses                                             |  |      | 678     |      |  |     
|Depreciation                                                          |  |      | 568     |      |  |     
|Deferred tax (benefit)                                                |  |      | (250    | )    |  |     
|Discount accretion and premium                                        |  |      |         |      |  |     
|amortization on securities, net                                       |  |      | (63     | )    |  |     
|(Gain) loss on sale or call of securities available for
      sale    |  |      | (1      | )    |  |     
|Loss on sale of other real estate                                     |  |      | 15      |      |  |     
|Loss on disposal of premises and equipment                            |  |      | 12      |      |  |     
|Loss on sale of repossessed assets                                    |  |      | 8       |      |  |     
|Stock-based compensation expense                                      |  |      | 110     |      |  |     
|Proceeds from sale of loans                                           |  |      | 11 002  |      |  |     
|Origination of loans for sale                                         |  |      | (18 730 | )    |  |     
|Changes in assets and liabilities:                                    |  |      |         |      |  |     
|Decrease (increase) in accrued interest
      receivable              |  |      | 65      |      |  |     
|(Increase) in other assets                                            |  |      | (2 220  | )    |  |     
|Increase in accrued interest payable                                  |  |      | 85      |      |  |     
|Increase (decrease) increase in other
      liabilities               |  |      | 10      |      |  |     
|Net cash (used in) provided by operating
      activities             |  | $    | (5 181  | )    |  | $   
|                                                                     
|CASH FLOWS FROM INVESTING ACTIVITIES                                  |  |      |         |      |  |     
|Proceeds from maturity of securities available for
      sale         |  | $    | 14 470  |      |  | $   
|Proceeds from sale of securities available
      for sale             |  |      | - -     |      |  |     
|Proceeds from call of securities available for sale                   |  |      | 10 035  |      |  |     
|Purchases of securities available for
      sale                      |  |      | (20 842 | )    |  |     
|Net decrease (increase) in loans                                      |  |      | 4 709   |      |  |     
|Purchases of premises and
      equipment                             |  |      | (384    | )    |  |     
|Proceeds from sale of other real estate                               |  |      | 61      |      |  |     
|Net cash provided by (used in) investing
      activities             |  | $    | 8 049   |      |  | $   
|                                                                     
|CASH FLOWS FROM FINANCING ACTIVITIES                                  |  |      |         |      |  |     
|Net (decrease) in noninterest-bearing
      deposits                  |  | $    | (1 879  | )    |  | $   
|Net increase in interest-bearing
      deposits                       |  |      | 3 475   |      |  |     
|Net proceeds (repayment) of securities sold under agreements
      to |  |      |         |      |  |     
|repurchase and federal funds purchased                                |  |      | 2 011   |      |  |     
|Net (repayment) of Federal Home Loan Bank
      advances              |  |      | (408    | )    |  |     
|Purchase of treasury shares                                           |  |      | (422    | )    |  |     
|Cash dividends                                                        |  |      | (1 420  | )    |  |     
|Net cash provided by financing activities                             |  | $    | 1 357   |      |  | $   
|Increase (decrease) in cash and cash
      equivalents                |  | $    | 4 225   |      |  | $   
|                                                                     
|CASH AND CASH EQUIVALENTS                                             |  |      |         |      |  |     
|Beginning                                                             |  |      | 6 926   |      |  |     
|Ending                                                                |  | $    | 11 151  |      |  | $   
|                                                                     
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION                     |  |      |         |      |  |     
|Cash payments for:                                                    |  |      |         |      |  |     
|Interest                                                              |  | $    | 8 076   |      |  | $   
|Income taxes                                                          |  | $    | 2 368   |      |  | $   
|                                                                     
|SUPPLEMENTAL DISCLOSURES OF NON-CASH                                  |  |      |         |      |  |     
|INVESTING AND FINANCING
      ACTIVITIES                              |  |      |         |      |  |     
|Unrealized gain (loss) on securities available for
      sale         |  | $    | 465     |      |  | $   
|Change in benefit obligations and plan assets for
      pension       |  |      |         |      |  |     
|and other postretirement benefits                                     |  | $    | 291     |      |  | $   
|Loans transferred to OREO                                             |  | $    | 506     |      |  | $   

See Notes to Consolidated Financial
Statements.

34

---

POTOMAC BANCSHARES, INC. AND
SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Nature of Banking Activities
and Significant Accounting Policies

Potomac
Bancshares, Inc. and Subsidiary (the company) grant commercial, financial,
agricultural, residential and consumer loans to customers, primarily in Berkeley
County and Jefferson County, West Virginia. The companys market area also
includes Washington County and Frederick County, Maryland and Frederick County,
Loudoun County and Clarke County, Virginia. The loan portfolio is well
diversified and loans generally are collateralized by assets of the customers.
The loans are expected to be repaid from cash flows or proceeds from the sale of
selected assets of the borrowers.

The
accounting and reporting policies of the company conform to accounting
principles generally accepted in the United States of America and to general
practices within the banking industry. The following is a summary of the more
significant policies.

Principles
of Consolidation

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

Interest-bearing Deposits in Financial Institutions

Interest-bearing deposits in financial institutions mature within one
year and are carried at cost.

Securities

Debt
securities that management has the positive intent and ability to hold to
maturity are classified as held to maturity and recorded at amortized cost.
Securities not classified as held to maturity, including equity securities with
readily determinable fair values, are classified as available for sale and
recorded at fair value, with unrealized gains and losses excluded from earnings
and reported in other comprehensive income.

Purchase
premiums and discounts are recognized in interest income using the interest
method over the terms of the securities. Declines in the fair value of
held-to-maturity and available-for-sale securities below their cost that are
deemed to be other than temporary are reflected in earnings as realized losses.
In estimating other-than-temporary impairment losses, management considers (l)
the length of time and the extent to which the fair value has been less than
cost, (2) the financial condition and near-term prospects of the issuer, and (3)
the intent and ability of the company to retain its investment in the issuer for
a period of time sufficient to allow for any anticipated recovery in fair value.
Gains and losses on the sale of securities are recorded on the trade date and
are determined using the specific identification method.

Loans

The company
grants mortgage, commercial and consumer loans to customers. A substantial
portion of the loan portfolio is comprised of loans secured by real estate. The
ability of the companys debtors to honor their contracts is dependent upon the
real estate and general economic conditions of the companys market area.

Loans that
management has the intent and ability to hold for the foreseeable future or
until maturity or payoff, generally, are reported at their outstanding unpaid
principal balances adjusted for the allowance for loan losses. Interest income
is accrued on the unpaid principal balance.

The accrual
of interest on loans is discontinued at the time the loan is 90 days delinquent
unless the credit is well-secured and in process of collection. In all cases,
loans are placed on nonaccrual or charged-off at an earlier date if collection
of principal or interest is considered doubtful.

All interest
accrued but not collected for loans that are placed on nonaccrual or charged-off
is reversed against interest income. The interest on these loans is accounted
for on the cash-basis or cost-recovery method, until qualifying for return to
accrual. Loans are returned to accrual status when all principal and interest
amounts contractually due are brought current and future payments are reasonably
assured.

35

---

Note 1. Nature of Banking Activities
and Significant Accounting Policies (Continued)

Allowance for Loan Losses

The
allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Loan losses
are charged against the allowance when management believes the uncollectibility
of a loan balance is confirmed. Subsequent recoveries, if any, are credited to
the allowance.

The
allowance is based on two basic principles of accounting: (1) SFAS No. 5,
Accounting for Contingencies, which requires that losses be accrued when they
are probable of occurring and are capable of estimation and (2) 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.

The
allowance for loan losses is evaluated on a regular basis by management and is
based upon managements periodic review of the collectability of the loans in
light of historical experience, the nature and volume of the loan portfolio,
adverse situations that may affect the borrowers ability to repay, estimated
value of any underlying collateral and prevailing economic conditions. This
evaluation is inherently subjective as it requires estimates that are
susceptible to significant revision as more information becomes available.

The
allowance consists of specific, general and unallocated components. The specific
component relates to loans that are classified as either doubtful or
substandard. For such loans that are also classified as impaired, an allowance
is established when the discounted cash flows (or collateral value or observable
market price) of the impaired loan is lower than the carrying value of that
loan. The general component covers non-classified loans and is based on
historical loss experience adjusted for qualitative factors. An unallocated
component is maintained to cover uncertainties that could affect managements
estimate of probable losses. The unallocated component of the allowance reflects
that margin of imprecision inherent in the underlying assumptions used in the
methodologies for estimating specific and general losses in the portfolio.

A loan is
considered impaired when, based on current information and events, it is
probable that the company will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment include
payment status, collateral value, and the probability of collecting scheduled
principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrower, including the length of the delay, the
reasons for the delay, the borrowers prior payment record, and the amount of
the shortfall in relation to the principal and interest owed. Impairment is
measured on a loan by loan basis for commercial and construction loans by either
the present value of expected future cash flows discounted at the loans
effective interest rate, the loans obtainable market price, or the fair value
of the collateral if the loan is collateral dependent.

Large groups
of smaller balance homogeneous loans are collectively evaluated for impairment.
Accordingly, the company does not separately identify individual consumer and
residential loans for impairment disclosures.

Loans Held
for Sale

Loans
originated and intended for sale in the secondary market are carried at the
lower of cost or market determined in the aggregate. The company does not retain
mortgage servicing rights on loans held for sale.

