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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549



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FORM 10-KSB



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | -------------------------------------------------------------------------------------



For the fiscal year ended December 31, 2003



| ̈ | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------



For the transition period from  to



Commission file number 0-11255



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Heritage Bankshares, Inc.

(Name of small business issuer in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Virginia                                                       |  | 54-1234322                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|200 East Plume Street Norfolk, Virginia                        |  | 23514                               
|(Address of Principal Executive Offices)                       |  | (Zip Code)                          



Issuers
telephone number (757) 523-2600



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Securities registered pursuant to Section 12(b) of the Exchange Act: None



Securities registered pursuant to Section 12(g) of the Exchange Act: Common
Stock, $5 par value



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Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 month (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 ̈



Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure
will be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.  x



State issuers revenues for its most
recent fiscal year: $6,392,806



State the aggregate market value of the voting
stock held by non-affiliates of the registrant as of March 17, 2004: $21,605,675*



As of March 17, 2004, 835,750 shares of common stock were issued and outstanding.



|* | In calculating the aggregate market value, we have used the most recent sales price of Common Stock known to the Company, which is $32.50 per share and voting stock held by
non-affiliates of the registrant as of March 24, 2004 of 664,790.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Documents incorporated by reference:



Part III of this Form 10-K incorporates information by reference from the registrants definitive proxy statement which will be filed no later than 120 days after December 31, 2003.



Transitional Small business Disclosure Format (Check
one):    Yes: ̈No:  x



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##### Table of Contents

TABLE OF CONTENTS



|           |  |                                                                                                |  |   
|---------- |  | ---------------------------------------------------------------------------------------------- |  | --
|Item 1.    |  | Description of Business                                                                        |  | 3 
|           |  |                                                                                               
|Item 2.    |  | Description of Property                                                                        |  | 4 
|           |  |                                                                                               
|Item 3.    |  | Legal Proceedings                                                                              |  | 4 
|           |  |                                                                                               
|Item 4.    |  | Submission of Matters to a Vote of Securities Holders                                          |  | 5 
|           |  |                                                                                               
|Item 5.    |  | Market for Common Equity and Related Stockholder Matters                                       |  | 5 
|           |  |                                                                                               
|Item 6.    |  | Managements Discussion and Analysis                                                           |  | 6 
|           |  |                                                                                               
|Item 7.    |  | Financial Statements                                                                           |  | 18
|           |  |                                                                                               
|Item 8.    |  | Changes In and Disagreements with Accountants on Accounting and Financial Disclosure           |  | 38
|           |  |                                                                                               
|Item 8A.   |  | Controls and Procedures                                                                        |  | 38
|           |  |                                                                                               
|Item 9.    |  | Directors, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act    |  | 38
|           |  |                                                                                               
|Item 10.   |  | Executive Compensation                                                                         |  | 38
|           |  |                                                                                               
|Item 11.   |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |  | 38
|           |  |                                                                                               
|Item 12.   |  | Certain Relationships and Related Transactions                                                 |  | 38
|           |  |                                                                                               
|Item 13.   |  | Exhibits and Reports on Form 8-K                                                               |  | 39
|           |  |                                                                                               
|Item 14.   |  | Principal Accountant Fees and Services                                                         |  | 40
|           | 
|Signatures |  | 41                                                                                            



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Part I

Forward-Looking Statements



Certain statements in
this annual report constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). Such forward-looking statements involve known and unknown risks,
uncertainties and other factors that may cause the actual results, performance or achievements of Heritage Bankshares, Inc. (the Company) and Heritage Bank & Trust (the Bank) to differ materially from the anticipated
results, performance or achievements expressed or implied by such forward-looking statements. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following
possibilities: (1) changes in the interest rate environment; (2) general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (3) changes in the
regulatory environment; and (4) changes in the securities markets.



In some cases, you can identify the forward-looking statements by the Companys use of the words such as may,  will, should, could, expect, plan,
intend, anticipate, believe, estimate, predict, potential or continue or the negative or other variations of these words, or other comparable words or phrases.



Although the Company believes that the expectations reflected
in its forward-looking statements are reasonable, the Company cannot guarantee future results, performance or achievements or other future events. The Company is under no duty to update any of its forward-looking statements after the date of this
annual report. Readers should not place undue reliance on such forward-looking statements.



Item 1. DESCRIPTION OF BUSINESS



General



The Company was incorporated under the laws of the
Commonwealth of Virginia in 1983. In August of 1992, two wholly owned subsidiaries, Princess Anne Bank and The Heritage Bank-McLean, were spun off, and the Company has operated as a one bank holding company since that time. The principal executive
office of the Company is located at 200 East Plume Street, Norfolk, Virginia. Currently, the Company does not transact any material business other than through its wholly owned banking subsidiary. The total consolidated assets of the Company on
December 31, 2003 were $144.97 million. Information concerning the Company may be found at www.heritagenorfolk.com.



Heritage Bank & Trust



The Bank is a state banking corporation engaged in the general commercial and retail banking business. The cities of Norfolk and Chesapeake, Virginia,
constitute the primary service area of the Bank and to a lesser extent the Bank includes the remaining areas of Hampton Roads in its market area. The Bank was incorporated as a Virginia corporation on September 19, 1975, and commenced business at
841 North Military Highway in Norfolk, Virginia on February 7, 1977. On December 31, 2003, the Bank had assets of $144.81 million, with total loans of $101.5 million and deposits of $124.75 million.



IBV Real Estate Holdings, Inc.



IBV Real Estate Holdings, Inc., is a corporation formed for the sole purpose of owning additional real estate assets
acquired by the Company or the Bank. Currently, IBV Real Estate Holdings, Inc. owns a 1% interest in IBV Partners, LP, a Virginia limited partnership formed in December 1986. IBV Real Estate Holdings, Inc., serves as the general partner of the
partnership. The partnerships sole asset is a 17,200 square-foot office building located at 1450 South Military Highway, Chesapeake, Virginia. Heritage Bank & Trust is a tenant in the property.



Sentinel Trust Services, L.L.C. and Sentinel Financial Group, Inc. (formerly Sentinel Title
Services, Inc.)



Sentinel Trust Services, L.L.C. is a wholly
owned subsidiary of the Company. Sentinel Financial Group, Inc. (formerly Sentinel Title Services, Inc.) is a wholly owned subsidiary of Heritage Bank & Trust. These entities own an interest in providers of various insurance products, investment
products and trust services. The strategic relationship with these entities provides the Bank with the ability to provide these services to its customers. The financial activities pertaining to these interests are recorded on the cost method of
accounting for investments.



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Competition



The banking business in the cities of Norfolk and Chesapeake, as well as all of the Hampton Roads area is highly competitive. The Bank encounters
competition from major commercial banking institutions, local banks, money market and mutual funds, small loan companies, credit unions, brokerage firms and other financial institutions. Current federal law allows the acquisition of banks by bank
holding companies nationwide. Further, federal and Virginia law permit interstate banking. As a consequence of these developments, competition in the Banks principal market may increase, and a consolidation of financial institutions in
Virginia may occur.



Employees



The Company and the Bank have 51 employees. Of this total, 46 are full-time
and 5 are part-time. Management considers its employee relations to be excellent.



Regulation and Supervision



The Company is registered
as a bank holding company, under the Bank Holding Company Act of 1956. As such, the Company is subject to regulation and examination by the Federal Reserve Board, and is required to file periodic reports and any additional information that the
Federal Reserve Board may require. The Bank Holding Company Act imposes certain restrictions upon the Company regarding the acquisition of substantially all of the assets of or direct or indirect ownership or control of any bank of which it is not
already the majority owner; or, with certain exceptions of any company engaged in nonbanking activities.



The Bank is subject to supervision, regulation and examination by the State Corporation Commission of the State of Virginia. Asset growth, deposits,
reserves, investments, loans, consumer law compliance, issuance of securities, establishment of branches, mergers and consolidation, changes in control, electronic funds transfer, management practices and other aspects of operations are subject to
regulation by the appropriate federal and state supervisory authorities. The Bank is also subject to various regulatory requirements of the Federal Reserve Board applicable to depository institutions insured by the Federal Deposit Insurance
Corporation.



Legislation



From time to time legislation is enacted which has the effect of imposing
operating restrictions and increasing the cost of doing business. This has been the case with recently enacted laws regarding anti-terrorism, consumer privacy and Check 21. Proposals to change the laws and regulations governing the banking industry
are frequently introduced in Congress, in the state legislatures and before the various bank regulatory agencies. The likelihood and timing of major proposals or legislation and the impact they might have on the Company and its subsidiaries is
impossible to predict.



Monetary Policy



The Company and the Bank are affected by fiscal and monetary policies of the
federal government, including those of the Federal Reserve Board, which regulates the national money supply in order to mitigate recessionary and inflationary pressures. Among the techniques available to the Federal Reserve Board are engaging in
open market transactions of U.S. Government securities, changing the discount rate and changing reserve requirements against bank deposits. These techniques are used in varying combinations to influence the overall growth of bank loans, investments
and deposits. Their use may also affect interest rates charged on loans and paid on deposits. The effect of governmental policies on the earnings of the Company and the Bank cannot be predicted.



Item 2. DESCRIPTION OF PROPERTY



The Bank owns four of its banking locations, 841 North Military Highway, 200 East Plume Street, 4815 Colley Avenue and 735 East Ocean View Avenue in Norfolk, Virginia. Management believes these locations are in excellent condition. A fifth
banking location and the banks operations center are located at 1450 South Military Highway in Chesapeake, Virginia. See IBV Real Estate Holdings, Inc. under Item 1 and Certain Relationships and Related Transactions
under Item 12.



Item 3. LEGAL PROCEEDINGS



At the
date of this report, the Company is not a party to any legal proceedings, the adverse outcome of which, in managements opinion, individually or in the aggregate, would have a material effect on the Companys results of operations or
financial position.



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Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS



No matters were submitted to a vote of securities holders during the fourth quarter of 2003.



PART II



Item 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS



The Companys common stock is listed on the Over The Counter Bulletin Board under the symbol HBKS. The Bank acts as the Companys transfer agent. At March 23, 2004, there were 984 record holders
of the 835,050 outstanding shares of common stock. As of March 23, 2004, the most recent sales price of common stock known to the Company is $32.50 per share.



The following table sets forth the closing price for the common stock by calendar quarters for the past two years as reported.



Calendar Quarter



|               |  |      |       |     |   |      
|-------------- |  | ---- | ----- | --- | - | -----
|               |  | HIGH |       | LOW
|2003           |  |      |       |     |   |      
|Fourth Quarter |  | $    | 33.00 |     | $ | 24.00
|Third Quarter  |  |      | 25.00 |     |   | 22.05
|Second Quarter |  |      | 23.50 |     |   | 19.19
|First Quarter  |  |      | 20.75 |     |   | 19.30
|               |  |     
|2002           |  |      |       |     |   |      
|Fourth Quarter |  | $    | 21.50 |     | $ | 18.60
|Third Quarter  |  |      | 19.00 |     |   | 17.25
|Second Quarter |  |      | 18.75 |     |   | 15.34
|First Quarter  |  |      | 15.75 |     |   | 14.75



Common Stock and Dividends



The Companys Board of Directors determines whether to declare
dividends and the amount of such dividends. Determinations by the Board take into account the Companys financial condition, results of operations, capital requirements, general business conditions and other relevant factors. The Companys
principal source of funds for cash dividends are the dividends paid to the Company by the Bank. The Company declared and paid annual dividends of $.34 and $.31 per share in 2003 and 2002, respectively. These dividends represented a dividend payout
ratio of 15% in 2003 and 17% in 2002. Regulatory restrictions on the payment of dividends by the Bank to the Company are disclosed in Note 3 to the Consolidated Financial Statements under Item 7- Financial Statements.



Equity Compensation Plan Information



The following table summarizes information, as of December 31, 2003,
relating to the equity compensation plans of the Company pursuant to which grants of options to acquire shares of common stock may be granted from time to time.



|                                                       |  |                                                                        |  |                                                        |       |                                                                                              |       
|------------------------------------------------------ |  | ---------------------------------------------------------------------- |  | ------------------------------------------------------ | ----- | -------------------------------------------------------------------------------------------- | ------
|Plan Category                                          |  | Number of Securities to be Issued Upon Exercise of Outstanding Options |  | Weighted-Average Exercise Price of Outstanding Options |       | Number of Securities Remaining Available for Future Issuance under Equity Compensation Plans
|Equity compensation plans approved by shareholders     |  | 114,075                                                                |  | $                                                      | 10.72 |                                                                                              | 38,950
|Equity compensation plans not approved by shareholders |  | N/A                                                                    |  |                                                        | N/A   |                                                                                              | N/A   



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Recent Sales of Unregistered Securities



The following table provides information, as of December 31, 2003, relating to the exercise of options to purchase common
stock of the Company. The exemption relied upon for the issuance of the securities underlying the options was Section (4) 2 of the Securities Act of 1933, as amended.



|                 |  |                   |  |        |  |                    |  |                  
|---------------- |  | ----------------- |  | ------ |  | ------------------ |  | -----------------
|Date of Exercise |  | Class of Security |  | Number |  | Exercise Price ($) |  | Cash Received ($)
|3/4/2003         |  | Common stock      |  | 200    |  | 6.50               |  | 1,300.00         
|3/4/2003         |  | Common stock      |  | 1,300  |  | 7.50               |  | 9,750.00         
|7/14/2003        |  | Common stock      |  | 2,000  |  | 12.30              |  | 24,600.00        
|8/25/2003        |  | Common stock      |  | 450    |  | 14.50              |  | 6,525.00         
|8/25/2003        |  | Common stock      |  | 1,050  |  | 10.25              |  | 10,762.50        
|9/17/2003        |  | Common stock      |  | 1,000  |  | 12.30              |  | 12,300.00        
|9/30/2003        |  | Common stock      |  | 1,000  |  | 10.25              |  | 10,250.00        
|11/12/2003       |  | Common stock      |  | 375    |  | 10.25              |  | 3,843.75         



Item 6. MANAGEMENTS DISCUSSION AND ANALYSIS



Critical Accounting Policies



The preparation of
financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates in certain circumstances that affect amounts
reported in our consolidated financial statements and the accompanying footnotes. Certain accounting estimates are particularly sensitive because of their significance to the financial statements and because of the possibility that future events
affecting them may differ significantly from managements current judgments.



The accounting policy related to the Allowance for Loan Losses is significantly affected by judgments, assumptions and estimates used by our management in the preparation of the consolidated financial statements.



Allowance for Loan Losses



A loan is considered impaired, based on current information
and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the
present value of expected future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral.



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



The adequacy of the allowance for loan losses is periodically evaluated by the Bank, in order to maintain the allowance at a level that
is sufficient to absorb probable credit losses. Managements evaluation of the adequacy of the allowance is based on a review of the Banks historical loss experience, known and inherent risks in the loan portfolio, including adverse
circumstances that may affect the ability of the borrower to repay interest and/or principal, the estimated value of collateral, and an analysis of the levels and trends of delinquencies, charge-offs, and the risk ratings of the various loan
categories.



Such factors as the level and
trend of interest rates and the condition of the national and local economies are also considered. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banks allowance for losses
on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their examination.



The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current
year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entitys financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that
have been recognized in the Companys consolidated financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could impact the Companys consolidated financial condition or results of
operations.



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Income Taxes



The Company files a consolidated tax return. Provisions for income taxes reflect tax expense incurred as a
consolidated group. Tax expense is allocated among the members of the consolidated group in accordance with an intercompany agreement for tax expense. Income taxes are provided for the tax effects of the transactions reported in the financial
statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of investment securities, deferred loan fees, allowance for loan losses, allowance for losses on foreclosed real estate, accumulated
depreciation and deferred compensation for financial and income tax reporting. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and
liabilities are recovered or settled. An allowance is provided if it is more likely than not that the Company will not realize the benefits of a deferred tax asset.



ANALYSIS OF RESULTS OF OPERATIONS FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003 COMPARED TO DECEMBER 31, 2002



Results of Operations



Heritage Bankshares, Inc. (the Company), recorded net income in 2003 of $1.74 million, $373 thousand
ahead of the $1.37 million reported in 2002. Heritage Bank & Trust earned $1.76 million and Heritage Bankshares, Inc. recorded a loss of $23 thousand. That earnings level represents a return on average assets of 1.31% and 1.15% at December 31,
2003 and December 31, 2002, respectively. The return on average equity was 13.83% at December 31, 2003 compared to 12.16% at December 31, 2002. On a diluted per share basis, net income for 2003 was $2.05 compared to the $1.65 earned in 2002. The
Bank attributes its performance to strong growth in average earning assets and its continued development of noninterest income sources.



