Table of Contents
**UNITED STATES****SECURITIES AND EXCHANGECOMMISSION****WASHINGTON, D. C. 20549****FORM 10-Q**
/X/     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934For the quarter period endedSeptember 30, 2004
/  /     TRANSITION REPORT PURSUANT TOSECTION 13 OR 15 (d) OF THESECURITIES EXCHANGE ACT OF 1934For thetransition period from _______ to _______
Commission File Number:33-81890
**Community Bankshares, Inc.**(Exact name ofregistrant as specified in its charter)

**Georgia**
 
**58-1415887**

*(State or other jurisdiction of* 
*(IRS Employer*
*incorporation or organization)* 
*Identification No.)*
 

**448 North Main Street,**  
**Cornelia, Georgia** 
**30531**
*(Address of principal executive offices)* 
*(Zip Code)*
**(706) 778-2265***(Registrant’s telephone number, including areacode)*
**N/A***(Former name, former address and former fiscal**year,if changed since last report)*
Indicate by check mark whether the registrant has (1) has  filed all reportsrequired to be filed by Section 13 or  15 (d) of the Securities Exchange Act of1934 during  the preceding 12 months (or for such shorter period  that theregistrant was required to file such reports)  and (2) has been subject to suchfiling requirements  for the past 90 days. Yes  þ   No   ̈
Indicate by check mark whether theregistrant is an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct.    Yes  ̈    No  þ   
APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as ofNovember 1, 2004;2,137,740

**COMMUNITY BANKSHARES, INC.****ANDSUBSIDIARIES****INDEX**
 
Page No.
**PART I. FINANCIAL INFORMATION**
 
**Item 1.**

**Financial Statements**
   
Consolidated Balance Sheets - 

 3 
September 30, 2004 and December 31, 2003
  
Consolidated Statements of Income

 4 
and Comprehensive Income for Three 
 
and Nine Months Ended September 30, 2004 and 2003
  
Consolidated Statements of Cash Flows - 

 5 
Nine Months Ended September 30, 2004 and 2003
  
Notes to Consolidated Financial Statements

6 
**Item 2.**

**Management’s Discussion and Analysis of**

 10** **
**Financial Condition and Results of Operations**
 
**Item 3.**

**Quantitative and Qualitative Disclosures about Market Risk**

 15 
**Item 4.**

**Controls and Procedures**

 16 
**PART II. OTHER INFORMATION**

 16 **Item 1.  ****Legal Proceedings**
 16 **Item 2.  ****Unregistered Sale of Equity Securities and use of Proceed**
 16 **Item 3.  ****Defaults Upon Senior Securities**
 16 **Item 4.  ****Submission of Matters to a Vote of Security Holders**
 16** **** **
 
**Item 6.**

**Exhibits and Reports on Form 8 - K**

 16  
31.1 and 31.2 - Rule 13a-15(e) and 15d-15(e) Certifications

   
32 - Certification of Chief Executive Officer and Chief FinancialOfficer,Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 9-6 of theSarbanes-Oxley Act of 2002.

   
Signatures

 17
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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

COMMUNITY BANKSHARES, INC.AND SUBSIDIARIES

CONSOLIDATEDBALANCE SHEETSSEPTEMBER 30, 2004 AND DECEMBER 31, 2003(Dollars in thousands)
  
**(Unaudited)**
         
**Assets**

 
**2004**

 
**2003**

Cash and due from banks

$

40,563 

 $

44,729 

Interest-bearing deposits in banks
 
745 
 
429 

Federal funds sold
 
17,405 
 
19,600 

Securities available-for-sale
 
101,844 
 
103,458 

Securities held-to-maturity (fair value     $22,661 and $24,352)
 
21,262 
 
22,628 

Restricted equity securities, at cost
 
1,471 
 
1,243 

Loans, net of unearned income
 
618,263 
 
545,466 

          Less allowance for loan losses
 
9,199 
 
7,561 

          Loans, net
 
609,064 
 
537,905 

Premises and equipment, net
 
17,799 
 
15,239 

Intangible assets, net
 
883 
 
1,090 

Goodwill
 
968 
 
968 

Other real estate
 
4,208 
 
5,272 

Other assets
 
13,961 
 
13,624 

**          Total assets**

$

     830,173 

$

     766,185 

**Liabilities, Redeemable Common Stock and Shareholders’ Equity**
    
Liabilities:   Deposits:     Noninterest-bearing

$

127,028 

$

111,562 

     Interest-bearing demand
 
186,261 
 
174,070 

     Savings
 
39,707 
 
35,157 

     Time, $100,000 and over
 
129,978 
 
123,975 

     Other time
 
234,363 
 
225,840 

**          Total deposits**

 
717,337 

 
670,604 

Other borrowings
 
25,884 
 
16,153 

Other liabilities
 
9,942 
 
7,986 

**          Total liabilities**

 
753,163 

 
694,743 

Redeemable common stock held by ESOP, net of unearned ESOP shares related to   ESOP debt guarantee of $682 and $974, at September 30, 2004   and December 31, 2003 respectively
 
15,710 
 
15,783 

Shareholders' equity   Common stock, par value $1; 5,000,000 shares authorized;     2,206,830 and 2,204,330 shares issued at September 30, 2004 and     December 31, 2003, respectively
 
