##### Table of Contents

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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549








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FORM 10-QSB





QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF 1934








For the Quarterly Period Ended September 30, 2002








Commission File Number: 33-77568








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VALLEY
FINANCIAL CORPORATION








VIRGINIA

54-1702380(State of Incorporation)

(I.R.S. Employer Identification Number)








36 Church Avenue, S.W.


Roanoke, Virginia 24011


(Address of principal executive
offices)








(540) 342-2265


(Issuers telephone number, including area code)








Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No  ̈





At October 31, 2002, 1,819,637 shares of the issuers
common stock, no par value, were outstanding.





Transitional small business disclosure format: Yes  ̈ No x.








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##### Table of Contents

VALLEY FINANCIAL CORPORATION


FORM 10-QSB


September 30, 2002





INDEX





Part I.    FINANCIAL INFORMATIONItem 1.    Financial StatementsConsolidated Balance Sheets

3Consolidated Statements of Income

4Consolidated Statements of Cash Flows

6Notes to Consolidated Financial Statements

7Item 2.    Managements Discussion and Analysis

11Item 3.    Controls and Procedures

23Part II.    OTHER INFORMATIONItem 4.    Submission of Matters to a Vote of Security Holders

24Item 5.    Other Information

24Item 6.    Exhibits and Reports on Form 8-K

24SIGNATURES AND CERTIFICATIONS

26EXHIBIT INDEX

29




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##### Table of Contents

PART 1FINANCIAL INFORMATION





Item 1.    Financial Statements.





VALLEY FINANCIAL CORPORATION


CONSOLIDATED BALANCE SHEETS


(In thousands, except per share data)





September 30 2002


December 31 2001(Unaudited)AssetsCash and due from banks

$
6,338


$
6,235Money market investments:Federal funds sold






Interest-bearing deposits in other banks


456



143Total money market investments


456



143Securities held to maturity (approximate market values of $16,363 at September 30, 2002and $0 at December 31,
2001)


16,523



Securities available for sale


32,776



31,338Restricted equity securities


2,427



1,927Loans:Commercial and industrial loans


40,013



35,366Commercial real estate loans


72,018



60,290Real estate construction


14,729



9,005Residential real estate loans


21,987



21,482Loans to individuals


24,709



21,430Total loans


173,456



147,573Less unearned income


(16
)


(22
)Less allowance for loan losses


(1,925
)


(1,468
)Net loans


171,515



146,083Premises and equipment


4,850



4,084Accrued interest receivable


1,064



930Other assets


3,798



3,128Total assets

$
239,747


$
193,868Liabilities and Shareholders EquityDeposits:Non-interest bearing demand deposits

$
24,946


$
24,297Interest bearing demand deposits


10,149



10,820Money market deposits


18,298



23,590Other savings deposits


2,935



2,220Certificates of deposits >100,000


35,882



25,591Other time deposits


79,594



52,348Total deposits


171,804



138,866Short-term borrowings


2,316



3,824Securities sold under agreements to repurchase


5,598



3,347Accrued interest payable


1,206



1,104Other liabilities


357



423Federal Home Loan Bank advances


40,000



30,000Total liabilities


221,281



177,564Commitments and other contingenciesPreferred stock, no par value. Authorized 10,000,000 shares;none issued and outstanding.Common stock, no par value. Authorized 10,000,000 shares;issued and outstanding 1,819,637 atSeptember 30, 2002
and 1,213,207 at December 31, 2001


12,295



12,295Accumulated retained earnings


5,677



4,113Accumulated other comprehensive income (loss)


494



(104
)Total shareholders equity


18,466



16,304Total liabilities and shareholders equity

$
239,747


$
193,868


See accompanying notes to consolidated financial statements.




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VALLEY FINANCIAL CORPORATION


CONSOLIDATED STATEMENTS OF INCOME


(Unaudited)


(In thousands, except per share data)





For the Period January 1, 2002 Through September 30, 2002

For the Period January 1, 2001 Through September 30, 2001Interest Income:Interest and fees on loans

$
8,597

$
8,036Interest on money market investments


27


30Interest on securities  taxable


1,263


1,355Interest on securities  nontaxable


245


274Total interest income


10,132


9,695Interest Expense:Interest on certificates of deposit > 100,000


844


1,000Interest on other deposits


2,161


3,527Interest on Federal Home Loan Bank advances


964


615Interest on repurchase agreements


55


134Interest on borrowed funds


12


44Total interest expense


4,036


5,320Net interest income


6,096


4,375Provision for loan losses


516


194Net interest income after provision for loan losses


5,580


4,181Noninterest income:Service charges on deposit accounts


363


284Income earned on bank owned life insurance


126


Other fee income


65


67Securities gains





93Total noninterest income


554


444Noninterest expense:Compensation expense


2,101


1,578Occupancy


263


227Data processing and equipment


436


347Franchise tax expense


113


105Loan expenses


275


161Other expense


748


617Total noninterest expense


3,936


3,035Net income before taxes


2,198


1,590Provision for income taxes


631


448Net income

$
1,567

$
1,142Basic earnings per share

$
0.86

$
0.63Diluted earnings per share

$
0.83

$
0.61





See accompanying notes to consolidated financial statements.




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##### Table of Contents

VALLEY FINANCIAL CORPORATION


CONSOLIDATED STATEMENTS OF INCOME


(Unaudited)


(In thousands, except per share data)





For the Period July 1, 2002 Through September 30, 2002

For the Period July 1, 2001 Through September 30, 2001Interest Income:Interest and fees on loans

$
2,990

$
2,783Interest on money market investments


15


9Interest on securities  taxable


450


417Interest on securities  nontaxable


92


84Total interest income


3,547


3,293Interest Expense:Interest on certificates of deposit > 100,000


300


367Interest on other deposits


791


1,098Interest on Federal Home Loan Bank advances


341


217Interest on repurchase agreements


20


40Interest on borrowed funds


2


4Total interest expense


1,454


1,726Net interest income


2,093


1,567Provision for loan losses


118


74Net interest income after provision for loan losses


1,975


1,493Noninterest income:Service charges on deposit accounts


134


103Income earned on bank owned life insurance


45


Other fee income


12


20Securities gains





53Total noninterest income


191


176Noninterest expense:Compensation expense


721


535Occupancy


94


78Data processing and equipment


160


120Franchise tax expense


39


37Loan expenses


91


62Other expense


252


183Total noninterest expense


1,357


1,015Net income before taxes


809


654Provision for income taxes


231


199Net income

$
578

$
455Basic earnings per share

$
0.32

$
0.25Diluted earnings per share

$
0.30

$
0.24





See accompanying notes to consolidated financial statements.