Net Interest Income



The Banks principal source of revenue is net interest income, the amount by which interest income exceeds interest expense. The largest component of
the Banks earning assets is its loan portfolio. Despite an 11.83% increase in overall average earning assets, the prevailing low interest rate environment negatively impacted the net interest margin. Conversely, the rate environment positively
impacted the net interest margin by reducing costs for the Banks interest bearing liabilities. The average yield on interest earning assets decreased from 6.90% to 6.08% while the average yield on interest bearing liabilities decreased from
3.02% to 2.32%. The net interest yield margin for 2003 was 4.24% compared with 4.50% in 2002. Interest income is presented on a tax-equivalent basis to recognize associated tax benefits. This presentation provides a basis for comparison of yields
with taxable earning assets. Tax-equivalent net interest income increased $260 thousand to $ 5.11 million compared to $4.85 million in 2002.



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##### Table of Contents

Components of Net Interest Income

For the years ended December 31,

(Dollars in thousands)



|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|--------------------------------------------------------------------------------------- |  | ------------------- | ------- | - | -------- | - | ----- | ------------------ |  | ---- | ------------------- |  | - | -------- | - |  | ------------------ | ----- | - |  | ---- | -
|                                                                                        |  | 2003                |         |   | 2002     |  
|                                                                                        |  | Average Balance (1) |         |   | Interest |   |       | Average yield/rate |  |      | Average Balance (1) |  |   | Interest |   |  | Average yield/rate |      
|Interest earning assets: (taxable equivalent basis (2))                                 |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Loans (net of unearned discount (3))                                                    |  | $                   | 91,826  |   |          | $ | 6,496 |                    |  | 7.07 | %                   |  | $ | 82,925   |   |  | $                  | 6,451 |   |  | 7.78 | %
|Investment securities-taxable (4)                                                       |  |                     | 16,882  |   |          |   | 652   |                    |  | 3.86 | %                   |  |   | 15,420   |   |  |                    | 777   |   |  | 5.04 | %
|Investment securities - non-taxable (1) (4)                                             |  |                     | 913     |   |          |   | 62    |                    |  | 6.79 | %                   |  |   | 871      |   |  |                    | 65    |   |  | 7.46 | %
|Federal Funds                                                                           |  |                     | 10,841  |   |          |   | 114   |                    |  | 1.05 | %                   |  |   | 8,500    |   |  |                    | 135   |   |  | 1.59 | %
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Total Interest earning assets                                                           |  | $                   | 120,462 |   |          | $ | 7,324 |                    |  | 6.08 | %                   |  | $ | 107,716  |   |  | $                  | 7,428 |   |  | 6.90 | %
|Noninterest earning assets:                                                             |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Cash and due from banks                                                                 |  |                     | 7,245   |   |          |   |       |                    |  |      |                     |  |   | 5,831    |   |  |                    |       |   |  |      |  
|Allowance for loan losses                                                               |  |                     | (1,156  | ) |          |   |       |                    |  |      |                     |  |   | (1,086   | ) |  |                    |       |   |  |      |  
|Other real estate owned                                                                 |  |                     | 433     |   |          |   |       |                    |  |      |                     |  |   | 433      |   |  |                    |       |   |  |      |  
|Premises and equipment                                                                  |  |                     | 2,333   |   |          |   |       |                    |  |      |                     |  |   | 2,410    |   |  |                    |       |   |  |      |  
|Other assets                                                                            |  |                     | 3,738   |   |          |   |       |                    |  |      |                     |  |   | 2,986    |   |  |                    |       |   |  |      |  
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Total Assets                                                                            |  | $                   | 133,055 |   |          |   |       |                    |  |      |                     |  | $ | 118,290  |   |  |                    |       |   |  |      |  
|                                                                                        |  |                     |         |   |          |  
|Liabilities and stockholders equity                                                    |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Interest bearing liabilities:                                                           |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Money Market and NOW accounts                                                           |  | $                   | 22,040  |   |          | $ | 94    |                    |  | 0.43 | %                   |  | $ | 19,716   |   |  | $                  | 171   |   |  | 0.87 | %
|Savings Deposits                                                                        |  |                     | 5,216   |   |          |   | 42    |                    |  | 0.81 | %                   |  |   | 5,916    |   |  |                    | 75    |   |  | 1.27 | %
|Savings Certificates                                                                    |  |                     | 42,515  |   |          |   | 1,406 |                    |  | 3.31 | %                   |  |   | 43,331   |   |  |                    | 1,840 |   |  | 4.25 | %
|Large denomination certificates                                                         |  |                     | 20,582  |   |          |   | 636   |                    |  | 3.09 | %                   |  |   | 12,184   |   |  |                    | 440   |   |  | 3.61 | %
|Securities sold under agreements to repurchase                                          |  |                     | 5,328   |   |          |   | 39    |                    |  | 0.73 | %                   |  |   | 4,197    |   |  |                    | 55    |   |  | 1.31 | %
|Short-term borrowings                                                                   |  |                     | 53      |   |          |   | 1     |                    |  | 1.89 | %                   |  |   | 47       |   |  |                    | 1     |   |  | 2.13 | %
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Total interest bearing liabilities                                                      |  | $                   | 95,734  |   |          | $ | 2,218 |                    |  | 2.32 | %                   |  | $ | 85,391   |   |  | $                  | 2,582 |   |  | 3.02 | %
|                                                                                        |  |                     |         |   |          |  
|Noninterest bearing liabilities:                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Demand deposits                                                                         |  |                     | 23,754  |   |          |   |       |                    |  |      |                     |  |   | 20,771   |   |  |                    |       |   |  |      |  
|Other                                                                                   |  |                     | 999     |   |          |   |       |                    |  |      |                     |  |   | 910      |   |  |                    |       |   |  |      |  
|Total Liabilities                                                                       |  |                     | 120,487 |   |          |   |       |                    |  |      |                     |  |   | 107,072  |   |  |                    |       |   |  |      |  
|Stockholders equity                                                                    |  |                     | 12,568  |   |          |   |       |                    |  |      |                     |  |   | 11,218   |   |  |                    |       |   |  |      |  
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Total liabilities and stockholders equity                                              |  | $                   | 133,055 |   |          |   |       |                    |  |      |                     |  | $ | 118,290  |   |  |                    |       |   |  |      |  
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Net interest earnings                                                                   |  |                     |         |   |          | $ | 5,106 |                    |  |      |                     |  |   |          |   |  | $                  | 4,846 |   |  |      |  
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Net interest yield margin on average interest earning assets (taxable equivalent basis) |  |                     |         |   |          |   |       |                    |  | 4.24 | %                   |  |   |          |   |  |                    |       |   |  | 4.50 | %
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Less tax equivalent adjustment                                                          |  |                     |         |   |          | $ | (57   | )                  |  |      |                     |  |   |          |   |  | $                  | (54   | ) |  |      |  
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Net interest income                                                                     |  |                     |         |   |          | $ | 5,049 |                    |  |      |                     |  |   |          |   |  | $                  | 4,792 |   |  |      |  
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  
|Net interest spread (taxable equivalent basis)                                          |  |                     |         |   |          |   |       |                    |  | 3.76 | %                   |  |   |          |   |  |                    |       |   |  | 3.87 | %
|                                                                                        |  |                     |         |   |          |   |       |                    |  |      |                     |  |   |          |   |  |                    |       |   |  |      |  

---

|(1) | Daily average balances are calculated using the aggregate daily average balances on a monthly basis.
|--- | ----------------------------------------------------------------------------------------------------

|(2) | Tax equivalent adjustments (using 34% federal income tax rates) have been made in calculating the yields on tax-free loans and investments. Virginia banks are exempt from state
income tax.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | For the purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding.
|--- | ----------------------------------------------------------------------------------------------------------------------

|(4) | The yield/rate of the investment securities is computed using the amortized cost basis.
|--- | ---------------------------------------------------------------------------------------



8



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##### Table of Contents

The following table illustrates the impact on the interest income of the Company resulting from changes
in average balances and average rates for the periods indicated. The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar of the changes in each.



Volume and Rate Analysis

For the years ended December 31,

(Dollars in thousands)



|                                               |  |                                       |     |   |                                       |   |      |       |  |   |        |   |  |      |       |   |       |   |        |   |  |   |        |  
|---------------------------------------------- |  | ------------------------------------- | --- | - | ------------------------------------- | - | ---- | ----- |  | - | ------ | - |  | ---- | ----- | - | ----- | - | ------ | - |  | - | ------ | -
|                                               |  | 2003 / 2002 (Dollars in thousands)    |     |   | 2002 / 2001 (Dollars in thousands)    |  
|                                               |  | Increase (Decrease) Due to Change in: |     |   | Increase (Decrease) Due to Change in: |  
|                                               |  | Volume                                |     |   | Rate                                  |   |      | Total |  |   | Volume |   |  | Rate |       |   | Total |  
|Interest income (1):                           |  |                                       |     |   |                                       |   |      |       |  |   |        |   |  |      |       |   |       |   |        |   |  |   |        |  
|Loans                                          |  | $                                     | 289 |   |                                       | $ | (244 | )     |  | $ | 45     |   |  | $    | 2,599 |   |       | $ | (2,708 | ) |  | $ | (109   | )
|Taxable securities                             |  |                                       | 85  |   |                                       |   | (210 | )     |  |   | (125   | ) |  |      | (47   | ) |       |   | (97    | ) |  |   | (144   | )
|Non-taxable securities                         |  |                                       | 3   |   |                                       |   | (6   | )     |  |   | (3     | ) |  |      | 7     |   |       |   | 3      |   |  |   | 10     |  
|Federal funds sold                             |  |                                       | 93  |   |                                       |   | (114 | )     |  |   | (21    | ) |  |      | 37    |   |       |   | (223   | ) |  |   | (186   | )
|                                               |  |                                       |     |   |                                       |   |      |       |  |   |        |   |  |      |       |   |       |   |        |   |  |   |        |  
|Total interest income                          |  | $                                     | 470 |   |                                       | $ | (574 | )     |  | $ | (104   | ) |  | $    | 2,596 |   |       | $ | (3,025 | ) |  | $ | (429   | )
|                                               |  |                                       |     |   |                                       |  
|Interest expense:                              |  |                                       |     |   |                                       |   |      |       |  |   |        |   |  |      |       |   |       |   |        |   |  |   |        |  
|Money Market and NOW accounts                  |  | $                                     | 23  |   |                                       | $ | (100 | )     |  | $ | (77    | ) |  | $    | 61    |   |       | $ | (269   | ) |  | $ | (208   | )
|Savings                                        |  |                                       | (8  | ) |                                       |   | (25  | )     |  |   | (33    | ) |  |      | (2    | ) |       |   | (80    | ) |  |   | (82    | )
|Certificates                                   |  |                                       | (34 | ) |                                       |   | (400 | )     |  |   | (434   | ) |  |      | 231   |   |       |   | (693   | ) |  |   | (462   | )
|Certificates of $100,000 or more               |  |                                       | 248 |   |                                       |   | (52  | )     |  |   | 196    |   |  |      | (27   | ) |       |   | (193   | ) |  |   | (220   | )
|Securities sold under agreements to repurchase |  |                                       | 25  |   |                                       |   | (41  | )     |  |   | (16    | ) |  |      | 17    |   |       |   | (91    | ) |  |   | (74    | )
|Short-term borrowings                          |  |                                       |    |   |                                       |   |     |       |  |   |       |   |  |      | (1    | ) |       |   |       |   |  |   | (1     | )
|                                               |  |                                       |     |   |                                       |   |      |       |  |   |        |   |  |      |       |   |       |   |        |   |  |   |        |  
|Total interest expense                         |  | $                                     | 254 |   |                                       | $ | (618 | )     |  | $ | (364   | ) |  | $    | 279   |   |       | $ | (1,326 | ) |  | $ | (1,047 | )
|                                               |  |                                       |     |   |                                       |   |      |       |  |   |        |   |  |      |       |   |       |   |        |   |  |   |        |  
|Net change in interest earnings                |  | $                                     | 216 |   |                                       | $ | 44   |       |  | $ | 260    |   |  | $    | 2,317 |   |       | $ | (1,699 | ) |  | $ | 618    |  
|                                               |  |                                       |     |   |                                       |   |      |       |  |   |        |   |  |      |       |   |       |   |        |   |  |   |        |  

---

|(1) | Interest income includes taxable equivalent adjustments of $57,000 in 2003 and $54,000 in 2002 which are used to adjust interest on tax exempt assets to a fully taxable basis.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Noninterest Income



Noninterest income is largely derived from mortgage banking activities and
fee-based services. Total noninterest income increased $497 thousand to $1,344 thousand. Fees related to mortgage banking activities increased $336 thousand reaching $584 thousand in 2003 compared to $248 thousand in 2002. This increase was largely
due to the historically low interest rate environment and to a lesser degree to the favorable market conditions in terms of local housing activity. Management does not anticipate the same level of refinancing activity in 2004. Fees related to credit
and debit card usage increased $33 thousand totaling $194 thousand in 2003 compared to $161 thousand in 2002. This increase reflects a higher level of both debit and credit card usage and the expansion of the Banks merchant card program. Other
income was impacted by non-recurring items related to the Banks deferred compensation program for Directors that totaled $90 thousand. The ratio of noninterest income to average assets was 1.01% compared to .72% in 2002.



9



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##### Table of Contents

Noninterest Income

For the Years Ended December 31,

(dollars in thousands)



|                             |  |      |       |      |   |                                   |  |   |         |   |  |        |  
|---------------------------- |  | ---- | ----- | ---- | - | --------------------------------- |  | - | ------- | - |  | ------ | -
|                             |  |      |       |      |   | Increase/(Decrease)2003 over 2002 | 
|                             |  | 2003 |       | 2002 |   | Amount                            |  |   | Percent |  
|Mortgage banking activities  |  | $    | 584   |      | $ | 248                               |  | $ | 336     |   |  | 135.48 | %
|Deposit account fees         |  |      | 303   |      |   | 295                               |  |   | 8       |   |  | 2.71   | %
|Other operating income       |  |      | 253   |      |   | 135                               |  |   | (118    | ) |  | -87.41 | %
|Card services and other fees |  |      | 204   |      |   | 169                               |  |   | 35      |   |  | 20.71  | %
|                             |  |      |       |      |   |                                   |  |   |         |   |  |        |  
|                             |  | $    | 1,344 |      | $ | 847                               |  | $ | 497     |   |  | 58.67  | %
|                             |  |      |       |      |   |                                   |  |   |         |   |  |        |  



Noninterest Expense



Noninterest expense increased 9.9% to $3.88 million in 2003 compared with
$3.53 million in 2002. Salaries and employee benefits increase $170 thousand due to revenue based employee incentives and higher health care costs. Automated services increased $80 thousand due to data processing and customer information system
enhancements. Other expenses increased due to growth in the customer base and supporting customer service. The ratio of noninterest expense to average assets was 2.91% compared to the 2.98% reported in 2002.



Noninterest Expense

For the Years Ended December 31,

(dollars in thousands)



|                                |  |      |       |      |   |                                   |  |   |         |   |  |       |  
|------------------------------- |  | ---- | ----- | ---- | - | --------------------------------- |  | - | ------- | - |  | ----- | -
|                                |  |      |       |      |   | Increase/(Decrease)2003 over 2002 | 
|                                |  | 2003 |       | 2002 |   | Amount                            |  |   | Percent |  
|Salaries and employee benefits  |  | $    | 2,102 |      | $ | 1,932                             |  | $ | 170     |   |  | 8.79  | %
|Other                           |  |      | 749   |      |   | 657                               |  |   | 92      |   |  | 14.00 | %
|Automated services              |  |      | 377   |      |   | 297                               |  |   | 80      |   |  | 26.93 | %
|Occupancy expenses              |  |      | 246   |      |   | 239                               |  |   | 7       |   |  | 2.92  | %
|Furniture and equipment expense |  |      | 181   |      |   | 199                               |  |   | (18     | ) |  | -9.04 | %
|Taxes and licenses              |  |      | 145   |      |   | 126                               |  |   | 19      |   |  | 15.07 | %
|Stationery and supplies         |  |      | 75    |      |   | 73                                |  |   | 2       |   |  | 2.73  | %
|                                |  |      |       |      |   |                                   |  |   |         |   |  |       |  
|                                |  | $    | 3,875 |      | $ | 3,525                             |  | $ | 350     |   |  | 9.93  | %
|                                |  |      |       |      |   |                                   |  |   |         |   |  |       |  



Income Taxes:



For the year ended December 31, 2003, the Company recognized an expense of
$740 thousand. This represents a $90 thousand increase from the $650 thousand expense for 2002. See Note 11 of the Consolidated Financial Statements under Item 7. Financial Statements for additional information with respect to
income taxes.