In 2007, the
bank entered into an agreement with BlueRidge Bank (In Organization) whereby
Bank of Charles Town would fund loans for BlueRidge Bank (In Organization) until
such time as BlueRidge Bank (In Organization) could get its charter. Upon
receiving its charter, BlueRidge Bank (In Organization) will buy the loans from
Bank of Charles Town. In the event that BlueRidge Bank (In Organization) exceeds
its legal lending limit, Bank of Charles Town will fund additional loan amounts
through participation agreements. Bank of Charles Town has funded $7.8 million
in loans on behalf of BlueRidge Bank (In Organization) as of December 31, 2007.

36

---

Note 1. Nature of Banking Activities
and Significant Accounting Policies (Continued)

Premises and
Equipment

Land is
carried at cost. Premises and equipment are stated at cost less accumulated
depreciation. Depreciation is computed primarily on the straight-line and
declining-balance methods. Estimated useful lives range from five to forty years
for premises and improvements and five to twenty-five years for furniture and
equipment.

Maintenance
and repairs of property and equipment are charged to operations and major
improvements are capitalized. Upon retirement, sale or other disposition of
property and equipment, the cost and accumulated depreciation are eliminated
from the accounts and gain or loss is included in operations.

Other Real
Estate

Assets
acquired through, or in lieu of, loan foreclosure are held for sale and are
initially recorded at the lower of the loan balance or the fair value net of
estimated selling costs at the date of foreclosure, establishing a new cost
basis. Subsequent to foreclosure, valuations are periodically performed by
management and the assets are carried at the lower of carrying amount or fair
value less cost to sell. Revenue and expenses from operations and changes in the
valuation allowance are included in net expenses from foreclosed assets.

Employee
Benefit Plans

The company
sponsors the following employee benefit plans:

- a noncontributory, defined benefit pension
  plan covering employees meeting certain age and service
  requirements,
- a postretirement life insurance plan
  covering current and future retirees with 25 years of service over the age of
  60,
- a postretirement life insurance plan
  covering certain current retirees who met certain requirements that is not
  available for future retirees,
- a health care plan for current retirees who met certain
  eligibility requirements that is not available for future retirees and
- a 401(k) retirement savings plan available to all employees
  meeting certain age and service requirements. Under this plan the employer may
  make a discretionary matching contribution each plan year and may also make
  other discretionary contributions to the plan.

Stock
Dividends

On March 14, 2006 the Board of Directors declared a 2% stock
dividend. Shares increased from 3,600,000 to 3,671,691. On February 8, 2005 the
Board of Directors declared a stock split in the form of a 100% stock dividend.
Shares increased from 1,800,000 to 3,600,000.

Earnings Per
Share

Basic
earnings per share represent income available to common stockholders divided by
the weighted-average number of common shares outstanding during the period.
Diluted earnings per share reflect additional common shares that would have been
outstanding if dilutive potential common shares had been issued, as well as any
adjustment to income that would result from the assumed issuance. Potential
common shares that may be issued by the company relate solely to outstanding
stock options and are determined using the treasury method. All amounts have
been retroactively restated for the stock dividends as described above.

Income Taxes

Deferred
income tax assets and liabilities are determined using the balance sheet method.
Under this method, the net deferred tax asset or liability is determined based
on the tax effects of the temporary difference between the book and tax bases of
the various balance sheet assets and liabilities and gives current recognition
to changes in tax rates and laws.

37

---

Note 1. Nature of Banking Activities
and Significant Accounting Policies (Continued)

Income Taxes
(Continued)

When tax
returns are filed, it is highly certain that some positions taken would be
sustained upon examination by the taxing authorities, while others are subject
to uncertainty about the merits of the position taken or the amount of the
position that would be ultimately sustained. The benefit of a tax position is
recognized in the financial statements in the period during which, based on all
available evidence, management believes it is more likely than not that the
position will be sustained upon examination, including the resolution of appeals
or litigation processes, if any. Tax positions taken are not offset or
aggregated with other positions. Tax positions that meet the
more-likely-than-not recognition threshold are measured as the largest amount of
tax benefit that is more than 50 percent likely of being realized upon
settlement with the applicable taxing authority. The portion of the benefits
associated with tax positions taken that exceeds the amount measured as
described above is reflected as a liability for unrecognized tax benefits in the
accompanying consolidated balance sheets along with any associated interest and
penalties that would be payable to the taxing authorities upon examination.
Interest and penalties associated with unrecognized tax benefits are classified
as additional income taxes in the consolidated statements of income.

Cash and
Cash Equivalents

For purposes
of reporting cash flows, cash and cash equivalents include cash on hand, amounts
due from banks, interest-bearing deposits in financial institutions, securities
purchased under agreements to resell and federal funds sold. Generally,
securities purchased under agreements to resell and federal funds sold are
purchased and sold for one-day periods.

Trust
Division

Securities
and other property held by the Trust Division in a fiduciary or agency capacity
are not assets of the company and are not included in the accompanying financial
statements.

Use of
Estimates

In preparing
consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet and the reported amounts of
revenues and expenses during the reported period. Actual results could differ
from those estimates. Material estimates that are particularly susceptible to
significant change in the near term relate to the determination of the allowance
for loan losses and the valuation of foreclosed real estate and deferred tax
assets.

Advertising

The company
follows the policy of charging the costs of advertising to expense as incurred.

Comprehensive Income

Accounting
principles generally require that recognized revenue, expenses, gains and losses
be included in net income. Although certain changes in assets and liabilities,
such as unrealized gains and losses on available for sale securities and changes
in pension and postretirement benefit obligations , are reported as a separate
component of the equity section of the balance sheet, such items, along with net
income, are components of comprehensive income.

Stock-Based
Compensation Plan

The 2003
Stock Incentive Plan was approved by stockholders on May 13, 2003. This is the
first stock incentive plan adopted by the company. Under the plan, the option
price cannot be less than the fair market value of the stock on the date
granted. An options maximum term is ten years from the date of grant.Options granted under the plan may be subject to
a graded vesting schedule.

38

---

Note 1. Nature of Banking Activities
and Significant Accounting Policies (Continued)

Stock-Based
Compensation Plan (Continued)

The
stockholders initially authorized up to 183,600 shares of common stock to be
used in the granting of incentive options to employees and directors. These
shares have been restated to reflect the 2% stock dividend declared March 14,
2006 and the 100% stock dividend declared February 8, 2005. On April 24, 2007
the shareholders authorized an additional 250,000 shares of common stock to be
used in the granting of incentive options to employees and directors.

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

The
following illustrates the effect on net income and earnings per share if the
company had applied the fair value method of SFAS 123R, prior to January 1,
2006:

For the Year EndedDecember 31, 2005(dollars in thousands exceptper share amounts)Net income, as reported
    
    
    $
    3 664Less pro forma stock option compensationexpense, net of tax
    
    
    
    (55
    )Pro forma net income
    
    
    $
    3 609Earnings per share:Basic  as reported
    
    
    $
    1.06Basic  pro forma
    
    
    $
    1.04Diluted  as reported
    
    
    $
    1.05Diluted  pro forma
    
    
    $
    1.04


Stock option
compensation expense is the estimated fair value of options granted amortized on
a straight-line basis over the requisite service period for each separately
vesting portion of the award. The weighted average estimated fair value of stock
options granted in the twelve months ended December 31, 2007, 2006 and 2005 was
$3.76, $3.88 and $2.91, respectively. Fair value is estimated using the
Black-Scholes option-pricing model with the following assumptions for grants
during 2007, 2006 and 2005: option term until exercise 10 years, expected
volatility of 19.56%, 17.86% and 19.46%, risk-free interest rates of 4.66%,
4.43% and 4.26%, and expected dividend yields of 2.74%, 2.66% and 3.15%,
respectively. Expected volatility is based on the historic volatility of the
companys stock price over the expected life of the options. We have determined
that the expected term for options is their contractual life of 10 years. The
risk-free interest rate is the U. S. Treasury zero-coupon issue with a remaining
term equal to the expected term of the options granted. The dividend yield is
estimated as the ratio of the companys historical dividends paid per share of
common stock to the stock price on the date of grant.

Reclassifications

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

39

---

Note 1. Nature of Banking Activities
and Significant Accounting Policies (Continued)

Recent
Accounting Pronouncements

In September
2006, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157).
SFAS 157 defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles, and expands disclosures about fair
value measurements. SFAS 157 does not require any new fair value measurements,
but rather, provides enhanced guidance to other pronouncements that require or
permit assets or liabilities to be measured at fair value. This statement is
effective for financial statements issued for fiscal years beginning after
November 15, 2007 and interim periods within those years. The FASB has approved
a one-year deferral for the implementation of the statement for nonfinancial
assets and nonfinancial liabilities that are recognized or disclosed at fair
value in the financial statements on a nonrecurring basis. The company does not
expect the implementation of SFAS 157 to have a material impact on its
consolidated financial statements.

In September
2006, the FASB issued Statement of Financial Accounting Standards No. 158,
Employers Accounting for Defined Benefit Pension and Other Postretirement
Plans  an amendment of FASB Statements No. 87, 88, 106, and 132(R) (SFAS 158).
This statement requires employers to measure plan assets and obligations as of
the balance sheet date. This requirement is effective for fiscal years ending
after December 15, 2008. The other provisions of SFAS 158 were implemented by
the company as of December 31, 2006. The company does not expect the
implementation of the measurement date provisions of SFAS 158 to have a material
impact on its consolidated financial statements.