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VALLEY FINANCIAL CORPORATION


CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)


(In thousands, except per share data)








For the Period January 1, 2002 Through September 30, 2002


For the Period January 1, 2001 Through September 30, 2001Cash Flows From Operating Activities:Net income

$
1,567


$
1,142Adjustments to reconcile net income to net cash provided by operating activities:Provision for loan losses


516



194Depreciation and amortization


295



228Net gains on sale of securities






(93
)Amortization (accretion) of premiums/discounts


31



9Decrease in unearned fees


(6
)


(29
)(Increase) decrease in interest receivable


(134
)


255Increase in other assets


(219
)


(49
)Increase in accrued interest payable


102



296Decrease in other liabilities


(66
)


(99
)Net cash provided by operating activities


2,086



1,854Cash Flows From Investing Activities:Increase in money market investments


(313
)


(1,672
)Purchases of premises and equipment


(1,022
)


(824
)Purchases of securities available-for-sale


(8,170
)


(17,170
)Purchases of securities held to maturity


(16,793
)


Purchases of restricted equity securities


(500
)


(317
)Principal repayments/calls of securities available for sale


7,618



29,190Principal repayments of securities held to maturity


260



Purchase of bank owned life insurance


(671
)


Increase in value of bank owned life insurance


(128
)


Increase in loans


(25,942
)


(21,696
)Net cash used in investing activities


(45,661
)


(12,489
)Cash Flows From Financing Activities:Increase in time deposits greater than $100,000


10,291



8,715Increase (decrease) in other time deposits


27,246



(8,757
)Increase (decrease) in other deposits


(4,599
)


5,351Decrease in short-term borrowings


(1,508
)


(1,762
)Increase in securities sold under agreements to repurchase


2,251



3,404Cash in lieu of fraction shares


(3
)


Proceeds from Federal Home Loan Bank advances


10,000



5,000Net cash provided by financing activities


43,678



11,951Net Increase in Cash and Due From Banks


103



1,316Cash and Due From Banks at Beginning of Period


6,235



3,988Cash and Due From Banks at End of Period

$
6,338


$
5,304Supplemental disclosure of cash flow information:Cash paid during the period for interest

$
3,934


$
5,024Cash paid during the period for taxes

$
813


$
478Noncash financing and investing activities:Transfer of loans to foreclosed property

$
349


$






See accompanying notes to consolidated financial statements.




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##### Table of Contents

VALLEY FINANCIAL CORPORATION





Notes to Consolidated Financial Statements


September 30, 2002


(Unaudited)


(In thousands, except share and per share data)





| | (1) |  | Organization and Summary of Significant Accounting Policies
| | --- |  | -----------------------------------------------------------




Valley Financial Corporation (the Company) was incorporated under the laws of the Commonwealth of Virginia on March 15, 1994, primarily to serve
as a holding company for Valley Bank (the Bank), which opened for business on May 15, 1995. The Companys fiscal year end is December 31.





The consolidated financial statements of the Company conform to generally accepted accounting principles and to general banking industry practices. The
interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments of a normal recurring nature which are necessary for a fair presentation of the consolidated financial statements herein have been
included. The consolidated financial statements herein should be read in conjunction with the Companys 2001 Annual Report on Form 10-KSB.





The Company reports its activities as a single business segment. In determining the appropriateness of segment definition, the Company considers components of the business about which financial
information is available and regularly evaluated relative to resource allocation and performance assessment.





| | (2) |  | Cash and Cash Equivalents
| | --- |  | -------------------------




For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks. To Comply with Federal Reserve regulations, the Bank will be required to maintain certain average
reserve balances. The daily cash reserve requirement for the week including September 30, 2002 was $2,100.





| | (3) |  | Securities
| | --- |  | ----------




The carrying values, unrealized gains, unrealized losses and approximate fair values of available for sale and held to maturity investment securities at September 30, 2002 are shown in the tables below. As of September 30,
2002, investments (including both available for sale and held to maturity) and restricted equity securities with amortized costs and fair values of $33,127 and $33,354, respectively, were pledged as collateral for public deposits, a line of credit
available from the Federal Home Loan Bank, customer sweep accounts, and for other purposes as required or permitted by law.





The following table sets forth the composition of securities available for sale, which are carried at approximate market value at September 30, 2002.




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##### Table of Contents

Available for Sale Investment Portfolio  Category Distribution


(dollars in thousands)





Amortized Costs

Unrealized Gains

Unrealized Losses


Approximate Fair
ValuesU.S. Treasury

$
199

$
6

$



$
205U.S. Government agencies


2,967


16


(1
)


2,982Mortgage-backed securities


5,264


188






5,452Collateralized mortgage obligations


15,605


112


(11
)


15,706States and political subdivisions


7,992


439






8,431Restricted equity securities


2,427









2,427Total securities available for sale

$
34,454

$
761

($
12
)

$
35,203





The following table sets forth the composition of
securities held to maturity, which are carried at amortized cost at September 30, 2002.





Held to Maturity Investment
Portfolio  Category Distribution


(dollars in thousands)





Amortized Costs

Unrealized Gains

Unrealized Losses


Approximate Fair
ValuesMortgage-backed securities


11,766


7


(158
)


11,615Collateralized mortgage obligations


4,015





(19
)


3,996States and political subdivisions


742


10






752Total securities available for sale

$
16,523

$
17

($
177
)

$
16,363





| | (4) |  | Allowance for Loan Losses
| | --- |  | -------------------------




The following table summarizes the loan loss experience for the nine-month periods ended September 30, 2002 and 2001.





Allowance for Loan Losses


(dollars in thousands)





2002


2001Balance at January 1

$
1,468


$
1,190Provision for loan losses


516



194Recoveries


0



0Charged off loansCommercial


(58
)


(7
)Credit Cards


(1
)


(8
)Balance at September 30

$
1,925


$
1,369




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| | (5) |  | Earnings Per Share
| | --- |  | ------------------




Basic earnings per share is based upon the weighted average number of common shares outstanding during the period. The weighted average shares outstanding for the diluted earnings per share
computations were adjusted to reflect the assumed conversion of shares available under stock options. The following table summarizes the shares utilized (adjusted for the three-for-two stock split declared on April 24, 2002 to shareholders of record
April 30, 2002 and payable on May 30, 2002) in the computations:





Weighted Average Shares Outstanding





Three months ending September 30:

Basic

Diluted2002

1,819,637

1,895,7892001

1,819,811

1,861,183Nine months ending September 30:

Basic

Diluted2002

1,819,732

1,889,6642001

1,819,811

1,868,771





| | (6) |  | Comprehensive Income
| | --- |  | --------------------




On January 1, 1998, The Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income.This Statement establishes standards for reporting and presentation
of comprehensive income and its components in a full set of general purpose financial statements. This Statement was issued to address concerns over the practice of reporting elements of comprehensive income directly in equity.





The Company is required to classify items of Other Comprehensive Income (such as net unrealized
gains (losses) on securities available for sale) by their nature in a financial statement. It does not require a specific format for that financial statement but requires the Company to display an amount representing comprehensive income for the
period in that financial statement. The Company is required to present the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in-capital in the equity section of a statement of financial position.
It does not require per share amounts of comprehensive income to be disclosed.





The adoption of
Statement 130 on January 1, 1998 did not have any effect on the consolidated financial position, results of operations or liquidity of the Company. However, Statement 130 does have an effect on financial statement displays presented by the Company
since the Company has net unrealized gains (losses) on available-for -sale securities, an item of other comprehensive income (loss). For the nine months ended September 30, 2002 and 2001, total comprehensive income was $2,165 and $1,397,
respectively. For the three months ended September 30, 2002 and 2001, total comprehensive income was $911 and $596, respectively.





The information that follows discloses the reclassification adjustments and the income taxes related to securities available-for-sale that are included in other comprehensive income, net of income
taxes for the nine and three month periods ended September 30, 2002 and 2001.




