UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC
20549

FORM 10-K

ANNUAL REPORTPURSUANT 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, 2008                                               
|    |  |                                                                                                 
|    |  | 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 |  |  |  | No |  | XX
|--- |  |  |  | -- |  | --

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 |  |  |  | No |  | XX
|--- |  |  |  | -- |  | --

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.

|Yes |  | XX |  | No |  | 
|--- |  | -- |  | -- |  | 

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 Company | XX | 
|----------------------------------- | ----------------------- | --------------------------- | ------------------------- | -- | 

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

|Yes |  |  |  | No |  | XX
|--- |  |  |  | -- |  | --

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. $40,270,956 as of
June 30, 2008

|Indicate the number of shares outstanding of
      each of the registrant's classes of common stock, as of the latest
      practicable date.
|---------------------------------------------------------------------------------------------------------------------------------------------
|3,390,178 as of March 24, 2009                                                                                                               

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 the 2009 Annual Meeting of
      Shareholders |  | Part III,
      Items 10, 11, 12, 13 and 14

2

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Potomac Bancshares, Inc.Annual
Report on Form 10-KFor the Year Ended
December 31, 2008

|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 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, the current economic environment posing
significant challenges and affecting our financial condition and results of
operations, the United States governments plan to purchase large amounts of
illiquid mortgage - backed and other securities from financial institutions may
not be effective, 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 Winchester office was closed in August of 2008. 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 91.0% of the bank's loans
are secured by real estate. These loans had an average delinquency rate of 2.89%
and a loss rate of 0.58% during 2008. The average delinquency rate and loss rate
are based on comparisons to 2008 average total loans.

As of December 31, 2008, aggregate dollar
amounts (in thousands) in loan categories secured by real estate are as
follows:

| | ·Construction and land
      development  | $ | 65 643 
| | ----------------------------------------- | - | -------
| | ·Secured by farmland                      |   | 1
  380
| | ·Secured by 1-4 family
      residential  |   | 97 064 
| | ·Secured by multifamily
      residential |   | 1
  937
| | ·Secured by nonfarm
      nonresidential  |   | 58 332 
| |                                          
| |                                           | $ | 224
356

Commercial loans
not secured by real estate with an aggregate balance of $9.7 million at December
31, 2008 make up approximately 3.9% 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
2008.

Retail loans to individuals for personal
expenditures are approximately 4.9% of the bank's total loans at December 31,
2008. The aggregate balance of these loans was $12 million at December 31, 2008.
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 0.09% and a loss rate of 0.11% in 2008 (based on comparisons
to 2008 average total loans).

All other loans total $457 thousand (0.2%
of total loans) at December 31, 2008. These loans had no delinquency rate and no
average loss rate in 2008 compared to 2008 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.
The bank is also a participant in the CDARS program. The bank offers CDARS
program certificates of deposit in various terms from 4 weeks 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 March 19, 2009, there were 65 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,
2008, there were six banks in Jefferson County with 16 banking offices. The
total deposits of these commercial banks as of June 30, 2008 were
$ 685
million, and the bank ranked number one in total deposits with $ 213 million or 31.05 % 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 4.21 % of the market share of deposits in Berkeley County where
there are ten banks with 30 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 prohibiting de novo interstate 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 for de novo branching 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 March 10, 2009, the bank had 95
full-time employees and 15 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
subsidiary is subject to affiliate transaction restrictions under federal law
that limit the transfer of funds by the subsidiary bank to its respective parent
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 regulations implementing The Federal
Deposit Insurance Reform Act of 2005 (FDIRA), assessments for FDIC deposit
insurance coverage are assessed and collected in the quarter following the
period of insurance. Starting with the fourth quarter of 2007 assessment rate
calculations have been based on a number of factors in order to assess more
accurately the risk level of a bank. These factors include a banks CAMELS
ratings, tier 1 leverage ratio, loans past due 30-89 days compared to gross
assets, nonperforming assets compared to gross assets, net loan charge offs
compared to gross assets and net income before taxes compared to risk-weighted
assets. These factors are updated quarterly from data reported on the most
recently filed call report of a bank. The FDIC assessed the bank for the period
October 1 through December 31 of 2008 (which was charged to the bank on March
30, 2009) as a Risk Category I bank at the annual rate of 7.00 basis points or
..0001750 times the total deposit assessment base. The FDIC set the Financing
Corporation (FICO) Bank Insurance Fund (BIF) premium for the bank at the annual
rate of 1.04 basis points or .0000260 times the total deposits of the bank for
this same time period. 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. Currently there is the possibility of a 20 basis point
special assessment based on June 30, 2009 deposits to be paid September 30,
2009. There is also the possibility of a 12 to 16 basis point increase in the
regular assessment for Category 1 risk classification banks. This would be
assessed on deposits as of March 31, 2009 and paid in the second quarter of
2009. These assessments have been heavily lobbied against by many banks and
banking organizations since these assessments would have a major impact on
earnings for these banks, including Bank of Charles Town.

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, 2008, Potomac had
capital in excess of all applicable requirements as shown below:

Actual
    
    Required
    
    Excess(in
      thousands)Tier 1 capital:Common stock
    $
    3,672Surplus
    
    3,851Retained earnings
    
    25,07032,593Less cost of shares acquired for the treasury
    
    2,837Total tier 1 capital
    $
    29,756
    
    $
    9,619
    
    $
    20,137Tier 2
      capital:Allowance for loan losses
(1)
    
    3,019Total risk-based capital
    $
    32,775
    
    $
    19,238
    
    $
    13,537Risk-weighted assets
    $
    240,471Tier 1 capital
    $
    29,756
    
    $
    12,081
    
    $
    17,674Average total assets
    $
    302,040Capital ratios:Tier 1 risk-based capital ratio
    
    12.37%
    
    
    4.00%
    
    
    8.37%Total risk-based capital
    ratio
    
    13.63%
    
    
    8.00%
    
    
    5.63%Tier 1 capital to average total assets (leverage)
    
    9.85%
    
    
    4.00%
    
    
    5.85%(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)*. The International 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 2009, Section 404 of Sarbanes-Oxley will become applicable to
Potomac.

Troubled Asset
Relief Program  Capital Purchase Program. On October 3, 2008, the Federal
government enacted the Emergency Economic Stabilization Act of 2008 (EESA).
EESA was enacted to provide liquidity to the U.S. financial system and lessen
the impact of looming economic problems. The EESA included broad authority. The
centerpiece of the EESA is the Troubled Asset Relief Program (TARP). EESAs
broad authority was interpreted to allow the U.S. Treasury to purchase equity
interests in both healthy and troubled financial institutions. The equity
purchase program is commonly referred to as the Capital Purchase Program
(CPP). Management and our Board of Directors have done a thorough evaluation
of both the positive and negative aspects of the CPP. In the end, we came to the
conclusion that based on our strong capital position, earnings capacity, and the
fact that it would dilute the earnings of existing shareholders we have decided
not to participate in the CPP.

America
Recovery and Reinvestment Act of 2009. On
February 17, 2009, President Obama signed into law the American Recovery and
Reinvestment Act of 2009 (ARRA), more commonly known as the economic stimulus
or economic recovery package. ARRA includes a wide variety of programs intended
to stimulate the economy and provide for extensive infrastructure, energy,
health, and education needs. In addition, ARRA imposes certain new executive
compensation and corporate expenditure limits on all current and future TARP
recipients that are in addition to those previously announced by the U.S.
Treasury, until the institution has repaid the U.S. Treasury, which is now
permitted under ARRA without penalty and without the need to raise new capital,
subject to the U.S. Treasurys consultation with the recipients appropriate
regulatory agency.

10

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Future
Legislation. Various other legislative and
regulatory initiatives, including proposals to overhaul the banking regulatory
system and to limit the investments that a depository institution may make with
insured funds, are from time to time introduced in Congress and state
legislatures, as well as regulatory agencies. Such legislation may change
banking statutes and the operating environment of the company and the bank in
substantial and unpredictable ways, and could increase or decrease the cost of
doing business, limit or expand permissible activities or affect the competitive
balance depending upon whether any of this potential legislation will be
enacted, and if enacted, the effect that it or any implementing regulations,
would have on the financial condition or results of operations of the company or
the bank. With the recent enactments of EESA and ARRA, the nature and extent of
future legislative and regulatory changes affecting financial institutions is
very unpredictable at this time. The company cannot determine the ultimate
effect that such potential legislation, if enacted, would have upon its
financial condition or operations.

*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.

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.

11

---

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.

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 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.

12

---

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 managements 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.

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.

Financial Market and Economic
Conditions May Adversely Affect Our Business.

The United States is considered to
be in a recession, and many businesses are having difficulty due to reduced
consumer spending and the lack of liquidity in the credit markets. Unemployment
has increased significantly.

Because of declines in home prices
and the values of subprime mortgages across the country, financial institutions
and the securities markets have been adversely affected by significant declines
in the values of most asset classes and by a serious lack of liquidity. These
conditions have led to the failure or merger of a number of prominent financial
institutions. In 2008, the U.S. government, the Federal Reserve and other
regulators have taken numerous steps to increase liquidity and to restore
investor confidence, but asset values have continued to decline and access to
liquidity continues to be very limited.

13

---

The companys financial performance
and the ability of borrowers to pay interest on and repay principal of
outstanding loans and the value of collateral securing those loans depends on
the business environment in the markets where the company operates.

An Increase in FDIC Assessments Could
Impact Our Financial Performance.

The FDIC imposes an assessment
against all depository institutions for deposit insurance. See Supervision and
Regulation  Depository Institution Subsidiary on page 7. The FDIC is assessing
the bank 7.00 basis points on an annual basis or .0001750 on a quarterly basis
on the banks December 31, 2008 deposits to be paid in the first quarter of
2009. There is a proposed increase to the assessment of 12 to 16 basis points to
begin the second quarter of 2009 plus a proposed special assessment of 20 basis
points to be paid in the third quarter of 2009. In the current economic
environment, it is likely that this assessment will increase in general for
financial institutions across the country, including the bank, thereby
increasing operating costs.

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, Martinsburg and Hedgesville. 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, constructed in 1967. In July of 2006, the bank completed the purchase
of a property adjacent to the main office for future expansion. In early 2008,
construction began on an addition to the main office facilities. The new
addition houses or will house a new drive through with 5 lanes (one ATM/night
deposit lane and four transaction lanes), the call center, the Information
Technology and Deposit Operations departments and certain administrative
offices. Renovations to the existing two buildings are being completed along
with the addition. The renovations are expected to be completed in June of 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 opened for business in July of 2001.
Originally housed in a leased facility on the property, the one story brick
building was completed in January 2005.

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

14

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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. As of March 16, 2009, 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 2007 and 2008 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 Share2007
    
    First
      Quarter
    
    $
    15.99
    
    $
    15.15
    
    $
    .1000Second Quarter
    
    
    15.99
    
    
    15.20
    
    
    .1025Third
      Quarter
    
    
    15.70
    
    
    14.55
    
    
    .1050Fourth Quarter
    
    
    15.45
    
    
    12.05
    
    
    .10752008
    
    First
      Quarter
    
    $
    13.75
    
    $
    12.00
    
    $
    .1100Second Quarter
    
    
    14.00
    
    
    12.00
    
    
    .1125Third
      Quarter
    
    
    12.20
    
    
    10.15
    
    
    .1150Fourth Quarter
    
    
    11.10
    
    
    8.00
    
    
    .1175


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. 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, 2008, 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.

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.

15

---

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



ASSUMES $100 WAS INVESTED ON JANUARY 1,
2004 AND ASSUMES DIVIDENDS WEREREINVESTED THROUGH FISCAL YEAR ENDING
DECEMBER 31, 2008

ISSUER PURCHASES OF EQUITY
SECURITIES

(c) Total Numberof Shares(a) Total
    
    
    
    
    Purchased as
    
    (d) Maximum NumberNumber of
    
    (b) Average
    
    Part of Publicly
    
    of Shares that MayShares
    
    Price Paid
    
    Announced
    
    Yet be PurchasedPeriod
    
    Purchased
    
    Per Share
    
    Programs
    
    Under the ProgramOctober 1 through October 31
    
    NONE
    
    $
    - -
    
    - -
    
    73 877November 1 through November 30
    
    NONE
    
    
    - -
    
    - -
    
    73 877December 1 through December 31
    
    7 935
    
    
    9.20
    
    280 126
    
    65
942


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.