ANALYSIS OF FINANCIAL CONDITION



At December 31, 2003, the Companys total assets were $144.97 million,
which is $16.84 million, and 13.14% greater than the $128.13 reported at December 31, 2002. The increase is chiefly due to growth in the loan portfolio which increased $18.99 million, or 22.99%, to $101.54 million at December 31, 2003, from December
31, 2002. The growth in total assets was also supported by growth in the investment portfolio which increased 27%, or $4.37 million to $20.27 million at December 31, 2003, from the December 31, 2002 balance of $15.90 million. Average earning assets
increased $12.75 million, or 11.83%, from $107.72 million in 2002 to $120.46 million in 2003.



Investment Securities



The
Companys investment portfolio is a source of liquidity and is the second largest category of earning assets. The portfolio includes U.S. Government securities, municipal securities, mortgage-backed securities and other debt securities. In
addition to the investment securities, the Company also invests in federal funds sold. Managements principal objectives for the investment portfolio during 2003 were to maintain an appropriate level of quality, ensure sufficient liquidity and
maximize yield. Securities available-for-sale were $18.57 million at December 31, 2003, compared with $14.26 million last year. These securities are held primarily for liquidity and yield purposes and also for asset liability management purposes.
Securities held-to-maturity were $1.69 million compared to $1.64 million in 2002. These securities are held primarily for yield purposes.



10



---

##### Table of Contents

The following table presents the maturity distribution and weighted average yields of the securities portfolio at
December 31, 2003.



Investment Securities

(dollars in thousands)



|                                                                     |  |                |       |       |             |   |        |             |       |  |             |        |  |              |       |  |        |   |       |   |       |        |      |       |  |   |       |  |      |  
|-------------------------------------------------------------------- |  | -------------- | ----- | ----- | ----------- | - | ------ | ----------- | ----- |  | ----------- | ------ |  | ------------ | ----- |  | ------ | - | ----- | - | ----- | ------ | ---- | ----- |  | - | ----- |  | ---- | -
|                                                                     |  | 1 year or less |       |       | 1  2 years |   |        | 2  3 Years |       |  | 3  4 Years |        |  | Over 5 years |      
|                                                                     |  | Amount         |       | Yield |             |   | Amount |             | Yield |  |             | Amount |  | Yield        |       |  | Amount |   | Yield |   |       | Amount |      | Yield | 
|U.S. Treasury, government agencies, state and political subdivisions |  | $              | 4,337 |       | 4.10        | % |        | $           | 4,398 |  | 3.30        | %      |  | $            | 5,548 |  | 2.42   | % |       | $ | 2,618 |        | 2.98 | %     |  | $ | 1,962 |  | 4.25 | %
|Other                                                                |  |                |      |       |            |   |        |             | 512   |  | 5.43        | %      |  |              |      |  |       |   |       |   |      |        |     |       |  |   | 686   |  | 6.40 | %
|                                                                     |  |                |       |       |             |   |        |             |       |  |             |        |  |              |       |  |        |   |       |   |       |        |      |       |  |   |       |  |      |  
|Total                                                                |  | $              | 4,337 |       | 4.10        | % |        | $           | 4,910 |  | 3.30        | %      |  | $            | 5,548 |  | 2.42   | % |       | $ | 2,618 |        | 2.98 | %     |  | $ | 2,648 |  | 5.33 | %



Loan
Portfolio



Loans, net of unearned income and deferred fees, at
December 31, 2003 were $101.54 million compared with $82.55 million at December 31, 2002 an increase of $18.99 million or 22.99%. As a percentage of average earning assets, average loans were 76.20% at December 31, 2003 and 76.9% at December 31,
2002. Loans secured by real estate increased $15.75 million and commercial loans increased $5.33 million.



Loan Portfolio Composition and Maturities

(dollars in thousands)



|                                  |  |              |        |                          |   |              |  |       |        |                                 |   |         |  |        |  
|--------------------------------- |  | ------------ | ------ | ------------------------ | - | ------------ |  | ----- | ------ | ------------------------------- | - | ------- |  | ------ | -
|                                  |  | Within 1year |        | After 1but within5 years |   | After 5years |  | Total |        | Percentageof totalloanportfolio |  
|Commercial                        |  | $            | 7,331  |                          | $ | 8,689        |  | $     | 3,700  |                                 | $ | 19,720  |  | 19.42  | %
|Real estate-mortgage              |  |              | 14,927 |                          |   | 13,772       |  |       | 42,724 |                                 |   | 71,423  |  | 70.34  | %
|Real estate-construction          |  |              | 3,551  |                          |   | 0            |  |       | 0      |                                 |   | 3,551   |  | 3.50   | %
|Consumer                          |  |              | 2,201  |                          |   | 4,232        |  |       | 412    |                                 |   | 6,845   |  | 6.74   | %
|                                  |  |              |        |                          |   |              |  |       |        |                                 |   |         |  |        |  
|                                  |  | $            | 28,010 |                          | $ | 26,693       |  | $     | 46,836 |                                 | $ | 101,539 |  | 100.00 | %
|                                  |  |              |        |                          |   |              |  |       |        |                                 |   |         |  |        |  
|Loans maturing after 1 year with: |  |              |        |                          |   |              |  |       |        |                                 |   |         |  |        |  
|Fixed interest rates              |  |              |        |                          | $ | 18,765       |  | $     | 41,228 |                                 |   |         |  |        |  
|Variable interest rates           |  |              |        |                          |   | 7,928        |  |       | 5,608  |                                 |   |         |  |        |  
|                                  |  |              |        |                          |   |              |  |       |        |                                 |   |         |  |        |  
|                                  |  |              |        |                          | $ | 26,693       |  | $     | 46,836 |                                 |   |         |  |        |  
|                                  |  |              |        |                          |   |              |  |       |        |                                 |   |         |  |        |  



Loan
Collateralized By Real Estate

(dollars in thousands)



|                                                       |  |        |        |                                   |       |  
|------------------------------------------------------ |  | ------ | ------ | --------------------------------- | ----- | -
|                                                       |  | Amount |        | Percentage of total loanportfolio |      
|Construction and land development                      |  | $      | 3,551  |                                   | 3.50  | %
|Collateralized by 1 - 4 family residential properties  |  |        | 30,240 |                                   | 29.78 | %
|Collateralized by multi-family residential properties  |  |        | 6,075  |                                   | 5.98  | %
|Collateralized by non-farm, non-residential properties |  |        | 34,962 |                                   | 34.43 | %
|                                                       |  |        |        |                                   |       |  
|                                                       |  | $      | 74,828 |                                   | 73.69 | %



Allowance For Loan Losses and Asset Quality



The
provision for loan losses is charged to operations in an amount sufficient to maintain the allowance for loan losses at a level management considers adequate to provide for future losses inherent in the loan portfolio. Loans are charged against this
allowance when management perceives the collection of the loan is unlikely. The level of the allowance is based on managements ongoing review of the loan portfolio and includes the present and prospective financial condition of borrowers,
consideration of actual loan loss experience and projected economic conditions in general and for the Banks service area. The 2003 provision for loan losses was $40 thousand compared to the 2002 provision of $99 thousand. The allowance for
loan losses of $1.19 million at year-end 2003 and $1.08 million at year-end 2002 reflects an allowance to year-end loans ratio of 1.17% and 1.32%, respectively. There were no restructured loans as defined by applicable securities rules and
regulations. For the year, recoveries from previously charged-off loans exceeded loans charged-off.



11



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##### Table of Contents

Summary of the Allowance For Loan Losses

Non-Performing Assets, Past Due Loans and Selected

Loan Loss Statistics



For The Years Ended December 31,

(Dollars in Thousands)



|                                                                   |  |      |       |   |      |   |       |  
|------------------------------------------------------------------ |  | ---- | ----- | - | ---- | - | ----- | -
|                                                                   |  | 2003 |       |   | 2002 |  
|Allowance for Loan Losses:                                         |  |      |       |   |      |   |       |  
|Balance, December 31                                               |  | $    | 1,088 |   |      | $ | 1,085 |  
|Charge-offs:                                                       |  |      |       |   |      |   |       |  
|Commercial                                                         |  |      | 0     |   |      |   | 41    |  
|Real estate                                                        |  |      | 0     |   |      |   | 0     |  
|Consumer                                                           |  |      | 33    |   |      |   | 58    |  
|                                                                   |  |      |       |   |      |   |       |  
|Total loans charged-off                                            |  |      | 33    |   |      |   | 99    |  
|Recoveries:                                                        |  |      |       |   |      |   |       |  
|Commercial                                                         |  |      | 0     |   |      |   | 0     |  
|Real estate                                                        |  |      | 56    |   |      |   | 0     |  
|Consumer                                                           |  |      | 36    |   |      |   | 3     |  
|                                                                   |  |      |       |   |      |   |       |  
|Total recoveries                                                   |  |      | 92    |   |      |   | 3     |  
|                                                                   |  |     
|Net (recoveries)charge-offs                                        |  |      | (59   | ) |      |   | 96    |  
|Provision for loan losses                                          |  |      | 40    |   |      |   | 99    |  
|                                                                   |  |      |       |   |      |   |       |  
|Balance                                                            |  | $    | 1,187 |   |      | $ | 1,088 |  
|                                                                   |  |     
|Ratio of net charge-offs to average loans outstanding              |  |      | -0.06 | % |      |   | 0.12  | %
|                                                                   |  |     
|Ratio of allowance for loan losses to loans at period-end          |  |      | 1.17  | % |      |   | 1.32  | %
|                                                                   |  |     
|Non-performing Assets and Loans Past Due 90 Days                   |  |      |       |   |      |   |       |  
|Non-accrual loans                                                  |  | $    | 11    |   |      | $ | 13    |  
|                                                                   |  |     
|Ratio of non-performing assets to total assets                     |  |      | 0.01  | % |      |   | 0.01  | %
|                                                                   |  |     
|Non-accrual loans:                                                 |  |      |       |   |      |   |       |  
|Interest income that would have been recorded under original terms |  | $    | 2     |   |      | $ | 4     |  
|                                                                   |  |     
|Interest income recorded during the period                         |  | $    | 0     |   |      | $ | 0     |  
|                                                                   |  |     
|Loans 90 days past due and still accruing                          |  | $    | 22    |   |      | $ | 43    |  



The allowance for loan
losses has two components, a specific and a general portion. The specific portion is determined by the Banks risk rating system. The Bank assigns a reserve amount consistent with each loans rating category. The reserve amount is based on
the loan rating system which focuses on current economic conditions and historical loss experience.



The actual amount of losses incurred can vary significantly from the estimated amount. The Banks methodology includes general factors intended to
minimize the differences in estimate and actual losses. These factors allow the Bank to adjust its estimates of losses based on the most recent information available. Although the Bank determines the amount of each element of the allowance for loan
losses separately, and this process is an important credit management tool, the entire allowance for loan losses is available for the entire loan portfolio.



12



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##### Table of Contents

The general reserves are necessary to deal with conditions that cannot be directly measured in the risk
rating system. These risks are subject to a higher degree of uncertainty but are a critical component of the total allowance for possible loan losses. Factors involved in determining the general reserve include national and local economic
conditions, downturns in specific industries including loss in collateral value, the results of bank regulatory exams, trends in credit quality at the Bank and in the banking industry, loan volumes and concentrations, findings of internal credit
reviews, and trends in risk rating changes.



The allowance is
allocated in the table based on the proportion of the loan types that make up the specific problem loans. The allowance shown in the table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or
proportions or that the allowance indicates future charge-off amounts or trends. Also, the allowance shown in the table does not assure that the allowance will be sufficient for all future charge-off amounts.



Allocation of Allowance for Loan Losses

December 31,

(dollars in thousands)



|                         |  |      |       |                                             |        |   |      |   |                                             |  |        |  
|------------------------ |  | ---- | ----- | ------------------------------------------- | ------ | - | ---- | - | ------------------------------------------- |  | ------ | -
|                         |  | 2003 |       | Percent of loans in category to total loans |        |   | 2002 |   | Percent of loans in category to total loans | 
|Specific Problem Loans   |  | $    | 50    |                                             |        |   |      | $ | 123                                         |  |        |  
|                         |  |      |       |                                            
|Loan Type Allocation:    |  |      |       |                                             |        |   |      |   |                                             |  |        |  
|Real Estate-Mortgage     |  |      | 415   |                                             | 72.70  | % |      |   | 76                                          |  | 70.35  | %
|Real Estate-Construction |  |      |      |                                             | 3.50   | % |      |   |                                            |  | 5.05   | %
|Commercial               |  |      | 25    |                                             | 18.93  | % |      |   | 319                                         |  | 16.83  | %
|Consumer                 |  |      | 94    |                                             | 4.87   | % |      |   | 39                                          |  | 7.77   | %
|                         |  |      |       |                                             |        |   |      |   |                                             |  |        |  
|                         |  |      | 534   |                                             | 100.00 | % |      |   | 434                                         |  | 100.00 | %
|                         |  |      |       |                                            
|Unallocated              |  |      | 603   |                                             |        |   |      |   | 531                                         |  |        |  
|                         |  |      |       |                                             |        |   |      |   |                                             |  |        |  
|Total                    |  | $    | 1,187 |                                             |        |   |      | $ | 1,088                                       |  |        |  
|                         |  |      |       |                                             |        |   |      |   |                                             |  |        |  



Potential Problem Loans:



At December 31, 2003 and
2002 loans on either non-accrual status or loans past due 90 days or more and still accruing amounted to $33 thousand and $43 thousand, respectively. In addition to these loans, at December 31, 2003, the Bank had approximately $326 thousand of loans
that have been internally classified, and $2.1 million that required more than normal attention and are potential problem loans. Management has considered these loans in establishing the level of the allowance for loan losses. At December 31, 2002,
loans that had been internally classified or which required more than normal attention and were potential problem loans were $800 thousand and $1.8 million, respectively.



Non-performing loans:



Non-performing loans are loans on non-accrual status. Loans are placed on non-accrual status when they become over 90 days
past due unless such loans are fully collateralized and, in managements judgment, are collectible. At December 31, 2003, there were 9 non-performing loans that totaled $11 thousand. All 11 loans were unsecured credit card loans.



Loans Held for Sale



Loans held for sale at December 31, 2003 were $171 thousand compared to
December 31, 2002 when such loans were $3.36 million. This decrease is due to a slowdown in mortgage refinancing activity. These loans have been pre-committed for sale to investors.



13



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##### Table of Contents

Deposits



Deposits increased $14.13 million or 12.77% to $124.75 million compared to $110.62 million at December 31, 2002. Noninterest
bearing deposits increased $7.91 million, or 36.55% to $29.53 million compared to $21.62 million at December 31, 2002. Interest bearing deposits grew $6.22 million or 6.99% to $95.22 million from $89.00 million at December 31, 2002. The increase in
deposits is a result of growth in the number of deposit accounts and in the number of deposit products per customer.



The Banks deposit base includes large denomination certificates of deposit of $100,000 or more. These deposits represented approximately 19% and 18%
of total deposits at December 31, 2003 and 2002, respectively. Generally management attempts to match large denomination certificates of deposit with rate sensitive assets.



Remaining Maturities of Large Denomination Certificates of Deposit

(Dollars in thousands)



|                               |  |                          |       
|------------------------------ |  | ------------------------ | ------
|                               |  | December 31, 2003 Amount
|Three months or less           |  | $                        | 5,253 
|Over three through six months  |  |                          | 4,560 
|Over six through twelve months |  |                          | 3,539 
|Over twelve months             |  |                          | 10,075
|                               |  |                          |       
|Total                          |  | $                        | 23,427



BANK
LIQUIDITY:



An important component of the Banks
asset/liability structure is the level of liquidity available to fund depositors withdrawals and extensions of credit to borrowers. Traditional sources of bank liquidity include deposit growth, loan repayments, investment maturities,
borrowings and interest received. Liquid assets include cash, federal funds sold and investments maturing within one year. The Banks ability to obtain deposits and purchase funds at favorable rates determines its liability liquidity. As a
result of the Banks management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity that is sufficient to satisfy its depositors requirements and
meet its customers credit needs.