2,207 
 
2,204 

Capital surplus
 
6,512 
 
6,342 

Retained earnings
 
54,233 
 
48,069 

Accumulated other comprehensive income
 
1,311
 
1,607 

Less cost of  69,090 and 60,135 shares of treasury stock atSeptember 30, 2004 and    December 31, 2003, respectively
 
(2,963)
 
(2,563)

**Total shareholders' equity**
 
61,300 
 
55,659 

**Total liabilities, redeemable common stock and shareholders' equity**

$

830,173 

$

766,185 

See Notes to Consolidated Financial Statements

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COMMUNITY BANKSHARES, INC.AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOMEAND COMPREHENSIVE INCOMETHREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 ANDNINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003(Dollars in thousands, except per share amounts)(Unaudited)

**Three Months EndedSeptember 30,**

**Nine Months EndedSeptember 30,**

2004

2003

2004

2003

Interest income:   Loans, including fees

$10,457

$ 9,442 

$30,168 

$28,189 

   Taxable securities

585

575 

1,732 

1,822 

   Nontaxable securities

648

746 

2,006 

2,268 

   Interest-bearing deposits in other banks

3

1 

8 

6 

   Federal funds sold

62

49 

139 

186 

          Total interest income

11,755

10,813 

34,053 

32,471 

Interest expense:   Deposits

3,047

2,985 

8,578 

9,656 

   Other borrowings

223

198 

652 

592 

          Total interest expense

3,270

3,183 

9,230 

10,248 

          Net interest income

8,485

7,630 

24,823 

22,223 

Provision for loan losses

579

546 

2,537 

1,686 

          Net interest income after             Provision for loan losses

7,906

7,084 

22,286 

20,537 

Other income:   Service charges on deposit accounts

2,507

1,404 

7,350 

4,010 

   Other service charges, commissions and fees

599

478 

1,676 

1,475 

   Gains on sale of loans

22

93 

183 

180 

   Nonbank subsidiary income

2,215

627 

5,346 

2,163 

   Security gains, net

--

-- 

63 

-- 

   Other operating income

134

159 

481 

456 

          Total other income

5,477

2,761 

15,099 

8,284 

Other expenses:   Salaries and employee benefits

5,255

4,316 

15,350 

12,940 

   Equipment expense

948

822 

2,636 

2,483 

   Occupancy expense

579

497 

1,674 

1,476 

   Other operating expenses

2,985

2,348 

8,661 

6,805 

          Total other expenses

9,767

7,983 

28,321 

23,704 

          Income before income taxes

3,616

1,862 

9,064 

5,117 

Income tax expense

1,118

437 

2,676 

1,061 

          Net income

$ 2,498

$ 1,425 

$ 6,388 

$   4,056 

Other comprehensive income (loss):   Unrealized gains (losses) on securities available      for sale:        Unrealized gains (losses) arising during           the period, net of taxes

 978

(1,132)

(258)

(402)

   Reclassification adjustment      for gains realized in net      income, net of taxes

--

-- 

(38)

-- 

   Total other comprehensive income (loss)

978

(1,132)

(296)

(402)

    Comprehensive income

$3,476

$      293 

$  6,092 

$   3,654 

Basic earnings per common share

$  1.17

$       .67 

$   2.99 

$    1.89 

Diluted earnings per common share

$    .16

$       .66 

$   2.98 

$     1.88 

Cash dividends per share of common stock

$    .08

$       .07 

$     .24 

$       .21 

     See Notes to Consolidated Financial Statements.

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COMMUNITY BANKSHARES, INC.AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OFCASH FLOWSNINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003(Dollars in thousands)(Unaudited)
 
**2004   **

**2003   **

**OPERATING ACTIVITIES**   Net income

$    6,388 

$     4,056 

   Adjustments to reconcile net income to     net cash provided by operating     activities:     Depreciation and amortization

2,304 

2,330 

     Provision for loan losses

2,537 

1,686 

     Deferred income taxes

(682)

(513)

     Net realized gains on securities         available-for-sale

(63)

-- 

     Net losses on sale of other real estate

3 

49 

     (Increase) decrease in interest receivable

(336)

272 

     Increase (decrease) in interest payable

345 

(985)

     Increase in taxes payable

274 

586 

     Increase in accounts        Receivable of nonbank subsidiary

(651)

(142)

     (Increase) decrease in work in        Process of nonbank subsidiary

(6)

319 

     Increase (decrease) in accruals and        payables of nonbank subsidiary

870 

(668)

     Net other operating activities

2,915 

55 

        Net cash provided by           operating activities

$   13,898 

$      7,044 

**INVESTING ACTIVITIES**   Purchases of securities available-for-sale

(21,536)

(25,311)

   Proceeds from sales of securities      available-for-sale

9,850 

-- 

   Proceeds from maturities of securities      available-for-sale

12,642 

19,717 

   Proceeds from maturities of securities      held-to-maturity

1,366 

4,006 

   Net (increase) decrease in Federal funds sold

2,195 

(15,950)

   Net (increase) decrease in interest-bearing      deposits in banks

(316)

