##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q (Mark One)  [X]
    Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934For the Quarter ended June 30, 2004  [   ]
    Transition report pursuant to Section 13 or 15(d)) of the Securities Exchange Act of 1934For Transition Period from ________________ to _______________
Commission File Number 000-30447   VALLEY COMMUNITY BANCSHARES, INC.  Washington
(State or other jurisdiction
of incorporation or organization)
    
    91-1913479
(I.R.S. Employer Identification No.)1307 East Main, Puyallup, Washington
(Address of principal executive offices)
    
    98372
(Zip Code)
 (253) 848-2316
(Registrants telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes [X] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act.) Yes [  ] No [X] The number of shares of the issuers Common Stock, $1.00 par value,
outstanding at August 3, 2004 was 1,238,083.




---



VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY
INDEX TO QUARTERLY REPORT ON FORM 10-Q  
 PagePART I FINANCIAL INFORMATIONItem 1.
    
    Financial StatementsCondensed Consolidated Balance Sheet June 30, 2004 and December 31, 2003
    
    
    1Condensed Consolidated Statement of Income  Three Months and Six Months Ended June 30, 2004 and 2003
    
    
    2Condensed Consolidated Statement of Cash Flows  Three Months and Six Months Ended June 30, 2004 and 2003
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition And Results of Operation
    
    
    8Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    19Item 4.
    
    Controls and Procedures
    
    
    19FORWARD-LOOKING STATEMENTS
    
    
    20PART II OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    20Item 2.
    
    Changes in Securities and Use of Proceeds
    
    
    20Item 3.
    
    Defaults upon Senior Securities
    
    
    20Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    20Item 5.
    
    Other Information
    
    
    20Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    21Signatures
    
    
    22Certifications
    
    
    23EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32
  i




---



##### Table of Contents



Item 1. FINANCIAL STATEMENTS VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY 
 CONDENSED CONSOLIDATED BALANCE SHEET
(unaudited)
(dollars in thousands) June 30,
    
    December 31,2004
    
    2003ASSETSCash and due from banks
    
    $
    6,047
    
    
    $
    5,199Interest-bearing deposits with banks
    
    
    8,960
    
    
    
    8,503Federal funds sold
    
    
    6,069
    
    
    
    9,765Securities available-for-sale
    
    
    34,002
    
    
    
    38,560Federal Home Loan Bank stock
    
    
    375
    
    
    
    37255,453
    
    
    
    62,399Loans
    
    
    118,878
    
    
    
    114,261Less allowance for loan losses
    
    
    1,388
    
    
    
    1,388Loans, net
    
    
    117,490
    
    
    
    112,873Accrued interest receivable
    
    
    590
    
    
    
    681Premises and equipment, net
    
    
    5,790
    
    
    
    5,850Other assets
    
    
    572
    
    
    
    417Total assets
    
    $
    179,895
    
    
    $
    182,220LIABILITIESDepositsNoninterest-bearing
    
    $
    35,611
    
    
    $
    34,675Interest-bearing
    
    
    119,616
    
    
    
    122,556Total deposits
    
    
    155,227
    
    
    
    157,231Other borrowed funds
    
    
    534
    
    
    
    580Accrued interest payable
    
    
    128
    
    
    
    145Other liabilities
    
    
    516
    
    
    
    611Total liabilities
    
    
    156,405
    
    
    
    158,567STOCKHOLDERS EQUITYCommon stock, par value $1 per share; 5,000,000 shares authorized; 1,238,083 and 1,175,267
shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively.
    
    
    1,238
    
    
    
    1,175Additional paid-in capital
    
    
    18,760
    
    
    
    16,903Retained earnings
    
    
    3,540
    
    
    
    5,204Accumulated other comprehensive income (loss), net of tax
    
    
    (48
    )
    
    
    371Total stockholders equity
    
    
    23,490
    
    
    
    23,653Total liabilities and stockholders equity
    
    $
    179,895
    
    
    $
    182,220
 The accompanying notes are an integral part of these financial statements -1-




---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY 
 CONDENSED CONSOLIDATED STATEMENT OF INCOME
(unaudited)
(dollars in thousands, except for per share amounts) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003INTEREST INCOMEInterest and fees on loans
    
    $
    1,873
    
    
    $
    1,942
    
    
    $
    3,716
    
    
    $
    3,846Interest on federal funds sold and deposits in banks
    
    
    64
    
    
    
    94
    
    
    
    129
    
    
    
    186Interest on securities
    
    
    257
    
    
    
    262
    
    
    
    542
    
    
    
    555Total interest income
    
    
    2,194
    
    
    
    2,298
    
    
    
    4,387
    
    
    
    4,587INTEREST EXPENSEInterest on deposits
    
    
    231
    
    
    
    330
    
    
    
    451
    
    
    
    707Interest on federal funds and other short-term borrowings
    
    
    2
    
    
    
    1
    
    
    
    3
    
    
    
    3Total interest expense
    
    
    233
    
    
    
    331
    
    
    
    454
    
    
    
    710Net interest income
    
    
    1,961
    
    
    
    1,967
    
    
    
    3,933
    
    
    
    3,877PROVISION FOR LOAN LOSSESNet interest income after provision
for loan losses
    
    
    1,961
    
    
    
    1,967
    
    
    
    3,933
    
    
    
    3,877NONINTEREST INCOMEService charges
    
    
    102
    
    
    
    122
    
    
    
    207
    
    
    
    237Gain on sale of investment securities, net
    
    
    7
    
    
    
    
    
    
    
    49
    
    
    
    15Origination fees on mortgage loans brokered
    
    
    50
    
    
    
    77
    
    
    
    78
    
    
    
    201Other operating income
    
    
    96
    
    
    
    133
    
    
    
    197
    
    
    
    218Total noninterest income
    
    
    255
    
    
    
    332
    
    
    
    531
    
    
    
    671NONINTEREST EXPENSESalaries
    
    
    631
    
    
    
    630
    
    
    
    1,297
    
    
    
    1,311Employee benefits
    
    
    159
    
    
    
    163
    
    
    
    336
    
    
    
    339Occupancy
    
    
    145
    
    
    
    133
    
    
    
    285
    
    
    
    272Equipment
    
    
    121
    
    
    
    104
    
    
    
    236
    
    
    
    215Other operating expenses
    
    
    500
    
    
    
    500
    
    
    
    974
    
    
    
    997Total noninterest expense
    
    
    1,556
    
    
    
    1,530
    
    
    
    3,128
    
    
    
    3,134INCOME BEFORE INCOME TAX
    
    
    660
    
    
    
    769
    
    
    
    1,336
    
    
    
    1,414PROVISION FOR INCOME TAX
    
    
    206
    
    
    
    242
    
    
    
    414
    
    
    
    442NET INCOME
    
    $
    454
    
    
    $
    527
    
    
    $
    922
    
    
    $
    972EARNINGS PER SHAREBasic
    
    $
    0.37
    
    
    $
    0.43
    
    
    $
    0.75
    
    
    $
    0.79Diluted
    
    $
    0.36
    
    
    $
    0.43
    
    
    $
    0.74
    
    
    $
    0.79Weighted average shares outstanding
    
    
    1,238,083
    
    
    
    1,230,566
    
    
    
    1,237,180
    
    
    
    1,230,345Weighted average diluted shares outstanding
    
    
    1,246,818
    
    
    
    1,235,507
    
    
    
    1,246,061
    
    
    
    1,235,285
 The accompanying notes are an integral part of these financial statements -2-




---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY 
 CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
(dollars in thousands, except for per share amounts) Six Months EndedJune 30,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIESNet income
    
    $
    922
    
    
    $
    972Adjustments to reconcile net income to net cash from operating activities:Depreciation
    
    
    233
    
    
    
    229Deferred income tax
    
    
    (23
    )
    
    
    (7
    )Net amortization on securities
    
    
    142
    
    
    
    151FHLB stock dividends
    
    
    (7
    )
    
    
    (11
    )Gain on sale of securities available-for-sale
    
    
    (49
    )
    
    
    (15
    )Amortization of intangible assets
    
    
    19
    
    
    
    23Deferred gain on the sale of real estate
    
    
    
    
    
    
    211Amortization of deferred gain on sale of real estate
    
    
    
    
    
    
    (38
    )Changes in operating assets and liabilities:Decrease in accrued interest receivable
    
    
    91
    
    
    
    39Increase in accrued interest payable
    
    
    (17
    )
    
    
    (79
    )Decrease in other assets
    
    
    33
    
    
    
    3Decrease in other liabilities
    
    
    (73
    )
    
    
    (41
    )Net cash from operating activities
    
    
    1,271
    
    
    
    1,437Net decrease (increase) in federal funds sold
    
    
    3,696
    
    
    
    (1,914
    )Net decrease (increase) in interest-bearing deposits with banks
    
    
    (457
    )
    