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For the Nine Months Ended September 30, 2002



For the Nine Months Ended September 30, 2001Net unrealized gains on securities available for sale:Net unrealized holding gains during the year

$
906


$
479Less reclassification adjustments for gains included in net income






(61
)Income tax expense


(308
)


(163
)Other comprehensive income, net of income taxes

$
598


$
255For the Three Months Ended September 30, 2002


For the Three Months Ended September 30, 2001Net unrealized gains on securities available for sale:Net unrealized holding gains during the quarter

$
504


$
266Less reclassification adjustments for gains included in net income






(35
)Income tax expense


(171
)


(90
)Other comprehensive income, net of income taxes

$
333


$
141





| | (7) |  | Financial Instruments With Off-Balance Sheet Risk
| | --- |  | -------------------------------------------------




In the normal course of business to meet the financing needs of its customers, the Company is a party to financial instruments with off-balance-sheet risk,
which involve commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.





The Companys exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit
is represented by the contractual amount of those instruments. The same credit policy is used in making commitments as is used for on-balance-sheet risk. At September 30, 2002, outstanding commitments to extend credit were $49,531 as compared to
$48,808 at December 31, 2001.





Commitments to extend credit are agreements to lend to a customer
as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments may expire without ever being drawn upon,
therefore, the total commitment amounts do not necessarily represent future cash outlays for the Company.





| | 8) |  | Related Party Transactions
| | -- |  | --------------------------




The Bank has entered into transactions with its directors, significant shareholders and their affiliates (related parties). Such transactions were made in the ordinary course of business on
substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit
risk or present other unfavorable features. As of September 30, 2002 aggregate loans to directors, executive officers, and principal shareholders total $7,937. An analysis of loan activity to directors, executive officers and principal shareholders
for the year ended December 31, 2001 is as follows:




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##### Table of Contents

Loans to Related Parties





Balances as of January 1, 2001

$
4,480Advances


1,742Repayments


(1,107
)Balances as of December 31, 2001

$
5,115





| | (9) |  | Other Debt
| | --- |  | ----------




The Company has outstanding debt with the Federal Home Loan Bank of Atlanta in the amount of $40.0 million as of September 30, 2002. There are four convertible advances in the amount of $5.0 million each currently drawn.
There is one $10.0 million convertible advance and one adjustable rate advance in the amount of $10.0 million currently drawn. The Federal Home Loan Bank of Atlanta has the option to convert the $30.0 million in convertible advances on the
conversion dates below and any interest payment date thereafter with at least two business days notice. If called, the four $5.0 million convertible advances will be converted into a 3-month LIBOR-based adjustable rate credit (ARC) at 3-month LIBOR
flat. The $10.0 million convertible advance may be converted into a 3-month LIBOR-based floating rate advance (ARC) at 3-month LIBOR flat only if 3-month LIBOR is greater than or equal to 7.0%. The $10.0 million adjustable rate advance is an ARC
with a current rate of 1.86%, subject to change on each quarterly interest payment date. The following table provides more information on the outstanding advances as of September 30, 2002.





FEDERAL HOME LOAN BANK ADVANCES





Advance Balance

Advance Date

Maturity Date

Rate

Interest Payment Dates

First Optional Conversion
Date$5,000,000

December 2, 1999

December 2, 2009

5.46%

Quarterly

December 4, 2000$5,000,000

May 24, 2000

May 24, 2010

6.49%

Quarterly

May 24, 2001$5,000,000

February 9, 2001

February 9, 2011

4.97%

Quarterly

February 9, 2004$5,000,000

November 7, 2001

November 7, 2011

3.91%

Quarterly

November 7, 2006$10,000,000

September 4, 2002

September 4, 2007

3.09%

Quarterly

September 4, 2003$10,000,000

December 14, 2001

December 16, 2002

Variable

Quarterly

N/A





Item 2.    Managements Discussion and Analysis.





The following
is managements discussion and analysis of the financial condition and results of operations of the Company as of and for the nine months ended September 30, 2002 and 2001. The discussion should be read in conjunction with the Companys
Consolidated Financial Statements and Notes thereto.





Forward-Looking Statements





This report contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ
materially from those reflected in such forward-looking statements, which are representative only on the date hereof. Readers of this report should not rely solely on the forward-looking statements and should consider all uncertainties and risks
discussed throughout this report. The Corporation takes no obligation to update any forward-looking statements contained herein. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements
include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce margins; (3) general economic
conditions, either nationally or regionally, may be less favorable than expected that could result in a deterioration of credit quality or a reduced demand for credit; (4) legislative or regulatory changes including changes in accounting standards,
may adversely affect the business.




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##### Table of Contents

Overview





The Company was incorporated as a Virginia stock corporation on March 15, 1994, primarily to own and control all of the capital stock of the Bank. The Bank opened for business on May 15, 1995. There are currently six full-service
branch locations, operating in various locations throughout the Cities of Roanoke and Salem and the County of Roanoke. The Bank plans to open its seventh full-service branch in the Lewis-Gale Hospital area in the spring of 2003.





Total assets at September 30, 2002 were $239.7 million, up 23.6% from $193.9 million at December 31, 2001. The principal
components of the Companys assets at the end of the period were $35.2 million in securities available-for-sale, including restricted equity securities, $16.5 million in securities held to maturity, and $173.5 million in gross loans.





Total liabilities at September 30, 2002 were $221.3 million, up 24.6% from $177.6 million at December 31, 2001
with the increase represented by a $32.9 million growth in deposits, a $2.3 million growth in securities sold under agreements to repurchase, a $10.0 million increase in Federal Home Loan Bank advances, offset by a $1.5 million decrease in
short-term borrowings.





Total shareholders equity at September 30, 2002 was $18.5 million consisting of $9.1
million in net proceeds from the Companys initial public offering, $3.2 million in net proceeds from the Companys secondary offering, $10,000 in proceeds from the exercise of stock options, increased by accumulated retained earnings of
$5.7 million and $494,000 of net unrealized gains on securities available-for-sale, net of related deferred tax liability. Total shareholders equity was $18.5 million at September 30, 2002 compared with $16.3 million at December 31, 2001, an
increase of $2.2 million or 13.5%. Exclusive of unrealized gains (losses) on investment securities, shareholders equity was $18.0 million at September 30, 2002 and $16.4 million at December 31, 2001.





The Company had net income of $1.6 million for the nine months ended September 30, 2002 compared with $1.1 million recorded for the nine
months ended September 30, 2001, an increase of $500,000 or 45.5%. Net income for the three months ended September 30, 2002 was $578,000, a 27.0% increase over the $455,000 recorded for the third quarter of 2001. An improved net interest margin
combined with increased noninterest income, offset by increases in noninterest expense in all categories, contributed to the 45.5% and 27.0% increase for the nine months ended September 30, 2002 as compared to the nine months ended September 30,
2001 and the three months ended September 30, 2002 as compared to the three months ended September 30, 2001, respectively.





Profitability as measured by the Companys return on average assets (ROA) was .98% for the nine months ended September 30, 2002 compared to .91% for the same period in 2001. ROA for the third quarter of 2002 was
1.00% versus 1.05% for the third quarter of 2001. Return on average equity (ROE) was 12.16% for the nine months ended September 30, 2002 compared to 10.00% for the same period in 2001. ROE for the third quarter of 2002 was 12.91% as
compared to 11.59% for the third quarter of 2001. The calculation of ROE excludes the effect of any unrealized gains or losses on investment securities.




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Net Interest Income





Net interest income is the amount by which interest and fees generated from loans and investments exceeds the interest expense associated with funding those assets, and represents the principal source of earnings for the
Company. Changes in the volume and mix of earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. Changes in the interest rate environment and the
Companys cost of funds also affect net interest income.