8 

   Net increase in loans

(76,788)

(32,936)

   Purchase of premises and equipment

(4,588)

(826)

   Proceeds from sales of other real estate

3,560 

3,254

   Net cash used in      investing activities

$ (73,615)

$ (48,038)

**FINANCING ACTIVITIES**   Net increase in deposits

46,733 

33,677 

   Net increase in other borrowings

10,175 

75 

   Repayment of other borrowings

(444)

(440)

   Proceeds from exercise of options

-- 

30 

   Purchase of treasury stock

(400)

(1,134)

   Dividends paid

(513)

(451)

          Net cash provided by financing activities

$55,551

$31,757 

Net decrease in cash and  due from banks

  $(4,166) 

(9,236)

Cash and due from banks at beginning of the period

44,729

44,966

Cash and due from banks at end of the period

$40,563

$35,730 

**SUPPLEMENTAL DISCLOSURES**  Cash paid for:     Interest

$8,885  

$11,233

      Income taxes

$3,084  

$1,988

**NONCASH TRANSACTIONS**   Principal balances on loans     Transferred to other real estate

$3,092  

$5,644

     See Notes to Consolidated Financial Statements.

5

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COMMUNITY BANKSHARES, INC.AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE1.          BASIS OF PRESENTATION

The consolidated financial information included herein is unaudited; however, suchinformation reflects all adjustments (consisting solely of normal recurring adjustments) which are, in the opinion of management,necessary for a fair statement of results for the interim periods.

The results of operations for the three and nine monthperiodsending September 30, 2004 are not necessarilyindicative of the results to be expected for the fullyear.

NOTE 2.          STOCK COMPENSATION PLAN

The Company has a stock-based employee compensationplan. TheCompany accounts for the plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issuedto Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all optionsgranted under the plan had an exercise price equal to the market value of the underlying stock on the date ofgrant. 

During the third quarter of 2004, 2,500 options were granted at a strike price of 45.06,but have not yet vested.  In addition, there were no options granted during the three and nine months ended September 30,2003.  Therefore, there would be no proforma effect on net income or earnings per share if the Company had applied the fairvalue recognitionprovisions of Statement of Financial AccountingStandards (SFAS) No.123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
 
6

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NOTE 3.          EARNINGS PER COMMON SHARE

The following is a reconciliation of net income (the numerator) and weighted-averageshares outstanding (the denominator) used in determining basic and diluted earnings per common share (EPS).
 
Three Months Ended September 30, 2004(Dollars and shares in Thousands,except per shareamounts)
 
NetIncome(Numerator)

Weighted-AverageShares(Denominator)

Per Share Amount
    
Basic EPS
 
$2,498  
2,139  
$1.17  
Effect of Dilutive Securities     Stock options
 
 –
  
6
  
(.01)
           
Diluted EPS
 
$2,498
  
2,145
  
$1.06 
               
Three Months Ended September 30, 2003(Dollars and shares inThousands, except per share amounts)
 
NetIncome(Numerator)
Weighted-AverageShares(Denominator)
Per ShareAmount        
Basic EPS
 
$1,425  
2,142  
$0.67  
Effect of Dilutive Securities    Stock options
 
–
  
7
  
(.01)
           
Diluted EPS
 
$1,425
  
2,149
  
$0.66 

 
          
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Nine Months Ended September 30, 2004(Dollars and shares inThousands, except per share amounts)
 
NetIncome(Numerator)
Weighted-AverageShares(Denominator)
Per ShareAmount        
Basic EPS
 
$6,388  
2,139  
$2.99  
Effect of Dilutive Securities    Stock options
 
–
  
4
  
(.01)
           
Diluted EPS
 
$6,388
  
2,143
  
$2.98 

 
              
 
 
Nine Months Ended September 30, 2003(Dollars and shares inThousands, except per share amounts)
 
NetIncome(Numerator)
Weighted-AverageShares(Denominator)
Per ShareAmount        
Basic EPS
 
$4,056  
2,151  
$1.89  
Effect of Dilutive Securities    Stock options
 
–
  
4
  
(.01)
           
Diluted EPS
 
$4,056
  
2,155
  
$1.88 

 
              
 

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NOTE4.          SEGMENT INFORMATION

Selected segment information by industry segment for the three and nine month periodsended September 30, 2004 and 2003 is as follows:
 
Reportable Segments(Dollars inthousands)

For the three month period ended Sept. 30, 2004
 
Banking
 
FinancialSupermarkets
 
AllOther
 
Total
             
Revenue from external customers
 
$
15,051  
$
2,048  
$
207  
$
17,306
Intersegment revenues (expenses)
  
(34)  
94   
493   
553
Segment profit (loss)
  
2,806   
1,074   
(1,202)  
2,678
Segment assets
  $
830,671   $
16,355   $
4,779   $
851,805
 
 
Reportable Segments(Dollars inthousands)

For the three month period ended Sept. 30, 2003
 
Banking
 
FinancialSupermarkets
 
AllOther
 
Total
             
Revenue from external customers
 
$
12,974  
$
595  
$
119  
$
13,688
Intersegment revenues (expenses)
  
(34)  
90   
585   
641
Segment profit (loss)
  