    
    8,306Purchase of securities available-for-sale
    
    
    (5,684
    )
    
    
    (17,107
    )Proceeds from sales of securities available-for-sale
    
    
    2,579
    
    
    
    2,672Proceeds from maturities of securities available-for-sale
    
    
    6,935
    
    
    
    9,462Federal Home Loan Bank stock redeemed
    
    
    4
    
    
    
    37Net increase in loans
    
    
    (4,617
    )
    
    
    (4,842
    )Additions to premises and equipment
    
    
    (163
    )
    
    
    (80
    )Sale of real estate held for investment
    
    
    
    
    
    
    224Net cash from investing activities
    
    
    2,293
    
    
    
    (3,242
    )CASH FLOWS FROM FINANCING ACTIVITIESNet increase (decrease) in deposits
    
    
    (2,004
    )
    
    
    4,164Net increase (decrease) in other borrowed funds
    
    
    2
    
    
    
    (129
    )Payment on other borrowed money
    
    
    (48
    )
    
    
    (48
    )Cash dividends paid
    
    
    (715
    )
    
    
    (675
    )Stock options exercised
    
    
    49
    
    
    
    11Net cash from financing activities
    
    
    (2,716
    )
    
    
    3,323NET INCREASE IN CASH AND DUE FROM BANKS
    
    
    848
    
    
    
    1,518CASH AND DUE FROM BANKS, beginning of year
    
    
    5,199
    
    
    
    4,847CASH AND DUE FROM BANKS, at end of period
    
    $
    6,047
    
    
    $
    6,365SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATIONCash payments forInterest
    
    $
    471
    
    
    $
    789Income taxes
    
    
    464
    
    
    
    317SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIESUnrealized losses on securities available-for-sale
    
    $
    (635
    )
    
    $
    (64
    )Deferred tax on unrealized losses on securities available-for-sale
    
    
    216
    
    
    
    22Distribution of five percent stock dividend
    
    
    1,871
    
    
    
    1,389
 The accompanying notes are an integral part of these financial statements -3-




---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC.
AND SUBSIDIARY 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1  Description of Business and Basis of Presentation Description of Business Valley Community Bancshares, Inc. (the Company) is a Washington State bank
holding company headquartered in Puyallup, Washington. The Company conducts its
business primarily through its wholly owned bank subsidiary, Valley Bank.
Valley Bank is referred to as the Bank in this Form 10-Q. The Companys main office is located in Puyallup, Washington, which also serves
as the main office of the Bank. The Bank provides a full range of commercial
banking services to small and medium-sized businesses, professionals and other
individuals through eight banking offices located in Puyallup, Auburn, and
Kent, Washington, and their environs. The Bank also provides mortgage banking services to its customers through Puget
Sound Mortgage Brokers, a division of the Bank. The principal sources of the Companys revenue are (i) interest and fees on
loans; (ii) deposit service charges; (iii) merchant credit card processing
fees; (iv) interest bearing deposits with Bank; (v) interest on investments
(principally government securities) and (vi) origination fees on mortgage loans
brokered. The Banks lending activity consists of short-to-medium-term
commercial and consumer loans, including operating loans and lines of credit,
equipment loans, automobile loans, recreational vehicle and truck loans,
personal loans or lines of credit, home improvement loans and rehabilitation
loans. The Bank also offers cash management services, merchant credit card
processing, safe deposit boxes, wire transfers, direct deposit of payroll and
social security checks, automated teller machine access, and automatic drafts
for various accounts. Basis of Presentation The condensed consolidated financial statements have been prepared by the
Company, for the three months and six months ended June 30, 2004 and June 30,
2003, without audit by the Companys independent auditors. However, the
financial statements have been prepared in conformity with accounting
principles generally accepted in the United States of America for interim
financial information and with instructions to Form 10-Q and Article 10 of
Regulation S-X. In the opinion of the Companys management, all adjustments
consisting of normal recurring accruals necessary for a fair presentation of
the financial condition and results of operations for the interim periods
included herein have been made. The consolidated balance sheet of the Company
as of December 31, 2003 has been derived from the audited consolidated balance
sheet of the Company as of that date. The results of operations for the three
months and six months ended June 30, 2004, are not necessarily indicative of
the results to be anticipated for the year ending December 31, 2004. Certain information and note disclosures normally included in the Companys
annual financial statements prepared in accordance with accounting principles
generally accepted in the United States of America have been condensed or
omitted. Therefore, these consolidated financial statements and notes thereto
should be read in conjunction with a reading of the financial statements for
the year ended December 31, 2003 and notes thereto included in the Companys
Form 10-K filed with the Securities and Exchange Commission. Certain amounts in
the 2003 financial statements have been reclassified to conform to the 2004
presentation. Note 2  Stock Option Plan The Company accounts for the stock option plan under recognition and
measurement principles of APB Opinion No. 25, Accounting for Stock Issued to
Employees,and related Interpretations using the intrinsic value method. No
stock-based employee compensation cost is reflected in net income, as all
options granted under the plan had an exercise price equal to the market value
of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition method as provided under FASB Statement No.
123, Accounting for Stock-Based Compensation,to stock-based employee
compensation. -4-




---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC. Three Months Ended
    
    Six Months EndedStock Option Plan
    
    June 30,
    
    June 30,In thousands, except for per-share amounts
    
    2004
    
    2003
    
    2004
    
    2003Pro forma disclosures:Net income as reported
    
    $
    454
    
    
    $
    527
    
    
    $
    922
    
    
    $
    972Additional compensation for fair
value of stock options
    
    
    1
    
    
    
    (2
    )
    
    
    (5
    )
    
    
    (4
    )Pro forma net income
    
    $
    455
    
    
    $
    525
    
    
    $
    917
    
    
    $
    968Earnings per share:BasicAs reported
    
    $
    0.37
    
    
    $
    0.43
    
    
    $
    0.75
    
    
    $
    0.79Pro forma
    
    $
    0.37
    
    
    $
    0.43
    
    
    $
    0.74
    
    
    $
    0.79DilutedAs reported
    
    $
    0.36
    
    
    $
    0.43
    
    
    $
    0.74
    
    
    $
    0.79Pro forma
    
    $
    0.36
    
    
    $
    0.43
    
    
    $
    0.74
    
    
    $
    0.78
 Note 3 - Earnings per share Basic earnings per share amounts are computed based on the weighted average
number of shares outstanding during the period after giving retroactive effect
to stock dividends and stock splits. Diluted earnings per share amounts are
computed by determining the number of additional shares that are deemed
outstanding due to stock options under the treasury stock method. The following table sets forth the computation of basic and diluted earnings
per share for the three months and six months ended June 30, 2004 and 2003
(dollars in thousands, except per share amounts): VALLEY COMMUNITY BANCSHARES, INC. Three Months Ended
    
    Three Months EndedJune 30,
    
    June 30,Earnings Per Share
    
    2004
    
    2003
    
    2004
    
    2003NUMERATOR:Net income
    
    $
    454
    
    
    $
    527
    
    
    $
    922
    
    
    $
    972DENOMINATOR:Denominator for basic earnings per share:
    
    
    1,238,083
    
    
    
    1,230,566
    
    
    
    1,237,180
    
    
    
    1,230,345Weighted average sharesEffect of diluted securities  stock options
    
    
    8,735
    
    
    
    4,941
    
    
    
    8,881
    
    
    
    4,940Denominator for diluted earnings per share:Weighted average shares and assumed
conversion of diluted stock options
    
    
    1,246,818
    
    
    
    1,235,507
    
    
    
    1,246,061
    
    
    
    1,235,285Basic earnings per share
    
    $
    0.37
    
    
    $
    0.43
    
    
    $
    0.75
    
    
    $
    0.79Diluted earnings per share
    
    $
    0.36
    
    
    $
    0.43
    
    
    $
    0.74
    
    
    $
    0.79
 Note 4 Comprehensive Income Total comprehensive income, which includes net income and unrealized gains and
losses on the Companys available-for-sale securities, amounted to $(6,000) and
$543,000, for the three months ended June 30, 2004 and 2003, respectively.
Total comprehensive income, amounted to $503,000 and $930,000, for the six
months ended June 30, 2004 and 2003, respectively. -5-




---



##### Table of Contents



Note 5  Investment Securities Investment securities have been classified as available-for-sale in according
with managements intent. The carrying amount of securities and their estimated
fair values are as follows (in thousands): June 30, 2004 Securities Available-For-Sale Gross
    
    Gross Unrealized LossesAmortized
    
    Unrealized
    
    Less than
    
    12 Months
    
    FairCost
    
    Gains
    
    12 Months
    
    or More
    
    ValueU.S. Treasury and U.S. Government
corporations and agencies
    
    $
    10,887
    
    
    $
    8
    
    
    $
    128
    
    
    $
    
    
    