Selected Liquidity Statistics

For the Years Ended December 31,



|                                                                       |  |                        |        |   |      |   |        |  
|---------------------------------------------------------------------- |  | ---------------------- | ------ | - | ---- | - | ------ | -
|                                                                       |  | 2003                   |        |   | 2002 |  
|                                                                       |  | (Dollars in thousands) |       
|Available short-term assets (1)                                        |  | $                      | 23,867 |   |      | $ | 26,303 |  
|Certificates of deposit $100,000 and over                              |  |                        | 23,427 |   |      |   | 20,226 |  
|                                                                       |  |                        |        |   |      |   |        |  
|Net available short-term assets                                        |  | $                      | 440    |   |      | $ | 6,077  |  
|                                                                       |  |                        |        |   |      |   |        |  
|Ratio of available short-term assets to certificates $100,000 and over |  |                        | 102    | % |      |   | 130    | %
|                                                                       |  |                       
|Ratio of loans to deposits                                             |  |                        | 81     | % |      |   | 75     | %
|                                                                       |  |                       
|Ratio of certificates $100,000 and over to total assets                |  |                        | 16     | % |      |   | 16     | %

---

|(1) | As of December 31, 2003, available short-term assets include cash of $8,930,000, federal funds sold of $10,600,000 and available-for-sale securities maturing within one year of
$4,337,00. As of December 31, 2002, available short-term assets include cash of $8,879,000, federal funds sold of $13,423,000 and held-to-maturity and available-for-sale securities maturing within one year of $250,000 and $3,751,000, respectively.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Companys Consolidated Statement of
Cash Flows, found in the Consolidated Financial Statements, provides information as to cash provided and used from operating, investing and financing activities. At December 31, 2003, cash and cash equivalents available to meet immediate liquidity
needs and reserve requirements were $19.53 million. The Companys cash and cash equivalents decreased $2.77 million from $22.30 million at December 31, 2002.



14



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##### Table of Contents

PARENT COMPANY LIQUIDITY:



The parent holding company incurred expenses for stockholder-related activities, stock transfer and other functions
necessary for the administration of the Company. See Note 3 of the Consolidated Financial Statements under Item 7.  Financial Statements for the parent companys Cash Flow Statement for further information on cash provided or used
by the parent for operating, financing and investing activities. In addition, certain restrictions on cash dividends, loans and advances are imposed by regulation of the Bank, which are also disclosed in Note 3 under of the Consolidated Financial
Statements Item 7.  Financial Statements.



CAPITAL:



Banking regulations established to ensure
capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of Total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as
defined). Management believes, as of December 31, 2003, that the Company meets all capital adequacy requirements to which it is subject.



Stockholders equity at December 31, 2003 was $13.31 million which is an increase $1.55 million compared to $11.76 million at the end of 2002.



The following table provides information on the Companys
risk-based, leverage and capital ratios at December 31, 2003 and 2002.



Capital Ratios

For the Years Ended December 31,



|                           |  |                        |         |   |      |   |        |  
|-------------------------- |  | ---------------------- | ------- | - | ---- | - | ------ | -
|                           |  | 2003                   |         |   | 2002 |  
|                           |  | (Dollars in thousands) |        
|Risk-based capital:        |  |                        |         |   |      |   |        |  
|Tier I Capital             |  |                        |         |   |      |   |        |  
|Stockholders equity       |  | $                      | 13,178  |   |      | $ | 11,498 |  
|Tier II Capital            |  |                        |         |   |      |   |        |  
|Allowance for loan losses  |  |                        | 1,187   |   |      |   | 1,088  |  
|                           |  |                        |         |   |      |   |        |  
|Total                      |  | $                      | 14,365  |   |      | $ | 12,586 |  
|                           |  |                        |         |   |      |   |        |  
|Risk adjusted assets       |  | $                      | 105,364 |   |      | $ | 89,985 |  
|Risk-based capital ratios: |  |                        |         |   |      |   |        |  
|Tier I                     |  |                        | 12.51   | % |      |   | 12.78  | %
|Total                      |  |                        | 13.63   | % |      |   | 13.99  | %
|                           |  |                       
|Leverage ratio             |  |                        | 9.90    | % |      |   | 9.72   | %
|Primary capital ratio      |  |                        | 9.83    | % |      |   | 9.74   | %



RATE
SENSITIVITY:



An important element of earnings performance is
proper management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest sensitive assets and interest sensitive liabilities at a specific time interval. A gap is considered positive when the amount of
interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities, and is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets during a given period.
Repricing assets or liabilities, selling investments that are classified as available-for-sale, replacing an asset or liability at maturity or adjusting the interest rate during the life of an asset or liability are all means by which a Bank can
manage the gap. Matching the amounts of assets and liabilities maturing in the same time interval helps to minimize the impact on net interest income in periods of interest rate volatility.



15



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##### Table of Contents

At December 31, 2003, the Bank had $3.18 million more liabilities than assets subject to repricing within
one year and was, therefore, in a liability-sensitive position. The following table presents the Banks interest sensitivity position at December 31, 2003. This one-day position, which continually is changing, is not necessarily indicative of
the Banks position at any other time.



Interest Sensitivity Analysis

December 31, 2003



|                                                                  |  |                           |        |   |                          |   |         |                         |  |   |                         |   |  |            |         |   |       |   |        |   |  |   |        
|----------------------------------------------------------------- |  | ------------------------- | ------ | - | ------------------------ | - | ------- | ----------------------- |  | - | ----------------------- | - |  | ---------- | ------- | - | ----- | - | ------ | - |  | - | -------
|                                                                  |  | Within 1 through 3 months |        |   | Over 3 through 12 months |   |         | Over 1 Yr through 3 yrs |  |   | Over 3 Yr through 5 yrs |   |  | Over 5 yrs |         |   | Total
|Earning assets:                                                   |  |                           |        |   |                          |   |         |                         |  |   |                         |   |  |            |         |   |       |   |        |   |  |   |        
|Federal funds                                                     |  | $                         | 10,600 |   |                          | $ |        |                         |  | $ |                        |   |  | $          |        |   |       | $ |       |   |  | $ | 10,600 
|Investment securities                                             |  |                           | 1,064  |   |                          |   | 3,870   |                         |  |   | 10,677                  |   |  |            | 2,905   |   |       |   | 1,543  |   |  |   | 20,059 
|Loans                                                             |  |                           | 34,825 |   |                          |   | 6,077   |                         |  |   | 12,043                  |   |  |            | 22,868  |   |       |   | 25,726 |   |  |   | 101,539
|                                                                  |  |                           |        |   |                          |   |         |                         |  |   |                         |   |  |            |         |   |       |   |        |   |  |   |        
|Total Earning Assets                                              |  | $                         | 46,489 |   |                          | $ | 9,947   |                         |  | $ | 22,720                  |   |  | $          | 25,773  |   |       | $ | 27,269 |   |  | $ | 132,198
|                                                                  |  |                           |        |   |                          |   |         |                         |  |   |                         |   |  |            |         |   |       |   |        |   |  |   |        
|Interest and non-interest bearing liabilities:                    |  |                           |        |   |                          |   |         |                         |  |   |                         |   |  |            |         |   |       |   |        |   |  |   |        
|Commercial DDA                                                    |  |                           | 11,906 |   |                          |   |        |                         |  |   | 7,144                   |   |  |            | 4,763   |   |       |   |       |   |  |   | 23,813 
|Personal DDA                                                      |  |                           |       |   |                          |   |        |                         |  |   | 3,428                   |   |  |            | 1,143   |   |       |   | 1,143  |   |  |   | 5,714  
|TT&L Note                                                         |  |                           | 57     |   |                          |   |        |                         |  |   |                        |   |  |            |        |   |       |   |       |   |  |   | 57     
|Savings                                                           |  |                           |       |   |                          |   |        |                         |  |   | 3,283                   |   |  |            | 1,094   |   |       |   | 1,094  |   |  |   | 5,471  
|Money Market                                                      |  |                           |       |   |                          |   | 3,763   |                         |  |   | 3,763                   |   |  |            |        |   |       |   |       |   |  |   | 7,527  
|NOW                                                               |  |                           |       |   |                          |   |        |                         |  |   | 10,776                  |   |  |            | 3,592   |   |       |   | 3,592  |   |  |   | 17,960 
|Certificates                                                      |  |                           | 10,285 |   |                          |   | 27,645  |                         |  |   | 13,061                  |   |  |            | 13,256  |   |       |   | 15     |   |  |   | 64,262 
|Repurchase Agreements                                             |  | $                         | 5,959  |   |                          | $ |        |                         |  | $ |                        |   |  | $          |        |   |       | $ |       |   |  | $ | 5,959  
|                                                                  |  |                           |        |   |                          |   |         |                         |  |   |                         |   |  |            |         |   |       |   |        |   |  |   |        
|Total Interest and non interest bearing liabilities               |  | $                         | 28,207 |   |                          | $ | 31,408  |                         |  | $ | 41,455                  |   |  | $          | 23,848  |   |       | $ | 5,844  |   |  | $ | 130,762
|                                                                  |  |                           |        |   |                          |   |         |                         |  |   |                         |   |  |            |         |   |       |   |        |   |  |   |        
|Interest sensitivity gap                                          |  | $                         | 18,282 |   |                          | $ | (21,461 | )                       |  | $ | (18,735                 | ) |  | $          | 1,925   |   |       | $ | 21,425 |   |  | $ | 1,434  
|                                                                  |  |                           |        |   |                          |  
|Cumulative gap                                                    |  | $                         | 18,282 |   |                          | $ | (3,180  | )                       |  | $ | (21,916                 | ) |  | $          | (19,990 | ) |       | $ | 1,435  |   |  |   |        
|                                                                  |  |                           |        |   |                          |  
|Ratio interest sensitive assets to interest-sensitive liabilities |  |                           | 1.65X  |   |                          |   | 0.32X   |                         |  |   | 0.55X                   |   |  |            | 1.08X   |   |       |   | 4.67X  |   |  |   | 1.01X  
|                                                                  |  |                           |        |   |                          |  
|Ratio of cumulative gap to total earning assets                   |  |                           | 13.83  | % |                          |   | -2.41   | %                       |  |   | -16.58                  | % |  |            | -15.12  | % |       |   | 1.09   | % |  |   |        

---

|(1) | Assets and liabilities are presented in the period they mature or reprice, whichever is earlier.
|--- | ------------------------------------------------------------------------------------------------



Credit Risk and Regulatory Matters:



Credit risk, the risk of loss from default, is inherent in lending. While management uses available information to recognize
losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. Management and the Board of Directors of the Company believe the allowance is a reasonable estimate of potential loss exposure in the loan
portfolio at year-end, however, many factors affecting the ability of borrowers to repay their loans, including economic factors beyond the control of the Bank or the borrowers, will impact this estimate on an ongoing basis.



Management also considers reports of examinations furnished by state and
federal banking authorities. Regulatory agencies periodically review the allowance for loan losses as part of their examination process and may require the Bank to recognize additions to the allowance based on their judgment of information available
to them at the time of their examination. A Federal Reserve Bank examination of the Company and the Bank was conducted in the first quarter of 2002 for the balance sheet dated December 31, 2001. No additions to the allowance for loan losses were
recommended as a result of the examination.



16



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##### Table of Contents

Recent Accounting Pronouncements



In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities(FIN 46) which establishes guidance for determining when an entity should consolidate another entity that meets the definition of a variable interest entity. The Interpretation had no effect on the Corporations
consolidated financial statements.



In April 2003, the FASB
issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This Statement amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities and clarifies
accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. This statement is effective for contracts entered into or modified after June 30, 2003,
except in certain circumstances, and for hedging relationships designated after June 30, 2003. This Statement had no effect on the Corporations consolidated financial statements.



In May 2002, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity. This Statement provides new rules on the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. Such financial instruments include mandatory redeemable
shares, instruments that require the issuer to buy back some of its shares in exchange for cash or other assets, or obligations that can be settled with shares, the monetary value of which is fixed. Most of the guidance in SFAS No. 150 is effective
for financial instruments entered into or modified after May 31, 2003, and other is effective at the beginning of the first interim period beginning after June 30, 2003. This Statement had no effect on the Banks consolidated financial
statements.



In December 2003, the FASB issued SFAS No. 132
(revised 2003), Employers Disclosures about Pensions and Postretirement Benefits. This Statement requires additional disclosures about the assets, obligations and cash flows of defined benefit pension and postretirement plans, as
well as the expense recorded for such plans. As of December 31, 2003, the Bank has disclosed the required elements related to its postretirement plans Note 10 to these consolidated financial statements.



Off Balance Sheet Arrangements



As of December 31, 2003, the Company had not entered into any transaction,
agreement or other contractual arrangement to which an entity unconsolidated with the Company was a party.



17



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##### Table of Contents

Item 7. FINANCIAL STATEMENTS



REPORT OF INDEPENDENT ACCOUNTANTS



The Stockholders and Board of Directors

Heritage Bankshares, Inc.

Norfolk, Virginia



We have audited the accompanying consolidated balance sheets of Heritage Bankshares, Inc. and its subsidiaries at December 31, 2003 and 2002
and the related consolidated statements of income, stockholders equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express
an opinion on these consolidated financial statements based on our audits.



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



In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of Heritage Bankshares, Inc. and its subsidiaries as of December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for
the years then ended in conformity with accounting principles generally accepted in the United States of America.



/s/Witt Mares Eggleston Smith, PLC



Virginia Beach, Virginia

February 6, 2004



18



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##### Table of Contents

HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS



|                                                                                                                        |  |      |             |   |      |   |             |  
|----------------------------------------------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|December 31,                                                                                                            |  | 2003 |             |   | 2002 |  
|ASSETS                                                                                                                  |  |      |             |   |      |   |             |  
|                                                                                                                        |  |     
|Cash and due from banks                                                                                                 |  | $    | 8,929,926   |   |      | $ | 8,878,558   |  
|Federal funds sold                                                                                                      |  |      | 10,600,345  |   |      |   | 13,423,376  |  
|Securities available for sale                                                                                           |  |      | 18,572,979  |   |      |   | 14,257,498  |  
|Securities held to maturity                                                                                             |  |      | 1,691,802   |   |      |   | 1,641,357   |  
|Loans, net                                                                                                              |  |      | 100,352,375 |   |      |   | 81,465,850  |  
|Loans held for sale                                                                                                     |  |      | 171,475     |   |      |   | 3,361,680   |  
|Accrued interest receivable                                                                                             |  |      | 571,655     |   |      |   | 477,100     |  
|Premises and equipment, net                                                                                             |  |      | 2,289,328   |   |      |   | 2,391,222   |  
|Other assets                                                                                                            |  |      | 1,789,389   |   |      |   | 2,232,691   |  
|                                                                                                                        |  |      |             |   |      |   |             |  
|                                                                                                                        |  | $    | 144,969,274 |   |      | $ | 128,129,332 |  
|                                                                                                                        |  |      |             |   |      |   |             |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                    |  |      |             |   |      |   |             |  
|                                                                                                                        |  |     
|Deposits                                                                                                                |  |      |             |   |      |   |             |  
|Noninterest bearing deposits                                                                                            |  | $    | 29,525,495  |   |      | $ | 21,623,273  |  
|Interest-bearing deposits                                                                                               |  |      | 95,221,901  |   |      |   | 89,000,702  |  
|                                                                                                                        |  |      |             |   |      |   |             |  
|                                                                                                                        |  |      | 124,747,396 |   |      |   | 110,623,975 |  
|Securities sold under agreements to repurchase                                                                          |  |      | 5,959,341   |   |      |   | 4,467,660   |  
|Short-term borrowings                                                                                                   |  |      | 57,477      |   |      |   | 65,349      |  
|Accrued interest payable                                                                                                |  |      | 201,942     |   |      |   | 248,356     |  
|Other liabilities                                                                                                       |  |      | 694,008     |   |      |   | 961,279     |  
|                                                                                                                        |  |      |             |   |      |   |             |  
|                                                                                                                        |  |      | 131,660,164 |   |      |   | 116,366,619 |  
|                                                                                                                        |  |      |             |   |      |   |             |  
|Stockholders equity                                                                                                    |  |      |             |   |      |   |             |  
|Common stock, $5 par value - authorized 3,000,000 shares; issued and outstanding: 2003 - 791,900 shares; 2002 - 784,525 |  |      | 3,959,500   |   |      |   | 3,922,625   |  
|Additional paid-in capital                                                                                              |  |      | (260,005    | ) |      |   | (302,461    | )
|Retained earnings                                                                                                       |  |      | 9,474,344   |   |      |   | 7,878,163   |  
|Accumulated other comprehensive income                                                                                  |  |      | 135,271     |   |      |   | 264,386     |  
|                                                                                                                        |  |      |             |   |      |   |             |  
|                                                                                                                        |  |      | 13,309,110  |   |      |   | 11,762,713  |  
|                                                                                                                        |  |      |             |   |      |   |             |  
|                                                                                                                        |  | $    | 144,969,274 |   |      | $ | 128,129,332 |  
|                                                                                                                        |  |      |             |   |      |   |             |  



The notes to
consolidated financial statements

are an integral part of this statement.