2,218   
(522)  
(236)  
1,460
Segment assets
  $
745,419   $
14,873   $
4,047   $
764,339
 
 
Reportable Segments(Dollars inthousands)

For the nine month period ended Sept. 30, 2003
 
Banking
 
FinancialSupermarkets
 
AllOther
 
Total
             
Revenue from external customers
 
$
12,974  
$
595  
$
119  
$
13,688
Intersegment revenues (expenses)
  
(34)  
90   
585   
641
Segment profit (loss)
  
2,218   
(522)  
(236)  
1,460
Segment assets
  $
745,419   $
14,873   $
4,047   $
764,339 
 
 
Reportable Segments(Dollars inthousands)

For the nine month period ended Sept. 30, 2004
 
Banking
 
FinancialSupermarkets
 
AllOther
 
Total
             
Revenue from external customers
 
$
43,849  
$
4,809  
$
675  
$
49,333 
Intersegment revenues (expenses)
  
(97)  
276   
1,765   
1,944 
Segment profit (loss)
  
7,091   
1,408   
(1,978)  
6,521
Segment assets
  $
830,671   $
16,355   $
4,779   $
851,805
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For the Three Months EndedSept. 30     
For the Nine Months EndedSept. 30  
2004
 
2003
 
2004
 
2003
              
Net Income
                           
Total profit for reportable segments

$

3,880  
$

1,696  
$

8,499  
$

4,900  
Non-reportable segment loss
  
(1,202)
  
(236)
   
(1,978)
  
(856)
 
Elimination of intersegment (gains)losses
  
(180)  
(35)   
(133)  
12 
 
Total consolidated net income

$

2,498  
$

1,425  
$

6,388 
$

4,056 
 
 

 

2004
   Total Assets     
Total assets for reportable segments

$

847,026 
Non-reportable segment assets
 
4,779 

Elimination of intersegment assets
 
(216,326)

Total consolidated assets

$

830,173 

 

 

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COMMUNITY BANKSHARES, INC.AND SUBSIDIARIES

ITEM 2. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

Our discussion below is based on the more detailed discussions about our business,operations and financial condition included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003, underItem 7. Our discussions here focus on our results during or as of the quarter and nine months ended September 30, 2004, and thecomparable period of 2003, and, to the extent applicable, any material changes from the information discussed in that Form 10-K orother important intervening developments or information since that time. These discussions should be read inconjunction with that 10-K for more detailed and background information.

Forward Looking Statements

This discussion contains forward-looking statements under the Private SecuritiesLitigation Reform Act of 1995 that involve risks and uncertainties. Although the Company believes the assumptions underlying theforward-looking statements contained in the discussion are reasonable, any of the assumptions could be inaccurate, and therefore,no assurance can be made that any of the forward-looking statements included in this discussion will be accurate. Factors thatcould cause actual results to differ from results discussed in forward-­looking statements include, but are not limited to:economic conditions (both generally and in the markets where the Company operates); competition from other providers of financialservices; government regulation and legislation; changes in interest rates; and material unforeseen changesin the financial stability and liquidity of the Company’s credit customers; allof which are difficult to predict and which may be beyond the control of the Company. The Company undertakes no obligation torevise forward-looking statements to reflect events or changes after the date of this discussionor to reflect the occurrence of unanticipated events.

Critical Accounting Policies

The accounting principles theCompany follows and its methods of applying these principles conform with accounting principles generally accepted in the UnitedStates and with general practices within the banking industry.  In connection with the application of those principles, theCompany has made judgments and estimates that, in the case of the determination of the allowance for loan losses have been criticalto the determination of the Company’s financial position, results of operations and cash flows.

Management’s judgment in determining the adequacy of the allowance for loan lossesis based on evaluations of the collectibility of loans in the portfolio.  The allowance is an amount that management believeswill be adequate to absorb estimated losses in the loan portfolio.  The allowance for loan losses is evaluated on a regularbasis by management and is based upon management’s periodic review of the collectibility of the loans in light of historicalexperience, the nature and volume of the loan portfolio, particular circumstances that may affect the borrower’s ability torepay, estimated value of any underlying collateral and prevailing economic conditions.  This evaluation is inherentlysubjective as it requires estimates that are susceptible to significant revision as more information becomes available.  Whilemanagement uses the best information available to make its evaluation, future adjustments to the allowance may be necessary ifthere are significant changes in economic conditions.  In addition, regulatory agencies, as an integral part of theirexamination process, periodically review the Company’s allowance for loan losses, and may require the Banks to make additionsto the allowance based on their judgment about information available to them at the time of their examinations.

Financial Condition

For the quarter ended September 30, 2004, we experienced growth in total assets, totalloans and total deposits as compared to December 31, 2003. Total assets, loans, and deposits increased by 8.35%, 13.35% and 6.97%respectively.  The growth in deposits is attributable toour expanding markets andincreased efforts to grow our deposit base to help fund our increased loan demand.  The growth in loans was funded by thematurity and sale of securities, advances from Federal Home Loan Bank, the growth in deposits and retention of earnings.

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Liquidity

As of September 30, 2004, the liquidity ratio was 19.88% which is within our target rangeof 15 - 20%.  Liquidity is measured by the ratio of net cash, short term and marketable securities to net deposits and shortterm liabilities.