Net interest income was $6.1 million for the nine
months ended September 30, 2002 and is attributable to interest income from loans and securities exceeding the cost of interest paid on deposits and borrowed funds. Net interest income for the first nine months of 2002 increased 38.6% from $4.4
million for the same period in 2001. The net interest margin on a fully taxable equivalent (FTE ) basis was 4.14% for the first nine months of 2002, an increase of 39 basis points from the 3.75% reported for the same period in 2001. The
Bank produced the 39 basis point increase by working diligently during 2001 to reprice deposits significantly downward and by restructuring the investment portfolio to shorten maturities and to obtain a more attractive yield. The Banks cost of
funds ratio was 2.75% for the nine months ended September 30, 2002, down 195 basis points from the 4.70% reported for the first nine months of 2001. The Banks yield on earning assets was 6.82% for the nine months ended September 30, 2002, down
136 basis points from the 8.18% reported for the nine months ended September 30, 2001. For the three months ended September 30, 2002 net interest income was $2.1 million, an increase of 31.3% from the $1.6 million reported for the three months ended
September 30, 2001. The FTE net interest margin was 3.94% and 3.88% for the three month periods ended September 30, 2002 and 2001, respectively.





Noninterest Income





Noninterest income for the nine months ended September 30, 2002 was
$554,000, an increase of $110,000 or 24.8% over the $444,000 reported for the same period one year earlier. Service charges and other fee income totaled $554,000 for the nine months ended September 30, 2002, an increase of $203,000 or 57.8% over the
$351,000 reported for the same period one year earlier. The largest component of the increase is attributable to tax-exempt income earned on bank owned life insurance in the amount of $126,000. Securities gains and losses totaled $0 during the first
nine months of 2002 as compared to $93,000 for the first nine months of 2001, which is comprised of $73,000 in gains from sales and a $20,000 gain generated from the pushdown of securities from the Company to the Bank at fair market value in a
capital injection effective April 20, 2001. For the three months ended September 30, 2002 noninterest income was $191,000, an increase of $15,000 or 8.5% over the $176,000 reported for the third quarter of 2001. Securities gains of $0 and $53,000
are included in the total noninterest income totals for the quarters ended September 30, 2002 and 2001, respectively. Future levels of noninterest income are expected to increase as a direct result of business growth and expansion.





Noninterest Expense





Noninterest expense for the first nine months of 2002 was $3.9 million, an increase of $900,000 or 30.0% over the $3.0 million reported for the same period in 2001. Expenses associated with the opening of the Banks sixth
full-service branch on May 20, 2002 are included in the nine months ended September 30, 2002, while expenses associated with the opening of the Banks fifth full-service branch on May 7, 2001 are included in the nine months ended September 30,
2001. Expenses associated with the introduction of online banking in May 2002 also contributed to the increase in noninterest expense in the




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first nine months of 2002 as compared to the first nine months of 2001. Noninterest expense for the quarter ended September 30, 2002 was $1.4
million, an increase of $400,000 or 40% over the $1.0 million reported for the third quarter of 2001. All major categories of noninterest expense increased due to growth and expansion. Noninterest expenses are expected to increase in future years as
a direct result of business growth and expansion.





Income Taxes





To reflect the Companys anticipated federal income tax liability, an expense of $631,000 and $448,000 at an effective tax rate of 28.7% and 28.2% was recognized for
the nine months ended September 30, 2002 and September 30, 2001, respectively. The provision for income taxes for the third quarter of 2002 and 2001 was $231,000 and $199,000 at an effective tax rate of 28.6% and 30.4%, respectively. The effective
tax rate differs from the statutory rate of 34 percent primarily due to tax-exempt interest income on municipal securities, net of disallowance and tax-exempt income earned on bank owned life insurance.





Investment Securities





The Companys investment portfolio is used both for investment income and liquidity purposes. Funds not used for capital expenditures or lending activities are invested in securities of the U.S. Government and its agencies,
mortgage-backed securities, municipal bonds, and equity securities. Obligations of the U.S. Government and its agencies include treasury notes and callable or noncallable agency bonds. Mortgage-backed securities and collateralized mortgage
obligations include pools issued by government agencies. Municipal bonds include tax-exempt general obligation and revenue issues. Equity securities include shares of the Federal Reserve Bank of Richmond, Federal Home Loan Bank of Atlanta, and
Community Bankers Bank. The Company does not invest in derivatives or other types of high-risk securities.





Investment securities (available for sale and held to maturity), including restricted equity securities, at September 30, 2002 were $51.7 million, an increase of $18.4 million or 55.3% from their level of $33.3 million on December
31, 2001. The increase of $18.4 million is primarily due to purchases in the amount of $25.5 million, offset by principal repayments and called proceeds in the amount of $7.9 million. An increase in unrealized gains on securities on the available
for sale portfolio, which is carried at approximate fair market value, in the amount of $900,000 contributed to the remainder of the increase. See Note 3 to the Consolidated Financial Statements.





Loan Portfolio





The Companys total loans
were $173.5 million at September 30, 2002, an increase of $25.9 million or 17.5% from the $147.6 million reported at December 31, 2001. The Companys ratio of total loans to total funding sources (customer deposits, securities sold under
agreements to repurchase, federal funds purchased and Federal Home Loan Bank advances) stood at 79.0% at September 30, 2002 and 83.9% at December 31, 2001. Management seeks to maintain the ratio of loans to funding sources at a maximum of 85%.




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The loan portfolio primarily consists of commercial, real estate (including real estate term loans, construction loans
and other loans secured by real estate) and loans to individuals for household, family and other consumer purposes. The Company adjusts its mix of lending and the terms of its loan programs according to economic and market conditions,
asset/liability management considerations and other factors. Loans typically (in excess of 90%) are made to businesses and individuals located within the Companys primary market area, most of whom maintain deposit accounts with the Bank. There
is no concentration of loans exceeding 10% of total loans which is not disclosed in the Consolidated Financial Statements and the Notes thereto or discussed below. The Company has not made any loans to any foreign entities, including governments,
banks, businesses or individuals. Commercial and construction loans and home equity lines of credit in the loan portfolio are primarily variable rate loans and have little interest rate risk.





The following table summarizes the loan portfolio by category as of the nine-month periods ended September 30, 2002 and 2001 and the year ended December 31, 2001.





Loan Portfolio Summary


(dollars in thousands)





September 30, 2002

December 31, 2001

September 30, 2001Commercial and industrial

$
40,013

$
35,366

$
34,200Commercial real estate


72,018


60,290


50,331Real estate construction


14,729


9,005


9,700Residential real estate


21,987


21,482


22,060Loans to individuals


24,709


21,430


19,878Total loans

$
173,456

$
147,573

$
136,169





Loan Category Analysis





Commercial Loans.    Commercial and industrial loans accounted for 23.1% of the loan portfolio as of September 30, 2002 and stood at $40.0
million versus $35.4 million nine months earlier. Such loans generally are made to provide operating lines of credit, to finance the purchase of inventory or equipment, and for other business purposes. The credit worthiness of the borrower is
analyzed and re-evaluated on a periodic basis. Most commercial loans are collateralized with business assets such as accounts receivable, inventory and equipment. Even with substantial collateral such as all the assets of the business and personal
guarantees, commercial lending involves considerable risk of loss in the event of a business downturn or failure of the business.