16

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Item 6. Selected Financial
Data.

|                                                   |  | 2008                                               |             | 2007 |   | 2006        |  | 2005 |             | 2004
|-------------------------------------------------- |  | -------------------------------------------------- | ----------- | ---- | - | ----------- |  | ---- | ----------- | ----
|                                                   |  | (Dollars in Thousands
      Except Per Share Data)
|Summary of Operations                              |  |                                                    |             |      |   |             |  |      |             |     
|                                                  
|Interest income                                    |  | $                                                  | 17 358      |      | $ | 19 691      |  | $    | 19 099      |     
|Interest expense                                   |  |                                                    | 6
      477 |      |   | 8
      161 |  |      | 6
      932 |     
|Net interest income                                |  |                                                    | 10 881      |      |   | 11 530      |  |      | 12 167      |     
|Provision for loan losses                          |  |                                                    | 2
      934 |      |   | 678         |  |      | 331         |     
|Net interest income after
      provision          |  |                                                    |             |      |   |             |  |      |             |     
|for loan losses                                    |  |                                                    | 7 947       |      |   | 10 852      |  |      | 11 836      |     
|Noninterest income                                 |  |                                                    | 4 355       |      |   | 4 364       |  |      | 3 766       |     
|Noninterest expense                                |  |                                                    | 9 587       |      |   | 9 688       |  |      | 9 261       |     
|Income before income taxes                         |  |                                                    | 2 715       |      |   | 5 528       |  |      | 6 341       |     
|Income tax expense                                 |  |                                                    | 853         |      |   | 1 998       |  |      | 2 306       |     
|                                                  
|Net income                                         |  | $                                                  | 1 862       |      | $ | 3 530       |  | $    | 4 035       |     
|                                                  
|Per
      Share Data **                            |  |                                                    |             |      |   |             |  |      |             |     
|                                                  
|Net income, basic                                  |  | $                                                  | .55         |      | $ | 1.03        |  | $    | 1.17        |     
|Net income, diluted                                |  |                                                    | .55         |      |   | 1.03        |  |      | 1.16        |     
|Cash dividends declared                            |  |                                                    | .46         |      |   | .42         |  |      | .38         |     
|Book value at period end                           |  |                                                    | 8.19        |      |   | 8.52        |  |      | 7.78        |     
|Weighted-average shares outstanding,
      basic   |  |                                                    | 3 401 717   |      |   | 3 423 239   |  |      | 3 454 961   |     
|Weighted-average shares outstanding,
      diluted |  |                                                    | 3 403 265   |      |   | 3 430 764   |  |      | 3 467 918   |     
|                                                  
|Average Balance Sheet Summary                      |  |                                                    |             |      |   |             |  |      |             |     
|                                                  
|Assets                                             |  | $                                                  | 303 749     |      | $ | 297 716     |  | $    | 289 303     |     
|Loans                                              |  |                                                    | 232 894     |      |   | 226 773     |  |      | 220 895     |     
|Securities                                         |  |                                                    | 34 178      |      |   | 42 040      |  |      | 48 891      |     
|Deposits                                           |  |                                                    | 259 536     |      |   | 254 908     |  |      | 243 833     |     
|Stockholders equity                               |  |                                                    | 30 118      |      |   | 28 207      |  |      | 26 632      |     
|                                                  
|Performance Ratios                                 |  |                                                    |             |      |   |             |  |      |             |     
|                                                  
|Return on average assets                           |  |                                                    | 0.61%       |      |   | 1.19%       |  |      | 1.39%       |     
|Return on average equity                           |  |                                                    | 6.18%       |      |   | 12.51%      |  |      | 15.15%      |     
|Dividend payout ratio                              |  |                                                    | 83.64%      |      |   | 40.78%      |  |      | 32.48%      |     
|                                                  
|Capital Ratios                                     |  |                                                    |             |      |   |             |  |      |             |     
|                                                  
|Leverage ratio                                     |  |                                                    | 9.85%       |      |   | 9.99%       |  |      | 9.34%       |     
|Risk-based capital ratios                          |  |                                                    |             |      |   |             |  |      |             |     
|Tier 1 capital                                     |  |                                                    | 12.37%      |      |   | 13.01%      |  |      | 12.71%      |     
|Total capital                                      |  |                                                    | 13.63%      |      |   | 14.23%      |  |      | 13.82%      |     

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

17

---

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.

|                                        |  | 2008           |             | 2007           |  | 2006          
|--------------------------------------- |  | -------------- | ----------- | -------------- |  | --------------
|                                        |  | Average        |             | Income/        |  | Average       
|                                        |  | Balances       |             | Expense        |  | Yield/Rate    
|                                        |  | (in thousands) |             | (in thousands) |  | (in
thousands)
|ASSETS                                  |  |                |             |                |  |               
|Loans                                   |  |                |             |                |  |               
|Taxable                                 |  | $              | 232 124     |                |  | $             
|Tax exempt                              |  |                | 770         |                |  |               
|Total
loans                             |  |                | 232 894     |                |  |               
|Taxable
    securities                  |  |                | 31 286      |                |  |               
|Nontaxable securities                   |  |                | 2 892       |                |  |               
|Securities purchased
      under        |  |                |             |                |  |               
|agreements to resell and                |  |                |             |                |  |               
|federal funds sold                      |  |                | 10 712      |                |  |               
|Other
      earning assets              |  |                | 7 765       |                |  |               
|Total earning assets                    |  |                | 285 549     |                |  | $             
|                                       
|Allowance for loan losses               |  |                | (2 940      | )              |  |               
|Cash and due from
      banks           |  |                | 4 396       |                |  |               
|Premises and equipment, net             |  |                | 6 934       |                |  |               
|Other assets                            |  |                | 9
      810 |                |  |               
|Total
    assets                        |  | $              | 303 749     |                |  |               
|                                       
|LIABILITIES AND                         |  |                |             |                |  |               
|STOCKHOLDERS EQUITY                    |  |                |             |                |  |               
|Deposits                                |  |                |             |                |  |               
|Savings and interest-                   |  |                |             |                |  |               
|bearing demand
      deposits           |  | $              | 120 853     |                |  | $             
|Time deposits                           |  |                | 111 574     |                |  |               
|Total
      interest-                   |  |                |             |                |  |               
|bearing
      deposits                  |  |                | 232 427     |                |  |               
|                                       
|Securities sold under agreements        |  |                |             |                |  |               
|to repurchase and federal               |  |                |             |                |  |               
|funds purchased                         |  |                | 9 963       |                |  |               
|Advances from
    FHLB                  |  |                | 1
      381 |                |  |               
|Total interest                          |  |                |             |                |  |               
|bearing liabilities                     |  |                | 243 771     |                |  | $             
|                                       
|Noninterest-bearing demand              |  |                |             |                |  |               
|deposits                                |  |                | 27 109      |                |  |               
|Other
liabilities                       |  |                | 2 751       |                |  |               
|Stockholders equity                    |  |                | 30 118      |                |  |               
|Total liabilities
      and             |  |                |             |                |  |               
|stockholders
      equity              |  | $              | 303 749     |                |  |               
|                                       
|Net interest income                     |  |                |             |                |  | $             
|                                       
|Net interest spread                     |  |                |             |                |  |               
|Interest
      expense as a             |  |                |             |                |  |               
|percent of average
      earning assets |  |                |             |                |  |               
|                                       
|Net interest margin                     |  |                |             |                |  |               

18

---

MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIALCONDITION 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

2008 was a challenging year for the
banking industry and the company. The economy has contracted, credit has
tightened for banks and consumers, and liquidity has become a concern.
Management was able to reach its perpetual goal to increase the loan portfolio
and, to a lesser degree, increase deposits. In addition, we were able to
maintain an adequate level of liquidity.

A look at the consolidated selected
financial data will show other areas of concern. Earnings decreased
significantly during 2008. However, the company was able to increase shareholder
dividends in each quarter of 2008. The decrease in capital, although small,
presents some challenges. Capital 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, 2009. Compliance costs add
additional pressure for management to find ways to increase income.

Interest income from loans and
investments is the largest source of revenue for the company. Decreasing
interest rates and the stagnant housing market have affected this income stream.
Therefore, management is continually looking for other sources of revenue. The
bank continues to produce a significant amount of income from the overdraft
protection plan. A new checking account, Smart Checking, that encourages use of
the check card and requires customers to receive their statements via e-mail was
introduced during 2008. The new account is expected to increase fee income from
check card transactions and reduce the expense of mailing customer statements.

19

---

Reducing expenses is another avenue
to increasing earnings. Lower interest rates reduce interest expense and are a
benefit to the overall goal of reducing costs. The company seeks 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 was a generous
income producer with the bank earning interest on the outstanding balances of
the official checks. With the decrease in interest rates in 2008, the company is
currently earning no income on the outsourcing of official checks.

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. These items reduce the income tax expense for the company
as well as produce income. We received proceeds from one of our bank owned life
insurance policies during 2008 upon the death of a covered former employee.

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, which is favorable. During 2008 the ratio fluctuated in both
directions within a few percentage points ending the year at the high end of the
fluctuation.

Management has recently been made
aware of the possibility of changes in the deposit assessment required by the
FDIC. Initial correspondence includes the possibility of a 12 to 16 point
increase in the annual deposit assessment. An additional one time assessment of
20 basis points has been proposed as well. Either of these proposals could have
a material adverse effect on earnings of the company.

The following table sets forth
selected quarterly results (with dollars in thousands) of the company for 2008
and 2007.

|                                         |  | 2008               |       | 2007              
|---------------------------------------- |  | ------------------ | ----- | ------------------
|                                         |  | Three Months Ended |       | Three Months Ended
|                                         |  | Dec 31             |       | Sept 30           
|Interest income                          |  | $                  | 4 171 |                   
|Interest expense                         |  |                    | 1 462 |                   
|Net
      interest income                |  |                    | 2 709 |                   
|Provision for loan
      losses          |  |                    | 1 371 |                   
|Net
      interest income after          |  |                    |       |                   
|provision for loan losses                |  |                    | 1 338 |                   
|Noninterest income                       |  |                    | 923   |                   
|Noninterest expense                      |  |                    | 2 614 |                   
|Income (loss) before
      taxes         |  |                    | (353  | )                 
|Income tax expense (benefit)             |  |                    | (129  | )                 
|                                        
|Net
      income (loss)                  |  | $                  | (224  | )                 
|                                        
|Earnings (loss) per share, basic         |  | $                  | (.07  | )                 
|Earnings (loss) per share,
      diluted |  | $                  | (.07  | )                 

NET INTEREST INCOME

The economy
worsened, as expected, during 2008. In spite of the economy, the loan portfolio
(net of reserves) increased 9% on the strength of increases mainly in the
commercial loan area. The bulk of the increase was related to participations and
other portfolio loans as a result of our relationship with BlueRidge Bank.
Still, net interest income decreased 6% as the interest rates continued to drop
throughout 2008. Interest on tax exempt securities and other interest and
dividends showed increases. The tax exempt securities portfolio increased
through new purchases at the end of 2007 and in 2008 and other interest
benefited from interest on loans held to sell to BlueRidge Bank during the time
they were waiting to receive their charter.

20

---

The loan
portfolio (net of reserves) decreased 3% during 2007 as compared to 2006. Net
interest income showed a 5% decrease when compared with the 2006 results. The
decline in 2007 was a combination of the reduction in the loan portfolio and
decreasing interest rates.

Interest
expense decreased 21% in 2008 compared to 2007. This is a significant change
from the 18% increase from 2006 to 2007. The reason for the decrease is the
decreases in interest rates enacted by the Federal Reserve during 2008.

Calendar
year 2008 ended with a lot of uncertainty. Most agree that the housing market
has still not found a bottom, business and consumers each need a boost to
their bottom lines and unemployment looms large for the economy in the coming
months. However, the experts do not agree on when any of these situations will
improve. Interest rates are expected to remain at current levels throughout 2009
and possibly beyond. Management is hopeful that interest rates will entice some
back into the loan market during 2009. We also expect cost of funds to remain
relatively inexpensive should the need arise.

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.

|                                 |  | 2008 Compared to 2007 |        | 2007 Compared to 2006
|-------------------------------- |  | --------------------- | ------ | ---------------------
|                                 |  | (in thousands)        |        | (in thousands)       
|                                 |  | Change in             |        |                      
|                                 |  | Income/               |        | Volume               
|                                 |  | Expense               |        | Effect               
|INTEREST INCOME                  |  |                       |        |                      
|Taxable loans                    |  | $                     | (1 820 | )                    
|Tax exempt loans                 |  |                       | (3     | )                    
|Taxable securities               |  |                       | (479   | )                    
|Nontaxable securities            |  |                       | 55     |                      
|Securities purchased under       |  |                       |        |                      
|agreements to resell             |  |                       |        |                      
|and federal funds sold           |  |                       | (186   | )                    
|Other earning assets             |  |                       | 116    |                      
|TOTAL                            |  | $                     | (2 317 | )                    
|                                
|INTEREST EXPENSE                 |  |                       |        |                      
|Savings and interest-bearing     |  |                       |        |                      
|demand deposits                  |  | $                     | (1 098 | )                    
|Time
      deposits              |  |                       | (436   | )                    
|Securities sold under agreements |  |                       |        |                      
|to repurchase and federal        |  |                       |        |                      
|funds purchased                  |  |                       | (186   | )                    
|Federal Home Loan Bank           |  |                       |        |                      
|advances                         |  |                       | 36     |                      
|TOTAL                            |  | $                     | (1 684 | )                    
|                                
|NET INTEREST INCOME              |  | $                     | (633   | )                    

21

---

NONINTEREST INCOME AND
EXPENSE

As in prior
years, fees generated through the banks overdraft protection plan 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 $2.3 million
in 2008, $2.1 million in 2007 and $1.7 million in 2006. Trust and financial
services is the next largest contributor to the 2008 noninterest income figure.
However, this income decreased 25.6% in 2008 compared to growth of 1.3% in 2007.
Most of the trust and financial services decrease was offset by the receipt of
proceeds from bank owned life insurance. VISA/MC fees have increased 13.9% in
2008. As consumers become increasingly comfortable with non cash transactions,
this trend should continue. As mentioned earlier, the new Smart Checking account
also contributed to the increase.