Interest Rate Risk

Our guideline is to allow no more than an 8% change in net interest income when interestrates rise or fall 200 basis points or more. Our overall interest rate risk within these parameters was less than 2% of netinterest income; therefore, we are within policy guidelines. We have attempted to position ourselves to minimize the impact offurther changes in rates in either direction

Capital

Banking regulations require the Company and the banks to maintain minimum capital levelsin relation to our assets. At September 30, 2004, the bank’scapital ratios were considered wellcapitalizedbased on regulatory capital requirements. The minimum capital requirements and the actualconsolidated capital ratios are as follows:
  
Actual

Regulatory Minimum
     
    Leverage

   9.02%

4.00               
 
    Core Capital

11646%

4.00               
 
    Total Capital

12.91%

8.00               
    
Off Balance Sheet Arrangements

Our financial statements do not reflect various commitments and contingent liabilitiesthat arise in the normal course of business. These off-balance sheet financial instruments include commitments to extend credit andstandby letters of credit. Such financial instruments are included in the financial statements when funds are advanced or theinstruments become payable. Our exposure to credit loss in the event of nonperformance by the other party to the financialinstrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of thoseinstruments. We use the same credit policies in making commitments as we do for on ­balance sheet instruments. Although theseamounts do not necessarily represent future cash requirements, a summary of our commitments as of September 30, 2004 and December31, 2003 are as follows:
                                                                 
September 30, 2004(Dollars in Thousands)
                 
December 31, 2003(Dollars in Thousands)
      
Commitments to extend credit

$

73,614          
 
$

52,733          

Financial standby letters of credit
 
2,745          
  
4,077          

The Company is currently constructing a main banking center in Clayton, Georgia.  Thecost to complete this facility is estimated to be approximately $2,100,000 and will be placed into service no later than the firstquarter of 2005.

12
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**A. Results of Operation**

*Net Income*

Net income for the nine month period ended September 30, 2004, was $6,388,000 or anincrease of 57.50% compared to the same period of 2003 and for the three month period ended September 30, 2004, was $2,498,000 oran increase of 75.30% over the same period of 2003.  These increases are directly attributed to the increase in revenue of ournon-bank subsidiary, increase in net interest income and the increase in service charges on deposit accounts, net of increasedprovisions for loan losses and increased other expenses.

*Net Interest Income*

Net interest income for the nine month period ended September 30, 2004 was up 11.70% overthe same period of 2003, from $22,223,000 to $24,823,000 and was up 11.21% for the three month period ending September 30, 2004from $7,630,000 in the same period in 2003 to $8,485,000 in 2004.  These increases were due to an increase in interest earnedon earning assets and a decrease in interest expense.  Interest income was up by 4.87% for the nine month period endingSeptember 30, 2004 from $32,471,000 to $34,053,000 and up 8.71% for the three month period ending September 30, 2004 from$10,813,000 to $11,755,000.  The increases were caused by the increase in earning assets.  Earning assets increased by13.20% or $88,717,000 at September 30, 2004 as compared to September 30, 2003.  The largest increase in earning assets sinceSeptember 30, 2003 was the increase in loans of $101,136,000 or 19.56%.  The primary reason for the increase in loans is ouropening of a stand-alone branch and a loan production office during the later part of 2003.  Securities decreased by$4,928,000 while federal funds decreased by $7,745,000, during the same period.  Interest expense wasdown 9.93% or $1,018,000 for the nine month period ended September 30, 2004, over the same period in 2003 and up 2.73% or $87,000for the three month period ending September 30, 2004, as compared to 2003.  Although total deposits increased, interestexpense decreased due to the continued re-pricing of interest paid on deposits.

The Company’s net interest margin was 4.69% for the nine month period endedSeptember 30, 2004 compared to 4.72% for the same period in 2003. Management anticipates a stable net interest margin over the nexttwelve months. Any increase in rates would have a slight positive effect on our net interest margin.

*Other Income*

Other income increased by $6,815,000 or 82.27% during the nine month period endedSeptember 30, 2004 as compared to the same period of 2003 and the three month period ending September 30, 2004 showed an increaseof $2,716,000 or 98.37% for the same three month period in 2003.  These increases are primarily due to increased servicecharges on deposit accounts of $3,340,000 or 83.29% for the nine month period ended September 30, 2004 as compared to the sameperiod in 2003 and increased sales of $2,942,000 or 162.45% by Financial Supermarkets, Inc. (“FSI”), our nonbanksubsidiary, as compared to the same period in 2003. Service charges on deposits increased primarily as a result of the banks addinga new check program that allows customers to overdraw their account, up to a specific limit.  The increase in FSI's sales isattributed to the increase in the number of sales compared to the prior year due to the expansion of our sales efforts nationwideand the resale of supermarket bank units in space released by the Canadian Imperial Bank of Commerce.