In February
2007, the FASB issued Statement of Financial Accounting Standards No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159).
This statement permits entities to choose to measure many financial instruments
and certain other items at fair value. The objective of this statement is to
improve financial reporting by providing entities with the opportunity to
mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. The fair value option established by this statement permits all
entities to choose to measure eligible items at fair value at specified election
dates. A business entity shall report unrealized gains and losses on items for
which the fair value option has been elected in earnings at each subsequent
reporting date. The fair value option may be applied instrument by instrument
and is irrevocable. SFAS 159 is effective as of the beginning of an entitys
first fiscal year that begins after November 15, 2007, with early adoption
available in certain circumstances. The company does not expect the
implementation of SFAS 159 to have a material impact on its consolidated
financial statements.

In December
2007, the FASB issued Statement of Financial Accounting Standards No. 141(R),
Business Combinations (SFAS 141(R)). The standard will significantly change
the financial accounting and reporting of business combination transactions.
SFAS 141(R) establishes principles for how an acquirer recognizes and measures
the identifiable assets acquired, liabilities assumed, and any noncontrolling
interest in the acquiree; recognizes and measures the goodwill acquired in the
business combination or a gain from a bargain purchase; and determines what
information to disclose to enable users of the financial statements to evaluate
the nature and financial effects of the business combination. SFAS 141(R) is
effective for acquisition dates on or after the beginning of an entitys first
year that begins after December 15, 2008. The company does not expect the
implementation of SFAS 141(R) to have a material impact on its consolidated
financial statements.

In December
2007, the FASB issued Statement of Financial Accounting Standards No. 160,
Noncontrolling Interests in Consolidated Financial Statements, an Amendment of
ARB No. 51 (SFAS 160). The standard will significantly change the financial
accounting and reporting of noncontrolling (or minority) interests in
consolidated financial statements. SFAS 160 is effective as of the beginning of
an entitys first fiscal year that begins after December 15, 2008, with early
adoption prohibited. The company does not expect the implementation of SFAS 160
to have a material impact on its consolidated financial statements.

40

---

Note 1. Nature of Banking Activities
and Significant Accounting Policies (Continued)

Recent
Accounting Pronouncements (Continued)

In September
2006, the Emerging Issues Task Force (EITF) issued EITF 06-4, Accounting for
Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements. This consensus concludes that for a
split-dollar life insurance arrangement within the scope of this issue, an
employer should recognize a liability for future benefits in accordance with
SFAS 106 (if, in substance, a postretirement benefit plan exists) or APB Opinion
No. 12 (if the arrangement is, in substance, an individual deferred compensation
contract) based on the substantive agreement with the employee. The consensus is
effective for fiscal years beginning after December 15, 2007, with early
application permitted. The company does not expect the implementation of EITF
06-4 to have a material impact on its consolidated financial statements.

In November
2006, the EITF issued Accounting for Collateral Assignment Split-Dollar Life
Insurance Arrangements (EITF 06-10). In this issue, a consensus was reached
that an employer should recognize a liability for the postretirement benefit
related to a collateral assignment split-dollar life insurance arrangement in
accordance with either SFAS 106 or APB Opinion No. 12, as appropriate, if the
employer has agreed to maintain a life insurance policy during the employee's
retirement or provide the employee with a death benefit based on the substantive
agreement with the employee. A consensus also was reached that an employer
should recognize and measure an asset based on the nature and substance of the
collateral assignment split-dollar life insurance arrangement. The consensuses
are effective for fiscal years beginning after December 15, 2007, including
interim periods within those fiscal years, with early application permitted. The
company does not expect the implementation of EITF 06-10 to have a material
impact on its consolidated financial statements.

In February
2007, the FASB issued FSP No. FAS 158-1, Conforming Amendments to the
Illustrations in FASB Statements No. 87, No. 88 and No. 106 and to the Related
Staff Implementation Guides. This FSP provides conforming amendments to the
illustrations in SFAS 87, 88, and 106 and to related staff implementation guides
as a result of the issuance of SFAS 158. The conforming amendments made by this
FSP are effective as of the effective dates of SFAS 158. The unaffected guidance
that this FSP codifies into SFAS 87, 88, and 106 does not contain new
requirements and therefore does not require a separate effective date or
transition method. The company does not expect the implementation of FSP No. FAS
158-1 to have a material impact on its consolidated financial statements.

In November
2007, the Securities and Exchange Commission (SEC) issued Staff Accounting
Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through
Earnings (SAB 109). SAB 109 expresses the current view of the staff that the
expected net future cash flows related to the associated servicing of the loan
should be included in the measurement of all written loan commitments that are
accounted for at fair value through earnings. SEC registrants are expected to
apply the views in Question 1 of SAB 109 on a prospective basis to derivative
loan commitments issued or modified in fiscal quarters beginning after December
15, 2007. The company does not expect the implementation of SAB 109 to have a
material impact on its consolidated financial statements.

In December
2007, the SEC issued Staff Accounting Bulletin No. 110, Use of a Simplified
Method in Developing Expected Term of Share Options (SAB 110). SAB 110
expresses the current view of the staff that it will accept a companys election
to use the simplified method discussed in SAB 107 for estimating the expected
term of plain vanilla share options regardless of whether the company has
sufficient information to make more refined estimates. The staff noted that it
understands that detailed information about employee exercise patterns may not
be widely available by December 31, 2007. Accordingly, the staff will continue
to accept, under certain circumstances, the use of the simplified method beyond
December 31, 2007. The company does not expect the implementation of SAB 110 to
have a material impact on its consolidated financial statements.

41

---

Note 2. Securities

There were
no securities held to maturity as of December 31, 2007 and 2006.

The
amortized cost and fair value of securities available for sale as of December
31, 2007 and 2006 (in thousands) are as follows:

2007Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    (Losses)
    
    ValueObligations of U.S. Government agencies
    $
    36 471
    
    $
    246
    
    $
    (16
    )
    
    $
    36 701State and
      municipal obligations
    
    2 868
    
    
    5
    
    
    (2
    )
    
    
    2 871$
    39 339
    
    $
    251
    
    $
    (18
    )
    
    $
    39 5722006Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    (Losses)
    
    ValueObligations of U.S. Government agencies
    $
    41 213
    
    $
    16
    
    $
    (242
    )
    
    $
    40 987State and
      municipal obligations
    
    1 725
    
    
    3
    
    
    (9
    )
    
    
    1 719$
    42 938
    
    $
    19
    
    $
    (251
    )
    
    $
    42
      706


The
amortized cost and fair value of the securities available for sale as of
December 31, 2007 (in thousands), by contractual maturity, are shown below:

Amortized
    
    FairCost
    
    ValueDue in one year
      or less
    $
    10 490
    
    $
    10 501Due after one year through five
      years
    
    27 008
    
    
    27 229Due after five
      years
    
    1 841
    
    
    1 842$
    39 339
    
    $
    39 572


There were
no sales of securities available for sale during 2007 or 2006. Proceeds from
sales of securities available for sale were $13.9 million during 2005. Gross
losses of $369 thousand were realized on sales in 2005.

The primary
purpose of the investment portfolio is to generate income and meet liquidity
needs of the company through readily saleable financial instruments. The
portfolio is made up of fixed rate bonds, whose prices move inversely with
rates. At the end of any accounting period, the investment portfolio has
unrealized gains and losses. The company monitors the portfolio which is subject
to liquidity needs, market rate changes and credit risk changes to see if
adjustments are needed. The primary concern in a loss situation is the credit
quality of the business behind the instrument. The primary cause of impairments
is the decline in the prices of the bonds as rates have risen. There are
approximately 8 accounts in the consolidated portfolio that have losses at
December 31, 2007. These securities have not suffered credit deterioration and
the company has the ability and intent to hold these issues to maturity or
recovery of value; therefore, the gross unrealized losses are considered
temporary as of December 31, 2007.

42

---

Note 2. Securities (Continued)

The
following table summarizes the fair value and gross unrealized losses for
securities aggregated by investment category and length of time that individual
securities have been in a continuous gross unrealized loss position as of
December 31, 2007 and 2006 (in thousands).

| |                                       | December 31, 2007  
| | ------------------------------------- | -------------------
| |                                       | Less than 12 months
| |                                       |                    
| |                                       |                    
| |                                       | Fair Value         
| | Obligations of U.S.                   |                    
| | Government agencies                   | $                  
| | State and
      municipal obligations |                    
| |                                       | $                  
| |                                      
| |                                      
| |                                       | December 31, 2006  
| |                                       | Less than 12 months
| |                                       |                    
| |                                       |                    
| |                                       | Fair Value         
| | Obligations of U.S.                   |                    
| | Government agencies                   | $                  
| | State and
      municipal obligations |                    
| |                                       | $                  

Securities
with a carrying value of $25.6 million and $25.2 million at December 31, 2007
and 2006 were pledged to secure public funds and other balances as required by
law.

Note 3. Loans and Related Party
Transactions

The loan
portfolio is composed of the following:

| |                                        | December
      31
| | -------------------------------------- | -----------------
| |                                        | 2007             
| |                                        |                  
| | Mortgage loans on real estate:         |                  
| | Construction and land development      | $                
| | Secured by farm land                   |                  
| | Secured by 1-4 family residential      |                  
| | Secured by multifamily residential     |                  
| | Secured by nonfarm nonresidential      |                  
| | Commercial loans (except those secured |                  
| | by real estate)                        |                  
| | Consumer
      loans                   |                  
| | All other loans                        |                  
| | Total loans                            | $                
| | Less: allowance for loan losses        |                  
| |                                        | $                

At December
31, 2007 and 2006, overdraft demand deposits reclassified to loans totaled $193
thousand and $144 thousand, respectively.

Loans to
directors and executive officers of the company or to their associates at
December 31, 2007 and 2006 totaled $2.8 million and $3.3 million, respectively.
Such loans were made on substantially the same terms as those prevailing for
comparable transactions with similar risks. During 2007, total principal
additions were $566 thousand and total principal payments were $1 million.