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 $93 thousand in 2008, $197 thousand
in 2007 and $117 thousand in 2006.

Salaries and employee benefits of
$5.1 million are about 54% of the total noninterest expense for 2008. This
percentage is similar to 2007 and 2006. 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. We expect these
expenses to increase in 2009 due to the depreciation of the recently completed
addition to the main office and the furniture and equipment purchased to furnish
the addition. Advertising and marketing expense increased 8.1% during 2008. This
increase is a combination of increased fees being charged by vendors, some
initial marketing expense for the new product, Smart Checking, and expense of
printing new product brochures.

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.

22

---

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, 2008 (in thousands).

|                                          |  | Mature or Reprice
|----------------------------------------- |  | -----------------
|                                          |  |                  
|                                          |  |                  
|                                          |  | Within           
|                                          |  | Three
    Months 
|Interest Earning Assets:                  |  |                  
|Loans                                     |  | $                
|Securities                                |  |                  
|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                                |  |                  
|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 2009, $11.5 million more
liabilities may reprice or will mature than assets. During April through
December of 2009, $29.9 million more liabilities may reprice or will mature than
assets. The total effect for 2009 is that $41.4 million more liabilities may
reprice or mature than assets. Since rates are not expected to change much
during 2009, the company will hold deposit rates steady for the most part and
insert floors in loans to help guard the banks income.

23

---

LOAN
PORTFOLIO

Loans at December
31 (in thousands) for each of the five years in the period ended 2008.

2008
    
    2007
    
    2006
    
    2005
    
    2004Commercial, financial and agricultural
    
    $
    9 671
    
    $
    4 987
    
    $
    4 247
    
    $
    6 046
    
    $
    5 949Mortgage loans on real
      estate:Construction and
      land development
    
    
    65 643
    
    
    55 042
    
    
    53 801
    
    
    41 174
    
    
    28 929Secured by farm land
    
    
    1 380
    
    
    1 328
    
    
    1 557
    
    
    2 381
    
    
    3 986Secured by 1-4 family
      residential
    
    
    97 064
    
    
    98 864
    
    
    103 983
    
    
    98 408
    
    
    79 800Secured by multifamily residential
    
    
    1 937
    
    
    1 749
    
    
    3 733
    
    
    3 486
    
    
    3 088Secured by nonfarm
      nonresidential
    
    
    58 332
    
    
    47 726
    
    
    46 367
    
    
    43 019
    
    
    39 671Consumer loans
    
    
    11 970
    
    
    14 718
    
    
    16 089
    
    
    15 549
    
    
    17 346All
      other loans
    
    
    457
    
    
    193
    
    
    292
    
    
    372
    
    
    236$
    246 454
    
    $
    224 607
    
    $
    230 069
    
    $
    210 435
    
    $
    179 005


Despite the poor housing market, both in our local market and through out
the country, we were able to increase our loan portfolio in 2008. Most of the
growth has come through commercial loans with much of the increase involving
participation loans with BlueRidge Bank. The mortgage loans have dipped slightly
but are very reasonable considering the current housing market.

In any year, it is the banks goal to increase the loan portfolio and
2009 will not be an exception. Most forecasts indicate 2009 will be another
challenging year. The housing market and overall economy are expected to remain
in decline through the second quarter of 2010. However, the loan staff continues
to seek new opportunities for loan production while sticking to sound financial
principles and judgment.

There were no categories of loans that exceeded 10% of outstanding loans
at December 31, 2008 that were not disclosed in the table above.

REMAINING MATURITIES OF SELECTED LOANS (in
thousands)

Commercial,Financial and
    
    Real Estate-At December 31, 2008
    
    
    Agricultural
    
    ConstructionLoans
      maturing within one year
    
    $
    3 283
    
    $
    25 709Variable rate loans due after one year
    
    
    657
    
    
    18 123Fixed
      rate loans due after one year through five years
    
    
    5 594
    
    
    11 853Fixed
      rate loans due after five years
    
    
    137
    
    
    9 958Total
      maturities
    
    $
    9 671
    
    $
    65
643


24

---

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.

2008
    
    2007
    
    2006
    
    2005
    
    2004(in
thousands)Balance at beginning of period
    $
    2 779
    
    $
    2 423
    
    $
    2 161
    
    $
    1 966
    
    $
    1 724Charge-offs:Commercial, financial
      and agricultural
    
    21
    
    
    14
    
    
    - -
    
    
    30
    
    
    - -Real estate  construction
    
    269
    
    
    32
    
    
    - -
    
    
    - -
    
    
    - -Real estate 
      mortgage
    
    1 102
    
    
    206
    
    
    - -
    
    
    - -
    
    
    - -Consumer
    
    441
    
    
    252
    
    
    207
    
    
    218
    
    
    202Total charge-offs
    
    1 833
    
    
    504
    
    
    207
    
    
    248
    
    
    202Recoveries:Commercial, financial and
      agricultural
    
    - -
    
    
    30
    
    
    - -
    
    
    - -
    
    
    - -Real estate  construction
    
    - -
    
    
    - -
    
    
    - -
    
    
    - -
    
    
    - -Real estate 
      mortgage
    
    17
    
    
    - -
    
    
    - -
    
    
    - -
    
    
    - -Consumer
    
    182
    
    
    152
    
    
    138
    
    
    113
    
    
    155Total
      recoveries
    
    199
    
    
    182
    
    
    138
    
    
    113
    
    
    155Net charge-offs
    
    1 634
    
    
    322
    
    
    69
    
    
    135
    
    
    47Additions charged to operations
    
    2 934
    
    
    678
    
    
    331
    
    
    330
    
    
    289Balance at end of period
    $
    4 079
    
    $
    2 779
    
    $
    2 423
    
    $
    2 161
    
    $
    1 966Ratio of net charge-offs
      during the periodto average loans outstanding
      duringthe period
    
    0.70%
    
    
    0.14%
    
    
    0.03%
    
    
    0.07%
    
    
    0.03%


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.

|                         | 2008       |       | 2007              |         | 2006       |   | 2005              |  | 2004      
|------------------------ | ---------- | ----- | ----------------- | ------- | ---------- | - | ----------------- |  | ----------
|                         | 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             | $          | 69    |                   | 3.92%   |            | $ | 35                |  | 2.22%     
|Mortgage loans
      on  |            |       |                   |         |            |   |                   |  |           
|real
      estate:       |            |       |                   |         |            |   |                   |  |           
|Construction             |            |       |                   |         |            |   |                   |  |           
|and land                 |            |       |                   |         |            |   |                   |  |           
|development              |            | 2 182 |                   | 26.63%  |            |   | 1 025             |  | 24.50%    
|Secured by
      farm    |            |       |                   |         |            |   |                   |  |           
|land                     |            | 76    |                   | .56%    |            |   | 9                 |  | .59%      
|Secured by
      1-4     |            |       |                   |         |            |   |                   |  |           
|family                   |            |       |                   |         |            |   |                   |  |           
|residential              |            | 845   |                   | 39.38%  |            |   | 924               |  | 44.02%    
|Secured by
      multi-  |            |       |                   |         |            |   |                   |  |           
|family                   |            |       |                   |         |            |   |                   |  |           
|residential              |            | 16    |                   | .79%    |            |   | 13                |  | .78%      
|Secured by
      nonfarm |            |       |                   |         |            |   |                   |  |           
|nonresidential           |            | 727   |                   | 23.67%  |            |   | 661               |  | 21.25%    
|Consumer loans           |            | 90    |                   | 4.86%   |            |   | 111               |  | 6.55%     
|All other loans          |            | 4     |                   | .19%    |            |   | 1                 |  | .09%      
|Unallocated              |            | 70    |                   | - -     |            |   | - -               |  | - -       
|                         | $          | 4 079 |                   | 100.00% |            | $ | 2 779             |  | 100.00%   

25

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RISK ELEMENTS IN THE LOAN PORTFOLIO

2008
    
    2007
    
    2006
    
    2005
    
    2004(in
thousands)Nonaccrual loans
    $
    2 669
    
    $
    1 584
    
    $
    144
    
    $
    122
    
    $
    - -Restructured
    loans
    
    - -
    
    
    - -
    
    
    - -
    
    
    - -
    
    
    - -Foreclosed properties
    
    1 644
    
    
    430
    
    
    - -
    
    
    - -
    
    
    - -Total nonperforming
      assets
    $
    4 313
    
    $
    2 014
    
    $
    144
    
    $
    122
    
    $
    - -Loans
      past due 90 daysaccruing
interest
    $
    1 263
    
    $
    21
    
    $
    - -
    
    $
    65
    
    $
    - -Allowance for loan lossesto period end
    loans
    
    1.66%
    
    
    1.24%
    
    
    1.05%
    
    1.03%
    
    
    1.10%Nonperforming assets toperiod end loans
    andforeclosed
      properties
    
    1.74%
    
    
    .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, 2008, other potential problem loans totaled $4.4 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 on securities available for sale, net of tax effects, is recognized in
stockholders equity.

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

|                                               | 2008           |             | Weighted |       | 2007           |   | Weighted    |  | 2006           |  | 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                 | $              | 5 600       |          | 5.03% |                | $ | 10 501      |  | 4.38%          |  | $       
|Maturing after one year
      but              |                |             |          |       |                |   |             |  |                |  |         
|within five
      years                        |                | 18 889      |          | 4.13% |                |   | 26 200      |  | 5.00%          |  |         
|Municipal
      obligations:                   |                |             |          |       |                |   |             |  |                |  |         
|Maturing within one
      year                 |                | 147         |          | 3.04% |                |   | - -         |  | - -            |  |         
|Maturing after one year
      but              |                |             |          |       |                |   |             |  |                |  |         
|within five
      years                        |                | 879         |          | 3.82% |                |   | 1 029       |  | 3.71%          |  |         
|Maturing after five
      years                |                | 1
      963 |          | 3.86% |                |   | 1
      842 |  | 3.87%          |  |         
|Total securities available
      for sale      | $              | 27 478      |          |       |                | $ | 39 572      |  |                |  | $       

26

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DEPOSITS

Deposits increased less than 1% in 2008. Periodically we have continued
to depend on alternative methods of funding. Even with only a slight increase in
deposits, the bank has increased market share percentages in both Jefferson and
Berkeley Counties of West Virginia as of June 30, 2008 compared to June 30,
2007. We have 31.05% of total deposits in Jefferson County and 4.21% of total
deposits in Berkeley County.

Schedule of Average Deposits and Average
Rates Paid

|                                      | Year
      Ended December 31   
|------------------------------------- | -------------------------------
|                                      | (average balances in thousands)
|                                      | 2008                           
|                                      | Average                        
|                                      | Balance                        
|Noninterest-bearing demand deposits   | $                              
|                                      |                                
|Interest-bearing demand deposits      |                                
|Savings deposits                      |                                
|Time
      deposits                   |                                
|                                      |                                
|Total
      interest-bearing deposits |                                
|                                      |                                
|Total deposits                        | $                              

At December 31, 2008, time deposits of $100 thousand or more were 12.50 %
of total deposits compared with 11.13% at December 31, 2007. Maturities of time
deposits of $100 thousand or more (in thousands) at December 31, 2008 are as
follows:

| | Within three months                         | $ | 5 255       
| | ------------------------------------------- | - | ------------
| | Over three through six
      months         |   | 10 064      
| | Over
      six months through twelve months |   | 3 380       
| | Over twelve
    months                      |   | 13
      121
| |                                             |   |             
| | Total                                       | $ | 31
  820    

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 13.63% and a
ratio of Tier 1 capital to risk-weighted assets of 12.37% at December 31, 2008.
These two ratios have decreased due to the small growth in capital compared to a
larger increase in both average total assets and risk weighted assets. Both
ratios exceed the capital requirements adopted by the federal regulatory
agencies.

27

---

2008
    
    2007
    
    2006(In
thousands)Tier
      1 capital:Common stock
    $
    3 672
    
    $
    3 672
    
    $
    3 672Surplus
    
    3 851
    
    
    3 771
    
    
    3 661Retained earnings
    
    25
      070
    
    
    24
      787
    
    
    22
      67732 593
    
    
    32 230
    
    
    30 010Less cost of shares acquired for the
      treasury
    
    2
      837
    
    
    2
      701
    
    
    2
      279Total
      tier 1 capital
    $
    29 756
    
    $
    29 529
    
    $
    27 731Tier 2 capital:Allowance for loan losses
      (1)
    
    3 019
    (1)
    
    2 779
    
    
    2 423Total
      risk-based capital
    $
    32 775
    
    $
    32 308
    
    $
    30 154Risk-weighted assets
    $
    240 471
    
    $
    227 013
    
    $
    218
193Capital ratios:Tier 1 risk-based capital
    ratio
    
    12.37%
    
    
    13.01%
    
    
    12.71%Total risk-based capital
      ratio
    
    13.63%
    
    
    14.23%
    
    
    13.82%Leverage ratio
    
    9.85%
    
    
    9.99%
    
    
    9.34%(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 2008 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 2008 net income as
adjusted has provided cash of $12.8 million. 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 used in investing activities in 2008 is $15 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 used in financing activities in 2008 is $600 thousand.

At December 31, 2008, 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 $51.1 million.