*Other Expenses*

Other expenses increased by 19.48% or $4,617,000 for the nine month period endingSeptember 30, 2004 compared to the sameperiod in 2003 and increased 22.35% or $1,784,000 for the three monthperiod ending September 30, 2004 compared to the same period in 2003.  These increases are primarily attributable to anincrease in full time equivalent employees from 395 at the end of September 2003 to 429 at the end of September 2004. The increasein full time equivalent employees was due to the addition of two new supermarket banking centers, one new stand-alone branch and aloan production office during the later part of 2003 as well as the overall growth of the Company’s banking operations. Inaddition, incentive commissions related to sales activity at FSI have increased due to increased sales over the previous year.These increases caused salaries and benefits to increase by 18.62% or $2,410,000 for the nine month period ended September 30, 2004and 21.76% or $939,000 for the three month period ended September 30,2004, as compared to the same period in 2003.

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Also attributable to the two new banking centers and new stand-alone branch, equipment andoccupancy expenses were up by 8.87% or $351,000 for the nine month period ending September 30, 2004, and 15.77% or $208,000 for thethree month period ended September 30, 2004, as compared to the same period in 2003.

Other operating expenses increased by 27.27% or $1,856,000 for the nine month periodending September 30, 2004 as compared to the same period in 2003. The single largest item included in this increase is attributedto $499,000 of expenses and losses associated with the new check program started in 2004.  In addition, legal fees increased$191,000 or 107.91% as compared to the same period in 2003 due to legal services related to past due loans, other real estate ownedand the class action lawsuit described in Part II information Item 1 of this Quarterly Report on From 10-Q.  Dataprocessing expense increased $327,000 or 39.26% as compared to the same period in 2003 due to growth of thebanks and improvements in our technology platform.  Advertising and marketing increased $125,000 or 22.20% and travel expenseincreased $10,000 or 1.2% as compared to the same period in 2003. These increases are attributed to the increased marketing andsales activity of FSI.  Losses related to customer forgeries and fraud increased $60,000 or 36.36 % as compared to the sameperiod in 2003.  Director and advisory director fees increased by $96,000 or 34.16% as compared to the same period in 2003.The Board of Directors added advisory directors for most of the counties that we have significant banking activity.  Ourpostage expense increased $80,000 or 19.61%, and our printing and office supplies increased $80,000 or 12.42% as compared to thesame period in 2003.  These increases are attributed to the growth in banking operations and increasedactivity. 

For the three month period ended September 30, 2004, other operating expenses increased27.13% or $637,000 compared to the same period in 2003.  Data processing expenseincreased $128,000 or 41.29% as compared to the same period in 2003 due to growth of the banks and improvements in our technologyplatform.  Advertising and marketing increased $28,000 or 14.07% as compared to the same period in 2003. This increase wasattributed to the increased marketing and sales activity of FSI.  Director and advisory director fees increased $40,000 or42.55% as compared to the same period in 2003.  Our printing and office supplies increased $28,000 or 12.90% as compared tothe same period in 2003.  These increases are attributed to the growth in banking operations and increasedactivity.   

*Income Taxes*

We incurred income tax expenses of $1,118,000, which represents an effective rate of30.92%, for the three month period ended September 30, 2004, as compared to $437,000, which represents an effective tax rate of23.47%, for the same period in 2003.  In addition, we incurred income tax expenses of $2,676,000, which represents aneffective rate of 29.52%, for the nine month period ended September 30, 2004, as compared to $1,061,000, which represents aneffective tax rate of 20.73%, for the same period in 2003.  These effective rate increases are due to a larger percentage ofour income being fully taxable as a result of our increased taxable income.

 

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We are not aware of any other known trends, events or uncertainties, that will have orthat are reasonably likely to have a material effect on its liquidity, capital resources or operations. Weare also not aware of any current recommendations by the regulatory authorities which, if they wereimplemented, would have such an effect.
**B. Asset Quality**
*Provision for Loan Loss*

The provision for loan losses was $2,537,000 and $1,686,000 for the first nine months of2004 and 2003, respectively.  For the three month period ended September 30, 2004, and 2003, respectively, the provision forloan losses was $579,000 and $546,000.  Approximately 50% of these increases was due to loan growth.  The reserve atSeptember 30, 2004 represented 244% of non-accrual loans while the reserve at September 30, 2003 represented 476% of non-accrualloans. Non accrual loans have increased from $1,658,000 at September 30, 2003 to $3,773,000 as of September 30, 2004.  Theincrease in non-accrual loans was mostly due to the addition of one loan of $2.3 million.  Past due loans greater than 90 daysand accruing interest have increased from $2,270,000 in 2003 to $2,539,000 in 2004.

Repossessed real estate owned by the bank decreased 20.18% from $5,272,000 at December 31,2003, to $4,208,000 in September 2004. Other real estate is carried in the books at the lesser of cost or fair market value, lessestimated costs to sell, with no significant losses anticipated.

Management has reviewed the non-accrual loans individually and determined that thelikelihood of any significant loss of principal is mitigated due to the value of the collateral securingthese loans. As of September 30, 2004, non-accrual loans and other real estate owned totaled approximately$7,981,000 as compared to $7,486,000 as of September 30, 2003. The ratio of the loan loss reserve balance tothe total loan balance at September 30, 2004 was 1.49% as compared to 1.39% at December 31, 2003.   As of September 30,2004, management considered our allowance for loan losses adequate to cover any anticipated losses.