43

---

Note 4. Allowance for Loan Losses

The
following is a summary of transactions in the allowance for loan losses for
2007, 2006 and 2005 (in thousands):

| |                                        | 2007 |       | 2006 |  | 2005
| | -------------------------------------- | ---- | ----- | ---- |  | ----
| | Balances at beginning of year          | $    | 2 423 |      |  | $   
| | Provision charged to operating expense |      | 678   |      |  |     
| | Recoveries added to the allowance      |      | 182   |      |  |     
| | Loan losses charged to the allowance   |      | (504  | )    |  |     
| | Balances at end of year                | $    | 2 779 |      |  | $   

The
following is a summary of information pertaining to impaired loans as of
December 31 for each of the years presented (in thousands):

| |                                                              | 2007 |       | 2006 |   |      | 
| | ------------------------------------------------------------ | ---- | ----- | ---- | - | ---- | 
| | Impaired loans without a valuation allowance                 | $    | 3 157 |      | $ | - -  | 
| | Impaired loans
      with a valuation allowance              |      | 2 656 |      |   | - -  | 
| |                                                              |      |       |      |   |      | 
| | Total impaired loans                                         | $    | 5 813 |      | $ | - -  | 
| |                                                              |      |       |      |   |      | 
| | Valuation allowance related to impaired loans                | $    | 636   |      | $ | - -  | 
| |                                                              |      |       |      |   |      | 
| | Total loans past due ninety days or more and still accruing  | $    | 21    |      | $ | - -  | 
| |                                                              |      |       |      |   |     
| |                                                              | 2007 |       | 2006 |   | 2005
| | Average investment in impaired loans                         | $    | 1 163 |      | $ | - -  | 
| | Interest income
      recognized on impaired loans           | $    | 48    |      | $ | - -  | 
| | Interest income recognized on a cash basis on impaired loans | $    | - -   |      | $ | - -  | 

No
additional funds are committed to be advanced in connection with impaired loans.
Nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 at
December 31, 2007 and 2006 totaled $517 thousand and $144 thousand,
respectively. If interest had been accrued on these nonaccrual loans, such
income would have approximated $3 thousand in 2007 and $14 thousand in 2006.

Note 5. Premises and Equipment, Net

Premises and
equipment consists of the following:

| |                                     | December 31
| | ----------------------------------- | -----------
| |                                     | 2007       
| |                                     |            
| | Premises and improvements           | $          
| | Furniture and
      equipment       |            
| |                                     | $          
| | Less accumulated
      depreciation |            
| |                                     | $          

Depreciation
included in operating expense for 2007, 2006 and 2005 was $568 thousand, $582
thousand and $578 thousand, respectively.

Note 6. Deposits

The
aggregate amount of time deposits with a balance of $100,000 or more was $28.2
million and $22.6 million at December 31, 2007 and 2006, respectively.

44

---

Note 6. Deposits (Continued)

At December
31, 2007, the scheduled maturities of all time deposits (in thousands) are as
follows:

| | 2008 | $ | 70 985 
| | ---- | - | -------
| | 2009 |   | 20 516 
| | 2010 |   | 7 957  
| | 2011 |   | 2 482  
| | 2012 |   | 4 136  
| |      | $ | 106 076

Brokered
deposits (all in the form of certificates of deposit) totaled $3.4 million and
$12.9 million at December 31, 2007 and 2006, respectively.

Deposits of
the companys directors, executive officers and associates totaled $104 thousand
and $96 thousand at December 31, 2007 and 2006, respectively.

Note 7. Borrowings

Short-term
borrowings may consist of securities sold under agreements to repurchase and
federal funds purchased. At December 31, 2007, short-term borrowings totaled
$12.5 million in securities sold under agreements to repurchase through secured
transactions with customers. There were no federal funds purchased.

At December
31, 2006 short-term borrowings totaled $10.5 million which included $10.3
million in securities sold under agreements to repurchase through secured
transactions with customers and $200 thousand in federal funds purchased.

In June
2001, the bank incurred fixed rate long term debt consisting of a Federal Home
Loan Bank seven year loan with an original balance of $2.5 million and monthly
payments of interest and principal with an interest rate of 5.51%. Total
non-securities collateral available to secure loans with the Federal Home Loan
Bank is $134 million. The remaining principal payments on the note are due
during 2008 in the amount of $212 thousand.

The balance
of this loan at December 31, 2006 was $620 thousand.

The company
has unused lines of credit with the Federal Home Loan Bank and other financial
institutions totaling approximately $150 million at December 31, 2007.

Note 8. Employee Benefit Plans

The company
sponsors a 401(k) retirement savings plan available to all employees meeting
certain age and service requirements. Employees become eligible to participate
in the plan upon reaching age 21 and completing one year of service. Entry dates
are January 1, April 1, July 1 and October 1. Employees can make a salary
deferral election authorizing the employer to withhold up to the amount allowed
by law each calendar year. The employer may make a discretionary matching
contribution each plan year. The employer may also make other discretionary
contributions to the plan. The company made 401(k) matching contributions of $92
thousand, $56 thousand and $50 thousand in 2007, 2006 and 2005, respectively.

The company
sponsors a funded noncontributory, defined benefit pension plan covering
full-time employees over 21 years of age upon completion of one year of service.
Benefits are based on average compensation for the five consecutive full
calendar years of service which produces the highest average.

The company
sponsors an unfunded postretirement life insurance plan covering current and
future retirees with 25 years of service over the age of 60 and an unfunded
health care plan for current retirees that met certain eligibility
requirements.

45

---

Note 8. Employee Benefit Plans
(Continued)

The company
has entered into contracts with four retirees where the company agrees to pay
the participants beneficiaries $50,000 upon the participants death. The
present value of this postretirement benefit has been accrued as of December 31,
2007 in the amount of $77 thousand. While these liabilities are unfunded, life
insurance has been obtained by the company to help offset these payments.

Obligations
and funded status:

| |                                         | Pension Benefits |        | Postretirement Benefits
| | --------------------------------------- | ---------------- | ------ | -----------------------
| |                                         | 2007             |        | 2006                   
| |                                         | (in thousands)   |        | (in thousands)         
| | Change in benefit obligation:           |                  |        |                        
| | Benefit obligation, beginning           | $                | 6 148  |                        
| | Service cost                            |                  | 254    |                        
| | Interest cost                           |                  | 362    |                        
| | Actuarial (gain) loss                   |                  | (144   | )                      
| | Benefits paid                           |                  | (246   | )                      
| | Benefit obligation, ending              | $                | 6 374  |                        
| |                                        
| | Change in plan assets:                  |                  |        |                        
| | Fair value of plan assets, beginning    | $                | 4 622  |                        
| | Actual return on plan assets            |                  | 442    |                        
| | Employer contributions                  |                  | 485    |                        
| | Benefits paid                           |                  | (246   | )                      
| | Fair value of plan assets, ending       | $                | 5 303  |                        
| |                                        
| | Funded status at end of year            | $                | (1 071 | )                      
| |                                        
| | Accounts recognized on consolidated     |                  |        |                        
| | balance sheet as:                       |                  |        |                        
| | Accrued benefit liabilities             | $                | (1 071 | )                      
| |                                        
| | Amounts recognized in accumulated other |                  |        |                        
| | comprehensive (loss) consist
      of:  |                  |        |                        
| | Net loss (gain)                         | $                | 936    |                        
| | Transition liability                    |                  | - -    |                        
| | Deferred tax benefit                    |                  | (318   | )                      
| |                                         | $                | 618    |                        

The
accumulated benefit obligation for the defined benefit pension plan was $5.9
million and $5.0 million at December 31, 2007 and 2006, respectively.

46

---

Note 8. Employee Benefit Plans
(Continued)

Components
of net periodic benefit cost and other amounts recognized in accumulated other
comprehensive (loss):

| |                                          | Pension Benefits |      | Postretirement Benefits
| | ---------------------------------------- | ---------------- | ---- | -----------------------
| |                                          | 2007             |      | 2006                   
| |                                          | (in thousands)   |      | (in thousands)         
| | Components of net periodic benefit cost: |                  |      |                        
| | Service cost                             | $                | 254  |                        
| | Interest cost                            |                  | 362  |                        
| | Expected return on plan assets           |                  | (356 | )                      
| | Amortization of net obligation           |                  |      |                        
| | (asset) at transition                    |                  | - -  |                        
| | Recognized actuarial (gain) loss         |                  | 40   |                        
| | Net periodic benefit cost                | $                | 300  |                        
| |                                         
| | Other changes in plan assets and benefit |                  |      |                        
| | obligations recognized in accumulated    |                  |      |                        
| | other comprehensive income (loss):       |                  |      |                        
| | Net loss (gain)                          | $                | (274 | )                      
| | Transition liability                     |                  | - -  |                        
| | Deferred tax                             |                  | 91   |                        
| | Total
      recognized in other          |                  |      |                        
| | comprehensive income (loss)              | $                | (183 | )                      
| | Total recognized in net periodic         |                  |      |                        
| | benefit
      cost and other             |                  |      |                        
| | comprehensive income (loss)              | $                | 117  |                        

The
estimated net loss and prior service cost for the defined benefit pension plan
that will be amortized from accumulated other comprehensive income into net
periodic benefit cost over the next fiscal year approximates $40 thousand. The
estimated unrecognized transition liability for the other defined benefit
postretirement plans that will be amortized from accumulated other comprehensive
income into net periodic benefit cost over the next fiscal year is $17 thousand.