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##### Table of Contents

HERITAGE BANKSHARES, INC

CONSOLIDATED STATEMENTS OF INCOME



|                                                    |  |      |           |      |   |          
|--------------------------------------------------- |  | ---- | --------- | ---- | - | ---------
|Years Ended December 31,                            |  | 2003 |           | 2002
|Interest income                                     |  |      |           |      |   |          
|Interest and fees on loans                          |  | $    | 6,460,321 |      | $ | 6,418,644
|Interest on investment securities:                  |  |      |           |      |   |          
|Available for sale                                  |  |      | 601,898   |      |   | 695,665  
|Held to maturity                                    |  |      | 90,236    |      |   | 124,070  
|                                                    |  |      |           |      |   |          
|                                                    |  |      | 692,134   |      |   | 819,735  
|                                                    |  |      |           |      |   |          
|Interest on federal funds sold                      |  |      | 114,309   |      |   | 135,251  
|                                                    |  |      |           |      |   |          
|Total interest income                               |  |      | 7,266,764 |      |   | 7,373,630
|                                                    |  |      |           |      |   |          
|Interest expense                                    |  |      |           |      |   |          
|Interest on deposits                                |  |      | 2,178,402 |      |   | 2,525,852
|Interest on short-term borrowings                   |  |      | 39,444    |      |   | 55,685   
|                                                    |  |      |           |      |   |          
|Total interest expense                              |  |      | 2,217,846 |      |   | 2,581,537
|                                                    |  |      |           |      |   |          
|Net interest income                                 |  |      | 5,048,918 |      |   | 4,792,093
|Provision for loan losses                           |  |      | 40,000    |      |   | 99,000   
|                                                    |  |      |           |      |   |          
|Net interest income after provision for loan losses |  |      | 5,008,918 |      |   | 4,693,093
|                                                    |  |      |           |      |   |          
|Noninterest income                                  |  |      |           |      |   |          
|Service charges                                     |  |      | 302,688   |      |   | 295,217  
|Other                                               |  |      | 1,041,200 |      |   | 551,957  
|                                                    |  |      |           |      |   |          
|                                                    |  |      | 1,343,888 |      |   | 847,174  
|                                                    |  |      |           |      |   |          
|Noninterest expense                                 |  |      |           |      |   |          
|Salaries and employee benefits                      |  |      | 2,102,315 |      |   | 1,932,129
|Other                                               |  |      | 749,306   |      |   | 657,362  
|Automated services                                  |  |      | 376,690   |      |   | 297,413  
|Occupancy expenses                                  |  |      | 246,192   |      |   | 239,177  
|Furniture and equipment expense                     |  |      | 181,173   |      |   | 199,443  
|Taxes and licenses                                  |  |      | 144,543   |      |   | 126,355  
|Stationery and supplies                             |  |      | 74,842    |      |   | 73,245   
|                                                    |  |      |           |      |   |          
|                                                    |  |      | 3,875,061 |      |   | 3,525,124
|                                                    |  |      |           |      |   |          
|Income before income taxes                          |  |      | 2,477,745 |      |   | 2,015,143
|                                                    |  |     
|Income tax expense                                  |  |      | 740,079   |      |   | 650,440  
|                                                    |  |      |           |      |   |          
|Net income                                          |  | $    | 1,737,666 |      | $ | 1,364,703
|                                                    |  |      |           |      |   |          
|Earnings per common share  basic                   |  | $    | 2.21      |      | $ | 1.75     
|                                                    |  |      |           |      |   |          
|Earnings per common share - assuming dilution       |  | $    | 2.05      |      | $ | 1.65     
|                                                    |  |      |           |      |   |          



The notes to consolidated financial
statements are an integral part of this statement.



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##### Table of Contents

HERITAGE BANKSHARES, INC,

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY



|                                                                                                          |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   |            |  
|--------------------------------------------------------------------------------------------------------- |  | ------------ |  | -------------------------- | --------- |  | ----------------- | -------- | - | -------------------------------------- | - | --------- | ----- |  | - | -------- | - |  | - | ---------- | -
|                                                                                                          |  | Common Stock |  | Additional Paid-in Capital |           |  | Retained Earnings |          |   | Accumulated Other Comprehensive Income |   |           | Total | 
|                                                                                                          |  | Shares       |  | Amount                     |           |  |                   |         
|Balance, December 31, 2001                                                                                |  | 777,625      |  | $                          | 3,888,125 |  | $                 | (323,421 | ) |                                        | $ | 6,880,776 |       |  | $ | 212,451  |   |  | $ | 10,657,931 |  
|Net income for 2002                                                                                       |  |              |  |                            |           |  |                   |          |   |                                        |   | 1,364,703 |       |  |   |          |   |  |   | 1,364,703  |  
|Net change in unrealized gain on securities available-for-sale, net of deferred income taxes of ($26,755) |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   | 51,935   |   |  |   | 51,935     |  
|                                                                                                          |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   |            |  
|Total comprehensive income                                                                                |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   | 1,416,638  |  
|                                                                                                          |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   |            |  
|Stock options exercised in 2002                                                                           |  | 6,900        |  |                            | 34,500    |  |                   | 20,960   |   |                                        |   |           |       |  |   |          |   |  |   | 55,460     |  
|Less: Dividends paid in 2002                                                                              |  |              |  |                            |           |  |                   |          |   |                                        |   | (367,316  | )     |  |   |          |   |  |   | (367,316   | )
|                                                                                                          |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   |            |  
|Balance, December 31, 2002                                                                                |  | 784,525      |  |                            | 3,922,625 |  |                   | (302,461 | ) |                                        |   | 7,878,163 |       |  |   | 264,386  |   |  |   | 11,762,713 |  
|Net income for 2003                                                                                       |  |              |  |                            |           |  |                   |          |   |                                        |   | 1,737,666 |       |  |   |          |   |  |   | 1,737,666  |  
|Net change in unrealized gain on securities available-for-sale, net of deferred taxes of $66,514          |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   | (129,115 | ) |  |   | (129,115   | )
|                                                                                                          |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   |            |  
|Total comprehensive income                                                                                |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   | 1,608,551  |  
|Stock options exercised in 2003                                                                           |  | 7,375        |  |                            | 36,875    |  |                   | 42,456   |   |                                        |   |           |       |  |   |          |   |  |   | 79,331     |  
|Less: Dividends paid in 2003                                                                              |  |              |  |                            |           |  |                   |          |   |                                        |   | (141,485  | )     |  |   |          |   |  |   | (141,485   | )
|                                                                                                          |  |              |  |                            |           |  |                   |          |   |                                        |   |           |       |  |   |          |   |  |   |            |  
|Balance, December 31, 2003                                                                                |  | 791,900      |  | $                          | 3,959,500 |  | $                 | (260,005 | ) |                                        | $ | 9,474,344 |       |  | $ | 135,271  |   |  | $ | 13,309,111 |  



The notes to consolidated financial
statements are an integral part of this statement.



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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOW



Years Ended December 31,



|                                                                               |  |      |             |   |      |   |            |  
|------------------------------------------------------------------------------ |  | ---- | ----------- | - | ---- | - | ---------- | -
|                                                                               |  | 2003 |             |   | 2002 |  
|Operating activities:                                                          |  |      |             |   |      |   |            |  
|Net income                                                                     |  | $    | 1,737,666   |   |      | $ | 1,364,703  |  
|Adjustments to reconcile to net cash provided by operating activities          |  |      |             |   |      |   |            |  
|Gain on sale of fixed assets                                                   |  |      |            |   |      |   | (7,332     | )
|Loss on disposal of fixed assets                                               |  |      |            |   |      |   | 7,237      |  
|Provision for loan losses                                                      |  |      | 40,000      |   |      |   | 99,000     |  
|Provision for depreciation and amortization                                    |  |      | 148,923     |   |      |   | 167,726    |  
|Amortization of investment security premiums, net of discounts                 |  |      | 182,059     |   |      |   | 79,610     |  
|Deferred loan origination fees, net of costs                                   |  |      | 54,291      |   |      |   | (9,174     | )
|Changes in:                                                                    |  |      |             |   |      |   |            |  
|Interest receivable                                                            |  |      | (94,555     | ) |      |   | 72,293     |  
|Interest payable                                                               |  |      | (46,414     | ) |      |   | (42,893    | )
|Loans held for sale                                                            |  |      | 3,190,205   |   |      |   | (1,108,580 | )
|Other assets                                                                   |  |      | 639,180     |   |      |   | (224,550   | )
|Other liabilities                                                              |  |      | (267,272    | ) |      |   | 65,310     |  
|                                                                               |  |      |             |   |      |   |            |  
|Net cash provided by operating activities                                      |  |      | 5,584,083   |   |      |   | 463,350    |  
|                                                                               |  |      |             |   |      |   |            |  
|Investing activities:                                                          |  |      |             |   |      |   |            |  
|Proceeds from maturities of available-for sale securities                      |  |      | 6,162,886   |   |      |   | 5,374,637  |  
|Proceeds from maturities, prepayments and calls of held-to-maturity securities |  |      | 266,538     |   |      |   | 666,734    |  
|Purchases of available-for-sale securities                                     |  |      | (10,850,238 | ) |      |   | (5,523,129 | )
|Purchases of held-to-maturity securities                                       |  |      | (322,800    | ) |      |   | (527,016   | )
|Loan originations, net of principal repayments                                 |  |      | (18,980,816 | ) |      |   | (2,866,431 | )
|Proceeds from sale or disposal of land, premises and equipment                 |  |      |            |   |      |   | 16,000     |  
|Purchases of land, premises and equipment                                      |  |      | (50,869     | ) |      |   | (146,462   | )
|                                                                               |  |      |             |   |      |   |            |  
|Net cash used by investing activities                                          |  |      | (23,775,299 | ) |      |   | (3,005,667 | )
|                                                                               |  |      |             |   |      |   |            |  
|Financing activities:                                                          |  |      |             |   |      |   |            |  
|Net increase in demand deposits, NOW and savings accounts                      |  |      | 11,127,107  |   |      |   | 2,617,777  |  
|Net increase in certificates of deposit                                        |  |      | 2,996,314   |   |      |   | 7,966,443  |  
|Net increase (decrease) in securities sold under agreements to repurchase      |  |      | 1,491,681   |   |      |   | (682,197   | )
|Net increase in short-term borrowings                                          |  |      | (7,872      | ) |      |   | 6,132      |  
|Net proceeds from exercise of stock options                                    |  |      | 79,331      |   |      |   | 55,460     |  
|Cash dividends paid                                                            |  |      | (267,009    | ) |      |   | (241,792   | )
|                                                                               |  |      |             |   |      |   |            |  
|Net cash provided by financing activities                                      |  |      | 15,419,552  |   |      |   | 9,721,823  |  
|                                                                               |  |      |             |   |      |   |            |  
|Increase in cash and cash equivalents                                          |  |      | (2,771,663  | ) |      |   | 7,179,506  |  
|Cash and cash equivalents at beginning of period                               |  |      | 22,301,934  |   |      |   | 15,122,428 |  
|                                                                               |  |      |             |   |      |   |            |  
|Cash and cash equivalents at end of period                                     |  | $    | 19,530,271  |   |      | $ | 22,301,934 |  
|                                                                               |  |      |             |   |      |   |            |  
|As shown on the Consolidated Balance Sheets:                                   |  |      |             |   |      |   |            |  
|Cash and due from banks                                                        |  | $    | 8,929,926   |   |      | $ | 8,878,558  |  
|Federal funds sold                                                             |  |      | 10,600,345  |   |      |   | 13,423,376 |  
|                                                                               |  |      |             |   |      |   |            |  
|                                                                               |  | $    | 19,530,271  |   |      | $ | 22,301,934 |  
|                                                                               |  |      |             |   |      |   |            |  
|Cash paid for:                                                                 |  |      |             |   |      |   |            |  
|Interest on deposits and other borrowings                                      |  | $    | 2,241,418   |   |      | $ | 2,624,430  |  
|                                                                               |  |      |             |   |      |   |            |  
|Income taxes                                                                   |  | $    | 821,075     |   |      | $ | 552,680    |  



The notes to consolidated financial
statements are an integral part of this statement.



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HERITAGE BANKSHARES, INC.



DECEMBER 31, 2002 AND 2001



NOTE 1 - ORGANIZATION AND BUSINESS



Heritage Bankshares, Inc. (the Company) was organized under the laws of the Commonwealth of Virginia in 1983. The Company has four wholly owned subsidiaries,
including one bank: Heritage Bank & Trust (the Bank) with five full-service branches in Norfolk and Chesapeake, Virginia. The Companys other subsidiaries are IBV Real Estate Holdings, Inc., a Virginia corporation, Sentinel
Title Services, Inc., a Virginia corporation, and Sentinel Trust Services, L.L.C., a Virginia limited liability company. The Bank is a state-chartered bank and a member of the Federal Reserve System. The deposits of the Bank are insured by the
Federal Deposit Insurance Corporation (the FDIC) to the extent and subject to the limitations set forth in the Federal Deposit Insurance Act, as amended.



The Bank is a full-service bank conducting a general commercial and consumer banking business with its customers located throughout the
Hampton Roads area of Virginia. Its principal banking activities include receiving demand, savings and time deposits for personal and commercial accounts; making commercial, real estate and consumer loans; acting as a United States tax depository
facility; providing money transfer and cash management services; selling travelers checks and bank money orders; issuing letters of credit; and investing in U.S. Treasury securities and securities of other U.S. government agencies and
corporations, and mortgage-backed and state and municipal securities.



IBV Real
Estate Holdings, Inc. was formed in December, 1986. Presently, its only business is owning a 1% general partnership interest in IBV Partners, L.P., the lessor of office space to Heritage Bank and Trust in Chesapeake, Virginia. Sentinel Title
Services, Inc. and Sentinel Trust Services, L.L.C. are wholly owned subsidiaries, which own an interest in providers of title and trust services. As these subsidiaries own a less than ten percent (10%) interest in other companies, the financial
activities pertaining to these interests are recorded on the cost method of accounting for investments. The Companys strategic relationship with these entities provides the Bank with the ability to provide title and trust services to its
customers.



NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES



Basis of Statement Presentation and
Principles of Consolidation



The accompanying consolidated financial
statements include the accounts of Heritage Bankshares, Inc. and its wholly owned subsidiaries, Heritage Bank and Trust, IBV Real Estate Holdings, Inc., Sentinel Title Services, Inc. and Sentinel Trust Services, L.L.C. All significant intercompany
balances and transactions have been eliminated in consolidation.



Cash
Equivalents



For purposes of reporting cash flows, cash and cash
equivalents include cash on hand, amounts due from banks, interest bearing deposits with banks and federal funds sold. Generally, federal funds are sold for one-day periods.



Securities



Investments in debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and reflected at
amortized cost. Investments that are purchased and held principally for the purpose of selling them in the near term, if any, are classified as trading securities and reflected at fair value, with unrealized gains and losses included in
earnings. Investments not classified as either of the above are classified as available for sale and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.



Purchase premiums and discounts are recognized in interest income using the interest
method over the period to maturity on held-to-maturity and available-for-sale securities. Other-than-temporary declines in the fair value of individual held-to-maturity and available-for-sale securities, if any, result in write-downs of the
individual securities to fair value. Gains and losses are determined using the specific-identification method.



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Loans



Loans are reported at their principal outstanding balance net of charge-offs, deferred loan fees and costs on originated loans, unearned income, and unamortized premiums
or discounts, if any, on purchased loans. Interest income is generally recognized when income is earned using the interest method. Loan origination fees and certain direct loan origination costs are deferred and the net amounts are amortized as an
adjustment to yield on the respective loans.



Loans Held For Sale



Mortgage loans originated and intended for sale in the secondary
market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.



Allowance for Loan Losses



A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate, except that all
collateral-dependent loans are measured for impairment based on the fair value of the collateral.



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



The adequacy of the allowance for loan losses is periodically evaluated by the
Bank, in order to maintain the allowance at a level that is sufficient to absorb probable credit losses. Managements evaluation of the adequacy of the allowance is based on a review of the Banks historical loss experience, known and
inherent risks in the loan portfolio, including adverse circumstances that may affect the ability of the borrower to repay interest and/or principal, the estimated value of collateral, and an analysis of the levels and trends of delinquencies,
charge-offs, and the risk ratings of the various loan categories.



Such factors
as the level and trend of interest rates and the condition of the national and local economies are also considered. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banks
allowance for losses on loans. Such agencies may require the Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their examination.



The allowance for loan losses is established through charges to earnings in the form of a
provision for loan losses. Increases and decreases in the allowance due to changes in the measurement of impaired loans, if applicable, are included in the provision for loan losses. Loans continue to be classified as impaired unless they are
brought fully current and the collection of scheduled interest and principal is considered probable.



When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance and subsequent recoveries, if any, are credited to the allowance.



Income Recognition on Impaired and Nonaccrual Loans



Loans, including impaired loans, are generally classified as nonaccrual if they are past due
as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful, or is partially charged off, the
loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual, if repayment in full of principal and/or interest is in doubt.