*Non-accrual, Past Due and Restructured Debt*

The following table, dollars in thousands,is a summary of nonaccrual, past due and restructured debt

September 30, 2004
 
**Non-accrual**
**Past Due**
**Restructured** 
**Loans**
**90 days**
**Debt**  
**Still accruing**     
Commercial Loans

$  707 
$   341 
$239 
Real Estate Loans

2,846 
1,733 
628 
Consumer Loans
 
220  
459  
26        
Total
 
$3,773
  
$2,533
  
$893
     
September 30, 2003
 
**Non-accrual**
**Past Due**
**Restructured** 
**Loans**
**90 days**
**Debt**  
**Still accruing**     
Commercial Loans

$  249 
$    508 
$  14 
Real Estate Loans

1,287 
1,216 
889 
Consumer Loans
 
122
  
546
  
-
        
Total
 
$1,658
  
$2,270
  
$903
 
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The Banks’ policy is to discontinue the accrual of interest income when, in theopinion of management, collection of such interest becomes doubtful. This status is accorded such interest when (1) there is asignificant deterioration in the financial condition of the borrower and full repayment of principal and interest is not expectedand (2) the principal or interest is more than ninety days past due, unless the loan is both well-secured and in the process ofcollection.  Accrual of interest on such loans is resumed, in management’s judgment, when the collection of interest andprincipal become probable.  Loans classified for regulatory purposes as substandard or special mention that have not beenincluded in the table above do not represent or result from trends or uncertainties which management reasonably expects willmaterially effect future operating results, liquidity or capital resources. These classified loans do not represent materialcredits about which management is aware and which causes management to have serious doubts as to the ability of such borrowers tocomply with the loan repayment terms.

*Allowance for Loan Loss*

The following table, dollars in thousands, furnishes information on the loan loss reservefor the current nine month reporting period and the same period for 2003.
 
2004
 
2003
 
(Dollars in Thousands)     
Beginning Balance

$  7,561  
$  7,742     
Less Charge Offs:
   
     Commercial Loans

(244) 
(263)
     Real Estate Loans

(321) 
(906)
     Consumer Loans

(614)
 
(537)
     
(1,179)
 
(1,706)    
Plus Recoveries:
   
     Commercial Loans

56  
18 
     Real Estate Loans

52  
17 
     Consumer Loans

172 
 
139 
     
280 
 
174 
    
Net Charge-offs

(899) 
(1,532)    
Provision for loan loss

2,537 
 
1,686 

Ending Balance

$ 9,199 

 
$  7,896 

Our Company operates in three distinct markets,northeast Georgia,midwest Georgia and mideast Alabama. Each of these markets has seen a modest increase in unemployment and bankruptcyfilings.

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ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed only to U.S. dollar interest rate changes and accordingly, theCompany manages exposure by considering the possible changes in the net interest margin. The Company does not have any tradinginstruments nor does it classify any portion of the investment portfolio as held for trading. The Company does not engage in anyhedging activities or enter into any derivative instruments other than mortgage backed securities, which are commonly pass throughsecurities. Finally, the Company has no exposure to foreign currency exchange rate risk, commodity price risk, and other marketrisks.

Interest rates play a major part in the net interest income of a financial institution.The sensitivity to rate changes is known as “interest rate risk”. The repricing of interest earning assets andinterest-bearing liabilities can influence the changes in net interest income. As part of the Company’s asset/liabilitymanagement program, the timing of repriced assets and liabilities is referred to as Gap management.

The Company’s objective in Gap management is to manage assets and liabilities tomaintain satisfactory and consistent profitability. Officers of each bank are charged with monitoring policies and proceduresdesigned to ensure an acceptable asset/liability mix. Management’s philosophy is to support asset growth primarily throughgrowth of core deposits within the banks’ market areas.

The Company’s asset/liability mix is monitored regularly witha report reflecting the interest rate sensitive assets and interest rate sensitive liabilities that is prepared and presented tothe Board of Directors of each bank on at least a quarterly basis. Management’s objective is to monitorinterest rate sensitive assets and liabilities so as to minimize the impact on earnings of substantialfluctuations in interest rates. An asset or liability is considered to be interest rate-sensitive if it will reprice or maturewithin the time period analyzed, usually one year or less. The interest rate-sensitivity gap is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or repricewithin the relevant period. A gap is considered positive when the amount of interest rate-­sensitiveassets exceeds the amount of interest rate-sensitive liabilities. A gap is considered negative when theamount of interest rate­-sensitive liabilities exceeds the interest rate-sensitive assets. During aperiod of rising interest rates, a negative gap would tend to adversely affect net interest income,while a positive gap would tend to result in an increase in net interest income.Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income,while a positive gap would tend to adversely affect net interest income. If the Company’s assets and liabilities were equallyflexible and moved concurrently, the impact of any increase or decrease in interest rates on net interest income would beminimal.

A simple interest rate “gap” analysis by itself may not be an accurateindicator of how net interest income will be affected by changes in interest rates. For example, whileinterest-bearing transaction accounts are by their terms immediately repricable, competitive conditions andother circumstances usually preclude repricing such deposits proportionately with changes in rates affecting interest-earningassets.