Assumptions

| |                                      | Pension Benefits |   | Postretirement Benefits
| | ------------------------------------ | ---------------- | - | -----------------------
| |                                      | 2007             |   | 2006                   
| |                                      | (in thousands)   |   | (in thousands)         
| | Weighted-average assumptions used to |                  |   |                        
| | determine net periodic benefit cost: |                  |   |                        
| | Discount rate                        | 6.00             | % |                        
| | Expected return on plan assets       | 7.50             | % |                        
| | Rate of compensation increase        | 4.50             | % |                        
| |                                     
| | Weighted-average assumptions used to |                  |   |                        
| | determine benefit obligations:       |                  |   |                        
| | Discount rate                        | 6.00             | % |                        
| | Rate of compensation increase        | 4.50             | % |                        

47

---

Note 8. Employee Benefit Plans
(Continued)

Long-Term
Rate of Return

The plan
sponsor selects the expected long-term rate-of-return-on-assets assumption in
consultation with their investment advisors and actuary. This rate is intended
to reflect the average rate of earnings expected to be earned on the funds
invested or to be invested to provide plan benefits. Historical performance is
reviewed, especially with respect to real rates of return (net of inflation),
for the major asset classes held or anticipated to be held by the trust, and for
the trust itself. Undue weight is not given to recent experience that may not
continue over the measurement period, with higher significance placed on current
forecasts of future long-term economic conditions.

Because
assets are held in a qualified trust, anticipated returns are not reduced for
taxes. Further, solely for this purpose, the plan is assumed to continue in
force and not terminate during the period during which assets are invested.
However, consideration is given to the potential impact of current and future
investment policy, cash flow into and out of the trust, and expenses (both
investment and non-investment) typically paid from plan assets (to the extent
such expenses are not explicitly estimated within periodic cost).

Asset Allocation

The pension
plans weighted-average asset allocations at October 31, 2007 and 2006 (the
plans valuation date), by asset category are as follows:

| |                   | Plan Assets at
      October 31
| | ----------------- | -------------------------------
| |                   | 2007                           
| | Asset Category    |                                
| | Equities          | 61                             
| | Fixed income/cash | 39                             
| |                  
| | Total             | 100                            

The trust
fund is sufficiently diversified to maintain a reasonable level of risk without
imprudently sacrificing return, with a targeted asset allocation of 60% equities
and 40% fixed income/cash. The trust fund allocation is reviewed on a quarterly
basis and rebalanced back to the original weighting if the actual weighting
varies by at least 5% from the target allocation. The investment manager selects
investment fund managers with demonstrated experience and expertise, and funds
with demonstrated historical performance, for the implementation of the plans
investment strategy. The investment manager will consider both actively and
passively managed investment strategies and will allocate funds across the asset
classes to develop an efficient investment structure.

It is the
responsibility of the trustee to administer the investments of the trust within
reasonable costs, being careful to avoid sacrificing quality. These costs
include, but are not limited to, management and custodial fees, consulting fees,
transaction costs and other administrative costs chargeable to the trust.

There is no
company common stock included in the equity securities of the pension plan at
December 31, 2007 and 2006.

48

---

Note 8. Employee Benefit Plans
(Continued)

Cash Flow

The company
expects to contribute $300 thousand to its pension plan in 2008 and $23 thousand
to its postretirement plan in 2008.

The
following benefit payments, which reflect future service, are expected to be
paid:

Pension Benefits
    
    Other Benefits(in thousands)2008
    
    $
    238
    
    
    
    $
    232009
    
    
    253
    
    
    
    
    262010
    
    
    254
    
    
    
    
    282011
    
    
    249
    
    
    
    
    302012
    
    
    300
    
    
    
    
    322013-2017
    
    
    1 838
    
    
    
    
    165


For
measurement purposes, an 8.5% annual rate of increase in per capita health care
costs of covered benefits was assumed for 2007, 2006 and 2005, with such annual
rate of increase gradually declining to 5% in 2013.

Assumed
health care cost trend rates have a significant effect on the amounts reported
for the health care plans. A 1% change in assumed health care cost trend rates
would have the following effects:

| |                                                                  | 1%
      Increase |                      | 1%
      Decrease
| | ---------------------------------------------------------------- | ----------------- | -------------------- | -----------------
| |                                                                  |                   | (in
      thousands) |                  
| | Effect on the health care component of the accumulated           |                   |                      |                  
| | postretirement benefit obligation                                | $                 | 20                   |                  
| | Effect on total
      of service and interest cost components of |                   |                      |                  
| | net periodic postretirement
      health care benefit cost       |                   | 2                    |                  

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

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

| |                                | December 31, 2007 |  | December 31, 2006 |      | December 31, 2005
| | ------------------------------ | ----------------- |  | ----------------- | ---- | -----------------
| |                                | Average           |  | Per
      Share   |      | Average          
| |                                | Shares            |  | Amount            |      | Shares           
| | Basic earnings per share       | 3 423 239         |  | $                 | 1.03 |                  
| |                               
| | Effect of dilutive securities: |                   |  |                   |      |                  
| | Stock
      options            | 7 525             |  |                   |      |                  
| |                               
| | Diluted earnings per share     | 3 430 764         |  | $                 | 1.03 |                  

Shares
outstanding have been restated to reflect the 2% stock dividend in 2006 and the
100% stock dividend in 2005.

Stock
options for 120,534, 83,811 and 40,574 shares of common stock were not
considered in computing diluted earnings per common share for 2007, 2006 and
2005, respectively, because they were antidilutive.

49

---

Note 10. Stock-Based Compensation

During 2003,
the company adopted an incentive stock plan which allows key employees and
directors to increase their personal financial interest in the company. This
plan permits the issuance of incentive stock options and non-qualified stock
options. The plan authorizes the issuance of up to 183,600 shares of common
stock (shares have been restated to reflect the 2% stock dividend declared March
14, 2006 and the 100% stock dividend declared on February 8, 2005). In 2007 the
shareholders authorized an additional 250,000 shares of common stock to be used
in the granting of incentive options to employees and directors.

A summary of
option activity under the plan as of December 31, 2007, and changes during the
year then ended is presented below:

| |                                  |  |        |         |       |  |               |       |                      | Weighted- |           |  |   |    | 
| | -------------------------------- |  | ------ | ------- | ----- |  | ------------- | ----- | -------------------- | --------- | --------- |  | - | -- | 
| |                                  |  |        |         |       |  | Weighted-     |       | Average              |           | Aggregate
| |                                  |  |        |         |       |  | Average       |       | Remaining            |           | Intrinsic
| |                                  |  |        |         |       |  | Exercise      |       | Contractual          |           | Value    
| | Options                          |  | Shares |         | Price |  | Life in Years |       | (in
      thousands)
| | Outstanding at beginning of year |  |        | 115 739 |       |  | $             | 14.31 |                      |           |           |  |   |    | 
| | Granted                          |  |        | 36 723  |       |  |               | 15.60 |                      |           |           |  |   |    | 
| | Exercised                        |  |        | - -     |       |  |               | - -   |                      |           |           |  |   |    | 
| | Forfeited                        |  |        | (1 346  | )     |  |               | 12.35 |                      |           |           |  |   |    | 
| | Outstanding at end of year       |  |        | 151 116 |       |  | $             | 14.77 |                      | 5         |           |  | $ | 87 | 
| | Exercisable at
      end of year |  |        | 81 757  |       |  | $             | 14.30 |                      | 7         |           |  | $ | 66 | 
| |                                  | 
| | Weighted average fair value      |  |        |         |       |  |               |       |                      |           |           |  |   |    | 
| | of options
      granted         |  | $      | 3.76    |       |  |               |       |                      |           |           |  |   |    | 

The
aggregate intrinsic value of a stock option in the table above represents the
total pre-tax intrinsic value (the amount by which the current market value of
the underlying stock exceeds the exercise price of the option) that would have
been received by the option holders had all option holders exercised their
options on December 31, 2007. The amount changes based on changes in the market
value of the companys stock.

The exercise
price of stock options granted under this plan, both incentive and
non-qualified, cannot be less than the fair market value of the common stock on
the date that the option is granted. The maximum term for an option granted
under this plan is ten years and options granted may be subject to a vesting
schedule. The non-qualified options granted are exercisable immediately. The
incentive options granted are subject to a five year vesting period whereby the
grantees are entitled to exercise one fifth of the options on the anniversary of
the grant date over the next five years. The following table summarizes options
outstanding at December 31, 2007:

Options
      Outstanding
    
    
    Options ExercisableWeightedAverage
    
    Weighted
    
    
    
    
    
    WeightedRemaining
    
    Average
    
    
    
    
    
    AverageExercise
    
    Number
    
    Contractual
    
    Exercise
    
    Number
    
    ExercisePrice
    
    Outstanding
    
    Life (in years)
    
    Price
    
    Exercisable
    
    Price$     11.28
    
    
    30 582
    
    
    6.0
    
    $     11.28
    
    
    23 238
    
    
    $     11.2814.00
    
    
    40 574
    
    
    7.0
    
    14.00
    
    
    25 397
    
    
    14.0017.25
    
    
    43 237
    
    
    8.0
    
    17.25
    
    
    20 879
    
    
    17.2515.60
    
    
    36 723
    
    
    9.0
    
    15.60
    
    
    12 243
    
    
    15.60151 116
    
    
    
    
    
    
    
    81 757


As of
December 31, 2007 there was $178 thousand of total unrecognized compensation
expense related to nonvested stock options, which will be recognized over the
remaining requisite service period. The unrecognized compensation expense has a
weighted average life of three years.

50

---

Note 11. Income Taxes

The company
files income tax returns in the U. S. federal jurisdiction and the state of West
Virginia. With few exceptions, the company is no longer subject to U. S.
federal, state and local income tax examinations by tax authorities for years
prior to 2004.