    $
    10,767State and political subdivisions
    
    
    8,186
    
    
    
    205
    
    
    
    80
    
    
    
    
    
    
    
    8,311Mortgage-backed securities
    
    
    15,001
    
    
    
    70
    
    
    
    141
    
    
    
    6
    
    
    
    14,924$
    34,074
    
    
    $
    283
    
    
    $
    349
    
    
    $
    6
    
    
    $
    34,002
 December 31, 2003 Securities Available-For-Sale Gross
    
    Gross Unrealized LossesAmortized
    
    Unrealized
    
    Less than
    
    12 Months
    
    FairCost
    
    Gains
    
    12 Months
    
    or More
    
    ValueU.S. Treasury and U.S. Government
corporations and agencies
    
    $
    13,614
    
    
    
    109
    
    
    $
    2
    
    
    $
    
    
    
    $
    13,721State and political subdivisions
    
    
    7,421
    
    
    
    361
    
    
    
    4
    
    
    
    
    
    
    
    7,778Mortgage-backed securities
    
    
    16,964
    
    
    
    151
    
    
    
    54
    
    
    
    
    
    
    
    17,061$
    37,999
    
    
    
    621
    
    
    $
    60
    
    
    $
    
    
    
    $
    38,560
 At June 30, 2004 and December 31, 2003, there were approximately 52 and 20
investment securities, respectively, that had fair values less than amortized
cost and therefore contains unrealized losses. The Company has evaluated these
securities and has determined that the decline in value is temporary and is
related to the change in market interest rates since purchase. The decline in
value is not related to any company or industry specific event. The Company
anticipates full recovery of amortized cost with respect to these securities at
maturity or sooner in the event of a more favorable market interest rate
environment. Note 6  Loans The major classifications of loans at June 30, 2004 and December 31, 2003 are
summarized as follows (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC. June 30,
    
    December 31,2004
    
    2003Loan Portfolio
(dollars in thousands)
    
    Amount
    
    Percent
    
    Amount
    
    PercentReal EstateConstruction
    
    $
    10,951
    
    
    
    9.2
    %
    
    $
    9,913
    
    
    
    8.7
    %Residential
    
    
    11,099
    
    
    
    9.3
    %
    
    
    12,095
    
    
    
    10.6
    %Commercial
    
    
    63,417
    
    
    
    53.3
    %
    
    
    65,114
    
    
    
    56.9
    %Commercial
    
    
    31,371
    
    
    
    26.4
    %
    
    
    24,872
    
    
    
    21.7
    %Consumer and other
    
    
    2,177
    
    
    
    1.8
    %
    
    
    2,409
    
    
    
    2.1
    %Lease financing
    
    
    52
    
    
    
    0.0
    %
    
    
    63
    
    
    
    0.0
    %Total loans
    
    
    119,067
    
    
    
    100.0
    %
    
    
    114,466
    
    
    
    100.0
    %Deferred loan fees
    
    
    (189
    )
    
    
    
    
    
    
    (205
    )Net loans
    
    $
    118,878
    
    
    
    
    
    
    $
    114,261
 -6-




---



##### Table of Contents



Note 7  Allowance for Loan Losses Management analyzes the loan portfolio to determine the adequacy of the
allowance for loan losses and the appropriate provision required to maintain an
adequate allowance. In assessing the adequacy of the allowance, management
reviews the size, quality and risks of loans in the portfolio and considers
factors such as specific known risks, past experience, the status and amount of
nonperforming assets and economic conditions. A specific percentage is
allocated to each major classification and not specifically reserved while
additional amounts are added for individual loans considered to have specific
loss potential. Loans identified as losses are charged-off. Based on total
allocations, the provision is recorded to maintain the allowance at a level
deemed appropriate by management. While management uses available information
to recognize losses on loans, there can be no assurance that future additions
to the allowance will not be necessary. The allowance for loan losses at June 30, 2004 and December 31, 2003, totaled
$1,388,000. Management believes that the allowance for loan losses at June 30,
2004 adequately reflects the risks in the loan portfolio. Various regulatory
agencies, as an integral part of their examination process, periodically review
the Banks allowance for loan losses. Such agencies may require the Bank to
recognize changes to the allowance based on their judgments of information
available to them at the time of their examination. The following table summarizes the activity in the allowance for loan losses
(dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC. Loan Loss Experience Three and six months June 30,2004
    
    2003Balance at beginning of period
    
    $
    1,388
    
    
    $
    1,388Charge-offsRecoveries:Net recoveries
    
    
    -0-
    
    
    
    -0-Additions charged to operationsBalance at end of period
    
    $
    1,388
    
    
    $
    1,388
 Note 8  Business Segment Information Beginning January 1999 and through December 2002, the Company owned two
community-banking institutions, Puyallup Valley Bank and Valley Bank. These
banks were managed at the subsidiary bank level. Each subsidiary bank had a
board of directors and an executive management team responsible for the
operation and performance of the respective subsidiary bank. On January 17, 2003, the Company merged the subsidiary banks into one community
bank named Valley Bank. In addition, the company consolidated its board of
directors and executive management team into a new organizational structure,
while converting separated banking systems into a single operation. As a result
of these system and organizational changes, the financial information that is
used by the chief operating decision maker in allocating resources and
assessing performance is only provided for one reportable segment for the three
months and six months ended June 30, 2004 and 2003. Note 9  Recent Accounting Pronouncements During the second quarter ended June 30, 2004 the Financial Accounting Standard
Board (FASB) did not issue any new accounting pronouncements. -7-




---



##### Table of Contents



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS Critical Accounting Policies The preparation of the Companys consolidated financial statements requires
management to make estimates and assumptions that affect amounts reported in
the consolidated financial statements. Changes in these estimates and
assumptions are considered reasonably possible and may have a material impact
on the consolidated financial statements and thus actual results could differ
from the amounts reported and disclosed herein. The Company considers the
allowance for loan loss a critical accounting policy subject to estimate. For a
full discussion of the Companys methodology of assessing the adequacy of the
allowance for loan losses, see Managements Discussion and Analysis of
Financial Condition and Results of Operation in the Companys 2003 Annual
Report on Form 10-K. Results of Operations The following table shows the various performance ratios for the Company for
the three months and six months ended June 30, 2004 and 2003, respectively: VALLEY COMMUNITY BANCSHARES, INC. Three Months Ended June 30,
    
    Six Months Ended June 30,Selected Financial Data 1
(dollars in thousands, except per share amounts)
    
    2004
    
    2003
    
    2004
    
    2003Financial PerformanceNet Income
    
    $
    454
    
    
    $
    527
    
    
    $
    922
    
    
    $
    972Average Assets
    
    
    178,738
    
    
    
    175,062
    
    
    
    178,652
    
    
    
    173,903Average Stockholders Equity
    
    
    23,620
    
    
    
    22,581
    
    
    
    23,564
    
    
    
    22,348Return on Assets (net income divided by average assets)
    
    
    1.02
    %
    
    
    1.21
    %
    
    
    1.04
    %
    
    
    1.13
    %Return on Equity (net income divided by average equity)
    
    
    7.73
    %
    
    
    9.36
    %
    
    
    7.87
    %
    
    
    8.77
    %Net Interest Margin (net interest income (tax adjusted)Divided by earning assets)
    
    
    4.83
    %
    
    
    4.94
    %
    
    
    4.83
    %
    
    
    4.93
    %Efficiency Ratio (noninterest expense divided by
noninterest income plus net interest income)
    
    
    70.22
    %
    
    
    66.55
    %
    
    
    70.07
    %
    
    
    68.91
    %Ratio of noninterest income to average assets
    
    
    3.50
    %
    
    
    3.51
    %
    
    
    3.52
    %
    
    
    3.63
    %
 The Company earned net income of $454,000 or $0.36 per diluted share for the
three months ended June 30, 2004, compared to net income of $527,000 or $0.43
per diluted share, for the three-months ended June 30, 2003, a decrease of 13.9
percent. The Companys return on average assets was 1.02 percent for the three
months ended June 30, 2004, compared to 1.21 percent for the three months ended
June 30, 2003. The decrease in net income for the three months ended June 30,
2004 was the result of decreases in net interest income and noninterest income
and a increase in noninterest expense. The Company earned net income of $922,000 or $0.74 per diluted share for the
six months ended June 30, 2004, compared to net income of $972,000 or $0.79 per
diluted share, for the six months ended June 30, 2003, a decrease of 5.1
percent. The Companys return on average assets was 1.04 percent for the six
months ended June 30, 2004, compared to 1.13 percent for the six months ended
June 30, 2003. The decrease in net income for the six months ended June 30,
2004 was the result of a decrease in noninterest income partially offset by a
increase in net interest income and a decrease in noninterest expense. The major factors impacting net income for the three months ended June 30, 2004
are as follows:  
    
    A continued decrease in net interest margin resulting from loan customers refinancing their fixed rate loans to a lower
interest rate.  
    