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Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages)
are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of interest and
principal.



While a loan is classified as nonaccrual and the future
collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectibility of the recorded loan balance is expected, interest income
may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual
interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.



Other Real Estate Owned



Other real estate owned is comprised of real estate acquired through foreclosure, acceptance of a deed in lieu of foreclosure, or loans in which the Bank receives
physical possession of the debtors real estate. Other real estate owned is carried at the lower of the recorded investment in the loan or the fair value less estimated costs to sell.



Restructured Loans



Loans are considered troubled debt restructurings if for economic or legal reasons, a
concession has been granted to the borrower related to the borrowers financial difficulties that the Bank would not have otherwise considered. The Bank has restructured certain loans in instances where a determination was made that greater
economic value will be realized under new terms than through foreclosure, liquidation, or other disposition. The terms of the renegotiation generally involve some or all of the following characteristics: a reduction in the interest pay rate to
reflect actual operating income, an extension of the loan maturity date to allow time for stabilization of operating income, and partial forgiveness of principal and interest. The carrying value of a restructured loan is reduced by the fair value of
assets or equity interest received, if any. Prior to demonstrating performance, the Bank generally classifies impaired restructured loans, if any, as nonaccrual. The accrual of interest resumes when such loans can demonstrate performance, generally
evidenced by six months of pre- or post-restructuring payment performance in accordance with the restructured terms, or by the presence of other significant factors. In addition, at the time of restructuring, loans are generally classified as
impaired. A restructured loan that is not impaired, based on the restructured terms and has a stated interest rate greater than or equal to a market interest rate at the date of the restructuring, is reclassified as unimpaired in the year
immediately following the year it was disclosed as restructured.



Premises and Equipment



Premises and equipment are
stated at cost less accumulated depreciation. For financial reporting purposes, assets are depreciated over their estimated useful lives using the straight-line method. For income tax purposes, the accelerated cost recovery system and the modified
accelerated cost recovery system are used.



Transfers of Financial Assets



Transfers of financial assets are accounted for as sales, when
control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank, (2) the transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.



Income Taxes



The Company files a consolidated tax return. Provisions for income taxes reflect tax expense incurred as a consolidated group. Tax expense
is allocated among the members of the consolidated group in accordance with an intercompany agreement for tax expense. Income taxes are provided for the tax effects of the transactions reported in



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the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between
the basis of investment securities, deferred loan fees, allowance for loan losses, allowance for losses on foreclosed real estate, accumulated depreciation and deferred compensation for financial and income tax reporting. The deferred tax assets and
liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. An allowance is provided if it is more likely than not that the
Company will not realize the benefits of a deferred tax asset. As of December 31, 2003, a valuation allowance has not been provided against the deferred tax asset.



Deferred Compensation Plans



The Bank maintains deferred compensation and retirement arrangements with certain directors and officers. The Companys policy is to accrue the present value of
estimated amounts to be paid under the contracts over the expected period of active employment. The Bank purchased life insurance contracts to fund the expected liabilities under the contracts.



Off-Balance-Sheet Financial Instruments



In the ordinary course of business, the Bank has entered into off-balance-sheet financial
instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit, standby letters of credit and financial guarantees written. Such financial instruments are recorded in the financial
statements when they become payable.



Use of Estimates



The preparation of financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.



Material estimates
that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. While management uses
available information to recognize losses on loans and foreclosed real estate, future additions to the allowance may be necessary based on changes in local economic conditions and other factors.



Earnings per Share



Basic earnings per share (EPS) excludes dilution and is computed by dividing income
available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised,
converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.



Comprehensive Income



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



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The components of other comprehensive income and related tax effects are as follows:



|                                                          |  |                          |          |   |      |   |         |  
|--------------------------------------------------------- |  | ------------------------ | -------- | - | ---- | - | ------- | -
|                                                          |  | Years Ended December 31, |         
|                                                          |  | 2002                     |          |   | 2003 |  
|Unrealized holding gains on available-for-sale securities |  | $                        | (195,629 | ) |      | $ | 78,690  |  
|Tax effect                                                |  |                          | 66,514   |   |      |   | (26,755 | )
|                                                          |  |                          |          |   |      |   |         |  
|Net-of-tax amount                                         |  | $                        | (129,115 | ) |      | $ | 51,935  |  
|                                                          |  |                          |          |   |      |   |         |  



Reclassifications



Certain reclassifications have been made to prior year financial
statements to conform them to the current years presentation. The financial position, results of operations and cash flows of Heritage Bankshares, Inc. are presented below on a parent company only basis for the years indicated.



|                                                                                  |  |                          |            |   |      |   |            |  
|--------------------------------------------------------------------------------- |  | ------------------------ | ---------- | - | ---- | - | ---------- | -
|                                                                                  |  | Years Ended December 31, |           
|Condensed Balance Sheets                                                          |  | 2003                     |            |   | 2002 |  
|Assets                                                                            |  |                          |            |   |      |   |            |  
|Cash on deposit with Heritage Bank & Trust                                        |  | $                        | 503,989    |   |      | $ | 468,767    |  
|Investment in Heritage Bank & Trust                                               |  |                          | 12,657,810 |   |      |   | 11,168,025 |  
|Investment in non-bank subsidiaries                                               |  |                          | 245,549    |   |      |   | 245,549    |  
|Other assets                                                                      |  |                          | 68,355     |   |      |   | 232,004    |  
|                                                                                  |  |                          |            |   |      |   |            |  
|Total assets                                                                      |  | $                        | 13,475,703 |   |      | $ | 12,114,345 |  
|                                                                                  |  |                          |            |   |      |   |            |  
|Liabilities and Stockholders Equity                                              |  |                          |            |   |      |   |            |  
|Other Liabilities                                                                 |  | $                        | 166,593    |   |      | $ | 351,632    |  
|Common Stock                                                                      |  |                          | 3,959,500  |   |      |   | 3,922,625  |  
|Additional paid-in capital                                                        |  |                          | (260,005   | ) |      |   | (302,461   | )
|Retained earnings                                                                 |  |                          | 9,474,344  |   |      |   | 7,878,163  |  
|Accumulated other comprehensive income                                            |  |                          | 135,271    |   |      |   | 264,386    |  
|                                                                                  |  |                          |            |   |      |   |            |  
|Total liabilities and stockholders equity                                        |  | $                        | 13,475,703 |   |      | $ | 12,114,345 |  
|                                                                                  | 
|                                                                                  |  | Years Ended December 31, |           
|Condensed Statement of Income                                                     |  | 2003                     |            |   | 2002 |  
|Income                                                                            |  |                          |            |   |      |   |            |  
|Dividends from subsidiary bank                                                    |  | $                        | 141,485    |   |      | $ | 367,316    |  
|Other income                                                                      |  |                          | 435        |   |      |   |           |  
|                                                                                  |  |                          |            |   |      |   |            |  
|Total income                                                                      |  | $                        | 141,920    |   |      | $ | 367,316    |  
|Expenses                                                                          |  |                          |            |   |      |   |            |  
|Other                                                                             |  |                          | 34,859     |   |      |   | 29,305     |  
|Income before income taxes and equity in undistributed net income of subsidiaries |  |                          | 107,061    |   |      |   | 338,012    |  
|                                                                                  |  |                          |            |   |      |   |            |  
|Applicable income tax benefit                                                     |  |                          | 11,704     |   |      |   | 8,570      |  
|                                                                                  |  |                          |            |   |      |   |            |  
|Income before equity in undistributed net income of subsidiaries                  |  |                          | 118,765    |   |      |   | 346,582    |  
|Equity in undistributed net income of subsidiaries                                |  |                          | 1,618,901  |   |      |   | 1,018,121  |  
|                                                                                  |  |                          |            |   |      |   |            |  
|Net income                                                                        |  | $                        | 1,737,666  |   |      | $ | 1,364,703  |  



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|                                                                       |  |                          |            |   |      |   |           |  
|---------------------------------------------------------------------- |  | ------------------------ | ---------- | - | ---- | - | --------- | -
|                                                                       |  | Years Ended December 31, |           
|Condensed Statements of Cash Flows                                     |  | 2003                     |            |   | 2002 |  
|Operating activities:                                                  |  |                          |            |   |      |   |           |  
|Net income                                                             |  | $                        | 1,737,666  |   |      | $ | 1,364,703 |  
|Adjustments to reconcile to net cash provided by operating activities: |  |                          |            |   |      |   |           |  
|                                                                       |  |                         
|Undistributed net income of subsidiaries                               |  |                          | (1,618,900 | ) |      |   | (986,023  | )
|Changes in:                                                            |  |                          |            |   |      |   |           |  
|                                                                       |  |                         
|Other assets                                                           |  |                          | 163,649    |   |      |   | (13,037   | )
|                                                                       |  |                         
|Other liabilities                                                      |  |                          | (185,039   | ) |      |   | 209,401   |  
|                                                                       |  |                          |            |   |      |   |           |  
|Net cash provided by operating activities                              |  |                          | 97,376     |   |      |   | 575,044   |  
|                                                                       |  |                          |            |   |      |   |           |  
|Investing activities:                                                  |  |                          |            |   |      |   |           |  
|Investment in non-bank subsidiary                                      |  |                          |           |   |      |   | (28,000   | )
|                                                                       |  |                          |            |   |      |   |           |  
|Net cash used by investing activities                                  |  |                          |           |   |      |   | (28,000   | )
|                                                                       |  |                         
|Financing activities:                                                  |  |                          |            |   |      |   |           |  
|Net proceeds from exercise of stock options                            |  |                          | 79,331     |   |      |   | 55,460    |  
|Cash dividends paid                                                    |  |                          | (141,485   | ) |      |   | (367,317  | )
|                                                                       |  |                          |            |   |      |   |           |  
|Net cash used by financing activities                                  |  |                          | (62,154    | ) |      |   | (311,857  | )
|                                                                       |  |                         
|Net increase in cash and cash equivalents                              |  |                          | 35,222     |   |      |   | 235,186   |  
|                                                                       |  |                         
|Cash and cash equivalents at beginning of year                         |  |                          | 468,767    |   |      |   | 233,581   |  
|                                                                       |  |                          |            |   |      |   |           |  
|Cash and cash equivalents at end of year                               |  | $                        | 503,989    |   |      | $ | 468,767   |  
|                                                                       |  |                          |            |   |      |   |           |  



Certain restrictions exist regarding
the ability of Heritage Bank and Trust to transfer funds to Heritage Bankshares, Inc. in the form of cash dividends, loans or advances. Pursuant to federal regulations, dividends are generally restricted to net profits, as defined, for the current
year, plus retained net profits for the previous two years. At December 31, 2003 the Bank could have paid dividends to the Company of approximately $3,780,000 under these regulations. The maximum amount available for transfer from Heritage Bank and
Trust to the Company in the form of loans and advances is 10% of Heritage Bank and Trusts stockholders equity. At December 31, 2003 such maximum amount available is approximately $1,266,000.



NOTE 4 - RESTRICTIONS ON CASH AND DUE FROM BANK ACCOUNTS



The Bank is required by the Federal Reserve Bank to maintain average reserve balances. The
average amount of maintained reserve balances was approximately $1,431,000 for the year ended December 31, 2003, with the average reserve requirement for the same period being approximately $1,227,000. On December 31, 2003, the reserve balances were
approximately $1,570,000.



28



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NOTE 5  SECURITIES



|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|-------------------------------- |  | -------------- | ---------- | ---------------------- | - | ----------------------- |  | -------------------- | ------ |  | - | ----------
|                                 |  | Amortized Cost |            | Gross Unrealized Gains |   | Gross Unrealized Losses |  | Estimated Fair Value
|December 31, 2003                |  |                |            |                        |   |                         |  |                      |        |  |   |           
|Securities available-for-sale    |  |                |            |                        |   |                         |  |                      |        |  |   |           
|U.S. Treasury                    |  | $              | 500,131    |                        | $ | 3,774                   |  | $                    |       |  | $ | 503,905   
|U.S. government agencies         |  |                | 16,926,157 |                        |   | 168,151                 |  |                      | 13,929 |  |   | 17,080,379
|Mortgage-backed securities       |  |                | 358,906    |                        |   | 14,756                  |  |                      |       |  |   | 373,662   
|State and political subdivisions |  |                | 582,828    |                        |   | 32,205                  |  |                      |       |  |   | 615,033   
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|                                 |  | $              | 18,368,022 |                        | $ | 218,886                 |  | $                    | 13,929 |  | $ | 18,572,979
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|Securities held-to-maturity      |  |                |            |                        |   |                         |  |                      |        |  |   |           
|Mortgage-backed securities       |  |                | 25,315     |                        |   | 286                     |  |                      |       |  |   | 25,601    
|State and political subdivisions |  |                | 469,234    |                        |   | 12,897                  |  |                      |       |  |   | 482,131   
|                                 |  |                |            |                       
|Other                            |  |                | 1,197,253  |                        |   | 31,852                  |  |                      |       |  |   | 1,229,105 
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|                                 |  | $              | 1,691,802  |                        | $ | 45,035                  |  | $                    |       |  | $ | 1,736,837 
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|December 31, 2002                |  |                |            |                        |   |                         |  |                      |        |  |   |           
|Securities available-for-sale    |  |                |            |                        |   |                         |  |                      |        |  |   |           
|U.S. Treasury                    |  | $              | 501,026    |                        | $ | 24,914                  |  | $                    |       |  | $ | 525,940   
|U.S. government agencies         |  |                | 12,027,119 |                        |   | 334,956                 |  |                      |       |  |   | 12,362,075
|Mortgage-backed securities       |  |                | 581,713    |                        |   | 25,295                  |  |                      |       |  |   | 607,009   
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|State and political subdivisions |  |                | 747,054    |                        |   | 15,420                  |  |                      |       |  |   | 762,474   
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|                                 |  | $              | 13,856,913 |                        | $ | 400,585                 |  | $                    |       |  | $ | 14,257,498
|                                 |  |                |            |                       
|Securities held-to-maturity      |  |                |            |                        |   |                         |  |                      |        |  |   |           
|U.S. government agencies         |  |                | 250,336    |                        |   | 5,211                   |  |                      |       |  |   | 255,548   
|Mortgage-backed securities       |  |                | 41,944     |                        |   | 982                     |  |                      |       |  |   | 42,926    
|State and political subdivisions |  |                | 194,067    |                        |   | 13,501                  |  |                      |       |  |   | 207,568   
|Other                            |  |                | 1,155,010  |                        |   |                        |  |                      |       |  |   | 1,155,010 
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           
|                                 |  | $              | 1,641,357  |                        | $ | 19,695                  |  | $                    |       |  | $ | 1,661,052 
|                                 |  |                |            |                        |   |                         |  |                      |        |  |   |           



Other securities include restricted
investments of $668,200 and $630,400 December 31, 2003 and 2002, respectively. These securities do not have a readily determinable fair value and lack a market. Therefore, they are carried at cost and periodically evaluated for impairment.



Investment securities having carrying values of $3,106,243 and $4,077,292 at
December 31, 2003 and 2002, respectively, are pledged to secure deposits of the U.S. government and the Commonwealth of Virginia, the estimated fair values of these securities were $3,151,138 and $4,224,631 at December 31, 2003 and 2002,
respectively.