Commercial Real Estate Loans.    Commercial real estate construction and commercial real estate mortgages represent interim and permanent financing of commercial properties that are secured by real estate,
and were 41.5% of total loans at September 30, 2002. Outstanding loans in this category equaled $72.0 million and $60.3 million at September 30, 2002 and December 31, 2001, respectively. The Company prefers to make commercial real estate loans
secured by owner-occupied properties. These borrowers are engaged in business activities other than real estate, and the primary source of repayment is not solely dependent on conditions in the real estate market.





Real Estate Construction Loans.    Real estate construction loans represent interim financing on residential
and commercial properties under construction, and are secured by real estate. Once construction is completed and the loan becomes permanent, the loans are reclassified as commercial real




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estate loans, which are secured by commercial property or residential real estate loans, which are secured by first deeds of trust. Outstanding
loans in this category totaled $14.8 million (8.5% of total loans) at September 30, 2002 as compared to $9.0 million at December 31, 2001.





Residential Real Estate Loans.    Residential real estate loans are secured by first deeds of trust on 1-4 family residential properties. This category had $22.0 million in loans (12.7% of total
loans) at September 30, 2002 and $21.5 million in such loans at December 31, 2001. To mitigate interest rate risk, the Company usually limits the final maturity of residential real estate loans held for its own portfolio to 15-20 years and offers a
bi-weekly payment option to encourage faster repayment. Residential real estate lending involves risk elements when there is lack of timely payment and/or a decline in the value of the collateral.





Loans to Individuals.    Loans to individuals include installment loans and home equity lines of credit/loans
secured by junior liens on residential real estate. The loan proceeds typically are used to purchase vehicles, finance home remodeling or higher education, or for other consumer purposes. Loans to individuals totaled $24.7 million (14.2% of total
loans) at September 30, 2002 compared to $21.4 million at December 31, 2001.





Summary of Allowance for Loan Losses





Certain credit risks are inherent in making loans. The Company seeks to prudently assess these risks
and attempts to manage them effectively. Repayment risks are reduced by adhering to our internal credit policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review, and follow-up on
exceptions to credit policies.





The allowance for loan losses is maintained at a level estimated to be adequate to
absorb probable losses. Some of the factors which management considers in determining the appropriate level of the allowance for loan losses are an evaluation of the current loan portfolio, identified loan problems, loan volume outstanding, past
loss experience, present and expected industry and economic conditions and, in particular, how such conditions relate to our market area. Bank regulators also periodically review the loan portfolio and other assets to assess their quality. The
provision for loan losses is charged to income in an amount believed to be necessary to maintain an allowance for loan losses adequate to provide for expected losses in the loan portfolio. Loans deemed uncollectible are charged to the allowance for
loan losses and recoveries on loans previously charged off are added to the allowance for loan losses. The Company believes the allowance for loan losses is adequate to provide for expected losses in the loan portfolio.





No assurance can be given that unforeseen adverse economic conditions or other circumstances will not result in increased provisions in
the future. Additionally, regulatory examiners may require the Company to recognize additions to the allowance based upon their judgment about the loan portfolio and other information available to them at the time of their examinations.





A provision for loan losses of $516,000 was provided during the nine months ended September 30, 2002, an
increase of $322,000 or 166.0% over the same period in 2001, in recognition of managements estimate of inherent risks associated with lending activities. The allowance for loan losses was $1.9 million as of September 30, 2002 and represented
approximately 1.1% of net loans outstanding versus 1.0% of net loans at December 31, 2001 (see Note 4 to the Consolidated Financial Statements). A total of $40,000 in specific reserves on foreclosed, repossessed and idle properties is included in
the balance of the allowance for loan losses as of September 30, 2002. Of the $40,000 specific reserve, $40,000 was




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accrued during the second quarter of 2002. During the first quarter of 2001, $25,000 of specific reserves accrued during 2000 on a second
commercial loan were reversed when the loan was repaid. Additional factors contributing to the increase in provision expense are strong year-over-year growth in average loans outstanding and managements concern about perceived continuing
economic weakness.





Nonperforming Assets and Impaired Loans





Nonperforming Assets.    Nonperforming assets include nonaccrual loans, loans past due 90 days or more, restructured loans and
foreclosed/repossessed property. A loan will be placed on nonaccrual status when collection of all principal or interest is deemed unlikely. A loan will automatically be placed on nonaccrual status when principal or interest is past due 90 days or
more, unless the loan is both well secured and in the process of being collected. In this case, the loan will continue to accrue interest despite its past due status.





A restructured loan is a loan in which the original contract terms have been modified due to a borrowers financial condition or there has been a transfer of assets in
full or partial satisfaction of the loan. A modification of original contractual terms is generally a concession to a borrower that a lending institution would not normally consider. The entire balance of restructured loans as disclosed below is
comprised of one loan customer. Due to a good loan to value ratio, a timely and proper review of credit quality and restructuring of the loan, the Company was able to collect all amounts of principal and interest.





An impaired loan as defined in SFAS 114 is a loan when, based on current information and events, it is likely that a lending institution
will be unable to collect all amounts, including both principal and interest, due according to the contractual terms of the loan agreement.





Once a quarter the board of directors will review all loans on the Banks watch list to determine proper action and reporting of any loans identified as substandard by the credit quality review.





The total recorded investment in impaired loans was $6,000, $539,000 and $1.5 million, respectively for the nine
month period ended September 30, 2002, the year ended December 31, 2001 and the nine-month period ended September 30, 2001. The loan loss allowance related to impaired loans was $0, $30,000 and $30,000, respectively for the above-referenced time
periods. The loan loss allowance related to foreclosed, repossessed and idle properties was $40,000, $0, and $0, respectively for the above-referenced time periods.





Nonperforming assets at September 30, 2002, December 31, 2001 and September 30, 2001 are presented in the following table.




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Nonperforming Assets


(dollars
in thousands)





September 30, 2002

December 31, 2001

September 30, 2001Nonaccrual loans

$


$
514

$
75Loans past due 90 days or more


6


25


989Restructured loans








403Total nonperforming loans


6


539


1,467Foreclosed, repossessed and idled properties


176





Total nonperforming assets

$
182

$
539

$
1,467





If nonaccrual loans had performed in accordance with their original
terms, additional interest income in the amount of $15,000, $23,000, and $5,000, respectively would have been recorded for the nine month period ended September 30, 2002, the year ended December 31, 2001 and the nine month period ended September 30,
2001.





Other Assets





The Companys other assets were $3.8 million at September 30, 2002, an increase of $700,000 over the $3.1 million reported as of December 31, 2001. An additional purchase of bank owned life insurance on key
employees contributed to $671,000 of the total increase during the first nine months of 2002. Bank owned life insurance on key employees in the amount of $2.3 million was purchased in the fourth quarter of 2001. Bank owned life insurance comprises a
total of $3.1 million of the $3.8 million other assets balance as of September 30, 2002.





Deposits





As of September 30, 2002 total deposits were $171.8 million, an increase of $32.9 million or 23.7% from their level of $138.9 million at
December 31, 2001. Certificates of deposit increased by $37.6 million to a total of $115.5 million at September 30, 2002, up from $77.9 million at December 31, 2001. Non-interest bearing demand deposits and savings increased by $600,000 and
$700,000, respectively. The major categories of decreases were interest bearing demand deposits and money market accounts in the amounts of $700,000 and $5.3 million, respectively.