    Service charges on deposit accounts, primarily NSF fees, decreased in 2004.   1
    
    The computation of the ratios is based on the recorded assets and liabilities
after the effect of changes in market values of securities available for sale. -8-




---



##### Table of Contents




    
    Origination fees on mortgage loans brokered declined as residential loan customers slowed their mortgage refinancing
activity.  
    
    Noninterest expense increased largely as a result of higher equipment expense associated with the re-signage of the Bank.  
    
    Included in 2003 was the amortization of a deferred gain on the sale of real estate held for investment. The Company anticipates higher non-interest expenses during the third quarter
of 2004 when the implementation of the Banks internet banking product is
completed. The Company does not anticipate sufficient revenues to offset the
added costs of this product, as a result profitability is anticipated to be
negatively impacted on a go forward basis. Net Interest Income Net interest income is the most significant component contributing to net
income. It is the difference between interest earned on earning assets
(primarily loans and investments) and interest paid on interest bearing
liabilities (deposits and borrowings). The volume of and yields earned on
earning assets and the volume of and the rates paid on interest bearing
liabilities determine net interest income. Interest earned and interest paid is
also affected by general economic conditions, particularly changes in market
interest rates, and by government policies and the action of regulatory
authorities. The earnings on certain assets are exempt from federal income tax. It is
customary in the financial services industry to analyze changes in net interest
income on a tax equivalent (TE) basis. TE is a non-GAAP performance measure
used by management in operating the business, which management believes
provides investors with a more accurate picture of the interest margin for
comparative purposes. Under this method, nontaxable income from loans and
investments is adjusted to an amount, which would have been earned if such
income were subject to federal income tax. The discussion below presents an analysis based on tax equivalent amounts at a
34% tax rate. VALLEY COMMUNITY BANCSHARES, INC. Three Months Ended June 30,Net Interest Income, adjusted to a Tax Equivalent Basis
(dollars in thousands),
    
    2004
    
    2003
    
    Six Months Ended June 30,Interest income, as reported
    
    $
    2,194
    
    
    $
    2,298
    
    
    $
    4,387
    
    
    $
    4,587Effect of tax exempt income
    
    
    40
    
    
    
    34
    
    
    
    79
    
    
    
    66TE interest income
    
    
    2,234
    
    
    
    2,332
    
    
    
    4,466
    
    
    
    4,653Interest expense
    
    
    233
    
    
    
    331
    
    
    
    454
    
    
    
    710TE net interest income
    
    $
    2,001
    
    
    $
    2,001
    
    
    $
    4,012
    
    
    $
    3,943
 TE net interest income, divided by average earning assets is referred to as net
interest margin. For the three months ended June 30, 2004 the Companys net
interest margin was 4.83 percent compared to 4.94 percent for the three months
ended June 30, 2003. For the six months ended June 30, 2004 the Companys net
interest margin was 4.83 percent compared to 4.93 percent for the six months
ended June 30, 2003. TE interest income was $2,234,000 and $4,466,000 for the three months and six
months ended June 30, 2004, respectively compared to $2,332,000 and $4,653,000
for the three months and six months ended June 30, 2003, respectively. The
yield on interest-earning assets decreased to 5.39 percent for the three months
ended June 30, 2004 compared to 5.76 percent during the same period a year ago
and decreased to 5.37 percent for the six months ended June 30, 2004 compared
to 5.82 percent during the same period a year ago. The three month and six
month decrease was the result of a decrease in the yield earned on earning
assets partially offset by the additional earnings received on the increased
volume of earning assets. Interest expense was $233,000 and $454,000 for the three months and six months
ended June 30, 2004, respectively compared to $331,000 and $710,000 for the
three months and six months ended June 30, 2003, respectively. The cost of
funds decreased to 0.78 percent for the three months ended June 30, 2004
compared to 1.10 percent during the same period a year ago and decreased to
0.76 percent for the six months ended June 30, 2004 compared to 1.19 percent -9-




---



##### Table of Contents



during the same period a year ago. The three month and six month decrease was
due to a decrease in the Companys cost of funds resulting from low market
interest rates. Market interest rates continue to be at historical lows as a result of a slow
national and regional economy and because of an aggressively accommodating
Federal Reserve monetary policy beginning in 2001. The significant decrease in
market interest rates initially had a positive impact on the Companys net
interest margin as the Company experienced a greater reduction in deposit costs
in comparison to the reduction in the earnings on loans and investments.
However, during 2003 and 2004 market interest remained relatively low which
resulted in a greater reduction in the earnings on loans and investments as
compared to the reduction in deposit costs. The Companys current interest rate risk position suggests that in the event of
an increase in market interest rates, the Companys TE net interest income and
margin may decrease. The decrease results because the Company has a greater
amount of interest bearing liabilities subject to repricing when compared to
the repricing of interest earning assets. Any TE net interest income and margin
decrease is dependent on the timing and magnitude of any interest rate
increase. Therefore, the decrease may be somewhat offset because the rate paid
on deposits, with administered interest rates, generally do not increase as
rapidly as an account whose rates change with market interest rates. In the
event of continued low market interest rates, the Company anticipates a further
decrease in net interest margin as interest-earning assets reprice to the lower
interest rate levels while the ability to lower deposit rates is somewhat
limited. The following table sets forth information concerning the Companys average
balance and average interest rates earned or paid, interest rate spread and net
interest margin for the three months ended June 30, 2004 and 2003: VALLEY COMMUNITY BANCSHARES, INC. For the Three Months Ended June 30,2004
    
    2003Average
    
    Revenue/
    
    Yield/
    
    Average
    
    Revenue/
    
    Yield/AVERAGE BALANCES AND INTEREST RATES EARNED/PAID
(dollars in thousands)
    
    Balance
    
    Expense
    
    Rate
    
    Balance
    
    Expense
    
    RateASSETSInterest-earning assetsLoans (including fees) 1
    
    $
    117,915
    
    
    $
    1,873
    
    
    
    6.39
    %
    
    $
    110,307
    
    
    $
    1,942
    
    
    
    7.06
    %Investment securities 2 3
    
    
    34,938
    
    
    
    297
    
    
    
    3.42
    %
    
    
    33,398
    
    
    
    303
    
    
    
    3.64
    %Other earning assets
    
    
    13,894
    
    
    
    64
    
    
    
    1.85
    %
    
    
    18,712
    
    
    
    94
    
    
    
    2.01
    %Total Interest-earning assets
    
    
    166,747
    
    
    
    2,234
    
    
    
    5.39
    %
    
    
    162,417
    
    
    
    2,332
    
    
    
    5.76
    %Total noninterest-earning assets
    
    
    11,991
    
    
    
    
    
    
    
    
    
    
    
    12,645TOTAL ASSETS
    
    $
    178,738
    
    
    
    
    
    
    
    
    
    
    $
    175,062Interest-bearing liabilitiesDeposits
    
    $
    118,725
    
    
    $
    231
    
    
    
    0.78
    %
    
    $
    119,970
    
    
    $
    330
    
    
    
    1.10
    %Other borrowed funds
    
    
    797
    
    
    
    2
    
    
    
    1.01
    %
    
    
    460
    
    
    
    1
    
    
    
    0.87
    %Total Interest-bearing liabilities
    
    
    119,522
    
    
    
    233
    
    
    
    0.78
    %
    
    
    120,430
    
    
    
    331
    
    
    
    1.10
    %Noninterest-bearing liabilities
    
    
    35,596
    
    
    
    
    
    
    
    
    
    
    
    32,051Stockholders equity
    
    
    23,620
    
    
    
    
    
    
    
    
    
    
    
    22,581TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    178,738
    
    
    
    
    
    
    
    
    
    
    $
    175,062Net interest spread
    
    
    
    
    
    $
    2,001
    
    
    
    4.60
    %
    
    
    
    
    
    $
    2,001
    
    
    
    4.65
    %Margin AnalysisTE interest income/earning assets
    
    
    
    
    
    $
    2,234
    
    
    
    5.39
    %
    
    
    
    
    
    $
    2,332
    
    
    
    5.76
    %Interest expense/earning assets
    
    
    
    
    
    
    233
    
    
    
    0.56
    %
    
    
    
    
    
    
    331
    
    
    
    0.82
    %Net interest margin
    
    
    
    
    
    $
    2,001
    
    
    
    4.83
    %
    
    
    
    
    
    $
    2,001
    
    
    
    4.94
    %
 The following table sets forth information concerning the Companys average
balance and average interest rates earned or paid, interest rate spread and net
interest margin for the six months ended June 30, 2004 and 2003:   1
    
    Average loan balance includes nonaccrual loans, if any. Interest income on
nonaccrual loans has been included.2
    