Accordingly, the Company also evaluates how changes in interest rates impacts therepayment of particular assets and liabilities. Income associated with interest-earning assets and costs associated withinterest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, the magnitude and duration ofchanges in interest rates may significantly affect net interest income. For example, although certain assetsand liabilities may have similar maturities or periods of repricing, they may react in different degrees tochanges in market interest rates. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types may lag behind changes ingeneral market rates. In addition, certain assets have features (generally referred to as “interest rate caps andfloors”) which limit changes in interest rates. Also, prepayments and early withdrawal levels could deviate significantlyfrom those reflected in the interest rate gap. The Company prepares a report monthly that measures the potential of thebanks’ impact on net interest margin by rising or falling rates. This report is reviewed monthly by the Asset/Liability Committee and quarterly by each Board of Directors.

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At September 30, 2004, the Company’s cumulative interest rate sensitivity gap ratiofor the next twelve months was 105.28% which was within its targeted range of 80% to 120%.

Gap management alone is not enough to properly manage interest rate sensitivity becauseinterest rates do not respond at the same speed or at the same level to market rate changes. For example, savings and money marketrates are more stable than loans tied to a “Prime” rate and thus respond with less volatility to a market rate change.Thus, the Company uses a simulation model to monitor changes in net interest income due to changes in market rates. The model ofrising, falling and stable interest rate scenarios allows management to monitor and adjust interest rate sensitivity to minimizethe impact of market rate swings. The analysis of impact on net interest margins as well as market value of equity over a twelvemonth period is subjected to a 200 basis point increase and decrease in rate. The September 2004 model reflects an increase of1.65% in net interest income and a 5.83% decrease in market value equity for a 200 basis point increase in rates. The same modelshows a  1.72% decrease in net interest income and a 2.29% increase in market value equity for a 200 basis point decrease inrates. The Company’s policy is to allow no more than +-8% change in net interest income and no more than +-25% change inmarket value equity for these scenarios. Therefore, the Company is within its policy guidelines.

ITEM4.          CONTROLS & PROCEDURES

Our management, including the chief executive and chief financial officers, supervised andparticipated in an evaluation of our disclosure controls and procedures (as defined in federal securities rules) as of the end ofthe period covered by this report. Based on, and as of the date of, that evaluation, our CEO and CFO have concluded that ourdisclosure controls and procedures are effective in accumulating and communicating information to our management, including our CEOand CFO, as appropriate to allow timely decisions regarding required disclosures of that information under the Securities andExchange Commission rules and forms and that our disclosure controls and procedures are designed to ensure that the information weare required to disclose in reports that we file or submit under all applicable federal securities laws isrecorded, processed, summarized and reported within the time periods specified in the Securities and ExchangeCommission rules and forms.

There were no significant changes in our internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of their evaluation.
 
 

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PART II – OTHER INFORMATION

 

**ITEM1.     Legal Proceedings**

The Company was named in a lawsuit in the Superior Court of Greene County, Georgia on May18, 2004.  The case was removed to the Middle District of Georgia in June 2004.  The plaintiff in the case is seekingclass action certification for owners of self-directed individual retirement accounts at the Company’s Georgia banksubsidiaries that included investments in securities issued by Stewart Finance Company, National Finance Company or D&EAcquisitions, Inc.  These issuing companies are bankrupt and have defaulted on the securities.  The plaintiff claims thatthe Company aided and abetted and conspired with the issuing companies in issuing unregistered securities, committing acts inviolation of the Georgia racketeering statute and in committing common law fraud.  Although the plaintiff has not made aspecific claim for damages, he is claiming that the proposed class is entitled to the amount of the lost investment in thesecurities and treble and punitive damages.  The Company has denied liability in this case and does not believe the case willhave a material adverse effect on the Company.

**ITEM 2.    Issuer Purchases of Equity Securities**

Issuer Purchases of Equity Securities in the quarter ended September 30,2004:

**Period**

**Total Number ofShares Purchased (1)**
**       **
**Average PricePaid Per Share**
**        **
**Total Number ofSharesPurchased asPart of PubliclyAnnouncedPlans orPrograms**
**        **
**MaximumNumber ofShares that MayYet BePurchasedUnder the PlansorPrograms**

July 1-31

-
 
-
 
-
 
-

August 1-31

-
 
-
 
-
 
-

September 1-30

1,347
 
$45.06
 
-
 
-

Total

1,347
 
$45.06
 
-
 
-

________________(1)           The shares purchasedduring the third quarter of 2004 were purchased as treasury stock.

**ITEM 3.    Defaults upon Senior Securities - None**

**ITEM 4.    Submission of matters to a vote of Security Holders - None**

**ITEM 5.     Other Information  - None**

**ITEM6.      EXHIBITS**

31.1 and 31.2 - Rule 13a-15(e) and 15d-15(e) Certifications

32 - Certification of Chief Executive Officer and Chief Financial Officer, Pursuant to 18U.S.C. Section 1350,       as Adopted Pursuant To Section 906 of the Sarbanes- Oxley Act of 2002.

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**SIGNATURES**

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
COMMUNITY BANKSHARES, INC.

 

 

DATE: November  12, 2004

BY:  /s/ Harry L. StephensHarry L. Stephens, Executive Vice Presidentand Chief Financial Officer