At September 30, 2002 noninterest-bearing demand deposits were $24.9 million or 14.5% of total deposits. On December 31, 2001 noninterest-bearing demand deposits were $24.3
million or 17.5% of total deposits. Nonmaturity deposits (noninterest bearing demand deposits, interest bearing demand deposits, money market accounts and savings accounts) were $56.3 million or 32.8% of total deposits at September 30, 2002,
compared with $61.0 million or 43.9% of total deposits at December 31, 2001. Total interest bearing deposits stood at $146.9 million at September 30, 2002, an increase of $32.3 million or 28.2% over their level of $114.6 million at December 31,
2001.





The levels and mix of deposits are influenced by such factors as customer service, interest rates paid,
service charges and the convenience of banking locations. Competition for deposits is intense from other depository institutions and money market funds, some of which offer interest rates higher than those paid by the Company. Management attempts to
identify and implement pricing and marketing strategies designed to control the overall cost of deposits and to maintain a stable deposit mix.





Short-Term Borrowings





The Company placed in service a commercial sweep account program in
third quarter 1999. The balance in the program grew by $2.3 million from its level of $3.3 million at December 31, 2001 to a total of $5.6 million as of September 30, 2002. The program consists of establishing a demand deposit account in which the
Bank invests available balances daily in securities on an overnight basis subject to repurchase. On the following business day, the Bank will repurchase from the customer the securities for an amount equal to the amount of available balances
invested in the securities. Interest is calculated daily




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at the rate applicable for each overnight period; however, it is posted to the customer accounts only once per month. The contractual agreement
states that a repurchase agreement is not a deposit and therefore is not insured by the Federal Deposit Insurance Corporation. Therefore, these repurchase balances are not reported as deposits but as short-term borrowings.





Exclusive of the commercial sweep accounts, the Companys short-term borrowings decreased by $1.5 million during the first nine
months of 2002 to a balance of $2.3 million. See the liquidity section for further information on the preceding borrowings.





Other
Debt





Other debt consists of Federal Home Loan Bank advances. These advances are relatively cost-effective
funding sources and provide the Company with the flexibility to structure borrowings in a manner that aids in the management of interest rate risk and liquidity. Federal Home Loan Bank advances totaled $40.0 million, an increase of $10.0 million
over the $30.0 million as of December 31, 2001. The increase in advances during the year reflects the funding to support investment growth.





Interest Rate Risk





Interest rate risk is the risk to earnings or capital generated by the
effects of changes in interest rates on the Companys on- and off-balance sheet positions, and can take one or more of several forms. Repricing risk comes from timing mismatches in the ability to alter contractual rates earned on financial
assets held or paid on interest-bearing liabilities. Basis risk refers to changes in the underlying relationships between market rates or indices, which result in a narrowing of the spread earned on a loan or investment relative to its cost of
funds. Option risk arises from embedded options in many financial instruments such as interest rate options, loan prepayment options, deposit early withdrawal options, callable Federal Home Loan Bank advances and potential prepayment of
the underlying collateral of asset-backed securities. Embedded options are complex risk positions that are difficult to predict and offset, and are a large component of the overall interest rate risk to the Company.





The Company has established risk measures, limits, policy guidelines and internal control mechanisms for managing the overall
asset/liability management (ALM) position. The responsibility for interest rate risk control resides with Management, with oversight by the Board of Directors and its Investment Committee. The Company seeks to balance the return
potential of the ALM position against the desire to limit volatility in earnings.





At least quarterly, the Company
measures the ALM position using earnings simulation modeling to estimate what assets and liabilities would reprice, and to what extent, within a one-year period in response to an immediate 200 basis point change in the Prime Rate, as well as in
response to more gradual interest rate change. The Companys objective is to keep the change in net interest income over twelve months at or below 5%, and the charge in net income at or below 10%, under an immediate 200 basis point interest
rate shock scenario. The model also incorporates managements forecasts for balance sheet growth, noninterest income and noninterest expense. The interest rate scenarios are used for analytical purposes and do not necessarily represent
managements view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may apply to the earnings of the Company. Modeling the sensitivity of earnings to interest rate
risk is highly dependent on numerous assumptions embedded in the simulation model. While the earnings sensitivity analysis incorporates Managements best estimate of interest rate and balance sheet dynamics under various market rate movements,
the actual behavior and




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resulting earnings impact likely will differ from that projected.





Capital Adequacy





The Companys financial position at
September 30, 2002 reflects liquidity and capital levels currently adequate to fund anticipated near-term business expansion. Capital ratios are in excess of required regulatory minimums for a well-capitalized institution. The adequacy of the
Companys capital is reviewed by management on an ongoing basis. Management seeks to maintain a capital structure adequate to support anticipated asset growth and serve as a cushion to absorb potential losses.





Major capital expenditures planned for the upcoming year include the construction of the Banks seventh full-service branch in the
Lewis Gale Hospital area. The land branch is planned to open in the spring of 2003, which will be funded by current operations.





Total shareholders equity increased by $2.2 million during the first nine months of 2002. The increase is attributable to net income for the first nine months of $1.6 million and a $598,000 increase in accumulated other
comprehensive income, resulting from unrealized gains on investment securities. Exclusive of unrealized gains (losses) on investment securities, shareholders equity was $18.0 million at September 30, 2002 and $16.4 million at December 31,
2001.





For the periods indicated, the Company had the following risk-based capital and leverage ratios relative to
regulatory minimums:





Capital Ratios





Ratio

9/30/02

12/31/01

9/30/01

MinimumTier 1

9.5%

10.2%

11.0%

4%Total


10.5%

11.1%

11.9%

8%Leverage

7.8%

9.1%

9.2%

4%





Liquidity





Asset/liability management activities are designed to ensure that adequate liquidity is available to meet loan demand or deposit outflows and, through the management of the
Companys interest sensitivity position, to manage the impact of interest rate fluctuations on net interest income.





Liquidity measures the ability of the Company to meet its maturing obligations and existing commitments, to withstand fluctuations in deposit levels, to fund its operations and to provide for customers credit needs. Liquidity
represents a financial institutions ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds from alternative funding sources.





The Companys asset liquidity is provided by cash and due from banks, money market investments, investments available for
sale including restricted equity securities, and through management of investment maturities/prepayments and loan repayments. The Companys ratio of liquid assets to deposits and short-term borrowings was 23.4% at September 30, 2002 and 27.1%
at December 31, 2001.




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The Company sells excess funds as overnight federal funds sold to provide an immediate source of liquidity. The Company had federal funds sold
of $0 at September 30, 2002 and December 31, 2001. During the first nine months of 2002, deposit growth and an increase in securities sold under agreements to repurchase in the amounts of $32.9 million and $2.3 million, respectively, a total of
$35.2 million, surpassed loan growth in the amount of $25.9 million. The excess $9.3 million coupled with Federal Home Loan Bank advances in the amount of $10.0 million, was used to fund investment purchases in excess of principal paydowns in the
amount of $17.6 million and repay $1.5 million in federal funds purchased.





The level of deposits may fluctuate,
perhaps significantly so, due to seasonal cycles of depositing customers and the promotional activities of competitor financial institutions. Similarly, the level of demand for loans may vary significantly and at any given time may increase or
decrease substantially. However, unlike the level of deposits, management has more direct control over lending activities and if necessary can adjust the level of those activities according to the amounts of available funds.