    Tax-exempt income has been adjusted to a tax-equivalent basis using an
incremental rate of 34%.3
    
    The yield on investment securities is calculated using historical cost basis. -10-




---



##### Table of Contents



VALLEY COMMUNITY BANCSHARES, INC. For the Six Months Ended June 30,2004
    
    2003Average
    
    Revenue/
    
    Yield/
    
    Average
    
    Revenue/
    
    Yield/AVERAGE BALANCES AND INTEREST RATES EARNED/PAID
(dollars in thousands)
    
    Balance
    
    Expense
    
    Rate
    
    Balance
    
    Expense
    
    RateASSETSInterest-earning assetsLoans
(including fees) 1
    
    $
    116,623
    
    
    $
    3,716
    
    
    
    6.41
    %
    
    $
    108,616
    
    
    $
    3,846
    
    
    
    7.14
    %Investment
securities 2 3
    
    
    36,018
    
    
    
    621
    
    
    
    3.47
    %
    
    
    32,517
    
    
    
    621
    
    
    
    3.85
    %Other earning assets
    
    
    14,242
    
    
    
    129
    
    
    
    1.82
    %
    
    
    20,158
    
    
    
    186
    
    
    
    1.86
    %Total Interest-earning assets
    
    
    166,883
    
    
    
    4,466
    
    
    
    5.37
    %
    
    
    161,291
    
    
    
    4,653
    
    
    
    5.82
    %Total noninterest-earning assets
    
    
    11,769
    
    
    
    
    
    
    
    
    
    
    
    12,612TOTAL ASSETS
    
    $
    178,652
    
    
    
    
    
    
    
    
    
    
    $
    173,903Interest-bearing liabilitiesDeposits
    
    $
    119,395
    
    
    $
    451
    
    
    
    0.76
    %
    
    $
    119,569
    
    
    $
    707
    
    
    
    1.19
    %Other borrowed funds
    
    
    638
    
    
    
    3
    
    
    
    0.95
    %
    
    
    472
    
    
    
    3
    
    
    
    1.28
    %Total Interest-bearing liabilities
    
    
    120,033
    
    
    
    454
    
    
    
    0.76
    %
    
    
    120,041
    
    
    
    710
    
    
    
    1.19
    %Noninterest-bearing liabilities
    
    
    35,055
    
    
    
    
    
    
    
    
    
    
    
    31,514Stockholders equity
    
    
    23,564
    
    
    
    
    
    
    
    
    
    
    
    22,348TOTAL LIABILITIES AND
STOCKHOLDERS EQUITY
    
    $
    178,652
    
    
    
    
    
    
    
    
    
    
    $
    173,903Net interest spread
    
    
    
    
    
    $
    4,012
    
    
    
    4.61
    %
    
    
    
    
    
    $
    3,943
    
    
    
    4.63
    %Margin AnalysisTE interest income/earning assets
    
    
    
    
    
    $
    4,466
    
    
    
    5.38
    %
    
    
    
    
    
    $
    4,653
    
    
    
    5.82
    %Interest expense/earning assets
    
    
    
    
    
    
    454
    
    
    
    0.55
    %
    
    
    
    
    
    
    710
    
    
    
    0.89
    %Net interest margin
    
    
    
    
    
    $
    4,012
    
    
    
    4.83
    %
    
    
    
    
    
    $
    3,943
    
    
    
    4.93
    %
   1
    
    Average loan balance includes nonaccrual loans, if any. Interest income on
nonaccrual loans has been included.2
    
    Tax-exempt income has been adjusted to a tax-equivalent basis using an
incremental rate of 34%.3
    
    The yield on investment securities is calculated using historical cost basis. -11-




---



##### Table of Contents



The following table sets forth information concerning the Companys change in
TE net interest income for the period that are attributable to changes in
interest rate and changes in volume for the three months and six month ended
June 30, 2004 compared to the three months and six months ended June 30, 2003: VALLEY COMMUNITY
BANCSHARES, INC. 2004 Compared to 2003Volume/Rate Analysis 1  For the Three Months ended June 30,
(dollars in thousands)
    
    Volume
    
    Rate
    
    NetTE Interest incomeLoans
(including fees) 2
    
    $
    126
    
    
    $
    (195
    )
    
    $
    (69
    )Investment
securities 3
    
    
    13
    
    
    
    (12
    )
    
    
    1Other earning assets
    
    
    (32
    )
    
    
    2
    
    
    
    (30
    )107
    
    
    
    (205
    )
    
    
    (98
    )Interest-bearing liabilitiesTotal deposits
    
    
    (3
    )
    
    
    (96
    )
    
    
    (99
    )Other borrowed funds
    
    
    1
    
    
    
    
    
    
    
    1(2
    )
    
    
    (96
    )
    
    
    (98
    )$
    109
    
    
    $
    (109
    )
    
    $
    0
 VALLEY COMMUNITY
BANCSHARES, INC. 2004 Compared to 2003Volume/Rate Analysis 1  For the Six Months ended June 30,
(dollars in thousands)
    
    Volume
    
    Rate
    
    NetTE Interest incomeLoans
(including fees) 2
    
    $
    277
    
    
    $
    (407
    )
    
    $
    (130
    )Investment
securities 3
    
    
    64
    
    
    
    (64
    )Other earning assets
    
    
    (76
    )
    
    
    19
    
    
    
    (57
    )265
    
    
    
    (452
    )
    
    
    (187
    )Interest-bearing liabilitiesTotal deposits
    
    
    (1
    )
    
    
    (255
    )
    
    
    (256
    )Other borrowed funds
    
    
    1
    
    
    
    (1
    )0
    
    
    
    (256
    )
    
    
    (256
    )$
    265
    
    
    $
    (196
    )
    
    $
    69
    1
    
    The change in interest due to both volume and yield/rate has been allocated
to change due to volume and change due to yield/rate in proportion to the
absolute value of the change in each.2
    
    Balances of nonaccrual loans, if any, and related income recognized have been
included for computational purposes.3
    
    Tax-exempt income has been converted to a tax-equivalent basis using an
incremental rate of 34%. -12-




---



##### Table of Contents



Provision for loan losses Provisions for loan losses reduce net interest income. The Company provided $0
for loan losses for the three months and six months ended June 30, 2004 and
2003. Management believes the amount of the allowance for loan losses to be adequate
to absorb losses in the current portfolio. This belief is based upon
managements continuing evaluation of inherent risks in the current loan
portfolio, current levels of classified assets, and economic factors. The
Company will continue to monitor the allowance and make future adjustments to
the allowance as conditions dictate. For further discussion regarding the
allowance for loan losses, see the discussion on allowance for loan losses
under Risk Elements. Noninterest income and expense Net income is increased by noninterest income (primarily service charges,
origination fees on mortgage loans brokered, and other operating income) and
reduced by noninterest expenses (primarily salaries and employee benefits,
occupancy, equipment, and other operating expenses). Noninterest income was $255,000 and $531,000 for the three months and six
months ended June 30, 2004, respectively, compared to $332,000 and $671, 000
during the same respective periods a year ago. The decrease in noninterest income was the result of lower deposit service
charges (NSF fees), lower loan origination fees on mortgage loans brokered, and
a decrease in the amortization of deferred gain on the sale of real estate. The
decrease was partially offset by gains realized on the sale of investment
securities. The significant reduction in origination fees on mortgage loans
brokered is the result of residential loan customer reducing their demand for
mortgage refinance loans. The reduction in demand occurred because most
mortgage loan refinance customers refinanced their mortgages shortly after the
Federal Reserve lowered interest rates for the last time in 2003. Included in
2003 was the amortization of a portion of the $211,000 deferred gain realized
on the sale of real estate that the Bank previously held for investment
purpose. The following table sets forth information concerning the various components of
the Companys noninterest income for the three months and six months ended June
30, 2004 and 2003, respectively: VALLEY COMMUNITY BANCSHARES, INC. Three Months Ended June 30,
    
    Three Months Ended June 30,Noninterest Income
(dollars in thousands)
    
    2004
    
    2003
    
    2004
    
    2003Noninterest IncomeService charges
    
    $
    102
    
    
    $
    122
    
    
    $
    207
    
    
    $
    237Gain on sale of investment securities, net
    
    
    7
    
    
    
    
    
    
    
    49
    
    
    
    15Origination fees on mortgage loans brokered
    
    
    50
    
    
    
    77
    
    
    
    78
    
    
    
    201Mutual fund and insurance commissions
    
    
    4
    
    
    
    5
    
    
    
    25
    
    
    
    14Customer
check charges
    
    
    12
    
    
    
    5
    
    
    
    23
    
    
    
    8ATM and debit card
    
    
    38
    
    
    
    37
    
    
    
    69
    
    
    
    68Merchant bank card income, net
    
    
    20
    
    
    