28

---

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 $8 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 $120 million. In September 2008, the subsidiary
bank borrowed $5.0 million amortized over five 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, 2008 and 2007 is as follows (in thousands):

2008
    
    2007Financial instruments
      whose contractamounts represent credit
      risk:Commitments to extend credit
    $
    48 726
    
    $
    53 389Standby letters of credit
    
    2 467
    
    
    3
294


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, 2008, the company
had $1.1 million in rate lock commitments to originate mortgage
loans.

*Short-Term Borrowings.*At December 31, 2008 and 2007, short-term
borrowings consist of securities sold under agreements to repurchase that are
secured transactions with customers. The total of short-term borrowings was $8.4
million on December 31, 2008 and $12.5 million on December 31, 2007.

29

---

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

|                                                       | December 31
|------------------------------------------------------ | -----------
|                                                       | 2008       
|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,
2008:

Payments (in thousands) Due By PeriodOver 1
    
    Over 3Less
    
    Year
    
    Yearsthan
      1
    
    through
    
    throughTotal
    
    Year
    
    3 Years
    
    5
YearsLong-Term Debt Obligations
    $
    4 776
    
    $
    921
    
    $
    1 973
    
    $
    1 882Lease
      Obligations for Real Estate
    $
    64
    
    $
    36
    
    $
    28
    
    $
    - -Lease
      Obligations for Equipment
    $
    57
    
    $
    33
    
    $
    24
    
    $
    - -


30

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Item 8. Financial Statements and
Supplementary Data.

REPORT OF INDEPENDENT REGISTERED
PUBLIC ACCOUNTING FIRM

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

We have audited the accompanying
consolidated balance sheets of Potomac Bancshares, Inc. and Subsidiary as of
December 31, 2008 and 2007, and the related consolidated statements of income,
changes in stockholders equity and cash flows for each of the three years in
the period ended December 31, 2008. 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 provide 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,
2008 and 2007, and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 2008, in conformity with
U.S. generally accepted accounting principles.

We were not engaged to examine
management's assessment of the effectiveness of Potomac Bancshares, Inc. and
Subsidiarys internal control over financial reporting as of December 31, 2008,
included in the accompanyingManagements
Report on Internal Control Over Financial Reportingand, accordingly, we do not express an opinion thereon.

Winchester, Virginia March 31,
2009

31

---

POTOMAC BANCSHARES, INC. AND
SUBSIDIARY CONSOLIDATED BALANCE SHEETSDecember 31, 2008 and 2007 (in thousands, except share
data)

|                                                                | 2008 |              | 2007
|--------------------------------------------------------------- | ---- | ------------ | ----
|ASSETS                                                          |      |              |     
|                                                                |      |              |     
|Cash and due from banks                                         | $    | 3 754        |     
|Interest-bearing
      deposits in other financial institutions |      | 1 282        |     
|Securities purchased under agreements to resell                 |      |              |     
|and federal funds
    sold                                      |      | 3 313        |     
|Securities
      available for sale, at fair value              |      | 27 478       |     
|Loans held for sale                                             |      | 329          |     
|Loans, net of
      allowance for loan losses of $4,079         |      |              |     
|in 2008 and $2,779 in 2007                                      |      | 242
375      |     
|Premises and equipment, net                                     |      | 8 015        |     
|Other real
      estate owned                                   |      | 1 644        |     
|Accrued interest receivable                                     |      | 1 108        |     
|Federal Home
      Loan Bank of Pittsburgh stock                |      | 725          |     
|CFSI stock                                                      |      | 117          |     
|Other
      assets                                              |      | 10 241       |     
|                                                                |      |              |     
|Total Assets                                                    | $    | 300
    381  |     
|                                                                |      |              |     
|LIABILITIES AND STOCKHOLDERS EQUITY                            |      |              |     
|                                                                |      |              |     
|LIABILITIES                                                     |      |              |     
|Deposits                                                        |      |              |     
|Noninterest-bearing                                             | $    | 25 469       |     
|Interest-bearing                                                |      | 228 619      |     
|Total Deposits                                                  | $    | 254 088      |     
|Securities sold under agreements to repurchase                  |      | 8
      352  |     
|Federal Home Loan Bank advances                                 |      | 4 776        |     
|Accrued interest payable                                        |      | 481          |     
|Other liabilities                                               |      | 4 880        |     
|Commitments and contingent liabilities                          |      | - -          |     
|Total Liabilities                                               | $    | 272
    577  |     
|                                                                |      |              |     
|STOCKHOLDERS EQUITY                                            |      |              |     
|Common stock,
      $1 per share par value; 5,000,000 shares    |      |              |     
|authorized; 3,671,691 shares issued                             | $    | 3
      672  |     
|Surplus                                                         |      | 3 851        |     
|Undivided
      profits                                         |      | 25
      070 |     
|Accumulated
      other comprehensive (loss)                    |      | (1
    952   | )   
|                                                                | $    | 30
      641 |     
|Less cost of shares acquired for the treasury,
      2008,      |      |              |     
|278,086 shares; 2007, 266,191 shares                            |      | 2
    837    |     
|Total Stockholders Equity                                      | $    | 27 804       |     
|                                                                |      |              |     
|Total Liabilities and Stockholders
    Equity                  | $    | 300
    381  |     

See Notes to Consolidated Financial
Statements.

32

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POTOMAC BANCSHARES, INC. AND
SUBSIDIARYCONSOLIDATED STATEMENTS OF INCOMEYears Ended December 31, 2008,
2007 and 2006(in thousands, except per share data)

|                                                                 | 2008 |              | 2007 |   | 2006        
|---------------------------------------------------------------- | ---- | ------------ | ---- | - | ------------
|Interest and Dividend Income:                                    |      |              |      |   |             
|Interest and fees on
      loans                                 | $    | 15 201       |      | $ | 17 093      
|Interest on securities available
      for sale - taxable        |      | 1
      415  |      |   | 1
      894 
|Interest on securities available for sale -
      nontaxable     |      | 110          |      |   | 74          
|Interest on securities purchased
      under agreements          |      |              |      |   |             
|to resell and federal funds sold                                 |      | 249          |      |   | 435         
|Other interest and
dividends                                     |      | 383          |      |   | 195         
|Total Interest and Dividend
      Income                         | $    | 17 358       |      | $ | 19 691      
|                                                                 |      |              |      |   |             
|Interest Expense:                                                |      |              |      |   |             
|Interest on deposits                                             | $    | 6 162        |      | $ | 7 696       
|Interest on securities sold under
      agreements to repurchase |      | 255          |      |   | 441         
|Federal Home Loan Bank
    advances                              |      | 60           |      |   | 24          
|Total Interest
      Expense                                     | $    | 6 477        |      | $ | 8 161       
|                                                                 |      |              |      |   |             
|Net Interest
      Income                                        | $    | 10
      881 |      | $ | 11
      530
|                                                                 |      |              |      |   |             
|Provision for Loan Losses                                        |      | 2 934        |      |   | 678         
|                                                                 |      |              |      |   |             
|Net Interest Income after
      Provision                        |      |              |      |   |             
|for Loan Losses                                                  | $    | 7 947        |      | $ | 10 852      
|                                                                 |      |              |      |   |             
|Noninterest Income:                                              |      |              |      |   |             
|Trust and financial
services                                     | $    | 807          |      | $ | 1 085       
|Service charges on deposit
      accounts                        |      | 2
      340  |      |   | 2
      102 
|Visa/MC Fees                                                     |      | 516          |      |   | 453         
|Cash surrender value of life
      insurance                     |      | 240          |      |   | 189         
|Miscellaneous income                                             |      | 246          |      |   | 8           
|Other operating
      income                                     |      | 206          |      |   | 527         
|Total Noninterest
      Income                                   | $    | 4 355        |      | $ | 4 364       
|                                                                 |      |              |      |   |             
|Noninterest Expenses:                                            |      |              |      |   |             
|Salaries and employee
    benefits                               | $    | 5 146        |      | $ | 5 252       
|Net occupancy expense of
      premises                          |      | 542          |      |   | 563         
|Furniture and equipment
      expenses                           |      | 933          |      |   | 925         
|Advertising and
      marketing                                  |      | 266          |      |   | 246         
|ATM and check card expense                                       |      | 313          |      |   | 328         
|Other operating
      expenses                                   |      | 2 387        |      |   | 2 374       
|Total Noninterest
      Expenses                                 | $    | 9 587        |      | $ | 9 688       
|Income Before Income Tax
      Expense                           | $    | 2 715        |      | $ | 5 528       
|Income Tax
    Expense                                           |      | 853          |      |   | 1
      998 
|                                                                 |      |              |      |   |             
|Net Income                                                       | $    | 1 862        |      | $ | 3 530       
|                                                                 |      |              |      |   |             
|Earnings Per Share, basic                                        | $    | .55          |      | $ | 1.03        
|Earnings Per Share,
      diluted                                | $    | .55          |      | $ | 1.03        

See Notes to Consolidated Financial
Statements.

33

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POTOMAC BANCSHARES, INC. AND
SUBSIDIARYCONSOLIDATED STATEMENTS OF
CHANGES IN STOCKHOLDERS EQUITY Years Ended December 31, 2008, 2007 and 2006
(in thousands, except per share data)

|                                       |        |       |         |   |         |           |       |          |        |               |        |               |       |  | Accumulated |        |   |     |   |       |  |  |  
|-------------------------------------- | ------ | ----- | ------- | - | ------- | --------- | ----- | -------- | ------ | ------------- | ------ | ------------- | ----- |  | ----------- | ------ | - | --- | - | ----- |  |  | -
|                                       |        |       |         |   |         |           |       |          |        |               |        |               |       |  | Other       |        |   |     |   |       |  |  |  
|                                       | Common |       |         |   |         | Undivided |       | Treasury |        | Comprehensive |        | Comprehensive |       |  |             |       
|                                       | Stock  |       | Surplus |   | Profits |           | Stock |          | (Loss) |               | Income |               | Total
|Balances, December 31,
      2005      | $      | 3 600 |         | $ | 2 400   |           | $     | 21 158   |        |               | $      | (1 850        | )     |  | $           | (276   | ) |     |   |       |  |  | $
|                                      
|Comprehensive
      income             |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|Net income 
      2006                |        | - -   |         |   | - -     |           |       | 4 035    |        |               |        | - -           |       |  |             | - -    |   |     | $ | 4 035 |  |  |  
|Other comprehensive
      income:      |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|Unrealized holding gains               |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|arising during the
      period        |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|(net of tax,
      $63)                |        | - -   |         |   | - -     |           |       | - -      |        |               |        | - -           |       |  |             | 123    |   |     |   | 123   |  |  |  
|Total comprehensive
      income       |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     | $ | 4 158 |  |  |  
|Adjustment to initially
    apply      |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|SFAS No.
    158,                      |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|in regard to pension
      and         |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|other
      postretirement             |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|benefits (net of tax,
      $441)      |        | - -   |         |   | - -     |           |       | - -      |        |               |        | - -           |       |  |             | (861   | ) |     |   |       |  |  |  
|2% stock
dividend                      |        | 72    |         |   | 1 149   |           |       | (1 221   | )      |               |        | - -           |       |  |             | - -    |   |     |   |       |  |  |  
|Purchase of treasury
shares:           |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|27,093
    shares                      |        | - -   |         |   | - -     |           |       | - -      |        |               |        | (429          | )     |  |             | - -    |   |     |   |       |  |  |  
|Stock-based                            |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|compensation
      expense             |        | - -   |         |   | 112     |           |       | - -      |        |               |        | - -           |       |  |             | - -    |   |     |   |       |  |  |  
|Cash dividends 
      2006            |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|($.38 per
      share)                 |        | - -   |         |   | - -     |           |       | (1 295   | )      |               |        | - -           |       |  |             | - -    |   |     |   |       |  |  |  
|Balances, December 31, 2006            | $      | 3 672 |         | $ | 3 661   |           | $     | 22 677   |        |               | $      | (2 279        | )     |  | $           | (1 014 | ) |     |   |       |  |  | $
|                                      
|Comprehensive
    income               |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|Net income 
      2007                |        | - -   |         |   | - -     |           |       | 3 530    |        |               |        | - -           |       |  |             | - -    |   |     | $ | 3 530 |  |  |  
|Other comprehensive
      income:      |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|Unrealized holding gains               |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|arising during the
      period        |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|(net of tax,
      $159)               |        | - -   |         |   | - -     |           |       | - -      |        |               |        | - -           |       |  |             | 306    |   |     |   | 306   |  |  |  
|Change in benefit
      obligations    |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|and plan assets for
      pension      |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|and other
      postretirement         |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     |   |       |  |  |  
|benefits (net of tax,
      $97)       |        | - -   |         |   | - -     |           |       | - -      |        |               |        | - -           |       |  |             | 194    |   |     |   | 194   |  |  |  
|Total other comprehensive
      income |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   | 500 |   |       |  |  |  
|Total comprehensive
      income       |        |       |         |   |         |           |       |          |        |               |        |               |       |  |             |        |   |     | $ | 4 030 |  |  |  
|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        | )     |  | $           | (514   | ) |     |   |       |  |  | $

See Notes to Consolidated Financial
Statements.