In addition to asset liquidity, the Company would have liquidity available to it through increasing certain categories of liabilities. It
could purchase overnight federal funds, borrow from correspondent banks, sell securities under a repurchase agreement or obtain advances from the Federal Home Loan Bank. The Bank also has established a credit line through the discount window of the
Federal Reserve Bank of Richmond as an additional source of cash flow. As a result of the Companys management of liquid assets and the ability to generate liquidity through alternative funding sources, management believes the Company maintains
overall liquidity sufficient to meet its depositors requirements and satisfy its customers credit needs.





Impact of
Inflation





The Consolidated Financial Statements and Notes thereto presented herein have been prepared in
accordance with generally accepted accounting principles, which requires the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due
to inflation. Unlike most industrial companies, nearly all the assets and liabilities of the Company and the Bank are monetary in nature. As a result, interest rates have a greater impact on the Companys performance than do the effects of
changes in the general rate of inflation and changes in prices. In addition, interest rates do not necessarily move in the same direction or in the same magnitude as do the prices of goods and services. Management seeks to manage the relationship
between interest-sensitive assets and liabilities in order to protect against the effects of wide interest rate fluctuations, including those resulting from inflation.





Recent and Future Accounting Considerations





In October
2002, the Financial Accounting Standards Board (FASB) issued Statement No. 147, Acquisitions of Certain Financial Institutions-an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9, which removes acquisitions of
financial institutions from the scope of both Statement 72 and Interpretation 9. The Statement requires that acquisitions of financial institutions be accounted for under the purchase method of accounting in accordance with Statement 141,
Business Combinations and Statement 142, Goodwill and Other Intangible Assets. Thus, the requirement in paragraph 5 of Statement 72 to recognize (and subsequently amortize) any excess of the fair market value of liabilities
assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions within the scope of this Statement. The




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provisions of this Statement relating to the application of the purchase method of accounting are effective for acquisitions initiated on or
after October 1, 2002. The provisions of this Statement relating to accounting for intangible assets are effective on October 1, 2002.





In June 2002, the Financial Accounting Standards Board (FASB) issued Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which nullifies Emerging Issues Task Force (EITF) Issue
No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The Statement requires that a liability for a cost associated with an
exit or disposal activity be recognized when the liability is incurred, not at the date of an entitys commitment to an exit plan. This Statement also establishes that fair value is the objective for initial measurement of the liability. The
provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002.





In October 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supercedes Statement No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. Statement 144 also supercedes the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. However, it retains the requirement in Opinion No. 30 to report separately
discontinued operations and extends that reporting to a component of an entity that either has been disposed of either by sale, abandonment, or distribution to owners or is classified as held for sale. Statement 144 carries over many of the
fundamental provisions of Statement No. 121. Statement No. 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted the provisions of this Statement effective January 1, 2002, as required. The adoption of the
Statement did not have any effect on the Companys financial position, results of operations, or liquidity.





In June 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 142, Goodwill and Other Intangible Assets, which supercedes APB Opinion No. 17, Intangible Assets. Statement No. 142 addresses
how intangible assets that are acquired individually or with a group of other assets, excluding those acquired in a business combination, should be accounted for in financial statements upon their acquisition as well as after they have been
initially recognized in the financial statements. The Statement eliminates the requirement to amortize goodwill and other intangible assets that have indefinite useful lives, instead requiring the assets be tested at least annually for impairment
based on the specific guidance in the Statement. The Company adopted the provisions of the Statement effective January 1, 2002 as required. The Statement requires a transition impairment test of goodwill and other intangible assets in connection
with the initial application of the Statement, with any resultant impairment losses being recognized as a cumulative effect of a change in accounting principle. The adoption of the Statement did not have any effect on the Companys financial
position, results of operations, or liquidity.





In June 2001, the Financial Accounting Standards Board (FASB)
issued Statement No. 141, Business Combinations, which supersedes Accounting Principles Board (APB) Opinion No. 16, Business Combinations, and FASB Statement No. 38, Accounting for Preacquisition Contingencies of
Purchased Enterprises. Statement 141 requires that all business combinations be accounted for by the




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purchase method of accounting. The purchase method of accounting requires the accounts of an acquired institution to be included with the
acquirers accounts as of the date of acquisition, recognizing any excess of purchase price over the fair value of the net assets acquired as goodwill. The Statement also requires that the assets of an acquired institution be recognized as
assets apart from goodwill if they meet specific criteria presented in the Statement. The provisions of the Statement apply to all business combinations initiated after June 30, 2001.





In September 2000, the Financial Accounting Standards Board (FASB) issued Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, as a replacement for FASB Statement No. 125, which has the same title. Statement No. 140 revises the standards for accounting for securitizations and other transfers of financial assets and collateral, but it
carries over most of the provisions of Statement No. 125 without change. The statement provides accounting and reporting standards for such transactions based upon consistent application of a financial components approach which focuses on control.
Under this approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, de-recognizes financial assets when control has been surrendered, and de-recognizes
liabilities when extinguished.





Statement No. 140 is effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after March 31, 2001. The Statement is effective for recognition and reclassification of collateral for fiscal years ending after December 15, 2000. The adoption of Statement No. 140 on January 1, 2001 did
not have any effect on the Companys consolidated financial position, results of operation or liquidity.





In
June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. Statement 133 established standards for accounting and
reporting for derivative instruments, including certain instruments embedded in other contracts and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position
and measure those instruments at fair value. The Statement requires that changes in a derivatives fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows
a derivatives gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting.





Statement 133 shall be effective for all fiscal quarters of all fiscal years beginning after June 15, 2000.
Initial application of this Statement shall be as of the beginning of an entitys fiscal quarter. Earlier application of all of the provisions of this Statement is encouraged but is permitted only as of the beginning of any fiscal quarter that
begins after issuance of this Statement. Earlier application of selected provisions of this Statement is not permitted. This Statement shall not be applied retroactively to financial statements of prior periods. Adoption of Statement 133 on January
1, 2000 did not have any effect on the Banks consolidated financial position, results of operation or liquidity.





Item 3.    Controls and Procedures.





Within 90 days prior to the
date of this report, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, including internal controls and procedures for financial reporting. Our principal executive officer and
principal financial officer supervised this evaluation and concluded that our disclosure controls and procedures are effective. Subsequent to this evaluation, (i) there have not been any significant changes to our internal controls or other factors
that could significantly affect our disclosure controls or procedures and (ii) we have not taken any corrective actions with respect to our disclosure controls and procedures to correct any significant deficiencies or weaknesses.





The design of any system of controls is based in part upon certain assumptions about the likelihood of future events. There can
be no assurance that any design will succeed in achieving its stated goal under every potential condition, regardless of how remote. In addition, the operation of any system of controls and procedures is dependent upon the employees responsible for
executing it. While we have evaluated the operation of our disclosure controls and procedures and found them effective, there can be no assurance that they will succeed in every instance to achieve their objective.




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##### Table of Contents

PART II.    OTHER INFORMATION





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





There were no matters
submitted to a vote of security holders during the quarter.





Item 5.    Other Information.





None.