The company
adopted the provisions of FIN 48, Accounting for Uncertainty in Income Taxes,
on January 1, 2007 with no impact on the financial statements.

Net deferred
tax assets consist of the following components as of December 31, 2007 and 2006:

2007
    
    2006(in thousands)Deferred tax assets:Reserve for loan losses
    $
    790
    
    $
    669Accrued pension expense
    
    438
    
    
    519Accrued postretirement benefits
    
    208
    
    
    175Nonaccrual interest
    
    17
    
    
    5Stock option expense
    
    35
    
    
    20Home equity closing costs
    
    72
    
    
    61Net loan origination fees
    
    14
    
    
    - -OREO expense
    
    11
    
    
    - -Securities available for sale
    
    - -
    
    
    79$
    1 585
    
    $
    1 528Deferred tax
      liabilities:Net loan origination costs
    $
    - -
    
    $
    9Depreciation
    
    122
    
    
    130Securities available for sale
    
    79
    
    
    - -$
    201
    
    $
    139Net
      deferred tax assets
    $
    1 384
    
    $
    1 389


The
provision for income taxes charged to operations for the years ended December
31, 2007, 2006 and 2005 consists of the following:

| |                                      | 2007           |       | 2006 |  | 2005
| | ------------------------------------ | -------------- | ----- | ---- |  | ----
| |                                      | (in thousands)
| | Current tax expense                  | $              | 2 248 |      |  | $   
| | Deferred tax
      expense (benefit) |                | (250  | )    |  |     
| |                                      | $              | 1 998 |      |  | $   

The income
tax provision differs from the amount of income tax determined by applying the
U.S. federal income tax rate to pretax income for the years ended December 31,
2007, 2006 and 2005 due to the following (in thousands):

| |                                                           | 2007 |       | 2006 |  | 2005
| | --------------------------------------------------------- | ---- | ----- | ---- |  | ----
| | Computed expected tax expense                           | $    | 1 880 |      |  | $   
| | Increase
      (decrease) in income taxes resulting from: |      |       |      |  |     
| | Tax exempt income                                         |      | (107  | )    |  |     
| | State income taxes, net of federal income tax benefit     |      | 191   |      |  |     
| | Other                                                     |      | 34    |      |  |     
| |                                                           | $    | 1 998 |      |  | $   

Note 12. Commitments and Contingent
Liabilities

In the
normal course of business, there are outstanding, various commitments and
contingent liabilities which are not reflected in the accompanying financial
statements. The company does not anticipate losses as a result of these
transactions. See Note 14 with respect to financial instruments with
off-balance-sheet risk.

51

---

Note 12. Commitments and Contingent
Liabilities (Continued)

The company
has approximately $92 thousand in deposits in other financial institutions in
excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) at
December 31, 2007.

The company
must maintain a reserve against its deposits in accordance with Regulation D of
the Federal Reserve Act. For the final bi-weekly reporting periods which
included December 31, 2007 and 2006, the aggregate amounts of daily average
required balances were approximately $300 thousand for each time period.

Note 13. Retained Earnings

Transfers of
funds from the banking subsidiary to the parent company in the form of loans,
advances and cash dividends are restricted by federal and state regulatory
authorities. As of December 31, 2007, the aggregate amount of unrestricted funds
which could be transferred from the banking subsidiary to the parent company,
without prior regulatory approval, totaled $6.3 million or 21.8% of the
consolidated net assets.

Note 14. Financial Instruments With
Off-Balance-Sheet Risk

The company
is a party to financial instruments with off-balance-sheet risk in the normal
course of business to meet the financing needs of its customers. Those financial
instruments include commitments to extend credit and standby letters of credit.
Those instruments involve, to varying degrees, elements of credit and interest
rate risk in excess of the amount recognized in the balance sheet. The contract
or notional amounts of those instruments reflect the extent of involvement the
company has in particular classes of financial instruments.

The
companys exposure to credit loss in the event of nonperformance by the other
party to the financial instruments for commitments to extend credit and standby
letters of credit is represented by the contractual notional amount of those
instruments. The company uses the same credit policies in making commitments and
conditional obligations as it does for on-balance-sheet instruments.

A summary of
the contract or notional amount of the companys exposure to off-balance-sheet
risk as of December 31, 2007 and 2006 (in thousands) is as follows:

2007
    
    2006Financial instruments whose contractamounts represent credit
      risk:Commitments to extend credit
    $
    53 389
    
    $
    60 683Standby letters of credit
    
    3 294
    
    
    4 750


Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee. Since many of the commitments are expected to expire without being
drawn upon, the total commitment amounts do not necessarily represent future
cash requirements. The company evaluates each customers credit worthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
the company upon extension of credit, is based on managements credit evaluation
of the counterparty. Collateral held varies but may include accounts receivable,
inventory, property and equipment, and income-producing commercial properties.

Unfunded
commitments under commercial lines of credit are commitments for possible future
extensions of credit to existing customers. The majority of these lines of
credit is collateralized and usually contains a specified maturity date and may
not be drawn upon to the extent to which the company is committed.

Standby
letters of credit are conditional commitments issued by the company to guarantee
the performance of a customer to a third party. Those guarantees are primarily
issued to support public and private borrowing arrangements, including
commercial paper, bond financing, and similar transactions. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers. The company generally holds
collateral supporting those commitments if deemed necessary.

52

---

Note 14. Financial Instruments With
Off-Balance-Sheet Risk (Continued)

At December
31, 2007, the company had rate lock commitments to originate mortgage loans
amounting to $603 thousand and mortgage loans held for sale in the amount of
$306 thousand. The company enters into corresponding mandatory commitments, on a
best-efforts basis, to sell the loans. These commitments to sell loans are
designed to eliminate the companys exposure to fluctuations in interest rates
in connection with rate lock commitments and loans held for sale.

Note 15. Fair Value of Financial
Instruments and Interest Rate Risk

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

Cash and
Short-Term Investments


For those
short-term instruments, the carrying amount is a reasonable estimate of fair
value.





Securities


For
securities held for investment purposes, fair values are based on quoted market
prices or dealer quotes.





Loans


For
variable rate loans that reprice frequently and with no significant change in
credit risk, fair values are based on carrying values. The fair values for other
loans were estimated using discounted cash flow analyses, using interest rates
currently being offered.





Loans Held
for Sale


The
carrying amount of loans held for sale approximates fair value.





Deposit
Liabilities


The fair
value of demand deposits, savings accounts, and certain money market deposits is
the amount payable on demand at the reporting date. The fair value of
fixed-maturity certificates of deposit is estimated using the rates currently
offered for deposits of similar remaining maturities.





Short-term
Borrowings


The
carrying amounts of borrowings under repurchase agreements and federal funds
sold approximate fair value.





FHLB
Advances


The fair
values of the companys FHLB advances are estimated using discounted cash flow
analysis based on the companys incremental borrowing rates for similar types of
borrowing arrangements.





Accrued
Interest


The
carrying amounts of accrued interest approximate fair value.


Off-Balance
Sheet Financial Instruments

The fair
value of commitments is estimated using the fees currently charged to enter into
similar agreements, taking into account the remaining terms of the agreements
and the present creditworthiness of the counterparties. For fixed-rate loan
commitments, fair value also considers the difference between current levels of
interest rates and the committed rates. The fair value of letters of credit is
based on fees currently charged for similar agreements or on the estimated cost
to terminate them or otherwise settle the obligations with the counterparties at
the reporting date.

At December
31, 2007 and 2006, the fair value of loan commitments and standby-letters of
credit was immaterial. Therefore, they have not been included in the following
table.

53

---

Note 15. Fair Value of Financial
Instruments and Interest Rate Risk (Continued)

The carrying
amounts and estimated fair values of the companys financial instruments are as
follows:

2007
    
    2006Carrying
    
    Fair
    
    Carrying
    
    FairAmount
    
    Value
    
    Amount
    
    Value(in thousands)
    
    (in thousands)Financial assets:Cash
    
    $
    6
      031
    
    $
    6
      031
    
    $
    6
      581
    
    $
    6
      581Securities purchased
      underagreements to resell andfederal funds sold
    
    
    5 120
    
    
    5 120
    
    
    345
    
    
    345Securities available for
      sale
    
    
    39
      572
    
    
    39
      572
    
    
    42
      706
    
    
    42
      706Loans, net
    
    
    221
      828
    
    
    223
      920
    
    
    227
      646
    
    
    226
      928Loans held for
      sale
    
    
    8
      133
    
    
    8
      133
    
    
    405
    
    
    405Accrued interest
      receivable
    
    
    1 366
    
    
    1 366
    
    
    1 431
    
    
    1 431Financial liabilities:Deposits
    
    
    253 374
    
    
    253 430
    
    
    251 778
    
    
    251 823Securities sold
      underagreements to repurchaseand federal fundspurchased
    
    
    12 537
    
    
    12 537
    
    
    10 526
    
    
    10 526FHLB
      advances
    
    
    212
    
    
    212
    
    
    620
    
    
    620Accrued interest
      payable
    
    
    757
    
    
    757
    
    
    672
    
    
    672


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

Note 16. Regulatory Matters

The company
(on a consolidated basis) and the bank are subject to various regulatory capital
requirements administered by the federal banking agencies. Failure to meet
minimum capital requirements can initiate certain mandatory  possibly
additional discretionary  actions by regulators that, if undertaken, could have
a direct material effect on the companys and the banks financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the company and bank must meet specific capital guidelines
that involve quantitative measures of their assets, liabilities, and certain
off-balance-sheet items as calculated under regulatory accounting practices. The
capital amounts and classification are also subject to qualitative judgments by
the regulators about components, risk weightings, and other factors. Prompt
corrective action provisions are not applicable to bank holding companies.