34

---

POTOMAC BANCSHARES, INC. AND
SUBSIDIARYCONSOLIDATED STATEMENTS OF
CHANGES IN STOCKHOLDERS EQUITY (CONTINUED)Years Ended December 31, 2008,
2007 and 2006(in thousands, except per share data)

|                                       |        |       |         |     |           |           |       |          |        |               |        |               |       |  | Accumulated |        |   |        |        |       |  |  |       
|-------------------------------------- | ------ | ----- | ------- | --- | --------- | --------- | ----- | -------- | ------ | ------------- | ------ | ------------- | ----- |  | ----------- | ------ | - | ------ | ------ | ----- |  |  | ------
|                                       |        |       |         |     |           |           |       |          |        |               |        |               |       |  | Other       |        |   |        |        |       |  |  |       
|                                       | Common |       |         |     |           | Undivided |       | Treasury |        | Comprehensive |        | Comprehensive |       |  |             |       
|                                       | Stock  |       | Surplus |     | Profits   |           | Stock |          | (Loss) |               | Income |               | Total
|Balances, December 31,
      2007      | $      | 3 672 |         | $   | 3
    771 |           | $     | 24 787   |        |               | $      | (2 701        | )     |  | $           | (514   | ) |        |        |       |  |  | $     
|Comprehensive
      income             |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|Net income 
      2008                |        | - -   |         |     | - -       |           |       | 1 862    |        |               |        | - -           |       |  |             | - -    |   |        | $      | 1 862 |  |  |       
|Other comprehensive (loss):            |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|Unrealized holding
      gains         |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|arising during the
      period        |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|(net of tax, $40)                      |        | - -   |         |     | - -       |           |       | - -      |        |               |        | - -           |       |  |             | 77     |   |        |        | 77    |  |  |       
|Change in benefit obligations          |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|and plan assets for
      pension      |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|and other
      postretirement         |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|benefits (net of tax, $780)            | - -    |       |         | - - |           |           | - -   |          |        |               | - -    |               |       |  | (1 515      | )      |   |        | (1 515 | )     |  |  | (1 515
|Total other comprehensive
      (loss) |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   | (1 438 | )      |       |  |  |       
|Total comprehensive income             |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        | $      | 424   |  |  |       
|Purchase of treasury
      shares:     |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|13,935
    shares                      |        | - -   |         |     | - -       |           |       | - -      |        |               |        | (149          | )     |  |             | - -    |   |        |        |       |  |  |       
|Sale of treasury
      shares:         |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|2,040
    shares                       |        | - -   |         |     | 10        |           |       | - -      |        |               |        | 13            |       |  |             | - -    |   |        |        |       |  |  |       
|Stock-based                            |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|compensation
      expense             |        | - -   |         |     | 70        |           |       | - -      |        |               |        | - -           |       |  |             | - -    |   |        |        |       |  |  |       
|Reduction due to change in             |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|pension measurement
      date         |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|(net of tax,
      $16)                |        | - -   |         |     | - -       |           |       | (31      | )      |               |        | - -           |       |  |             | - -    |   |        |        |       |  |  |       
|Cash dividends 
      2008            |        |       |         |     |           |           |       |          |        |               |        |               |       |  |             |        |   |        |        |       |  |  |       
|($.46 per
      share)                 |        | - -   |         |     | - -       |           |       | (1 548   | )      |               |        | - -           |       |  |             | - -    |   |        |        |       |  |  |       
|Balances, December 31, 2008            | $      | 3 672 |         | $   | 3 851     |           | $     | 25 070   |        |               | $      | (2 837        | )     |  | $           | (1 952 | ) |        |        |       |  |  | $     

See Notes to Consolidated Financial
Statements.

35

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POTOMAC BANCSHARES, INC. AND
SUBSIDIARYCONSOLIDATED STATEMENTS OF CASH FLOWSYears Ended December 31, 2008, 2007 and 2006(in
thousands)

|                                                                          | 2008 |               | 2007 |  | 2006
|------------------------------------------------------------------------- | ---- | ------------- | ---- |  | ----
|CASH FLOWS FROM OPERATING ACTIVITIES                                      |      |               |      |  |     
|Net income                                                                | $    | 1 862         |      |  | $   
|Adjustments
      to reconcile net income to net cash                     |      |               |      |  |     
|provided by (used in) operating
    activities:                           |      |               |      |  |     
|Provision for loan losses                                                 |      | 2 934         |      |  |     
|Depreciation                                                              |      | 532           |      |  |     
|Deferred tax (benefit)                                                    |      | (474          | )    |  |     
|Discount accretion and premiumamortization on
      securities, net       |      | (21           | )    |  |     
|Loss on sale of other real estate                                         |      | 185           |      |  |     
|Loss on disposal of premises and
    equipment                            |      | 5             |      |  |     
|Loss on sale of repossessed assets                                        |      | 23            |      |  |     
|Stock-based compensation expense                                          |      | 70            |      |  |     
|Proceeds from sale of loans                                               |      | 12 153        |      |  |     
|Origination of loans for sale                                             |      | (4 349        | )    |  |     
|Changes in assets and liabilities:                                        |      |               |      |  |     
|Decrease (increase) in accrued interest
      receivable                  |      | 258           |      |  |     
|(Increase) in other assets                                                |      | (441          | )    |  |     
|(Decrease) increase in accrued interest
      payable                     |      | (276          | )    |  |     
|Increase (decrease) in other liabilities                                  |      | 304           |      |  |     
|Net cash provided by (used in) operating
      activities                 | $    | 12 765        |      |  | $   
|                                                                         
|CASH FLOWS FROM INVESTING ACTIVITIES                                      |      |               |      |  |     
|Proceeds from
      maturity of securities available for sale             | $    | 5 500         |      |  | $   
|Proceeds from
      call of securities available for sale                 |      | 22 000        |      |  |     
|Purchases of
      securities available for sale                          |      | (15
      267 | )    |  |     
|Net
      (increase) decrease in loans                                    |      | (26 719       | )    |  |     
|Purchases of
      premises and equipment                                 |      | (2 315        | )    |  |     
|Proceeds from
      sale of other real estate                             |      | 1 815         |      |  |     
|Net cash (used in) provided by investing
      activities                 | $    | (14 986       | )    |  | $   
|                                                                         
|CASH FLOWS FROM FINANCING ACTIVITIES                                      |      |               |      |  |     
|Net
      (decrease) in noninterest-bearing deposits                      | $    | (2 525        | )    |  | $   
|Net increase
      in interest-bearing deposits                           |      | 3 239         |      |  |     
|Net
      (repayment) proceeds of securities sold under agreements
    to |      |               |      |  |     
|repurchase and federal funds purchased                                    |      | (4 185        | )    |  |     
|Net proceeds
      (repayment) of Federal Home Loan Bank advances         |      | 4 564         |      |  |     
|Purchase of
      treasury shares                                         |      | (149          | )    |  |     
|Sale of
      treasury shares                                             |      | 23            |      |  |     
|Cash
      dividends                                                      |      | (1 548        | )    |  |     
|Net cash (used in) provided by financing
      activities                 | $    | (581          | )    |  | $   
|(Decrease) increase in cash and cash
      equivalents                    | $    | (2 802        | )    |  | $   
|                                                                         
|CASH AND CASH EQUIVALENTS                                                 |      |               |      |  |     
|Beginning                                                                 |      | 11 151        |      |  |     
|Ending                                                                    | $    | 8 349         |      |  | $   
|                                                                         
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION                         |      |               |      |  |     
|Cash payments for:                                                        |      |               |      |  |     
|Interest                                                                  | $    | 6 753         |      |  | $   
|Income taxes                                                              | $    | 1 642         |      |  | $   
|                                                                         
|SUPPLEMENTAL DISCLOSURES OF NON-CASH                                      |      |               |      |  |     
|INVESTING AND
      FINANCING ACTIVITIES                                  |      |               |      |  |     
|Unrealized gain on securities available for
      sale                    | $    | 117           |      |  | $   
|Change in benefit obligations and plan assets for
      pension           |      |               |      |  |     
|and other postretirement benefits                                         | $    | (2 295        | )    |  | $   
|Loans
      transferred to OREO                                           | $    | 3 238         |      |  | $   
|Loans made on sale of other real estate
      owned                       | $    | 775           |      |  | $   

See Notes to Consolidated Financial
Statements.

36

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POTOMAC BANCSHARES, INC. AND
SUBSIDIARYNOTES 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 and any deferred
fees or costs on originated loans. Interest income is accrued on the unpaid
principal balance. Loan origination fees, net of certain direct origination
costs, are deferred and recognized as an adjustment of the related loan yield
using the interest method.

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.

37

---

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

Loans
(Continued)

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.

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 and special mention 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.

38

---

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

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 whereby Bank of Charles Town
would fund loans for BlueRidge Bank until such time as BlueRidge Bank could
obtain its charter. The balance of these loans was $7.8 million at December 31,
2007. Upon receiving its charter in 2008, BlueRidge Bank purchased the loans
from Bank of Charles Town.

Premises and
Equipment

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

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.

39

---

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

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.

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
consolidated 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 reporting 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, deferred tax assets
and the pension benefit obligation.

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.

40

---

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

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.

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. 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.

Stock option
compensation expense is the estimated fair value of options granted, and is
amortized on a straight-line basis over the requisite service period for each
separately vesting portion of the award. There were no options granted in 2008.
The weighted average estimated fair value of stock options granted in the twelve
months ended December 31, 2007 and 2006 was $3.76 and $3.88, respectively. Fair
value is estimated using the Black-Scholes option-pricing model with the
following assumptions for grants during 2007 and 2006: option term until
exercise of 10 years, expected volatility of 19.56% and 17.86%, risk-free
interest rates of 4.66% and 4.43%, and expected dividend yields of 2.74% and
2.66%, 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.

Recent
Accounting Pronouncements

In September
2006, the Financial Accounting Standards Board (FASB) reached a consensus on
Emerging Issues Task Force (EITF) Issue 06-4, Accounting for Deferred
Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life
Insurance Arrangements, (EITF Issue 06-4). In March 2007, the FASB reached a
consensus on EITF Issue 06-10, Accounting for Collateral Assignment
Split-Dollar Life Insurance Arrangements, (EITF Issue 06-10). Both of these
standards require a company to recognize an obligation over an employees
service period based upon the substantive agreement with the employee such as
the promise to maintain a life insurance policy or provide a death benefit
postretirement. The company adopted the provisions of these standards effective
January 1, 2008. The adoption of these standards was not material to the
consolidated financial statements.

In September
2006, the 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 adopted SFAS 157 effective January 1, 2008. The
adoption of SFAS 157 was not material to the consolidated financial
statements.

41

---

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

Recent
Accounting Pronouncements (Continued)

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 adopted SFAS 159 effective
January 1, 2008. The company decided not to report any existing financial assets
or liabilities at fair value that are not already reported, thus the adoption of
this statement did not have a material impact on the 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, at this time.

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, at this
time.

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. Implementation of SAB 109 did not have a material impact on the
companys 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. Implementation of SAB 110 did not have a material impact on
the companys consolidated financial statements.

42

---

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

Recent
Accounting Pronouncements (Continued)

In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments
and Hedging Activities  an amendment of SFAS No. 133, (SFAS 161). SFAS 161
requires that an entity provide enhanced disclosures related to derivative and
hedging activities. SFAS 161 is effective for the company on January 1, 2009 and
is not expected to have a material impact on the companys consolidated
financial statements.

In April
2008, the FASB issued FASB Staff Position (FSP) No. 142-3, Determination of the
Useful Life of Intangible Assets (FSP 142-3). FSP 142-3 amends the factors an
entity should consider in developing renewal or extension assumptions used in
determining the useful life of recognized intangible assets under SFAS No. 142,
Goodwill and Other Intangible Assets (SFAS 142). The intent of FSP 142-3 is to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the assets under SFAS 141(R). FSP 142-3 is effective for the company on
January 1, 2009, and applies prospectively to intangible assets that are
acquired individually or with a group of other assets in business combinations
and asset acquisitions.The adoption of FSP 142-3 is not expected to have a material
impact on the companys consolidated financial statements.

In May 2008,
the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting
Principles, (SFAS 162). SFAS 162 identifies the sources of accounting
principles and the framework for selecting the principles to be used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles. SFAS 162
is effective 60 days following the SECs approval of the Public Company
Accounting Oversight Board amendments to AU Section 411, The Meaning of Present
Fairly in Conformity With Generally Accepted Accounting Principles. Management
does not expect the adoption of the provision of SFAS 162 to have any impact on
the consolidated financial statements.

In September
2008, the FASB issued FSP FAS 133-1 and FIN 45-4, Disclosures about Credit
Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and
FASB Interpretation No. 45; and Clarification of the Effective Date of FASB
Statement No. 161, (FSP 133-1 and FIN 45-4). FSP 133-1 and FIN 45-4 require a
seller of credit derivatives to disclose information about its credit
derivatives and hybrid instruments that have embedded credit derivatives to
enable users of financial statements to assess their potential effect on its
financial position, financial performance and cash flows. The disclosures
required by FSP 133-1 and FIN 45-4 will be effective for the company on December
31, 2008 and are not expected to have a material impact on the consolidated
financial statements.

In October
2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial
Asset When the Market for That Asset Is Not Active, (FSP 157-3). FSP 157-3
clarifies the application of SFAS 157 in determining the fair value of a
financial asset during periods of inactive markets. FSP 157-3 was effective as
of September 30, 2008 and did not have material impact on the companys
consolidated financial statements.