    22
    
    
    
    32
    
    
    
    37Amortization of deferred gain on sale of real estate
    
    
    
    
    
    
    38
    
    
    
    
    
    
    
    38Other
    
    
    22
    
    
    
    26
    
    
    
    48
    
    
    
    53Total noninterest income
    
    $
    255
    
    
    $
    332
    
    
    $
    531
    
    
    $
    671
 Noninterest expense was $1,556,000 and $3,128,000 for the three months and six
months ended June 30, 2004, respectively, compared to $1,530,000 and $3,134,000
during the same respective periods a year ago. The decrease in noninterest expense was primarily the result of decreased
salaries and employee benefits and from lower professional fees. The 2004
decrease in salaries and benefits was the result of decreased commissions paid
to residential mortgage originators resulting from a drop in mortgage
refinancing activity. The decrease in professional fees in 2004 occurred
largely as a result of non-recurring merger related expenses (between Puyallup
Valley Bank and Valley Bank) that were paid in 2003. The percentage of
noninterest expense to average assets was 3.50 percent for the three months
ended June 30, 2004, compared to 3.51 percent during the same period last year -13-




---



##### Table of Contents



The following table sets forth information concerning the various components of
the Companys noninterest expense for the three months and six months ended
June 30, 2004 and 2003, respectively: VALLEY COMMUNITY BANCSHARES, INC. Three Months Ended June 30,
    
    Six Months Ended June 30,Noninterest Expense
(dollars in thousands)
    
    2004
    
    2003
    
    2004
    
    2003Noninterest ExpenseSalaries
    
    $
    631
    
    
    $
    630
    
    
    $
    1,297
    
    
    $
    1,311Employee benefits
    
    
    159
    
    
    
    163
    
    
    
    336
    
    
    
    339Occupancy
    
    
    145
    
    
    
    133
    
    
    
    285
    
    
    
    272Equipment
    
    
    121
    
    
    
    104
    
    
    
    236
    
    
    
    215Operating
    
    
    131
    
    
    
    139
    
    
    
    261
    
    
    
    278Software
    
    
    50
    
    
    
    52
    
    
    
    99
    
    
    
    105Advertising and marketing
    
    
    43
    
    
    
    44
    
    
    
    72
    
    
    
    75Professional
    
    
    54
    
    
    
    51
    
    
    
    114
    
    
    
    132Directors
    
    
    28
    
    
    
    28
    
    
    
    56
    
    
    
    56ATM and debit card
    
    
    39
    
    
    
    44
    
    
    
    74
    
    
    
    76Business and occupation tax
    
    
    37
    
    
    
    35
    
    
    
    68
    
    
    
    67Other
    
    
    118
    
    
    
    107
    
    
    
    230
    
    
    
    208Total noninterest expense
    
    $
    1,556
    
    
    $
    1,530
    
    
    $
    3,128
    
    
    $
    3,134
 The Companys efficiency ratio, which is the ratio of noninterest expense to
net interest income plus noninterest income, was 70.1 percent for the six
months ended June 30, 2004 compared to 68.9 percent for the six months ended
June 30, 2003. Provision for income tax The Companys provision for income tax is a significant reduction of operating
income. The provision for the three months ended June 30, 2004, was $206,000
compared to $242,000 for the three months ended June 30, 2003. The provision
for the six months ended June 30, 2004, was $414,000 compared to $442,000 for
the six months ended June 30, 2003. The provision represents an effective tax
rate of 31 percent during 2004 and 2003, respectively. The Companys marginal
tax rate is currently 34 percent. The difference between the Companys
effective and marginal tax rate is primarily related to investments made in
tax-exempt securities. Financial Condition The Companys total consolidated assets decreased 1.3 percent to $179.9 million
as of June 30, 2004, compared to $182.2 million as of December 31, 2003. Loans
increased and deposits decreased 4.0 percent and 1.3 percent, respectively
during the six months ended June 30, 2004. The increase in loans was funded
with maturities of investments securities. The decrease in deposits was funded
by a draw down of federal funds sold. Stockholders equity decreased as a
result of the payment of a 60¢ per share cash dividend to stockholders and a
decrease in other comprehensive income partially offset by earnings during the
six months ended June 30, 2004. Investment Portfolio The major classifications of investments at June 30, 2004 and December 31,
2003, are summarized in Note 4  Investment Securities in the Notes to
Condensed Consolidated Financial Statements. At June 30, 2004, the Company had $34.0 million of securities
available-for-sale, compared to $38.6 million as of December 31, 2003. The
investment portfolio decreased by $4.6 million during 2004, as a result of the
sale and maturity of approximately $9.5 million of securities and a $.6 million
decrease in the market value of securities partially offset by the purchase of
approximately $5.7 million in securities. The funds received by the decrease in
the securities portfolio were invested in more profitable loans. At June 30, 2004, all of the Companys securities were classified as
available-for-sale. Management believes that holding securities as
available-for-sale provides greater flexibility to respond to interest rate
changes and liquidity needs to fund loan growth. -14-




---



##### Table of Contents



Loan Portfolio The major classifications of loans at June 30, 2004 and December 31, 2003, are
summarized in Note 5  Loans in the Notes to Condensed Consolidated Financial
Statements. In addition to the major classifications of loans summarized in Note 5, the
Company has additional loan concentrations exceeding 10 percent of total loans
at June 30, 2004. They include loans to medical doctors and dentists in the
amount of approximately $25.8 million. Loans were $118.9 million as of June 30, 2004, compared to $114.3 million as of
December 31, 2003, an increase of 4.0 percent. The increase was primarily in
real estate construction and commercial loans, partially offset by a decrease
in real estate residential and real estate commercial loans. The percentage of
loans to total assets increased to 66.1 percent at June 30, 2004 compared to
62.7 percent at December 31, 2003. It continues to be managements intent to
grow the loan portfolio and to increase the percent of loans to assets, which
potentially could improve the Companys net interest margin. Risk Elements The following table sets forth information concerning the Companys
non-performing assets as of the dates indicated (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC. June 30,
    
    December 31,Non-performing Assets
    
    2004
    
    2003Non-performing assets:Nonaccrual loans
    
    $
    
    
    
    $
    10Loans 90 days or more past dueRestructured loans
    
    
    -0-
    
    
    
    10Other real estate ownedTotal non-performing assets
    
    $
    -0-
    
    
    $
    10
 As of June 30, 2004, the Company had no nonperforming assets, which include
nonaccrual loans, loans 90 days or more past due and still accruing interest,
and restructured loans. The Company had $10,000 in nonperforming assets as of
December 31, 2003. The accrual of interest on nonaccrual and other impaired loans is discontinued
at 90 days or when, in the opinion of management, the borrower may be unable to
meet payments as they become due. When interest accrual is discontinued, all
unpaid accrued interest is reversed. Interest income is subsequently recognized
only to the extent cash payments are received. Interest income on restructured
loans is recognized pursuant to the terms of the new loan agreement. Interest
income on other impaired loans is monitored and based upon the terms of the
underlying loan agreement. However, the recorded net investment in impaired
loans, including accrued interest, is limited to the present value of the
expected cash flows of the impaired loan or the observable fair market value of
the loans collateral. During the six months ended June 30, 2004, and 2003 there was one loan on
nonaccrual status. The gross income that would have been recorded for the six
months ended June 30, 2004, and 2003 if the nonaccrual loan had been current
and in accordance with its original term was insignificant. Interest recognized
on the loan for the year was insignificant. Potential Problem Loans At June 30, 2004 and December 31, 2003, the Company had potential problem loans
totaling approximately $3,451,000 and $2,349,000, respectively. The increase
occurred as a result of the Companys recent adverse classification of loan
credits within the Companys Auburn and Kent markets. The Company believes that
the loans are secured by sufficient collateral and guarantor financial strength
to repay the loans, although there can be no assurances given with respect to
potential losses in these credits. These loans are in addition to those
categorized as non-performing listed above. Although these loans are currently
classified as performing, management has information regarding credit weakness
inherent in the loans. -15-