Quantitative
measures established by regulation to ensure capital adequacy require the
company and the bank to maintain minimum amounts and ratios (set forth in the
table below) of total and Tier 1 capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average
assets (as defined). Management believes, as of December 31, 2007 and 2006, that
the company and the bank meet all capital adequacy requirements to which they
are subject.

54

---

Note 16. Regulatory Matters (Continued)

As of
December 31, 2007, the most recent notification from the Federal Deposit
Insurance Corporation categorized the bank as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as well
capitalized, an institution must maintain minimum total risk-based, Tier 1
risk-based, and Tier 1 leverage ratios as set forth in the table. There are no
conditions or events since that notification that management believes have
changed the institutions category.

The
companys and the banks actual capital amounts and ratios are also presented in
the table.

MinimumTo Be WellMinimum
    
    Capitalized UnderCapital
    
    Prompt CorrectiveActual
    
    Requirement
    
    Action ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    Ratio(in thousands)As of December 31, 2007:Total capital (to risk-weightedassets):Consolidated
    
    $
    32 308
    
    14.23%
    
    $
    18 161
    
    8.0%
    
    
    N/A
    
    N/ABank of Charles Town
    
    $
    31
      814
    
    14.04%
    
    $
    18
      124
    
    8.0%
    
    $
    22
      656
    
    10.0%Tier 1 capital (to
      risk-weightedassets):Consolidated
    
    $
    29
      529
    
    13.01%
    
    $
    9
      081
    
    4.0%
    
    
    N/A
    
    N/ABank of Charles Town
    
    $
    29 035
    
    12.82%
    
    $
    9 062
    
    4.0%
    
    $
    13 593
    
    6.0%Tier 1 capital (to
      averageassets):Consolidated
    
    $
    29 529
    
    9.99%
    
    $
    11 818
    
    4.0%
    
    
    N/A
    
    N/ABank of Charles Town
    
    $
    29
      035
    
    9.84%
    
    $
    11
      799
    
    4.0%
    
    $
    14
      749
    
    5.0%As of December 31, 2006:Total capital (to
      risk-weightedassets):Consolidated
    
    $
    30 154
    
    13.82%
    
    $
    17 455
    
    8.0%
    
    
    N/A
    
    N/ABank of Charles Town
    
    $
    29
      695
    
    13.64%
    
    $
    17
      421
    
    8.0%
    
    $
    21 776
    
    10.0%Tier 1 capital (to
      risk-weightedassets):Consolidated
    
    $
    27
      731
    
    12.71%
    
    $
    8
      728
    
    4.0%
    
    
    N/A
    
    N/ABank of Charles Town
    
    $
    27 272
    
    12.52%
    
    $
    8 710
    
    4.0%
    
    $
    13 066
    
    6.0%Tier 1 capital (to
      averageassets):Consolidated
    
    $
    27 731
    
    9.34%
    
    $
    11 882
    
    4.0%
    
    
    N/A
    
    N/ABank of Charles Town
    
    $
    27
      272
    
    9.20%
    
    $
    11
      863
    
    4.0%
    
    $
    14
      829
    
    5.0%


55

---

Note 17. Parent Company Only Financial
Statements

POTOMAC BANCSHARES, INC. (Parent
Company Only) Balance Sheets December 31, 2007 and 2006 (in
thousands)

2007
    
    2006ASSETSCash
    $
    36
    
    
    $
    25Investment in
      subsidiary
    
    28 521
    
    
    
    26 258Other assets
    
    458
    
    
    
    434Total Assets
    $
    29 015
    
    
    $
    26 717LIABILITIES AND STOCKHOLDERS EQUITYLIABILITIES, other
    $
    - -
    
    
    $
    - -STOCKHOLDERS EQUITYCommon stock
    $
    3 672
    
    
    $
    3 672Surplus
    
    3 771
    
    
    
    3 661Undivided profits
    
    24 787
    
    
    
    22 677Accumulated other
      comprehensive (loss)
    
    (514
    )
    
    
    (1 014
    )$
    31 716
    
    
    $
    28 996Less cost of shares acquired for the
      treasury
    
    2 701
    
    
    
    2 279Total Stockholders Equity
    $
    29 015
    
    
    $
    26 717Total Liabilities and Stockholders Equity
    $
    29 015
    
    
    $
    26 717


POTOMAC BANCSHARES, INC. (Parent
Company Only) Statements of Income Years Ended December 31, 2007, 2006
and 2005 (in thousands)

2007
    
    2006
    
    2005IncomeDividends from subsidiary
    $
    1 942
    
    
    $
    1 905
    
    
    $
    1 487Interest
      income
    
    1
    
    
    
    1
    
    
    
    - -Total Income
    $
    1
      943
    
    
    $
    1
      906
    
    
    $
    1
      487ExpensesStock-based compensation
      expense
    $
    110
    
    
    $
    112
    
    
    $
    -
      -Other professional
      fees
    
    57
    
    
    
    39
    
    
    
    34Other operating
      expenses
    
    65
    
    
    
    56
    
    
    
    60Total Expenses
    $
    232
    
    
    $
    207
    
    
    $
    94Income before Income Tax
      (Benefit) andEquity in Undistributed Income of Subsidiary
    $
    1
      711
    
    
    $
    1
      699
    
    
    $
    1
      393Income Tax (Benefit)
    
    (56
    )
    
    
    (51
    )
    
    
    (31
    )Income before Equity in
      UndistributedIncome of Subsidiary
    $
    1
      767
    
    
    $
    1
      750
    
    
    $
    1
      424Equity in Undistributed Income of
      Subsidiary
    
    1 763
    
    
    
    2 285
    
    
    
    2 240Net
      Income
    $
    3 530
    
    
    $
    4 035
    
    
    $
    3 664


56

---

Note 17. Parent Company Only Financial
Statements (Continued)

POTOMAC BANCSHARES, INC. (Parent
Company Only) Statements of Cash Flows Years Ended December 31, 2007,
2006 and 2005 (in thousands)

2007
    
    2006
    
    2005CASH FLOWS FROM OPERATING ACTIVITIESNet income
    $
    3
      530
    
    
    $
    4
      035
    
    
    $
    3
      664Adjustments to reconcile
      net income to net cashprovided by operating activities:Equity in undistributed (income) ofsubsidiary
    
    (1 763
    )
    
    
    (2 285
    )
    
    
    (2 240
    )Stock-based compensation expense
    
    110
    
    
    
    112
    
    
    
    -
      -(Increase) in other assets
    
    (24
    )
    
    
    (153
    )
    
    
    (251
    )(Decrease) in other liabilities
    
    - -
    
    
    
    - -
    
    
    
    (3
    )Net cash provided by operating
      activities
    $
    1 853
    
    
    $
    1 709
    
    
    $
    1 170CASH FLOWS FROM FINANCING ACTIVITIESCash
      dividends
    $
    (1 420
    )
    
    $
    (1 295
    )
    
    $
    (1 137
    )Purchase of treasury
      shares
    
    (422
    )
    
    
    (429
    )
    
    
    - -Net cash (used in) financing
      activities
    $
    (1 842
    )
    
    $
    (1 724
    )
    
    $
    (1 137
    )Increase (decrease) in cash and cashequivalents
    $
    11
    
    
    $
    (15
    )
    
    $
    33CASH AND CASH EQUIVALENTSBeginning
    
    25
    
    
    
    40
    
    
    
    7Ending
    $
    36
    
    
    $
    25
    
    
    $
    40


57

---

Item 9. Changes In and Disagreements
with Accountants on Accounting and Financial Disclosure.

Not Applicable.

Item 9A(T). Controls and Procedures.

The companys chief
executive officer and chief financial officer, based on their evaluation as of
the date of this report of the companys disclosure controls and procedures (as
defined in Rule 13(a)-14(e) of the Securities Exchange Act of 1934), have
concluded that the companys disclosure controls and procedures are adequate and
effective for purposes of Rule 13(a)-14(c) and timely, alerting them to material
information relating to the company required to be included in the companys
filings with the Securities and Exchange Commission under the Securities
Exchange Act of 1934.

This annual report does not include an attestation report of the
companys registered public accounting firm regarding internal control over
financial reporting. Managements report was not subject to attestation by the
companys registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the company to provide only
managements report in this annual report.

There were no significant changes in the companys internal controls or
in other factors that could significantly affect internal controls subsequent to
the date of their evaluation.

Managements Report on Internal
Control Over Financial Reporting

To the Stockholders:

Management is responsible for the preparation and fair presentation of
the financial statements included in this annual report. The financial
statements have been prepared in conformity with accounting principles generally
accepted in the United States of America and reflect managements judgments and
estimates concerning effects of events and transactions that are accounted for
or disclosed.

Management is also responsible for establishing and maintaining adequate
internal control over financial reporting. The companys internal control over
financial reporting includes those policies and procedures that pertain to the
companys ability to record, process, summarize and report reliable financial
data. Management recognizes that there are inherent limitations in the
effectiveness of any internal control over financial reporting, including the
possibility of human error and the circumvention or overriding of internal
control. Accordingly, even effective internal control over financial reporting
can provide only reasonable assurance with respect to financial statement
preparation. Further, because of changes in conditions, the effectiveness of
internal control over financial reporting may vary over time.