In December
2008, the FASB issued FSP No. FAS 140-4 and FIN 46(R)-8, Disclosures by Public
Entities (Enterprises) about Transfers of Financial Assets and Interests in
Variable Interest Entities. FSP No. FAS 140-4 and FIN 46(R)-8 requires enhanced
disclosures about transfers of financial assets and interests in variable
interest entities. The FSP is effective for interim and annual periods ending
after December 15, 2008. Since the FSP requires only additional disclosures
concerning transfers of financial assets and interest in variable interest
entities, adoption of the FSP will not affect the companys financial condition,
results of operations or cash flows.

43

---

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

Recent
Accounting Pronouncements (Continued)

In January
2009, the FASB reached a consensus on EITF Issue 99-20-1. This FSP amends the
impairment guidance in EITF Issue No. 99-20, Recognition of Interest Income and
Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial Assets, to achieve
more consistent determination of whether an other-than-temporary impairment has
occurred. The FSP also retains and emphasizes the objective of an
other-than-temporary impairment assessment and the related disclosure
requirements in SFAS No. 115, Accounting for Certain Investments in Debt and
Equity Securities, and other related guidance. The FSP is effective for interim
and annual reporting periods ending after December 15, 2008 and shall be applied
prospectively. The FSP was effective as of December 31, 2008 and did not have a
material impact on the consolidated financial statements.

Note 2. Securities

There were
no securities held to maturity as of December 31, 2008 and 2007.

The
amortized cost and fair value of securities available for sale as of December
31, 2008 and 2007 (in thousands) are as follows:

2008Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    (Losses)
    
    ValueObligations of U.S. Government agencies
    $
    23 996
    
    $
    493
    
    $
    - -
    
    
    $
    24
      489State and municipal
      obligations
    
    3 132
    
    
    8
    
    
    (151
    )
    
    
    2
      989$
    27 128
    
    $
    501
    
    $
    (151
    )
    
    $
    27 4782007Gross
    
    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
572


The
amortized cost and fair value of the securities available for sale as of
December 31, 2008 (in thousands), by contractual maturity, are shown below:

| |                                             | Amortized |        | Fair 
| | ------------------------------------------- | --------- | ------ | -----
| |                                             | Cost      |        | Value
| | Due
      in one year or less               | $         | 5 645  |      
| | Due after one year through
      five years |           | 19 377 |      
| | Due
      after five years                  |           | 2 106  |      
| |                                             | $         | 27 128 |      

There were
no sales of securities available for sale during 2008 or 2007.

44

---

Note 2. Securities (Continued)

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 9 accounts in the consolidated portfolio that have losses at
December31, 2008. 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, 2008.

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, 2008 and 2007 (in thousands).

December 31, 2008Less than 12 months
    
    More than 12 months
    
    TotalGross
    
    
    
    
    Gross
    
    
    
    
    GrossUnrealized
    
    
    
    
    Unrealized
    
    
    
    
    UnrealizedFair Value
    
    Losses
    
    Fair Value
    
    Losses
    
    Fair Value
    
    LossesState
      and municipal obligations
    
    $
    2 077
    
    $
    (151
    )
    
    $
    - -
    
    $
    - -
    
    
    $
    2 077
    
    $
    (151
    )December 31, 2007Less than 12 months
    
    More than 12 months
    
    TotalGross
    
    
    
    
    Gross
    
    
    
    
    GrossUnrealized
    
    
    
    
    Unrealized
    
    
    
    
    UnrealizedFair Value
    
    Losses
    
    Fair Value
    
    Losses
    
    Fair Value
    
    LossesObligations of U.S. Government agencies
    
    $
    - -
    
    $
    - -
    
    
    $
    4 984
    
    $
    (16
    )
    
    $
    4 984
    
    $
    (16
    )State and municipal
      obligations
    
    
    469
    
    
    (1
    )
    
    
    371
    
    
    (1
    )
    
    
    840
    
    
    (2
    )$
    469
    
    $
    (1
    )
    
    $
    5 355
    
    $
    (17
    )
    
    $
    5 824
    
    $
    (18
    )


Securities
with a carrying value of $18.4 million and $25.6 million at December 31, 2008
and 2007 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 312008
    
    2007(in
      thousands)Mortgage loans on real estate:Construction and
      land development
    
    $
    65 643
    
    $
    55 042Secured by farm
      land
    
    
    1
      380
    
    
    1
      328Secured by 1-4
      family residential
    
    
    97 064
    
    
    98 864Secured by
      multifamily residential
    
    
    1
      937
    
    
    1
      749Secured by nonfarm
      nonresidential
    
    
    58 332
    
    
    47 726Commercial loans (except those secured by real
      estate)
    
    
    9
      671
    
    
    4
      987Consumer
      loans
    
    
    11 970
    
    
    14 718All other loans
    
    
    457
    
    
    193Total
      loans
    
    $
    246 454
    
    $
    224
607Less: allowance for loan losses
    
    
    4 079
    
    
    2 779$
    242 375
    
    $
    221
828


45

---

Note 3. Loans and Related Party
Transactions (Continued)

At December
31, 2008 and 2007, overdraft demand deposits reclassified to loans totaled $457
thousand and $193 thousand, respectively.

Loans to
directors and executive officers of the company or to their associates at
December 31, 2008 and 2007 totaled $3.1 million and $2.8 million, respectively.
Such loans were made on substantially the same terms as those prevailing for
comparable transactions with similar risks. During 2008, total principal
additions were $963 thousand and total principal payments were $725 thousand.

Note 4. Allowance for Loan Losses

The
following is a summary of transactions in the allowance for loan losses for
2008, 2007 and 2006 (in thousands):

2008
    
    2007
    
    2006Balances at beginning of year
    
    $
    2 779
    
    
    $
    2 423
    
    
    $
    2 161Provision charged to
      operating expense
    
    
    2 934
    
    
    
    678
    
    
    
    331Recoveries added to the
      allowance
    
    
    199
    
    
    
    182
    
    
    
    138Loan losses charged to
      the allowance
    
    
    (1 833
    )
    
    
    (504
    )
    
    
    (207
    )Balances at end of year
    
    $
    4 079
    
    
    $
    2 779
    
    
    $
    2 423


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

2008
    
    2007Impaired loans without a valuation allowance
    
    $
    7
      469
    
    $
    3
      157Impaired
      loans with a valuation allowance
    
    
    4 245
    
    
    2 656Total impaired
      loans
    
    $
    11 714
    
    $
    5 813Valuation
      allowance related to impaired loans
    
    $
    1 302
    
    $
    636Total nonaccrual loans
    
    $
    2 669
    
    $
    1 584Total loans
      past due ninety days or more and still accruing
    
    $
    1 263
    
    $
    212008
    
    2007
    
    2006Average investment in impaired loans
    
    $
    7 770
    
    $
    1 163
    
    $
    - -Interest
      income recognized on impaired loans
    
    $
    471
    
    $
    48
    
    $
    - -Interest income recognized on a cash basis on impaired
      loans
    
    $
    4
    
    $
    - -
    
    $
    -
  -


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, 2008 and 2007 totaled $607 thousand and $517 thousand,
respectively. If interest had been accrued on these nonaccrual loans, such
income would have approximated $36 thousand in 2008 and $3 thousand in 2007.

46

---

Note 5. Premises and Equipment,
Net

Premises and
equipment consists of the following:

December 312008
    
    2007(in
thousands)Premises and improvements
    
    $
    8 676
    
    $
    6 614Furniture and
      equipment
    
    
    4 539
    
    
    4 393$
    13 215
    
    $
    11 007Less accumulated
      depreciation
    
    
    5 200
    
    
    4 770$
    8 015
    
    $
    6 237


Depreciation
included in operating expense for 2008, 2007 and 2006 was $532 thousand, $568
thousand and $582 thousand, respectively.

Note 6. Deposits

The
aggregate amount of time deposits with a balance of $100,000 or more was $31.8
million and $28.2 million at December 31, 2008 and 2007,
respectively.

At December
31, 2008, the scheduled maturities of all time deposits (in thousands) are as
follows:

2009
    
    $
    70 4842010
    
    
    18 1302011
    
    
    18 3682012
    
    
    5 5502013
    
    
    2 800$
    115 332


Brokered
deposits (all in the form of certificates of deposit) totaled $9.6 million and
$3.4 million at December 31, 2008 and 2007, respectively.

Deposits of
the companys directors, executive officers and associates totaled $1.6 million
and $1.4 million at December 31, 2008 and 2007, respectively.

Deposits of
one public funds entity exceed 5% of the banks total deposits.

Note 7. Borrowings

Short-term
borrowings consist of securities sold under agreements to repurchase.

Short-term
borrowings totaled $8.4 million and $12.5 million as of December 31, 2008 and
2007, respectively, in securities sold under agreements to repurchase through
secured transactions with customers.

During 2008,
the bank incurred fixed rate long term debt consisting of a Federal Home Loan
Bank, five year loan, with an original balance of $5 million and monthly
payments of interest and principal with an interest rate of 4.61%. The seven
year loan with Federal Home Loan Bank with an original balance of $2.5 million
was paid off in June 2008.

Principal
payments on the note are due as follows:

2009
    $
    9212010
    
    9642011
    
    1
      0092012
    
    1 0572013
    
    825$
    4
776


47

---

Note 7. Borrowings (Continued)

The company
has unused lines of credit with the Federal Home Loan Bank and other financial
institutions totaling approximately $135 million at December 31, 2008.

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
$100 thousand, $92 thousand and $56 thousand in 2008, 2007 and 2006,
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.

The company
has entered into contracts with three 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,
2008 in the amount of $127 thousand. While these liabilities are unfunded, life
insurance has been obtained by the company to help offset these payments.

48

---

Note 8. Employee Benefit Plans
(Continued)

Obligations
and funded status:

OtherPension Benefits
    
    Postretirement
      Benefits2008
    
    2007
    
    2008
    
    2007(in
      thousands)
    
    (in
      thousands)Change in benefit obligation:Benefit obligation,
      beginning
    
    $
    6 374
    
    
    $
    6 148
    
    
    $
    536
    
    
    $
    515Service
      cost
    
    
    344
    
    
    
    254
    
    
    
    12
    
    
    
    11Interest
      cost
    
    
    474
    
    
    
    362
    
    
    
    30
    
    
    
    30Actuarial (gain)
      loss
    
    
    514
    
    
    
    (144
    )
    
    
    (6
    )
    
    
    -
      -Benefits
      paid
    
    
    (305
    )
    
    
    (246
    )
    
    
    (25
    )
    
    
    (20
    )Benefit obligation,
      ending
    
    $
    7 401
    
    
    $
    6 374
    
    
    $
    547
    
    
    $
    536Change in plan assets:Fair value of plan
      assets, beginning
    
    $
    5 303
    
    
    $
    4 622
    
    
    $
    - -
    
    
    $
    - -Actual return on
      plan assets
    
    
    (1
      457
    )
    
    
    442
    
    
    
    -
      -
    
    
    
    -
      -Employer
      contributions
    
    
    485
    
    
    
    485
    
    
    
    25
    
    
    
    20Benefits
      paid
    
    
    (305
    )
    
    
    (246
    )
    
    
    (25
    )
    
    
    (20
    )Fair value of plan
      assets, ending
    
    $
    4 026
    
    
    $
    5 303
    
    
    $
    - -
    
    
    $
    - -Funded status at end of year
    
    $
    (3
      375
    )
    
    $
    (1 071
    )
    
    $
    (547
    )
    
    $
    (536
    )Unrecognized
      net (gain)
    
    
    - -
    
    
    
    - -
    
    
    
    (53
    )
    
    
    (47
    )Unrecognized transition asset
    
    
    -
      -
    
    
    
    -
      -
    
    
    
    105
    
    
    
    122Accounts recognized on consolidated balance sheet
      as:Accrued benefit
      liabilities
    
    $
    (3 375
    )
    
    $
    (1 071
    )
    
    $
    (495
    )
    
    $
    (461
    )Amounts recognized in accumulated other comprehensive
      loss consist of:Net loss
      (gain)
    
    $
    3 255
    
    
    $
    936
    
    
    $
    (53
    )
    
    $
    (47
    )Transition
      liability
    
    
    -
      -
    
    
    
    -
      -
    
    
    
    104
    
    
    
    122Deferred tax
      asset
    
    
    (1 107
    )
    
    
    (318
    )
    
    
    (17
    )
    
    
    (26
    )$
    2 148
    
    
    $
    618
    
    
    $
    34
    
    
    $
    49


The
accumulated benefit obligation for the defined benefit pension plan was $7.4
million and $5.9 million at December 31, 2008 and 2007, respectively.