---



##### Table of Contents



Summary of Loan Loss Experience Changes in the Allowance for Loan Losses The activity in the allowance for loan losses is summarized in Note 6 -
Allowance for Loan Losses in the Notes to Condensed Consolidated Financial
Statements. The allowance for loan losses is increased by charges to income and decreased
by charge-offs (net of recoveries), and established through a provision for
loan losses charged to expense. Loans are charged against the allowance for
credit losses when management believes that the collectibility of the principal
is unlikely. The allowance is an amount that management believes will be
adequate to absorb losses inherent in existing loans, commitments to extend
credit and standby letters of credit based on evaluations of collectibility and
prior loss experience of loans, commitments to extend credit and standby
letters of credit. The evaluations take into consideration such factors as
changes in the nature and volume of the portfolio, overall portfolio quality,
loan concentrations, specific problem loans, commitments, standby letters of
credit and current economic conditions that may affect the borrowers ability
to pay. The majority of the Companys loan portfolio consists of commercial loans and
single-family residential loans secured by real estate in the Puyallup and
Pierce County areas and also in the Auburn, Kent and King County areas. Real
estate prices in this market are stable at this time but may weaken as a result
of a slow local and national economy. Therefore, the ultimate collectibility of
a substantial portion of the Companys loan portfolio may be susceptible to
change as local market conditions change in the future. While management uses available information to recognize losses on loans,
further reductions in the carrying amounts of loans may be necessary based on
changes in local economic conditions. In addition, regulatory agencies, as an
integral part of their examination process, periodically review the estimated
losses on loans. Such agencies may require the Company to recognize additional
losses based on their judgment about information available to them at the time
of their examination. The following table sets forth other information regarding the allowance for
loan losses for the dates indicated (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC. Analysis of the Allowance for Loan LossesThree months ended
    
    Six months endedJune 30,
    
    June 30,Loan Loss Experience
    
    2004
    
    2003
    
    2004
    
    2003Average Allowance for Loan Losses
    
    $
    1,388
    
    
    $
    1,388
    
    
    $
    1,388
    
    
    $
    1,388Average Loans Outstanding
    
    $
    117,915
    
    
    $
    110,307
    
    
    $
    116,623
    
    
    $
    108,616Ratio of net charge-offs during the
period to average loans outstanding
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Ratio of average allowance for loan losses
to average loans outstanding
    
    
    1.18
    %
    
    
    1.26
    %
    
    
    1.19
    %
    
    
    1.28
    %
 The ratio of the allowance for loan losses as a percentage of loans decreased
to 1.17 percent at June 30, 2004 compared to 1.21 percent and 1.28 percent at
December 31, 2003 and June 30, 2003, respectively. The decrease in the ratio
during the past year was due to several factors including positive credit
performance within several of the Companys larger classified credits, no loan
charge-offs, slowing loan demand, the effects of an improving economy, and
managements current evaluation of the loan portfolio. Management continues to
emphasize credit quality and carefully monitors the loan portfolio especially
given the softness within the local economy. Any changes to the Companys loan
loss allowance will be considered as circumstances warrant. -16-




---



##### Table of Contents



Deposits The Companys primary source of funds is customer deposits. The Company
attempts to maintain a high percentage of noninterest-bearing deposits, which
are a low cost funding source. In addition, the Company offers a variety of
interest-bearing accounts designed to attract both short-term and longer-term
deposits from customers. Interest-bearing accounts earn interest at rates
established by management based on competitive market factors and the Companys
need for funds. The Company traditionally has not purchased brokered deposits
and does not intend to do so in the future. Deposits decreased 1.3 percent to $155.2 million as of June 30, 2004, compared
to $157.2 million as of December 31, 2003. The decrease occurred primarily in
money market deposits and time certificates of deposit less than $100,000
during the six months, partially offset by an increase in demand deposits and
in time certificates of deposit greater than $100,000. The following table sets forth the balances for each major category of deposit
by amount and percent during the period indicated: VALLEY COMMUNITY BANCSHARES, INC. Period ended,June 30, 2004
    
    December 31, 2003Deposits
(dollars in thousands)
    
    Amount
    
    Percent
    
    Amount
    
    PercentNoninterest bearing demand
    
    $
    35,611
    
    
    $
    22.9
    %
    
    $
    34,675
    
    
    
    22.1
    %Interest bearing demand
    
    
    24,528
    
    
    
    15.8
    %
    
    
    24,110
    
    
    
    15.3
    %Money market
    
    
    36,622
    
    
    
    23.6
    %
    
    
    39,018
    
    
    
    24.8
    %Savings
    
    
    16,106
    
    
    
    10.4
    %
    
    
    16,500
    
    
    
    10.5
    %Time certificates < $100,000
    
    
    20,057
    
    
    
    12.9
    %
    
    
    21,657
    
    
    
    13.8
    %Time certificates > $100,000
    
    
    22,303
    
    
    
    14.4
    %
    
    
    21,271
    
    
    
    13.5
    %$
    155,227
    
    
    $
    100.0
    %
    
    $
    157,231
    
    
    
    100.0
    %
 Liquidity and Capital Resources Management actively analyzes and manages the Companys liquidity position. The
objective of liquidity management is to ensure the availability of sufficient
cash flows to meet all financial commitments and to capitalize on opportunities
for profitable business expansion. Management believes that the Companys cash
flow will be sufficient to support its existing operations for the foreseeable
future. Cash flows from operations contribute to liquidity as well as proceeds from
maturities of securities and customer deposits. As indicated on the Companys
Condensed Consolidated Statement of Cash Flows, net cash from operating
activities for the six months ended June 30, 2004 contributed $1.3 to liquidity
compared to $1.4 million for the six months ended June 30, 2003. The majority
of the Companys funding comes from customer deposits within its operating
region. However, during the six months ended June 30, 2004 customer deposits
decreased $2.0 million compared to a 4.2 million increase for the six months
ended June 30, 2003. Other sources of liquidity include investments in federal
funds and interest-bearing deposits with banks and the Companys securities
portfolio. The Company generally maintains a ladder of securities that provides
prepayments and payments at maturity and a portfolio of available-for-sale
securities that could be converted to cash quickly. Proceeds from maturity and
sale of securities provided $9.5 million for the six months ended June 30, 2004
compared to $12.1 million for the three months ended June 30, 2003. At June 30, 2004, the Company held cash and due from banks, interest-bearing
deposits with banks, and federal funds sold of approximately $21.1 million. In
addition, at such date $34.0 million of the Companys investments were
classified as available for sale. The Bank has the capacity to borrow funds, up to ten percent of assets, from
the Federal Home Loan Bank of Seattle (FHLB) through pre-approved credit
lines as a secondary source of liquidity. However, these credit lines have
pledge requirements whereby the Bank must maintain unencumbered collateral with
a value at least equal to the outstanding balance. In addition to the FHLB
credit line, the Bank has committed line of credit agreements totaling
approximately $9.5 million from unaffiliated banks. At June 30, 2004, the Bank
had no advances outstanding to the FHLB or from unaffiliated banks. -17-




---



##### Table of Contents



The Bank has commitments to extend credit, which may have an impact on the
Companys liquidity position. Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition
established in the commitment. Commitments generally have fixed expiration
dates. Since some commitments are expected to expire without being drawn upon,
the total commitment amounts do not represent future cash requirements. The
Company experience suggests customers draw on approximately 75 percent of loan
commitments. Commitments to extend credit at June 30, 2004 and December 31,
2003 were $17.0 and $21.5 million, respectively. The Companys total stockholders equity decreased to $23.5 million at June 30,
2004 from $23.7 million at December 31, 2003. The decrease was the result of a
60¢ dividend per share paid to stockholders of record on December 31, 2003 and
unrealized losses recorded on securities available for sale, net of income tax,
partially offset by net income earned during the six months ended June 30,
2004. At June 30, 2004, stockholders equity was 13.1 percent of total assets,
compared to 13.0 percent at December 31, 2003. The market value of available-for-sale securities was less than book value at
June 30, 2004 and higher than book value at December 31, 2003. The decrease in
market value was primarily the result of higher market interest rates, which
resulted in unrealized losses in the investment portfolio. In the event market
interest rates continue to increase, the market value of the Companys
investment portfolio may continue to decrease. Because changes in the market
value of available-for-sale securities are a component of other comprehensive
income, within stockholders equity, a decrease in market value of securities
would negatively impact stockholders equity. At June 30, 2004, the Company
performed a simulation analysis of changes in the market value of the
investment portfolio given a 300 basis point increase in interest rates. The
analysis indicated a decrease in market value of approximately $1.5 million net
of federal income tax. Although stockholders equity would be reduced by
approximately 6.4 percent, the Company would still be well in excess of capital
adequacy requirements in the event the Company would be required to liquidate
these securities for unforeseen liquidity needs. Capital Adequacy Requirements The capital levels of the Company currently exceed applicable regulatory
guidelines, and the Bank is qualified as well-capitalized at June 30, 2004.
Management believes that under the current regulations the Bank will continue
to meet well-capitalized capital requirements in the foreseeable future.
However, events beyond the control of the Bank such as a downturn in the
economy where the Bank have most of their loans, could adversely affect future
earnings and, consequently, the ability of the Bank to meet future
well-capitalized capital requirements. For a full discussion of capital adequacy requirements, refer to the Companys
annual report on Form 10-K for the year ended December 31, 2003. The capital amounts and ratios for the Company and the Bank as of June 30,
2004, are presented in the following table (dollars in thousands): VALLEY COMMUNITY BANCSHARES, INC. To Be WellCapitalized UnderFor Capital
    