In order to ensure that the companys internal control over financial
reporting is effective, management regularly assesses such controls and did so
most recently for its financial reporting as of December 31, 2007. This
assessment was based on criteria for effective internal control over financial
reporting described inInternal Control
IntegratedFrameworkissued by the Committee of
Sponsoring Organizations (COSO) of the Treadway Commission. Based on this
assessment, management has concluded that the internal control over financial
reporting was effective as of December 31, 2007.

The Board of Directors, acting through its Audit Committee, is
responsible for the oversight of the companys accounting policies, financial
reporting and internal control. The Audit Committee of the Board of Directors is
comprised entirely of outside directors who are independent of management. The
Audit Committee is responsible for the appointment and compensation of the
independent registered public accounting firm and approves decisions regarding
the appointment or removal of the companys internal auditor. It meets
periodically with management, the independent registered public accounting firm
and the internal auditor to ensure that they are carrying out their
responsibilities. The Audit Committee is also responsible for performing an
oversight role by reviewing and monitoring the financial, accounting and
auditing procedures of the company in addition to reviewing the companys
financial reports. The independent registered public accounting firm and the
internal auditor have full and unlimited access to the Audit Committee, with or
without management, to discuss the adequacy of internal control over financial
reporting, and any other matter which they believe should be brought to the
attention of the Audit Committee.

Item 9B. Other
Information.

None.

58

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PART III

Item 10. Directors and Executive
Officers of the Registrant.

The information contained on pages 7-8 of the Proxy Statement dated March
31, 2008, for the April 22, 2008 Annual Meeting under the captions Management
Nominees to the Board of Potomac and Directors Continuing to Serve Unexpired
Terms, and page 15 under the caption Section 16(a) Beneficial Ownership
Reporting Compliance is incorporated herein by reference.

The Executive Officers are as follows:

|Name                    |  | Position Since                                              |  | Age |  | Principal Occupation                                                                                                                                
|----------------------- |  | ----------------------------------------------------------- |  | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------
|Robert F. Baronner, Jr. |  | President & CEO2001                                         |  | 49  |  | Employed by bank as of 1/1/01 as President and CEO.                                                                                                 
|                        |  |                                                             |  |     |  |                                                                                                                                                     
|David W. Irvin          |  | Executive Vice President2004                                |  | 44  |  | Employed at bank from 2001 to present as Commercial Loan Division
      Manager.                                                                    
|                        |  |                                                             |  |     |  |                                                                                                                                                     
|Gayle Marshall Johnson  |  | Sr. Vice President & Chief     
      Financial Officer1994 |  | 58  |  | Employed with the bank 1977-1985 and 1988-present; Vice President
      and Chief Financial Officer since 1990. Sr. Vice President since
      2005.
|                       
|Donald S. Smith         |  | Vice President1994                                          |  | 79  |  | Employed at bank 1947 to 1991; President 1979 to 1991
      (retired).                                                                              

The bank has adopted a Code of Ethics that applies to all employees,
including Potomacs and the banks chief executive officer and chief financial
officer and other senior officers. Additionally, there is a Code of Ethics for
Senior Financial Officers which applies to Potomacs and the banks chief
executive officer and chief financial officer. These Codes of Ethics are
attached to this document as Exhibits 14.1 and 14.2. If we make any substantive
amendments to this code or grant any waiver from a provision of the code to our
chief executive officer or chief financial officer, we will disclose the
amendment or waiver in a report on Form 8-K.

Item 11. Executive Compensation.

The information contained on pages 10-13 of the Proxy Statement dated
March 31, 2008, for the April 22, 2008 Annual Meeting under the captions
Executive Compensation, Employee Benefit Plans, Employment Agreement, and
Compensation of Directors is incorporated herein by reference.

Item 12. Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder Matters.

The
information contained on pages 9-10 of the Proxy Statement dated March 31, 2008,
for the April 22, 2008 Annual Meeting under the caption Ownership of Securities
by Nominees, Directors and Officers is incorporated herein by reference.

Securities authorized for issuance under Potomacs 2003 Stock Incentive
Plan are listed below:

Number of securitiesNumber of securities
    
    
    
    
    
    remaining available forto be issued
    
    Weighted-average
    
    future issuance underupon exercise of
    
    exercise price of
    
    equity compensation plansoutstanding options,
    
    outstanding options,
    
    (excluding securitiesPlan category
    
    warrants and rights
    
    warrants and
      rights
    
    reflected in column
      (a))2003 Stock Incentive Planamended by shareholdersApril 24, 2007
    
    
    152,462
    
    
    
    $14.62
    
    
    
    281,138


Item 13. Certain Relationships and
Related Transactions.

The information contained on page 14 of the Proxy Statement dated March
31, 2008, for the April 22, 2008 Annual Meeting under the caption Certain
Transactions with Directors, Officers and Their Associates is incorporated
herein by reference.

59

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Item 14. Principal Accountant Fees
and Services.

The information contained on pages 6-7 of the Proxy Statement dated March
31, 2008, for the April 22, 2008 Annual Meeting under the caption Audit
Committee Report is incorporated herein by reference.

Item 15. Exhibits and Financial
Statement Schedules.

(a)(1)Financial
Statements. Reference is made to Part II,
Item 8 of this Annual Report on Form 10-K.

(2)Financial Statement Schedules. These schedules are omitted as the required information is
inapplicable or the information is presented in the consolidated financial
statements or related notes.

(3)Exhibits.
See below.

2.1 Agreement and Plan of Merger dated March 8, 1994, by and between
Potomac Bancshares, Inc., and Bank of Charles Town filed with and incorporated
by reference from the Registration on Form S-4 filed with the Securities and
Exchange Commission on June 10, 1994, Registration No. 33-80092.

3.1 Articles of Incorporation of Potomac Bancshares, Inc. filed with and
incorporated by reference from the Registration Statement on Form S-4 filed with
the Securities and Exchange Commission on June 10, 1994, Registration No.
33-80092.

3.2 Amendments to Articles of Incorporation of Potomac Bancshares, Inc.
adopted by shareholders on April 25, 1995 and filed with the West Virginia
Secretary of State on May 23, 1995, and incorporated by reference from Potomacs
Form 10-KSB for the year ended December 31, 1995 and filed with the Securities
and Exchange Commission, File No. 0-24958.

3.3 Amended and Restated Bylaws of Potomac Bancshares, Inc. adopted by
shareholders April 25, 1995 and incorporated by reference from Potomacs Form
10-KSB for the year ended December 31, 1995, and filed with the Securities and
Exchange Commission, File No. 0-24958.

10.1 2003 Stock Incentive Plan adopted by the Potomac Board February 20,
2003 and approved by the Companys shareholders on May 13, 2003, amended by the
Companys shareholders on April 24, 2007 and incorporated by reference from
Potomacs Form 10-K for the year ended December 31, 2006 and filed with the
Securities and Exchange Commission, File No. 0-24958.

10.2 Employment Agreement of Mr. Robert F. Baronner, Jr., filed with and
incorporated by reference from Form 10-KSB for the year ended December 31, 2001,
and filed with the Securities and Exchange Commission, File No. 0-24958.

14.1Code of Ethics (for all employees)*

14.2Code of Ethics for Senior Financial Officers*

21 Subsidiaries of the Registrant*

23.1 Consent of Independent Accountants*

31.1 Rule 13a-15(e)/15d-15(e) Certification of Chief Executive Officer*

31.2 Rule 13a-15(e)/15d-15(e) Certification of Chief Financial Officer*

32.1 Section 1350 Certification of Chief Executive Officer*

32.2 Section
1350 Certification of Chief Financial Officer*

99.1 Proxy Statement for the 2008 Annual Meeting for Potomac, portions
are incorporated by reference in Form 10-K Annual Report*

* Filed herewith.

60

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SIGNATURES

In accordance with Section 13 or 15(d)
of the Exchange Act, the registrant caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

POTOMAC BANCSHARES, INC.

|By | /s/ Robert F. Baronner,
      Jr.                  |  | March 24,
      2008
|-- | -------------------------------------------------- |  | --------------------
|   | Robert F.
      Baronner, Jr.                      |  |                     
|   | President &
      Chief Executive Officer          |  |                     
|   |                                                   
|   |                                                   
|By | /s/ Gayle Marshall
      Johnson                   |  | March 24,
      2008
|   | Gayle Marshall
      Johnson                       |  |                     
|   | Sr. Vice
      President & Chief Financial Officer |  |                     

In accordance with the Exchange Act,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

|Signature & Title |                                         | Date
|----------------- | --------------------------------------- | ----
|                  |                                        
|By                | /s/ J. Scott Boyd                       |     
|                  | J. Scott Boyd,
      Director           |     
|                  |                                        
|By                | /s/ John P. Burns, Jr.                  |     
|                  | John P. Burns,
      Jr., Director      |     
|                  |                                        
|By                | /s/ Guy Gareth
      Chicchirichi       |     
|                  | Guy Gareth
      Chicchirichi, Director |     
|                  |                                        
|By                | /s/ Margaret Cogswell                   |     
|                  | Margaret
      Cogswell, Director       |     
|                  |                                        
|By                | /s/ William R. Harner                   |     
|                  | William R.
      Harner, Director       |     
|                  |                                        
|By                | /s/ Barbara H. Pichot                   |     
|                  | Barbara H.
      Pichot, Director       |     
|                  |                                        
|By                | /s/ John C. Skinner, Jr.                |     
|                  | John C. Skinner,
      Jr., Director    |     
|                  |                                        
|By                | /s/ Donald S. Smith                     |     
|                  | Donald S. Smith,
      Director         |     
|                  |                                        
|By                | /s/ C. Larry Togans                     |     
|                  | C. Larry Togans,
      Director         |     

61

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