49

---

Note 8. Employee Benefit Plans
(Continued)

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

OtherPension Benefits
    
    Postretirement Benefits2008
    
    2007
    
    2006
    
    2008
    
    2007
    
    2006(in thousands)
    
    (in
thousands)Components of net periodic benefit cost:Service
    cost
    
    $
    301
    
    
    $
    254
    
    
    $
    274
    
    
    $
    12
    
    
    $
    11
    
    
    $
    10Interest cost
    
    
    410
    
    
    
    362
    
    
    
    323
    
    
    
    30
    
    
    
    30
    
    
    
    30Expected return on plan assets
    
    
    (313
    )
    
    
    (356
    )
    
    
    (331
    )
    
    
    - -
    
    
    
    - -
    
    
    
    - -Amortization of net
      obligation at transition
    
    
    - -
    
    
    
    - -
    
    
    
    - -
    
    
    
    17
    
    
    
    17
    
    
    
    18Recognized actuarial loss
    
    
    71
    
    
    
    40
    
    
    
    35
    
    
    
    -
      -
    
    
    
    -
      -
    
    
    
    -
      -Net periodic benefit
      cost
    
    $
    469
    
    
    $
    300
    
    
    $
    301
    
    
    $
    59
    
    
    $
    58
    
    
    $
    58Other
      changes in plan assets and benefit      
      obligations recognized in
      accumulated       other comprehensive
      loss:Net loss (gain)
    
    $
    2 319
    
    
    $
    (274
    )
    
    
    N/A
    
    
    $
    (6
    )
    
    $
    - -
    
    
    
    N/ATransition
      liability
    
    
    - -
    
    
    
    - -
    
    
    
    N/A
    
    
    
    (18
    )
    
    
    (17
    )
    
    
    N/ADeferred tax
    
    
    (789
    )
    
    
    91
    
    
    
    N/A
    
    
    
    9
    
    
    
    6
    
    
    
    N/ATotal recognized
      in                           
      accumulated
      other                           
      comprehensive loss
    
    $
    1 530
    
    
    $
    (183
    )
    
    
    N/A
    
    
    $
    (15
    )
    
    $
    (11
    )
    
    
    N/ATotal recognized in net
      periodic                           
      benefit cost and
      accumulated                           
      other comprehensive loss
    
    $
    1 999
    
    
    $
    117
    
    
    
    N/A
    
    
    $
    44
    
    
    $
    47
    
    
    
    N/AYear Ended December 312008
    
    2007
    
    2006Adjustment to retained earnings due to change in
      measurement date:Service cost
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    42
    
    
    $
    N/A
    
    
    $
    N/AInterest cost
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    64
    
    
    
    N/A
    
    
    
    N/AExpected return on plan assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (66
    )
    
    
    N/A
    
    
    
    N/ADeferred tax
    benefit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16
    )
    
    
    N/A
    
    
    
    N/AAmortization of loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7
    
    
    
    N/A
    
    
    
    N/ANet period benefit
      cost
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    31
    
    
    
    N/A
    
    
    
    N/A


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 $71 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.

50

---

Note 8. Employee Benefit Plans
(Continued)

Assumptions

Pension Benefits
    
    Other Postretirement
  Benefits2008
    
    2007
    
    2006
    
    2008
    
    2007
    
    2006Weighted-average assumptions used todetermine net
      periodic benefit cost:Discount rate
    
    6.00%
    
    6.00%
    
    6.00%
    
    6.00%
    
    6.00%
    
    6.00%Expected return on plan
      assets
    
    6.00%
    
    7.50%
    
    8.00%
    
    - -
    
    - -
    
    - -Rate of compensation
      increase
    
    3.50%
    
    4.50%
    
    4.00%
    
    3.00%
    
    3.00%
    
    3.00%Weighted-average assumptions used todetermine benefit
      obligations:Discount
    rate
    
    6.00%
    
    6.00%
    
    6.00%
    
    6.00%
    
    6.00%
    
    6.00%Rate of compensation
      increase
    
    3.50%
    
    4.50%
    
    4.00%
    
    3.00%
    
    3.00%
    
    3.00%


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 December 31, 2008 and October 31,
2007 (the plans valuation date), by asset category are as follows:

Plan Assets atDecember 31
    
    October 312008
    
    2007Asset CategoryEquities
    
    57%
    
    61%Fixed
income/cash
    
    43%
    
    39%Total
    
    100%
    
    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, 2008 and 2007.

51

---

Note 8. Employee Benefit Plans
(Continued)

Cash
Flow

The company
expects to contribute $1 million to its pension plan in 2009 and $26 thousand to
its postretirement plan in 2009.

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

OtherPostretirementPension Benefits
    
    Benefits(in
thousands)2009
    
    $
    285
    
    $
    262010
    
    
    286
    
    
    272011
    
    
    291
    
    
    282012
    
    
    338
    
    
    302013
    
    
    340
    
    
    312014-2019
    
    
    2 213
    
    
    174


For
measurement purposes, a 7.10%, 7.35% and 7.60% annual rate of increase in per
capita health care costs of covered benefits was assumed for 2008, 2007 and
2006, 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
    accumulatedpostretirement benefit
      obligation
    
    $
    60
    
    $
    (53
    )Effect on total of service
      and interest cost components ofnet periodic postretirement health care benefit cost
    
    
    3
    
    
    (4
    )


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.

2008
    
    2007
    
    2006Average
    
    Per Share
    
    Average
    
    Per Share
    
    Average
    
    Per ShareShares
    
    Amount
    
    Shares
    
    Amount
    
    Shares
    
    Amount(in thousands)
    
    
    
    
    (in thousands)
    
    
    
    
    (in thousands)Basic
      earnings per share
    
    3 402
    
    $
    .55
    
    3 423
    
    $
    1.03
    
    3 455
    
    $
    1.17Effect of dilutive securities:Stock options
    
    2
    
    
    
    
    8
    
    
    
    
    13Diluted earnings per share
    
    3 404
    
    $
    .55
    
    3 431
    
    $
    1.03
    
    3 468
    
    $
    1.16


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

Stock
options for 132,620, 120,534 and 83,811 shares of common stock were not
considered in computing diluted earnings per common share for 2008, 2007 and
2006, respectively, because they were anti-dilutive.

52

---

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). 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, 2008, and changes during the
year then ended is presented below:

Weighted-Weighted-
    
    Average
    
    AggregateAverage
    
    Remaining
    
    IntrinsicExercise
    
    Contractual
    
    ValueShares
    
    Price
    
    Life in Years
    
    (in thousands)Outstanding at beginning of year
    
    151 116
    
    
    $
    14.77Granted
    
    - -
    
    
    
    - -Exercised
    
    (2 040
    )
    
    
    11.28Forfeited
    
    (16 456
    )
    
    
    15.33Outstanding at end of year
    
    132 620
    
    
    $
    14.75
    
    7
    
    $
    - -Exercisable at end of
      year
    
    90 381
    
    
    $
    14.41
    
    6
    
    $
    -
      -


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, 2008. 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, 2008:

Options Outstanding
    
    Options ExercisableWeightedAverage
    
    Weighted
    
    
    
    WeightedRemaining
    
    Average
    
    
    
    AverageExercise
    
    Number
    
    Contractual
    
    Exercise
    
    Number
    
    ExercisePrice
    
    Outstanding
    
    Life (in years)
    
    Price
    
    Exercisable
    
    Price$
    11.28
    
    27 184
    
    5.0
    
    $
    11.28
    
    23 920
    
    $
    11.2814.00
    
    35
819
    
    6.0
    
    
    14.00
    
    27
169
    
    
    14.0017.25
    
    37 787
    
    7.0
    
    
    17.25
    
    23 774
    
    
    17.2515.60
    
    31 830
    
    8.0
    
    
    15.60
    
    15 518
    
    
    15.60132 620
    
    
    
    
    
    
    90 381


As of
December 31, 2008, there was $97 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 two years.

53

---

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 2005.

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, 2008 and
2007:

2008
    
    2007(in
thousands)Deferred tax assets:Reserve for loan
      losses
    
    $
    1 229
    
    $
    790Accrued pension
      expense
    
    
    1 148
    
    
    438Accrued postretirement benefits
    
    
    229
    
    
    208Nonaccrual
    interest
    
    
    80
    
    
    17Stock option expense
    
    
    35
    
    
    35Home equity closing
      costs
    
    
    64
    
    
    72Net loan origination fees
    
    
    35
    
    
    14OREO expense
    
    
    11
    
    
    11$
    2 831
    
    $
    1 585Deferred tax liabilities:Depreciation
    
    $
    114
    
    $
    122Securities available for
      sale
    
    
    119
    
    
    79$
    233
    
    $
    201Net deferred tax
      assets
    
    $
    2 598
    
    $
    1
384


The
provision for income taxes charged to operations for the years ended December
31, 2008, 2007 and 2006 consists of the following:

2008
    
    2007
    
    2006(in
thousands)Current tax expense
    
    $
    1 327
    
    
    $
    2 248
    
    
    $
    2 496Deferred tax expense
      (benefit)
    
    
    (474
    )
    
    
    (250
    )
    
    
    (190
    )$
    853
    
    
    $
    1 998
    
    
    $
    2 306


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,
2008, 2007 and 2006 due to the following (in thousands):

2008
    
    2007
    
    2006Computed expected tax expense
    
    $
    923
    
    
    $
    1 880
    
    
    $
    2 156Increase
      (decrease) in income taxes resulting from:Tax exempt income
    
    
    (217
    )
    
    
    (107
    )
    
    
    (87
    )State income
      taxes, net of federal income tax benefit
    
    
    123
    
    
    
    191
    
    
    
    202Other
    
    
    24
    
    
    
    34
    
    
    
    35$
    853
    
    
    $
    1 998
    
    
    $
    2 306


54

---

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.

The company
has approximately $1 million in deposits in other financial institutions in
excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) at
December 31, 2008.

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, 2008 and 2007, 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, 2008, the aggregate amount of unrestricted funds
which could be transferred from the banking subsidiary to the parent company
without prior regulatory approval, totaled $3.5 million or 12.5% 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, 2008 and 2007 (in thousands) is as follows:

2008
    
    2007Financial instruments
      whose contract amounts represent credit risk:Commitments to extend
      credit
    
    $
    48 726
    
    $
    53 389Standby letters of
      credit
    
    
    2 467
    
    
    3
294


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 are collateralized and usually contain 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.

55

---

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

At December 31,
2008, the company had rate lock commitments to originate mortgage loans
amounting to $1.1 million and mortgage loans held for sale in the amount of $329
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 Measurements

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,
2008 and 2007, the fair value of loan commitments and standby-letters of credit
was immaterial. Therefore, they have not been included in the following table.

56

---

Note 15. Fair Value Measurements
(Continued)

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

2008
    
    2007Carrying
    
    Fair
    
    Carrying
    
    FairAmount
    
    Value
    
    Amount
    
    Value(in
      thousands)
    
    (in
      thousands)Financial assets:Cash
    $
    5 036
    
    $
    5 036
    
    $
    6 031
    
    $
    6 031Securities purchased underagreements to resell andfederal funds sold
    
    3 313
    
    
    3 313
    
    
    5 120
    
    
    5 120Securities available for sale
    
    27 478
    
    
    27 478
    
    
    39 572
    
    
    39 572Loans, net
    
    242 375
    
    
    244 138
    
    
    221 828
    
    
    223 920Loans held for sale
    
    329
    
    
    329
    
    
    8 133
    
    
    8 133Accrued interest receivable
    
    1 108
    
    
    1 108
    
    
    1 366
    
    
    1 366Financial liabilities:Deposits
    
    254 088
    
    
    252 521
    
    
    253 374
    
    
    253 430Securities sold underagreements to repurchase
    
    8 352
    
    
    8 352
    
    
    12 537
    
    
    12 537FHLB advances
    
    4 776
    
    
    5 034
    
    
    212
    
    
    212Accrued interest payable
    
    481
    
    
    481
    
    
    757
    
    
    757


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.

The
companyadopted SFAS No. 157, Fair Value Measurements (SFAS 157), on January 1,
2008 to record fair value adjustments to certain assets and liabilities and to
determine fair value disclosures. SFAS 157 clarifies that fair value of certain
assets and liabilities is an exit price, representing the amount that would be
received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants.

In February of
2008, the FASB issued Staff Position No. 157-2 (FSP 157-2) which delayed the
effective date of SFAS 157 for certain nonfinancial assets and nonfinancial
liabilities except for those items that are recognized or disclosed at fair
value in the financial statements on a recurring basis. FSP 157-2 defers the
effective date of SFAS 157 for such nonfinancial assets and nonfinancial
liabilities to fiscal years beginning after November 15, 2008, and interim
periods within those fiscal years. Thus, the company has only partially applied
SFAS 157. The items affected by FSP 157-2 include other real estate owned.

In October of
2008, the FASB issued Staff Position No. 157-3 (FSP 157-3) to clarify the
application of SFAS 157 in a market that is not active and to provide key
considerations in determining the fair value of a financial asset when the
market for that financial asset is not active. FSP 157-3 was effective upon
issuance, including prior periods for which financials statements were not
issued.