29



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The amortized cost and fair value of securities by maturity date, including the contractual maturities of mortgage-backed
securities, at December 31, 2003 are as follows:



|                                 |  |                             |           |                               |   |                |  |                      |            |  |   |           
|-------------------------------- |  | --------------------------- | --------- | ----------------------------- | - | -------------- |  | -------------------- | ---------- |  | - | ----------
|                                 |  | Securities Held-to-Maturity |           | Securities Available-for-Sale
|                                 |  | Amortized Cost              |           | Estimated Fair Value          |   | Amortized Cost |  | Estimated Fair Value
|Due in one year or less          |  | $                           |          |                               | $ |               |  | $                    | 4,336,585  |  | $ | 4,399,232 
|Due from one year to five years  |  |                             | 511,598   |                               |   | 543,450        |  |                      | 12,564,109 |  |   | 12,656,922
|Due from five years to ten years |  |                             | 194,234   |                               |   | 207,131        |  |                      | 1,111,688  |  |   | 1,146,544 
|Due after ten years              |  |                             | 985,970   |                               |   | 986,256        |  |                      | 355,640    |  |   | 370,281   
|                                 |  |                             |           |                               |   |                |  |                      |            |  |   |           
|                                 |  | $                           | 1,691,802 |                               | $ | 1,736,837      |  | $                    | 18,368,022 |  | $ | 18,572,979



NOTE 6 - LOANS



Loans consist of the following:



|                               |  |                          |             |   |      |   |            |  
|------------------------------ |  | ------------------------ | ----------- | - | ---- | - | ---------- | -
|                               |  | Years Ended December 31, |            
|                               |  | 2003                     |             |   | 2002 |  
|Gross loans                    |  |                          |             |   |      |   |            |  
|Commercial                     |  | $                        | 19,218,188  |   |      | $ | 13,892,187 |  
|Real estate-mortgage           |  |                          | 73,822,691  |   |      |   | 58,077,032 |  
|Real estate-construction       |  |                          | 3,551,281   |   |      |   | 4,170,760  |  
|Installment and consumer       |  |                          | 4,947,069   |   |      |   | 6,413,711  |  
|                               |  |                          |             |   |      |   |            |  
|Total gross loans              |  |                          | 101,539,229 |   |      |   | 82,553,690 |  
|Less-allowance for loan losses |  |                          | (1,186,854  | ) |      |   | (1,087,840 | )
|                               |  |                          |             |   |      |   |            |  
|Loans, net                     |  | $                        | 100,352,375 |   |      | $ | 81,465,850 |  
|                               |  |                          |             |   |      |   |            |  



A summary of the
activity in the allowance for loan losses account is as follows:



|                                |  |                          |           |   |      |   |           |  
|------------------------------- |  | ------------------------ | --------- | - | ---- | - | --------- | -
|                                |  | Years Ended December 31, |          
|                                |  | 2003                     |           |   | 2002 |  
|Balance, beginning of year      |  | $                        | 1,087,840 |   |      | $ | 1,085,148 |  
|Provision charged to operations |  |                          | 40,000    |   |      |   | 99,000    |  
|Loans charged-off               |  |                          | (32,800   | ) |      |   | (98,771   | )
|Recoveries                      |  |                          | 91,814    |   |      |   | 2,462     |  
|                                |  |                          |           |   |      |   |           |  
|Balance, end of year            |  | $                        | 1,186,854 |   |      | $ | 1,087,840 |  
|                                |  |                          |           |   |      |   |           |  



The following is a summary of
information pertaining to impaired loans:



|                                              |  |              |           |      |   |          
|--------------------------------------------- |  | ------------ | --------- | ---- | - | ---------
|                                              |  | December 31,
|                                              |  | 2003         |           | 2002
|Impaired loans without a valuation allowance  |  | $            |          |      | $ |         
|Impaired loans with a valuation allowance     |  |              | 2,441,613 |      |   | 2,613,790
|                                              |  |              |           |      |   |          
|Total impaired loans                          |  | $            | 2,441,613 |      | $ | 2,613,790
|                                              |  |              |           |      |   |          
|Valuation allowance related to impaired loans |  | $            | 533,081   |      | $ | 556,910  
|                                              |  |              |           |      |   |          



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|                                             |  |                          |           |      |   |          
|-------------------------------------------- |  | ------------------------ | --------- | ---- | - | ---------
|                                             |  | Years Ended December 31,
|                                             |  | 2003                     |           | 2002
|Average investment in impaired loans         |  | $                        | 3,056,920 |      | $ | 1,101,083
|                                             |  |                          |           |      |   |          
|Interest income recognized on impaired loans |  | $                        | 173,971   |      | $ | 61,499   
|                                             |  |                          |           |      |   |          



No additional funds are committed to
be advanced in connection with impaired loans.



Loans on which the accrual of
interest has been discontinued amount to $10,969 and $13,305 at December 31, 2003 and 2002 respectively. If interest on these loans had been accrued, such income would have approximated $1,771 and $3,969 for 2003 and 2002, respectively. No interest
income was recognized or received on these loans in 2003 and 2002.



NOTE 7 -
PREMISES AND EQUIPMENT



Premises and equipment consist of the following:



|                                  |  |              |            |   |      |   |            |  
|--------------------------------- |  | ------------ | ---------- | - | ---- | - | ---------- | -
|                                  |  | December 31, |           
|                                  |  | 2003         |            |   | 2002 |  
|Land and improvements             |  | $            | 612,567    |   |      | $ | 612,567    |  
|Buildings                         |  |              | 1,995,238  |   |      |   | 1,987,562  |  
|Leasehold improvements            |  |              | 7,951      |   |      |   | 7,951      |  
|Equipment, furniture and fixtures |  |              | 1,517,023  |   |      |   | 1,473,831  |  
|                                  |  |              |            |   |      |   |            |  
|                                  |  | $            | 4,132,779  |   |      | $ | 4,081,911  |  
|                                  |  |             
|Less - accumulated depreciation   |  |              | (1,843,451 | ) |      |   | (1,690,689 | )
|                                  |  |              |            |   |      |   |            |  
|                                  |  | $            | 2,289,328  |   |      | $ | 2,391,222  |  
|                                  |  |              |            |   |      |   |            |  



Depreciation charged to operating
expense for the years ended December 31, 2003 and 2002 was $148,923 and $167,726, respectively.



NOTE 8 - DEPOSITS



Interest-bearing
deposits consist of the following:



|                                          |  |              |            |      |   |           
|----------------------------------------- |  | ------------ | ---------- | ---- | - | ----------
|                                          |  | December 31,
|                                          |  | 2002         |            | 2002
|Money market and NOWs                     |  | $            | 25,486,868 |      | $ | 23,115,766
|Savings                                   |  |              | 5,472,470  |      |   | 4,618,687 
|Certificates of deposit $100,000 and over |  |              | 23,427,025 |      |   | 20,225,821
|Other time deposits                       |  |              | 40,835,538 |      |   | 41,040,428
|                                          |  |              |            |      |   |           
|                                          |  | $            | 95,221,901 |      | $ | 89,000,702
|                                          |  |              |            |      |   |           



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At December 31, 2003 the scheduled maturities of time deposits are as follows:



|           |  |   |           
|---------- |  | - | ----------
|2004       |  | $ | 37,870,434
|2005       |  |   | 7,625,760 
|2006       |  |   | 5,435,160 
|2007       |  |   | 4,756,890 
|2008       |  |   | 8,499,553 
|Thereafter |  |   | 74,766    
|           |  |   |           
|           |  | $ | 64,262,563
|           |  |   |           



NOTE 9 - SECURITIES SOLD UNDER
AGREEMENTS TO REPURCHASE AND SHORT-TERM BORROWINGS



Securities sold under
agreements to repurchase generally mature within one to four days from the transaction date. Investment securities with carrying values of $7,775,564 and $7,880,694 at December 31, 2003 and 2002, respectively, are pledged to secure these agreements.
Information concerning securities sold under agreements to repurchase is summarized, as follows:



|                                          |  |      |           |   |      |   |           |  
|----------------------------------------- |  | ---- | --------- | - | ---- | - | --------- | -
|                                          |  | 2003 |           |   | 2002 |  
|Average balance during the year           |  | $    | 5,328,410 |   |      | $ | 4,169,521 |  
|                                          |  |      |           |   |      |   |           |  
|Average interest rate during the year     |  |      | .73       | % |      |   | 1.30      | %
|                                          |  |      |           |   |      |   |           |  
|Maximum month-end balance during the year |  | $    | 6,665,212 |   |      | $ | 5,962,695 |  
|                                          |  |      |           |   |      |   |           |  



Short-term borrowings consist of U.S.
Treasury tax and loan deposit notes, which are payable on demand and fully collateralized by investment securities.



The Bank is a member of the Federal Home Loan Bank of Atlanta. One of the benefits of membership is a borrowing capacity of $15.8 million secured by a blanket floating
lien on the unpaid principal balance of the Banks one-to-four unit residential real estate loans. In addition, the Bank may borrow up to 10% of its total assets under a separate credit availability program with the Federal Home Loan Bank of
Atlanta. As of December 31, 2003 the Bank had no outstanding balance on these lines of credit.



NOTE 10  EMPLOYEE BENEFIT PLANS



Stock Compensation Plans



At December 31, 2003, the Bank had
fixed stock compensation plans for its employees. The Bank applies Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and related interpretations in accounting for its plans. Accordingly, no
compensation cost has been recognized for these plans against earnings. For those companies applying APB 25, FASB Statement No. 123, Accounting for Stock-Based Compensation,requires certain pro-forma disclosures of net income and earnings
per share. Net income and earnings per share computed under FASB Statement No. 123 do not materially differ from the amounts reported.



All options have ten-year terms, vest and become fully exercisable in three years. The option exercise price equals or exceeds the market price of the stock as of the
date the option was granted.



32



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The following is a summary of the Banks stock option activity, and related information for the years ended December
31:



|                                |  |         |   |      |                                |       |         |         |   |                                |   |      
|------------------------------- |  | ------- | - | ---- | ------------------------------ | ----- | ------- | ------- | - | ------------------------------ | - | -----
|                                |  | 2003    |   | 2002
|                                |  | Options |   |      | WeightedAverage Exercise Price |       | Options |         |   | WeightedAverage Exercise Price
|Outstanding - beginning of year |  | 121,825 |   |      | $                              | 10.82 |         | 122,850 |   |                                | $ | 10.36
|Granted                         |  |        |   |      |                                |      |         | 6,500   |   |                                |   | 16.24
|Exercised                       |  | (7,375  | ) |      |                                | 10.76 |         | (6,900  | ) |                                |   | 8.04 
|Forfeited                       |  | (375    | ) |      |                                | 10.25 |         | (625    | ) |                                |   | 4.60 
|                                |  |         |   |      |                                |       |         |         |   |                                |   |      
|Outstanding - end of year       |  | 114,075 |   |      | $                              | 10.82 |         | 121,825 |   |                                | $ | 10.82
|                                |  |         |   |      |                                |       |         |         |   |                                |   |      
|Exercisable  end of year       |  | 112,743 |   |      | $                              | 10.72 |         | 107,331 |   |                                | $ | 10.48
|                                |  |         |   |      |                                |       |         |         |   |                                |   |      



Deferred Compensation Plans



In 1985, the Bank entered into a deferred compensation and retirement
arrangement with seven directors and in 1998 with one officer. The Bank purchased life insurance contracts in order to fund the expected liabilities under the contracts. The Banks policy is to accrue the estimated amounts to be paid under the
contracts over the expected period of active employment. At December 31, 2003 and 2002 other liabilities included $451,149 and $316,224, respectively, related to the deferred compensation plans.



Employee Stock Ownership Plan



The Board of Directors adopted an Employees Stock Bonus Plan (the ESOP)
effective January 1, 1998. The ESOP covered substantially all employees, whereby funds contributed were used to purchase outstanding common stock of the Company. Employees become eligible after they have completed six consecutive months of
employment. Contributions to the plan are funded as accrued. The Company expensed approximately $43,177 and $39,300, for the years ended December 31, 2003 and 2002 respectively.



401k Retirement Program



Effective January 1, 1993, the Board of Directors adopted a Retirement Program (the 401K). Eligible participants in the 401K include all employees who have
completed six months of service beginning with the effective date of the 401K. Contributions to the plan are funded by the employees with an associated employer match. At December 31, 2003 and 2002, other liabilities included $2,382 and $13,084,
respectively, related to this program. The accrued contribution at December 31, 2003 and 2002 was $32,083 and $3,000, respectively.



NOTE 11- INCOME TAXES



The principal components of income tax expense are as follows:



|                                              |  |                          |         |   |      |   |        
|--------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | -------
|                                              |  | Years Ended December 31,
|                                              |  | 2003                     |         |   | 2002
|Federal income tax expense-current            |  | $                        | 786,476 |   |      | $ | 629,186
|Deferred federal income tax expense (benefit) |  |                          | (46,397 | ) |      |   | 21,254 
|                                              |  |                          |         |   |      |   |        
|Income tax expense                            |  | $                        | 740,079 |   |      | $ | 650,440
|                                              |  |                          |         |   |      |   |        



33



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Differences between income tax expense calculated at the statutory rate and that shown in the statements of income are
summarized as follows:



|                                                   |  |                          |         |   |      |   |         |  
|-------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | -
|                                                   |  | Years Ended December 31, |        
|                                                   |  | 2003                     |         |   | 2002 |  
|Federal income tax expense - at 34% statutory rate |  | $                        | 842,509 |   |      | $ | 685,150 |  
|Tax effect of:                                     |  |                          |         |   |      |   |         |  
|Tax-exempt interest                                |  |                          | (34,435 | ) |      |   | (32,195 | )
|Exercised stock options                            |  |                          | (30,041 | ) |      |   | (22,594 | )
|Other                                              |  |                          | (37,954 | ) |      |   | 20,079  |  
|                                                   |  |                          |         |   |      |   |         |  
|                                                   |  | $                        | 740,079 |   |      | $ | 650,440 |  
|                                                   |  |                          |         |   |      |   |         |  



A cumulative net deferred tax asset is
included in other assets at December 31, 2003 and 2002. The components of the asset are as follows:



|                                                  |  |      |          |   |      |   |          |  
|------------------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | -
|                                                  |  | 2003 |          |   | 2002 |  
|Deferred tax assets:                              |  |      |          |   |      |   |          |  
|Deferred compensation                             |  | $    | 153,391  |   |      | $ | 150,275  |  
|Bad debts and other provisions                    |  |      | 364,943  |   |      |   | 351,343  |  
|Other                                             |  |      | 11,902   |   |      |   | 12,201   |  
|Interest income                                   |  |      | 3,317    |   |      |   | 3,889    |  
|                                                  |  |      |          |   |      |   |          |  
|Total deferred tax assets                         |  | $    | 533,553  |   |      | $ | 517,708  |  
|                                                  |  |     
|Deferred tax liabilities:                         |  |      |          |   |      |   |          |  
|Net unrealized appreciation on available-for sale |  |      | (69,685  | ) |      |   | (136,199 | )
|Deferred loan fees                                |  |      | (37,525  | ) |      |   | (34,964  | )
|Discount accretion on securities                  |  |      | (2,994   | ) |      |   | (16,300  | )
|Fixed assets                                      |  |      | (62,235  | ) |      |   | (63,718  | )
|Other                                             |  |      | (38,592  | ) |      |   | (38,591  | )
|                                                  |  |      |          |   |      |   |          |  
|Total deferred tax liabilities                    |  |      | (211,031 | ) |      |   | (289,772 | )
|                                                  |  |     
|Net deferred tax assets                           |  | $    | 322,522  |   |      | $ | 227,936  |  
|                                                  |  |      |          |   |      |   |          |  



NOTE 12 - COMMITMENTS AND
CONTINGENCIES- RELATED PARTY



The Company has entered into a long-term
lease with a related party to provide space for one branch and the Banks operations center. This lease has been classified as an operating lease for financial reporting purposes. Future minimum lease payments of $75,810 are required each year
under the noncancellable lease agreement as of December 31, 2003, which expires on December 31, 2004. Total lease expense was $64,439 for the years 2003 and 2002, respectively.



NOTE 13 - OTHER RELATED PARTY TRANSACTIONS



The Bank has loan and deposit transactions with its officers and directors, and with companies in which the officers and directors have a financial interest. Related
party deposits amounted to approximately $7,234,000 and $7,539,000 at December 31, 2003 and 2002, respectively. In addition to related party deposits, securities sold under agreements to repurchase with related parties amounted to approximately
$4,094,564 and $2,737,000 at December 31, 2003 and 2002, respectively. A summary of related party loan activity for Heritage Bank and Trust is as follows during 2003



A summary of related party loan activity for Heritage Bank and Trust is as follows during 2003:



|                           |  |   |            |  
|-------------------------- |  | - | ---------- | -
|Balance, December 31, 2002 |  | $ | 4,990,154  |  
|Originations  2003        |  |   | 1,325,276  |  
|Repayments  2003          |  |   | (2,627,936 | )
|                           |  |   |            |  
|Balance, December 31, 2003 |  | $ | 3,687,494  |  
|                           |  |   |            |  



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In the opinion of management, such loans are made in the ordinary course of business at normal credit terms, including
interest rate and collateral requirements and do not represent more than normal credit risk.



In the ordinary course of business, the Company has engaged in transactions with certain of its directors companies for legal services and insurance.



Commitments to extend credit and letters of credit to related parties amounted to $921,262 and $627,019 at December 31, 2003 and 2002,
respectively.