    
    
    
    
    Prompt CorrectiveCapital
    
    Actual
    
    
    
    
    
    Adequacy Purposes
    
    
    
    
    
    Action ProvisionsAs of June 30, 2004
    
    Amount
    
    Ratio
    
    
    
    
    
    Amount
    
    Ratio
    
    
    
    
    
    Amount
    
    RatioTotal Capital(to Risk-Weighted Assets)Consolidated
    
    $
    24,872
    
    
    
    18.4
    %
    
    
    3
    
    
    $
    10,787
    
    
    
    8.0
    %
    
    
    3
    
    
    $
    13,484
    
    
    
    10.0
    %Valley Bank
    
    $
    23,296
    
    
    
    17.3
    %
    
    
    3
    
    
    $
    10,787
    
    
    
    8.0
    %
    
    
    3
    
    
    $
    13,484
    
    
    
    10.0
    %Tier I Capital(to Risk-Weighted Assets)Consolidated
    
    $
    23,484
    
    
    
    17.4
    %
    
    
    3
    
    
    $
    5,394
    
    
    
    4.0
    %
    
    
    3
    
    
    $
    8,090
    
    
    
    6.0
    %Valley Bank
    
    $
    21,908
    
    
    
    16.2
    %
    
    
    3
    
    
    $
    5,394
    
    
    
    4.0
    %
    
    
    3
    
    
    $
    8,090
    
    
    
    6.0
    %Tier I Capital(to Average Assets)Consolidated
    
    $
    23,484
    
    
    
    13.2
    %
    
    
    3
    
    
    $
    7,139
    
    
    
    4.0
    %
    
    
    3
    
    
    $
    8,924
    
    
    
    5.0
    %Valley Bank
    
    $
    21,908
    
    
    
    12.3
    %
    
    
    3
    
    
    $
    7,137
    
    
    
    4.0
    %
    
    
    3
    
    
    $
    8,921
    
    
    
    5.0
    %
 -18-




---



##### Table of Contents



Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Companys results of operation are dependent upon its ability to manage
interest rate risk. Management considers interest rate risk to be a significant
risk that could have a material effect on the Companys financial condition and
results of operations. The Company does not currently use derivatives to manage
market and interest rate risk. A number of measures are used to monitor and manage interest rate risk,
including income simulations and interest sensitivity (gap) analyses. An
income simulation model is the primary tool used to assess the direction and
magnitude of changes in net interest income resulting from changes in interest
rates. Key assumptions in the model include repayment speeds on certain
assets, cash flows and maturities of other investment securities, loan and
deposit volumes and pricing. These assumptions are inherently uncertain and,
as a result, the model cannot precisely estimate net interest income or
precisely predict the impact of higher or lower interest rates on net interest
income. Actual results will differ from simulated results due to timing, magnitude and
frequency of interest rate changes and changes in market conditions and
management strategies, among other factors. At June 30, 2004, based on the
measures used to monitor and manage interest rate risk, there has not been a
material change in the Companys interest rate risk since December 31, 2003.
For additional information, refer to the Companys annual report on Form 10-K
for the year ended December 31, 2003. 
 Item 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures: An evaluation of the
Companys disclosure controls and procedures (as defined in Section 13(a)-14(c)
of the Securities Exchange Act of 1934 (the Act)) was carried out under the
supervision and with the participation of the Companys Chief Executive
Officer, Chief Financial Officer and several other members of the Companys
senior management as of June 30, 2004. The Companys Chief Executive Officer
and Chief Financial Officer concluded that the Companys disclosure controls
and procedures as currently in effect are effective in ensuring that the
information required to be disclosed by the Company in the reports it files or
submits under the Act is (i) accumulated and communicated to the Companys
management (including the Chief Executive Officer and Chief Financial Officer)
in a timely manner, and (ii) recorded, processed, summarized and reported
within the time period specified in the SECs rules and forms. (b) Changes in Internal Controls: In the quarter ended June 30, 2004, the
Company did not make any significant changes in, nor take any corrective
actions regarding, its internal controls or other factors that has materially
affected or is reasonably likely to affect these controls. Limitations on the Effectiveness of Controls.The Companys management,
including the CEO and CFO, does not expect that our Disclosure Controls or our
Internal Controls will prevent all error and all fraud. A control system, no
matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are met.
Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative
to their costs. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, within the company have been detected. These
inherent limitations include the realities that judgments in decision-making
can be faulty, and that breakdowns can occur because of simple error or
mistake. Additionally, controls can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the control. The design of any system of controls also is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions; over time, control may become inadequate because
of changes in conditions, or the degree of compliance with the policies or
procedures may deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur
and not be detected. -19-




---



##### Table of Contents



FORWARD-LOOKING STATEMENTS This quarterly report on Form 10-Q includes forward-looking statements about
the future operations of the Company. These forward-looking statements involve
certain risks and uncertainties that could cause actual results to differ
materially from those in the forward-looking statements. Such risks and
uncertainties include, but are not limited to, the following factors:
unforeseen legal proceedings, unexpected costs in connection with internet
banking initiative, competitive pressure in the banking industry significantly
increasing; increases or decreases in the interest rate environment reducing
margins; general economic conditions, either nationally or regionally, are less
favorable than expected, resulting in, among other things, a deterioration in
credit quality and an increase in the provision for possible loan losses;
changes in the regulatory environment; loan delinquency rates; changes in
business conditions; volatility of rate sensitive deposits; operational risks
including data processing system failures or fraud; asset/liability matching
risks and liquidity risks; and changes in the securities markets. Because of
these uncertainties, actual future results may be materially different from the
results indicated by these forward-looking statements. In addition, the
Companys past results do not necessarily indicate its future results. See also
the risk factors in the Companys 2003 Annual Report on Form 10-K. 
 PART II   OTHER INFORMATION 
 Item 1. LEGAL PROCEEDINGS The Company faces ordinary routine litigation arising in the normal course of
business. In the opinion of management, liabilities (if any) arising from such
claims will not have a material adverse effect upon the business, results of
operations or financial condition of the Company. 
 Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable 
 Item 3. DEFAULTS UPON SENIOR SECURITIES Not applicable 
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Shareholders of Valley Community Bancshares, Inc. (the
Meeting) was held on April 29, 2004. The only matter of business conducted at
the Meeting was the election of Directors. At the Meeting, the following
Directors were elected to server on the board until the 2007 Annual Meeting of
Shareholders: A. Eugene Hammermaster, Warren D. Hunt and Roger L Knutson. The
least number of votes in favor of any such Director was 95% of the shares voted
at the Meeting. The terms of Directors, Ronald E. Claudon, William E. Fitchitt, David K. Hamry
, Thomas R. Absher, David H. Brown, and Thomas M. Pasquier continued after
the meeting. 
 Item 5. OTHER INFORMATION Not applicable. -20-




---



##### Table of Contents



Item 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits  3.1
    
    Articles of Incorporation of Valley Community Bancshares,
Inc. *3.2
    
    Restated Bylaws of Valley Community Bancshares, Inc. ^10.
    
    Material contracts of Valley Community Bancshares, Inc.  10.1
    
    Severance agreement for Mr. Brown *10.2
    
    Severance agreement for Mr. Thompson *10.3
    
    Severance agreement for Mr. Riordan *10.4
    
    Deferred Compensation Agreement for Mr. Brown *10.5
    
    Deferred Compensation Agreement for Mr. Thompson #10.6
    
    1998 Stock Option Plan *10.7
    
    401(k) Defined Contribution Plan and Noncontributory Profit Sharing
Plan Adoption Agreement *  31.
    
    Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002  31.1
    
    Certification of Chief Executive Officer31.2
    
    Certification of Chief Financial Officer  32.
    
    Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002  *
    
    Incorporated by reference to the Exhibits set forth on Registrants
Amended Registration Statement on Form 10 filed with the Securities and
Exchange Commission on September 6, 2000.  #
    
    Incorporated by reference to the Exhibits set forth on Registrants 2000
Annual Report on Form 10-K filed with the Securities and Exchange
Commission on March 27, 2001.  
    
    Incorporated by reference to the Exhibits set forth on Registrants June
2002 Quarterly Report on Form 10-Q filed with the Securities and Exchange
Commission on August 9, 2002. (b) Reports on Form 8-K The Company filed a current report on Items 7 and 12 of Form 8-K on April 29,
2004. The report included a press release announcing financial results for the
three months ended March 31, 2004. -21-




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. VALLEY COMMUNITY BANCSHARES, INC.
                              (Registrant)Date: July 28, 2004
    By       /s/ David H. BrownDavid H. BrownPresident and
Chief Executive Officer Date: July 28, 2004
    By       /s/ Joseph E. RiordanJoseph E. RiordanExecutive Vice President and
Chief Financial Officer -22-