Item 6.    Exhibits and Reports on Form 8-K.





|(a) |  | The Company filed the following exhibits for the quarter ended September 30, 2002:
|--- |  | ----------------------------------------------------------------------------------




| |  | Exhibits:
| |  | ---------




3.1

Articles of Incorporation (incorporated herein by reference to Exhibit No. 3.1 of Registration Statement No. 33-77568, on form S-1, as
amended).3.2

Bylaws (incorporated herein by reference to Exhibit No. 3.2 of Registration Statement No. 33-77568, on form S-1, as
amended).*10.2

Employment Agreement dated April 8, 1994, by and between the Company and A. Wayne Lewis (incorporated herein by reference to Exhibit
No. 10.2 of Registration Statement No. 33-77568, on Form S-1, as amended).*10.3

Severance Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to
Exhibit No. 10.3 of Form 10-KSB filed March 27, 1997, File No. 33-77568).*10.4

Stock Option Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to
Exhibit No. 10.4 of Form 10-KSB filed March 27, 1997, File No. 33-77568).10.5

Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated
herein by reference to Exhibit No. 10.5 of Registration Statement No. 33-77568, on Form S-1, as amended).10.10

First amendment dated August 5, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and
Valley Financial Enterprises, L.C. (incorporated herein by reference to Exhibit No. 10.10 of Form 10-K filed March 30, 1995, File No. 33-77568).10.12

Second amendment dated December 14, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and
Valley Financial Enterprises, L.C. (incorporated herein by reference to Exhibit No. 10.12 of Form 10-K filed March 30, 1995, File No. 33-77568).10.13

Lease agreement for office space dated September 20, 1996, by and between Valley Bank, N.A. and Betty J. Burrows (incorporated herein
by reference to Exhibit No. 10.13 of Form 10-KSB filed March 27, 1997, File No. 33-77568).




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##### Table of Contents

*10.6

Severance agreement dated February 9, 1998, by and between the Company and J. Randall Woodson ( incorporated herein by reference to
Exhibit No. 10.6 of Form 10-KSB filed March 30, 2000, File No. 33-77568).*10.7

Employment agreement dated September 21, 2000, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to
Exhibit 10.2 of Form SB-2, filed September 27, 2000, and Form SB-2/A filed October 25, 2000).*10.14

Valley Bank Supplemental Retirement Plan effective January 1, 2002 (incorporated herein by reference to Exhibit 10.14 of Form 10-QSB
filed May 15, 2002, File No. 33-77568).*10.15

Employment agreement dated August 26, 2002, by and between the Company and J. Randall Woodson22

Proxy Statement for the 2002 Annual Meeting of Shareholders (incorporated herein by reference to Valley Financial Corporations
Proxy Statement filed on Schedule 14A on March 28, 2002).





* Management contract or compensatory plan or agreement required to be filed as an Exhibit
to this Form 10-QSB pursuant to


Item 13(a).





|(b) |  | Reports on Form 8-K filed during the last quarter of the period covered by this report:
|--- |  | ---------------------------------------------------------------------------------------




| |  | The Company filed two reports on Form 8-K during the quarter ended September 30, 2002. The first report, dated July 26, 2002, reported the Companys
consolidated financial results for the quarter ended June 30, 2002. The second report, dated August 14, 2002, reported that Valley Financial Corporation furnished to the Securities and Exchange Commission the certification of its Chief Executive
Officer and its Chief Financial Officer with respect to Form 10-QSB for the period ended June 30, 2002 as required by the Sarbanes-Oxley Act of 2002.
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



25




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##### Table of Contents

SIGNATURES





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








VALLEY FINANCIAL CORPORATIONNovember 14, 2002



/s/    Ellis L.
GutshallDate



Ellis L. Gutshall, President and Chief Executive Officer








November 14, 2002



/s/    A. Wayne
LewisDate



A. Wayne Lewis, Executive Vice President and Chief Financial Officer




26




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##### Table of Contents

CERTIFICATIONS





I, Ellis L. Gutshall, certify that:





| | 1. |  | I have reviewed this quarterly report on Form 10-QSB of Valley Financial Corporation;
| | -- |  | -------------------------------------------------------------------------------------




| | 2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (a) |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is
made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (b) |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly
report (the Evaluation Date); and
| | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 5. |  | The registrants other certifying officers and I have disclosed based on our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors:
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the registrants ability to record, process,
summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------




| | 6. |  | The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Date:    November 14, 2002



By:

/s/    Ellis L. GutshallPresident and Chief Executive Officer




27




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##### Table of Contents

CERTIFICATIONS





I, A. Wayne Lewis, certify that:





| | 1. |  | I have reviewed this quarterly report on Form 10-QSB of Valley Financial Corporation;
| | -- |  | -------------------------------------------------------------------------------------




| | 2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (a) |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is
made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (b) |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly
report (the Evaluation Date); and
| | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 5. |  | The registrants other certifying officers and I have disclosed based on our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors:
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the registrants ability to record, process,
summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | (b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------




| | 6. |  | The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Date:    November 14, 2002



By:

/s/    A. Wayne LewisExecutive Vice-President and Chief Financial Officer










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##### Table of Contents

INDEX TO EXHIBITS





Exhibit Number

Description

Page Number3.1

Articles of Incorporation (incorporated herein by reference to Exhibit No. 3.1 of Registration StatementNo. 33-77568, on Form S-1,
as amended).3.2

Bylaws (incorporated herein by reference to Exhibit No. 3.2 of Registration Statement No. 33-77568, on Form S-1, as
amended).10.2

Employment Agreement dated April 8, 1994, by and between the Company and A. Wayne Lewis (incorporated herein by reference to Exhibit
No. 10.2 of Registration Statement No. 33-77568, onForm S-1, as amended).10.3

Severance Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to
Exhibit No. 10.3 of Form 10-KSB filed March 27, 1997,File No. 33-77568).10.4

Stock Option Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to
Exhibit No. 10.4 of Form 10-KSB filed March 27, 1997,File No. 33-77568).10.5

Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated
herein by reference to Exhibit No. 10.5 of Registration StatementNo. 33-77568, on Form S-1, as amended).10.10

First amendment dated August 5, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and
Valley Financial Enterprises, L.C. (incorporated herein by reference toExhibit No. 10.10 of Form 10-K filed March 30, 1995, File No. 33-77568).10.12

Second amendment dated December 14, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and
Valley Financial Enterprises, L.C. (incorporated herein by reference to Exhibit No. 10.12 of Form 10-K filed March 30, 1995, File No. 33-77568).10.13

Lease agreement for office space dated September 20, 1996, by and between Valley Bank, N.A. and Betty J. Burrows (incorporated herin
by reference to Exhibit No. 10.13 of Form 10-KSB filed March 27, 1997, File No. 33-77568).




29




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##### Table of Contents

10.6

Severance agreement dated February 9, 1998, by and between the Company and J. Randall Woodson (incorporated herein by reference to
Exhibit 10.6 of Form 10-KSB filed March 30, 2000, File No. 33-77568).10.7

Employment agreement dated September 21, 2000, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to
Exhibit 10.2 of Form SB-2, filed September 27, 2000, and Form SB-2/A filed October 25, 2000).10.14

Valley Bank Supplemental Retirement Plan effective January 1, 2002 (incorporated herein by reference to Exhibit 10.14 of Form 10-QSB
filed May 15, 2002, File No. 33-77568).10.15

Employment agreement dated August 26, 2002, by and between the Company and J. Randall Woodson.22

Proxy Statement for the 2002 Annual Meeting of Shareholders (incorporated herein by reference to Valley Financial Corporations
Proxy Statement filed on Schedule 14A on March 28, 2002).




30