NOTE 14 - CREDIT COMMITMENTS AND CONCENTRATIONS OF CREDIT
RISK



The Bank has outstanding at any time a significant dollar amount of
commitments to extend credit. To accommodate major customers, the Bank also provides standby letters of credit and guarantees to third parties. Those arrangements are subject to strict credit control assessments. Guarantees and standby letters of
credit specify limits to the Banks obligations. The amounts of loan commitments, guarantees and standby letters of credit are set out in the following table as of December 31, 2003 and 2002. Because many commitments and almost all standby
letters of credit and guarantees expire without being funded in whole or in part, the contract amounts are not estimates of future cash flows. The majority of commitments to extend credit have terms up to one year. Interest rates on fixed-rate
commitments range from 3.50% to 18%.



|                                                 |  |                          |            |                       |   |                          |  |                       |            |  |   |          
|------------------------------------------------ |  | ------------------------ | ---------- | --------------------- | - | ------------------------ |  | --------------------- | ---------- |  | - | ---------
|                                                 |  | December 31, 2003        |            | December 31, 2002    
|                                                 |  | Variable Rate Commitment |            | Fixed Rate Commitment |   | Variable Rate Commitment |  | Fixed Rate Commitment
|Loan Commitments                                 |  | $                        | 19,730,802 |                       | $ | 2,174,091                |  | $                     | 17,052,489 |  | $ | 2,363,465
|Standby letters of credit and guarantees written |  | $                        | 400,669    |                       | $ | 205,422                  |  | $                     | 227,047    |  | $ | 369,371  



All of the guarantees outstanding at
December 31, 2003 expire during 2004.



Loan commitments, standby letters of
credit and guarantees written have off-balance-sheet credit risk because only origination fees and accruals for probable losses, if any, are recognized in the statement of financial position, until the commitments are fulfilled or the standby
letters of credit or guarantees expire. Credit risk represents the accounting loss that would be recognized at the reporting date if counterparties failed completely to perform as contracted. The credit risk amounts are equal to the contractual
amounts, assuming that the amounts are fully advanced and that, in accordance with the requirements of FASB Statement No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with
Concentrations of Credit Risk,collateral or other security is of no value. The Banks policy is to require customers to provide collateral prior to the disbursement of approved loans. For retail loans, the Bank usually retains a security
interest in the property or products financed, which provides repossession rights in the event of default by the customer. For business loans and financial guarantees, collateral is usually in the form of inventory or marketable securities (held in
trust) or property (notations on title).



Concentrations of credit risk
(whether on or off balance sheet) arising from financial instruments exist in relation to certain groups of customers. A group concentration arises when a number of counterparties have similar economic characteristics that would cause their ability
to meet contractual obligations to be similarly affected by changes in economic or other conditions. The Bank does not have significant exposure to any individual customer or counterparty. The major concentrations of credit risk for the Bank arise
by customer loan type in relation to loans and credit commitments. A geographic concentration arises because the Bank operates primarily in southeastern Virginia.



The credit risk amounts represent the maximum accounting loss that would be recognized at the reporting date if counterparties failed
completely to perform as contracted and any collateral or security proved to be of no value. The Bank has experienced little difficulty in accessing collateral when required. The amounts of credit risk shown, therefore, greatly exceed expected
losses, which are included in the allowance for loan losses.



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NOTE 15 - REGULATORY MATTERS



The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Banks financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Banks assets, liabilities, and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Banks capital amounts and classification are also subject to qualitative judgments by the regulators about components (such as interest rate risk), risk weighting, and other factors.



Quantitative measures established by regulation to ensure capital adequacy require the Bank
to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management
believes, as of December 31, 2003, the Bank meets all capital adequacy requirements to which it is subject.



As of February 28, 2002, the most recent notification from the Federal Reserve Bank of Richmond categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized
as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the
institutions category.



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



|                                         |  |        |            |       |                              |   |        |                                                                |           |  |      |        |  |       |            |  |       |  
|---------------------------------------- |  | ------ | ---------- | ----- | ---------------------------- | - | ------ | -------------------------------------------------------------- | --------- |  | ---- | ------ |  | ----- | ---------- |  | ----- | -
|                                         |  | Actual |            |       | For Capital AdequacyPurposes |   |        | To Be Well CapitalizedUnder Prompt CorrectiveAction Provisions |          
|                                         |  | Amount |            | Ratio |                              |   | Amount |                                                                | Ratio     |  |      | Amount |  | Ratio |           
|As of December 31, 2003:                 |  |        |            |       |                              |   |        |                                                                |           |  |      |        |  |       |            |  |       |  
|Total Capital (to risk-weighted assets)  |  | $      | 13,710,000 |       | 13.07                        | % |        | $                                                              | 8,393,000 |  | 8.00 | %      |  | $     | 10,492,000 |  | 10.00 | %
|Tier 1 Capital (to risk-weighted assets) |  | $      | 12,523,000 |       | 11.194                       |   |        | $                                                              | 4,197,000 |  | 4.00 | %      |  | $     | 6,295,000  |  | 6.00  | %
|Tier 1 Capital (to average assets)       |  | $      | 12,523,000 |       | 9.23                         | % |        | $                                                              | 5,314,000 |  | 4.00 | %      |  | $     | 6,643,000  |  | 5.00  | %
|                                         |  |        |            |       |                              |  
|As of December 31, 2002                  |  |        |            |       |                              |   |        |                                                                |           |  |      |        |  |       |            |  |       |  
|Total Capital (to risk-weighted assets)  |  | $      | 11,992,000 |       | 13.35                        | % |        | $                                                              | 7,196,000 |  | 8.00 | %      |  | $     | 8,983,000  |  | 10.00 | %
|Tier 1 Capital (to risk-weighted assets) |  | $      | 10,904,000 |       | 12.14                        | % |        | $                                                              | 3,593,000 |  | 4.00 | %      |  | $     | 5,390,000  |  | 6.00  | %
|Tier 1 Capital (to average assets)       |  | $      | 10,904,000 |       | 9.23                         | % |        | $                                                              | 4,723,000 |  | 4.00 | %      |  | $     | 5,904,000  |  | 5.00  | %



There is no significant difference
between the Banks actual ratios disclosed above, and the related actual ratios of the Company.



NOTE 16 - FAIR VALUE OF FINANCIAL INSTRUMENTS



The following table presents the carrying amounts and fair value of the Banks financial instruments at December 31, 2003 and 2002. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a
current transaction between willing parties, other than in a forced or liquidation sale. The carrying amounts in the table are included in the balance sheet under the indicated captions.



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|                          |  |                        |         |                        |   |                |  |            |         |  |   |        
|------------------------- |  | ---------------------- | ------- | ---------------------- | - | -------------- |  | ---------- | ------- |  | - | -------
|                          |  | 2003                   |         | 2002                  
|                          |  | CarryingAmount         |         | Fair Value             |   | CarryingAmount |  | Fair Value
|                          |  | (Dollars in thousands) |         | (Dollars in thousands)
|Financial Assets          |  |                        |         |                        |   |                |  |            |         |  |   |        
|Cash and cash equivalents |  | $                      | 19,530  |                        | $ | 19,530         |  | $          | 22,301  |  | $ | 22,301 
|Loans                     |  |                        | 100,524 |                        |   | 105,699        |  |            | 84,828  |  |   | 91,240 
|Investment securities     |  |                        | 20,247  |                        |   | 20,292         |  |            | 15,891  |  |   | 15,939 
|                          |  |                        |         |                       
|Financial Liabilities     |  |                        |         |                        |   |                |  |            |         |  |   |        
|Deposit liabilities       |  |                        | 125,252 |                        |   | 126,265        |  |            | 111,093 |  |   | 112,995
|Short-term borrowings     |  |                        | 6,016   |                        |   | 6,016          |  |            | 4,533   |  |   | 4,533  



Estimation of Fair Values



The following notes summarize the major methods and assumptions used in
estimating the fair values of financial instruments:



Short-term financial
instruments are valued at their carrying amounts included in the Banks balance sheet, which are reasonable estimates of fair value due to the relatively short period to maturity of the instruments. This approach applies to cash and cash
equivalents, short-term borrowings, and securities sold under agreements to repurchase.



Loans are valued on the basis of estimated future receipts of principal and interest, which are discounted at various rates. Loan prepayments are assumed to occur at the same rate as in previous periods when interest rates were at
levels similar to current levels. Future cash flows for homogeneous categories of consumer loans, such as motor vehicle loans, are estimated on a portfolio basis and discounted at current rates offered for similar loan terms to new borrowers with
similar credit profiles. The fair value of nonaccrual loans also is estimated on a present value basis, using higher discount rates appropriate to the higher risk involved.



Investment securities are valued at quoted market prices if available. For unquoted securities, the fair value is estimated by the
Bank on the basis of financial and other information.



The fair value of
demand deposits and depositswith no defined maturity is taken to be the amount payable on demand at the reporting date. The fair value of fixed-maturity deposits is estimated using rates currently offered for deposits of
similar remaining maturities. The intangible value of long-term relationships with depositors is not taken into account in estimating the fair values disclosed.



It is not practicable to separately estimate the fair values for off-balance-sheetcredit commitments,including standby letters of credit and guarantees
written, due to the lack of cost-effective reliable measurement methods for these instruments.



NOTE 17 - EARNINGS PER SHARE RECONCILIATION



The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations.



|                                                  |  |      |           |      |   |          
|------------------------------------------------- |  | ---- | --------- | ---- | - | ---------
|                                                  |  | 2003 |           | 2002
|Net income (numerator, basic and diluted)         |  | $    | 1,737,666 |      | $ | 1,364,703
|                                                  |  |     
|Weighted average shares outstanding (denominator) |  |      | 788,129   |      |   | 781,179  
|                                                  |  |      |           |      |   |          
|Earnings per common share-basic                   |  | $    | 2.20      |      | $ | 1.75     
|                                                  |  |      |           |      |   |          
|Effect of dilutive securities:                    |  |      |           |      |   |          
|                                                  |  |     
|Weighted average shares outstanding               |  |      | 788,129   |      |   | 781,179  
|                                                  |  |     
|Effect of stock options                           |  |      | 61,303    |      |   | 47,030   
|                                                  |  |      |           |      |   |          
|Diluted average shares outstanding (denominator)  |  |      | 849,432   |      |   | 828,209  
|                                                  |  |      |           |      |   |          
|Earnings per common share-assuming dilution       |  | $    | 2.05      |      | $ | 1.65     
|                                                  |  |      |           |      |   |          



* * * * *



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##### Table of Contents

Item 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE



None.



Item 8A. CONTROLS AND PROCEDURES



The management of the Company including Mr. Robert J. Keogh as President and Chief Executive Officer and Mrs. Catherine P. Jackson as Chief Financial Officer have evaluated the effectiveness of the design and operation of the Companys
disclosure controls and procedures (the Evaluation Date). Based on the evaluation of the Companys disclosure controls and procedures, it was determined that such controls and procedures were effective as of the Evaluation Date in
timely alerting them to the material information relating to the Company required to be included in the reports the Company files or submits under the Exchange Act.



During the quarter ended December 31, 2003, there was no change in the Companys internal control over financial
reporting that has materially affected, or is reasonably likely to materially affect, the Companys internal control over financial reporting.



Part III



Item 9. DIRECTORS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT



The text and tables under Nominees and Continuing Directors in the Companys 2004 Proxy Statement are incorporated herein by
reference.



Item 10. EXECUTIVE COMPENSATION



The text under Director Compensation in the Companys 2004 Proxy Statement is incorporated herein by reference.



The text and tables under Executive Compensation in the Companys 2004 Proxy Statement are incorporated herein by reference.



ITEM 11: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS



The text and tables under Security Ownership of Certain Beneficial Owners and Management in the Companys 2004 Proxy Statement are
incorporated herein by reference.



The text and tables under
Equity Compensation Plan Information in the Companys 2004 Proxy Statement are incorporated herein by reference.



ITEM 12: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



The text under Certain Relationships and Related Transactions in the Companys 2004 Proxy Statement are incorporated herein by reference.



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##### Table of Contents

Item 13: EXHIBITS AND REPORTS ON FORM 8-K



Exhibits:



|      |  |                                                                                                                                                                                                                                                                                                                                  
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1   |  | Articles of Incorporation. (Incorporated herein by reference to the Companys Form 10-K for 1983 filed March 29, 1984.)                                                                                                                                                                                                          
|      | 
|3.2   |  | Articles of Amendment to Articles of Incorporation filed on December 31, 1985. (Incorporated herein by reference to the Companys form S-8 filed January 26, 2004)                                                                                                                                                               
|      | 
|3.3   |  | Articles of Amendment to Articles of Incorporation filed on August 9, 1990. (Incorporated herein by reference to the Companys form S-8 filed January 26, 2004)                                                                                                                                                                  
|      | 
|3.4   |  | Articles of Amendment to Articles of Incorporation filed on August 12, 1992. (Incorporated herein by reference to the Companys form S-8 filed January 26, 2004)                                                                                                                                                                 
|      | 
|3.5   |  | Bylaws as amended (Incorporated herein by reference to the Companys Form 10-K for 1983 filed March 29, 1984.)                                                                                                                                                                                                                   
|      | 
|*10.1 |  | 1987 Stock Option Plan. (Incorporated herein by reference to the Corporations Form S-8 filed January 26, 2004.)                                                                                                                                                                                                                 
|      | 
|10.2  |  | Lease dated December 29, 1996, between IBV Partners, L.P. as landlord, and Heritage Bank & Trust, as Tenant, for the lease of 7,581 square feet of space in a building located at 1450
South Military Highway, Chesapeake, Virginia. (Incorporated herein by reference to the Corporations Form 10-K for 1986 filed March 1987.)
|      | 
|10.3  |  | Amendment to 1987 Employees Stock Ownership Plan, which provided for certain changes required by IRS regulations including changes in participant vesting schedules. (Incorporated herein
by reference to the Corporations Form 10-K for 1990 filed March 30, 1991.)                                                           
|      | 
|*10.4 |  | Employees Stock Ownership Plan. (Incorporated herein by reference to the Corporations Form 10-KSB for 1998 filed March 30,1999.)                                                                                                                                                                                               
|      | 
|*10.5 |  | 1999 Stock Option Plan for Employees. (Incorporated herein by reference to the Corporations Form S-8 filed January 26, 2004.)                                                                                                                                                                                                   
|      | 
|*10.6 |  | Amendment to the 1999 Stock Option Plan. (Incorporated herein by reference to the Corporations Form S-8 filed January 26, 2004.)                                                                                                                                                                                                
|      | 
|21.1  |  | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                                   
|      | 
|23.1  |  | Consent of Witt Mares Eggleston Smith, PLC                                                                                                                                                                                                                                                                                       
|      | 
|31.1  |  | Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                          
|      | 
|31.2  |  | Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                          
|      | 
|32.1  |  | Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                           
|      | 
|32.2  |  | Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                           

---

|* | Indicates management contract or compensatory plan or arrangement.
|- | ------------------------------------------------------------------



Reports on Form 8-K



A Form 8-K was filed by the Company on October 9, 2003, with a press released attached thereto.



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##### Table of Contents

Item 14: PRINCIPAL ACCOUNTANT FEES AND SERVICES



The text under Auditor Fee Information in the Companys 2004 Proxy Statement is incorporated herein by reference.



40



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##### Table of Contents

SIGNATURES



In accordance with Section
13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.



Heritage Bankshares, Inc.

(Registrant)



|                     |  |                                      
|-------------------- |  | -------------------------------------
|Date: March 24, 2004 |  | /s/ Robert J. Keogh                  
|                     |  | Robert J. Keogh,                     
|                     |  | President and Chief Executive Officer



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



|                                                                                                                                           |  |               
|------------------------------------------------------------------------------------------------------------------------------------------ |  | --------------
|/s/ Robert J. KeoghRobert J. Keogh President and Chief Executive Officer (Principal Executive Officer)                                     |  | March 24, 2004
|                                                                                                                                           | 
|/s/ Catherine P. JacksonCatherine P. Jackson Executive Vice President Chief Financial Officer (Principal Financial and Accounting Officer) |  | March 24, 2004
|                                                                                                                                           | 
|/s/ Peter M. Meredith, Jr.Peter M. Meredith, Jr. Chairman of the Board of Directors and Director                                           |  | March 24, 2004
|                                                                                                                                           | 
|/s/ Stephen A. JohnsenStephen A. Johnsen Secretary of the Board of Directors and Director                                                  |  | March 24, 2004
|                                                                                                                                           | 
|/s/ Lisa F. ChandlerLisa F. Chandler Director                                                                                              |  | March 24, 2004
|                                                                                                                                           | 
|/s/ James A. CummingsJames A. Cummings Director                                                                                            |  | March 24, 2004
|                                                                                                                                           | 
|/s/ F. Dudley FultonF. Dudley Fulton Director                                                                                              |  | March 24, 2004
|                                                                                                                                           | 
|/s/ Thomas G. Johnson, IIIThomas G. Johnson, III Director                                                                                  |  | March 24, 2004



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|                                                          |  |               
|--------------------------------------------------------- |  | --------------
|/s/ L. Allan ParrottL. Allan Parrott Director             |  | March 24, 2004
|                                                          | 
|Ross C. Reeves Director                                   |  |               
|                                                          | 
|/s/ Harvey W. Roberts, IIIHarvey W. Roberts, III Director |  | March 24, 2004



42