SFAS 157
specifies a hierarchy of valuation techniques based on whether the inputs to
those valuation techniques are observable or unobservable. Observable inputs
reflect market data obtained from independent sources, while unobservable inputs
reflect the companys market assumptions. The three levels of the fair value
hierarchy under SFAS 157 based on these two types of inputs are as
follows:

57

---

Note 15. Fair Value Measurements
(Continued)

|Level
      1 | Valuation is
      based on quoted prices in active markets for identical assets and
      liabilities.                                                                                                                                                                                                                                                                                         
|------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|             
|Level
      2 | Valuation is
      based on observable inputs including quoted prices in active markets for
      similar assets and liabilities, quoted prices for identical or similar
      assets and liabilities in less active markets, and model-based valuation
      techniques for which significant assumptions can be derived primarily from
      or corroborated by observable data in the market.
|             
|Level
      3 | Valuation is
      based on model-based techniques that use one or more significant inputs or
      assumptions that are unobservable in the
market.                                                                                                                                                                                                                                            

The following
describes the valuation techniques used by the company to measure certain
financial assets and liabilities recorded at fair value on a recurring basis in
the financial statements:

Securities
available for sale: Securities available for
sale are recorded at fair value on a recurring basis. Fair value measurement is
based upon quoted market prices, when available (Level 1). If quoted market
prices are not available, fair values are measured utilizing independent
valuation techniques of identical or similar securities for which significant
assumptions are derived primarily from or corroborated by observable market
data. Third party vendors compile prices from various sources and may determine
the fair value of identical or similar securities by using pricing models that
consider observable market data (Level 2).

The following
table presents the balances of financial assets and liabilities measured at fair
value on a recurring basis as of December 31, 2008:

Fair Value Measurements at December 31,
      2008 UsingQuoted Pricesin
      Active
    
    SignificantMarkets for
    
    Other
    
    SignificantBalance as of
    
    Identical
    
    Observable
    
    UnobservableDecember 31
    
    Assets
    
    Inputs
    
    InputsDescription
    
    
    2008
    
    (Level 1)
    
    (Level 2)
    
    (Level 3)Available for sale securities
    
    $
    27 478
    
    $
    - -
    
    $
    27 478
    
    $
    - -


Certain
financial assets are measured at fair value on a nonrecurring basis in
accordance with generally accepted accounting principles. Adjustments to the
fair value of these assets usually result from the application of
lower-of-cost-or-market accounting or write-downs of individual
assets.

The following
describes the valuation techniques used by the company to measure certain
financial assets recorded at fair value on a nonrecurring basis in the financial
statements:

Loans held
for sale: Loans held for sale are carried at
the lower of cost or market value. These loans currently consist of one-to-four
family residential loans originated for sale in the secondary market. Fair value
is based on the price secondary markets are currently offering for similar loans
using observable market data which is not materially different than cost due to
the short duration between origination and sale (Level 2). As such, the company
records any fair value adjustments on a nonrecurring basis. No nonrecurring fair
value adjustments were recorded on loans held for sale during the year ended
December 31, 2008. Gains and losses on the sale of loans are recorded within
other operating income on the consolidated statements of income.

58

---

Note 15. Fair Value Measurements
(Continued)

Impaired
Loans: Loans are designated as impaired when,
in the judgment of management based on current information and events, it is
probable that all amounts due according to the contractual terms of the loan
agreement will not be collected. The measurement of loss associated with
impaired loans can be based on either the observable market price of the loan or
the fair value of the collateral. Fair value is measured based on the value of
the collateral securing the loans. Collateral may be in the form of real estate
or business assets including equipment, inventory, and accounts receivable. The
vast majority of the collateral is real estate. The value of real estate
collateral is determined utilizing an income or market valuation approach based
on an appraisal conducted by an independent, licensed appraiser outside of the
company using observable market data (Level 2). However, if the collateral is a
house or building in the process of construction or if an appraisal of the real
estate property is over two years old, then the fair value is considered Level
3. The value of business equipment is based upon an outside appraisal if deemed
significant, or the net book value on the applicable business financial
statements if not considered significant using observable market data. Likewise,
values for inventory and accounts receivables collateral are based on financial
statement balances or aging reports (Level 3). Impaired loans allocated to the
Allowance for Loan Losses are measured at fair value on a nonrecurring basis.
Any fair value adjustments are recorded in the period incurred as provision for
loan losses on the consolidated statements of income.

The following
table summarizes thecompanys financial assets that were measured at fair value on
a nonrecurring basis during the period.

Carrying Value at December 31,
      2008Quoted
      Pricesin
      Active
    
    SignificantMarkets for
    
    Other
    
    SignificantBalance as of
    
    Identical
    
    Observable
    
    UnobservableDecember 31
    
    Assets
    
    Input
    
    InputDescription
    
    
    2008
    
    (Level 1)
    
    (Level 2)
    
    (Level 3)AssetsImpaired
      Loans
    
    $
    2 943
    
    $
    - -
    
    $
    2 943
    
    $
    - -


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, 2008 and 2007, that
the company and the bank meet all capital adequacy requirements to which they
are subject.

As of December
31, 2008, 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.

59

---

Note 16. Regulatory Matters (Continued)

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

MinimumCapital
    
    Minimum To BeActual
    
    Requirement
    
    Well CapitalizedAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    Ratio(in
      thousands)As of December 31, 2008:Total capital (to risk-weighted assets):Consolidated
    $
    32 775
    
    13.63
    %
    
    $
    19 238
    
    8.0
    %
    
    
    N/A
    
    N/ABank of Charles Town
    $
    31 423
    
    13.14
    %
    
    $
    19 133
    
    8.0
    %
    
    $
    23 917
    
    10.0%Tier
      1 capital (to risk-weighted assets):Consolidated
    $
    29 756
    
    12.37
    %
    
    $
    9 619
    
    4.0
    %
    
    
    N/A
    
    N/ABank of Charles Town
    $
    28 420
    
    11.88
    %
    
    $
    9 567
    
    4.0
    %
    
    $
    14 350
    
    6.0%Tier 1 capital (to average assets):Consolidated
    $
    29 756
    
    9.85
    %
    
    $
    12 081
    
    4.0
    %
    
    
    N/A
    
    N/ABank of Charles Town
    $
    28 420
    
    9.45
    %
    
    $
    12 030
    
    4.0
    %
    
    $
    15 038
    
    5.0%As of December 31, 2007:Total capital (to risk-weighted assets):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-weighted
      assets):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 average assets):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%


60

---

Note 17. Parent Company Only Financial
Statements

POTOMAC BANCSHARES, INC.(Parent
Company Only)Balance SheetsDecember 31, 2008 and 2007(in thousands)

2008
    
    2007ASSETSCash
    $
    48
    
    
    $
    36Investment in subsidiary
    
    26 468
    
    
    
    28 521Other assets
    
    1 288
    
    
    
    458Total Assets
    $
    27 804
    
    
    $
    29 015LIABILITIES AND STOCKHOLDERS EQUITYSTOCKHOLDERS EQUITYCommon stock
    $
    3 672
    
    
    $
    3 672Surplus
    
    3 851
    
    
    
    3 771Undivided profits
    
    25 070
    
    
    
    24 787Accumulated other comprehensive
      (loss)
    
    (1 952
    )
    
    
    (514
    )$
    30 641
    
    
    $
    31 716Less cost of shares acquired for the
      treasury
    
    2 837
    
    
    
    2 701Total Stockholders Equity
    $
    27 804
    
    
    $
    29 015Total Liabilities and Stockholders Equity
    $
    27 804
    
    
    $
    29 015


POTOMAC BANCSHARES, INC.(Parent
Company Only)Statements of IncomeYears Ended December 31, 2008, 2007 and
2006(in thousands)

2008
    
    2007
    
    2006IncomeDividends from subsidiary
    $
    2
      582
    
    
    $
    1
      942
    
    
    $
    1
      905Interest income
    
    3
    
    
    
    1
    
    
    
    1Total Income
    $
    2 585
    
    
    $
    1 943
    
    
    $
    1 906ExpensesStock-based compensation expense
    $
    70
    
    
    $
    110
    
    
    $
    112Other professional fees
    
    43
    
    
    
    57
    
    
    
    39Other operating expenses
    
    58
    
    
    
    65
    
    
    
    56Total Expenses
    $
    171
    
    
    $
    232
    
    
    $
    207Income before Income Tax (Benefit) andEquity in Undistributed Income of
      Subsidiary
    $
    2 414
    
    
    $
    1 711
    
    
    $
    1 699Income Tax (Benefit)
    
    (32
    )
    
    
    (56
    )
    
    
    (51
    )Income before Equity in UndistributedIncome of Subsidiary
    $
    2 446
    
    
    $
    1 767
    
    
    $
    1 750Equity in Undistributed (Loss) Income of Subsidiary
    
    (584
    )
    
    
    1 763
    
    
    
    2 285Net Income
    $
    1 862
    
    
    $
    3 530
    
    
    $
    4 035


61

---

Note 17. Parent Company Only Financial
Statements (Continued)

POTOMAC BANCSHARES, INC.(Parent
Company Only)Statements of Cash FlowsYears Ended December 31, 2008, 2007
and 2006(in thousands)

2008
    
    2007
    
    2006CASH FLOWS FROM OPERATING ACTIVITIESNet income
    $
    1 862
    
    
    $
    3 530
    
    
    $
    4 035Adjustments to reconcile net income to net
      cashprovided
      by operating activities:Equity in undistributed loss (income) ofsubsidiary
    
    584
    
    
    
    (1 763
    )
    
    
    (2 285
    )Stock-based compensation expense
    
    70
    
    
    
    110
    
    
    
    112(Increase) in other assets
    
    (830
    )
    
    
    (24
    )
    
    
    (153
    )Net cash provided by operating activities
    $
    1 686
    
    
    $
    1 853
    
    
    $
    1 709CASH FLOWS FROM FINANCING ACTIVITIESCash dividends
    $
    (1 548
    )
    
    $
    (1 420
    )
    
    $
    (1 295
    )Purchase of treasury shares
    
    (149
    )
    
    
    (422
    )
    
    
    (429
    )Sale of treasury shares
    
    23
    
    
    
    - -
    
    
    
    - -Net cash (used in) financing activities
    $
    (1 674
    )
    
    $
    (1 842
    )
    
    $
    (1 724
    )Increase (decrease) in cash and cashequivalents
    $
    12
    
    
    $
    11
    
    
    $
    (15
    )CASH AND CASH EQUIVALENTSBeginning
    
    36
    
    
    
    25
    
    
    
    40Ending
    $
    48
    
    
    $
    36
    
    
    $
    25


62

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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, 2008. 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, 2008.

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.

63

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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 April 8, 2009,
for the May 19, 2009 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 & CEO 2001                                    |  | 50  |  | Employed by bank as of 1/1/01 as President and CEO.                                                                                                 
|                       
|David W. Irvin          |  | Executive Vice President 2004                           |  | 45  |  | Employed at bank from 2001 to present as Commercial Loan Division
      Manager.                                                                    
|                       
|Gayle Marshall Johnson  |  | Sr.
      Vice President & Chief Financial Officer 1994 |  | 59  |  | Employed with the bank 1977-1985 and 1988-present; Vice President
      and Chief Financial Officer since 1990. Sr. Vice President since
      2005.

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 10-14 of the Proxy Statement dated April 8, 2009,
for the May 19, 2009 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, 2009,
for the May 19, 2009 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
      securities     
|------------------------------- |  | -------------------------- | ------- | -------------------------- |  | -------------------------------
|                                |  | Number of
      securities |         |                            |  | remaining
      available for  
|                                |  | to be
      issued         |         | Weighted-average           |  | future issuance
      under    
|                                |  | upon exercise
      of     |         | exercise price
      of    |  | equity
      compensation plans
|                                |  | outstanding
      options, |         | outstanding
      options, |  | (excluding
      securities    
|Plan category                   |  | warrants and rights        |         | warrants and rights        |  | reflected in column (a))       
|2003 Stock
      Incentive Plan |  |                            |         |                            |  |                                
|amended by
      shareholders   |  |                            |         |                            |  |                                
|April 24,
      2007            |  |                            | 132,620 |                            |  | $                              

Item 13. Certain Relationships and Related
Transactions.

The
information contained on page 14 of the Proxy Statement dated April 8, 2009, for
the May 19, 2009 Annual Meeting under the caption Certain Transactions with
Directors, Officers and Their Associates is incorporated herein by
reference.

64

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Item 14. Principal Accountant Fees and
Services.

The information contained on pages 6-7 of the Proxy Statement dated April
8, 2009, for the May 19, 2009 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. and subsequent amendments
thereto.*

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 Registered Public Accounting Firm *

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 2009 Annual Meeting for Potomac, portions are incorporated by
reference in Form 10-K Annual Report*

* Filed herewith.

65

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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 31,
      2009
|-- | -------------------------------------------------- |  | --------------------
|   | Robert F.
      Baronner, Jr.                      |  |                     
|   | President &
      Chief Executive Officer          |  |                     
|   |                                                   
|   |                                                   
|By | /s/ Gayle Marshall
      Johnson                   |  | March 31,
      2009
|   | 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/ Dr. Keith Berkeley                  |     
|                  | Dr. Keith
      Berkeley, Director      |     
|                  |                                        
|                  |                                        
|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/ Mary Clare Eros                     |     
|                  | Mary Clare Eros,
      Director         |     
|                  |                                        
|                  |                                        
|By                | /s/ William R. Harner                   |     
|                  | William R.
      Harner, Director       |     
|                  |                                        
|                  |                                        
|By                | /s/ Barbara H. Pichot                   |     
|                  | Barbara H.
      Pichot, Director       |     

66

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|By | /s/ John C. Skinner, Jr.       |  | March 31,
      2009
|-- | ------------------------------ |  | --------------------
|   | John C. Skinner, Jr., Director | 
|   |                               
|By | /s/ C. Larry Togans            |  | March 31,
      2009
|   | C. Larry Togans, Director      | 

67

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